Basel Committee’s risk categories

The Basel II Capital Accord is the successor of the Basel I Capital Accord (1988). The Basel I Capital Accord represented the first step toward risk-based capital adequacy requirements. However, since 1988 the financial world has changed dramatically and there existed a growing need within the financial world for a new capital accord. In 2007 a new capital accord will become operative, and it will improve the Basel I Capital Accord on several aspects.

The first part of this report describes the framework for bank and financial services supervision and regulation as outlined by the Basel committee. This is part of ongoing efforts to promote adequate transparency and effective market discipline. In addition, a well-informed investors, depositors, creditors and other bank counterparties can provide a bank with strong incentives to maintain sound risk management systems and internal controls and to conduct its business in a manner that is both prudent and consistent with stated business objectives.

In the second part of the document, I will apply the committee's framework to non-financial institutions and the private sector. The first initiative from BIS came in the form of Basel I accord with over 100 central banks in different countries accepting the benchmarks stipulated under the agreement [4]. The Basel I Capital Accord represented the first step toward risk-based capital adequacy requirements. The accord was an agreement by the members of the Basel committee on Banking Supervision (BCBS) with respect to minimum regulatory capital for credit risk.

Credit risk is the possibility of a loss as a result of a situation that those who owe money to the bank may not fulfil their obligation. Regulatory capital refers to the risk-based capital requirements under the Capital Accord. The purpose of regulatory capital is to ensure adequate resources are available to absorb bank-wide unexpected losses [4, 5, and 6]. Under the rules of the Basel I accord, the minimum regulatory capital associated with loans or other cash assets, guarantees, or derivative contract is calculated as: Regulatory Capital = Risk Weight ?

Exposure ? 8% = Risk-Weighted-Assets x 8% In the above formula the constant 8% is the minimum ratio of regulatory capital to total risk-weighted assets (RWA), this value was determined by the Basel Committee [7]. In the following paragraphs in the next subsection, the formula for the calculation of regulatory capital is discussed. The risk weights reflect the relative credit risk across different types of exposures. The Risk Weight for a transaction is determined by characteristics of the obligor. In Table 1 the risk weights from the Basel I Capital Accord are given.

Roughly speaking, three kinds of obligors can be distinguished: Sovereigns, Banks and Corporates institutions with corresponding risk weights of 0%, 20% and 100%. This follows Basel I by grouping exposures into a series of risk categories. However, while previously each risk category carried a fixed risk weighting, under Basel II three of the categories (loans to sovereigns, corporate institutions and banks) have risk weights determined by the external credit ratings assigned to the borrower, this could vary from zero percent to 150 percent depending on credit assessment from 'AAA' to below B- [10, 12, 18].

Thus, a bank with a credit portfolio with superior rating may be able to save capital while banks having lower rated credit exposure will have to mobilize more capital [10, 12, and 18]. The consultative paper introduces the possibility of an internal ratings-based approach for more sophisticated banks [22]. This alternative would allow banks to use their internal credit risk rating systems in determining regulatory capital requirements, conditioned on the supervisor's acceptance of the rating process used by the bank [12].

Subject to supervisory review, qualifying banks would be permitted to assign individual credits to distinct credit risk categories based on their internal ratings [18]. Through discussions with the industry, the Committee will be studying the feasibility of accepting internal ratings for regulatory capital purposes, and the design of such a capital regime [22]. Two of the more significant issues involve (1) the comparability of credit risk assignments across banks, and (2) the adaptability of those systems for use in establishing prudent capital requirements [13].