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Managing risk has become the single most important issue for the regulators and financial institutions. Over the years, these institutions have realized the cost of ignoring this risk. However, growing research and improvements in information technology have improved the measurement and management of risk.
Capital adequacy of a bank has become an important benchmark to assess its financial soundness and strength. The idea is that banks should be free to engage in their asset-liability management as long as they are backed by a level of capital sufficient to cushion their potential losses. In other words, capital requirement should be determined by the risk profile of a bank.

The Basel Committee on Banking Supervision (BCBS) was established in 1974 to facilitate information sharing and cooperation among bank regulators in major countries. It came out with the Capital Accord (Basel I) in 1988, which was very successful with more than 100 countries accepting it as a benchmark. Basel I was criticized due to its arbitrary nature of both the risk classes and risk weights. A Revised Framework, popularly known as Basel II Accord, was released on June 26, 2004.

The main feature of Basel II is that its structure rests on a set of three "mutually reinforcing" pillars, namely,

1. capital requirements

2. supervisory review

3. market discipline

Pillar 1, capital requirements is based on the banks own measure of risks. There are three major types of risks associated with banks: -