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Two-Tiered Capital
Basil I defines capital based on two tiers:
1. Tier 1 (Core Capital): Tier 1 capital includes stock issues
(or share holders equity) and declared reserves, such
as loan loss reserves set aside to cushion future losses or
for smoothing out income variations.
2. Tier 2 (Supplementary Capital): Tier 2 capital includes all
other capital such as gains on investment assets, long-
term debt with maturity greater than five years andhidden reserves (i.e. excess allowance for losses on loans
and leases). However, short-term unsecured debts (or
debts without guarantees), are not included in the
definition of capital.
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Basel II much more risk sensitive, as it is aligning capital
requirements to risks of loss. Better risk management in a
bank means bank may be able to allocate less regulatory
capital.
The objective of Basel II is to modernise existing capital
requirements framework to make it more comprehensive and
risk sensitive.
The Basel II framework therefore designed to be more
sensitive to the real risks that firms face than Basel I.
Apart from looking at financial figures, it also considers
operational risks, such as risk of systems breaking down or
people doing the wrong things, and also market risk.
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Ensuring that capital allocation is more risksensitive
Separating operational risk from credit risk,and quantifying both
Attempting to align economic andregulatory capital more closely to reducescope for regulatory arbitrage
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Pillar 1 sets out the minimum capital requirements firms will be required tomeet to cover credit, market and operational risk.
Pillar 2 sets out a new supervisory review process. Requires financialinstitutions to have their own internal processes to assess their overall capital
adequacy in relation to their risk profile.
Pillar 3 cements Pillars 1 and 2 and is designed to improve market discipline
by requiring firms to publish certain details of their risks, capital and risk
management as to how senior management and the Board assess and will
manage the institution's risks.
Three Pillars of Basel II Framework
Pill 1 Mi i it l i t
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Pillar 1 : Minimum capital requirements
Institution's total regulatory capital must be at least 8%
(ratio same as in Basel I) of its risk
weighted assets, based on measures of THREE RISKS
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Covers Supervisory Review Process, describing principles for
effective supervision.
Supervisors obliged to evaluate activities, corporate governance,
risk management and risk profiles of banks to determine
whether they have to change or to allocate more capital for their
risks (called Pillar 2 capital)
Deals with regulatory response to the first pillar, giving
regulators much improved tools over those available to them
under Basel I
Also provides framework for dealing with all the other risks a
bank may face, such as Systemic risk, pension risk,
concentration risk, strategic risk, reputation risk, liquidity risk
and legal risk, which the accord combines under the title of
residual risk
It gives banks a power to review their risk management system.
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Covers transparency and the obligation of
banks to disclose meaningful information to
all stakeholders
Clients and shareholders should have
sufficient understanding of activities of
banks, and the way they manage their risks