Basel II

What Does Basel II Mean? A set of banking regulations put forth by the Basel Committee on Bank Supervision, which regulates finance and banking internationally. Basel II attempts to integrate Basel capital standards with national regulations, by setting the minimum capital requirements of financial institutions with the goal of ensuring institution liquidity.

Investopedia explains Basel II Basel II is the second of the Basel Committee on Bank Supervision's recommendations, and unlike the first accord, Basel I, where focus was mainly on credit risk, the purpose of Basel II was to create standards and regulations on how much capital financial institutions must have put aside. Banks need to put aside capital to reduce the risks associated with its investing and lending practices Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II, which was initially published in June 2004, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face while maintaining sufficient consistency so that this does not become a source of competitive inequality amongst internationally active banks. Advocates of Basel II believe that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. In theory, Basel II attempted to accomplish this by setting up risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability Objective The final version aims at:

1. Ensuring that capital allocation is more risk sensitive;

2. Enhance disclosure requirements which will allow market participants to assess the capital adequacy of an institution; 3. Ensuring that credit risk, operational risk and market risk are quantified based on data and formal techniques; 4. Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.

While the final accord has largely addressed the regulatory arbitrage issue, there are still areas where regulatory capital requirements will diverge from the economic capital. Basel II has largely left unchanged the question of how to actually define bank capital, which diverges from accounting equity in important respects. The Basel I definition, as modified up to the present, remains in place. [edit] The accord in operation Basel II uses a "three pillars" concept (1) minimum capital requirements (addressing risk), (2) supervisory review and (3) market discipline. The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk was not dealt with at all. [edit] The first pillar The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk, and market risk. Other risks are not considered fully quantifiable at this stage. The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach, Foundation IRB and Advanced IRB. IRB stands for "Internal Rating-Based Approach". For operational risk, there are three different approaches - basic indicator approach or BIA, standardized approach or TSA, and the internal measurement approach (an advanced form of which is the advanced measurement approach or AMA). For market risk the preferred approach is VaR (value at risk). As the Basel 2 recommendations are phased in by the banking industry it will move from standardised requirements to more refined and specific requirements that have been developed for each risk category by each individual bank. The upside for banks that do develop their own bespoke risk measurement systems is that they will be rewarded with potentially lower risk capital requirements. In future there will be closer links between the concepts of economic profit and regulatory capital. Credit Risk can be calculated by using one of three approaches: 1. Standardised Approach 2. Foundation IRB (Internal Ratings Based) Approach

3. Advanced IRB Approach The standardized approach sets out specific risk weights for certain types of credit risk. The standard risk weight categories used under Basel 1 were 0% for government bonds, 20% for exposures to OECD Banks, 50% for first line residential mortgages and 100% weighting on consumer loans and unsecured commercial loans. Basel II introduced a new 150% weighting for borrowers with lower credit ratings. The minimum capital required remained at 8% of risk weighted assets, with Tier 1 capital making up not less than half of this amount. Banks that decide to adopt the standardised ratings approach must rely on the ratings generated by external agencies. Certain banks used the IRB approach as a result. [edit] The second pillar The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputational 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. Internal Capital Adequacy Assessment Process (ICAAP) is the result of Pillar II of Basel II accords [edit] The third pillar This pillar aims to complement the minimum capital requirements and supervisory review process by developing a set of disclosure requirements which will allow the market participants to gauge the capital adequacy of an institution. Market discipline supplements regulation as sharing of information facilitates assessment of the bank by others including investors, analysts, customers, other banks and rating agencies which leads to good corporate governance. The aim of pillar 3 is to allow market discipline to operate by requiring institutions to disclose details on the scope of application, capital, risk exposures, risk assessment processes and the capital adequacy of the institution. It must be consistent with how the senior management including the board assess and manage the risks of the institution. When market participants have a sufficient understanding of a banks activities and the controls it has in place to manage its exposures, they are better able to distinguish between banking organisations so that they can reward those that manage their risks prudently and penalise those that do not.

These disclosures are required to be made at least twice a year, except qualitative disclosures providing a summary of the general risk management objectives and policies which can be made anually. Institutions are also required to create a formal policy on what will be disclosed, controls around them along with the validation and frequency of these disclosures. In general, the disclosures under Pillar 3 apply to the top consolidated level of the banking group to which the Basel II framework applies. [edit] Recent chronological updates [edit] September 2005 update On September 30, 2005, the four US Federal banking agencies (the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision) announced their revised plans for the U.S. implementation of the Basel II accord. This delays implementation of the accord for US banks by 12 months.[1] [edit] November 2005 update On November 15, 2005, the committee released a revised version of the Accord, incorporating changes to the calculations for market risk and the treatment of double default effects. These changes had been flagged well in advance, as part of a paper released in July 2005.[2] [edit] July 2006 update On July 4, 2006, the committee released a comprehensive version of the Accord, incorporating the June 2004 Basel II Framework, the elements of the 1988 Accord that were not revised during the Basel II process, the 1996 Amendment to the Capital Accord to Incorporate Market Risks, and the November 2005 paper on Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework. No new elements have been introduced in this compilation. This version is now the current version.[3] [edit] November 2007 update On November 1, 2007, the Office of the Comptroller of the Currency (U.S. Department of the Treasury) approved a final rule implementing the advanced approaches of the Basel II Capital Accord. This rule establishes regulatory and supervisory expectations for credit risk, through the Internal Ratings Based Approach (IRB), and operational risk, through the Advanced Measurement Approach (AMA), and articulates enhanced standards for the supervisory review of capital adequacy and public disclosures for the largest U.S. banks.[4]

[edit] July 16, 2008 update On July 16, 2008 the federal banking and thrift agencies (the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision) issued a final guidance outlining the supervisory review process for the banking institutions that are implementing the new advanced capital adequacy framework (known as Basel II). The final guidance, relating to the supervisory review, is aimed at helping banking institutions meet certain qualification requirements in the advanced approaches rule, which took effect on April 1, 2008. [5] [edit] January 16, 2009 update For public consultation, a series of proposals to enhance the Basel II framework was announced by the Basel Committee. It releases a consultative package that includes: the revisions to the Basel II market risk framework; the guidelines for computing capital for incremental risk in the trading book; and the proposed enhancements to the Basel II framework.[6] [edit] July 89, 2009 update A final package of measures to enhance the three pillars of the Basel II framework and to strengthen the 1996 rules governing trading book capital was issued by the newly expanded Basel Committee. These measures include the enhancements to the Basel II framework, the revisions to the Basel II market-risk framework and the guidelines for computing capital for incremental risk in the trading book.[7] [edit] Basel II and the regulators One of the most difficult aspects of implementing an international agreement is the need to accommodate differing cultures, varying structural models, and the complexities of public policy and existing regulation. Banks senior management will determine corporate strategy, as well as the country in which to base a particular type of business, based in part on how Basel II is ultimately interpreted by various countries' legislatures and regulators. To assist banks operating with multiple reporting requirements for different regulators according to geographic location, there are several software applications available. These include capital calculation engines and extend to automated reporting solutions which include the reports required under COREP/FINREP. For example, U.S. Federal Deposit Insurance Corporation Chair Sheila Bair explained in June 2007 the purpose of capital adequacy requirements for banks, such as the accord:

There are strong reasons for believing that banks left to their own devices would maintain less capitalnot morethan would be prudent. The fact is, banks do benefit from implicit and explicit government safety nets. Investing in a bank is perceived as a safe bet. Without proper capital regulation, banks can operate in the marketplace with little or no capital. And governments and deposit insurers end up holding the bag, bearing much of the risk and cost of failure. History shows this problem is very real as we saw with the U.S. banking and S & L crisis in the late 1980s and 1990s. The final bill for inadequate capital regulation can be very heavy. In short, regulators can't leave capital decisions totally to the banks. We wouldn't be doing our jobs or serving the public interest if we did.[8] [edit] Implementation progress Regulators in most jurisdictions around the world plan to implement the new accord, but with widely varying timelines and use of the varying methodologies being restricted. The United States' various regulators have agreed on a final approach.[9] They have required the Internal Ratings-Based approach for the largest banks, and the standardized approach will be available for smaller banks.[10] In India, Reserve Bank of India has implemented the Basel II standardized norms on 31 March 2009 and is moving to internal ratings in credit and AMA norms for operational risks in banks. Existing RBI norms for banks in India (as of September 2010): Common equity (incl of buffer): 3.6%(Buffer Basel 2 requirement requirements are zero.); Tier 1 requirement: 6%. Total Capital : 9 % of risk weighted assets. Basel III asks for those ratios as 7-8.5%(4.5% +2.5%(conservation buffer) + 0-2.5%(seasonal buffer)) and 8.5-11% for tier 1 cap and 10.5 to 13.5 for total capital (Proposed Basel III Guidelines: A Credit Positive for Indian Banks) In response to a questionnaire released by the Financial Stability Institute (FSI), 95 national regulators indicated they were to implement Basel II, in some form or another, by 2015.[11] The European Union has already implemented the Accord via the EU Capital Requirements Directives and many European banks already report their capital adequacy ratios according to the new system. All the credit institutions adopted it by 2008. Australia, through its Australian Prudential Regulation Authority, implemented the Basel II Framework on 1 January 2008.[12]

Overview
Basel III will require banks to hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) of risk-weighted assets (RWA). Basel III also introduces additional capital buffers, (i) a mandatory capital conservation buffer of 2.5% and (ii) a discretionary countercyclical buffer, which allows national regulators to require up to another 2.5% of capital during periods of high credit growth. In addition, Basel III introduces a minimum 3% leverage ratio and two required liquidity ratios. The Liquidity Coverage Ratio requires a bank to hold sufficient high-quality liquid assets to cover its total net cash flows over 30 days; the Net Stable Funding Ratio requires the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.[4]

[edit] Summary of proposed changes

First, the quality, consistency, and transparency of the capital base will be raised. o Tier 1 capital: the predominant form of Tier 1 capital must be common shares and retained earnings o Tier 2 capital instruments will be harmonised o Tier 3 capital will be eliminated.[5] Second, the risk coverage of the capital framework will be strengthened. o Promote more integrated management of market and counterparty credit risk o Add the CVA (credit valuation adjustment)-risk due to deterioration in counterparty's credit rating o Strengthen the capital requirements for counterparty credit exposures arising from banks derivatives, repo and securities financing transactions o Raise the capital buffers backing these exposures o Reduce procyclicality and o Provide additional incentives to move OTC derivative contracts to central counterparties (probably clearing houses) o Provide incentives to strengthen the risk management of counterparty credit exposures o Raise counterparty credit risk management standards also by including the wrong-way risk Third, the Committee will introduce a leverage ratio as a supplementary measure to the Basel II risk-based framework. o The Committee therefore is introducing a leverage ratio requirement that is intended to achieve the following objectives: Put a floor under the build-up of leverage in the banking sector Introduce additional safeguards against model risk and measurement error by supplementing the risk based measure with a simpler measure that is based on gross exposures. Fourth, the Committee is introducing a series of measures to promote the build up of capital buffers in good times that can be drawn upon in periods of stress ("Reducing procyclicality and promoting countercyclical buffers").

The Committee is introducing a series of measures to address procyclicality: Dampen any excess cyclicality of the minimum capital requirement; Promote more forward looking provisions; Conserve capital to build buffers at individual banks and the banking sector that can be used in stress; and o Achieve the broader macroprudential goal of protecting the banking sector from periods of excess credit growth. Requirement to use long term data horizons to estimate probabilities of default, downturn loss-given-default estimates, recommended in Basel II, to become mandatory Improved calibration of the risk functions, which convert loss estimates into regulatory capital requirements. Banks must conduct stress tests that include widening credit spreads in recessionary scenarios. o Promoting stronger provisioning practices (forward looking provisioning): Advocating a change in the accounting standards towards an expected loss (EL) approach (usually, EL amount := LGD*PD*EAD).[6] Fifth, the Committee is introducing a global minimum liquidity standard for internationally active banks that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio called the Net Stable Funding Ratio. The Committee also is reviewing the need for additional capital, liquidity or other supervisory measures to reduce the externalities created by systemically important institutions.
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As on Sept 2010, Proposed Basel III norms ask for ratios as: 7-9.5%(4.5% +2.5% (conservation buffer) + 0-2.5%(seasonal buffer)) for Common equity and 8.5-11% for tier 1 cap and 10.5 to 13 for total capital (Proposed Basel III Guidelines: A Credit Positive for Indian Banks)'

[edit] Macroeconomic Impact of Basel III

An OECD study [2] released on 17 February 2011, estimates that the medium-term impact of Basel III implementation on GDP growth is in the range of 0.05 to 0.15 percentage point per annum. Economic output is mainly affected by an increase in bank lending spreads as banks pass a rise in bank funding costs, due to higher capital requirements, to their customers. To meet the capital requirements effective in 2015 (4.5% for the common equity ratio, 6% for the Tier 1 capital ratio), banks are estimated to increase their lending spreads on average by about 15 basis points. The capital requirements effective as of 2019 (7% for the common equity ratio, 8.5% for the Tier 1 capital ratio) could increase bank lending spreads by about 50 basis points. The estimated effects on GDP growth assume no active response from monetary policy. To the extent that monetary policy will no longer be constrained by the zero lower bound, the Basel III

impact on economic output could be offset by a reduction (or delayed increase) in monetary policy rates by about 30 to 80 basis points.[7]

[edit] Key dates

[edit] Capital Requirements
Date 2013 2015 2016 2019 Milestone: Capital Requirements Minimum capital requirements: Start of the gradual phasing-in of the higher minimum capital requirements. Minimum capital requirements: Higher minimum capital requirements are fully implemented. Conservation buffer: Start of the gradual phasing-in of the conservation buffer. Conservation buffer: The conservation buffer is fully implemented.

[edit] Leverage Ratio

Date 2011 2013 2015 2017 2018 Milestone: Leverage Ratio Supervisory monitoring: Developing templates to track the leverage ratio and the underlying components. Parallel run I: The leverage ratio and its components will be tracked by supervisors but not disclosed and not mandatory. Parallel run II: The leverage ratio and its components will be tracked and disclosed but not mandatory. Final adjustments: Based on the results of the parallel run period, any final adjustments to the leverage ratio. Mandatory requirement: The leverage ratio will become a mandatory part of Basel III requirements.

[edit] Liquidity Requirements

Milestone: Liquidity Requirements Observation period: Developing templates and supervisory monitoring of the 2011 liquidity ratios. 2015 Introduction of the LCR: Introduction of the Liquidity Coverage Ratio (LCR). 2018 Introduction of the NFSR: Introduction of the Net Stable Funding Ratio (NSFR). Date

[edit] In the news

In addition to articles used for references (see References), this section lists links to recent high-quality publicly-available studies on Basel III. This section may be updated frequently as Basel III is currently under development. Date Source Jul The Banker 2011 Article Title / Link Comments Has Basel got its Regulators face a tricky task in setting numbers wrong? appropriate capital charges for counterparty risk, particularly in

addressing the complex area of counterparty valuation adjustment risk. BNP Paribas: Jun Economic 2011 Research Department OECD: Feb Economics 2011 Department Jan Moody's 2011 Analytics Basel III: no Achilles' BNP Paribas' Economic Research spear Department study on Basel III. Macroeconomic Impact of Basel III OECD analysis on the macroeconomic impact of Basel III.

Basel III New Capital Basel III standards, key elements of new and Liquidity regulations, framework, and key Standards FAQs implementation dates. OECD study on Basel I, Basel II and III. Bair said regulators around the world need to work together on the next round of capital standards for banks ... the next round of international standards, known as Basel III, which Bair said must meet very aggressive goals. Finance ministers from the G20 group of industrial and emerging countries meet in Busan, Korea, on June 45 to review pledges made in 2009 to strengthen regulation and learn lessons from the financial crisis. "The most important bit of reform is the international set of rules known as Basel 3, which will govern the capital and liquidity buffers banks carry. It is here that the most vicious and least public skirmish between banks and their regulators is taking place." "Bank capital is like a train in a dark tunnel -- nobody can see it and when it does come out, it does not capture the public's imagination,"

OECD Journal: May Thinking Beyond Financial Market 2010 Basel III Trends May Bloomberg 2010 BusinessWeek FDICs Bair Says Europe Should Make Banks Hold More Capital

May Reuters 2010

FACTBOX-G20 progress on financial regulation The banks battle back A behind-the-scenes brawl over new capital and liquidity rules G20 ministers face more wrangling over bank tax

May The Economist 2010

May Reuters 2010