Risk Management under Basel I :
The Basel Committee on Banking Supervision (BCBS) is a committee which was set up by the Central Bank Governors of a group of ten countries, to address international issues relating to the banking supervision. The Basel Committee on Banking Supervision in 1988 came out with a Capital Accord for banks, covering the areas of risks in respect of banks’ assets and liabilities in the balance sheet and off balance sheet exposures. Under the Basel I Accord, only the credit risk factor was considered and the minimum requirement of capital funds was fixed at 8 per cent of the total risk weighted assets. In India, banks are required to maintain a minimum of 9 percent (Capital to Risk Weighted Asset Ratio – CRAR) on an ongoing basis.
Pitfalls of Basel I
Basel I Capital Accord has been criticized on several grounds. The main criticisms include the following:
• Limited differentiation of credit risk
There are four broad risk weightings (0%, 20%, 50% and 100%), based on an 8% minimum capital ratio.
• Static measure of default risk
The assumption that a minimum 8% capital ratio is sufficient to protect banks from failure does not take into account the changing nature of default risk.
• No recognition of term-structure of credit risk
The capital charges are set at the same level regardless of the maturity of a credit exposure.
• Simplified calculation of potential future counter party risk
The current capital requirements ignore the different level of risks associated with different currencies and macroeconomic risk. In other words, it assumes a common market to all actors, which is not true in reality.
• Lack of recognition of portfolio diversification effects
In reality, the sum of individual risk exposures is not the same as the risk reduction through portfolio diversification. Therefore, summing all risks might provide incorrect judgment of risk. A remedy would be to create an internal credit risk model – for example, one similar to the model as developed by the bank to calculate market risk. This remark is also valid for all other weaknesses.
These criticisms have led to the creation of a new Basel Capital Accord, known as Basel II, which added operational risk and also defined new calculations of credit risk. Operational risk is the risk of loss arising from human error or management failure. Basel II Capital Accord was implemented in 2007