The operations of Basil Essay Example for Free

The operations of Basil Essay 1.1 The operations of Basil II Basel II was developed to ensure that there is less risk on capital allocation, unraveling operational risk from credit risk and quantifying both, and attempting to align economic and regulatory capital more closely to reduce the possibility of regulatory arbitrage. 1.2 The pillars used in Basel II The Basel II International Convergence of Capital Measurement and Capital Standards, the reviewed framework is based on three main pillars. 1.2.1 First Pillar – Minimum Capital Requirements The first principle of this revised framework comprises the minimum capital requirements necessary to cater for the three fundamental risks that a bank faces in business operations. These consist of Credit risk, Capital risk and Operational risk, which shall be further expounded below: A choice between two main methodologies is allowed by the Basel Committee on Banking Supervision for the determination of credit risk. These consist of the standardized approach and the internal rating based approach, which is further divided into the foundation and advanced internal rating based system.   Under the standardized scheme, a set of external credit ratings achieved from recognized agencies are utilized in the determination of capital risk.   A number of countries intend to authorize only this approach in credit risk measurement. The internal rating based model permits banks to develop their own experimental model to determine the probability of default for isolated clients or segmented customer groups.   Adoption of the regulator’s loss given default and other set parameter is necessary. As regards the Operational Risk, three approaches are suggested under the Basel II International Convergence of Capital Maintenance and Capital Standards revised framework, which consist of the Basic Indicator Approach, Standardized Method, and the Advanced Measurement Scheme. The standardized approach is similar to the same model applied for capital risk, explained in the previous bullet.   As regards the Advanced Measurement System, this entails the development of an empirical business model originating by the bank for the quantification of operation risk.   Section 664 of the original Basel demands that a minimum of a board of directors and senior management, a conceptually sound operational risk management structure and enough resources for the proper adoption of this scheme. Under the Basic Indicator Approach, banks are required to hold capital for operational risk corresponding to the average over a three year time frame of a fixed percentage of a positive annual gross income. For the Market risk there is on suggested approach, commonly known as the Value at Risk Method. The positioning of financial instruments should either be made with the objective of trading or hedging.   The three main parameters is this model are: The confidence level at which the forecast is made; The monetary currency unit that will be adopted to denominate the market risk; and The time horizon that will be examined. 1.2.2 Second Pillar – Supervisory Review Process The basic principles of this pillar of the Basel II International Convergence of Capital Maintenance and Capital Standards revised framework include the supervisory review and transparency, risk management direction and accountability of the adoption of the aforementioned revised concept. The supervisory review process is designed not only to ensure that targeted banks possess proper capital to sustain all the risks in their business, but also to induce banks to develop and maintain better risk management techniques in monitoring and assessing their respective risks.   There are the following four key principles of the supervisory review: A process for evaluating the overall capital adequacy of banks with respect to their risk profile and strategy. Supervisors assigned ought to review the banks’ internal capital adequacy assessments/strategies, and monitor to make sure compliance with regulatory capital ratios. Monitoring that banks operate above the minimum regulatory capital ratios. Supervisors are expected to arbitrate at an early stage to avoid banks’ capital from falling below the minimum levels set. The Committee has also identified the following vital issues that banks and supervisors are required to focus on:   interest rate risk in the banking book, credit risk and operational risk.   It is also recognized that since supervision of banks is not an exact science, discretionary measures and procedures ought to be adopted.   The importance of transparency, accountability and proper cross-border communication and cooperation arise in this respect. 1.2.3 Third Pillar – Market Discipline Disclosure requirements are highly focused in this final pillar in order to induce the market to perceive a better picture of the general risk position of the banks and thus sustain counterparties of the bank to price and deal correctly.   This last pillar is also aimed to compliment the previous two important areas discussed. The Committee recognizes the factor that the supervisor is a key player in the achievement of disclosure requirements.   Such market discipline is a vital feature for a safe and sound banking environment.   This safe environment arises from additional information disclosed in periodic and annual financial reports.   The methods that can be adopted in order to induce these disclosure requirements may vary depending on the countries legislation and present practices.   Examples that come to mind are through penalties, advices and more. The Basel II International Convergence of Capital Maintenance and Capital Standards revised framework also notes that such necessary disclosure requirements ought to be practical and in line with accounting standards and other relevant regulations.   For instance, management is allowed to use his discretion in the determination of the location and medium of these disclosures.   Materiality, frequency and proprietary and confidential information are also considered in order to minimize such reporting costs and ensure that organizations are not put in any competitive disadvantage with the application of such information requirement. The disclosure requirements demanded encompass a number of factors, such as: General qualitative disclosure requirements on each risk area. Capital structure. Capital adequacy. Brief description of different entities in case of business combinations. Aggregate amounts of firm’s total interest in insurance entities. References: Bank for International Settlements (2004). Basel II International Convergence of Capital Maintenance and Capital Standards: a Revised Framework (on line). Available from: http://www.bis.org/publ/bcbs107.htm (Accessed 16th April 2007). Basel Committee on Banking Supervision (2004).   International Convergence on Capital Measurement and Capital Standards. Switzerland: Bank for International Settlements