Financial Message Board

Basel Three Pillars

		Pillar 1” of the new capital framework revises the 1988 Accord’s guidelines by aligning the minimum capital requirements more closely to each bank's actual risk of economic loss.
		Pillar 2 ” Supervisors will evaluate the activities and risk profiles of individual banks to determine whether those organisations should hold higher levels of capital than the minimum requirements in Pillar 1 would specify and to see whether there is any need for remedial actions.
		Pillar 3” leverages the ability of market discipline to motivate prudent management by enhancing the degree of transparency in banks’ public reporting to shareholders and customers.

I. “Pillar 1” of the new capital framework revises the 1988 Accord’s guidelines by aligning the minimum capital requirements more closely to each bank’s actual risk of economic loss.

• First, Basel II improves the capital framework’s sensitivity to the risk of credit losses generally by requiring higher levels of capital for those borrowers thought to present higher levels of credit risk, and vice versa. Three options are available to allow banks and supervisors to choose an approach that seems most appropriate for the sophistication of a bank’s activities and internal controls.
  • Under the “standardised approach” to credit risk, banks that engage in less complex forms of lending and credit underwriting and that have simpler control structures may use external measures of credit risk to assess the credit quality of their borrowers for regulatory capital purposes.

  • Banks that engage in more sophisticated risk-taking and that have developed advanced risk measurement systems may, with the approval of their supervisors, select from one of two “internal ratings-based” (“IRB”) approaches to credit risk. Under an IRB approach, banks rely partly on their own measures of a borrowers’ credit risk to determine their capital requirements, subject to strict data, validation, and operational requirements.

• Second, the new Framework establishes an explicit capital charge for a bank’s exposures to the risk of losses caused by failures in systems, processes, or staff or that are caused by external events, such as natural disasters. Similar to the range of options provided for assessing exposures to credit risk, banks will choose one of three approaches for measuring their exposures to operational risk that they and their supervisors agree reflects the quality and sophistication of their internal controls over this particular risk area.

• By aligning capital charges more closely to a bank’s own measures of its exposures to credit and operational risk, the Basel II Framework encourages banks to refine those measures. It also provides explicit incentives in the form of lower capital requirements for banks to adopt more comprehensive and accurate measures of risk as well as more effective processes for controlling their exposures to risk.

II. “Pillar 2” of the new capital framework recognises the necessity of exercising effective supervisory review of banks’ internal assessments of their overall risks to ensure that bank management is exercising sound judgement and has set aside adequate capital for these risks.

• Supervisors will evaluate the activities and risk profiles of individual banks to determine whether those organisations should hold higher levels of capital than the minimum requirements in Pillar 1 would specify and to see whether there is any need for remedial actions.
• Basel Three Pillars - The Committee expects that, when supervisors engage banks in a dialogue about their internal processes for measuring and managing their risks, they will help to create implicit incentives for organisations to develop sound control structures and to improve those processes.

III. “Pillar 3” leverages the ability of market discipline to motivate prudent management by enhancing the degree of transparency in banks’ public reporting. It sets out the public disclosures that banks must make that lend greater insight into the adequacy of their capitalisation.

• Basel Three Pillars - The Committee believes that, when marketplace participants have a sufficient understanding of a bank’s activities and the controls it has in place to manage its exposures, they are better able to distinguish between banking organisations so that they can reward those that manage their risks prudently and penalise those that do not.