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Banking industry is the backbone of any country's economy; the sounder it is, the better the performance of the financial markets and the economy as a whole. Just like any other industry, banking industry is susceptible to various types of risks which might occasionally occur in losses, and at times they tend to be so severe that they take entire
firm down with them. To hedge against such risks, banks keep a minimum buffer of equity and provisions (regulatory capital), given a certain amount of various kinds of risks.

The size of this regulatory capital was determined by Based Accord (Basel I) earlier and now by Basel II Framework. Basel Committee on Banking Supervision (BCBS) is responsible to frame these rules; the committee has members from various (13) countries that are represented by their respective central banks or equivalent authority.

Basel II Framework on capital adequacy takes into account the elements of credit risk in various types of assets in the balance sheet as well as off-balance sheet business and also attempts to strengthen the capital base of banks. BCBS released the "International Convergence of Capital Measurement and Capital Standards: A Revised Framework" on 26 June 2004. This was then updated in November 2005 to include trading activities and the treatment of double default effects. The revised framework seeks to arrive at significantly more risk-sensitive approaches to capital requirements and provides a range of options to determine the capital requirements for credit risk and operational risks.

Basically, the Basel II Framework is known as having a "three mutually reinforcing pillar" approach, and these three pillars are: -

1. Minimum Capital Requirements

2. Supervisory Review of Capital Adequacy

3. Market Discipline

Pillar 1

Offers three distinct options for computing capital requirements for "credit risk", three other options for "operational risk" and two options for computing "market risk".

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* Contributed by: -
Vijay Singh Poonia,
PGDM 2007-09,
IIM Calcutta.