The original Basel Accord in 1988 resulted from concerns expressed by the then G10 Central Banks that the capital of the world’s banks had become dangerously low after persistent erosion through stiff competition and other factors. Capital was at that time viewed as necessary for banks as a cushion against losses and it provided a mechanism to create an incentive for the owners of the business to manage it in a prudent manner.

Thus the regulators were seeking for banks to have sufficient capital in the banking system to prevent systematic collapse and secondly they wanted to use capital to encourage institutions to implement systems such that banking business was managed in a prudent and professional manner.In summary, the 1988 Accord required internationally active banks to hold capital equal to at least 8% of a basket of assets measured in different ways according to their riskness. Although the 1988 Accord was implemented successfully in more than 100 countries, it was later found not to be sufficiently risk sensitive. Whilst the 1988 Accord put greater emphasis on credit risk, the New Accord or Basel II is aimed at coming up with a better way of calculating regulatory minimum capital that includes operational risk and market risk and also raises the quality of operational risk management, supervisory responsibilities and introduces market discipline.

On 1 January 2007, the new Capital Adequacy Directive is expected to enter into force. The Directive is based on the Basel II Accord. The new rules make it possible for financial institutions to use the standardized approach or advanced measurement approach for calculating the capital requirement for operational risks.

The risk management framework will involve the assessment of the consequences and likelihood of risks, evaluation of individual controls in place and determination of mitigating controls to be introduced, and assessment of risk exposures. The potential cost for each risk exposure will be estimated based on the previous losses incurred in the bank due to similar risk exposures; and the expected losses and unexpected losses related to the risk exposures. The estimated costs will then be used in calculating the capital adequacy provision from the operating losses.

The bank set up a Basel II Task Force in October 2004 to review the Basel II principles in relation to operational risk, credit risk and market risk and assess which approaches the bank should adopt in order to be Basel II compliant. The Basel II Task Force concluded the Gap Analysis in December 2005.

The Gap Analysis covered the assessment and planning in the phase 1 of the Basel II Implementation Life Cycle (i.e. the other three phases involve: design and implementation, users test and approval; and monitoring and control). The bank’s data, systems, methods and processes were reviewed in view of meeting the requirements and conduct the impact analysis and Basel II implementation plan was recommended. The following areas/functions were included in the scope: the different approaches in risk management were assessed, the requirements to be met under each risk management approach were reviewed, the bank’s current situation in regard to data, systems, methods and processes was reviewed and the challenges in meeting the risk management approaches assessed, recommendation of the risk management approaches to be adopted by the bank; and formulated an action plan to achieve the bank’s master plan.

It is believed that the Basel II implementation will result in important public policy benefits that can be obtained by improving the capital adequacy framework along two important dimensions. First, by developing capital regulation that encompasses not only minimum capital requirements, but also supervisory review and market discipline. Second, by increasing substantially the risk sensitivity of the minimum capital requirements.

An improved capital adequacy framework will foster a strong emphasis on risk management and to encourage ongoing improvements in banks’ risk assessment capabilities. This will be accomplished by closely aligning banks’ capital requirements with prevailing modern risk management practices, and by ensuring that this emphasis on risk makes its way into supervisory practices and into market discipline through enhanced risk and capital related disclosures.