LO 58.7: Describe the key elements of the three pillars of Basel II: minimum

LO 58.7: Describe the key elements of the three pillars of Basel II: minimum capital requirements, supervisory review, and market discipline.
While Basel I improved the way capital requirements were determined for banks worldwide, it had some major limitations. First, all corporate loans were treated the same (i.e., a risk
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weight of 100%) regardless of the creditworthiness of the borrower. A firm with an AAA credit rating was treated the same as a borrower with a C rating. Basel I also ignored the benefits of diversification (i.e., there was no model of default correlation). Basel II, proposed in June 1999 and after multiple revisions was published in 2004 and implemented in 2007, corrected a number of the deficiencies in Basel I. The rules applied to internationally active banks and thus many small regional banks in the United States were not subject to the requirements but fell under Basel IA, similar to Basel I, instead. All European banks are regulated under Basel II.
There are three pillars under Basel II: (1) minimum capital requirements, (2) supervisory review, and (3) market discipline.
Pillar 1: Minimum Capital Requirements
The key element of Basel II regarding capital requirements is to consider the credit ratings of counterparties. Capital charges for market risk remained unchanged from the 1996 Amendment. Basel II added capital charges for operational risk. Banks must hold total capital equal to 8% of risk-weighted assets under Basel II, as under Basel I. Total capital under Basel II is calculated as:
total capital = 0.08 x (credit risk RWA + market risk RWA + operational risk RWA)
Pillar 2: Supervisory Review
Basel II is an international standard, governing internationally active banks across the world. A primary goal of Basel II is to achieve overall consistency in the application of capital requirements. However, Pillar 2 allows regulators from different countries some discretion in how they apply the rules. This allows regulatory authorities to consider local conditions when implementing rules. Supervisors must also encourage banks to develop better risk management functions and must evaluate bank risks that are outside the scope of Pillar 1, working with banks to identify and manage all types of risk.
Pillar 3: Market Discipline
The goal of Pillar 3 is to increase transparency. Banks are required to disclose more information about the risks they take and the capital allocated to these risks. The key idea behind Pillar 3 is that if banks must share more information with shareholders (and potential shareholders), they will make better risk management decisions. Banks have discretion in determining what is relevant and material and thus what should be disclosed. According to Basel II, banks should disclose: The entities (banks and other businesses such as securities firms in Europe) to which
A description of the characteristics, terms, and conditions of all the capital instruments
Basel II rules are applied.
held by the bank.
A list of the instruments comprising the banks Tier 1 capital. The amount of capital
provided by each instrument should also be disclosed.
A list of the instruments comprising the banks Tier 2 capital.
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The capital requirements for each type of risk covered under Basel II: credit, market, and
operational risks. Information about other bank risks. Information about the banks risk management function, how it is structured, and how it operates.

S o l v e n c y II F r a m e w o r k

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