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 II. This was a far reaching revision of the 1988 / 1996 Accord (Basel I) affecting 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

The Basel II framework consists of a 'menu' of different approaches to meet capital requirements for credit risk, market risk and operational risk:

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 I but must meet specified qualification criteria.

Basel II 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 II 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:

• Policies 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 II 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.

EU Implementation of Basel II

Although the Basel Committee formulates international supervisory standards and guidelines it has no legal authority. Within the European Union, the passing of Basel II standards into legislation has been achieved through the means of directives implemented through national measures. (In contrast, most of Basel III is applied through direct regulation.

The Capital Requirements Directive (CRD) that implemented Basel II throughout the EU came into force on 1 January 2007. The legal framework has since been regularly updated to reflect revisions to Basel II by means of a series of amendments, which are sequentially numbered for ease of reference.

CRD II amendments, effective from end-2010, included:

• Criteria for assessing the eligibility of hybrid capital to be counted as part of a firm’s overall capital. Proposals specify the features that hybrid capital must have regarding permanence, flexibility of payments and loss absorbency to be eligible as tier one capital
• Changes to the large exposures regime, further restricting a firm’s lending beyond a certain limit to any one party
• Risk management of securitisation, including a requirement to ensure that a firm does not invest in a securitisation unless the originator retains an economic interest of at least 5%
• Supervision of cross-border banking groups by establishing ‘colleges of supervisors’ for banking groups that operate in multiple EU countries
• Operation of the CRD by amending various technical provisions to correct unintended errors and to introduce additional clarity.

CRD III amendments covering capital changes effective from end-2011, and other aspects effective from start-2011, included:

• Increasing capital requirements for the trading book to ensure that a firm’s assessment of the risks connected with its trading book better reflects the potential losses from adverse market movements in stressed conditions
• Increasing capital requirements for re-securitisations to ensure firms take proper account of the risks of investing in such complex financial products
• Upgrading Pillar 3 disclosure standards for securitisation exposures to increase market confidence
• Changes to rules on remuneration policies, requiring firms not to encourage or reward excessive risk-taking.

CRD IV amendments implement certain Basel III proposals, most notably those concerning the capital conservation and counter-cyclical buffers. However, the most significant part of Basel III / CRD IV is implemented by direct regulation, without the need to be written into national law.

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. Selected FSA consultation papers and policy documents are listed in the references section of this website. Regulatory requirements are set out in the FSA Handbook.