BIS II is a redevelopment of the original capital accord BIS I. However BIS II encompasses more than just a minimum capital for credit risk. The total structure of the BIS II accord can be graphically presented as follows:
| Pillar One Minimum capital requirements
|
Pillar two Supervisory review process |
Pillar three Market discipline |
The structure of BIS II consists of three main pillars.
Pillar one
The first pillar is the main part of BIS II. It comprises 192 pages of the total 242 pages (excluding the annexes). The pillar contains the rules for calculating the regulatory capital. The rules for capital requirements are given for three types of risk.
Credit risk is the risk of loss because a customer does not repay the full loan. Operational risk is the risk of loss due to operational issues (bad management decisions, fraud, incorrect administration, etc.). Market risk is the risk of losses due to a decrease in the value of investments (for instance stock or bond investments).
Credit risk is split into three more sections.
In the standardized approach the credit risk is calculated using standard benchmarks. This method is much like the BIS I method. The internal ratings based approach allows a bank to develop and use its own risk models to calculate the credit risk. A bank must choose which method to use. The third section is the securitisation framework. More and more banks sell the risk (and return) associated with a part of their assets (for instance the mortgages). Because in these cases the risk is (partly) not run by the bank the actual credit risk will have to be calculated.
Pillar two
The second pillar considers the method in which banks and central banks should review the implementation and usage of BIS II. This pillar requires banks to develop their risk management beyond the minimum requirements set out in pillar one. Additional risk types such as interest rate risk should be incorporated in this more comprehensive risk management system. Furthermore it dictates that the BIS II framework should be an integral part of the banks activities. This means for instance the banks general management should be aware of BIS II and should be involved in the decisions surrounding BIS II.
Pillar three
The third pillar is the inspiration for this site. It dictates that banks should publish the outcome of their risk calculations and also their methodology. The idea behind this requirement is that the market will guide the banks towards a set of well established methodologies, thereby making the capital requirements stable throughout the banking world.
The purpose of the first pillar is to set out the rules by which the regulatory capital can be calculated. The pillar is divided in three types of risk for which capital should be held.
Credit Risk
Credit risk is the risk that those who owe you money will not pay you back. Historically credit risk is the larges risk banks run. It is at the core of its business. BIS II proposes three approaches by which a bank may calculate its required capital for credit risk.
Standardised approach.
This approach is a slight improvement on BIS I. It recognises a few more collateral types and has a few more risk weights for different asset types. Beyond that the approach is very similar to BIS I.
Internal rating based (IRB) advanced.
The internal rating based (IRB) advanced approach is the most comprehensive approach suggested by BIS II. In this approach a bank may develop their own risk models. The central bank will monitor a bank on the quality of its risk management to ensure robust calculations of the regulatory capital.
Internal rating based (IRB) foundation.
The internal rating based (IRB) foundation approach is a combination of the previous two. It is comparable to the advanced approach but with standard values given by BIS II for some of the risk parameters.
Operational Risk
Operational risk is defined by BIS II as follows:
Operational risk is defined as the risk of loss resulting from inadequate or failed
internal processes, people and systems or from external events. This definition includes legal
risk, but excludes strategic and reputational risk.
Comparable to credit risk, BIS II proposes three methods for measuring operational risk.
The basic indicator approach is a very simple approach. It states that a bank should calculate required capital for operational risk by multiplying the average positive annual gross income (ignore the negative annual gross income) over the last three years by 15%.
The standardized approach is very similar to the basic indicator approach. However the standardized approach has a different percentage for different types of business.
The advanced measurement approach (AMA) is the most comprehensive. It requires the bank to develop its own risk models. BIS II does not specify any particular methodologies for modelling.
Market risk
Market risk is the risk of losses due to changes in the market price of an asset. Obviously this is only relevant if the asset is obtained for trading. If you buy a bond and intent to hold it until its maturity, the market price movements of the bond are irrelevant (as it won’t be sold). Therefore the market risk will only have to be calculated for assets in the trading book. Besides this risk the foreign exchange rate risk and commodities risk are part of the market risk. These two risk are not limited to the trading book and should be calculated for the entire bank.
Again several methods may be used:
The standardized approach dictates a set of rules for calculating the capital charge for different types of financial products available for trading.
As with credit risk and operational risk the second approach is more elaborate. It allows the bank to develop their own models.
Summery
A bank should choose which method to use for each risk type. In summery pillar one describes the following risks and measurement methods:
The second pillar considers the method in which banks and central banks should review the implementation and usage of BIS II. This pillar requires banks to develop their risk management beyond the minimum requirements set out in pillar one. Additional risk types such as interest rate risk should be incorporated in this more comprehensive risk management system. Furthermore it dictates that the BIS II framework should be an integral part of the banks activities. This means for instance the banks general management should be aware of BIS II and should be involved in the decisions surrounding BIS II. The BIS II paper itself defines the purpose of pillar two as:
The supervisory review process of the Framework is intended not only to ensure that banks have adequate capital to support all the risks in their business, but also to encourage banks to develop and use better risk management techniques in monitoring and managing their risks.”
In pillar two, four principles of supervisory review
are defined.
Principle three
The third principle is not divided into sub features. The idea behind this principle is to ensure that supervisors consider the pillar one, capital calculation a minimum requirement. A supervisor should expect
banks to hold capital in excess of the minimum. This can be necessary for risks which have not been incorporated in the first pillar. It can also be advisory because of bank specific issues. Or a bank may wish a larger buffer in order to position itself as a safe bank in the market. Furthermore the capital requirement will change through
time. If the available capital equals the required capital any negative change will lead to a breach of the regulatory capital requirement. No bank is expected to find such a situation acceptable.
Principle four
The fourth principle is also not divided into sub features. This principle states that a supervisor should signal a move towards inadequate capital, before it is actually deemed inadequate. A supervisor has several actions which it can take if there is a serious thread that the available capital becomes less than the required capital. It can increase monitoring of a bank, Forbid (or restrict) payment of dividends, require the bank to create and implement a capital restoration plan or force a bank to attract capital from the market immediately. These actions may be used permanently or temporarily while a bank is improving the situation at hand.
The third pillar dictates that banks should publish the outcome of their risk calculations and also their methodology. The idea behind this requirement is that the market will guide the banks towards a set of well established methodologies, thereby making the capital requirements stable throughout the banking world.
The third pillar requires banks to publish the outcome of several calculations and risk estimates, but also the methods and assumptions used to make those calculations. In other words banks need to publish qualitative information and quantitative information. Investors can use both to determine whether: