The impressive advances in technology that have enhanced the industry’s ability to collect and process large amounts of information in real time could hardly have been suspected 20 years ago. Collecting risk data across many business lines has catalysed further efforts to aggregate those measures of risk by quantifying them in a more rigorous and more consistent fashion. The “ultimate expression” of risk aggregation is the summation of many types of risk into a single measure based on the concept of economic capital, which estimates the amount of capital a firm requires to protect itself against these risks with a certain degree of confidence. Using the concept of economic capital, banks can develop sound policies for monitoring exposure limits, risk-adjusted pricing policies and sound provisioning practices based on the inherent risks of the portfolios. They can also measure returns and assign capital on a risk-adjusted basis. Likewise, the progressive widening and deepening of financial markets and the continuous creation of new assets has enlarged the menu of choices available for banks to manage, share and transfer risks. The Basel II process started, more than 6 years ago, against this background of increasingly sophisticated risk management practices, heightened complexity in the financial markets and stronger interaction between the real and the financial economy. Rather than simply resetting the quantitative standards, we sought to develop a new forward-looking approach that would be more sensitive to the actual risks that banks take on. The new framework is a significant step towards achieving a more comprehensive and risk-sensitive supervisory approach.
It seeks to provide banks with stronger incentives to employ the most advanced techniques to calculate risk exposures and, hence, to push risk-management towards the best available practices. Specifically, Basel II makes these general principles operative by building on three complementary pillars. The first pillar is intended to achieve a more precise and sensitive mapping between banks’ actual risks and the minimum regulatory capital requirements. Under the new framework, banks are allowed and, indeed, encouraged to rely on their own measures of certain risk parameters, thus fostering a wider usage of the best available techniques and tools for that purpose. The Committee firmly believes that a better alignment between regulatory and economic capital is conducive to a more efficient allocation of credit and a less distortionary regulatory system. The framework is also extended to operational risks, which have proved to be more relevant in an increasingly complex world that demands highly sophisticated processes. The second pillar, supervisory review, requires banks to assess their own capital needs for their overall risk profiles, including whether any activities or exposures may incorporate more risk – and hence may require more capital – than is assumed in Pillar 1. Supervisors, in turn, must evaluate the banks’ assessments and processes, and respond if these are not appropriate.