The pillarsPillar 1, capital requirements, calculates minimum capital requirement for credit risk in the banking book in a new way that accounts for the credit ratings of the counter parties. The capital requirement for market risk is unchanged.
Pillar 2, supervisory review, gives supervisors in different countries some discretion in how they apply the rules to account for local conditions. Emphasis is however placed on overall consistency and early intervention
Pillar 3, market discipline, requires banks to make more information public. The hope is that this will increase pressure from investors and markets to make sound risk management decisions.
Background
I have previously talked about the BIS (1988) Accord and the 1996 Amendment. These belong to what we today refer to as Basel I. In 1999 these rules were replaced by Basel II to account for some serious weaknesses in Basel I.
These were (1) all loans from banks to corporations carried a risk weight of 100%, making lending to AAA companies unprofitable, and (2) no model for default correlation.
Basel II consists of three pillars: capital requirements, regulatory review, and market discipline. The capital requirements calculations has changed from Basel I to account for different credit ratings of the counterparty. The capital requirement from market risk is unchanged and there is a new capital charge for operational risk.
Total risk = 0.08 x (Credit risk RWA + Market risk RWA + Operational risk RWA)
Credit risk RWA = sum(w*on balance sheet assets) + sum(w*off balance sheet assets)
Market risk RWA = 12.5 x (k*VaR + SRC)
If a capital requirement for risk is calculated so that it does not involve RWAs, it is multiplied by 12.5 to convert it.
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