Basel II Basics

Like any industry, banking involves specific business risks, but at the same time banks have a special position in the economy. Since banks act as lenders and borrowers (from their depositors) at the same time and function as intermediaries which provide businesses with funds, they play a crucial role in the overall economy with regard to the availability of these funds and the costs of financing.

Of course, granting any type of loan involves the risk that the borrower will fail to meet payment obligations and that the lender will lose part or all of the loan amount: This is referred to as credit risk. However, as banks do not (or not only) operate using their own financial funds (i.e. their own equity, for example in the form of nominal capital) but also funds they manage for depositors as well as other funds, lending involves additional responsibilities. Naturally, banks are also aware of these responsibilities and thus make separate provisions for risk; at the same time, however, they also face national and international competition – and risk provisioning costs money. Therefore, the only alternative is to ensure sufficient capital ratios in the global banking system and to create as level a playing field as possible by defining internationally coordinated regulatory capital requirements.

With the Basel Capital Accord of 1988, the Basel Committee on Banking Supervision pursued precisely these intentions as well as the ultimate objective of increasing the stability of financial markets. The original accord was based on "actual" banking risk (i.e. credit risk), for which banks were required to hold a minimum capital standard of 8% of the volume of outstanding loans (in the form of risk-weighted assets). In 1996, the accord saw comprehensive extensions to include regulations which accounted for market risk.

However, in light of ongoing developments and events in the banking industry, the Basel Committee began revising the original accord in 1999 with the following objectives:

• to bring regulatory capital requirements closer to the actual risk profile of banks
• to cover all essential banking risks with theoretically grounded, flexible and operable requirements which create incentives for advanced implementation and
• to allow banks to use in-house methods.

Given these demands and the large number of new developments in banking, the new regulatory capital requirements had to be more comprehensive and complex than the previous capital adequacy framework. However, if possible, the simplest approaches under the new requirements should not significantly exceed the current capital accord in terms of complexity, and above all they should be neutral in terms of capital requirements, at least on average.

As experience has shown that risk-based capital resources alone cannot ensure the solvency of a bank and the stability of the overall banking system, an approach based on three pillars was chosen: Pillar 1 – Minimum capital requirements, Pillar 2 – Supervisory review process, and Pillar 3 – Market discipline. Thus the already existing instrument of minimum capital requirements, which has already proven to be effective, was developed further and complemented with the framework of a qualitative review process involving close contact between banks and supervisory authorities as well as extended disclosure requirements. The philosophy behind this approach is based on synergies arising from the use of the three pillars, which should mutually enhance each other’s efficacy.

The first pillar is concerned with the minimum capital requirements arising from credit risk, market risk and operational risk, each of which has to be calculated using an approach which is suitable and sufficient for the individual bank. For the sake of an evolutionary approach, both standardized methods and more refined measurement methods have been defined for each risk category, and the transition to using the latter methods is rewarded with lower capital requirements. This provides banks with an incentive to continue developing their risk management methods for the various risk categories.

For credit risk, there will be a standardized approach and two internal ratings-based (IRB) approaches. As in the previous accord, the standardized approach prescribes specific risk weights for certain types of credit exposures (0%, 20%, 50%, or 100% of the 8% standard), and there is now a weight of 150% for borrowers with poor credit ratings. In the future, risk assessments under the standardized approach will depend heavily on the ratings assigned by external rating agencies in the individual risk groups (sovereigns, banks, nonbanks). In this approach, securitized claims will also be assigned their own risk weights depending on their external ratings. Credit risk mitigation instruments such as collateral (e.g. cash balances or securities), guarantees or credit derivatives will also be recognized to a greater extent than they have been to date.

In addition, the approval of IRB approaches for the calculation of regulatory capital requirements builds on already proven credit risk management techniques at banks (and continues the strategy chosen in 1996, when market risk was recognized for banking supervision purposes). Using these approaches, the bank does not rely on information provided by an external rating agency but carries out its own assessments, which form the basis for determining potential future losses. These calculated losses are in turn used as the basis for the corresponding capital requirements. Depending on whether the bank is only allowed to determine a borrower’s probability of default or may also determine other parameters in credit risk calculations, these approaches are referred to as the foundation IRB approach or the advanced IRB approach. In order to use these approaches, banks are required to fulfill a number of requirements in any case.

Under the IRB approaches, capital requirements are calculated using five asset classes: corporates, banks, sovereigns, retail customers and equity. A borrower’s creditworthiness is assigned to a specific in-house rating class for which a probability of default (PD) has been estimated over a one-year time horizon. If the borrower actually defaults, the potential loss depends on additional risk parameters: If the payments made to date and the realization of collateral are not sufficient to cover the credit amount outstanding, the expected value of the actual loss at the time of default is the loss given default (LGD), which is usually expressed as a percentage of the outstanding claim at the time of default (exposure at default, EAD). In addition, the effective maturity (M) of the loan is also taken into account as a risk component in the IRB approach. Banks can estimate LGD and EAD only in the advanced IRB approach; in the foundation IRB approach, these parameters are prescribed by the banking supervisory authority. The definition of a credit default, that is, which credit event is considered a default (e.g. payments more than 90 days past due, insolvency proceedings, etc.), is naturally of crucial importance in the estimation of risk components. Credit risk mitigation instruments are treated as in the foundation IRB approach.

While the methods of calculating capital requirements for market risk have remained the same as in the existing accord (standardized methods and internal models), the new accord will contain a new capital requirement for operational risk. The capital accord of 1988 only required banks to set aside capital for credit risk, but the simultaneous coverage of other risks was certainly implied in those capital requirements. The main factors which influenced the decision to take these risks into account explicitly were the growing dependence of banking operations on IT systems, the propagation of electronic banking and especially the increasing complexity of business processes in banking.

In this context, operational risk is by nature very different from credit risk and market risk. Operational risk is far more difficult to capture because it is inherent to many activities and is often not taken consciously, but it is still inevitable – in fact, banks set aside approximately one fifth of their economic capital for operational risks. Concepts for delineating, quantifying and controlling operational risk are not nearly as well developed as in the other risk categories, but as recent events have shown, operational risks can be significant, and the resulting losses can even threaten a bank’s existence.

For this reason, the Basel Committee on Banking Supervision decided to introduce capital requirements for operational risk and to offer three levels of approaches in this context. First of all, there is the basic indicator approach, in which a bank’s operational risk is estimated as a percentage (alpha factor) of a single indicator; this approach is too rough for (and therefore cannot be used by) banks which operate internationally. Next is the standardized approach, also referred to as business line approach, which uses a set of indicators and factors (betas) based on the bank’s business lines: This can be seen as a basic indicator approach applied to each business line. Basel II is also meant to allow partial use of the standardized approach in combination with the third and most sophisticated group of approaches, the advanced measurement approaches, which use a bank’s internal loss data and model-based methods to calculate regulatory capital requirements. These data always form a matrix of business lines and loss events, on the basis of which banks, depending on the detailed approach chosen, are to determine the probability of event (PE)and loss given event (LGE) for potential operational losses. The application of advanced measurement approaches will be subject to both qualitative and quantitative criteria, and banks will be allowed to recognize the risk mitigating impact of insurance.

The supervisory review process, the second pillar of the new capital adequacy framework, requires banking supervisory authorities to carry out qualitative reviews in order to ensure that the internal processes necessary for assessing the bank’s specific risk situation and appropriate capital resources exist, function and undergo constant improvement in each bank.

The third pillar, market discipline, could also be referred to as "disclosure,"as certain minimum effective disclosure requirements (i.e. rules for the publication of information such as a bank’s risk profile, the adequacy of capital items, etc.) are a basic prerequisite for sound information standards among all market participants. This in turn allows market forces to take effect without obstructions, thus indicating the prevalence of market discipline. The new accord contains disclosure requirements and recommendations for various areas of banking operations, including the methods a bank uses to estimate its risks or how the bank determines its capital adequacy(i.e. the relationship between equity and overall risk). The bulk of these disclosure requirements will apply to all banks, and more detailed requirements will be developed for approaches which are based on banks’ internal methods and require supervisory approval.