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26 June 2004
Central bank governors and the heads of bank
supervisory authorities in the Group of Ten (G10) countries
met today and endorsed the publication of the International
Convergence of Capital Measurement and Capital Standards: a
Revised Framework, the new capital adequacy framework
commonly known as Basel II. The meeting took place at the Bank
for International Settlements in Basel, Switzerland, one day
after the Basel Committee on Banking Supervision, the author
of the text, approved its submission to the governors and
supervisors for review.
The Basel II Framework sets out the details
for adopting more risk-sensitive minimum capital requirements
for banking organisations. The new framework reinforces these
risk-sensitive requirements by laying out principles for banks
to assess the adequacy of their capital and for supervisors to
review such assessments to ensure banks have adequate capital
to support their risks. It also seeks to strengthen market
discipline by enhancing transparency in banks’ financial
reporting. The text that has been released today reflects the
results of extensive consultations with supervisors and
bankers worldwide. It will serve as the basis for national
rule-making and approval processes to continue and for banking
organisations to complete their preparations for the new
Framework’s implementation.
“Basel II embraces a comprehensive approach
to risk management and bank supervision,” explained Mr
Jean-Claude Trichet, Chairman of the G10 group of central bank
governors and heads of bank supervisory authorities and
President of the European Central Bank. “It will enhance
banks’ safety and soundness, strengthen the stability of the
financial system as a whole, and improve the financial
sector’s ability to serve as a source for sustainable growth
for the broader economy. I am pleased to offer this revised
framework to the international community.”
“The new Framework represents an unparalleled
opportunity for banks to improve their risk measurement and
management systems,” added Mr Jaime Caruana, Chairman of the
Basel Committee on Banking Supervision and Governor of the
Bank of Spain. “It builds on and consolidates the progress
achieved by leading banking organisations and provides
incentives for all banks to continue to strengthen their
internal processes. By motivating banks to upgrade and improve
their risk management systems, business models, capital
strategies and disclosure standards, the Basel II Framework
should improve their overall efficiency and resilience.”
The G10 governors and supervisors supported
the Basel Committee’s plans to continue discussions on key
implementation issues with the industry and other authorities
as domestic adoption and approval processes proceed.
The Basel Committee intends for the new
framework to be available for implementation in member
jurisdictions as of year-end 2006. The most advanced
approaches to risk measurement will be available for
implementation as of year-end 2007, in order to allow banks
and supervisors to benefit from an additional year of impact
analysis or parallel capital calculations under the existing
and new rules. The G10 governors and supervisors encouraged
authorities in other jurisdictions to consider the readiness
of their supervisory structures for the Basel II Framework and
recommended that they proceed at their own pace, based on
their own priorities.
The governors and supervisors also extended
their thanks to all those who had contributed to the process
to develop and strengthen the quality of the revised framework
over the past six years and expressed appreciation for the
leadership exercised by William McDonough and Jaime Caruana,
the Committee’s prior and current chairmen, respectively. They
indicated that the Basel Committee’s work benefited from the
transparency and scale of the public consultations that took
place both within the G10 countries and around the world,
helping to make the new framework a global product. The
governors and supervisors noted that the Basel Committee would
continue to work in the spirit of openness and consultation in
the future. Regular communication by the Committee of its
future plans will enable the Committee and the industry to
prioritise their work effectively.
Note to Editors
What is the Basel II Framework?
The International Convergence of Capital
Measurement and Capital Standards: a Revised Framework, or
the “Basel II Framework,” offers a new set of standards for
establishing minimum capital requirements for banking
organisations. It was prepared by the Basel Committee on
Banking Supervision, a group of central banks and bank
supervisory authorities in the G10 countries, which developed
the first standard in 1988.
Why are banks subject to capital requirements?
Nearly all jurisdictions with active banking
markets require banking organisations to maintain at least a
minimum level of capital. Capital serves as a foundation for a
bank’s future growth and as a cushion against its unexpected
losses. Adequately capitalised banks that are well managed are
better able to withstand losses and to provide credit to
consumers and businesses alike throughout the business cycle,
including during downturns. Adequate levels of capital thereby
help to promote public confidence in the banking system.
The technical challenge for both banks and
supervisors has been to determine how much capital is
necessary to serve as a sufficient buffer against unexpected
losses. If capital levels are too low, banks may be unable to
absorb high levels of losses. Excessively low levels of
capital increase the risk of bank failures which, in turn, may
put depositors’ funds at risk. If capital levels are too high,
banks may not be able to make the most efficient use of their
resources, which may constrain their ability to make credit
available.
What requirements apply currently to banking
organisations?
The 1988 Basel Capital Accord set out the
first internationally accepted definition of, and a minimum
measure for, bank capital. The Basel Committee designed the
1988 Accord as a simple standard so that it could be applied
to many banks in many jurisdictions. It requires banks to
divide their exposures up into broad “classes” reflecting
similar types of borrowers. Exposures to the same kind of
borrower – such as all exposures to corporate borrowers – are
subject to the same capital requirement, regardless of
potential differences in the creditworthiness and risk that
each individual borrower might pose.
While the 1988 Accord was applied initially
only to internationally active banks in the G10 countries, it
quickly became acknowledged as a benchmark measure of a bank’s
solvency and is believed to have been adopted in some form by
more than 100 countries. The Committee supplemented the 1988
Accord’s original focus on credit risk with requirements for
exposures to market risk in 1996.
Why is a new capital standard necessary today?
Advances in risk management practices,
technology, and banking markets have made the 1988 Accord’s
simple approach to measuring capital less meaningful for many
banking organisations. For example, the 1988 Accord sets
capital requirements based on broad classes of exposures and
does not distinguish between the relative degrees of
creditworthiness among individual borrowers.
Likewise, improvements in internal processes,
the adoption of more advanced risk measurement techniques, and
the increasing use of sophisticated risk management practices
such as securitisation have changed leading organisations’
monitoring and management of exposures and activities.
Supervisors and sophisticated banking organisations have found
that the static rules set out in the 1988 Accord have not kept
pace with advances in sound risk management practices. This
suggests that the existing capital regulations may not reflect
banks’ actual business practices.
How does Basel II differ from the 1988 Basel Capital
Accord?
The Basel II Framework is more reflective of
the underlying risks in banking and provides stronger
incentives for improved risk management. It builds on the 1988
Accord’s basic structure for setting capital requirements and
improves the capital framework’s sensitivity to the risks that
banks actually face. This will be achieved in part by aligning
capital requirements more closely to the risk of credit loss
and by introducing a new capital charge for exposures to the
risk of loss caused by operational failures.
The Basel Committee, however, intends to
maintain broadly the aggregate level of minimum capital
requirements, while providing incentives to adopt the more
advanced risk-sensitive approaches of the revised Framework.
Basel II combines these minimum capital requirements with
supervisory review and market discipline to encourage
improvements in risk management.
What is the goal for the Basel II Framework and how will
it be accomplished?
The overarching goal for the Basel II
Framework is to promote the adequate capitalisation of banks
and to encourage improvements in risk management, thereby
strengthening the stability of the financial system. This goal
will be accomplished through the introduction of “three
pillars” that reinforce each other and that create incentives
for banks to enhance the quality of their control processes.
The first pillar represents a significant strengthening of the
minimum requirements set out in the 1988 Accord, while the
second and third pillars represent innovative additions to
capital supervision.
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.
- 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.
- 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.
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