13.4 The problems of globalisation and the growing complexity of derivatives markets

risk parameters used in the estimate of the overall value-at-risk against which capital

must be held.

In July 1994, the Basel Committee (1994) and the International Organisation

of Securities Commissions (IOSCO) produced a joint policy statement on the over-

sight of the risk management process by senior management; the measurement,

control and reporting of risk exposures; and the internal controls and audits re

risk management. In April 1995, following the collapse of Barings (see Box 9.5), the

Basel Committee agreed to allow banks to use their own computer models to assess

the risks arising from market volatility, rather than complying with standardised

measures of volatility and risk for particular nancial instruments. In addition, for

the rst time, capital charges were required to cover commodities risks. The Com-

mittee later supported a number of steps to improve the quality of risk management.

These included stress tests that examine the overall impact of a worse case scenario

(such as a repeat of the 1987 stock market crash) on a bank’s capital base. In addition,

it supported the separation of the trading and settlement arms of banks’ trading

divisions.

There are still worries about the reliability of the computer models concerning the

more complex derivatives products and about the ability of regulators to evaluate

the models. It is also feared that the use of the models will greatly reduce the trans-

parency of nancial markets because only banks and regulators will know the basis

on which risks have been measured.

In June 1999, the Basel Committee issued a proposal for a new, capital adequacy

framework that will replace the 1988 accord and be known as the New Basel Capital

Accord or Basel II. The original Basel framework is now known as Basel I. Following

consultation, a modied proposal was published in January 2001. Yet further con-

sultations were needed with the industry, however, and a third version was pub-

lished in April 2003. The present plan is for the new accord to go into operation

from the end of 2006. Basel II will apply to large complex organisations. In the US,

for example, one or two dozen banks are expected to move to Basel II at the end of

2006. Other banks will remain Basel I institutions but amendments are also being

made to Basel I to enhance the risk sensitivity of the Basel I rules and to mitigate

potential competitive distortions from the introduction of Basel II.

The Basel II rules incorporate the use of internal risk models to assess credit risk,

the allowance for market risk and operational risk in the standardised calculation of

the risk–asset ratio, and attempts to deal with the greater use of off-balance-sheet

asset securitisation by banks.

The new capital framework consists of three pillars:

l	Minimum capital requirements, developing and expanding on the standardisedrules set forth in the 1988 Accord.

l	A supervisory review of an institution’s capital adequacy and internal assessmentprocess.

l	The effective use of market discipline to strengthen disclosure and encourage safeand sound banking practices.

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Chapter 13 • The regulation of nancial markets

The three pillars are seen as part of a single package and are to be implemented

together. Basel II has been designed to improve the extent to which regulatory

capital requirements reect underlying risks and to address specically the nancial

innovation that has occurred in recent years. It also aims to reward the improve-

ments in risk management and control and to provide incentives for these to

continue.

Basel II retains the standardised formula for the risk-weighting of assets and makes

no changes to the denition of capital. The minimum ratio of capital to risk-weighted

assets including operational and market risks will remain at 8 per cent for total

capital. Tier II capital will continue to be limited to 50 per cent of total Tier I and

Tier II capital. Under the New Basel Accord, the denominator of the ratio will consist

of two parts:

l	the sum of all risk-weighted assets for credit risk; plus
l	12.5 times the sum of the capital charges for market risk and operational risk.

Assuming that a bank has $875 of risk-weighted assets, a market risk capital charge

of $10 and an operational risk capital charge of $20, the denominator of the total

capital ratio would equal 875 [(10 20) 12.5)] or $1250.*

The major difference from the 1988 Accord lies in the adoption of an internal-

ratings-based (IRB) approach, which places greater emphasis on banks’ own assess-

ment of the risks to which they are exposed. The IRB approach aims to be more

sensitive to different kinds and degrees of risk, allowing the incorporation of a much

wider range of assets. It is to be introduced at two levels: foundation and advanced.

A foundation IRB approach combines a signicant external assessment of risk factors

with elements of a bank’s own risk assessment. Thus, banks that meet robust super-

visory standards will make their own assessment of the probability of default associated

with assets, but estimates of additional risk factors, such as the expected exposure

of the bank if a default occurs, will be made externally through the application of

standardised supervisory estimates. The advanced IRB approach will be available to

banks that meet even more rigorous supervisory standards and will allow more of the

risk components to be estimated internally by the bank. However, the Committee

has stopped short of permitting banks to calculate fully their capital requirements

on the basis of their own portfolio credit risk models.

The Basel Committee, while acknowledging that asset securitisation can be an

efcient way for a bank to redistribute its credit risks to other banks and non-bank

investors, has become increasingly worried by the way in which some banks have

used it to avoid holding a sufcient level of capital for their risk exposures. Thus, the

New Basel Capital Accord develops standardised and IRB approaches for treating the

explicit risks that securitisations pose for banks, setting out operational, disclosure

and minimum capital requirements for them.

* This example is taken from Overview of the New Basel Capital Accord published by the Basel

Committee on Banking Supervision (Basel: BIS, January 2001).

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