A round of deliberation took place in Basel, Switzerland. Carried out by the central bankers around the world I.e. the Basel committee published a set of minimum requirement of capital for a bank. This agreement is known as the Basel accords, it was implemented by law in the G10 countries, which are the countries who have a general agreement on borrowing. In nearly all these countries the central bankers have responsibilities in terms of managing banking regulations and financial markets. By enforcing the Basel accords within the banking sector in the G10 countries, it has structured various approaches banks can use in terms of dealing with the credit risk to some degree. Basel aims to classify and group all banks assets into five categories of credit risk. Basel II was the second of the published accords by Basel central committee on banking supervision. There was need to build a frame work which deals with risk management, particularly in terms of borrowing, banks needed an international platform that they can rely on to operate their lending and borrowing safe and soundly on an international level. Due to current instability in financial markets many banks have faced bail-out by government regulators this was a result trigged by defaults on subprime mortgages in the US. (Benink & Kaufman) Hence there was a need to strengthen the supervision of institutes that pose a potential risk to the stability of the financial system. The Chairman of FSA (Financial services authority) said that monitoring was not effectively conducted on the banks by regulators in the US (P Larsen). In Today financial system it is clear that banks need to set international framework for capital reserve. So that each banks can be assessed.
The core purpose of Basel II was to create an international standard that banking regulators can use in terms of setting aside capital against potentially operating and credit risk faced. (G.Harber) The Basel I had to be revised as it only dealt with credit risk. It failed to back up other potential risks such as operating, market risk. (T Congdon) The Basel II aims to address weaknesses in the Basel I capital adequacy framework for banks, by incorporating more detail calibration of credit risk and by requiring the pricing of other forms of risks a bank may face. Basel II framework allows the banks with sophisticated risk management systems to use risk assessment based on banks personal models in terms of determining the minimum capital they are required to hold by the regulators just in case they see an unexpected loss. Basel II uses a three pillar concept. The first pillar aims of maintain minimum capital requirements by addressing risks that banks faced. It focuses mainly on the credit risk, operational and market risk. It also provides a flexible structure in which banks, subject to supervisory review and adapts approaches that are best fit accordingly. (J Hashagen) The second pillar aims to give regulators improved tools and provides a regulatory framework for dealing with all other risks such as systematic risk, market risk, default risk etc. It also aims to give banks power to review their risk management approach by using effective risk measuring tools by which banks can reduce and identify their potential risks. The third pillar in Basel II emphasises that banks need to increase the sharing of information by doing this banks can gain insight of the overall risk faced in the market. Henceforth by having a set mutual standard in the banking sector it can help protect the international financial systems from collapsing. The most important aspect of the Basel Accords is that is related to credit risk management and it minimises capital requirements for loans. The core idea of Basel II is to set aside percentage of principal amount of loan which has to be backed up by equity. Although market risk and operational risk are important elements of Basel II framework, however the most important aspects of Basel II are related to credit risk and minimum capital requirements for loans. Another important factor being the need for a certain amount of equity to bear the risk of financial loss stemming from default or other elements of credit risks, another important factor is that Basel II framework aims to set aside percentage of principal amount which has been backed by equity, backing up means to hypothetically allocate the minimum capital requirements to a specific loan, this capital cannot be used to back up another loans or other risks hence it is declared as a limited resource. Basel II emphasises on using various approaches to identify and determine credit risks. Standard approach (SARB) Foundation Internal rating based approach (FIRB), Advanced Internal rating based approach (AIRB). By using above mentioned approaches banks can get some idea of the potential risk of borrowing of lending. Basel II gives some degree of freedom to banks in terms of improving safety and soundness in the financial world by placing increased emphasises on banks’ own internal control and risk management procedures. (Pingaley & Kiran) Banks can use their own approach in terms of identifying risks this could be advantages for banks as some banks may find it hard to come up with resources and funds or may not have the internal capability to carrying out some set frameworks that Basel ii suggests. Basel II has provided banks with more robust risk sensitive approach for assessment of banking organisations (K Ott, Basel Briefing 13); It requires an examination of the off balance sheet instruments such as liquidity facilities and the effectiveness of risk transfer. The Pillar II in particular provides a scope for a through firm wide view of risk considering and internal and external factors. Basel II has not only helped banks to develop more risks sensitive measurements but also helped link risk assessments methods with business and operational use incorporated. The pillar iii in the Basel accords the aims to do disclosure of information with banks aim to improve market forces driving towards improve overall risk management. The Basel trading book review introduction has enhanced guidance to provide clarity around the eligibility of instruments for trading books, with a revised focus on the liquidity of underlying positions and the ability to price them effectively. Banks can take advantage of new approaches and make use of more sophisticated risk measurements systems. ( R Varadachari)