The Basel framework—comprising Basel I, Basel II, and Basel III—establishes international standards for banking regulation, with a primary focus on capital adequacy, risk management, and market discipline. This framework is structured around three mutually reinforcing pillars, designed to promote the safety and soundness of the global banking system.
Scope of Application
- The Basel norms are primarily applicable to internationally active banks, with the standards typically enforced on a consolidated basis—covering the parent bank and its subsidiaries.
- However, many jurisdictions also extend the application to domestic banks to strengthen overall financial stability.
Pillar 1: Minimum Capital Requirements
Pillar 1 defines the minimum regulatory capital that banks must maintain to cover key risk types:
- Credit Risk: Risk of loss due to a borrower’s failure to repay.
- Market Risk: Risk of loss due to fluctuations in market prices.
- Operational Risk: Risk arising from failed internal processes, people, or systems.
Key aspects:
- Banks must calculate Risk-Weighted Assets (RWAs) and maintain a Capital Adequacy Ratio (CAR) above the regulatory minimum.
- Basel II introduced more refined approaches for risk assessment (Standardized and Internal Ratings-Based), which were further enhanced under Basel III with additional buffers (e.g., Capital Conservation Buffer, Countercyclical Buffer).
Pillar 2: Supervisory Review Process (SRP)
Pillar 2 emphasizes the role of supervisors in evaluating a bank’s internal capital adequacy relative to its risk profile.
Key aspects:
- Banks are expected to implement an Internal Capital Adequacy Assessment Process (ICAAP).
- Supervisors assess whether banks hold capital above the minimum regulatory requirement, to cover all material risks, including those not fully captured under Pillar 1 (e.g., interest rate risk in the banking book, concentration risk).
- Enables supervisory authorities to intervene when banks hold insufficient capital or face significant risk exposures.
Pillar 3: Market Discipline
Pillar 3 seeks to promote transparency and market discipline through enhanced public disclosures.
Key aspects:
- Banks must disclose comprehensive information on:
- Capital structure and adequacy
- Risk exposures and management strategies
- Risk assessment methodologies and outcomes
- Effective disclosure helps market participants assess a bank’s risk profile and capital strength, thereby reinforcing prudent behavior.
Risk Coverage and Evolution
- The Basel framework addresses multiple risk categories:
- Credit Risk
- Market Risk
- Operational Risk
- Liquidity Risk (addressed more explicitly in Basel III through Liquidity Coverage Ratio and Net Stable Funding Ratio)
- Evolution of Basel Norms:
- Basel I (1988): Focused on credit risk and simple capital requirements.
- Basel II (2004): Introduced the three-pillar structure, enhanced risk sensitivity.
- Basel III (2010 onwards): Strengthened capital base, introduced liquidity standards, and addressed systemic risks following the global financial crisis.
Conclusion
The three pillars of the Basel framework work in tandem to ensure:
- Banks maintain adequate capital to absorb potential losses (Pillar 1),
- Supervisors can effectively evaluate and enforce capital adequacy and risk management (Pillar 2),
- Transparency and market discipline are upheld through public disclosures (Pillar 3).
Together, they aim to enhance the resilience of the banking sector and safeguard the broader financial system.
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