Basel 2 and the three pillars approach
Basel 2 is the second set of recommendations issued by the Basel Committee on Banking Supervision. Published in 2004, the recommendations were intended to improve the international standard for banking regulators set by Basel 1.
Since the Basel Committee had (and still has) no kind of authority on its members, the recommendations had to be enforced at the national level, which explains the delay between the date of publication of the recommendations by the committee (2004) and the date most of the recommendations were implemented at a national level. The 2008 crisis was in this respect a wake up call and encouraged the enforcement of the recommendations in many countries.
Basel 2 introduces a three pillars approach: it recommends a new definition of minimum capital requirements (pillar one), improves the tools given to local regulators to monitor banks’ risk management (pillar two) and requires more detailed disclosures from the banks on their risk exposure (pillar three).
First pillar: minimum capital requirements
Basel 2 first pillar contains a quantity of rules for determining the minimum capital requirement. Seen from afar, the general rules remain very similar to the ones set by Basel 1. Indeed, the total capital of a bank has still to be at least equal to 8% of its total RWAs. However, if the definition of capital remains the same, Basel 2 introduces major changes in the way to calculate RWAs.
First of all, unlike the original 1988 Basel 1 recommendations, Basel 2 does not only focus on credit risk. Other risks such operational risks and market risks are now taken into account. Then, for each category of risk, Basel II suggests that banks can assess these risks either by using a standard approach or an internal-based approach (if they have enough data to convince their local regulators to let them do so).
To assess credit risk for instance, three options are available:
• Standardised approach: under this approach banks are required to use ratings from external credit rating agencies to quantify required capital.
• Foundation internal ratings-based approach (F-IRB): under this approach banks are allowed to develop their own empirical model to estimate the probability of default (PD) for individual clients or groups of clients.
• Advanced internal ratings-based approach (A-IRB): under this approach banks are supposed to use their own quantitative models to estimate PD, exposure at default (EAD), loss given default (LGD) and other parameters required for calculating RWAs.
Banks can use the F-IRB and A-IRB methods (and all the other internal based approaches to assess operational and market risk) only subject to approval from their local regulators.
Second pillar: supervisory review
Basel 2 second pillar is meant to complement the first pillar. The local regulators are given additional tools to monitor the risk management process of banks.
Third pillar: market discipline
Basel 2 third pillar imposes market discipline by imposing disclosure requirements for the banks about their risk exposure. The goal is to better inform the investors. The idea behind this third pillar is that when market participants have a sufficient understanding of a bank’s activities and the controls it has in place to manage its exposures, they are better able to distinguish between banking organisations so that they can reward those that manage their risks prudently and penalise those that do not.