Basel II Accord – The bankers bond

Over the last few years in banking circles, the sleeping city of Basel in Switzerland has established an overriding association: the Basel II Accord.

Throughout the 1990s, the banking environment changed almost beyond recognition: the introduction of automated technologies created global systems and global – rather than local – risks; the development of ecommerce increased the potential for misuse and fraud; systems integration problems arose following large-scale mergers and consolidations; exponentially high transaction rates and volumes concentrated risks and increased the scale of potential losses; and the use of outsourcing agencies meant the aggregation and transfer of risks.

The original set of rules designed to established minimum capital requirements for banks around the globe – the Basel Capital Accord agreed between the G-10 central banks in 1988 and implemented in 1992 – were rendered archaic by that rapid evolution.


Behind Basel II

The New Basel Capital Accord, or Basel II, is due to take effect on 1 January 2006 and will set demanding new standards on financial institutions, and their systems and processes, with the aim of ensuring that they can more confidently manage credit and commercial and operational risk.

The proposals utilise the ‘three pillar' system used in Basel I, which has been in effect between 1992 and 2005:

  • PILLAR 1: Capital Requirements
    This pillar covers the calculation of minimum capital requirements for credit, market and operational risk. A new floor of 8% – down from 20% – has been established.

  • PILLAR 2: Supervisory Review
    Largely relating to developing a globally consistent supervisory process, this pillar refers to the key principles of supervisory review, risk management guidance and supervisory transparency and accountability with respect to banking risks. It includes the terms relating to the treatment of interest rate risk in the banking book, operational risk and aspects of credit risk (stress testing, definition of default, residual risk, credit concentration risk and securitisation).

  • PILLAR 3: Market Discipline
    This pillar covers the introduction of disclosure requirements for banks using the New Accord. Supervisors have an array of measures that they can use to require banks to make such disclosures. Some of these disclosures will be qualifying criteria for the use of particular methodologies or the recognition of particular instruments and transactions.



So in January 2001 a proposal for a new Basel Capital accord, Basel II, was issued by the banks.

One of the key changes in Basel II relates to the proportion of a bank's capital assets that must be set aside in case unexpected payments need to be made (such as a default on a major loan).

While historically that proportion might have been 20% or more, Basel II offers a reduction to as little as 8% – as long as the bank can prove it complies with a new set of rules, representing a major incentive to comply with the regulations.

One of the central thrusts of Basel II is that it requires banks to take a wider view of risk by including operational risk as a factor in determining capital requirements. The lower the operational risk, the lower the capital requirements.

Thus operational risk is defined as "the risk of losses resulting from inadequate or failed internal processes, people and systems, or external events".

A range of operational risk types have been identified in Basel II and these include :

  • internal fraud
  • external fraud
  • employment practices and workplace safety
  • clients, products and business practices damage to physical assets
  • business disruption and system failures
  • execution, delivery and process management.

Critics of Basel II claim that it will lead to further consolidation among banks, so limiting access to credit and increasing the cost of debt. There is also an argument that the mechanics of Basel II will increase the amplitude of economic cycles, as access to capital becomes constrained during the downward leg of an economic cycle, intensifying corporate financial distress.

A recent research report from management consultants McKinsey suggests that Basel II has demanded substantial investment. For large, diversified global banks, the cost has typically been in the region of $100 million, but the biggest spenders have invested as much as $250 million.

Basel II's objective – instilling best-practice, sophisticated, analytically-driven risk management policies based on the quality of each bank's experience – will significantly increase overall technology requirements. And for most banks, enhanced IT systems and large-scale data integration will account for more than 75% of the investment that the new accord requires – and that has made Basel II the main drain on banking budgets.

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Ben Rossi

Ben was Vitesse Media's editorial director, leading content creation and editorial strategy across all Vitesse products, including its market-leading B2B and consumer magazines, websites, research and...

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