The impact of Basel II on commercial banks

By Odhiambo Ocholla

Basel II is an international capital measurement system. The official name for this system is the ‘International Convergence of Capital Measurement and Capital Standards – a revised framework’.

The first capital measurement system – the Basel Capital Accord – was introduced in 1988 by the Basel Committee on Banking Supervision. Due to changing financial markets and developments in risk measurement techniques, the Committee carried out a major review of the Accord in 1999.

Basel II is a regulatory framework for the banking sector, defining best practices for dealing especially with risk. In principle, Basel II is simply a recommendation addressing various issues related to the management of credit risk, operational risk and market risk.

Although market risk and operational risk are important elements of the Basel II framework, the most important aspects of Basel-II are related to credit risk management and minimum capital requirements for loans.

The Capital Accord was developed by the Basel Committee on Banking Supervision, which was established in 1975. The Committee does not have any official countrywide supervisory authority.

As a consequence, its initiatives are not legal requirements, rather guidelines for individual country authorities to adopt.

The Basel Committee considers that the security and soundness of the financial system can only be obtained by combining supervision, market discipline and effective internal administration of risks by the banks.

According to this view, the rationality of the new accord is based on the need to build a larger and more flexible framework of rules that will adjust to the new financial products and be sensitive to risks. Therefore, it will be more adequate to the constant transformations in the financial markets and in the risk management practices.

Impact of Basel II

The Basel 1 was introduced because of concern by central banks that the level of capital held by international banks was too low.

The Basel 1 was designed to ensure these international banks did not compete for business with inadequate capital backing. In this respect, the Basel 1 was successful and became an international framework. Despite some reform to the original Accord, it was felt there was a need to radically update the capital adequacy framework hence Basel II was devised.

In essence, the original Accord was simply not sufficiently flexible to take account of the new risk management techniques. Basel II adopts a more risk-sensitive approach to capital adequacy.

The immediate impact of Basel II is that some credit-based banking services will become more expensive as banks will need to cover the additional costs incurred from meeting the minimum capital requirements and the increased level of operational risk capital required.

Basel-II might contribute to improving market efficiency because Basel-II is globally accepted and implemented.

There is no legal way to circumvent the Basel-II rules, and the supervisory pillar of the Basel-II systems works nearly equally well in all countries and regions. Further highly efficient financial markets force commercial banks to adhere to the international best practices defined by the Basel II.

Capital Market Integration

Due to the fact, that capital markets are highly integrated on the international level with exception of our capital market which has been argued is less integrated into the global financial market, most local regulatory authorities should reference Basel II explicitly.

Although market risk and operational risk are important elements of the Basel-II framework, the most important aspects of Basel-II are related to credit risk management and minimum capital requirements.

Basel II is not as innovative as most people think. Banks have been implementing internal rating systems at least for the last two decades long before the invention of a new regulative framework.

However the effective risk management will enable the financial institutions to enhance revenues, decrease costs, through the improvement of efficiency and operational losses reduction, resulting from the better operational risk management and hence, to allocate capital in a more efficient way.

Mr Odhiambo Ocholla is the Head of Investment Banking and Fund Management with Suntra Investment Bank. email: [email protected]