Since 1992 over 100 countries have implemented the Basel Capital Accord. One can say that generally the document deals with bank capital level and its adequacy to the business size. The First Basel Capital Accord focused on the total amount of bank capital, which is vital in reducing the risk of bank insolvency and the potential cost of a bank’s failure for depositors. It emphasized single risk measure . At the end of 2001 the Committee released another, newer version which is called the Second Capital Accord. It is considered to be more flexible to the modern, changeable world of business. It also allows banks to implement their own, internal methodologies on measuring the risk exposure.
The structure of the new Accord consists of three pillars:
1) minimum capital requirement,
2) supervisory review process,
3) market discipline.
These three pillars together should contribute to the safety of international financial system.
As we consider the international regulations on a single commercial bank’s situation, we do emphasize the first pillar, and briefly summarize the rest.
The first pillar of the Accord was implemented in almost entire world of business. According to this many national supervisory bodies demand that the banks keep capital adequacy on at least 8% level. But there has been a great change in defining the capital adequacy. Before 2001, supervisory bodies described it as total bank’s capital over weighted average in assets and off-balance sheet liabilities. The new Accord differs slightly, because right now the capital adequacy is defined as bank’s capital over total of credit, market and operational risks. The temporary problem is how to measure these kinds of banking risks.
The Capital Accord introduces new models of measuring the risks:
1. The list of approaches to measure credit risks:
a) standardized approach;
b) foundation internal rating based approach;
c) advanced internal rating based approach.
2. The list of approaches to measure market risks:
a) standardized approach;
b) internal models approach.
3. The list of approaches to measure operational risks:
a) basic indicator approach;
b) standardized approach.
c) internal measurement approach.
The first pillar is generally accepted all over the world and almost every commercial bank must keep its capital of 8% of risk-weighted assets.
That requirement is very important for bank’s management, because when they have very ‘poor’ (of low quality) credit (and other assets) portfolio, they must either raise the capital or release that asset. Otherwise, they may face very serious consequences, including license withdrawal.
But new Accord allows banks to establish their own systems of calculating probability of creditors’ collapse. According to this banks may implement external or even internal ratings into their clients evaluations. If they do this, they may create new, much more flexible, systems of calculating provisions for likely bad debts.
The second pillar ‘Supervisory review process’, considers how national supervisory bodies should ensure that each bank implement Basel recommendations. As the new Accord stresses the importance of bank’s own systems for calculating capital adequacy, the role of supervisors has dramatically changed. Instead of being standards setters, they must only evaluate and consult appropriateness of these systems.
The last, the third pillar concentrates on market discipline as a power, which push banks into clear and fair disclosure of all risks. This is the power of market that should make banks interested in publishing more information covering banks’ risk profiles and capital adequacy.
As we can see, the Basel Committee propositions, which in fact are not obligatory to any single bank, have a huge influence on their activity, because many national supervisors state them as a bench-mark.
And now let’s consider the International Accounting Standards Board’s principles.
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