Originally published December 17 2004
On June 26 2004 the Basel Committee on Banking Supervision introduced the New Basel Capital Accord (Basel II). The existing Basel Capital Accord (Basel I) regulated the capital requirements of banks and authorized deposit-taking institutions. Basel II revises the existing regime by creating a stronger link between risk and capital requirements. The Australian Prudential Regulation Authority (APRA) has announced that Basel II will be implemented in Australia over the next three years.
The overall goal of Basel II, according to the Bank of International Settlements, is "to promote the adequate capitalization of banks and to encourage improvements in risk management, thereby strengthening the stability of the financial system". Basel II aims to accomplish this through the introduction of three guiding principles, termed 'pillars'.
Pillar one: minimal capital requirements
Pillar one revises the Basel I framework to align minimal capital requirements more closely with a bank's actual risk of economic loss. Basel II requires higher levels of capital for borrowers thought to represent a higher risk of credit loss, thus offering a more sophisticated approach to risk. Banks now have three options from which to choose the most appropriate approach to calculating credit risk. Those that engage in less complex forms of lending and whose control structures are simpler may adopt a standardized approach, using external measures to assess the credit risk of their borrowers. Banks that engage in more sophisticated risk taking that have developed advanced risk measurement systems may use one of the two internal ratings-based approaches: foundation or advanced. Under these approaches, a bank will rely in part on its own measures of a borrower's credit risk in order to determine its capital requirements.
Pillar one also establishes an explicit capital change for a bank's exposure to operational risk. This includes risks associated with system and process failures and staff, as well as risks resulting from external events (eg, natural disasters). Based on the attributes of their internal mechanisms, banks have three options for measuring their exposure to operational risks.
Pillar two: supervisory review process
Pillar two of the framework:
"recognizes the necessity of exercising effective supervisory review of banks' internal assessments of their overall risks to ensure that bank management is exercising sound judgment and has set aside adequate capital for these risks."
Pillar two comprises four principles aimed at assisting regulated entities to develop better risk management techniques in monitoring and managing risk, and provides guidelines for supervisors to assist such entities in reviewing and regulating internal capital adequacy assessments.
Pillar three: market discipline
Pillar three aims to encourage market discipline by enforcing disclosure requirements which will allow market participants to assess key pieces of information indicative of the capital adequacy of institutions. It is intended that the implementation of a single framework for disclosure will enhance consistency and comparability.
Predicted Effect in Australia
Australia's largest banks are very sound in world terms, all currently possessing at least AA minus debt ratings. Notwithstanding this, APRA believes that the Australian banking system will be even safer and more efficient under the Basel II regulatory structure. According to Bernie Egan:1
"The system is safer because authorized deposit-taking institutions, their supervisors and market participants will have available capital measures that better reflect their risk profile and therefore true financial condition. And furthermore, the system is more efficient because banks' business decisions will be more closely based on the underlying economics of transactions rather than the regulatory distortions created by the existing rules."
Further, the authority believes that compliance with Basel II is essential for Australia to remain internationally competitive in the global finance sector.
Conversely, the cost of conversion to Basel II may in some cases be high, particularly for institutions which opt to apply the more advanced methods of risk calculation. The authority has noted that Australian banks have already spent between A$50 million and A$100 million planning to implement the advanced internal ratings-based approach.
Additionally, while there are well-established statistical and mathematical methods for calculating credit, trading and interest rate risks, the determination of operational, strategic or business risk is far more difficult.
An issue that is being considered is how banking organizations which operate in two or more countries will be affected. Given that jurisdictions are likely to interpret Basel II in different ways, an Australian bank with overseas operations may find itself subject to different capital and regulatory requirements.
The object of Basel II is to overcome the clunky 'one size fits all' approach to risk calculation evident in Basel I. The new regime is structured to be a flexible system, more suited to the complex business structures of modern banking institutions. The Bank for International Settlements intends to monitor market developments and advances in risk management practices so that future revisions to the framework can be made when necessary. As a result, it is hoped that the framework of Basel II is structured so that it has the capacity to evolve with time.
1 Australian Prudential Regulation Authority speech, "Monitoring Risk in the Financial System", September 2 2003. Bernie Egan is the programme director, Basel II Policy, Research and Statistics, Australian Prudential Regulation Authority.
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