Not only the internal rating, but also the governance and the quality of risk management will be a major factor in being able to use internal ratings as a basis for calculating regulatory capital requirements.
National supervisors will authorise firms to use one of the internal-ratings based approaches on a case by case basis. Basel II also introduces capital requirements for operational risk, a risk category that was not explicitly addressed under the Basel I rules.
To a large extent, the proposed Basel II was in response to widespread criticism of Basel I. But it also reflected additional thought and analysis of the role of bank capital regulation. In particular, Basel II added two new "pillars" - supervisory review (pillar 2) and market discipline (pillar 3) - to the single pillar of minimum capital requirement of Basel I. In response to public comments, the Committee revised its proposal twice and issued a third consultative paper (CP3) in early 2003. If approved, the proposed standards are scheduled for implementation in most countries at the beginning of 2007. In preparation, in August 2003, U.S. regulators circulated an Advance Notice of Proposed Rulemaking (ANPR) for the application of Basel II to U.S. banks for public comment by the end of the year, and the major features have been incorporated by the European Union in a proposed revision of its Capital Adequacy Directive (CAD) for financial institutions, for approval by the European Parliament and the member national parliaments before adoption
A key feature of the New Accord, as noted above, is that it is structured on the basis of three pillars:
(1) Pillar 1. Minimum capital requirements for market credit and operational risk (2) Pillar 2. Supervisory review process and
(3) Pillar 3. Market discipline
These pillars are interlocking and mutually reinforcing. For example, the use of the more sophisticated approaches to credit or operational risk will bring additional disclosure requirements under Pillar 3, and will affect the nature of the supervisory review conducted under Pillar 2.
Pillar 1 - Minimum capital requirements
Under Basel II, the definition of regulatory capital as well as the minimum required ratio of 8% of risk-weighted assets remains substantially unchanged from the Basel I Accord2. The treatment of position risk arising from trading activities as set out in the 1996 Amendment of Basel I Accord also remains substantially un-changed, although significant changes are proposed to the treatment of counterparty credit risk that have been discussed in a joint working group established by the Basel Committee and the International Organisation of Securities Commissions (IOSCO).
The principal modifications relate to the methodology for calculating risk-weighted assets categories, credit and operational risk. The minimum capital requirements and methods used to measure the risks faced by banks, as defined under Pillar 1 of the Basel II Ac-cord, are given in the paragraphs below.
Credit Risk: Pillar 1
Three methods for calculating credit risk capital are offered. In order of increasing sophistication and risk