Last week, the Basel Committee on Banking Supervisionreleased a series of consultative papers and guidelines for public comment designed to enhance the three pillars of the current Basel II capital framework. The proposed changes are part of the Committee’s initiative announced last November, to develop “a comprehensive strategy to adapt the new Basel II capital regime to address risk issues that have emerged in the global financial crisis.”

The Basel II capital framework which remains a priority for the Basel Committee, once formally implemented will “provide[s] comprehensive tools for banks and bank supervisors to better capture and assess an increasing set of complex risks.” The Committee has published consultative papers that propose overall “enhancements to the Basel II framework” and consultative papers and guidelines that propose specific changes to the current Basel II’s market risk framework.  

Mr. Nout Wellink, Chairman of the Basel Committee and President of the Netherlands’ Bank, stated that “the proposed enhancements will help ensure that the risks inherent in the bank’s portfolios related to trading activities, securitisations and exposures to off-balance sheet vehicles are better reflected in minimum capital requirements, risk management practices and accompanying disclosures to the public.” He further noted that “the Committee intends to coordinate and implement this work programme in a manner that strengthens financial confidence and avoids aggravating current market conditions.”

The Committee’s proposed changes to the Basel II framework include the following enhancements:

  • Pillar 1 Minimum Capital Requirements: Measures that focus on ‘strengthening the risk capture of the framework,’ seek to “increase capital requirements for liquidity lines extended to support asset-backed commercial paper” programs, and require banks to obtain information with respect to “the underlying exposure characteristics of their externally-rated securitization positions.”
  • Pillar 2 Supervisory Review Process: Measures that address present discrepancies in the risk management practices of financial institutions which include guidance on implementing “[f]irm wide governance and risk management,” recognizing and indentifying off-balance sheet exposures and risk (including securitisation activities), and the adopting “[i]ncentives to manage risk and returns over the long-term.”
  • Pillar 3 Market Discipline: Includes proposed revisions to current Pillar 3 requirements in six areas with a particular focus on disclosure obligations related to securitisation related exposures. The Committee has stated that “[t]hese disclosures are intended to complement the other two pillars of the Basel II framework by allowing market participants to assess capital adequacy of a bank through key pieces of information on the scope of application, capital, risk exposure and risk assessment process.”  

The Committee’s proposed changes to the Basel II’s market risk framework and guidelines for “computing capital for incremental risk in the trading book” include:

measures to “supplement the current value-at-risk-based trading book framework with an incremental risk capital charge (IRC) which includes default risk as well as migration risks for unsecuritised products,” however, in the case of securitised products the capital charges related to banking books would apply;

  • implementation of a ‘stressed value-at-risk requirement’;
  • discontinuance of the preferential treatment of “a 4% capital charge for specific risk of equities that is currently applicable to portfolios that are both liquid and well diversified”; and
  • adoption of a long-term extensive review of risk-based related capital framework trading activities.  

The Basel Committee on Banking Supervision is responsible for instituting the Basel II’s three-pillar framework. Basel II seeks to implement sound international financial regulatory standards and “make regulatory capital more risk sensitive and more reflective of risk exposures arising from complex financial instruments not contemplated by Basel I, while promoting intended to protect the international financial system from banking failures. The United States is presently a participating member of the Committee, but the Committee's recommendations do not automatically apply to U.S. financia institutions. The federal bank regualtory agencies must adopt implementing regulations.