An investigation of the impact of Basel II on the improvement in risk management practice globally

Executive summary:

The new Basel Accord will be introduced in 2007, this essay examines in how far the new package of regulations will benefit risk management globally. After evaluating contradictory points of view of several internationally active groups, the author comes to the conclusion that even though the final impact cannot yet be observed Basel II is likely to improve the current situation of risk management in the market.

Keywords: Basel II, Risk management.

Introduction

This essay is going to have a deeper look on how risk management globally is affected by Basel II. Therefore the author is going to summarise the key aspects of Basel II in comparison to Basel I, followed by a critical evaluation of these changes taking the reader through points widely considered as positive accompanied by some opinions from market representatives, equally drawing the attention to some drawbacks and suggested improvements. The essay will be closed with concluding remarks from the author.

The initial Accord: An Overview.

Basel II is going to replace the former Basel I accord by the beginning of 2007. The initial accord, adopted in 1988, basically set a capital reserve requirement on internationally active banks from the G10 countries of eight percent of risk-adjusted assets (Basel Committee on Banking Supervision, 1999, 2001). This measure was to cover expected losses on loans outstanding (Diana, 2005). Table 1 gives a brief overview over the Basel I accord risk weights.

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The initial intention of Basel I was to create a playing field for international banking. Large financial institutions of some countries were able to take tremendous risks without having large amounts of capital as their governments spoke out implicit guarantees (Rochet, 2004). “So the fundamental idea behind the Cooke ratio was harmonization” (Rochet, 2004, p. 14).

Jim Herrity, a Director of Moody’s KMV, noted that “Many bankers were dissatisfied with the one size fits all regulatory capital requirements of Basel I, arguing that banks that have more accurate risk rating systems should be allowed to calculate their own regulatory capital requirements” (cited in Diana, 2005). The exact figure of eight percent, into the bargain, was always a topic for discussion and was usually criticised for being too crude (Decamps et al, 2002). For example an adequately collateralised loan required equal capital weighting as an inadequately collateralised one. However, more than 100 countries adopted the Basel I Accord which makes it a major milestone in the history of banking regulations (Ghosh, 2004).

Basel II: the key points

In June 1999 the Basel Committee on Banking Supervision (“Basel Committee”) of the Bank for International Settlements (BIS), with its headquarter in Basel, Switzerland released a proposal for a new capital accord with the name: “International Convergence of Capital Measurement and Capital Standards: A Revised Framework” which came to be referred to as Basel II. Basel II introduces more sophisticated risk measurement techniques and allows the use of internal ratings, called IRB-approaches, in addition to external ratings (Grunert et al, 2002).

The main objectives of the new Basel Capital Accord are: an improvement of risk-sensitivity in banks’ capital allocation, calculation of detached capital charges for operational risk^[1] and credit risk and bringing the Regulatory capital requirements more in formation with banks’ Economic Capital requirements.

Finally Basel II is supposed to give confidence to banks to use their internal systems and models in order to calculate adequate levels of Regulatory Capital as Jaime Caruana, Chairman of the Basel Committee on Banking Supervision and Governor of the Banco de España, said in his Hong Kong speech on February 4th 2005: “Basel II is to provide an economic incentive for banks to develop reliable risk management techniques, because those with the best risk assessment systems will be viewed more favourably in the marketplace” (Caruana, 2005). To reinforce these objectives the regulatory framework of the new Basel Accord consists of three pillars that reciprocally reinforce each other: Minimum Capital Requirements, Supervisory Review process and Market Discipline (Ghosh, 2004). Three factors determine the amount of capital requirements faced by a bank: Capital Risk, Market Risk and Operational Risk. Figure 1 shows in how far Basel II revises the requirements and tools used to measure Credit Risk and Operational Risk. There is no re-regulation of Market Risk in Basel II (Grunert et al, 2002).

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^[1] The Basel definition of operational risk states it is “the risk of direct and indirect loss resulting from failed or inadequate processes, systems or people or from external events” (Basel Committee on Banking Supervision, 2001)