A New Capital Adequacy Framework

by Basel Committee on Banking Supervision of the Bank for International Settlements

June 1999

EXECUTIVE SUMMARY

1. The Basel Committee on Banking Supervision (the Committee) 1 has decided to introduce a new capital adequacy framework to replace the 1988 Accord. 2 The Committee seeks views on its proposed approaches and on its plans for future work.

2. This new capital framework consists of three pillars: minimum capital requirements, a supervisory review process, and effective use of market discipline. With regard to minimum capital requirements, the Committee recognises that a modified version of the existing Accord should remain the "standardised" approach, but that for some sophisticated banks use of internal credit ratings and, at a later stage, portfolio models could contribute to a more accurate assessment of a bank's capital requirement in relation to its particular risk profile. It is also proposed that the Accord's scope of application be extended, so that it fully captures the risks in a banking group.

3. The world financial system has witnessed considerable economic turbulence over the last two years and, while these conditions have generally not been focused on G-10 countries directly, the risks that internationally active banks from G-10 countries have had to deal with have become more complex and challenging. This review of the Accord is designed to improve the way regulatory capital requirements reflect underlying risks. It is also designed to better address the financial innovation that has occurred in recent years, as shown, for example, by asset securitisation structures. As a result of this innovation, the current Accord has been less effective in ensuring that capital requirements match a bank's true risk profile. The review is also aimed at recognising the improvements in risk measurement and control that have occurred.

4. The Committee is committed to ensuring that any review of the Accord should meet the following supervisory objectives:

• the Accord should continue to promote safety and soundness in the financial system and, as such, the new framework should at least maintain the current overall level of capital in the system;
• the Accord should continue to enhance competitive equality;
• the Accord should constitute a more comprehensive approach to addressing risks; and
• the Accord should focus on internationally active banks, although its underlying principles should be suitable for application to banks of varying levels of complexity and sophistication.

5. In constructing a revised capital framework, the importance of minimum regulatory capital requirements continues to be recognised. This is the first pillar of the framework. The Committee is now stressing the importance of the supervisory review of an institution's capital adequacy and internal assessment process as the second pillar. The third pillar, which the Committee has underlined in recent years, is the need for greater market discipline. The Committee believes that, taken together, these three elements are the essential pillars of an effective capital framework.

6. With regard to minimum regulatory capital requirements, the Committee is building on the foundation of the current Accord, which will serve as a "standardised" approach for capital requirements at the majority of banks. In so doing, the Committee proposes to clarify and broaden the scope of application of the current Accord. With regard to risk weights to be applied to exposures to sovereigns, the Committee proposes replacing the existing approach by a system that would use external credit assessments for determining risk weights. It is intended that such an approach will also apply, either directly or indirectly and to varying degrees, to the risk weighting of exposures to banks, securities firms and corporates. The result will be to reduce risk weights for high quality corporate credits, and to introduce a higher-than-100% risk weight for certain low quality exposures. A new risk weighting scheme to address asset securitisation, and the application of a 20% credit conversion factor for certain types of short-term commitments are also proposed.

7. For some sophisticated banks, the Committee believes that an internal ratings-based approach could form the basis for setting capital charges, subject to supervisory approval and adherence to quantitative and qualitative guidelines. The Committee will (in consultation with the industry) be examining these issues, and will seek to develop an alternative approach based on internal ratings within the same timeframe as its review of the "standardised" approach. The Committee believes that this will be an important step in the effort to align more closely capital charges with underlying risk. Looking further ahead, the Committee will closely monitor developments in portfolio credit risk modelling for its possible use in regulatory capital calculations.

8. The Committee is also examining the capital treatment of a number of important credit risk mitigation techniques. To assist in this process, the Committee is seeking comment on approaches for devising a sound and consistent approach for credit derivatives, collateral, guarantees, and on-balance-sheet netting.

9. The existing Accord specifies explicit capital charges only for credit and market risks (in the trading book). Other risks, including interest rate risk in the banking book and operational risk, are also an important feature of banking. The Committee therefore proposes to develop a capital charge for interest rate risk in the banking book for banks where interest rate risk is significantly above average, and is proposing to develop capital charges for other risks, principally operational risk.

10. The second pillar of the capital adequacy framework, the supervisory review of capital adequacy, will seek to ensure that a bank's capital position is consistent with its overall risk profile and strategy and, as such, will encourage early supervisory intervention. Supervisors should have the ability to require banks to hold capital in excess of minimum regulatory capital ratios - a point underscored in the course of the Committee's discussions with supervisors from non-G-10 countries. Furthermore, the new framework stresses the importance of bank management developing an internal capital assessment process and setting targets for capital that are commensurate with the bank's particular risk profile and control environment. This internal process would then be subject to supervisory review and intervention, where appropriate.

11. The third pillar, market discipline, will encourage high disclosure standards and enhance the role of market participants in encouraging banks to hold adequate capital. The Committee proposes to issue later this year guidance on public disclosure that will strengthen the capital framework.

12. Looking to the future, the Committee believes that the Accord must be responsive to financial innovation and developments in risk management practices. The Committee's longer-term aim is to develop a flexible framework that reflects more accurately the risks to which banks are exposed. The Committee therefore will examine further ways of making the capital adequacy framework more risk sensitive and welcomes comments on how best to do this.

13. The Committee seeks comments from all interested parties by 31 March 2000, and plans to set forth more definitive proposals later in the year 2000.

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