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Read the text about Basel Accords and be ready to compare Basel 1 and Basel 2 in terms of their purposes and regulatory tools.

Capital Requirements Directive/Basel 2

The original Basel Accord was agreed in 1988 by the Basel Committee on Banking Supervision. The 1988 Accord, now referred to as Basel 1, helped to strengthen the soundness and stability of the international banking system as a result of the higher capital ratios that it required.

Basel 2 is a revision of the existing framework, which aims to make the framework more risk sensitive and representative of modern banks' risk management practices. There are four main components to the new framework:

• It is more sensitive to the risks that firms face: the new framework includes an explicit measure for operational risk and includes more risk-sensitive risk weightings against credit risk.
• It reflects improvements in firms' risk-management practices, for example the internal ratings-based approach (IRB) allows firms to rely to a certain extent on their own estimates of credit risk.
• It provides incentives for firms to improve their risk-management practices, with more risk-sensitive risk weightings as firms adopt more sophisticated approaches to risk management.
• The new framework aims to leave the overall level of capital held by banks collectively broadly unchanged.

The new Basel Accord has been implemented in the European Union via the Capital Requirements Directive (CRD). It affects banks and building societies and certain types of investment firms. The new framework consists of three 'pillars'. Pillar 1 of the new standards sets out the minimum capital requirements firms will be required to meet for credit, market and operational risk. Under Pillar 2, firms and supervisors have to take a view on whether a firm should hold additional capital against risks not covered in Pillar 1 and must take action accordingly. The aim of Pillar 3 is to improve market discipline by requiring firms to publish certain details of their risks, capital and risk management.

Basel 2 takes a different approach to capital, charging banks on the basis of how risky their assets are. These “risk weights” will also become far more punitive

The liquidity of banks’ balance-sheets will also be regulated more intensively. Britain’s Financial Services Authority (FSA) has already issued proposed guidelines on liquidity which will require banks to hold a greater cushion of liquid assets, mainly in the form of government bonds.

If the regulation of balance-sheets is set to become more prescriptive, other things will be designed to increase levels of uncertainty. Take the stance of Britain’s newly scary FSA. Its previous philosophy meant that the regulator focused primarily on the management controls and systems that banks had in place. That passive approach will be replaced by a more intrusive and capricious regime, which questions the decisions of individual institutions.