In June 2004, the Basel Committee on Banking Supervision published its revised capital requirements framework ("International Convergence of Capital Measurement and Capital Standards"), commonly known as Basel 2. This is a far reaching revision of the 1988 / 1996 Accord (Basel 1) which affect banks, building societies and certain types of investment firms.

Capital Requirements Framework

The framework consists of three '"mutually reinforcing pillars":

Pillar 1 sets out the minimum capital requirements banks will be required to meet for credit, market and operational risk.

Pillar 2 requires that firms and supervisors (the FSA in UK) take a view on the amount of additional capital that should be held against Pillar 1 risks, and those risks not covered by Pillar 1, and take action accordingly.

Pillar 3 aims to improve market discipline by requiring banks to publish certain details of their risks, capital and risk management practice.

Pillar 1 - Minimum Capital Requirements

Unlike Basel 1, the Basel 2 framework consists of a 'menu' of different approaches to meet capital requirements for credit risk (rather than a one-size-fits-all approach) and introduces operational risk requirements, again offering a menu of approaches:

Under the Standardised Approach to credit risk regulatory capital requirements are calculated by multiplying the value of the firm's exposure by an appropriate risk weight. Risk weightings for exposures to institutions are determined by their credit rating. Risk weights for personal loans and mortgages are lower than Basel 1 but must meet specified qualification criteria.

Basel 2 offers two further Internal Ratings Based approaches to credit risk: Foundation and Advanced. These allow banks to use their own internal models to calculate regulatory capital requirements, the Advanced being the more sophisticated of the two.

In addition to credit risk and market risk, Basel 2 sets out capital requirements for operational risk. Again, different approaches are offered. Under the Basic Indicator Approach and Standardised Approach regulatory capital is determined by the firm's average gross income (in total or split by business line) multiplied by a given risk weighting.

The Advanced Measurement Approach allows firms to use their own internal operational risk models using past loss data, provided they meet specified qualification criteria.

As banks move from the simple to the advanced approaches (that are subject to stiffer qualification criteria - bank's policies, procedures, methods, data quality and controls and so on), so regulatory capital requirements are reduced.

Pillar 2 - Supervisory Review

The Supervisory Review process places obligations on firms to undertake a 'self assessment' of their internal capital requirements and have a strategy for maintaining capital levels.

This is known as an 'Internal Capital Adequacy Assessment Process' or ICAAP, and must include:

• Polices and procedures to identify, measure and report on its risks
• A process to relate internal capital to risks
• A process to state the Bank's goals in terms of capital adequacy
• Internal controls, review and audit procedures

The framework only outlines high level principles; there is no 'template' for the ICAAP. Rather, it is the responsibility of firms to design and develop their own which fits their particular circumstances and needs. The essential requirement is that the methodology is risk based and recognises that Pillar 1 may only partially cover the risks that pose a threat to the firm's business.

The FSA still uses its ARROW process to undertake their Supervisory Review and Evaluation Process, but this has been adapted to take account of the firm's ICAAP. Following review, the FSA may issue the firm with Individual Capital Guidance (among other measures).

Pillar 3 - Market Discipline & Disclosure

Basel 2 aims to encourage market discipline by allowing market participants to assess banks' capital adequacy from disclosure of their capital, risk exposures and risk assessment processes.

Pillar 3 is intended to compliment Pillars 1 and 2, consistent with how the bank assesses and manages risks and proportionate to its degree of sophistication.

Disclosure requirements include:

• Describing capital instruments, the bank's approach to assessing capital adequacy, a breakdown of eligible capital and capital requirements for credit, market and operational risk
• For each risk exposure and risk assessment, a description of the policies, strategies, methods, processes, and responsibilities within the bank
• A breakdown of exposures, outstandings, past losses, capital requirements and other data depending on the risk and approach taken.

UK Implementation of Basel 2 Proposals

Although the Basel Committee formulates international supervisory standards and guidelines it has no legal authority. Within the European Union, the passing of its banking regulatory standards into legislation is achieved through the means of directives, which in turn are implemented through national measures.

In July 2004, the European Commission published draft text of the Capital Requirements Directive that implemented the revised Basel Accord (Basel 2) throughout the EU. Note that this legislative proposal actually took the form of amendments to two earlier directives; the Banking Consolidation Directive and the Capital Adequacy Directive.

Within the UK, the FSA acts as the national 'supervisor' under the Financial Services and Markets Act and, unlike other countries, only needs to undertake a consultation process in order to make a directive lawful. Regulatory requirements are set out in the FSA's handbook which is comprised of Prudential Sourcebooks.

The FSA has some limited flexibility in regarding the details of implementation, as set out in the Directive's Annex. For certain aspects the FSA has 'national discretions' concerning how the Directive is applied in the UK.