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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, (i) capital requirements, (ii) supervisory review and (iii) 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: - Market Risk, Credit Risk and Operational Risk. Pillar 2, supervisory review is intended to ensure that banks have adequate capital to support all the risks in their business determined both by pillar 1 and by supervisory evaluation of risks not explicitly captured in pillar 1. Pillar 3, market discipline is intended to complement the first two pillars and to encourage market discipline by developing a set of disclosure requirements which will allow market participants to assess the capital adequacy of the institution.

Through this approach Basel-II aims to correct most of the deficiencies that Basel-I had suffered from. The new standards are more risk sensitive to business type and assets classes. This approach is multi-dimensional and focuses on all the operations of the bank. Accordingly banks, which have a larger risk exposure, will have to set apart more capital to meet the unexpected losses that go with it. The New Framework intends to improve safety, soundness in the financial system and enhance competitive equality.

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* Contributed by -
Nishant Bachkheti & Nilesh Maheshwari,
Core Committee Members, Fin-Niche,
IMT, Ghaziabad.