handout06_bankreg.pdf

7/28/2019 handout06_bankreg.pdf

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Outline Basel II The three pillars of Basel II

Bank Regulation Basel II

Haipeng Xing

Haipeng Xing AMS517, SUNY Stony Brook



Outline

1 Basel II Accord

2 The three pillars of Basel II




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Basel Capital Accord I

We now focuses on the new Basel Captial Accord with respect to ratingbased modeling, probabilities of default, and the required economic

capital of financial institutions. Almost two decades have passed sincethe Basel Committee on Banking Supervision (BCBS) introduced its1988 Captial Accord (the Accord). The major impetus for this Basel IAccord was the concern of the governors of the central banks that thecaptial as a cushion against losses of the worlds major bankshad become dangerously low after persistent erosion throughcompetition. Since 1988 the business of banking, risk mangamentpractices, supervisory approaches, and financial markets have undergonesignificant transformations. Consequently, BCBS released a proposal inJune 1999 to replace the old Accord with a more risk-sensitive

framework, the New Basel Capital Accord (Basel II). The initialconsultative proposal contained three fundamental innovations, eahdesigned to introduce greater risk sensitivity into the accord:




Basel Capital Accord II

1 The current standard should be supplemented with two additionalpillars dealing with supervisory review and market discipline. Theyshould reduce the stress on the quantitative pillar one by providing amore balanced approach to the capital assessment process.

2 Banks with advanced risk management capabilities should bepermitted to use their own internal systems for evaluating credit risk

known as internal rating instead of standardized riskweights for each class of asset.

3 Banks should be allowed to use gradings provided by approvedexternal credit assessment institutions to classify their sovereignclaims into five risk buckets and their claims on corporates andbanks into three risk buckets.




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Basel Capital Accord III

In addition, there were a number of other proposals including therefinement of the risk weighting as well as the introduction of a capital

charge for other sources of risk. After the committee received severalcomments by the industry and research institutions in January 2001, thesecond consultative document was published. Reflecting the commentson the proposal and the results of the ongoing dialogue with the industryworldwide, the committee published a revised version in 2004 with thenew corrections.The 1998 Accord focused on the total amount of bank capital, which isvital in reducing the risk of bank insolvency and the potential cost of abanks failure for depositors. Building on this, the new framework intendsto improve safety and soundness in the financial system by placing more

emphasis on banks own internal control and managment, the supervisoryreview process, and the market discipline.




Basel Capital Accord IV

The 1998 Accord provided esstentiallyonly one option for measuring theappropriate capital of banks, although the way to measure, manage, andmitigate risks differs from bank to bank. In 1996 an amendment wasintroduced focusing on trading risks and allowing some banks for the firsttime to use their own systems to measure their market risks. The newframework provides a spectrum of approaches from simple to advancedmethodologies for the measurement of both credit risk and operationalrisk in determining capital levels.




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The first pillar Mnimum capital requirement

The first pillar sets out the minimum capital requirements and defines theminimum ratio of capital to risk-weighted assets. Therefore, it isnecessary to know how the total capital is adequately measured by banks.The new framework maintains both the current definition of the totalcapital and the minimum requirement of at least 8% of the banks capitalto its risk weighted assets.

Capital Ratio =Total Capital

Credit Risk+Market Risk+Operational Risk. (1)




The second pillar Supervisory review process

The supervisory review pillar requires supervisors to undertake aqualitative review of their banks capital allocation techniques andcompliance with relevant standards. Supervisors have to ensure that eachbank has sound internal processes to assess the adequacy of its capitalbased on a thorough evaluation of its risks. The new framework stressesthe importance of bank management developing an internal capital

assessment process and setting targets for capital that are commensuratewith the banks particular risk profile and control environment. Thus,supervisors are responsible for evaluating how well banks are assessingtheir capital adequacy needs relative to their risks. This internal processis subject to supervisory review and intervention.




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The third pillar Market discipline

The third pillar aims to bolster market discipline through enhanceddisclosure requirements by banks which facilitate market discipline.Effective disclosure is essential to ensure that market participants dobetter understand banks risk profiles and the adequacy of their capitalpositions. The new framework sets out disclosure requirements andrecommendations in several areas, including the way a bank calculates itscapital adequacy and risk assessment methods. The core set of disclosurerecommendations applies to all banks with more detailed requirements forsupervisory recognition of internal methodologies for credit risk,mitigation techniques and asset securitizaton.



handout06_bankreg.pdf

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