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Two-Tiered Capital

Basil I defines capital based on two tiers:

1. Tier 1 (Core Capital): Tier 1 capital includes stock issues

(or share holders equity) and declared reserves, such

as loan loss reserves set aside to cushion future losses or

for smoothing out income variations.

2. Tier 2 (Supplementary Capital): Tier 2 capital includes all

other capital such as gains on investment assets, long-

term debt with maturity greater than five years andhidden reserves (i.e. excess allowance for losses on loans

and leases). However, short-term unsecured debts (or

debts without guarantees), are not included in the

definition of capital.

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Basel II much more risk sensitive, as it is aligning capital

requirements to risks of loss. Better risk management in a

bank means bank may be able to allocate less regulatory

capital.

The objective of Basel II is to modernise existing capital

requirements framework to make it more comprehensive and

risk sensitive.

The Basel II framework therefore designed to be more

sensitive to the real risks that firms face than Basel I.

Apart from looking at financial figures, it also considers

operational risks, such as risk of systems breaking down or

people doing the wrong things, and also market risk.

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Ensuring that capital allocation is more risksensitive

Separating operational risk from credit risk,and quantifying both

Attempting to align economic andregulatory capital more closely to reducescope for regulatory arbitrage

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Pillar 1 sets out the minimum capital requirements firms will be required tomeet to cover credit, market and operational risk.

Pillar 2 sets out a new supervisory review process. Requires financialinstitutions to have their own internal processes to assess their overall capital

adequacy in relation to their risk profile.

Pillar 3 cements Pillars 1 and 2 and is designed to improve market discipline

by requiring firms to publish certain details of their risks, capital and risk

management as to how senior management and the Board assess and will

manage the institution's risks.

Three Pillars of Basel II Framework

Pill 1 Mi i it l i t

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Pillar 1 : Minimum capital requirements

Institution's total regulatory capital must be at least 8%

(ratio same as in Basel I) of its risk

weighted assets, based on measures of THREE RISKS

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Covers Supervisory Review Process, describing principles for

effective supervision.

Supervisors obliged to evaluate activities, corporate governance,

risk management and risk profiles of banks to determine

whether they have to change or to allocate more capital for their

risks (called Pillar 2 capital)

Deals with regulatory response to the first pillar, giving

regulators much improved tools over those available to them

under Basel I

Also provides framework for dealing with all the other risks a

bank may face, such as Systemic risk, pension risk,

concentration risk, strategic risk, reputation risk, liquidity risk

and legal risk, which the accord combines under the title of

residual risk

It gives banks a power to review their risk management system.

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Covers transparency and the obligation of

banks to disclose meaningful information to

all stakeholders

Clients and shareholders should have

sufficient understanding of activities of

banks, and the way they manage their risks