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: