Charta is on Google Play: practise on the go. Get the app
Charta

Set out what Basel II changed, including its three pillars.

FRM® Part II · Operational Risk and Resilience · Capital Regulation Before the Global Financial Crisis · FRM2.ORR.21.d

The idea

Basel II was published in 2004 and phased in from about 2007. It kept the 8 percent minimum ratio on total risk-weighted assets (RWA), the 1996 market risk rules and the capital definitions, but rebuilt the framework on three pillars. Pillar 1 is minimum capital. It has more risk-sensitive credit risk charges (standardized, foundation IRB, advanced IRB), market risk as before, and a new operational risk charge. Pillar 2 is supervisory review. Supervisors assess a bank's own capital assessment process and may require more than the Pillar 1 minimum, for example for concentration risk. Pillar 3 is market discipline through public disclosure of risk exposures and capital adequacy. Market and operational risk are capital charges, so they are converted into RWA terms as follows: RWA = credit RWA + 12.5 × market risk capital + 12.5 × operational risk capital. Capital must then be at least 8 percent of that total. The usual mistake is adding capital charges to RWA without the 12.5 factor.

Formulas

Basel II total risk-weighted assets

RWA = RWAc + 12.5 × (MRC + ORC)

RWAc
credit risk-weighted assets
MRC
the market risk capital charge
ORC
the operational risk capital charge

Capital must be at least 8 percent of this total. Adding the charges without the 12.5 factor is the usual mistake.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which Basel II pillar encourages prudent behaviour by requiring banks to publish information on their risk exposures and capital adequacy?

  1. Pillar 1, minimum capital requirementsWhy not: Pillar 1 sets the capital formulas, not public disclosure.
  2. Pillar 3, market discipline - correct
  3. Pillar 2, supervisory reviewWhy not: Pillar 2 involves supervisors assessing the bank, not public disclosure to the market.
  4. The Tier 3 capital provisionWhy not: Tier 3 capital was a type of short-term subordinated debt allowed under the 1996 amendment, not a pillar.

Pillar 3 relies on disclosure so that investors and counterparties can reward well-capitalised banks and penalise weak ones.

A harder one

A bank has credit risk-weighted assets of USD 600 million, a market risk capital charge of USD 15 million and an operational risk capital charge of USD 12 million. Under Basel II, minimum total capital at 8 percent is closest to:

  1. USD 75.0 million - correct
  2. USD 50.2 millionWhy not: Adds the two capital charges to RWA without the 12.5 multiplier.
  3. USD 48.0 millionWhy not: Covers credit risk only, leaving out the market and operational risk charges.
  4. USD 63.0 millionWhy not: Includes market risk but omits the new Basel II operational risk charge.

Total RWA = 600 + 12.5 x (15 + 12) = 937.5. Capital = 8% x 937.5 = 75.0.

The hardest tier

A bank has Tier 1 capital of USD 70 million, credit risk-weighted assets of USD 700 million, a market risk capital charge of USD 8 million and an operational risk capital charge of USD 6 million. Its Basel II Tier 1 ratio, against total RWA, is closest to:

  1. 9.8 percentWhy not: Adds the capital charges to RWA without converting them with the 12.5 multiplier.
  2. 10.0 percentWhy not: Divides by credit RWA only and ignores the market and operational risk components.
  3. 8.8 percentWhy not: Converts market risk but omits the operational risk charge from the denominator.
  4. 8.0 percent - correct

Total RWA = 700 + 12.5 x (8 + 6) = 875. Tier 1 ratio = 70/875 = 8.0 percent, which comfortably exceeds the 4 percent Tier 1 minimum.

In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.

Start free →

More in Capital Regulation Before the Global Financial Crisis