The aim of Basel II is to better align the minimum capital required by regulators (so-called regulatory capital) with risk. This inevitably requires a more complex regime, given that some of the greatest anomalies in the first Basel Accord stemmed from its simplicity – for example all unsecured corporate exposures were weighted 100% whether the company was a highly profitable global giant or a struggling small business. As a result Basel II is far more complex than Basel I and goes far beyond Basel I is its scope.

Basel II came into effect in the European Union on 1 January 2007 under the Capital Requirements Directive (CRD) and all lenders covered by the CRD have had to implement it from the beginning of 2008.

Structure of Basel II

Basel II consists of 3 ‘pillars’ which enshrine the key principles of the new regime. Collectively, they go well beyond the mechanistic calculation of minimum capital levels set by Basel I, allowing lenders to use their own models to calculate regulatory capital while seeking to ensure that lenders establish a culture with risk management at the heart of the organisation up to the highest managerial level.

Pillar 1 sets out the mechanism for calculating minimum regulatory capital. Under Basel I this calculation related only to credit risk, with a calculation for market risk added in 1996. Basel II adds a further charge to allow for operational risk.

Credit Risk

While Basel I offered a single approach to calculating regulatory capital for credit risk, one of the greatest innovations of Basel II is that it offers lenders a choice between:

1. The standardised approach.

This follows Basel I by grouping exposures into a series of risk categories. However, while previously each risk category carried a fixed risk weighting, under Basel II three of the categories (loans to sovereigns, corporates and banks) have risk weights determined by the external credit ratings assigned to the borrower.
Amongst the other categories that continue to have fixed risk weights applied by Basel II, loans secured on residential property carry a risk weight of 35% against 50% previously, as long as the loan-to-value (LTV) ratio is up to 80%. This lower weighting is a recognition of the historically low rate of losses typically incurred on residential mortgage loan portfolios across different countries and over a range of economic environments.

2. Foundation internal ratings based (IRB) approach.

Lenders are able to use their own models to determine their regulatory capital requirement using the IRB approach. Under the foundation IRB approach, lenders estimate a probability of default (PD) while the supervisor provides set values for loss given default (LGD), exposure at default (EAD) and maturity of exposure (M). These values are plugged into the lender’s appropriate risk weight function to provide a risk weighting for each exposure or type of exposure.

3. Advanced IRB approach.

Lenders with the most advanced risk management and risk modelling skills are able to move to the advanced IRB approach, under which the lender estimates PD, LGD, EAD and M. In the case of retail portfolios only estimates of PD, LGD and EAD are required and the approach is known as retail IRB.

Given that a key objective of Basel II is to improve risk management culture, it is unsurprising that the regime encourages lenders to move towards the IRB approach and ultimately, the advanced or retail IRB approach. To this end, most banks can expect to see a modest release of regulatory capital in moving from the standardised to foundation IRB approach and on to the advanced or retail IRB approach.

Operational Risk

The Accord defines operational risk as ‘the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events’. In keeping with the approach to credit risk, it provides three mechanisms for computing operational risk of rising complexity to suit lenders’ varying characteristics.

Pillar 2 is meant to identify risk factors not captured in Pillar 1, giving regulators discretion to adjust the regulatory capital requirement against that calculated under Pillar 1. For most lenders, the Pillar 2 process results in a higher regulatory capital requirement than calculated under Pillar 1 alone. Pillar 2 requires banks to think about the whole spectrum of risks they might face including those not captured at all in Pillar 1 such as interest rate risk.

Pillar 3 is designed to increase the transparency of lenders’ risk profile by requiring them to give details of their risk management and risk distributions. Information is released through the normal mandatory financial statements lenders are required to publish or through lenders’ websites.

The recent global financial crisis has revealed weaknesses in the whole approach to risk management that has been developed through the Basel II process. Management has been expected to be vigilant about risk but risks have come from unexpected places. Assumptions about the liquidity of financial instruments such as mortgage backed securities (MBS) that were based on past performance have proven unfounded as has the reliability of credit ratings on many of these MBS.

The financial crisis has also shown that at times of severe stress the inter linkages amongst banks and between banks and other financial institutions have the potential to create a domino effect whereby seemingly safe lenders can be put at risk by exposure to counterparties that turned out to be less safe than thought.