Key Elements of the New Accord

The New Accord consists of three pillars:

1. minimum capital requirements,

2. supervisory review of capital adequacy, and

3. public disclosure.

While the proposed New Accord differs from the current Accord along a number of dimensions, it is important to begin with a description of elements that have not changed. The current Accord is based on the concept of a capital ratio where the numerator represents the amount of capital a bank has available and the denominator is a measure of the risks faced by the bank and is referred to as risk-weighted assets. The resulting capital ratio may be no less than 8%.

Under the proposed New Accord, the regulations that define the numerator of the capital ratio (i.e. the definition of regulatory capital) remain unchanged. Similarly, the minimum required ratio of 8% is not changing. The modifications, therefore, are occurring in the definition of risk-weighted assets, that is in the methods used to measure the risks faced by banks. The new approaches for calculating risk-weighted assets are intended to provide improved bank assessments of risk and thus to make the resulting capital ratios more meaningful.

The current Accord explicitly covers only two types of risks in the definition of riskweighted assets: (1) credit risk and (2) market risk. Other risks are presumed to be covered implicitly through the treatments of these two major risks. The treatment of market risk arising from trading activities was the subject of the Basel Committee's 1996 Amendment to the Capital Accord. The proposed New Accord envisions this treatment remaining unchanged.

The pillar one proposals to modify the definition of risk-weighted assets in the New Accord have two primary elements:

1. substantive changes to the treatment of credit risk relative to the current Accord; and

2. the introduction of an explicit treatment of operational risk that will result in a measure of operational risk being included in the denominator of a bank's capital ratio. The discussions below will focus on these two elements in turn.

In both cases, a major innovation of the proposed New Accord is the introduction of three distinct options for the calculation of credit risk and three others for operational risk. The Committee believes that it is not feasible or desirable to insist upon a one-size-fits-all approach to the measurement of either risk. Instead, for both credit and operational risk, there are three approaches of increasing risk sensitivity to allow banks and supervisors to select the approach or approaches that they believe are most appropriate to the stage of development of banks' operations and of the financial market infrastructure. The following table identifies the three primary approaches available by risk type.

The standardised approach is similar to the current Accord in that banks are required to slot their credit exposures into supervisory categories based on observable characteristics of the exposures (e.g. whether the exposure is a corporate loan or a residential mortgage loan). The standardised approach establishes fixed risk weights corresponding to each supervisory category and makes use of external credit assessments to enhance risk sensitivity compared to the current Accord. The risk weights for sovereign, interbank, and corporate exposures are differentiated based on external credit assessments. For sovereign exposures, these credit assessments may include those developed by OECD export credit agencies, as well as those published by private rating agencies.

The standardised approach contains guidance for use by national supervisors in determining whether a particular source of external ratings should be eligible for banks to use. The use of external ratings for the evaluation of corporate exposures, however, is considered to be an optional element of the framework. Where no external rating is applied to an exposure, the standardised approach mandates that in most cases a risk weighting of 100% be used, implying a capital requirement of 8% as in the current Accord. In such instances, supervisors are to ensure that the capital requirement is adequate given the default experience of the exposure type in question. An important innovation of the standardised approach is the requirement that loans considered past-due be risk weighted at 150%, unless a threshold amount of specific provisions has already been set aside by the bank against that loan.

Another important development is the expanded range of collateral, guarantees, and credit derivatives that banks using the standardised approach may recognise. Collectively, Basel II refers to these instruments as credit risk mitigants. The standardised approach expands the range of eligible collateral beyond OECD sovereign issues to include most types of financial instruments, while setting out several approaches for assessing the degree of capital reduction based on the market risk of the collateral instrument. Similarly, the standardised approach expands the range of recognised guarantors to include all firms that meet a threshold external credit rating.

The standardised approach also includes a specific treatment for retail exposures. The risk weights for residential mortgage exposures are being reduced relative to the current Accord, as are those for other retail exposures, which will now receive a lower risk weight than that for unrated corporate exposures. In addition, some loans to small- and mediumsized enterprises (SMEs) may be included within the retail treatment, subject to meeting various criteria.

By design the standardised approach draws a number of distinctions between exposures and transactions in an effort to improve the risk sensitivity of the resulting capital ratios. The same can also be said of the IRB approaches to credit risk and those for assessing the capital requirement for operational risk where capital requirements are more closely linked to risk. In order to assist banks and national supervisors where circumstances may not warrant a broad range of options, the Committee has developed the 'simplified standardised approach' outlined in Annex 9 of CP3. The annex collects in one place the simplest options for calculating risk weighted assets. Banks intending to adopt the simplified standardised methods are also expected to comply with the corresponding supervisory review and market discipline requirements of the New Accord.