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US Implementation of the Basel II Accord
Practical Law Article 5-386-1051 (Approx. 4 pages)
US Implementation of the Basel II Accord
by PLC Finance
| Published on 14 May 2009 • USA (National/Federal) |
A discussion of the US implementation of the Basel II framework.
Background to the Basel Accords (Basel I)
The Basel Accord (also known as Basel I) is a policy agreement on the supervision of banks developed in 1988 by the Basel Committee. Basel I aims to achieve international agreement on the measurement of capital adequacy of banks and to establish minimum capital standards.
Banks are required to hold a minimum level of regulatory capital to reduce the risk and impact of adverse events, both on their depositors or other creditors and on the wider industry. The key aims of capital adequacy rules are therefore to:
- Ensure as far as possible that any losses arising from the crystallization of risks to which a bank is exposed to are borne by the bank's shareholders without impacting the bank's creditors and its depositors.
- Assist in preventing systemic risk (that is, the risk that a failure of one party within the financial system will cause failure of other parties in the system or even have a catastrophic impact on the system as a whole).
Basel II
Following extensive consultations, Basel I was revised to develop capital requirements that reflect more accurately the risks faced by the banking industry. "Basel II" was published by the Basel Committee in June 2004. The Basel II framework is based on three "pillars":
- Pillar 1: banks must determine their eligible capital and minimum capital requirements in relation to their credit risk, operational risk and market risk.
- Pillar 2: a supervisory review process by which supervisors are required to assess how well banks are assessing their capital requirements relative to the risks to which they are exposed and to intervene where necessary.
- Pillar 3: market discipline, achieved by requiring banks to disclose key information to their peers.
While Basel I contains more standard capital requirements, Basel II contains more bank-specific requirements, such as allowing banks to choose between two broad methods for calculating their credit risk. The standardized approach enables a bank to calculate its risk in a standardized manner supported by external credit assessments. The internal ratings-based (IRB) approach enables a bank to use its own internal rating systems for credit risk, subject to the explicit approval of the bank's supervisor. As noted in US Implementation of Basel II, the US bank regulators adopted only the advanced approaches (described below), including the IRB approach for credit risk.
For more information on the Basel II framework and the different approaches to risk, see PLC UK Financial Services Practice Note, Basel II: an overview.
US Implementation of Basel II
In December 2007, US bank regulators published the rule for US implementation of the capital adequacy framework set out in Basel II (see Federal Register/Vol. 72, No. 235/Friday, December 7, 2007/Rules and Regulations). In April 2008, the rule became effective and in July 2008, US bank regulators published final guidance outlining the supervisory review process for banks that are implementing Basel II (see FRB: Press Release, Agencies issue statement on Basel II advanced approaches qualification process (the Interagency Statement)).
According to the Interagency Statement:
"On December 7, 2007, the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (Board), the Federal Deposit Insurance Corporation (FDIC), and the Office of Thrift Supervision (OTS) (collectively, the agencies) issued a new risk-based capital framework (advanced approaches rule) that requires some and permits other qualifying banks to use an internal ratings-based approach (IRB) and other methodologies to calculate risk-based capital requirements for credit risk and advanced measurement approaches (AMA) to calculate risk-based capital requirements for operational risk. Collectively, these methodologies are referred to as the advanced approaches. The rule describes the qualification requirements for banks required or seeking to operate under the new framework and the applicable risk-based capital requirements."
In the US, only certain large banks (core banks) must comply with the US version of Basel II and use the advanced approaches. Core banks are generally defined as those with at least $250 billion of consolidated total assets, at least $10 billion of on-balance sheet foreign exposure, or that are a parent or subsidiary of a bank using the advanced approaches. Non-core US banks may opt in to using the advanced approaches if they meet the applicable qualification requirements.
US banks implementing the US version of Basel II must go through a qualification process. The process consists of three major stages:
- Adoption of an implementation plan.
- Completion of a satisfactory parallel run (when a bank continues to be subject to the general risk-based capital rules for all regulatory, supervisory and reporting purposes, but also reports to its primary Federal supervisor its risk-based capital as calculated according to the advanced approaches rule).
- Advancement through three transitional periods.
For more information on US implementation of Basel II (including additional supervisory guidance and the proposed optional US standardized risk-based capital framework for banks not subject to the advanced approaches), see FRB: Basel II Capital Accord, Basel I Initiatives, and Other Basel-Related Matters.
Reform of the International Bank Capital Framework (Basel III)
Since the financial crisis, focus has again turned to strengthening bank capital requirements. Many of the banks that failed or required government bailouts during the crisis were in compliance with their bank capital regulatory requirements. This did not prevent the liquidity problems these banks subsequently faced and the resulting harm to the financial sector and the economy.
On December 17, 2009, the Bank for International Settlements published for consultation the proposals of the Basel Committee to strengthen the global regulation of banks' capital and liquidity (see Legal Update, BCBS Consults on Proposals to Strengthen Global Capital and Liquidity Regulation). These proposals have been dubbed "Basel III" and basically require more capital to be raised by banks. They also impose new liquidity and other requirements on banks. For more information on the Basel III proposals and their implementation, see Practice Note, Basel III: an overview and Article, Basel III: Overview and Implementation in the US.