Basel II: Challenges and Risks

ABSTRACT This paper presents a comprehensive overview of the New Basel Capital Accord (Basel II). The study raises a number of issues and research questions concerning the Basel II capital adequacy as well as the regulatory capital treatment of asset and their potential impact on current competitive positions of banks and the markets. The article also briefly discusses the challenges and risks of implementation of Basel II in the U.S. and Asia-Pacific countries. INTRODUCTION The Basel Committee on Banking Regulation and Supervisory Practices devoted significant resources and considerable attention to the development of the capital adequacy for internationally active banks, known as the 1988 Basel Accord (Basel I). The primary purpose of the 1988 Capital Accord was to make regulatory capital requirements more responsive to the credit risk associated with a bank's portfolio of assets and off-balance sheet activities. However, critics have argued that the simplified approach to credit risks under Basel I has encouraged many depository institutions to shroud credit risk embedded in their assets as well as in off-balance sheet activities. In response to the deficiencies of Basel I, the Basel Committee created a new capital adequacy including a new securitization framework to determine the risk-based capital requirements for banks against credit risk, operational risk, and market risk arising from their on-balance assets, off- balance sheet and activities. The new capital adequacy framework, which is often referred to as Basel II (1), was developed to better align regulatory capital to the underlying risks. The primary goal of Basel II is to improve safety and soundness in the global financial system by placing increased emphasis on bank's risk measurement, internal control, risk management processes and models, the supervisory review process, and market discipline. The implementation of Basel II has begun in EU countries and is due to take effect in the U.S. by the year end 2007. The primary purpose of this paper is to discuss the reasons for Basel II and the likely effects of Basel II on banking industry and markets in the United States. The rest of the paper proceeds as follows. In Section 2, I outline some weaknesses associated with Basel I and provide the rationale for the development of Basel II. In this section, I present an overview of Basel II. Section 3 discusses the criticisms on Internal Ratings Based (IRB) approach prescribed by Basel II and their impact on competitive positions of banks in the U.S. In this section, I also provide rationale for supervisory concern for inherent risks associated with activities and the reasons for new regulatory capital treatments for asset securitization. In Section 4, I discuss the potential challenges of the implementation of Basel II including some issues associated with the cross-border implementation in the U.S. In this section, I address the key challenges and risks faced by bank managers and supervisors in the emerging Asia-Pacific countries. Section 5 discusses the capital adequacy beyond Basel II and its potential impact on financial services industry. Section 6 concludes with some final thoughts. BASEL I CAPITAL REGIME AND REASONS FOR BASEL II The basic principles of the Basel Capital Accord of 1988 known as Base I (2) are based on minimum capital requirements that a bank must hold against its assets, which allows the bank to sustain losses before depositors are hit (3). This relies on the concept that different asset categories represent differing degrees of risk, and that capital must be calculated appropriately to guard against such risks. The minimum capital requirements comprise three fundamental specifications: 1. What constitutes regulatory capital, 2. …