Basel II

The revision of the first version of the Capital Accord (1988) – including the amendments incorporated in the meantime (the last one on market risk, in January 1996) - began in 1999  and can be found in a document entitled “International Convergence of Capital Measurement and Capital Standards: A revised Framework”, known as “Basel II”, published in June 2004 and codified in July 2006 by the Basel Committee on Banking Supervision.

The amendment to the Capital Accord, in addition to the core objectives of capital sufficiency and competitive neutrality, has set the following objectives:

• To ensure that capital requirements are more sensitive  to the risk profile of institutions through the recognition for regulatory purposes of their management systems and risk measures, provided certain conditions are met, as well as the autonomisation of  operational risk;
• To extend the capital framework beyond the setting of minimum regulatory capital ratios, recognising the importance of action taken by supervisory authorities and market discipline; and
• To disseminate “best practices” in the financial system by creating a set of incentives to award the ability of institutions in terms of risk assessment and management. In effect, the new rules, in principle, will introduce changes in the way institutions assess and manage their risks , giving rise, inevitably, to adjustments in organisational structures, internal processes and even institutional culture.

The capital adequacy framework proposed in “Basel II” was incorporated in Community legislation in Directives 2006/48/EC and 2006/49/EC, of 14 June 2006, amending Directives 2000/12/EC and 93/6/EC, respectively. The regulatory framework comprising the recast versions of the two Directives is usually referred to as the Capital Requirements Directive (CRD).

The new prudential regime is structured into three areas – the so-called three pillars:

The First Pillar – Calculation of minimum capital requirements

This pillar sets out the rules for the calculation of the minimum capital requirements for credit, market and operational risk.

Two methodologies may be used to calculate the capital requirements for credit risk. The first one is the Standardised Approach, which is largely based on ratings published by external credit assessment institutions recognised for this purpose. This methodology generally consists of risk-weighting assets according to the borrower and exposure types. The second methodology, the Internal Ratings-Based Approach (IRB), which comprises two different approaches, allows for the calculation of capital requirements based on own estimates of risk parameters, namely the probability of default (PD), under the Foundation approach, and also the loss given default (LGD) and of the individual gross exposure at default (EAD) under the Advanced approach.

Changes to the prudential framework for market risks are less significant than those arising from the rules introduced in 1996, basically consisting of a revision of the trading book definition, an introduction of principles for the valuation  of positions held in the trading book, and the imposition of capital requirements in relation to new instruments (e.g. derivative instruments).

Under the prudential framework regarding the treatment of market risks, institutions shall calculate the capital requirements to cover:

• The position risk on instruments booked in the trading book (debt instruments, interest rate-dependent instruments, equities  and derivatives), including both specific risk – price changes arising from characteristics specific to the security – and general market risk – arising from interest rate changes or overall movements in equity markets; and
• Foreign-exchange and commodity risks in relation to global activity. In general terms, two alternative methodologies may be used to calculate  capital requirements for these types of risk: the Standardised approach and the Internal Models method. The use of internal models is subject to the fulfilment of a set of qualitative and quantitative criteria, and to approval by the supervisory authorities.

According to the new Capital Accord, institutions shall also calculate capital requirements to cover counterparty credit risk of certain positions in the trading book.

As regards operational risk, three main methods are presented to calculate minimum capital requirements, each of them corresponding to an increasing sophistication and risk sensitivity, and therefore, to more stringent approval and utilisation criteria. Under the Basic Indicator Approach, requirements are determined as a percentage (15%) of a relevant operating indicator. Under the Standardised Approach, requirements are determined as a percentage (from 12% to 18%) of a relevant operating indicator for each business line. Under the Advanced Measurement Approaches (AMA), institutions may use their own models to calculate operational risk capital requirements, provided they meet specific qualitative and quantitative criteria.

The Second Pillar – Supervisory Review Process

Pillar 2 sets out the “Supervisory Review Process” concept, which combines a set of principles essentially intended to reinforce  the linkage between internal capital held by institutions the risks arising from their business. On the one hand, these principles encourage institutions to adopt systems and procedures aimed at calculating and maintaining levels of internal capital appropriate to the nature and size of the risks incurred.  On the other hand, supervisory authorities are responsible for assessing the quality of such systems and procedures and imposing corrective measures where internal capital assessment is inconsistent with the risk profile.

Pillar 2 includes risks considered under Pillar 1 that are not fully captured by that  process (e.g. credit concentration risk), and those factors not taken into account in  Pillar 1 (e.g. interest rate risk in the banking book and strategic risk).

In 2006, the Committee of European Banking Supervisors (CEBS) published the “Guidelines on the Application of the Supervisory Review process under Pillar 2”, designed to promote convergence of supervisory practice and consistency of approach by supervisors in implementing the Pillar 2 provisions.

In order to apply the principles laid down in the “Supervisory Review Process”, institutions shall adopt sound procedures of internal corporate governance, and implement their self-assessment process to identify the level internal capital adequate to cover risks associated with their activities (the so-called ICAAP – Internal Adequacy Assessment Process), as defined in the relevant legislation and regulations. At the same time, as the supervisory authority, Banco de Portugal shall perform its own assessment of the risks underlying institutions' activities, and verify whether internal corporate governance procedures, the assumptions and results set out in the ICAAP, as well as existing own funds, ensure an appropriate risk coverage. This assessment shall be supported  by the risk assessment model developed in Banco de Portugal – MAR - , which was aims at broader objectives than Pillar 2 and was designed to include  all relevant aspects under supervision in terms of risk and risk control in a systematic and articulated manner.

The Third Pillar – Market Discipline

This Pillar aims to promote disclosure of information by institutions, in different markets,  in a sufficient, consistent and transparent manner in order to ensure effective market discipline. Market discipline involves the monitoring (by market participants, namely other institutions, clients, counterparties and investors) of disclosed information on the solvency and risk profile of institutions. In particular, market participants shall have at their disposal a wide range of information to reward or penalise management practices – according to their soundness – through their influence on borrowing capacity/ costs and capital valuation, thus contributing to the stability and soundness of the financial system.

In general, the above mentioned three-pillar structure is laid down in Directive 2006/48/EC. In turn, the changes introduced in Directive 2006/49/EC, setting out, inter alia, rules determining market risk related capital requirements (reviewed by the Basel Committee on Banking Supervision in 1996), are less extensive and result namely from: (i) the application of new capital adequacy requirements to investment firms in the European Union; (ii) the revision of the trading book concept; and (iii) the introduction of market risk related capital requirements in relation to new instruments (e.g. credit derivatives).

The new regulatory framework is transposed into national law by Decree-Law No 103/2007 and Decree-Law No 104/2007, both of 3 April, and by a set of Notices and Instructions of Banco de Portugal governing the provisions defined in these Decree-Laws.