Capital Adequacy Under Basel I :
Under Basel Accords - I and II, capital is considered as the key component to ensure health of banking system . Capital adequacy ratios prescribed under these Accords are mainly intended to ensure that banks maintain a minimum amount of own funds in relation to the risks they face so that in times of crisis these Banks can absorb the unexpected losses.
However, from the Supervisor’s perspective (i.e. RBI in India), , capital is the last line of defense in a bank. The risk weighted capital adequacy framework (Basel 1) requires banks to hold different categories of capital against both on balance sheet assets and off balance sheet items with different risk weights. The 1988 Basel Capital Accord is considered as a watershed in this regard. Under this Accord, supervisors in the major banking markets for the first time agreed on a definition of capital and the minimum requirement. Under Basel I, it was very simple approach and was easy to apply. Thus, it was widely accepted and slowly adopted by more than 100 countries. The scope of the Accord was widened in 1996 to incorporate market risks.
However, soon it was felt that with advances in technology and telecommunications, innovation in banking products and services, and the increasing globalisation of financial markets have changed the way banks used to measure and manage risks. The Banks were taking much bigger risks in derivatives and new innovative products. The explosive growth in the markets for securitised assets and for credit derivatives has offered banks new ways to manage and transfer credit risk . Operational risk was considered as another threat to the banking, due to failures in internal processes or systems or from damage caused by an external disruption.
Thus it was felt that 1988 Accord no longer provides the internationally active banks - and their supervisors - with reliable measures of the actual risks they face. The 1988 Accord was considered as too broad brush and not enough sensitive to the risks which the banks are exposed to. The 1988 Accord was considered to be too simple an approach to capital regulation.
BASEL II :
Thus, the new Accord (popularly known as Basel II) was released by Basel Committee. The new accord seeks to capture the relationship between capital adequacy and risk management . This new Accord includes not only quantitative measures of risk but also incorporates supervisory review and public disclosure (market discipline).
Basel II framework is popular discussed under three pillars.
Under Pillar One : Minimum capital : The definition of risk weighted assets in the New Accord have two primary elements:
(i) substantial changes to the treatment of credit risk relative to the current accord; and
(ii) the introduction of an explicit treatment of operational risk.
In both cases a major innovation of the new Accord is the introduction of three distinct options for the calculation of credit risk and three for operational risk. The Committee believes that it is not feasible or desirable to adopt a one-size-fits all approach to the measurement of either risk. Instead for both credit and operational risk there are three approaches of increasing risk sensitivity to allow banks and supervisors to select the approach or approaches that they believe are most appropriate to the stage of development of banks operations and of the financial market infrastructure.
The standardized approach allows use of external credit assessments to enhance risk sensitivity compared to the current accord. The risk weights for sovereign inter-bank and corporate exposures are differentiated based on external credit assessments. Where no external rating is applied to an exposure a risk weight of 100% can be used. Loans considered past due will be risk weighted at 150% unless a threshold amount of specific provisions has already been set aside by the bank against that loan. Certain types of mainly financial collateral are allowed as credit risk mitigants.
Retail exposures are given a specific treatment. The risk weights for residential mortgage exposures are at 35% and other retail exposures including SME’s can be risk weighted at 75 percent subject to meeting certain criteria.
The IRB approach to credit risk includes two variants; a foundation approach and an advanced approach. The approach differs substantially from the standardized approach in that banks’ internal assessments of key risk drivers serve as primary inputs to the capital calculation. They are based on modern risk management techniques that involve a statistical and thus quantitative assessment of risk. Under Basel II banks are required to hold capital against operational risk – this is not an option but a fundamental part of Basel II.
Operational Risk is defined as the risk of losses resulting from inadequate or failed internal processes, people and systems or external events. There are two simple approaches to Operational risk; the basic indicator and the standardized approach which are targeted to banks with less significant operational risk exposures. In general terms the basic indicator and standardized approaches require banks to hold capital for operational risk equal to a fixed percentage of a specified risk measure. The advanced approach allows banks to use their own method for assessing their exposure to operational risk so long as it is sufficiently comprehensive and systematic
Under PILLAR Two : An important dimension of Basel II is the supervisory review The supervisory review contains a set of four principles all of which point to the need for banks to assess their capital adequacy positions relative to their overall risks and for supervisors to review and take appropriate actions in response to those assessments. Pillar 2 recogniises that banks face risks not included in pillar 1 and that banks choose to operate at capital levels above those implied by pillar 1 minimum. Supervisors should seek to intervene at an early stage to prevent capital falling below minimum levels
Under PILLAR THREE : Market discipline is sought to be encouraged by developing a set of disclosure requirements that allow market participants to assess key information about a bank’s risk profile and level of capitalization. Market discipline reinforces efforts to promote safety and soundness in banks
