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Basel II - questions and answers

Last reviewed 08/01/2013: any recent updates in this colour.

1. What was Basel I?

Basel I was an international accord to set minimum levels of capital for banks, building societies and other deposit taking institutions. It was designed to create a level playing field for lenders from different countries and to ensure that lenders were sufficiently well capitalised to protect depositors and the financial system.

2. Why were the requirements changed through Basel II?

The first Basel Accord has been replaced by a new accord, Basel II. The new accord has been introduced to keep pace with the increased sophistication of lenders' operations and risk management and overcome some of the distortions caused by the lack of granularity in Basel I. Lenders had been able under Basel I to reduce required capital in ways that did not reflect lower real risk (in what has become known as regulatory capital arbitrage). The intention is that Basel II will align required minimum capital more closely with lenders' real risk profile.

3. What is the status of Basel II?

Basel II is a voluntary agreement between the banking authorities of the major developed countries.  However, the provisions of Basel II have been enshrined in an EU directive – the Capital Requirements Directive (CRD).  This means that they are law throughout the EU.

4. What are the main differences between Basel I and Basel II?

Basel I required lenders to calculate a minimum level of capital based on a single risk weight for each of a limited number of asset classes, eg, mortgages, consumer lending, corporate loans, exposures to sovereigns. Basel II goes well beyond this, allowing some lenders to use their own risk measurement models to calculate required regulatory capital whilst seeking to ensure that lenders establish a culture with risk management at the heart of the organisation up to the highest managerial level.

5. What are the 3 pillars?

The 3 Pillars of Basel II enshrine the key principles of the new regime.

Pillar 1 covers the calculation of risk weights to determine a basic minimum capital figure. The Accord provides for a choice of ways to calculate required capital. The simplest is the standardised approach, which provides set risk weights for some asset classes and requires the weight on others to be determined by the public credit rating assigned to the particular asset by the rating agencies. Lenders are able to choose the more sophisticated 'internal ratings based' (IRB) approach, either foundation, advanced or retail. These allow lenders to use their own risk models to determine appropriate minimum capital. Pillar 1 also requires lenders to assess their market and operational risk and provide capital to cover such risk.

Under Pillar 2, lenders are required to assess risks to their business not captured in Pillar 1, for which additional capital may be required (for example the risk caused by interest rate mismatches between assets and liabilities).

Finally, Pillar 3 requires lenders to publish information on their approach to risk management and is designed to raise standards through greater transparency.

6. When was Basel II implemented?

In the EU all deposit takers had to implement Basel II by no later than 1 January 2008.  The US delayed this date to January 2009.

7. What's the difference between the standardised approach and the IRB approaches?

The standardised approach is the simplest and most similar to Basel I, providing set risk weights for some asset classes and requiring the weight on others to be determined by the public credit rating assigned to the particular asset by the rating agencies. Under the IRB approach, lenders use their own models of risk to determine the appropriate minimum capital requirement.

8. How does an institution choose which will be better for it?

In making a judgement about which approach to adopt, lenders have to consider the complexity of their business, the sophistication of their risk management, the cost of developing and maintaining their own risk models and systems and the likely impact on capital requirements of each approach.

Since Basel II is designed to encourage lenders to become more sophisticated in their risk management, lenders will usually see a modest reduction in capital using the IRB approach compared with the standardised approach. However, this potential for a lower capital requirement must be weighed against the additional cost of implementing the IRB approach and the complexity of the lender's business. For smaller and less complex businesses, the standardised approach could be more appropriate.

9. What counts as capital?

Capital includes those sums that the lender and its shareholders put at risk. It is divided into Tier 1 - the purest form of capital - and Tier 2 - which is all other capital. Tier 1 capital includes shareholders' funds (including retained earnings) and non-cumulative preference shares. Tier 2 capital includes cumulative preference shares, general provisions and subordinated bonds, which are classed as capital because they are paid after the ordinary creditors (such as bond holders or depositors) in the event of an insolvency.

For building societies capital includes the general reserve (the accumulated profit of the organisation) and permanent interest bearing shares (PIBS), which rank behind ordinary creditors or depositors.

10. Why do financial institutions need to hold capital?

Lenders are financial intermediaries, taking funds from savers and lending them on to borrowers. Given the risk that some borrowers will be unable to repay their loans or that losses will occur for other reasons, lenders need capital of their own to protect their depositors (the savers) from the risk of losing money. Capital thus acts as a cushion to absorb unexpected losses.

11. How much capital, and of what type, do institutions have to hold under Basel II?

Lenders must hold total capital equal to at least 8% of risk-weighted assets and Tier 1 capital of at least 4% of risk-weighted assets. These figures are carried over from Basel I.

12. How much capital do mortgage lending institutions have to hold compared with other types of financial institution?

The minimum level of capital required to be held by financial institutions will depend on the risk profile of their assets (encapsulated in the risk weighting), their operational risk and any requirement under Pillar 2 to allow for risk factors not captured in Pillar 1 (such as risk caused by interest rate mismatches between assets and liabilities).

Under Basel I mortgages carried a 50% risk weight, against 100% for unsecured personal and corporate loans. Basel II takes a more granular approach by stipulating a 35% risk weight for loans with a loan-to-value ratio (LTV) of up to 80%. Loans to highly rated corporate borrowers (ie, relatively safe companies) have seen an even larger reduction in risk weighting but loans to many other corporates continue to be weighted 100%.

For banks using the retail IRB approach, the risk weight attached to mortgages depends on the lender's historical loss experience, subject to downturn assumptions, which drives the internal risk model. This can give rise to risk weights on mortgages well below 35%.

13. How are lenders using any capital released as a result of the move to Basel II?

The Basel Committee did not intend Basel II to reduce the total capital held in the banking system as a whole. Moreover, it has introduced floors to ensure that individual lenders' capital requirements cannot fall too quickly from Basel I levels in the early years.

It should also be remembered that lenders hold capital for a variety of reasons, not just to satisfy the regulatory minimum. There are strategic reasons for holding additional capital, to finance acquisitions for example. Moreover, the higher a lender's capital ratios, the safer it will appear to investors, allowing it to raise funds more cheaply. For building societies, the interest in reducing actual capital levels is likely to be particularly muted, as they need capital to support future balance sheet growth and, for this reason alone, many have no real interest in reducing capital.

14. Will this make a difference to any institution's (or group of institutions') apparent financial strength – eg, returns on capital measurements?

With the introduction of Basel II, the return on regulatory capital changed simply because the calculation of regulatory capital had changed. But this is not a measure that analysts and investors pay particular attention to. Investors are usually more interested in the return on the actual capital held by the lender and this would only change if the lender decided to change the size of its capital base in response to a change in the minimum requirement.

Where a lender sees a reduction in regulatory capital and does not reduce actual capital in response, its capital ratios will be further above the regulatory minimum. This may make the lender appear safer, but nothing real has changed.

15. Are capital requirements the same across the world?  If not, how do they differ?

Basel II covers all OECD countries (the advanced economies). Within this group the largest anomaly is in the US, where only the largest banks will be required to adopt the accord, it being optional for others. In the EU, Basel II has been introduced via the Capital Requirements Directive (CRD). Although the CRD creates a common detailed framework for implementation, it does allow for 'national discretions' in a number of areas, giving national regulators some limited flexibility in how they implement Basel II. One example of a national discretion is the LTV limit within which residential mortgages qualify for the preferential risk weighting of 35%. In the UK, the Financial Services Authority (FSA) has set this LTV limit at 80%.

16. There is an EU directive, but does the implementation of Basel II require UK legislation or just FSA rules?

The Financial Services and Markets Act 2000 gave the FSA the power to implement directives through the use of FSA 'rules'. It is under such rules that the FSA implemented the CRD.

17. What happens if an institution breaches the Basel II requirements?

National regulators monitor and maintain a dialogue with lenders to ensure that problems are identified and addressed as early as possible. If it looked as though a lender was in danger of breaching its capital requirements, an action plan would be required as to how the lender intended to prevent this from happening.

18. Why are there 3 different possible approaches?

The choice of 3 approaches to calculating risk assets under Pillar 1 is designed to accommodate the different levels of sophistication in lenders' risk measurement and management. In this way, Basel II recognises that a small lender with a relatively simple business cannot be expected to manage risk in the same way as a large and complex financial institution.

19. Does Basel II have any practical implications for consumers?  If so, what are they?

For lenders, Basel II is an internal management exercise that does not directly affect customers. However, there has been a good deal of talk about Basel II leading to greater risk-based pricing in loan markets, as it increases the difference in capital required between risky and safer lending categories. This could lead to riskier types of debt, such as consumer finance, costing more relative to safer categories such as low LTV mortgages then they do now. However, many lenders already use risk-based pricing, especially for higher risk lending such as sub-prime mortgages and consumer loans, and the impact of Basel II on consumers is hard to discern.

20. Will Basel II increase the likelihood of risk-based pricing in the mainstream mortgage market?

It is thought by some commentators that a lower capital requirement for mortgage loans could lead to lower mortgages rates. However, it should be remembered that non-deposit taking institutions have never been covered by the Basel Accords. Moreover, many of the largest lenders already use risk-based pricing. All this suggests that the impact on pricing in the mortgage market may not be as large as some predict.

21. How much does Basel II matter – is it just a technical exercise, or is it genuinely making a difference to the way that financial institutions run themselves?

The transition to Basel II was a major exercise with some larger lenders spending between £50-100m on implementation. Probably its greatest effect will be on raising the standard of risk management across the lending industry and increasing the understanding of senior management in issues related to risk.

22. What impact has the financial crisis had on Basel II?

The recent global financial crisis has revealed weaknesses in the whole approach to risk management that has been developed through the Basel II process. Risks have come from sources that Basel II did not adequately anticipate such as a collapse in market liquidity as investor confidence disappeared and deep losses in the market value of securities held by banks. 

Assumptions about the liquidity of financial instruments such as mortgage backed securities (MBS) that were based on past performance have proven to be unfounded as has the reliability of credit ratings on many of these MBS.

The financial crisis has also shown that at times of severe stress the inter linkages amongst banks and between banks and other financial institutions have the potential to create a domino effect whereby seemingly safe lenders can be put at risk by exposures to counterparties that turned out to be less safe than thought.

As a result of the above, policymakers are proposing and implementing changes to Basel II. These changes are being considered by both the Basel Committee and at an EU level, where the CRD, which implements Basel II, is being updated through a range of changes embodied in legislative revisions known as CRD2, 3 and 4.