three pillars of basel ii

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    The Three Pillars of Basel II

    The diagram below depicts the three pillars of Basel II

    Pillar 1 specifies the methodologies to arrive at minimum capital

    requirement for credit risk, operational risk and market risk. These

    approaches are dealt with in detail later.

    Pillar 2 deals with the supervisory review process which is guided by

    the principle that banks must have risk control and managementprocesses that are adequate to their business structure and risk profile.

    Supervisory review would be in the form of onsite inspections, offsitereviews, discussions with the banks management, review of workdone by external auditors, etc.

    Pillar 3 deals with market disclosure and the purpose is to imposemarket discipline in order to reinforce minimum capital requirements,

    impose incentives for firms that behave prudently and promote safety

    and soundness in banks and financial systems. This requires

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    siginficant amount of additional information that needs to be

    disclosed.

    Basel II - Approaches for Credit Risk

    Basel II defines three approaches for calculating credit risk weights toaccommodate different levels of sophistication across banks:

    Standard Approach : Simplest to implement. Requires as input : Probability of

    default (PD) of obligor, as specified by an external (i.e. public ratingagencys) rating.

    Foundation Internal Ratings Approach : Slightly more complex. Requires as

    input an obligors PD as specified by an internal calculation of obligorsrating.

    Advanced Internal Ratings Approach : Most complex to implement and most

    risk sensitive. Requires several internally calculated risk parameters

    The following diagram depicts the various approaches for credit risk based on

    complexity and their impact on capital charge:

    Basel II - Approaches for Operational Risk

    Basel II also requires banks to calculate risk weighted assets for operational risk. It

    defines three approaches for this calculation to accommodate different levels ofsophistication across banks:

    Basic Approach : Simplest to implement

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    Standardised Approach : Slightly more complex

    Advanced Modelling Approach (AMA) : Relies on internal simulation of potentialloss distribution

    Unlike Credit Risk, the AMA allows a bank to calculate risk weighted assets foroperational risk by its own internal simulation model and data. This simulation model

    and data can also be used to calculate economic capital for operational risk.

    The following diagram depicts the various methods of calculating economic capital for

    operational risk: