Basel-II consists of three pillars:◦ Minimum capital requirements for credit risk,

market risk and operational risk—expanding the 1988 Accord (Pillar I)

◦ Supervisory review of an institution’s capital adequacy and internal assessment process (Pillar II)

◦ Effective use of market discipline as a lever to strengthen disclosure and encourage safe and sound banking practices (Pillar III)

Implementation of the Basel II Framework continues to move forward around the globe. A significant number of countries and banks already implemented the standardized and foundation approaches as of the beginning of 2007.

In many other jurisdictions, the necessary infrastructure (legislation, regulation, supervisory guidance, etc) to implement the Framework is either in place or in process, which will allow a growing number of countries to proceed with implementation of Basel II’s advanced approaches in 2008 and 2009.

This progress is taking place in both Basel Committee member and non-member countries.

Minimum Capital Requirement (MCR)

8%CapitalMCRCredit Risk Market Risk Operational Risk

PILLAR I: Minimum Capital Requirement

1) Capital Measurement: New Methods2) Market Risk: In Line with 1993 & 19963) Operational Risk: Working on new

methods

Pillar I is trying to achieve◦ If the bank’s own internal calculations show that

they have extremely risky, loss-prone loans that generate high internal capital charges, their formal risk-based capital charges should also be high

◦ Likewise, lower risk loans should carry lower risk-based capital charges

Credit Risk Measurement 1) Standard Method: Using external rating for determining risk weights 2) Internal Ratings Method (IRB) a) Basic IRB: Bank computes only the

probability of default b) Advanced IRB: Bank computes all risk

components (except effective maturity)

Operational Risk Measurement 1) Basic Indicator Approach

2) Standard Approach

3) Internal Measurement Approach

Pillar I also adds a new capital component for operational risk◦ Operational risk covers the risk of loss due to

system breakdowns, employee fraud or misconduct, errors in models or natural or man-made catastrophes, among others

PILLAR 2: Supervisory Review Process

1) Banks are advised to develop an internal capital assessment process and set targets for capital to commensurate with the bank’s risk profile

2) Supervisory authority is responsible for evaluating how well banks are assessing their capital adequacy

PILLAR 3: Market Discipline Aims to reinforce market discipline through

enhanced disclosure by banks. It is an indirect approach, that assumes sufficient competition within the banking sector.

To determine if the proposed rules are likely to yield reasonable risk-based capital requirements within and between countries for banks with similar portfolios, four quantitative impact studies (QIS) have been undertaken

Results of the QIS studies have been troubling◦ Wide swings in risk-based capital requirements◦ Some individual banks show unreasonably large

declines in required capital As a result, parts of the Basel II Accord

have been revised

The practices in Basel II represent several important departures from the traditional calculation of bank capital◦ The very largest banks will operate under a

system that is different than that used by other banks

◦ The implications of this for long-term competition between these banks is uncertain, but merits further attention

Basel II’s proposals rely on banks’ own internal risk estimates to set capital requirements◦ This represents a conceptual leap in

determining adequate regulatory capital For regulators, evaluating the integrity of bank

models is a significant step beyond the traditional supervisory process

Despite Basel II’s quantitative basis, much will

still depend on the judgments 1) of banks in formulating their estimates and 2) of supervisors in validating the assumptions

used by banks in their models