Basel II background and Risks relate to Banking Activities

Basel II background  and Risks relate to Banking Activities

Basel –II & its background:

Basel II background  and Risks relate to Banking Activities

Basel –II framework was finalized in 2004 & it states that bank should maintain capital not only covering Credit Risk but also covering Market Risk & Operational Risk. Here RWA should be calculated covering Market Risk & Operational Risk.

Capital Base:

  1. Regulatory Capital:

(a) Tier – 1 : Core Capital, comprises of highest quality capital elements and shall include:

  • Paid up Capital
  • Non-Repayable share premium account
  • Statutory Reserve
  • General Reserve
  • Retained Earnings
  • Minority interest in Subsidiaries
  • Non-Cumulative irredeemable Preferences Shares
  • Dividend Equalization account
  • Tier –2: Supplementary Capital, represents other elements, which fall short of some of the characteristics of core capital but contribute to overall strength of a bank and shall includes :
    • General Provision (1% of unclassified loan)
    • Asset Revaluation reserves
    • All Other Preference Shares
    • Perpetual Subordinate Debt
    • The balance of Exchange Equalization A/C.

(c)     Tier –3: Additional Supplementary, consists of short term sub-ordinate debts(maturity less than or equal to 5- years but greater that or equal to 2-years) for the purpose of meeting a proportion of the capital requirement for market risk

  • Short Term subordinated debt

The framework of Basel II captured whole lot of risks and requires banks to develop an Internal Capital Adequacy Assessment Process (ICAAP) and assign an appropriate amount of capital commensurate with their risk profile and control environment.

The Basel II framework recognizes the risk mitigates available to the banks for providing relief in the minimum capital requirement for the fact that the discipline exerted by the markets can be powerful as imposed by the Regulator and banks may get forwarded or penalized by the market forces in tune with the disclosures.  It governs capital adequacy of banks across the national border.

The Basel II consists of three mutually reinforced pillars and rules do apply to – commercial banks, savings banks, credit institutions, investment firms etc:

Pillar-I Minimum capital requirements :

Deals with the maintenance of regulatory capital calculated for three major components of risk-weighted assets (RWA) that a bank faces i.e. Credit risk, operational risk and market risk & other Supervisory risk

Pillar-II  Supervisory review of capital adequacy :

Deals with regulatory response to the first pillar, giving regulators much-improved tools over those available to them under basel-1. It is in the hands of the regulator to monitor and assess the Internal Capital Adequacy Assessment Process (ICAAP) of the bank.

Supervisors should determine whether a bank has in place a sound firm-wide risk management framework that enables it to define its risk appetite and recognise all material risks, including the risks posed by concentrations, securitisation, off-balance sheet exposures, valuation practices and other risk exposures. This can be achieved by:

  • Adequately identifying, measuring, monitoring, controlling and mitigating these risks;
  • Clearly communicating the extent and depth of these risks in an easily understandable, but accurate, manner in reports to senior management and the board of directors, as well as in published financial reports;
  • Conducting ongoing stress testing to identify potential losses and liquidity needs under adverse circumstances; and
  • Setting adequate minimum internal standards for allowances or liabilities for losses, capital, and contingency funding.

Pillar II also provides a framework for dealing with all other risks a bank may face such as –name risk, liquidity risk and legal risk, which the accord combines under the title of residual risk.

Bank Management will clearly bear primary responsibility for ensuring that the bank has adequate capital to its risks and a sound risk management system should have the following key features:

  • Active board and senior management oversight;
  • Appropriate policies, procedures and limits;
  • Comprehensive and timely identification, measurement, mitigation, controlling, monitoring and reporting of risks;
  • Appropriate management information systems (MIS) at the business and firm-wide level; and
  • Comprehensive internal controls.
Pillar-III  Market discipline:

Greatly increases the disclosures that the bank must make. This is designed to allow to have a better picture of the overall risk position of the bank and to allow the counter parties of the bank to price and deal appropriately.

In response to observed weaknesses in public disclosure and after a careful assessment of leading disclosure practices, the Committee proposed enhancements also respond to the Financial Stability Forum’s recommendations for strengthened Pillar III requirements and draw upon the Senior Supervisors Group’s analysis of disclosure practices.

(i) Securitisation exposures in the trading book;

(ii) Sponsorship of off-balance sheet vehicles;

(iii) Internal Assessment Approach (IAA) and other Asset Backed Commercial Paper (ABCP) liquidity facilities;

(iv) Resecuritisation exposures;

(v) Valuation with regard to securitisation exposures; and

(vi) Pipeline and warehousing risks with regard to securitisation exposures


What does Basel- II demand over Basel-I

 Basel –II demands a dedicated review body that will analysis real risk accordingly adequate capital planning (Pillar- II)

  • Basel –II cover capital charge for market & operational risk along with credit risk of Basel-I (Pillar-I)
  • Calculating risk weight of credit exposure in more rational than of Basel-I
  • Capital adequacy is supported by review of reality of risks relating with banking activities.
  • Basel –II assures more shock absorbent capacity of bank’s than Basel –I
  • Basel –II requires disclosure of risk as well as capital to meet the risk for attracting public confidence (Pillar-III)

Risks relate to Banking Activities:

Risk is nothing but possibility of losing assets through some activities i.e. in case of banking credit activity, market activity, operational activity etc.

Risk inherent with banking activities are:

  1. Credit Management Risk – Risk of counter party, Rates of Return, Operational Risk, Supervisory Risk
  2. Asset Liability Management Risk – Market Risk, Liquidity Risk, Operational Risk, Supervisory Risk
  3. Internal Control & Compliance Risk – Operational Risk, Supervisory Risk & Information Risk
  4. Foreign Exchange Transaction Risk – Market Risk & Operational Risk
  5. Money Laundering Prevention Risk –Credit Risk & Operational Risk
  6. Information & Communication Technology Risk – Operational Risk, Supervisory Risk & Disaster Risk
  7. Commodity/ Inventory Risk – Market Risk & Operational Risk
Basel II background  and Risks relate to Banking Activities

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