Basel I had been modified later to Basel II in 2004 to make it more effective to regulate the banks. While Basel I had considered only the credit risk, Basel II has considered other risk factors as well and suggested international standard guidelines to guard all the banks against the same.
Basel II has published the new international standards to calculate the minimum capital requirement to guard the banks against all types of possible financial and operational risks.
Three Pillars of Basel II
Basel II used three pillars to deal with all risk management for the banks. The three pillars are
1. Minimum Capital Requirements
2. Supervisory Review
3. Market Discipline
All these pillars will be explained now with more details.
Minimum Capital Requirements
Basel II has introduced two more risks along with credit risk to calculate the minimum capital requirement for the banks. They are Market risk and operational risks. The Market risks mainly deals with the market related issues and macro-economic factors while the operational risk deals with the banking business functions operational and regulatory failures which also increases the risk of losing money. Basel II requires banks to hold capital for all these three risks market risk, operational risk and credit risk.
Basel II has also introduced different methodologies to calculate these different types of risks.
Credit Risk can be calculated by these three methods
1. Standardized Approach: This is the most commonly used approach to find the credit risk. Here in this approach, the banks use the ratings provided by the global external rating agencies to calculate the credit risk percentage. Suppose for investment in bonds with credit rating “AAA” has 10% credit risk and investment in bonds with credit rating “BBB” has 50% credit risk.
This does not require any investment by the bank as the credit rating process is completely external and completely dependent on the credibility of the external credit rating agencies.
2. Internal Rating Based Approach: This approach is used by the banks without depending upon the external credit rating agencies. Here the banks develop their own statistical model to calculate the probability of default based on the client details and client’s business.
From the probability of default they calculate the default rate of a particular group of customer and risk percentage for the same. As this is completely internal process, Banks need prior approval from the local regulator (central bank of the country) to use this approach to calculate the credit risk. Banks are also required to use the other important parameters provided by the Regulator to calculate the Risk Weighted Assets (RWA).
3. Advanced Internal Rating Based Approach: As the name suggests this is the advanced version of earlier used internal rating based approach to calculate the market risks. Here with the proper approval, large Banks can use their internally developed parameters to calculate market risk components and their risk percentages.
Operational risk can be calculated by these three methods
1. Basic Indicator Approach: This is the simplest approach to calculate the operational risk. Based on this approach, the banks must hold some capital for operational risk which is a fixed percentage of the total annual gross income from the banking operations. The fixed percentage amount is calculated based on the average risk over the previous three years. This is mainly used by banks without significant operational risks.
2. Standardized Approach: Here the banks divide their business into eight categories for which a separate beta factor is assigned based on the risk involved in that particular business function. The beta for each business function is calculated based on the industry wide operational risk involved for that particular business line.
The capital for each business line is calculated based on the past three year average and after that the capital is multiplied with the corresponding beta value to achieve the minimum capital requirement for the operational risk involved in each business function. The whole sum gives the total minimum capital requirement for operational risks.
3. Measurement Approach: Here the banks develop their own statistical model to calculate the operational risk based on their operations and business system performance and failures. Banks use probably to calculate the operational defects and system errors to finally achieve the operational risk requirement. Banks are required to get the necessary approval from the local regulator or the central bank before using this method.
Market risk denotes the Macro-economic risks related to the market like high interest rate, inflation, equity risk, currency exchange rate risk etc. Market risk is calculated based on VaR or Value at Risk.
This is the second pillar of Basel II norms which deals with the supervisory and regulatory part of the first pillar risk management processes. It provides the framework about how the central bank or the country regulator supervises and regulates different banks and their risk management processes.
With the supervisory and regulatory review power, it also provides some more framework and processes to deal with other risk areas in the banking and financial systems like strategic risks, liquidity risks, legal and political risks which were not included in the first pillar.
Here not only the country’s central bank or regulatory authority review the bank’s risk management process, but banks can also review their own risk management processes to handle probable risks properly.
Financial and banking system is very important for a country and it acts as a back bone for the whole economic system. Stability issue in the financial and banking system can derail the economic and GDP growth. The same thing has happened during subprime crisis in US which led to worldwide recession in 2008 and 2009. The worldwide banking and financial system went into deep crisis due to subprime lending and lower stability in the financial system. After that the third pillar of Basel II norms, “Market Discipline” has become very much important to keep the financial and banking system stable and properly functioning.
These norms make compulsory for banks to share the financial and lending details to the regulators, investors and analysts so that they can analyze the bank’s financial health. Banks are also required to publish their lending exposure in different market segments and the adopted risk measurement and management process for the same. It always lead to good corporate governance system and helps the banks to gain customer and investor confidence regarding their business functions and processes.
Use of Basel II
Basel II is the most widely used norms for banking and financial sector. After the introduction in 2004, it has witnessed lots of progresses.
The last point is very much important if we consider the subprime lending crisis which had put the whole world’s financial system into its worst financial crisis after the great depression. So why did this happen if the banks had implemented the Basel II norms? Was that a failure of Basel II norms?
No, actually it was not the failure of the Basel II norms. It was the failure of the central regulatory authorities who failed to regulate or supervise the banks properly and review their risk exposure.
Basel II norms provides the risk measurement and management process with more supervisory and regulatory power but it neither stops banks to derive complex derivatives to increase the risk exposure without changing the minimum capital requirement guidelines nor protects the banks from taking huge exposure in the very risky subprime lending market without even reviewing the credit rating of the customers. Banks have created complex derivative like credit default swap, Collateral Debt obligations (CDO) and Mortgage Backed Securities (MBS) and diversified the risk to other financial institutions to satisfy the Basel II norms. All these steps failed at that time and spooked the financial market.
The subprime crisis has happened because of the banks and financial institutions, which had taken different steps to bypass the Basel II norms to increase their exposure in the subprime market. The regulatory authorities or the central banks have also failed to scrutiny their risk exposure and risk management properly.
After this financial crisis, the Basel Committee on Banking Supervision (BCBS) has started thinking of some more stringent and superior norms to protect the financial system. Thus Basel III was born from Basel II after some modification. The Basel Committee on Banking Supervision (BCBS) is still working on the Basel III norms.