Which one of the following statements is true about the risk considered for capital requirements under Basel II?

Option 2 : Credit risk, market risk and operational risk

The correct answer is Credit risk, market risk and operational risk

 BASEL-II

• The Basel II Accord was enacted in response to significant losses in worldwide markets since 1992, which were blamed on weak risk management procedures.
• The Basel II Accord requires financial firms to adopt standardised credit, market risk, and operational risk metrics.
• Different levels of compliance, on the other hand, enable financial institutions to employ advanced risk management strategies in order to free up resources for investment.

 Basel II uses a three-pillars concept:

Pillar 1: minimum capital requirements (addressing risk)

The first pillar deals with ongoing maintenance of regulatory capital that is required to safeguard against the three major components of risk that a bank faces - Credit Risk, Operational Risk, and Market Risk.

• Credit Risk component can be calculated in three different ways of varying degree of sophistication, namely Standardized Approach, Foundation Internal Rating-Based (IRB) Approach, and Advanced IRB Approach.
• For Operational Risk, there are three different approaches:
  • Basic Indicator Approach (BIA)
  • Standardized Approach (STA)
  • Internal Measurement Approach, an advanced form of which is the Advanced Measurement Approach (AMA)
• For Market Risk, Basel II allows for Standardized and Internal approaches. The preferred approach is Value at Risk (VaR).

Pillar 2 - supervisory review:

• This is a regulatory response to the first pillar, providing regulators with more 'tools' than before.
• It also lays out a structure for dealing with Pension Risk, Systemic Risk, Concentration Risk, Strategic Risk, Reputational Risk, Liquidity Risk, and Legal Risk, all of which are grouped together as Residual Risk in the agreement.

Pillar 3 - market discipline

• This pillar attempts to promote market discipline by establishing disclosure rules that allow market players to analyse critical pieces of information such as the scope of application, capital, risk exposures, risk assessment systems, and hence the institution's capital adequacy.
• Market discipline supplements regulation since sharing of information allows others (such as investors, analysts, customers, other banks, and rating agencies) to appraise the bank, resulting in excellent corporate governance.
• By providing disclosures that are based on a common framework, the market is effectively informed about a bank’s exposure to certain risks, and provides a clear and understandable disclosure framework that increases comparability.