What are the three pillars of the Basel II Capital Accord?

Three pillars of the Basel II Capital Accord

What is the Basel Accord?

• The Basel Accords are a set of banking regulation recommendations created by the Basel Committee on Banking Supervision (BCBS), which itself is a committee that is dedicated to providing and maintaining regular cooperation on banking supervision matters around the globe.
• Just like any other business, banks too can run the risk of going bankrupt. This can be a major cause of concern because banks are a vital part of the financial ecology and their collapse can result in a huge disruption in national and international economies.

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• This is something that history has also shown as again and again – one example could be the wall street crash of 1929, in which the collapse of the US economy majorly affected the other national economies as well.
• Remember the collapse of Lehman Brothers in 2008, which turned into a complete domino effect scenario and ultimately brought the whole global economy to its knees.
• The study of cases like these helps us understand the importance of maintaining the stability of banks and financial institutions in a more general sense to preserve the overall stability of global economies due to its interconnected nature.

This is what the Basel Accord tries to do – introduce rules, regulations, and standards for banking supervision.

What is the Basel II Accord?

The first Basel Accord came into existence in around 1988 and focused majorly on Credit Risk. Risks types like Operational Risk were simply not talked about in these sets of standards and thus the first Basel Accord only partially prepared the banks for crisis events. The values of credit exposure taken into consideration were Book Values and not Market Values. One other aspect that the Basel I failed at was actually taking into consideration the quality of different debtors and the risk that these different classes of debtors actually pose. These, along with other shortcomings only became evident after the system was implemented.

This necessitates the need for an improvement in the form of Basel II.

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Adopted in around 2004, Basel II promised improvement and nullification of all the shortcomings present in the previous accord – as such, it was seen as an extension of Basel I. Therefore, a little was actually removed but a lot was added that would improve the quality of Bank Supervision.

What are the 3 ‘Pillars’?

The Basel Accord organizes the most important aspects under categories that it calls the 3 Pillars. These are:

1. Capital Adequacy Requirements – Requires the banks to maintain a minimum capital adequacy requirement of 8% of its Risk-Weighted Assets. It also suggests approaches for calculating capital requirements based on credit ratings.
   1. Standardized Approach – Suitable for smaller banks with simple control structures. It involves the use of credit rating from external credit assessment institutions for evaluation of the creditworthiness of bank’s debtors
   2. Internal Ratings-based Approach – Suited for bigger banks with more complex operations and developed risk systems.
      1. Foundation Internal Ratings-based approach (FIRB) – Banks use their own assessment of parameters such as Probability of default, while the assessment methods of other parameters, mainly risk components such as Loss Given Default and Exposure at Default, are determined by the supervisor.
      2. Advanced Internal Ratings-based approach (AIRB) – Banks use their own assessment for all risk components.
2. Supervisory Review – The supervisor is responsible for ascertaining whether the bank uses appropriate assessment approaches and covers all risks associated. This process includes:
   1. 1. 1. Internal Capital Adequacy Process (ICAAP) that a bank must undertake in accordance with their risk profile and determine a strategy for maintaining the necessary capital level.
         2. Supervisory Review and Evaluation process for evaluating ICAAP as well as monitor relevant compliance with regulatory capital ratios.
         3. Capital above the minimum level must be ensured.
         4. Supervisor’s interventions: Supervisors must seek to intervene in the daily decision-making process in order to prevent capital from falling below the minimum level.
3. Market Discipline requires the banks to disclose any relevant market information. This is done to make sure that the users of financial information receive information relevant to them and make informed trading decisions and ensure market discipline.

Author: Aman Aggarwal

About the Author: Aman is an Economics and Finance graduate with a budding interest in Strategic Management and Investment. An avid reader of all things Behavioral and Data Science –I strongly believe in solving problems with creative solutions backed up by quantitative rigor.

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