Financial Risk Management

CHAPTER 4Implementation of the Basel II Framework

THE THREE PILLARS

The finalized Basel II framework was published in June 2004, but its effective implementation date was June 2006, due to the difficulty the regulator and the banking industry experienced in reaching a general agreement, more or less acceptable for both. As illustrated in Figure 4, the Basel II framework is designed along three main strands:

• The first pillar (Minimum Capital Requirements) explains how to calculate the total minimum capital requirements for credit risk, market risk and operational risk. For the most part, the definition of eligible regulatory capital (constituents of capital in Figure 4), as outlined in the 1988 Accord and extended in BCBS (1996), remains in place.¹
• The second pillar (Supervisory Review Process) is intended to ensure that banks have adequate capital to support all the risks in their business; it discusses the key principles of the internal assessment process with respect to banking risks.
• The third pillar (Market Discipline) develops a set of disclosure requirements to encourage safe and sound banking practices.

In what follows, we focus on the first pillar because minimum regulatory capital requirements play the most important role in Basel II. First of all, they ensure that banks maintain adequate capital. Moreover, since they are supposed to accurately reflect a bank's risk, minimum regulatory capital requirements provide more effective triggers for prompt corrective action. ...