The Basel Capital Accord, known as Basel II, sets down the agreement among central banks to apply common minimum capital standards to the banking industry. The agreement is almost entirely addressed to credit risk, the main risk incurred by banks. Basel II aims to build a solid foundation of prudent capital regulation, supervision and market discipline, to enhance risk management and financial stability for the worldwide banking system.
Banks are required under the supervisory review process to address such risks as:
- Interest rate risk in the banking book;
- Credit risk:
- Stress tests under the IRB approaches;
- Definition of default;
- Residual risk;
- Credit risk concentration and,
- Operational risk.
The scope of application has three pillars:
“The First Pillar”
∑ =MCR (II+III+IV+V+VI)
MCR = Minimum Capital Requirement;
II = Credit risk - The Standardised Approach;
III = Credit risk - The Internal Ratings Based Approach;
IV = Credit Risk - Securitisation Framework;
V = Operational Risk;
VI = Trading Book Issues (including market risk).
“The Second Pillar”
Supervisory Review Process
“The Third Pillar”
Market Discipline.
The Internal Rating-Based (“IRB”) approach to credit risk is subject to certain minimum conditions and disclosure requirements. Banks that have received supervisory approval to use the IRB approach may rely on their own internal estimates of risk components in determining the capital requirement for a given exposure.
The risk components include measures of the:
- PD (probability of default);
- LGD (loss given default);
- EOD (exposure of default);
- M (effective maturity).
The IRB approach is based on measures of UL (unexpected losses) and EL (expected losses). The risk- weighted functions produce capital requirements for the UL portion. Expected losses are treated separately.