1. Basel -II
The basis for credit risk management is the requirements of “Basel II”, the agreement by
the major central banks on how commercial banks should be regulated. Basel II is the
second of the Basel Accords, which are recommendations on banking laws and
regulations issued by the Basel Committee on Banking Supervision. The reason for
regulation is that banks lend long term but their deposits are liquid and short term, and
so they are exposed (as all firms are) to cash flow problems. In order to ensure that
banks don‟t fail, and to ensure confidencee in them by depositors, they must hold
capital reserves to cover from possible default by their borrowers.
The first Basel Accord (1988) focused on credit risk, but it soon became clear that its
approach was too common. In 1996 the Basel committee allowed banks to choose for
their own Valuation Risk models. However there were still issues in the way different
asset classes and borrowers were handled by Basel I and by 2001 a new accord (Basel II)
was being developed.
The purpose of Basel II, which was initially published in June 2004, is to create an
international standard that banking regulators can use when creating regulations about
how much capital banks need to put aside to guard against the types of financial and
operational risks banks face.
1

2. Three Pillars
Basel II is based on three pillars:
Minimum capital requirements are the calculation of the minimum level of
regulatory capital that a bank should hold. There are two approaches,
standardized and internal rating based approaches. These approaches will enable
the calculation of the risk weighted assets and a bank is required to hold 8% of its
risk weighted assets as risk capital.
Supervisory review process provides guidelines for supervisors to ensure that
each bank has robust internal processes for risk management and that banks
could have adequate capital to support all the risks in their business
Outline of the New Basel Capital Accord
Pillar I
Minimum Pillar II
Pillar III Market
Supervisory
Capital Review process
Discipline
Requirement
Operational
Credit Risk Market Risk
Risk
Internal Rating Event Risk Business Risk
Standardised Standardised Inernal Models
Based
Approach Approach Approach
Approach
Foundation Advanced
Advanced
Basic Indicator Standardised
Measurement
Approach Approach
Approach
2

3. Market disciple to encourage market discipline by developing a set of disclosure
requirements which will allow market participants to assess key pieces of
information on the scope of application, capital, risk exposures, risk assessment
processes, and hence the capital adequacy of the institution.
Objective of Basel-II
The Main objectives of Basel-II are
 Ensuring that capital allocation is more risk sensitive;
 Separating operational risk from credit risk, and quantifying both;
 Attempting to align economic and regulatory capital more closely to reduce the
scope for regulatory arbitrage.
3

4. Recent chronological updates
September 2005 update
On September 30, 2005, the four US Federal banking agencies announced their revised
plans for the U.S. implementation of the Basel II accord. This delays implementation of
the accord for US banks by 12 months.
November 2005 update
On November 15, 2005, the committee released a revised version of the Accord,
incorporating changes to the calculations for market risk and the treatment of double
default effects. These changes had been flagged well in advance, as part of a paper
released in July 2005.
July 2006 update
On July 4, 2006, the committee released a comprehensive version of the Accord,
incorporating the June 2004 Basel II Framework, the elements of the 1988 Accord that
were not revised during the Basel II process, the 1996 Amendment to the Capital
Accord to Incorporate Market Risks, and the November 2005 paper on Basel II:
International Convergence of Capital Measurement and Capital Standards: A Revised
Framework. No new elements have been introduced in this compilation. This version is
now the current version.
November 2007 update
On November 1, 2007, the Office of the Comptroller of the Currency (U.S. Department
of the Treasury) approved a final rule implementing the advanced approaches of the
Basel II Capital Accord. This rule establishes regulatory and supervisory expectations
for credit risk, through the Internal Ratings Based Approach (IRB), and operational risk,
through the Advanced Measurement Approach (AMA).
4

5. July 16, 2008 update
On July 16, 2008 the federal banking and thrift agencies issued a final guidance
outlining the supervisory review process for the banking institutions that are
implementing the new advanced capital adequacy framework (known as Basel II).
January 16, 2009 update
For public consultation, a series of proposals to enhance the Basel II framework was
announced by the Basel Committee announced. It releases a consultative package that
includes: the revisions to the Basel II market risk framework.
July 8-9, 2009 update
A final package of measures to enhance the three pillars of the Basel II framework and
to strengthen the 1996 rules governing trading book capital was issued by the newly
expanded Basel Committee. These measures include the enhancements to the Basel II
framework, the revisions to the Basel II market-risk framework and the guidelines for
computing capital for incremental risk in the trading book.
Basel-II in Bangladesh
In Bangladesh, Basel II Road Map has already been issued by Bangladesh Bank, the
central bank of the country. Basel II was implemented from January 2009. Basel II is
implemented with the following specific approaches as an initial step with the parallel
calculations was started from January 2009:
 Standardized Approach for calculating Risk Weighted Assets (RWA) against
Credit Risk supported by External Credit Assessment Institutions (ECAIs)
 Standardized Rule Based Approach against Market Risk and
 Basic Indicator Approach for Operational Risk.
5

6. Implementation of Basel II in Developed Countries
Implementation of Basel II in developed countries would impact the developing
economies in the following ways:
High Cost Lending and Reduced Lending to Developing Economies
The Basel II accord has provided two approaches towards credit risk management.
Banks in advanced countries and multilateral lending institutions are expected to
implement Basel II and they are the major lenders to the developing economies. On the
other hand, an IRB approach would be even more stringent and applies extraordinarily
heavy risk weights.
The Vicious Circle of Curtailment of Credit to Developing Countries
The lower ratings will reduce the availability of funds in the developing countries. The
reduced market access and high costs of funding will further impact the ratings of these
countries leading to a vicious circle with each aspect feeding the other in a downward
spiral.
Higher Interest Costs and Competitive advantage of corporate borrowers
The Higher Interest costs to the banks will ultimately translate into higher cost of
borrowing for the corporate skewing the playing field in favor of the developed
countries.
Impact on Infrastructure development
The Basel II document impacts the Interest rate determination process and attributes
higher risk to project finance than corporate finance. All the developing economies have
been suffering from the paucity of Infrastructure to sustain development and this has
the potential of severely hampering the Infrastructure development process.
Shorter Term to maturity of lending
6

7. Basel II accords have a preference for short-term lending. This is because of the ease in
exiting the investment in case the situation turns adverse. Also the interest rates on
short term will also tend to be lower further incentivizing such borrowings. This shall
impact both banks and ultimate borrowers in developing economies because of the
change in the interest rate term structure and the need for Asset and Liability
Management (ALM).
Impact on capital flows
Short Term lending will further increase the volatility of capital flows within
developing countries. This was a major reason of the Asian financial crises. There
would be a tendency to press the panic button at the smallest change in the situation,
further deteriorating it, leading to crisis. In the highly integrated global economy of
today this will lead to stronger world economic cycles.
Impact on Companies
This would impact output levels in corporate and skew the capital structure in favor of
short term borrowings and working capital finance. The Liquidity position and the
companies‟ ability to globalize would be hampered by this difficulty in raising long-
term capital.
Impacts of Basel II Implementation in Developing Countries
Improved Risk Management and Capital Adequacy
It will tighten the risk management process, improve capital adequacy and strengthen
the banking system.
Curtailment of Credit to Infrastructure Projects
The norms require a higher weight age for project finance, curtailing credit to this very
crucial sector. The long-term impacts for this could be disastrous.
Preference for Mortgage Credit to Consumer Credit
7

8. Lower Risk Weights to Mortgage credit would accentuate bankers‟ preference towards
it vis-à-vis consumer credit.
Basel II: Advantage Big Banks
It would be far easier for the larger banks to implement the norms, raising their quality
of risk management and capital adequacy.
Consolidation in the banking Industries
To the greatest extent possible, all banking and other relevant financial activities
conducted within a group containing an internationally active bank has to be captured
through consolidation.
Problems in Implementation of Basel II in Developing Countries
There are some problems in implementation of Basel-II in developing countries like
Bangladesh. Some of those problems are:-
Standardized Approach and External Credit Rating Problems
One of the two approaches prescribed for Credit Risk in Basel II is the standardized
approach, which makes use of external credit ratings for attaching risk weights. One of
the major problems is the availability of credit ratings in developing countries. While
Bangladesh has been fortunate in this respect with two Credit Rating agencies(Credit
Rating Information and Services Limited and Credit Rating Agency of Bangladesh
Ltd.),many developing countries are not so equipped in this field.
Difficulties in Implementation of IRB based Credit Risk Management
Approach
8

9. Various models have been proposed for the Internal Rating Based Credit Risk
Assessment. A major problem is data availability. In Bangladesh, State-owned banks are
still in the process of computerization. The extent of historical data required to
formulate and then convincingly test Indigenous IRB models is simply not available.
Costs of Implementation: IT spending and Training Costs
The single largest cost of implementing Basel II is the IT costs. The required capital
expenditure would be far higher than small banks could bear. There is an unavailability
of trained manpower for risk management and audits.
Multiple Supervisory bodies and dearth of skilled professionals
The Basel II definition of a banking company is very broad and includes banking
subsidiaries such as insurance companies. In many developing countries, there is no
single regulator to govern the whole „bank‟ as per Basel II. In Bangladesh, Securities
Exchange Commission, Bangladesh Bank, National Board of Revenue, Dhaka Stock
Exchange and Ministry of Finance would regulate different aspects of Basel II. In
Bangladesh, Regulatory capital norms do not apply to Insurance companies. The
availability of trained risk auditors is another problem.
Ineffective Pillar 3
Aside from the broader issue of the relevance of specific disclosures for market
participants, this Pillar is not a very useful discipline device in countries with small
private markets or few incentives for creditors to monitor banks .In addition, the Pillar 3
might be inapplicable in those countries whose systems are dominated by foreign
banks.
Unavailability of required risk data in easily accessible or
comprehensive format
Historical loss data is required to calculate the main IRB risk parameters; that data are
frequently incomplete/unavailable or prohibitively expensive to collect .Particularly for
9

10. the development of rating systems parameters, individual banks may not have a
meaningful loss dataset to enable them to build the required models and back-test their
performance.
Conclusion
Since, there are many problems in implementation of Basel II in developing countries
but Basel II is here to stay and the competitive forces will compel banks to follow this. It
is very important to select carefully “what form of the Basel II standard” should be
applied and “to what extent” to ensure the survival and growth for the developing
countries. Ultimately, the standard are for strengthening the banking systems globally
and this objective should not be lost. Bangladesh Bank is giving highest concentration
and best possible effort for the implementation of Basel II. We think the new accord
would provide a level playing field for banking organizations meeting in international
competition.
References
www.wikipedia.com
International Research Journal Of finance and Economics
10

11. Bangladesh Bank presentation
International Convergence of Capital Measurement and Capital Standards.
- T.C. Johnson And A.J. McNeil
11