Basel 1 was designed to establish minimum requirements of capital for internationally active banks. However, the framework was crude and deeply problematical. It was aimed at setting standards based on "rules of the thumb". It relied on a relatively crude method of assigning risk weights to balance sheet and off balance sheet asset categories; furthermore it focussed only on credit risks while ignoring the other risks. However, OECD Central Banks encouraged over 100 countries across the world not only to adopt the Basel 1 framework but also to apply it across the entire banking sector without restricting it to the internationally active banks. Although not all countries are fully compliant with all the aspects of Basel 1, it has served the banking industry well since its introduction in 1988. However, Basel 1 was lagged behind the financial market developments and innovation especially when the time it increasingly because Basel 1 did not fully capture the increasing range of large and complex banking operations and the accompanying range of diverse set of economic risks. Besides, academics like McKenzie and Khalidi (1996) also questioned the very basis at the regulatory philosophy based on central engineering framework and emphasized on the need for improving the supervisory capacity of the home country supervisors (Pillar-II), and improving the transparency to enhance the markets self regulatory system (Pillar-III).
The Basel 2 framework has substantive breadth and depth. It setting different approaches for different sized banks and domestic or internationally active banks and recognizes properly different buckets of assets and assigns risk weights based on the quality of issues or assets through rating mechanism. To allow this flexibility Basel 2 is elaborate and is bedecked with three mutually reinforcing pillars:
Minimum capital requirement (MCR - Pillar I)
The Pillar 1 provides for minimum capital requirement for 3 main risks: credit risk, operational risk and market risk. The Pillar I of MCR is interconnected and reinforced with the two other pillars.
Supervisory review process (Pillar II)
Is financial institutions should have their own internal capital assessment processes to capture risks which remained uncovered under Pillar 1 and thus set aside capital in line with the bank's risk profile and control environment. The supervisory review process validates the bank's internal assessments by ensuring that the whole array of risks has been taken care of.
Market Discipline (Pillar III)
Pillar III seeks to enhance disclosure and transparency by strengthening banks' financial reporting system and by encouraging market discipline and allowing the key stakeholders to assess key pieces of information in the scope of application, capital risk exposures, risk assessment processes, and capital adequacy of the institution. Pillar III complements and reinforces the first two pillars and infuses market pressures to bring in better risk management and adequate levels of capital in the banks and keep key stakeholders fully informed about the risk profile of banks and enables them to take prudent decisions while transacting business with them.
From Basel 2 to Basel 3:
Basel 3 is part of the Committee's continuous effort to enhance the banking regulatory framework. It builds on the International Convergence of Capital Measurement and Capital Standards documents (Basel 2). The crisis was exacerbated by a procyclical deleveraging process and the interconnectedness of systemically important financial institutions. In response, the Committee's reforms seek to improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spill over from the financial sector to the real economy.
The reforms strengthen bank-level or micro prudential, regulation, which will help raise the stable of individual banking institutions in periods of stress. The reforms also have a macro prudential focus, addressing system wide risks, which can build up across the banking sector, as well as the procyclical amplification of these risks over time. Clearly, these micro and macro prudential approaches to supervision are interrelated, as greater resilience at the individual bank level reduces the risk of system wide shocks.
In conclusion, the new global standards to address both firm-specific and broader, systemic risks have been referred to as Basel 3. The Committee and Financial Stability Board were addressing the risks of systemic banks and the Governors and Heads of Supervision agreed that systemically important banks should have loss absorbing capacity beyond the minimum standards of the Basel III framework on 12 September 2010. The Committee's reforms will transform the global regulatory framework and promote a stable banking sector. So, the Committee has undertaken a comprehensive assessment of Basel III's potential effects, both on the banking sector and on the broader economy. This will make a stronger capital and liquidity standards impact on economic growth. Moreover, the long-run economic will benefits substantially outweigh the costs associated with the higher standards.
