Basel II, is the second Basel Accord and represents recommendations by bank supervisors and central bankers from the 13 countries making up the Basel Committee on Banking Supervision to revise the international standards for measuring the adequacy of a bank's capital. It was created to promote greater consistency in the way banks and banking regulators approach risk management across national borders. An earlier Accord, Basel I, adopted in 1988, is now widely viewed as outmoded as it is risk insensitive and can easily be circumvented by regulatory arbitrage. The Basel II deliberations began in January 2001, driven largely by concern about the arbitrage issues that develop when regulatory capital requirements diverge from accurate economic capital calculations.
IMPLEMENTATION OF BASEL II IN PAKISTAN
State Bank of Pakistan vide its BSD Circular No. 3 of 2005 dated March 31, 2005 has decided to adopt the Basel II in Pakistan. The timeframe for adoption of different approaches under Basel II is as under:-
i) Standardised approach for credit risk and basic indicator / standardised approach for operational risk from January 1, 2008.
ii) Internal Ratings Based (IRB) approach from January 1, 2010.
Banks/DFIs will be required to adopt a parallel run of one and a half year for standardised approach and two years for IRB approach starting from July 1, 2006 and January 1, 2008 respectively. State Bank of Pakistan has also issued a roadmap for implementation of Basel II requiring all Banks / Development Financial Institutions (DFIs) to ensure completion of the actions on their part within the specified timeframe. The roadmap is available on SBP’s website.
SALIENT FEATURES AND OVERVIEW
The objectives of the Accord are:
• to maintain safety and soundness in the financial system and to therefore maintain at least
the current level of capital in the system;
• to enhance competitive equality;
• to introduce a more risk sensitive framework that closely aligns internal economic capital
with regulatory capital; and
• to focus on internationally active banks.
The Accord has formalised a framework consisting of three pillars:
• Pillar 1 - minimum capital requirements
• Pillar 2 - supervisory review
• Pillar 3 - market disclosure
Pillar 1
Pillar 1 provides approaches to the calculation of capital charges in the areas of credit, operational and market risk. Increasingly complex methods of calculation are allowed and the Basel Committee expects banks to move to the advanced approaches as their internal risk management techniques develop.
Capital charges in relation to Operational Risk have been considered for the first time in the Accord and are due to a number of areas: new complex financial products and strategies, specialised processing operations and reliance on rapidly evolving technology, outsourcing and recent bank failures and associated losses. A wider range of credit risk mitigants has also been considered for the first time.
Pillar 2
Pillar 2 provides the framework to ensure that each bank has sound internal processes to enable it to perform a thorough evaluation of its risks and therefore assess the required economic capital.
Supervisors are required to assess the banks internal processes based upon their knowledge of best practices elsewhere.
The Accord promotes an active dialogue between the banks and their supervisors to enable the supervisors to focus their attention on those banks who most warrant it.
Interest rate risk arising from the banking book is treated under Pillar 2 and supervisors will have the responsibility for assessing the various methodologies for calculating this risk.
Pillar 3
This requires new disclosures to encourage market discipline. The disclosures address market, credit and operational risks and supervisors are required to implement at least a minimum core set of disclosure requirements. In addition, they can request further supplementary disclosures where appropriate. It is assumed that this will not be an onerous task, as the banks should be already producing this information.
The new Accord will apply on a fully consolidated basis including holding companies, which are parents of groups that are predominantly banking groups. The Accord should be applied to every tier within a banking group on a consolidated basis and on a stand-alone basis. Transitional periods have been suggested for those countries where sub-consolidation is not a current requirement.
Insurance activities are currently excluded as the requirements of the Accord do not specifically address insurance risks, supervisors should look at the capitalisation of these activities separately.
Supervisors need to ensure that the various components of the organisation, as well as the organisation space as a whole, are adequately capitalised.
It is hoped that the members would find this information and education series useful in
understanding this complex but important subject.
