Pillar I - Minimum Capital Requirement

Designed to help cover risks within a financial institution, the first pillar aims to set minimum capital requirements. It defines the current amount of capital and the minimum capital requirement allocated for risk-weighted assets. This pillar also stresses on defining the capital amount by quantifying risks such as Credit Risk, Operational Risk and Market Risk.

Measuring Credit Risk Credit Risk defines the minimum capital required to cover exposure to customers and counter parties. This risk can be measured using the following approaches:

1. Standardized Approach - In this approach, the bank allocates a risk-weight to each of its assets and off-balance sheet positions
2. Internal Rating Based Approach (IRB) - In this approach, banks use their internal evaluation systems to assess a borrower’s credit risk. The results, attained by this process, are translated into estimates of a potential future loss, thereby defining the basis of minimum capital requirements.

The IRB Approach supports the following methodologies for corporate, sovereign and bank exposures: 

1. Foundation - Using this methodology, banks can estimate the risk of default or the Probability of Default (PD) associated with each borrower. 
2. Advanced - This methodology allows banks with sufficient internal capital to assess additional risk factors. These factors include Exposure at Default (EAD), Loss Given Default (LGD) and Maturity (M). It also allows banks to provide guarantees and credit derivatives on the risk of exposure.

Measuring Operational Risk Operational risk is the risk of loss resulting from the failure of internal processes, people and systems. It also includes risk from external events such as earthquakes, droughts and other natural or man-made disasters. Frequent occurrences of such events in the past few years have highlighted the need to cover such risks. In fact, many major banks now allocate 20% of their internal capital to operational risk. 

In Basel 2, this risk can be measured using the following approaches: 

1. Basic Indicator Approach - This is a traditional approach, which links the capital charge for operational risk to a single operational parameter, such as the Bank’s gross annual revenue. 
2. Standardized Approach - This approach is a variant of the Basic Indicator Approach. Here, the activities of a bank are divided into standard industry business lines, such as Corporate Banking, Trade Finance and many more. These business lines are then mapped by banks into their internal framework. A percentage of capital charge, known as the ‘Beta Factor’, is defined for each business line. 
3. Internal Measurement Approach - This is the most sophisticated of all the approaches. Here, risk is measured using the bank’s internal loss data. Typically, a bank collects data inputs for a specified set of business lines and risk types.

Measuring Market Risks Market Risk determines the capital required to cover exposure to changes in market conditions such as fluctuations in interest rates, foreign exchange rates, equity prices, and commodity prices. The approaches to determine market risk are the same as those defined in the earlier Accord.

Benefits of the First Pillar The first pillar aims to refine the measurement framework set out in the 1988 Accord by effectively reducing risk across the banking system. Different reporting systems, which comply with objectives set by this pillar, will help track and report risks as they occur, thus eliminating them at the outset. It will allow banks to set up independent audit functions to scrutinize the possibilities of risks. The minimum capital requirement is expected to reduce considerably for banks and other financial institutions. Furthermore, banks will support a complete alignment of regulatory, book and economic capital. This will result in a capital charge of at least 20% of the regulatory capital. Thus, a major refinement of charges will reflect the risks of individual business lines more accurately.