Three Pillars Of Basel Accord And Global Financial Markets

Dependents among nations for various purposes have a long history though integration of global markets to the present position is of recent origin.  As of now, the decision taken by one country has the potential to alter the economic climate of other countries and this has necessitated better harmonization among central banks of different countries. This role is being carried out by the Bank for International Settlements (BIS) based in Basel , Swtzerland. It is pertinent to note that the central banks and nations abide by the guidelines known as BASEL guidelines, though the guidelines have no backing of national or international laws.  

The Basel committee issues guidelines on maintenance of capital banks are required to maintain based on the nature of business, quality and quantity to be in a position to withstand adverse trends in economy and face various risks associated with banking business. The individual central banks have the freedom to tweak the norms to suit the requirement of the country. 

So far three accords, Basel I, II and III are published with Basel III in various stages of adoption by member countries. These guidelines in their core follow the principle of capital adequacy, the ratio of the capital of a bank to its risk weighted assets, measured by the methods specified.  

Basel I accord of 1988 demanded a minimum capital of 8% linked to credit. Market risk was brought under its ambit in 1997. 

Basel II (1999) started with credit risk and market risk and later on in 2001 introduced the concept of operational risk. The concept of three pillars was also introduced by this accord. 

Basel III (2010) covers the credit , market and operational risks as in the previous accord.  But introduced   counter cyclical buffers, capital conservation buffer, leverage ratio and liquidity coverage ratios. 

Three Pillars of Basel accord

Pillar I specifies the minimum capital to be maintained in relation to the credit risk, market risk and operational risk. 

Credit risk is the risk of loss that a bank may have to face if the borrower fails to repay the debt or an issuer of an investment instrument fails to make repayment of principal amount and interest on due dates.  Market risk arises because of the changes in interest rate in market and associated reasons. For example, the market value of a bond decreases if interest rate moves upward.  Risks arising from the people, processes and systems in use within a firm, or from external events are classified under operational risks.  

Pillar II enables the bank itself to offer its own view of the level of capital it should hold by assessing nature of business like concentration risk, liquidity risk, strategic risk, pension risk etc. and enables regulators to set the level which they think is most appropriate. In Europe and certain other countries, Pillar 2 is known as ICAAP (Internal Capital Adequacy Assessment Process).

Pillar III is the public disclosure of prescribed aspects of the capital and approach of the bank to risk management.  This pillar is aimed at providing a tool to investors and other stakeholders to gauge the soundness and quality of operation and deployment of resources. Proper declaration reinforces good corporate governance and throws light on application, capital, risk exposures, risk assessment processes, and the capital adequacy of the bank.  It must be consistent with how the senior management, including the board, assess and manage the risks of the institution.

As evident from the above, the concept of Basel norms have evolved imbibing changes that have taken place in economic environment like collapse of Bearing Bank, Lehman Brother, 2008 economic recession etc. As per the concept of Pillar III, public disclosures are tools in the hands of market participants to assess a bank and reward reward those banks that manage their risks prudently.  Despite all these efforts, recent news that relates to banks and financial institutions which are available in the public domain make one wonder whether these principles are really practiced.