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Banking Regulations: The Basel 2 Accord

The New Basel Accord, or Basel 2, enforced in 2007, focuses on capital requirement definitions (Pillar 1), with major enhancements to credit risk measures, a first coverage of operational risk, disclosure, supervisory review process (Pillar 2), and market discipline (Pillar 3). Simultaneously, it enhances some features of the 1988 "Accord."

This chapter does not follow the complex set of intertwined rules as expanded in the final version of the Accord [7]. Rather, it focuses on the main building blocks of Basel 2 for providing an overview of the principles implemented in the accord. Basel 2 offers several approaches and sub-approaches that banks may select. The entry point is the asset class for describing approaches (available on the BIS site). This chapter is based on the document: Basel Committee on Banking Supervision, (June 2006), "International Convergence of Capital Measurement and Capital Standards - A Revised Framework, Comprehensive Version," Bank for International Settlements, Basel, Switzerland.

For having a comprehensive overview of regulatory issues, the reader should also refer to the introduction and conclusion of this text, which summarizes some main features of current proposals at the time of writing.

THE NEW BASEL ACCORD

The New Basel Accord sets new rules for making credit risk capital charges more risk sensitive, recognizing various form of credit risk mitigation, providing various enhancements to the former Basel 1 Accord credit risk measures, adding capital requirements to operational risk, and detailing the "supervision" and the "market discipline" "pillars." The new accord is not simple, with several approaches and sub-approaches differentiated across several asset classes, and adding up as well sub-approaches for credit risk mitigation and dedicated approaches to specialized finance and securitizations.

The new accord defines capital charges for credit risk and operational risk. It treats interest rate risk of the banking book under Pillar 2 (supervisory review process), rather than imposing capital requirements.

The new accord provides a more "risk-sensitive" framework that should considerably reduce distortions between the standard capital charges of Basel 1 and the actual credit risk of counterparties and facilities. It differentiates the risk according to the credit standing of borrower and the transaction-specific guarantees.

The new accord comprises three pillars:

• Pillar 1: minimum capital requirements

• Pillar 2: supervisory review process

• Pillar 3: market discipline.

The accord provides three main approaches for Pillar 1: the "Standardized" approach and the "Foundation" and "Advanced" approaches, which are internal ratings-based (IRB) approaches. A distinctive feature of Basel 2 is to rely on credit ratings for making capital more risk-sensitive. Only the foundation and the advanced approaches use internal credit ratings assigned by the bank to all counterparties, while the standardized approach relies on external ratings when available.

The standardized approach is used only for banks that have no eligible credit rating system, and capital charges are driven by supervisory rules in this case. Basel 2 allows a broader recognition of guarantees for reducing the capital charge. This is the credit risk mitigation (CRM) building block of Basel 2.

Pillar 1 is dedicated to capital treatment. For capital treatment, asset classes are the entry point. Each portfolio of facilities of a bank is assigned an asset class. Capital charge for credit risk proceeds from there and depends, among other factors, on credit ratings of borrowers and on CRM, by asset class. Specialized lending and securitization exposures have a special capital treatment.

The calculation of capital is based, as in Basel 1, on risk weights (RW). A risk weight of 100% corresponds to a ratio of capital to asset value of 8%. The capital charge is calculated as:

capital — RW x exposure x 8%

The risk weights, under the IRB approaches, depend on "credit risk components," except for specialized lending and securitizations, the main ones being the size of exposure, the default probability, and the loss under default after recoveries. The Basel 2 Accord requires an extensive usage of credit risk data, and imposed a significant enhancement of existing data. It extends the scope of required data as well as their quality. For operational risk, the risk data had to be collected according to a new taxonomy of such risks for quantification purposes.

This chapter presents the major Basel 2 building blocks. The purpose is to introduce the main features of the accord, without blurring the description with the overwhelming amount of rules and conditions imposed in the detailed accord. In some instances, excerpts of the Basel 2 Accord are used, which are self-explaining.

 
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