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Basel II

What is it?

A new framework for international financial regulation determined by the Basel Committee, also known as the Committee on Banking Supervision. Basel 2 is an international banking accord that will replace the capital rules of 1988. It is intended to mitigate the risks that affect modern financial markets.

Who does it affect?

All financial institutions, not just banks.

When is the compliance deadline?

2006

What is required for compliance?

Rich stocks of legacy data are essential for drawing up the picture of enterprise-wide exposure that the legislation demands, so companies must start gathering the right data now, as well as addressing the current level of risk management capabilities.

At a time when any regulatory development is seized upon as an opportunity to reengineer processes, realise savings or pursue competitive advantage, Basel stands out as the real thing. According to Riccardo Rebonato, Head of Group Market Risk at RBS Group, it is difficult to underestimate the impact of the New Basel Capital Accord. "The current Basel proposal will change in fundamental ways the regulatory framework for credit and operational risk; it will have an impact on the conduct of business of banks around the world; it will have profound consequences on the types of activity they will find viable and on the market segments they will concentrate on; ultimately it will affect the overall stability and robustness of the implementation details of the financial system," wrote Rebonato last year1. Despite the hype, it's hard to avoid the conclusion that Basel II represents a major shift in banks' management of credit and operational risk, taking capital adequacy regulation light years from the first hesitant steps taken more than 15 years ago.

The 1988 Basel Capital Accord was a bold attempt to create a global capital adequacy framework for banks which matched, however crudely, banks' capital requirements against their credit exposures. Banks set aside capital to offset corporate, sovereign and institutional credit exposures, but new risk mitigation tools were quick to undermine the principles of the Accord. Partly in response to developments in (and criticisms from) the banking sector, partly a reaction to the impact of economic turbulence on the world's financial markets, the Basel Committee announced in June 1999 its intention to introduce a new capital adequacy framework that would be both more risk sensitive and able to "better address" financial innovations such as asset securitisation. Looking back, it seems extremely optimistic to expect the details of such an ambitious project to be finalised within 12 months of its January 2001 public release, even more so for implementation in member jurisdictions to be slated for 2004. Such were the strength of objections that now, in May 2004, we know that the final proposals scheduled for release next month will include caveats for future clarification. Consensus Achieved on Basel II Proposals

However, the three pillars of the Accord (calculation of minimum capital requirements; supervisory review of risk assessment and capital adequacy; and external reporting of exposures, risk management processes and capital provisions) have stood firm Overview of The New Capital Accord. Banks are expected to adopt either a standard or foundation internal rating based (IRB) model by 2006, with advanced IRB scheduled for implementation year-end 2007. An addition threat to the deadlines and guidelines lies in the fact that the Basel Committee's recommendations have no legal force. They are interpreted by the local financial authorities according to existing market structures and regulations. For example, U.S. regulators have been reluctant to issue guidelines on Basel's Pillar 2, the supervisory review element of the new Accord, largely on grounds that existing regulations create the necessary infrastructure.

The cost of compliance with Basel II differs widely between banks. According to a survey of 30 banks (average assets: US$100m) published by Standard & Poor's Risk Solutions in March 2004, costs varied between US$1m and US$100m. Other cost estimates have topped US$180m. Although the deadlines for Basel II compliance continue to be pushed back, many banks are still struggling to stay on schedule. Only a third of respondents to a survey conducted by GARP (Global Association Of Risk Professionals) in the first quarter of 2004 2 rated their chances of meeting the 2006 Basel II deadline as "very probable"; a further 40 per cent said compliance was "somewhat probable".

Nevertheless, respondents appeared largely convinced that the effort would yield benefits. More than half (56 per cent) said internal risk management within their own institution would be "somewhat improved"; 30 per cent said it would be greatly improved.