Why Basel II’s pillar 1 focused on bank capital requirements

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Sep. 9 2014, Updated 1:00 p.m. ET

Pillar one

The first pillar updated the 1988 solvency ratio. Risk-weighted assets (or RWA) capital is still viewed as the most relevant control ratio, as capital is the main buffer against losses when profits become negative. The 8% requirement continued to be the reference value, but the way assets were weighted was significantly refined.

The 1988 values were rough estimates, while the Basel II values were directly and explicitly derived from a standard simplified credit risk model. Capital requirements were required to be more closely aligned to internal capital estimates, the adequate capital level estimated by the bank itself through its internal models.

There were three approaches, of increasing complexity, to compute the risk-weighted assets for credit risk. These approaches were called the standardized approach, foundation IRB, and advanced IRB. “IRB” stands for internal rating-based approached to be calculated by banks themselves.

The more advanced approaches were designed to consume less capital for the bank. These approaches also imposed heavier qualitative and quantitative requirements on internal systems and processes. This was an incentive for banks to increase their internal risk management practices.

All types of banks like JPMorgan (JPM), Wells Fargo (WFC), Morgan Stanley (MS), Goldman Sachs (GS), and other banks in an ETF like the Financial Select Sector SPDR Fund (XLF) were to implement these norms.

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Another important innovation in pillar one was the new requirement for operational risk. In the Basel II Accord, there was an explicit capital requirement for risks related to possible losses arising from process errors, internal fraud, and information technology problems. However, the eligible capital had to cover at least 8% of the risk-weighted requirements related to the three broad kinds of risks.

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