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The rules of Basel I for calculating risk weighted assets are said not to reflect the true economic risk of a transaction in its entirety, but only to a limited extent. Under the Basel 1, a corporate exposure with a high rating and low risk attracts the same credit risk weighting as a corporate exposure with a low rating and a high risk1.
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. ...