Basel II

Basel II is the result of several year long intensive cooperation of the BCBS with banks and institutions from financial sector and it improves many weaknesses of Basel I. For further enhancement of strength and stability of the international banking system, with the convergence of capital requirements by country, in June 2004 the Committee issued a revised Framework, and two years later its comprehensive version. The version from June 2006 includes additional guidelines which primarily relate to the treatment of trading activities and double default effects and amendments related to market risks and includes all provisions of Basel I which remained effective.

New Framework (Basel II) consists of three pillars:

  • Pillar 1 improves capital framework by aligning minimum capital requirements of a bank with the volume and type of its operations and the nature of risks that arise from them. Pillar 1 includes minimum capital requirements for three types of risks: credit, market and operational risk. The most significant changes concerning Pillar 1, compared to Basel I and its amendments, are related to the treatment of credit risk and the introduction of capital requirement for operational risk, while the treatment of market risk remained unchanged.
    First, Basel II provides banks with more sophisticated approaches to calculating capital requirements for credit risk taking into account specific risk profile and other characteristics of each individual bank. There are two main approaches enabling banks to select one that is most applicable to them:

    • Banks with smaller volume of operations and with simpler control structure primarily choose the Standardized Approach. According to this approach, for the assessment of creditworthiness of a debtor the bank uses the rating from external credit assessment institutions, previously approved by the supervisor. 
    • Banks engaged in more complex activities with more developed risk management systems, and which have developed advanced risk measuring systems, can, with a prior approval of the supervisor, select one of two approaches for calculating capital requirements for credit risk based on internal ratings (“IRB”):
    • Foundation internal ratings based approach (FIRB): banks use their own assessments of probability of default (PD) while assessments of other parameters – risk components (LGD – Loss Given Default, EAD – Exposure at Default and M – Maturity) are determined by the supervisor.
    • Advanced internal ratings based approach (AIRB): banks use their own assessments for all risk components and conversion factors. 

    Second, the new Framework introduces capital requirement for operational risk, as the risk of loss due to employees’ negligence at work, inadequate procedures and processes in banks, inadequate IT management and other systems in banks, as well as due to the occurrence of unforeseeable external events. There are three approaches for calculating capital requirements for operational risk available to banks (BIA – Basic Indicator Approach, SA – Standardized Approach, and AMA – Advanced Measurement Approach). The selection of a specific approach depends on the volume and type of operations of a bank as well as on quality and level of sophistication of its risk management systems.

    Pillar 1 of the Basel II standard was implemented in Serbia by the Decision on capital adequacy of banks (RS Official Gazette, No. 46/2011).

  • Pillar 2 introduces a new approach to risk management and capital adequacy assessment by banks and points out the necessity of efficient supervision focused on the analysis of a bank’s internal capital adequacy assessment. Banks are obliged to assess capital adequacy for covering all risks that they face in the course of their operations, including risks which are not (entirely) covered by Pillar 1. The supervisor should analyze and assess the adequacy of this internal process of a bank, in order to determine whether the bank’s management uses appropriate assessment of all risks and whether it has allocated an adequate amount of capital in relation to the volume and nature of its business activities. 

    Four principles of Pillar 2

    The supervision process is based on the following four principles aimed at improving the internal risk management and control systems:

    • Internal Capital Adequacy Assessment Process (ICAAP): Banks should conduct continuous internal capital adequacy assessment in accordance with their risk profile and, based on this assessment, to determine the strategy of maintaining the necessary level of capital.
    • Supervisory Review and Evaluation Process (SREP): Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action If they are not satisfied with the result of this process.
    • Capital above the minimum level: One of the innovations of Basel II is a requirement and expectation of supervisors that banks have capital above the minimum level (defined by Pillar 1) and which adequately reflects the complexity of bank’s business activities and is sufficient to cover all risks arising from these activities.  
    • Supervisor’s interventions: Supervisors should seek to intervene in an early stages in order to prevent capital from falling below the minimum level necessary to support the risks that the bank is exposed to, and should require rapid remedial action if capital is not maintained and restored.
  • Pillar 3 aims to encourage market discipline by requesting disclosure of relevant information.

    The goal is to enable other participants to have access to key information about financial market participants such as information related to: scope of application, capital, risk exposures, risk assessment process and hence the capital adequacy of a particular bank or other institution in the financial sector. In this way, all participants in the financial market have the opportunity to conduct their own assessment of bank’s operations, its risk management as well as capital adequacy of the bank.

    Reliance on internal methodology of banks and granting discretional rights to banks, especially within Pillar 1, ascribes special significance to the disclosure of relevant information. Development of market discipline of financial market participants in accordance with Pillar 3 contributes to the safety and stability of the banking sector and financial system.

    Pillar 3 of the Basel II standard was implemented in Serbia by the Decision on disclosure of data and information by banks (RS Official Gazette, No. 45/2011).