The Basel II Accord, which addresses recommendations on banking sector regulations and laws, is split into three main categories, often referred to as the “three pillars” of the accord, being: Minimum Capital Requirements, Supervisory Committee, and Market Discipline. As the name suggests, the first pillar deals with the requirement of having sufficient capital to cover the three main risk components faced by banks, that of credit risk, market risk and operational risk, and while banks are exposed to additional risks in day-to-day business, these are addressed in the second pillar of the Basel II Accord. Credit risk is calculated by using the Standardized Approach utilizing external assessment procedures; the Foundation Internal Rating-Based Approach (IRB); or the Advanced IRB. Operational risk is measured in one of three ways, being the Basic Indicator Approach (BIA), Standardized Approach (TSA), or the Internal Measurement Approach – an adaptation of the Advanced Measurement Approach (AMA). The preferred method of assessing market risk is by means of Value at Risk (VaR).
The second pillar, Supervisory Committee, sets regulating guidelines based on the response to the first pillar. In addition to providing regulators with these guidelines, the second pillar deals with other risks not addressed under the first pillar (credit risk, market risk and operational risk), such as systemic risk, pension risk, strategic risk, concentration risk, reputation risk, legal risk and liquidity risk, these being combined under residual risk. The second pillar, therefore, provides a framework within which banks can review, and revise where necessary, their risk management systems.
The third pillar, Market Discipline, encourages prudent management and a high degree of transparency with regard to reporting to shareholders and customers, particularly when it comes to revealing their compliancy with Minimum Capital Requirements (pillar one).
It is anticipated that the implementation of Basel II will enable all parties concerned to discern whether a banking organization is managing their risk adequately. This could lead to a bank being rewarded for managing their risks well, while those that don’t are likely to face penalties. At the very least, it will give investors more insight into which bank to add to their investment portfolios.
