Foundations of Financial Risk: An Overview of Financial Risk and Risk-based Financial Regulation, 2nd Edition

CHAPTER 8 Regulatory Capital and Supervision

The Basel Accords aim to maintain the stability of the international bank­ing industry by setting international standards for capital adequacy and, in the case of the most recent accord, for liquidity.

The first Basel Accord set a minimum standard for risk-weighted capital adequacy and provided a simple methodology for calculating it. The Basel II Accord introduced a three-pillar framework for assessing capital adequacy. Under Pillar 1 of Basel II, Basel I's measurement of risk-weighted capital was increased in scope and made more sensitive (and more complicated). Basel II increased the minimum capital requirements by including operational and market risk alongside credit risk within the scope of Pillar 1.

Pillar 2 introduced the concept of supervisory review, under which bank supervisors would review how a bank was calculating its capital ratios and assess the adequacy of that process. Under Pillar 2, the supervisor can require a bank to hold more capital than the regulatory minimum specified under Pillar 1.

Pillar 3 introduced the concept of market discipline. Under Pillar 3, banks are required to disclose significant amounts of information about the risks they face and the capital they hold, on the assumption that with that information available, market participants will form an opinion on a bank's capital adequacy.

Basel III retains the three pillars introduced by Basel II and also the requirement to hold capital against credit, ...