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HMRC internal manual

Corporate Finance Manual

Understanding corporate finance: the legal and regulatory framework: regulatory capital: ‘Basel II’

Basel II: three pillars

Basel II is built on three pillars. Pillar 1 provides a calculation of minimum capital requirements. Pillar 2 requires firms and supervisors to review the risk management process and take action to deal with failings. Pillar 3 requires comparisons with other banks.

Pillar 1: minimum capital requirements to cover Pillar 2: supervisory review process of capital adequacy Pillar 3: market discipline and disclosure
Credit risk    

Market risk

Operational risk Ensures banks have good monitoring and management of risk processes Allow comparisons of capital adequacy across institutions

Pillar 1: minimum capital requirements

The minimum capital requirement will include elements to cover credit risk, market risk and operational risk. The risk weight allocated to different types of asset held will vary. For example, the weight allocated to a corporate bond will depend on its credit rating. Residential mortgages are weighted 35%. The minimum capital requirement must not be lower than 8%, of which half must be Tier 1 capital.

Example of minimum capital requirements

A bank has the following assets

Gilts £20,000
Cash £10,000
Corporate bonds £20,000
Mortgages £20,000
Total £70,000

If the risk weights for gilts and cash were 0%, corporate bonds 100%, and mortgages 35%, the notional risk weighted asset value would be £27,000. The FSA Handbook sets out how these calculations are to be done and, in practice, they are much more sophisticated than this.

Pillar 2: the supervisory review process

Regulators are required to check that systems are adequate to assess and manage risk.

Pillar 3: market discipline

This is intended to complement the first two pillars. This contains a disclosure requirement so that institutions can compare risk exposures, risk assessment processes and capital adequacy. This is important because banks may have more discretion in assessing their own capital requirements under Basel II. The need to disclose risk data is intended to discourage imprudent behaviour and act as an incentive to improve risk management processes.