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P2.T7.518. Three Pillars of Basel II (Hull)

Nicole Seaman

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Learning outcome: Describe the key elements of the three pillars of Basel II: minimum capital requirements, supervisory review, and market discipline. Describe and contrast the major elements of the three options available for the calculation of operational risk: basic indicator approach, standardized approach, and the Advanced Measurement Approach.

(Source: John Hull, Risk Management and Financial Institutions, 5th Edition (New York: John Wiley & Sons, 2018))

518.1. The Second Pillar (Pillar 2) of Basel II is concerned with the supervisory review process. Four key principles of supervisory review are specified. Each of the following is a principle EXCEPT which is inaccurate?

a. Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.
b. Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.
c. Supervisors should discourage banks from operating above the minimum regulatory capital limits because this tends to be associated with regulatory arbitrage
d. Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

518.2. In regard to the Third Pillar, Hull writes "Pillar 3 of Basel II is concerned with increasing the disclosure by a bank of its risk assessment procedures and capital adequacy. The extent to which regulators can force banks to increase their disclosure varies from jurisdiction to jurisdiction. However, banks are unlikely to ignore directives on this from their supervisors, given the potential of supervisors to make their life difficult. Also, in some instances, banks have to increase their disclosure in order to be allowed to use particular methodologies for calculating capital." (Source: John Hull, Risk Management and Financial Institutions, 5th Edition (New York: John Wiley & Sons, 2018))

According to Hull, each of the following is true about this Third Pillar, EXCEPT which is inaccurate?

a. Banks should disclose the structure of the risk management function and how it operates
b. Banks should disclose the terms and conditions of the main features of all capital instruments
c. If a bank publishes an annual report with GAAP-compliant financial reports, then additional Third Pillar are waived due to redundancies
d. Banks should disclose the entities in the banking group to which Basel II is applied and adjustments made for entities to which it is not applied

518.3. You are trying to help your bank decide on its approach to the calculation of operational risk under Basel II. You are reading Hull who writes, "In addition to changing the way banks calculate credit risk capital, Basel II requires banks to keep capital for operational risk. This is the risk of losses from situations where the bank’s procedures fail to work as they are supposed to or where there is an adverse external event such as a fire in a key facility. The impact of the Basel II credit risk calculation is to reduce the credit risk capital requirements for most banks and the capital charge for operational risk has the effect of restoring the total level of capital in the banking system to roughly where it was under Basel I." (Source: John Hull, Risk Management and Financial Institutions, 5th Edition (New York: John Wiley & Sons, 2018))

You decide to ask your colleague Robert to give you a really brief summary of the difference between the three approaches. He replies with the following three statements:

I. In the basic indicator approach, total capital is 25% of last year's annual revenue
II. In the standardized approach, gross income is calculated for different business lines, and capital as a percentage of gross income is different for different business lines
III. In the advanced measurement approach, the bank uses internal models to determine the 99.9% one-year VaR

Which of the above is (are) correct?

a. None are correct
b. I. only
c. II. and III. only
d. All are correct

Answers here:
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