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Capital adequacy ratio

From Wikipedia, the free encyclopedia Jump to: navigation, search All or part of this article may be confusing or unclear. Please help clarify the article. Suggestions may be on the talk page. (July 2007) This article or section is in need of attention from an expert on the subject. WikiProject Economics or the Economics Portal may be able to help recruit one. If a more appropriate WikiProject or portal exists, please adjust this template accordingly. (November 2008) Capital adequacy ratio (CAR), also called Capital to Risk(Weighted) Assets Ratio (CRAR)[1], is a ratio of a bank's capital to its risk. National regulators track a bank's CAR to ensure that it can absorb a reasonable amount of loss [2] and are complying with their statutory Capital requirements. Contents [hide] 1 Formula 2 Use 3 Risk weighting o 3.1 Risk weighting example 4 Types of capital 5 See also 6 References 7 External links [edit] Formula This section or article contains too much jargon and may need simplification or further explanation. Please discuss this issue on the talk page, and/or remove or explain jargon terms used in the article. Editing help is available. (July 2007) Capital adequacy ratios ("CAR") are a measure of the amount of a bank's capital expressed as a percentage of its risk weighted credit exposures. Capital adequacy ratio is defined as where Risk can either be weighted assets () or the respective national regulator's minimum total capital requirement. If using risk weighted assets, 8%.[1] The percent threshold (8% in this case, a common requirement for regulators conforming to the Basel Accords) is set by the national banking regulator. Two types of capital are measured: tier one capital (T1 above), which can absorb losses without a bank being required to cease trading, and tier two capital (T2 above), which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors. [edit] Use Capital adequacy ratio is the ratio which determines the capacity of the bank in terms of meeting the time liabilities and other risk such as credit risk, operational risk, etc. In the most simple formulation, a bank's capital is the "cushion" for potential losses, which protect the bank's depositors or other lenders. Banking regulators in most countries define

and monitor CAR to protect depositors, thereby maintaining confidence in the banking system.[1] CAR is similar to leverage; in the most basic formulation, it is comparable to the inverse of debt-to-equity leverage formulations (although CAR uses equity over assets instead of debt-to-equity; since assets are by definition equal to debt plus equity, a transformation is required). Unlike traditional leverage, however, CAR recognizes that assets can have different levels of risk. [edit] Risk weighting Since different types of assets have different risk profiles, CAR primarily adjusts for assets that are less risky by allowing banks to "discount" lower-risk assets. The specifics of CAR calculation vary from country to country, but general approaches tend to be similar for countries that apply the Basel Accords. In the most basic application, government debt is allowed a 0% "risk weighting" - that is, they are subtracted from total assets for purposes of calculating the CAR. [edit] Risk weighting example Local regulations establish that cash and government bonds have a 0% risk weighting, and residential mortgage loans have a 50% risk weighting. All other types of assets (loans to customers) have a 100% risk weighting. Bank "A" has assets totaling 100 units, consisting of: Cash: 10 units. Government bonds: 15 units. Mortgage loans: 20 units. Other loans: 50 units. Other assets: 5 units. Bank "A" has deposits of 95 units, all of which are deposits. By definition, equity is equal to assets minus debt, or 5 units. Bank A's risk-weighted assets are calculated as follows: Cash 10 * 0% = 0 Government bonds 15 * 0% = 0 Mortgage loans Other loans Other assets Total risk Weighted assets Equity 65 5 20 * 50% = 10 50 * 100% = 50 5 * 100% = 5

CAR (Equity/RWA) 7.69% Even though Bank "A" would appear to have a debt-to-equity ratio of 95:5, or equity-toassets of only 5%, its CAR is substantially higher. It is considered less risky because some of its assets are less risky than others. [edit] Types of capital The Basel rules recognize that different types of equity are more important than others. To recognize this, different adjustments are made: 1. Tier I Capital: Actual contributed equity plus retained earnings.

2. Tier II Capital: Preferred shares plus 50% of subordinated debt. Different minimum CAR ratios are applied: minimum Tier I equity to risk-weighted assets may be 4%, while minimum CAR including Tier II capital may be 8%. There is usually a maximum of Tier II capital that may be "counted" towards CAR, depending on the jurisdiction

Capital requirement
From Wikipedia, the free encyclopedia (Redirected from Capital requirements) Jump to: navigation, search Contents [hide] 1 Regulatory capital o 1.1 Tier 1 (core) capital o 1.2 Tier 2 (supplementary) capital 1.2.1 Undisclosed Reserves 1.2.2 Revaluation reserves 1.2.3 General provisions 1.2.4 Hybrid instruments 1.2.5 Subordinated-term debt 2 Different International Implementations 3 Common capital ratios o 3.1 Example 4 See also 5 External links 6 References The capital requirement is a bank regulation, which sets a framework on how banks and depository institutions must handle their capital. The categorization of assets and capital is highly standardized so that it can be risk weighted. Internationally, the Basel Committee on Banking Supervision housed at the Bank for International Settlements influence each country's banking capital requirements. In 1988, the Committee decided to introduce a capital measurement system commonly referred to as the Basel Capital Accords (Basel Accord). This framework is now being replaced by a new and significantly more complex capital adequacy framework commonly known as Basel II. While Basel II significantly alters the calculation of the risk weights, it leaves alone the calculation of the capital. The capital ratio is the percentage of a bank's capital to its risk-weighted assets. Weights are defined by risk-sensitivity ratios whose calculation is dictated under the relevant Accord. Each national regulator normally has a very slightly different way of calculating bank capital, designed to meet the common requirements within their individual national legal framework. Brazil limits bank lending to 10 times the bank's capital, adjusted to inflation . Most developed countries and Basel I and II, stipulate lending limits as a multiple of a banks capital eroded by the yearly inflation rate. The 5 C's of Credit, Character, Cash Flow, Collateral, Conditions and Capital, have been substituted by one single criterion. While the international standards of bank capital were

laid down in the 1988 Basel I accord, Basel II makes significant alterations to the interpretation, if not the calculation, of the capital requirement. Examples of national regulators implementing Basel II include the FSA in the UK, BAFIN in Germany, and OSFI in Canada. An example of a national regulator implementing Basel I, but not Basel II, is in the United States. Depository institutions are subject to risk-based capital guidelines issued by the Board of Governors of the Federal Reserve System (FRB). These guidelines are used to evaluate capital adequacy based primarily on the perceived credit risk associated with balance sheet assets, as well as certain off-balance sheet exposures such as unfunded loan commitments, letters of credit, and derivatives and foreign exchange contracts. The risk-based capital guidelines are supplemented by a leverage ratio requirement. To be adequately capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 4%, a combined Tier 1 and Tier 2 capital ratio of at least 8%, and a leverage ratio of at least 4%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. To be well-capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 6%, a combined Tier 1 and Tier 2 capital ratio of at least 10%, and a leverage ratio of at least 5%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. These capital ratios are reported quarterly on the Call Report or Thrift Financial Report. [edit] Regulatory capital In the Basel I accord bank capital was divided into two "tiers", each with some subdivisions. [edit] Tier 1 (core) capital Tier 1 capital, the more important of the two, consists largely of shareholders' equity. This is the amount paid up to originally purchase the stock (or shares) of the Bank (not the amount those shares are currently trading for on the stock exchange), retained profits and subtracting accumulated losses. In simple terms, if the original stockholders contributed $100 to buy their stock and the Bank has made $10 in profits each year since, paid out no dividends and made no losses, after 10 years the Bank's tier one capital would be $200. Regulators have since allowed several other instruments, other than common stock, to count in tier one capital. These instruments are unique to each national regulator, but are always close in nature to common stock. These are commonly referred to as upper tier one capital. [edit] Tier 2 (supplementary) capital There are several classifications of tier 2 capital, which is composed of supplementary capital. In the Basel I accord, these are categorized as undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt. [edit] Undisclosed Reserves Undisclosed reserves are not common, but are accepted by some regulators where a Bank has made a profit but this has not appeared in normal retained profits or in general reserves. Most of the regulators do not allow this type of reserve because it does not reflect a true and fair picture of the results. [edit] Revaluation reserves

A revaluation reserve is a reserve created when a company has an asset revalued and an increase in value is brought to account. A simple example may be where a Bank owns the land and building of its headquarters and bought them for $100 a century ago. A current revaluation is very likely to show a large increase in value. The increase would be added to a revaluation reserve. [edit] General provisions A general provision is created when a company is aware that a loss may have occurred but is not sure of the exact nature of that loss. Under pre-IFRS accounting standards, general provisions were commonly created to provide for losses that were expected in the future. As these did not represent incurred losses, regulators tended to allow them to be counted as capital. [edit] Hybrid instruments Hybrids are instruments that have some characteristics of both debt and shareholders' equity. Provided these are close to equity in nature, in that they are able to take losses on the face value without triggering a liquidation of the Bank, they may be counted as capital. [edit] Subordinated-term debt Subordinated-term debt is debt that is not redeemable (it cannot be called upon to be repaid) for a set (usually long) term and ranks lower than (it will only be paid out after) ordinary depositors of the bank. [edit] Different International Implementations Regulators in each country have some discretion on how they implement capital requirements in their jurisdiction. For example, it has been reported[1] that Australia's Commonwealth Bank is measured as having 7.6% Tier 1 capital under the rules of the Australian Prudential Regulation Authority, but this would be measured as 10.1% if the bank was under the jurisdiction of the UK's Financial Services Authority. This demonstrates that international differences in implementation of the rule can vary considerably in their level of strictness. [edit] Common capital ratios Tier 1 capital ratio = Tier 1 capital / Risk-adjusted assets >=6% Total capital (Tier 1 and Tier 2) ratio = Total capital (Tier 1 and Tier 2) / Riskadjusted assets >=10% Leverage ratio = Tier 1 capital / Average total consolidated assets >=5% Common stockholders equity ratio = Common stockholders equity / Balance sheet assets [edit] Example Listed below are the capital ratios in Citigroup at the end of 2003 [1]. Ratios At year-end Tier 1 capital Leverage (1) 2003 8.91% 5.56%

Total capital (Tier 1 and Tier 2) 12.00% Common stockholders equity 7.67% (1) Tier 1 capital divided by adjusted average assets.

Components of Capital Under Regulatory Guidelines In millions of dollars at year-end Tier 1 capital Common stockholders equity Qualifying perpetual preferred stock Qualifying mandatorily redeemable securities of subsidiary trusts Minority interest Less: Net unrealized gains on securities available-for-sale Intangible assets: (2) Goodwill Other disallowed intangible assets 50% investment in certain subsidiaries (3) Other Total Tier 1 capital Tier 2 capital Allowance for credit losses (4) Qualifying debt (5) Unrealized marketable equity securities gains (1) Less: 50% investment in certain subsidiaries (3) Total Tier 2 capital Total capital (Tier 1 and Tier 2)
(6) (1)

2003 $ 96,889 1,125 6,257 1,158 (2,908)

Accumulated net gains on cash flow hedges, net of tax (751) (1,242) (751) (27,581) (6,725) (45) (548) 66,871 9,545 13,573 399 (45) 23,472 $ 90,343

Risk-adjusted assets $750,293 (1) Tier 1 capital excludes unrealized gains and losses on debt securities available-forsale in accordance with regulatory risk-based capital guidelines. The federal bank regulatory agencies permit institutions to include in Tier 2 capital up to 45% of pretax net unrealized holding gains on available-for-sale equity securities with readily determinable fair values. Institutions are required to deduct from Tier 1 capital net unrealized holding losses on available-for-sale equity securities with readily determinable fair values, net of tax. (2) The increase in intangible assets is primarily due to the acquisition of the Sears credit card portfolio in November 2003. (3) Represents unconsolidated banking and finance subsidiaries. (4) Includable up to 1.25% of risk-adjusted assets. Any excess allowance is deducted from risk-adjusted assets. (5) Includes qualifying subordinated debt in an amount not exceeding 50% of Tier 1 capital.

(6) Includes risk-weighted credit equivalent amounts, net of applicable bilateral netting agreements, of $39.1 billion for interest rate, commodity and equity derivative contracts and foreign exchange contracts, as of December 31, 2003, compared to $31.5 billion as of December 31, 2002. Market risk-equivalent assets included in risk-adjusted assets amounted to $40.6 billion and $30.6 billion at December 31, 2003 and 2002, respectively. Risk-adjusted assets also includes the effect of other off-balance sheet exposures such as unused loan commitments and letters of credit and reflects deductions for certain intangible assets and any excess allowance for credit losses

Tier 1 capital
From Wikipedia, the free encyclopedia Jump to: navigation, search This article does not cite any references or sources. Please help improve this article by adding citations to reliable sources. Unverifiable material may be challenged and removed. (April 2008) Tier 1 capital, also known as core capital,[1] is the core measure of a bank's financial strength from a regulator's point of view. It consists primarily of equity capital and cash reserves, but may also include irredeemable non-cumulative preferred stock and retained earnings. Capital in this sense is related to, but different from, the accounting concept of shareholder's equity. Both tier 1 and tier 2 capital were first defined in the Basel I capital accord and remained substantially the same in the replacement Basel II accord. Each country's banking regulator, however, has some discretion over how differing financial instruments may count in a capital calculation. This is appropriate, as the legal framework varies in different legal systems. The theoretical reason for holding capital is that it should provide protection against unexpected losses. Note that this is not the same as expected losses which are covered by provisions, reserves and current year profits. The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total risk-weighted assets. Risk-weighted assets are the total of all assets held by the bank which are weighted for credit risk according to a formula determined by the Regulator (usually the country's Central Bank). Most central banks follow the Bank of International Settlements (BIS) guidelines in setting formulae for asset risk weights. Assets like cash and coins usually have zero risk weight, while debentures might have a risk weight of 100%. A good definition of Tier I capital is that it includes equity capital and disclosed reserves, where equity capital includes instruments that can't be redeemed at the option of the holder (meaning that the owner of the shares cannot decide on his own that he wants to withdraw the money he invested and so cannot leave the bank without the risk coverage). Reserves are, as they are held by the bank, by their nature not an amount of money on which anybody but the bank can have an influence on. Tier 1 capital is also seen as a metric of a bank's ability to sustain future losses. In October 2008,[2] a number of British banks have seen an erosion of their market capitalization due of their lower Tier 1 capital. In order to boost the Tier 1 capital of these banks and restore confidence in the banking system, the UK Treasury has decided to partnationalise the UK banks. The plan will allow seven banks, Abbey, Barclays, HBOS,

HSBC, Lloyds TSB, Royal Bank of Scotland and Standard Chartered and the Nationwide Building Society to apply for an initial amount of 25bn in permanent capital. The Treasury may possibly impose conditions on executive compensation and dividend cuts from the banks. This capital is expected to come in the form of preference shares or other permanent interest bearing shares

Tier 2 capital
From Wikipedia, the free encyclopedia Jump to: navigation, search Tier 2 capital is a measure of a bank's financial strength with regard to the second most reliable form of financial capital, from a regulator's point of view. The forms of banking capital were largely standardised in the Basel I accord, issued by the Basel Committee on Banking Supervision and left untouched by the Basel II accord. National regulators of most countries around the world have implemented these standards in local legislation. Tier 1 capital is considered the more reliable form of capital. There are several classifications of tier 2 capital. In the Basel I Accord, tier 2 capital is composed of supplementary capital, which is categorised as undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt. Supplementary capital can be considered tier 2 capital up to an amount equal to that of the core capital.[1] Contents [hide] 1 Undisclosed Reserves 2 Revaluation Reserves 3 General Provisions 4 Hybrid Instruments 5 Subordinated Term Debt 6 See also 7 References 8 External links [edit] Undisclosed Reserves Undisclosed reserves are not common, but are accepted by some regulators where a bank has made a profit but this has not appeared in normal retained profits or in general reserves of the bank. [edit] Revaluation Reserves A revaluation reserve is a reserve created when a company has an asset revalued and an increase in value is brought to account. A simple example may be where a bank owns the land and building of its head-offices and bought them for $100 a century ago. A current revaluation is very likely to show a large increase in value. The increase would be added to a revaluation reserve. [edit] General Provisions A general provision is created when a company is aware that a loss may have occurred but is not sure of the exact nature of that loss. Under pre-IFRS accounting standards, general provisions were commonly created to provide for losses that were expected in the

future. As these did not represent incurred losses, regulators tended to allow them to be counted as capital. [edit] Hybrid Instruments Hybrids are instruments that have some characteristics of both debt and shareholders' equity. Provided these are close to equity in nature, in that they are able to take losses on the face value without triggering a liquidation of the bank, they may be counted as capital. Preferred stocks are hybrid instruments. [edit] Subordinated Term Debt Subordinated debt is debt that ranks lower than ordinary depositors of the bank.

Subordinated debt
From Wikipedia, the free encyclopedia Jump to: navigation, search In finance, subordinated debt (also known as subordinated loan, subordinated bond, subordinated debenture or junior debt) is debt which ranks after other debts should a company fall into receivership or be closed. Such debt is referred to as subordinate, because the debt providers (the lenders) have subordinate status in relationship to the normal debt. A typical example for this would be when a promoter of a company invests money in the form of debt, rather than in the form of stock. In the case of liquidation (e.g. the company winds up its affairs and dissolves) the promoter would be paid just before stockholders -- assuming there are assets to distribute after all other liabilities and debt has been paid. Subordinated debt has a lower priority than other bonds of the issuer in case of liquidation during bankruptcy, below the liquidator, government tax authorities and senior debt holders in the hierarchy of creditors. Because subordinated debt is repayable after other debts have been paid, they are more risky for the lender of the money. It is unsecured and has lesser priority than that of an additional debt claim on the same asset. Subordinated loans typically have a higher rate of return than senior debt due to the increased inherent risk. Accordingly, major shareholders and parent companies are most likely to provide subordinated loans, as an outside party providing such a loan would normally want compensation for the extra risk. Subordinated bonds usually have a lower credit rating than senior bonds. Here are a couple examples for subordinated bonds. First of all, the main example of subordinated bonds can be found in bonds issued by banks. Subordinated debt is issued by most large banking corporations in the U.S. periodically. It is believed that subordinated notes are risk-sensitive. That is, subordinated debt holders have claims on bank assets after senior debtholders and they lack the upside gain enjoyed by shareholders. This status of subordinated debt makes it perfect for experimenting on the significance of market discipline. This can be accomplished in two separate ways. First, a simple look at secondary market prices of subordinated debt would suffice. Second, one can have a look at issue price of these bonds initially in the primary markets. For a second example for subordinated bond, consider asset-backed securities. These are often issued in tranches. The senior tranches get paid back first, the subordinated tranches later. Finally, Mezzanine debt is another example of subordinated debt.

Subordinated bonds are regularly issued (as mentioned earlier) as part of the securitization of debt, such as asset-backed securities, collateralized mortgage obligations or collateralized debt obligations. Corporate issuers tend to prefer not to issue subordinated bonds because of the higher interest rate required to compensate for the higher risk, but may be forced to do so if indentures on earlier issues mandate their status as senior bonds. Also, subordinated debt may be combined with preferred stock to create so called monthly income preferred stock, a hybrid security paying dividends for the lender and funded as interest expense by the issuer.

Basel Accord
From Wikipedia, the free encyclopedia (Redirected from Basel accord) Jump to: navigation, search Basel II Bank for International Settlements Basel Accord Basel I Basel II Background Banking Monetary policy - Central bank Risk Risk management Regulatory capital Tier 1 - Tier 2 Pillar 1: Regulatory Capital Credit risk Standardized - F-IRB - A-IRB PD LGD EAD Operational risk Basic - Standardized - AMA Market risk Duration - Value at risk Pillar 2: Supervisory Review Economic Liquidity risk - Legal risk Pillar 3: Market Disclosure Disclosure Business and Economics Portal The Basel Accord(s) or Basle Accord(s) (see spelling section below) refers to the banking supervision Accords (recommendations on banking laws and regulations), Basel I and capital

Basel II issued by the Basel Committee on Banking Supervision (BCBS). They are called the Basel Accords as the BCBS maintains its secretariat at the Bank of International Settlements in Basel, Switzerland and the committee normally meets there. Contents [hide] 1 The Basel Committee 2 Spelling 3 See also 4 References [edit] The Basel Committee The Basel Committee consists of representatives from central banks and regulatory authorities of the Group of Ten (economic) countries, plus others (specifically Luxembourg and Spain). The committee does not have the authority to enforce recommendations, although most member countries (and others) tend to implement the Committee's policies. This means that recommendations are enforced through national (or EU-wide) laws and regulations, rather than as a result of the committee's recommendations - thus some time may pass between recommendations and implementation as law at the national level. [edit] Spelling The Basel Committee is named after the Swiss town of Basel. In early publications, the committee sometimes used the English spelling "Basle" or the French spelling "Ble," names that are sometimes still used in the press. More recently, the Committee has deferred to the predominantly German population of the region and used the spelling "Basel."

Basel I
From Wikipedia, the free encyclopedia Jump to: navigation, search Basel I is the round of deliberations by central bankers from around the world, and in 1988, the Basel Committee (BCBS) in Basel, Switzerland, published a set of minimal capital requirements for banks. This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten (G-10) countries in 1992, with Japanese banks permitted an extended transition period. Basel I is now widely viewed as outmoded, and a more comprehensive set of guidelines, known as Basel II are in the process of implementation by several countries. [edit] Background The Committee was formed in response to the messy liquidation of a Cologne-based bank in 1974. On 26 June 1974, a number of banks had released Deutschmark to the Bank Herstatt in exchange for dollar payments deliverable in New York. On account of differences in the time zones, there was a lag in the dollar payment to the counter-party banks, and during this gap, and before the dollar payments could be effected in New York, the Bank Herstatt was liquidated by German regulators. This incident prompted the G-10 nations to form towards the end of 1974, the Basel Committee on Banking Supervision, under the auspices of the Bank of International Settlements (BIS) located in Basel, Switzerland. [edit] Main framework

Basel I, that is, the 1988 Basel Accord, primarily focused on credit risk. Assets of banks were classified and grouped in five categories according to credit risk, carrying risk weights of zero (for example home country sovereign debt), ten, twenty, fifty, and up to one hundred percent (this category has, as an example, most corporate debt). Banks with international presence are required to hold capital equal to 8 % of the risk-weighted assets. Since 1988, this framework has been progressively introduced in member countries of G10, currently comprising 13 countries, namely, Belgium, Canada, France, Germany, Italy, Japan, Luxemburg, Netherlands, Spain, Sweden, Switzerland, United Kingdom and the United States of America. Most other countries, currently numbering over 100, have also adopted, at least in name, the principles prescribed under Basel I. The efficiency with which they are enforced varies, even within nations of the Group of Ten.

Basel II Accord
From Wikipedia, the free encyclopedia (Redirected from Basel II) Jump to: navigation, search Basel II Bank for International Settlements Basel Accord Basel I Basel II Background Banking Monetary policy - Central bank Risk Risk management Regulatory capital Tier 1 - Tier 2 Pillar 1: Regulatory Capital Credit risk Standardized - F-IRB - A-IRB PD LGD EAD Operational risk Basic - Standardized - AMA Market risk Duration - Value at risk Pillar 2: Supervisory Review Economic Liquidity risk - Legal risk Pillar 3: Market Disclosure capital

Disclosure Business and Economics Portal This article or section is missing information about: the global financial crisis and how Basel II relates to it.. This concern has been noted on the talk page where it may be discussed whether or not to include such information. (November 2008) This article or section includes a list of references or external links, but its sources remain unclear because it lacks inline citations. You can improve this article by introducing more precise citations where appropriate. (April 2008) Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II, which was initially published in June 2004, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. Advocates of Basel II believe that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. In practice, Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability. The final version aims at: 1. Ensuring that capital allocation is more risk sensitive; 2. Separating operational risk from credit risk, and quantifying both; 3. Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage. While the final accord has largely addressed the regulatory arbitrage issue, there are still areas where regulatory capital requirements will diverge from the economic. Basel II has largely left unchanged the question of how to actually define bank capital, which diverges from accounting equity in important respects. The Basel I definition, as modified up to the present, remains in place. Contents [hide] 1 The Accord in operation o 1.1 The first pillar o 1.2 The second pillar o 1.3 The third pillar 2 September 2005 update 3 November 2005 update 4 July 2006 update 5 November 2007 update 6 July 16, 2008 update

7 Basel II and the regulators o 7.1 Implementation progress 8 See also 9 References 10 External links [edit] The Accord in operation Basel II uses a "three pillars" concept (1) minimum capital requirements (addressing risk), (2) supervisory review and (3) market discipline to promote greater stability in the financial system. The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk was not dealt with at all. [edit] The first pillar The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk and market risk. Other risks are not considered fully quantifiable at this stage. The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach, Foundation IRB and Advanced IRB. IRB stands for "Internal Rating-Based Approach". For operational risk, there are three different approaches - basic indicator approach or BIA, standardized approach or TSA, and advanced measurement approach or AMA. For market risk the preferred approach is VaR (value at risk). [edit] The second pillar The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputation risk, liquidity risk and legal risk, which the accord combines under the title of residual risk.It gives bank a power to review their risk management system. [edit] The third pillar The third pillar greatly increases the disclosures that the bank must make. This is designed to allow the market to have a better picture of the overall risk position of the bank and to allow the counterparties of the bank to price and deal appropriately. [edit] September 2005 update On September 30, 2005, the four US Federal banking agencies (the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision) announced their revised plans for the U.S. implementation of the Basel II accord. This delays implementation of the accord for US banks by 12 months [1]. [edit] November 2005 update On November 15, 2005, the committee released a revised version of the Accord, incorporating changes to the calculations for market risk and the treatment of double default effects. These changes had been flagged well in advance, as part of a paper released in July 2005. [2] [edit] July 2006 update

On July 4, 2006, the committee released a comprehensive version of the Accord, incorporating the June 2004 Basel II Framework, the elements of the 1988 Accord that were not revised during the Basel II process, the 1996 Amendment to the Capital Accord to Incorporate Market Risks, and the November 2005 paper on Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework. No new elements have been introduced in this compilation. This version is now the current version. [3] [edit] November 2007 update On November 1, 2007, the Office of the Comptroller of the Currency (U.S. Department of the Treasury) approved a final rule implementing the advanced approaches of the Basel II Capital Accord. This rule establishes regulatory and supervisory expectations for credit risk, through the Internal Ratings Based Approach (IRB), and operational risk, through the Advanced Measurement Approach (AMA), and articulates enhanced standards for the supervisory review of capital adequacy and public disclosures for the largest U.S. banks [4]. [edit] July 16, 2008 update On July 16, 2008 The federal banking and thrift agencies ( The Board of Governors of the Federal Reserve System; the Federal Deposit Insurance Corporation; the Office of the Comptroller of the Currency, and; the Office of Thrift Supervision) issued a final guidance outlining the supervisory review process for the banking institutions that are implementing the new advanced capital adequacy framework (known as Basel II). The final guidance, relating to the supervisory review, is aimed at helping banking institutions meet certain qualification requirements in the advanced approaches rule, which took effect on April 1, 2008. http://www.occ.gov/ftp/release/2008-81a.pdf [edit] Basel II and the regulators One of the most difficult aspects of implementing an international agreement is the need to accommodate differing cultures, varying structural models, and the complexities of public policy and existing regulation. Banks senior management will determine corporate strategy, as well as the country in which to base a particular type of business, based in part on how Basel II is ultimately interpreted by various countries' legislatures and regulators. To assist banks operating with multiple reporting requirements for different regulators according to geographic location, there are several software applications available. These include capital calculation engines and extend to automated reporting solutions which include the reports required under COREP/FINREP. [edit] Implementation progress Regulators in most jurisdictions around the world plan to implement the new Accord, but with widely varying timelines and use of the varying methodologies being restricted. The United States of America's various regulators have agreed on a final approach - see [5] for the Notice of Proposed Rulemaking. They have required the Internal Ratings-Based approach for the largest banks, and the standardized approach will not be available to anyone. In India, RBI has implemented the Basel II norms. In response to a questionnaire released by the Financial Stability Institute (FSI)[6], 95 national regulators indicated they were to implement Basel II, in some form or another, by 2015.

The European Union has already implemented the Accord via the EU Capital Requirements Directives and many European banks already report their capital adequacy ratios according to the new system. All the credit institutions will adopt it by 2008.

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