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"Basel II Accord"


This article draws heavily from the papers provided by the Basel Committee on Banking Supervision

The economic credit capital (abbreviated: "ECC") is the capital needed to act as a buffer against credit risk. The ECC can be estimated in various ways. The most common approach is the calculation of a CVaR ("Credit Value-at-Risk") and to use the CVaR as an estimator for ECC.

In the chapter "Credit Risk" a formula to calculate CVaR was presented and an alternative calculation method of CVaR was explained. Here we will focus on the current regulatory framework created by the Basel Committee on Banking Supervision (BCBS) , which is now the basis for banking regulation around the globe.

The Basel I Accord from 1988 was replaced by a more adequate Basel II Accord (published in June 2004). The Basel II Accord consists of three pillars: minimum capital requirements, supervisory review, and market discipline.



Pillar 1: Minimum Capital Requirements
The Minimum Capital Requirements has to satisfy the minimum ratio of 8 % (regulatory capital requirement in relation to the sum of the risk weighted assets of the bank). This sum is calculated by adding the Minimum Capital Requirements for market risk and operational risk together and then multiplying this sum by 12.5. To this term we add the risk weighted assets (RWA) regarding credit risk.

Or expressed by a formula:

Regulatory capital >= (0.08 * RWA regarding credit risk) + (capital requirements for market risk and operational risk)

The RWA regarding credit risk can be calculated by a standardized approach (supported by external credit assessments) or by a internal ratings based approach (IRB approach). The latter is divided into the foundation type approach and the advanced type approach. These two approaches are characterized by increasing complexity and risk-sensitivity. Which approach the bank chooses is up to the manager in charge.


If the standardized approach is chosen than the bank has to categorize their credit exposures. The categories are sovereigns, banks, corporate, and retail, to name a few. Then the bank has to apply different risk weights to the exposures. See Exhibit B.1 for an example:


Exhibit B.1: Standardised Risk Weights for Soverigns, Banks, and Corporates



Banks that have received supervisory approval to use the IRB approach may rely on their own internal estimates of risk components to determine the capital requirements of a given exposure.

In this IRB approach the risk weights for each exposure class are calculated through a risk weighted function. By multiplication of the function's result with the exposure at default (EAD) we get the risk weighted assets.

In the exhibit below the procedure is shown schematically. (Here we only discuss the exposure classes "Sovereigns", "Banks", and "Corporates".)


Exhibit B.2: RWA's calculated by the IRB approach

As it can be seen from the exhibit above, the Foundation Approach and the Advanced Approach differ primarily by the input risk components the banks provide. In the Foundation Approach only the risk component PD (Probability of Default) is based on the bank's own estimate, whereby the risk components LGD (Loss given Default), EAD (Exposure at Default), and M (Maturity) are supervisory values set by the Committee. On the other hand, in the Advanced Approach all risk components (PD, LGD, EAD, M) are based on the bank's own estimates.



Pillar 2: Supervisory Review Process
This section discusses the key principles of supervisory review, risk management guidance and supervisory transparency with respect to banking risks.

In this Pillar 2 - section the guidance relates to the treatment of interest rate risks in the banking books. This pillar also treats credit risk (stress testing, definition of default, residual risk, and credit concentration risk) is discussed.



Pillar 3: Market discipline
Here the Committee aims to encourage market discipline by developing a set of disclosure requirements which will allow an effective means of informing the market about a bank's exposure to their risks and provide a consistent and understandable disclosure framework that enhances comparability.

The Basel II Accord puts a strong emphasis on risk management and encourages improvements in bank's risk assessment capabilities. By the use of modern risk management practices, the Accord sets minimum capital requirements.



References

Basel Committee on Banking Supervision (2006) International Convergence of Capital Measurements and Capital Standards. Available at http://www.bis.org