BASEL II – how has BASEL 2 attempted to address the problems associated with Basle I

Basel II framework was published in 2006 with an objective to improve control on banking sector through capital prerequisite directives. The measures embraces in Basel II are international standards for capital reserve condition for the banks based on financial as well as operational risk.  The three pillar of Basel II are; 1) regulatory requirement of the capital; 2) supervisory review of the first pillar; 3) Greater market disclosure. The Basel II offers better risk management approach and increase market security (Demirgüç-Kunta, Detragiacheb and Tresselc, 2008).

Goodhart (2011) mentioned that the shorting of Basel I in terms of fails to address risk management, interpretation problems as well as a narrow focus on G-10 countries has reduced the scope of first Basel Accord.  Therefore, this paper examines how Basel II has managed to address the shortcoming associated with Basel I.

Roebuck (2012) elaborated that Basel Accord which came into effect in 1992 sets a requirement of 8% capital requirement for bank assets. The objectives associated with Basel I were; 1) stability of the banking system and 2) competitive environment in the banking sector. The justification for the Basel I was to recognise the need for the transition to the banking system especially related to regulation ineffectiveness and debt crisis of less developed markets in 1987.

Therefore, Basel committee developed an approach for a bank in G-10 to have risk-weighted capital directives. The inkling behind the Basel I was raising capital is difficult and costly task and if it is linked to capital ratio, this will force banks to perform risk and return calculation to achieve a balance between two. Therefore, against an asset more capital will be held by banks and this will result in lower profitability but enhanced ability to absorb the risk. The risk weighting criteria were 0 % for first class assets, 20% capital requirement for second assets as well as 100% of most risky assets (bis.org, 2014).

Roebuck (2012) analysed that Basel I was proposed to manage the deregulation of markets after 1980 along with management of capital ratio of the bank to reduce the risk as well as increase the international presence of the banks. However, there was a range of problems associated with Basel I such as risk weight of Basel I was different compared to actual market risk. Moreover, it fails to recognise the need to manage the credit risk. Furthermore, on size does not fit problem exist as being of the member of OECD does not address the problem of credit risk.  Basel I used simple measure for the risk and did not give any attention to risk sensitivity.

However, the limitation involved with Basel I was that banks were supposed to hold the asset in of classified category. At last not least, it does not consider the operational risk or explicit measure involve with the banking sector (Wagster, 1999).

Goodhart (2011) added that Basel I measures resulted in reduce incentives for the banks because of the distribute model. In order to tackle the problem banks introduced collateral loans and other investment vehicles in the market to get the maximum benefit without any consideration of risk. Therefore, Basel I fail to address the problem of credit risk and resulting it put pressure on the capital of the banks because of risk addition on the balance sheet.

Basel I had limited scope which gives banks the additional flexibility to interpret rules according to their own needs. The criticism of Basel I include over-concentration on G-10 countries and interpretation problems resulted in poor risk management and low capital reserves hold by the banks. The approach to hold securities in class has resulted in the difficulty (Jablecki, 2009).

The Corporate loan has 100% risk but bank prefer to have assets which offer greater return after the predictable losses. In efforts to maximise their advantage bank mispriced the asset because of the board definition of the asset class in Basel I. This divert attention of the banks from own risk calculation towards the risk weight cost. Therefore, to address the nonconformity of economic capital and shield the bank from the losses, Basel II reforms were developed (petersoninstitute.org, 2015).

Decampsa, Rocheta and Rogera (2004) mentioned that Basel II helps to eliminate the arbitrage risk by purposing risk weight, the position of risk management with best practices in the market as well as provided incentives to the banks for improved and enhanced risk management and measurement. Basel II is based on the three pillars which are; 1) the amount of minimum regulatory capital; 2) independent and supervisory review; and, 3) Market exposure disclosure.

The fundamental outline of the framework was the capital reserve of a bank should be based on the amount of risk. The first pillar is concerned with the decision on the regulatory capital requirement. The amount is calculated based on three factors. The first factor involves assessment of the credit risk based on the internal rating-Based approach (IRB) (Chernobai, Rachev and Fabozzi, 2008).

The second component is operation risk and devised through Basic indicator approach (BIA) and advanced measurement approach (AMA).  The third factor is an estimation of market risk through deploying market at risk approach (VaR). The second pillar is concerned with an overview of the first pillar as well as it helps to deal with a range of risk such as liquidity, financial and reputation risk. At last, not least, the last pillar is concerned with offering stability to the financial system. (ZICCHINO, 2006) The market disclosures are managed through sharing information on a range of stakeholders such as customer, investor and credit rating agencies. The key features of Basel II in comparison to Basel I was; 1) bank have internal risk quantitative measures, advanced risk management, improved administration of risk understanding along with operation risk management in order to devise the capital requirement. (Chorafas, 2004)

Basel II proves a better framework which has helped the banks to classify the risk along with the freedom to develop their own risk estimation. It helps to develop a striking combination of market disclosure as well as well design and defined regulation and policies to help the supervisors and increase the cooperation and coordination between the banks. In addition, the regulatory capital requirements proposed by the Basel II are in line with the economic capital requirement (Chernobai, Rachev and Fabozzi, 2008).

This has overcome the problem of gaming the regulation and bank more focus on the optimise capital reserves. Basel II has helped to achieve the balance between internal risk rating and capital requirement along with greater flexibility to cooperate with external credit rating agencies. Basel II has helped strong control on bank sector and offer stability for risk management. Basel II did offer an improvement on the Basel I through improved standards and quantification of risk management. Moreover, it offers more structured and effective policies governance and risk management technique to develop a robust, as well as integrated approach, to managing economic risk and credit risk (Tarullo, 2008).

Gregoriou (2009) added that Basel II sets a rule of thumb through offering codes and policies as well as it lay out best practise for banking. It introduces the market risk assessment in order to managing the multiple risks associated with the bank. This has helped to overcome the shortage of Basel I of lack of risk sensitivity management through integration of external credit rating agencies.

This helps to benchmark and determine the risk associated with sharing of information under the pillar of market disclosure. The market disclosure helps to identify the external elements and deals with unforeseen events which might not be identifiable.

Basel II helps to achieve the balance between market and government role in belief of the market and policies and regulations. Basel II helps the borrowers, depositor as well as an investor to understand the internal and external risk, as well as interest rate implication. This has overcome the problem of lack of risk sensitivity in Basel I. The risk sensitivity and impact of an external factor are evident in Basel II, because of market disclosure and integration of credit rated agencies (Roebuck, 2012).

Moreover, countries with weakness financial regulation can overcome the problems and increase confidence in the banking sector with the help of external credit rating agencies. Basel II model is helpful to understand the cyclical fluctuation to highlight the effect of interest rate differentials and its linkage to demand of capital (Akkizidis and Bouchereau, 2005).

Williams (2012) studied that Basel II works beyond the traditional scope of Basel I in terms of regulation of capital requirement. Nevertheless, the purpose of these two accords remains the same which is the stability of the banking system. In Basel II approach banks calculate internal risk in order to identify the risky nature if loans. This helps to classify high internal capital charges for high-risk securities and low charges for low-risk securities.

The next stage involves is credit risk management based on the internal and external risk measurement. The mix of internal and external credit rating helps to effectively evaluate the credit risk. The integration of operation risk is based on the three approaches which are; basic, standard and internal measurement. In addition, it also considers the range losses due to fraud, misconduct as well as catastrophes (Roebuck, 2012).

Demirguv-Kunta, Detragiacheb and Tresselc (2008) mentioned that the supervisory review process helps the bank to develop a risk profile to proportionate and set a target for capital cost. Moreover, the role of the supervisor is making judgement on how the effectively back is performing to manage the capital adequacy. The next factor of market discipline or disclosure enhances the bank disclosure through sharing information and maintains sufficient competition in the market.

Basel I did establish linkage, but credit risk and capital requirement and it marks the outline stating that in case of high credit risk banks should have a high level of capital.  However, the shortage in Basel I was that it fails to understand and express multiple risks faced by the banks. In response to shortcoming of Basel I, Basel II helped through better risk assessment, incentives offering for better risk management as well as through market disclosure and supervision it offers better transparency in the banking sector (Schutzenhofer, 2008).

World Bank and International Monetary Fund (2015) mentioned that Basel II aligned economic capital with risk and the regulatory capital requirement to enhance the competitive equality. The risk assessment offered by the Basel II is based on default risk as well as the cost of default based on the market signals. The riskiness of the securities helps to mitigate the risk and the bank can take a safer position. Basel II has played a prominent role in developing standards for weight of risk, integration of credit rating agencies, and disclosure for the supervisor and determines and assesses the internal risk and its alignment with economic capital. These factors helped to create a banking field of international standard and increase competition through financial stability.

Frenkel et al (2015) studied that both Base I and Basel II have contained capital requirement condition. Therefore, in the light if these two, the bank should hold minimum capital in order to mitigate their risk. The Basel I have limited degree of risk sensitivity induced, but Basel II have a significant higher level of risk sensitivity attached to the capital requirement for the bank. Basel II effectively tackles the negative function of Basel I in terms of the capital requirement (relationship of audit frequency and risk sensitivity). It puts more emphasis on the capital regulatory requirement by prescribing different objectives, as well as principles. This offers more risk sensitivity, better internal risk quantification as well as market disclosure based on credit rating and supervisors.

The broad range of benefits of Basel II includes better pricing of the assets; reduce the risk of the portfolio, economic capital based on the risk, stress testing as operational risk management. The integrated risk approach (IRB) helps to assign weightage of the risk through effective internal rating system. The criteria under the IRB approach is distribution of the losses based on the default of instrument. For operation risk, Basel II offers multiple approaches such standard and advance risk measurement approach (Jimenez-Martín, McAleer and Perez-Amaral, 2009).

In addition, Roebuck (2012) highlighted that Basel I have range of limitations such as restricted differentiation of the credit risk, statistic measure of the credit and other associated risks, failure to recognise structure of the credit risk, non-quantification of the counterparty risk as well as it fails to recognise the diversification effect on the portfolio. Basel II tackles this inadequacy through minimum capital after adjusting the risk, supervisor role to increase confidence in the system along with market discipline which helps to share information among large number stakeholder to enhance disclosure and involvement of credit rating agencies.

Moosa (2008) argued that in Basel II, credit, operational and market risk is recognised. Moreover, credit risk is managed through advanced, standardised and internal rating approach. Operational and market risk managed through standardised and advanced approach. Basel II has helped to resolve the discrepancy between the regulatory capitals through the introduction of bank own risk assessment, measurement and quantification. It has taken more risk sensitive approach and greater emphasis has been put on risk mitigation (Akkizidis and Bouchereau, 2005).

Goodhart (2011) discussed the implications of Basel II involve wide range differentiation from Basel I as well as from traditional banking capital calculation. In the light of Basel II, large bank operate in different system compare to smaller banks. Moreover, Basel II relies on the internal risk assessment of the banks in order to determine the regulatory capital requirement. Basel II serves to benchmark and focus the danger connected with offering of data under the mainstay of business exposure. The business sector divulgence serves to distinguish the outer components and manages unforeseen occasions which may not be identifiable.

Markham (2012) explained that this marks a significant step in terms of supervisor role in terms of evaluating the bank rather supervisor role. The risk of the securities serves to alleviate the danger and the bank can take a more secure position. Basel II has assumed an unmistakable part in creating gauges for weight of danger and revelation for the chief and decides and surveys the inside danger and its arrangement with monetary capital. These variables served to make a keeping money field of global standard and expand rivalry through monetary security.

Basel II demonstrates a superior system which has helped the banks to pool risk alongside the opportunity to build up their own particular risk estimation. It serves to add to a striking mix of business exposure and additionally well plan and characterized regulation and strategies to help the managers and build the participation and coordination between the banks. Furthermore, the administrative capital prerequisites proposed by the Basel II are in accordance with the financial capital prerequisite (Zicchino, 2006).

Nevertheless, the major limitation attached to Basel II is it role in the business cyclicality. When bank have more losses from the loan and it is likely to get the rating downgrade. This will result in holding more capital during the difficult financial times and it has to reduce the activity. Therefore, the model does not address the cyclical fluctuations the business. Moreover, a factor of portfolio diversification raises concern on the part of Basel II application (Herring, 2015)

Williams (2009) examined that the objectives of Basel II is to increase reliability and safety of global financial system, establish a approach for more rigours risk management framework, manage the capital adequacy in line with risk sensitivity, promote competitive equality in the financial markets as well as focus on providing principle and policies to tackle the vary complexities in the banking sector. Basel I set overall capital requirement in terms of simple risk whereas Basel II introduce a range of risk sensitivity measure for market and credit. The fundamental of Basel II is to promote sound, stable and reliable global banking system (Decampsa, Rocheta and Rogera, 2014).

In conclusion, Basel II represents a significant improvement in comparison to Basel I for the banking industry. It has helped to overcome the shortcoming presently in the base I framework through offering additional measure. Basel I and Basel II both have a capital requirement, but Basel II offered an additional risk sensitivity approach to effectively calculate the risk and manage the regulatory capital requirement. Moreover, Basel II addresses the issue of risk sensitivity which were absent in the Basel I.

Basel II integrates additional two pillars in terms of supervisory role as well as market disclosure. The integration of market disclosure and used of the credit rating agency has helped to increase the confidence in the banks. Moreover, Basel II offers the management of the operational risk through basic and advanced risk management approach. Banks have more incentive for the effective management of risk in Basel II compare to Basel I in which banks did not have an incentive for risk managed the portfolio. Basel I was more focused on the G-10 countries whereas Basel II attempt to reduce the risk of the banking sector and eliminate the unfair competitive advantage through standard global financial stability.

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