Basel I was produced by the Basel Committee on Banking Supervision in response to concerns that financial institutions in general were not maintaining adequate capital and required that banks hold 8% of risk weighted assets – which were in turn categorized in percentile terms as to perceptions of the risk that they carried, e.g. 0% for loans to government, and 100% for loans to the commercial arena.

Basel I for the most part encouraged banks to consider capital adequacy against the credit risk underlying their book of loans, i.e. the risk of failure by borrowers to fulfill repayment obligations. A later amendment in 1996 introduced a new emphasis on market risk, i.e. the risk of fluctuations in the value of investments.

The new Basel Capital Accord was published in 2004 following rigorous consultation with supervisors, and significantly revised the first effort. Basel II consists of three reinforcing pillars: the first concerned with capital requirements against credit, market and operational risk; the second outlining the processes surrounding governance and supervision of bank capital; and the third imposing new disclosure requirements upon financial institutions to aid market discipline and transparency.

Basel II brought about a migration away from the first Accord’s simplistic assessment of bank risks towards a more holistic approach across a spectrum of risks and with a range of methodologies to calculate exposures. For instance banks can choose from three approaches in calculating capital requirements against both credit and operational risk, the intention being alignment with their expertise and size, and in turn risk management capabilities.

The chief reason for development of Basel II was the realization that financial markets and products were advancing rapidly both in terms of modern complexity and scale – particularly given the effects of globalization. In turn, more comprehensive and robust regulation was required to manage this evolution, a framework that recognized capital requirements more intelligently.

Indeed, it is the risk sensitive nature of Basel II that distinguishes it particularly from its predecessor. Whereas the first Accord assessed capital requirements against risk from a very one dimensional perspective, Basel II not only introduced new risks, but removed restrictive debtor categorizations that didn’t truly reflect the associated risk of a claim. Rather than calculating the capital to be ring-fenced based upon type of entity, personalized ratings could now be utilized – internal or external dependent upon approach – so that ‘capital requirements should drop substantially at a bank with a prime business portfolio’ (KPMG, 2004:3).

However commentators have questioned whether the more sophisticated capital adequacy calculations detailed under Basel II have truly added value to risk management in the banking sector, claiming that legislation has given banks a ‘strong incentive to employ the most advanced risk management techniques’ (ERisk, 2005:5).

One of the principal objectives of the first Accord was to increase capital across the industry, an aim inherited by Basel II, though Adair Turner’s recent FSA review concluded that significant capital increases are required globally.

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Questions have also been raised as to whether Basel II places an over-reliance upon external credit rating agencies within its most simplistic model for calculation of capital adequacy, in effect encouraging banks to outsource their management of risk. Basel proponents would argue that the framework allows for more advanced methodologies which take account of relevant, tailored data garnered by the banks themselves – therefore removing the requirement for external ratings.

The Basel Committee based much rationale for their decision to release updated recommendation upon Basel I’s limited (albeit positive as far as it went) scope. Where the first Accord outlined a basic analysis of credit risk and later market risk, these were both refined in Basel II, along with the introduction of consideration for operational risk, defined as, ‘the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events’ (Basel, 2006:144).

Banks were encouraged under Basel II to consider not only the credit and market risks that can arguably be controlled more effectively through expert underwriting and asset management, but also this wider operational bracket which had thus far been neglected in terms of direct allocation of capital. Operational risk was considered particularly pertinent due to the prevalence of those loss events considered low frequency, high impact in the sector.

Another major reason for introduction of Basel II was the perceived need for promotion of sound corporate governance within banks and of purposeful supervision alongside such efforts – highlighted in the creation of the second pillar. Basel Committee members realized that capital adequacy regulation is only meaningful insofar as it is conveyed appropriately and assessed independently, so as to encourage good practice in firms from the top down, and develop cultures of accountability. The second pillar introduces the intention ‘to ensure that banks have adequate capital to support all the risks in their business’ (Basel, 2006:204).

This principle implies an enterprise approach to risk for senior manager and supervisor alike, particularly important for the larger international banks with wide ranging operations, who can pose systemic risks to the economy given the nature of their businesses.

Although the premise behind the second pillar should clearly add value to risk management in banking, this is contingent not only upon skilled board members and senior managers in implementing adequate controls and asking challenging questions of their businesses, but the concept is also highly reliant upon strong supervision by the relevant authorities.

Basel II’s third pillar indicates another important reason for the revised Accord’s implementation: support for heightened transparency across financial markets and ‘market discipline through enhanced disclosure by banks’ (KPMG, 2004:5).

Given the broad range of stakeholders to whom banks are ultimately answerable – from depositors and shareholders to employees and regulators – and in light of the impact that these institutions can have upon not only the financial but also the real economy, it’s imperative that their risk profile and associated controls can be assessed with readily available information. The third pillar’s implications were particularly resonant given the new freedom afforded to banks in deciding their approach to capital adequacy and risk management.

Whilst the introduction of the third pillar is understandable and suggests particular benefits for key stakeholders, it is not clear whether the increased provision of information surrounding risk management in the banking sector has actually aided market discipline. The FSA’s recent review of the financial crisis contends that ‘a strong case can be made that the events of the last five years have illustrated the inadequacy of market discipline’ (Turner, 2009:45).

It is suggested that the revised Accord doesn’t go far enough in developing disclosure of bank risk management capabilities and exposures, particularly with regards the complex credit models that grew in popularity leading up to the credit crunch.

Aside from the central aims underlined across the new Accord’s three pillars, another motive for Basel II’s establishment was the fact that banks had began to develop more sophisticated internal control systems, which could be leveraged to support new capital adequacy regulation.

In effect, supervisors acknowledged that value could be gained by allowing banks to utilize their legacy information systems in gauging the risks posed by particular clients or transactions, rather than relying on futile assumptions of broad categorizations where a debtor very near bankruptcy could in theory be treated exactly the same as one with excellent creditworthiness.

Basel II introduced a number of benefits in strengthening risk management across the banking sector, including provision for more accurate depictions of capital requirements, alongside demanding disclosure obligations to dissuade improper behavior in financial institutions.

However whilst the revised Accord – like its predecessor – was applauded initially as a welcome development, it too has become subject to challenge, perhaps even more so than the original Accord given the unprecedented events that have unfolded over the past three years.

It seems unlikely that Basel II will be scrapped absolutely, given that even its most ardent critics admit to its qualities, but further revisions to the recommendations are certain. An interesting point to note is that financial markets consistently appear to advance ahead of their regulations, deeming subsequent responses very much reactive – a signal perhaps that greater attention should be focused upon endowing greater resources to the supervisory authorities.

Blame for the recent financial crisis cannot be attributed wholly to the new Accord or indeed to supervision in general, but the Basel Committee’s recent proposals for enhancement of the framework are certainly welcome.

Of particular concern should be emphasis upon calculation of capital requirements for complex credit products, and heightened rules as to utilization of both internal and external credit ratings. The chairman of the Basel Committee stated that there are ‘no quick-fix, simple measures or ratios that will achieve our objective… but the market turmoil has already provided some important lessons that will help guide the Basel committee in further strengthening the framework’ (Wellink, 2008).

Whether or not global authorities will accept the Basel Committee’s reading of the crisis as merely an exercise in lessons learnt or not remains to be seen.

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