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Business Policy

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Introduction

Basel II is the term which refers to a round of deliberations by central bankers from round the world. In 1988, the Basel Committee (BCBS) in Basel, Switzerland, published a set of minimal capital requirements for banks. This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten (G-10) countries in 1992, with Japanese banks permitted an extended transition period. Purpose of the original 1988 accord was twofold:

First, it aimed at creating a "level playing field" among banks by raising capital ratios, which were generally perceived as too low in many countries; and second, it also aimed at promoting financial stability by adopting a relatively simple approach to credit risk with the potential to distort incentives for bank risk-taking. The guidelines of Basle accord were originally adopted by the central banking authorities from 12 developed countries (all G-10 countries plus Luxembourg and Switzerland) in July, 1988. Their implementation started in 1989 and was completed four years later in 1993. Basel I served banking industry well since its introduction in 1988 but it lagged behind the financial market developments and innovation. It increasingly became outdated and flawed as it relied on a relatively crude method of assigning risk weights to assets, emphasizing mostly on balance sheet risks relative to multiple risks facing financial firms today. Furthermore, it offered a regulatory approach to capital determination and standard setting which did not capture fully the range of large and complex banking operations and the accompanying range of diverse set of economic risks. Addressing the perceived shortcomings and structural weaknesses of Basel I, the Basel II Accord - a landmark regulatory framework - offers a newer and comprehensive approach and methodology for financial sector regulatory capital calculation which recognizes well the advancements and innovations in banks' businesses, policies and structures and the accompanying financial engineering and innovation. The relevance and significance of Basel II stems from its ability to recognize effectively the different types of risks facing industry and the new products as well as off balance sheet transactions. Basel I is now widely viewed as outmoded, and a more comprehensive set of guidelines, known as Basel II are in the process of implementation by several countries.

Background

The Basel Committee was formed in response to the messy liquidation of a Frankfurt bank in 1974. On 26 June 1974, a number of banks had released Deutschmark to the Bank Herstatt in Frankfurt in exchange for dollar payments deliverable in New York. On account of differences in the time zones, there was a lag in the dollar payment to the counter-party banks, and during this gap, and before the dollar payments could be effected in New York, the Bank Herstatt was liquidated by German regulators.

This incident prompted the G-10 nations to form towards the end of 1974, the Basel Committee on Banking Supervision, under the auspices of the Bank of International Settlements (BIS).

Main framework

Basel I, that is, the 1988 Basel Accord, primarily focused on credit risk. Assets of banks in this framework were classified and grouped in five categories according to credit risk, carrying risk weights of zero (for example home country sovereign debt), ten, twenty, fifty, and up to one hundred percent (this category has, as an example, most corporate debt). Banks with international presence are required to hold capital equal to 8 % of the risk-weighted assets.

Since 1988, this framework has been progressively introduced in member countries of G-10, currently comprising 13 countries, namely, Belgium, Canada, France, Germany, Italy, Japan, Luxemburg, Netherlands, Spain, Sweden, Switzerland, United Kingdom and the United States of America.

Most other countries, currently numbering over 100, have also adopted, at least in name, the principles prescribed under Basel I. The efficiency with which they are enforced varies, however, even within nations of the Group of Ten.

Basel II framework:

Basel II aims to build on a solid foundation of prudent capital regulation, supervision, and market discipline, and to enhance further risk management and financial stability. As such, the Committee encourages each national supervisor to consider carefully the benefits of the new Framework in the context of its own domestic banking system and in developing a timetable and approach to implementation. Given resource and other constraints, these plans may extend beyond the Committee's implementation dates. That said, supervisors should consider implementing key elements of the supervisory review and market discipline components of the new Framework even if the Basel II minimum capital requirements are not fully implemented by the implementation date. National supervisors should also ensure that banks that do not implement Basel II are subject to prudent capital regulation and sound accounting and provisioning policies.

Distinct Characteristics of Basel II:

Some distinct characteristics of Basel II are noteworthy:

* It aligns capital of banks with their basic risk profiles,

* It is elaborate and far superior in terms of its coverage and details,

* It has the ability to exploit effectively new frontiers of risk management and gives impetus to the development of sound risk management systems, which in turn are expected to promote efficiency and more prudent allocation of resources.

* It is perceived to be the harbinger of the future disposition of bank supervision and the evolutionary path on which the banking industry would tread, and

* Finally, it is designed to promote financial stability by making the risk management systems more robust and responsive to tackle the complexities arising out of a host of new risks.

Why Basel II:

The Basel I had a number of flaws. For instance, it provided "one size fit all" approach and did not differentiate between assets having less risk and assets having higher risk. There was no capital allocation against operational risk as well as no consideration was given to other risks such as concentration risk, liquidity risk etc. The new accord has risk management embedded in it; so it will be a driving force for bringing improvement in risk management capabilities of banks. Basel II provides incentive to banks having good risk management and punishes those that are not managing their risk profile appropriately by requiring higher capital .

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