The Basel Committee on Banking Supervision (BCBS) was formed to provide a platform for banking supervisory authorities to work for the financial stability of the banking sector. The BCBS introduced the Basel Capital Accord (BASEL I) in 1988 which sought to strengthen the soundness and stability of the international banking system by requiring higher capital ratios. This accord established a minimum ratio of required Tier 1 capital – to – risk weighted assets (RWA). The Risk-weights for assets were assigned only for credit risk, based on simplistic categorization of types of assets and obligors.
It was amended in 1996 and capital charge for market risk of trading portfolios was added. Basel I was very simplistic in its approach towards credit risk. For example, Basel I does not distinguish the risk characteristics between a 1 year loan and a 5 year loan and does not distinguish between collateralized and non-collateralized loans. After lengthy consultations with the market participants, the revised framework was issued on 26th June 2004 and is known as Basel II.
To enable the participants have greater understanding of the calculation methodology used in Standardized approaches.
To enable the participants to develop an understanding of the implications involved in changes in the RWA on the Capital Adequacy Requirement (CAR).
To enable the students comprehend the linkage of the model with underlying Finance theories.
Basel II is a modern, sophisticated and more risk-sensitive framework of capital. The Basel II framework consists of three ‘pillars’:
Pillar 1sets out the minimum capital requirements firms will be required to meet to cover credit, market and operational risk. It provides different options like standardized or advanced approaches for calculation of minimum capital requirements.
Pillar 2 deals with supervisory review process. This requires financial institutions to have their own internal processes to assess their capital needs and appoint supervisors to evaluate an institutions’ overall risk profile, to ensure that they hold adequate capital.
Pillar 3 aims to improve market discipline by requiring firms to publish certain details of their risks, capital and risk management.