Financial markets have always been sensitive towards incurring heavy losses due to either poor risk management policies or frauds as both would reduce public confidence, which is the mainstay of the sector. Thus, banking institutions and investment firms felt the need to improve their measures for security and risk management. To achieve this, the Basel Accord was signed in 1988. The Basel Accord was adopted by the Central Banks of over 100 countries as a basis of risk management within their banking system. It aimed to ensure an adequate level of capital in the international banking system. However, the regulatory capital requirement set by the Accord proved to be incompatible with the new sophisticated internal measures of economic capital. In addition, the Accord was unable to recognize credit risk techniques, such as collateral and guarantees. This resulted in an inflexible system and ultimately increased the risk for financial institutions. Basel II was devised to plug these gaps. A Basel II implementation allows bankers to adequately emphasize their own internal risk management methodologies. Bankers can also provide more incentives and options for risk management, thereby increasing flexibility of their systems. In addition to this, Basel II provides a variety of benefits to the banking system. These include enhanced risk management, efficient operations, and higher revenues to the banking community. Along with the increased benefits, Basel II has also laid down some controls on the international banking system. This is primarily in the form of a higher capital requirement to underwrite mismanagement of risks and lack of infrastructural controls in many economies. The global acceptance for Basel II is not far and most banks across the world will soon come under the purview of this Accord. Comparing the new Accord with the existing one.
Existing AccordNew Accord
1. Focus on single risk.1. More emphasis on banks' measures own internal methodology, supervisory review and market discipline. 2. One size fits all.2. Flexibility, menu of approaches, incentive for better risk management. 3. Broad brush structure.3. More risk sensitivity.
After a series of revisions, Basel II has been finalized. A major part of it will be applicable by the end of 2006. During this intervening period, banks and supervisors must develop the necessary systems and...