Capital requirements rules state that credit institutions, like banks and building societies, must at all times maintain a minimum amount of financial capital, in order to cover the risks to which they are exposed. The aim is to ensure the financial soundness of such institutions, to maintain customer confidence in the solvency of the institutions, toensure the stability of the financial system at large, and to protect depositors against losses.
The Basel Committee on Banking Supervision was established at the end of 1974 to provide a forum for banking supervisory matters. The Basel Committee is made up of senior officials responsible for banking supervision or financial stability issues in central banks and other authorities in charge of theprudential supervision of banking businesses. Members of the Basel Committee come from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the UK and the US.
Although the Basel Committee is not a formal regulatory authority in itself, it has great influence over the supervising authorities in many countries. The hope is that by agreeing basicgoals, the Committee can achieve common approaches and common standards across many member countries, without attempting detailed harmonisation of each member country's supervisory techniques.
In 1988, recognising the emergence of larger more global financial services companies, the Committee introduced the Basel Capital Accord (Basel I). This sought to strengthen the soundness and stability ofthe international banking system by requiring higher capital ratios.
Since 1988, the framework contained in Basel I has been progressively introduced not only in member countries but also in virtually all other countries with active international banks. In June 1999, the Committee issued a proposal for a new Capital Adequacy Framework to replace Basel I. Following extensive communication withbanks and industry groups, the revised framework was issued on 26th June 2004 and is known as Basel II.
II. BASEL II BASICS
The objective of Basel II is to modernise the existing capital requirements framework to make it more comprehensive and risk-sensitive, taking account of many modern financial institutions' thorough risk management practices.
The Basel II framework is therefore more sensitiveto the real risks that firms face. As well as looking at financial figures, such as how much money the firm controls, it also considers operational risks, such as the risk of systems breaking down or people doing the wrong things.
It reflects improvements in firms' risk management practices, for example by the introduction of the internal ratings based approach ( IRB ). The IRB approach allowsfirms to rely to a certain extent on their own estimates of credit risk. It also introduced the Advanced Measurement Approach ( AMA ) which allows firms to take account of their operational risks in assessing capital adequacy.
A key aspect of the new framework is its flexibility. It provides institutions with the opportunity to adopt the approaches most appropriate to their situation and to thesophistication of their risk management.
The Basel II framework consists of three 'pillars':
• Pillar 1 sets out the minimum capital requirements firms will be required to meet to cover credit, market and operational risk.
• The rules under Pillar 2 create a new supervisory review process. This requires financial institutions to have their own internal processes to assess their capitalneeds and appoint supervisors to evaluate an institutions’ overall risk profile, to ensure that they hold adequate capital.
• The aim of Pillar 3 is to improve market discipline by requiring firms to publish certain details of their risks, capital and risk management.
III. BASEL II AND THE CAPITAL REQUIREMENTS DIRECTIVE
Basel II applies to internationally-active banks. In the European Union,...