Basel II Accord

Basel II is the second of the Basel Accords, which are recommendations on banking laws
and regulations issued by the Basel Committee on Banking Supervision. The purpose of
Basel II, which was initially published in June 2004, is to create an international standard
that banking regulators can use when creating regulations about how much capital banks
need to put aside to guard against the types of financial and operational risks banks face.
Advocates of Basel II believe that such an international standard can help protect the
international financial system from the types of problems that might arise should a major
bank or a series of banks collapse. In practice, Basel II attempts to accomplish this by setting
up rigorous risk and capital management requirements designed to ensure that a bank holds
capital reserves appropriate to the risk the bank exposes itself to through its lending and
investment practices. Generally speaking, these rules mean that the greater risk to which the
bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its
solvency and overall economic stability.

The final version aims at:

1. Ensuring that capital allocation is more risk sensitive;

2. Separating operational risk from credit risk, and quantifying both;
3. Attempting to align economic and regulatory capital more closely to reduce the
scope for regulatory arbitrage.

While the final accord has largely addressed the regulatory arbitrage issue, there are still
areas where regulatory capital requirements will diverge from the economic.
Basel II has largely left unchanged the question of how to actually define bank capital,
which diverges from accounting equity in important respects. The Basel I definition, as
modified up to the present, remains in place.

Basel II - a guide to new capital adequacy standards for lenders

In the late 1980s it was decided that, as banks were becoming increasingly international in
their operations, there was a need for a uniform regime to set minimum levels of capital that
banks must hold across the developed countries. An international regime was deemed
necessary to ensure that a level playing field operated and that banks had adequate capital to
ensure their soundness and thereby protect the global financial system and their depositors.
The Bank for International Settlements, based in Basel in Switzerland, was the body charged
with establishing a framework for setting a minimum level of capital each bank should have
to hold.
It was decided that this minimum level of capital would be determined with regard to the
riskiness of the assets banks held. Each asset on the balance sheet of a bank was given a
weighting between 0% and 100%, where 0% represented the safest assets such as sovereign
bonds and 100% the riskiest exposures such as corporate debt and unsecured personal loans.
Loans secured on residential property were given a 50% risk weighting. Banks would be
required to hold tier 1 capital of at least 4% of risk weighted assets (RWA) and total capital
of at least 8%. Tier 1 capital is the purest form of capital, comprised of shareholders funds
and preference shares. Total capital also comprises capital/debt hybrids such as subordinated
debt (which counts as capital because it is at risk before deposits and other bonds).
By the late 1990s, banks had become much more sophisticated in their operations and risk
management and were increasingly able to find ways to reduce a bank's risk weighted assets
in ways that did not reflect lower real risk (what has become known as regulatory capital
arbitrage). It was therefore decided that a new capital standard was required and work began
on Basel II. The aim of Basel II is to better align the minimum capital required by regulators
(so-called regulatory capital) with risk. This inevitably requires a more complex regime,
given that some of the greatest anomalies in the first Basel Accord stemmed from its
simplicity – for example all unsecured corporate exposures were weighted 100% whether
the company was a highly profitable global giant or a struggling small business.
But the outcome of the discussion on the form of Basel II is an Accord which is far more
complex than Basel I and goes far beyond Basel I is its scope.
Basel II came into effect in the European Union on 1 January 2007 under the Capital
Requirements Directive (CRD) and all lenders covered by the CRD will have to implement
it from the beginning of 2008.
Structure of Basel II
Basel II consists of 3 'pillars' which enshrine the key principles of the new regime.
Collectively, they go well beyond the mechanistic calculation of minimum capital levels set
by Basel I, allowing lenders to use their own models to calculate regulatory capital while
seeking to ensure that lenders establish a culture with risk management at the heart of the
organisation up to the highest managerial level.
Pillar 1 sets out the mechanism for calculating minimum regulatory capital. Under Basel I
this calculation related only to credit risk, with a calculation for market risk added in 1996.
Basel II adds a further charge to allow for operational risk.

Credit risk
While Basel I offered a single approach to calculating regulatory capital for credit risk, one
of the greatest innovations of Basel II is that it offers lenders a choice between:
1. The standardised approach. This follows Basel I by grouping exposures into a series of
risk categories. However, while previously each risk category carried a fixed risk weighting,
under Basel II three of the categories (loans to sovereigns, corporates and banks) have risk
weights determined by the external credit ratings assigned to the borrower. Amongst the
other categories that continue to have fixed risk weights applied by Basel II, loans secured
on residential property will carry a risk weight of 35% against 50% previously, as long as
the loan-to-value (LTV) is up to 80%. This lower weighting is a recognition of the
historically low rate of losses typically incurred on residential mortgage loan portfolios
across different countries and over a range of economic environments.
2. Foundation internal ratings based (IRB) approach. Lenders will be able to develop
their own models to determine their regulatory capital requirement using the IRB approach.
Under the foundation IRB approach, lenders will estimate a probability of default (PD)
while the supervisor provides set values for loss given default (LGD), exposure at default
(EAD) and maturity of exposure (M). These values are plugged into the lender's appropriate
risk weight function to provide a risk weighting for each exposure or type of exposure.
3. Advanced IRB approach. Lenders with the most advanced risk management and risk
modelling skills will be able to move to the advanced IRB approach, under which the lender
will estimate PD, LGD, EAD and M. In the case of retail portfolios only estimates of PD,
LGD and EAD are required and the approach is known as retail IRB.
Given that a key objective of Basel II is to improve risk management culture, it is
unsurprising that the regime encourages lenders to move towards the IRB approach and
ultimately, the advanced or retail IRB approach. To this end, it is expected that banks will
see a modest release of regulatory capital in moving from the standardised to foundation
IRB approach and on to the advanced or retail IRB approach.

Operational risk
The Accord defines operational risk as 'the risk of loss resulting from inadequate or failed
internal processes, people and systems or from external events'. In keeping with the
approach to credit risk, it provides three mechanisms for computing operational risk of
rising complexity to suit lenders' varying characteristics.
Pillar 2 is meant to identify risk factors not captured in Pillar 1, giving regulators
discretion to adjust the regulatory capital requirement against that calculated under Pillar 1.
For most lenders, the Pillar 2 process is expected to result in a higher regulatory capital
requirement than calculated under Pillar 1. Pillar 2 requires banks to think about the whole
spectrum of risks they might face including those not captured at all in Pillar 1 such as
interest rate risk.
Pillar 3 is designed to increase the transparency of lenders' risk profile by requiring them
to give details of their risk management and risk distributions. Information is likely to be
released through the normal mandatory financial statements lenders are required to publish
or through lenders' websites.
Timetable
All lenders covered by the CRD will be required to have fully implemented Basel II from
the beginning of 2008.

Market risk
Market risk is the risk that the value of an investment will decrease due to moves in market
factors. The four standard market risk factors are:

• Equity risk, the risk that stock prices will change.

• Interest rate risk, the risk that interest rates will change.
• Currency risk, the risk that foreign exchange rates will change.
• Commodity risk, the risk that commodity prices (e.g. grains, metals) will change.

Measuring

As with other forms of risk, market risk may be measured in a number of ways.
Traditionally, this is done using a Value at Risk methodology. Value at risk is well
established as a risk management technique, but it contains a number of limiting
assumptions that constrain its accuracy. The first assumption is that the composition of the
portfolio measured remains unchanged over the single period of the model. For short time
horizons, this limiting assumption is often regarded as acceptable. For longer time horizons,
many of the transactions in the portfolio may mature during the modeling period.
Intervening cash flow, embedded options, changes in floating rate interest rates, and so on
are ignored in this single period modeling technique.

Implications of Basel II
There has been a considerable amount of debate concerning the potential impact of Basel II.
Perhaps the most obvious effect will be to alter the percentage return on regulatory capital
by altering the denominator (the amount of regulatory capital required). For residential
mortgages, the release of regulatory capital under both the standardised and retail IRB
approaches should be considerable. Many commentators see this as the basis for significant
changes in industry pricing, which they believe could alter the competitive landscape and
drive consolidation.
However, there are a number of reasons why the impact on market pricing might not be as
dramatic as some suppose:

• Many of the largest financial institutions already set their pricing on the basis of
economic rather than regulatory capital. For them Basel II should not lead directly to
a desire to reappraise their pricing.
• Non-deposit taking lenders face different regulatory capital requirements under
which they are required to hold much lower levels of capital, so the introduction of
Basel II should have no direct impact on their pricing. The fact that non-deposit
taking lenders have not come to dominate the lending industry is testament to the
competitive importance of factors other than capital (like access to a stable retail
deposit base).
• Lenders routinely hold capital well above the regulatory minimum. Even where the
minimum level of regulatory capital alters significantly, a lender may choose not to
alter its actual capital profile in response. Lenders hold capital for a number of
reasons, such as to enhance their credit rating or allow for future possible
acquisitions, and not just to satisfy the regulator.
• Lenders face a risk/reward trade-off: The higher their capital ratio, the lower the
perceived risk, other things being equal. This provides lenders with an incentive to
hold more capital independent of the requirements of the regulator.

The conclusion from the above must be that the impact of Basel II on pricing may not be
particularly large, especially in markets like mortgages served by a heterogeneous group of
lenders including non-deposit taking institutions. Therefore, this may not be much of a force
driving industry consolidation.
The other possible drivers of mortgage market consolidation from Basel II that have been
discussed are the cost of compliance and the lower capital requirement of the retail IRB as
opposed to the standardised approach. Here again there is a risk of overstating the impact.
The reason for a three tier approach to credit and operational risk is to allow for the fact that
smaller lenders are not going to be able to devote the same resources as the larger ones. And
although a move from standardised to retail IRB should see a reduction in regulatory capital
for mortgage lenders, the move to Basel II could see much larger changes driven by relative
portfolio mix. As a result, the pressure that Basel II will create for further consolidation may
not be as great as some commentators claim.
The other area where Basel II will be felt is in firms' 'risk culture'. A key objective of the
Accord is to promote a more rigorous approach to risk management. It will require
increasingly sophisticated risk management and greater senior management engagement in
issues relating to risk. The requirement for public disclosure outlined in Pillar 3 and the
expected regulatory capital relief for IRB banks against those on the standardised approach
support this objective.
Summary
In summary, Basel II aims not only to align regulatory capital more closely with risk but to
promote a more sophisticated approach to risk management and to create a 'risk culture'
inside lenders, whereby the organisation, and senior management in particular, understand
risk and remain alert to risk as a core issue. As lenders begin to gear up for its introduction,
they are discovering just how substantial a change the move to Basel II really is.