This week’s movie is published for customers:a one hour review of Basel II focused specifically on the AIMs. Thehistory of Basel II might be described as an attempt to defineregulatory capital so that it more closely resembles economic capital.
Theregs include three pillars. The Committee expects a supervisory review(the second pillar) to enforce the first pillar and, in many cases,impose greater capital requirements than required by the first pillar(i.e., the "minimum" in the first pillar is important). The thirdpillar enlists the "informal oversight" of the investment community.
TheCooke ratio in the orignal Basel Accord is preserved. So is thedefinition of capital, generally. Capital of at least eight percent(8%) must be held against total risk (credit plus market plusoperational risk).
Market risk was added in the 1996 Amendment…
…andoperational risk is evolving. Currently, the operational risk charge iseither 15% of gross income (basic) or its a weighted percentage ofgross income (standardized approach; weighted by the business line’sgross income and a beta factor). Under the standardized approach, thebetas are either 12%, 15% or 18% so the result is a weighted averagesomewhere between 12% and 18% of gross income.
Welook at the "traffic light" system used to backtest value at risk underthe supervisory framework (i.e., internal models approach to marketrisk). An important idea here is that the three zones are a way ofdealing with the fact that banks cannot simultaneously minimize
bothType I and Type II errors. If we were to shrink the green zone, forexample, that reflects a philosophy that really wants to avoid Type IIerrors. If we were to push up the red zone for example (i.e., togreater numbers of exceptions), that would reflect a philosophy thatwants to avoid Type I errors.