Basel II: Changing The Way Banks Account For RiskBasel II: Changing The Way Banks Account For Risk

The information technology needed to assess a bank's risk is relatively new. And that's a big reason the people who regulate banks around the world decided it's time to update the rules used to police those risks.

But what exactly is Basel II, and who's behind it?

In January 2001, the Basel Committee on Banking Supervision issued a proposal for a New Basel Capital Accord, referred to as Basel II, to replace a 1988 agreement. The committee is made up banking industry execs and high-ranking banking regulators. National regulators use the accord's principles to craft their countries' banking rules.

Basel II is influenced by the belief that bank executives can understand their risk better today, so the funds they set aside for possible failure can be more closely tuned to those risks. "Until quite recently, systematically and formally managing many of the key risks taken by banks, in particular their credit risk, was difficult," Federal Reserve vice chairman Roger Ferguson said in a speech last month. "The techniques for quantifying and measuring risk, and the technology and instruments to manage and distribute it, simply did not exist."

The strategy and new formulas may work because banks tend to be more conservative when there are greater unknowns about risk, says Peter Keppler, senior analyst of capital markets group at Financial Insights Group, formerly Meridien Research. As an institution improves its approach and technologies to better know the risks, it should be comfortable lowering its reserve requirement. "The way that they're trying to encourage more sophisticated practices is by holding out the carrot to banks," Keppler says.

The rules still aren't final, however, and most likely won't be until the end of this year. Yet banks are getting ready, as the new accord will begin to be enforced as early as 2006, which means financial institutions that want to change practices and install new technologies to aid in compliance should start today.

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Illustration by Michael Klein