Basel II uses a "three pillars" concept:
- minimum capital requirements (addressing risk),
- supervisory review and
- market discipline.
The first pillar
The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk, and market risk. Other risks are not considered fully quantifiable at this stage. The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach, Foundation IRB and Advanced IRB. IRB stands for "Internal Rating-Based Approach". For operational risk, there are three different approaches - basic indicator approach or BIA, standardized approach or TSA, and the internal measurement approach (an advanced form of which is the advanced measurement approach or AMA). For market risk the preferred approach is VaR (value at risk). Asymptotix promotes Siag's Market Risk Engines. Siag’s paradigm advance in Market Risk Engine calculation speed and performance with Tier 1 portfolio data volumes means that a full range of VaR calculations may be modelled along with other statistical measures such as VaE, ESF and P&L Vectors; fully stress tested and back tested to full portfolio revaluation in typically only an hour.
Credit Risk can be calculated by using one of three approaches:
- Standardised Approach
- Foundation IRB (Internal Ratings Based) Approach
- Advanced IRB Approach
The standardised approach sets out specific risk weights for certain types of credit risk. The standard risk weight categories are used under Basel 1 and are 0% for short term government bonds, 20% for exposures to OECD Banks, 50% for residential mortgages and 100% weighting on unsecured commercial loans. A new 150% rating comes in for borrowers with poor credit ratings. The minimum capital requirement (the percentage of risk weighted assets to be held as capital) remains at 8%.
For those Banks that decide to adopt the standardised ratings approach they will be forced to rely on the ratings generated by external agencies. Certain Banks are developing the IRB approach as a result.
The second pillar
The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk and legal risk, which the accord combines under the title of residual risk. It gives banks a power to review their risk management system.
The third pillar
This pillar aims to promote greater stability in the financial system. Market discipline supplements regulation as sharing of information facilitates assessment of the bank by others including investors, analysts, customers, other banks and rating agencies. It leads to good corporate governance. The aim of pillar 3 is to allow market discipline to operate by requiring lenders to publicly provide details of their risk management activities, risk rating processes and risk distributions. It sets out the public disclosures that banks must make that lend greater insight into the adequacy of their capitalisation. when marketplace participants have a sufficient understanding of a bank’s activities and the controls it has in place to manage its exposures, they are better able to distinguish between banking organisations so that they can reward those that manage their risks prudently and penalise those that do not.