Basel II was implemented in the year 2004 by BCBS (Basel Committee on banking supervision), it was to create an international standard of banking regulations on bank's capital to safeguard financial, operational and market risks.
Basel II has 3 pillars
Pillar 1 - Minimum Capital Requirement It focuses on Credit risk Operational risk Market risk
Standardised Approach Standardised approach focuses on regulatory capital with key elements of the banking risk; it helps in credit risk mitigation techniques and differentiating risk weights. Capital requirement is calculated by dividing bank asset into 5 categories Corporate Sovereign Bank Retail and Equity Risk weights are determined for each risk category and is rated by borrower's credit rating
Foundation internal ratings based approach Focuses on probability of loan defaults and feeds data into complex probability based formula, this helps in finding risk weight and the capital amount to be held against the loan.
Advanced internal ratings based approach Estimates loss given default and other risks in prescribed formula to determine risk weight and capital charge against a loan. This was implemented in 1990 and Basel II was followed in banking industry.
Operational Risk: Risk that occurs within the business due to lack of control process
Pillar 2: The Supervisory Review Process Pillar 2 has two aspects. First aspect requires banks to assess their overall risk profile like credit concentration risk, liquidity risk, reputation and model risk. Second aspect is supervisory review processes. This analyzes overall risk and creates a higher prudential capital ratio
Pillar 3: Market Discipline It requires disclosure of information on bank capital positions and risk-management processes; this is to strengthen the market.
2. Role of FSA to bank supervision The Financial Services Authority (FSA) is an independent non-governmental body, and a company limited by guarantee responsible for the financial regulation.FSA aims to provide efficient, orderly and fair financial markets to help customers achieve fair deal and to improve its business capability and effectiveness The objective of FSA includes • Standard market confidence in financial system; • promoting public understanding of the financial system; • securing the appropriate degree of protection for consumers; and • helping reduce financial crime The FSA is wholly responsible for the Treasury and to Parliament for the effective discharge of its functions. à FSA is responsible for the authorisation and prudential supervision of financial services firms, including banks, building societies, investment firms, insurance companies and brokers, credit unions and friendly societies. The FSA also applies conduct of business regulation for the mortgage, insurance and investment mediation activities of these firms. àThe Board provides advice on the following matters: - Policies and principles of supervision of institutions authorised under banking supervisory legislation; - The development and evolution of supervisory practice; - Administration of banking supervisory legislation, including advice on individual cases; -Structure, staffing and training of banking supervisors àThe Board and its members are free to take the initiative in raising matters within these areas and have rights of access to the Chancellor. Q---3 Introduction of Basel II made change in return on regulatory capital as the calculation for regulatory capital changed. This changed the lending practices in banks, financial institutions and other insurance companies, Basel II made changes in the internal environment for all lenders; it created great risk based pricing in the loan market and creates difference in capital required between risky and safer lenders, different types of lenders such as consumer finance are safer and lenders for mortgage they become riskier. In this competitive world, due to global financial crisis has revealed that there is need for risk management and self-assessment in every process. The financial crisis has revealed the weakness in approach to risk management that was developed by Basel II. Basel II has failed to provide adequate information such as collapse in market liquidity as investor confidence was disappeared, huge losses that occurred in the market value of securities held by the bank. Mortgage backed securities were on to liquidity, the past performance on reliability of credit ratings were not credibility, due to risk in the lenders the financial crisis shows at time of severe stress the banks and other financial institutions have potential to create domino effect where safe lenders can be put to risk, because of other banks and institutions are at risk the counter parties are also put to risk These are the criteria's which resulted in implementation of Basel III, these changes are considered by the Basel committee and the place where changes required are analysed, updated through a range of changes embodied as Basel III