| Basel II 101 |
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| 09/12/2007 | |
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Dr. Alessandra Mongiardino, Risk Management Specialist at Moody's Investors Services, answers this week's questions on Basel II. 1. How does the Basel II regime differ from Basel I? At very high level, there are two main areas in which Basel II differ from Basel I. First, the range of risks covered in Basel II is broader. Under Basel I only credit risk and market risk in the trading book had a capital charge attached to them. Basel II Pillar 1 has introduced also a capital charge for operational risk. In addition, Pillar 2 focuses on a bank's internal assessment of all risks to which a firm is exposed and the supervisory review of this assessment. The most important risks beyond 'Pillar 1' risks (credit risk, market risk in the trading book and operational risk) are: interest rate risk in the banking book, liquidity risk, concentration risk, reputational and strategic risk. Second, Basel II aims at providing a more risk-sensitive framework for the calculation of required capital, while broadly maintaining the aggregate level of minimum capital requirement. Basel II gets away from the 'one size fits' all' approach of Basel I, by providing a range of options for the calculation of capital , depending on an institution's operations and level of sophistication, while at the same time providing incentives to the banks to improve their risk management practices. Basel II – Pillar I offers three different options for the calculation of the credit risk capital charge, respectively standardised, Foundation IRB (Internal Ratings Based) approach, and Advanced IRB approach, and three options for the calculation of the operational risk capital charge, respectively the basic approach, standardised approach and the Advanced Measurement Approach (AMA). In the case of the IRB approach for credit risk and AMA for operational risk, internal risk estimates are among the inputs for the calculation of the capital charge. 2. Why did Basel I not adequately address interest-rate risk? What has changed in the last 20 years? The Basel Committee issued a paper on 'Principles for the management of interest rate risk' in September 1997 and established a supervisory capital requirement to cover interest rate risk in the trading activities of a bank, which became effective at the end of 1997. As interest rate risk in the banking book is concerned, the Committee set out in that paper the principles for sound interest rate risk management, but decided not to set a capital charge for this type of risk. Following on these lines, in Basel II, the treatment of interest rate risk in the banking book is one of the key risks captured under Pillar 2 of Basel II. In this perspective, banks will not have a specific capital charge applied to it, but are nevertheless required to hold sufficient capital to cover the risk they are taking in this area. 3. Has the credit crisis resulted in challenges to the implementation of Basel II? How so? The credit crisis has made even more important a thorough review of banks' liquidity and risk management practices as they relate to complex credit products and off-balance sheet vehicles. This process can be developed within Pillar 2 of Basel II and the regulatory review of the internal capital adequacy model. 4. What is the impact of Basel II on banks? Broadly speaking, Basel II has facilitated a significant enhancement in risk systems and data quality and overall improvement in risk management practices. As indicated by the results of QIS5, a large number of institutions, in particular those with large retail mortgage portfolios, would benefit from a lower level of minimum required capital under Pillar 1. The QIS5 results show that the average estimated reduction in minimum capital requirement for the large banks in G10 countries participating in the study would be 6.8% and for the relatively smaller banks in G10 countries participating in the study about 11.3%. However, in a number of jurisdictions, the regulators might set an additional capital charge for certain banks, if it is perceived that the capital requirement set under Pillar 1 is not sufficient to cover all the risks taken by an institution. |
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Articles of the same Serie : 101 |
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