broad risk buckets viz., sovereign, banks and corporates, with each category attracting a risk weight of zero, 20 and 100 per cent, respectively. such a risk weighting scheme did not provide for sufficient calibration of the counterparty risk since, for instance, a corporate with “ aaa ” rating and one with “ c ” rating would attract identical risk weight of 100 per cent and require the same regulatory capital charge, despite significant difference in their credit standing. this, in turn, engendered a rather perverse incentive for the banks to acquire higher - risk customers in pursuit of higher returns, without necessitating a higher capital charge. such bank behaviour could potentially heighten the risk profile of the banking systems as a whole. the design of the accord was, therefore, viewed as distorting the incentive structure in the banking markets and dissuading better risk management. second, the accord addressed only the credit risk and market risk in the banks ’ operations, ignoring several other types of risks inherent in any banking activity. for instance, the operational risk, that is, the risk of human error or failure of systems leading to financial loss, was not at all addressed – as were the liquidity risk, credit concentration risk, interest rate risk in the banking book, etc. third, since 1988, the emergence of innovative financial products had transformed the contours of the banking industry and its business model the world over. the credit - risk transfer products, such as securitisation and credit derivatives, enabled removal of onbalance sheet exposures from the books of the banks when they perceived that the regulatory capital requirement for such exposures was too high and hiving off such exposures would be a better strategy. the basel i framework did not accommodate such innovations and was, thus, outpaced by the market developments. 6. in this background, a need was felt to create a more comprehensive and risk - sensitive capital adequacy framework to address the infirmities in the basel - i accord. the basel committee on banking supervision ( bcbs ), therefore, after a world - wide consultative process and several impact assessment studies, evolved a new capital regulation framework, called “ international convergence of capital measurement and capital standards : a revised framework ”, which was released in june 2004. the revised framework has come to be commonly known as “ basel ii ” framework and seeks to foster better risk management practices in the banking industry. the objectives of basel ii 7.

in order to better appreciate the impact of basel ii on the banking industry, it is worth recalling the objectives of the basel committee regarding the overall level of capital requirements. according to the revised framework, issued in june 2004 : “ the objectives are to broadly maintain the aggregate level of minimum capital requirements, while also providing incentives to adopt more advanced risk - sensitive approaches of the revised framework ”. governor susan schmidt bies of the federal reserve system of the usa has described the objectives of basel ii a little more elaborately in the following words : “ the major objectives of basel ii include creating a better linkage between the minimum regulatory capital and risk, enhancing market discipline, supporting a level playing field in an increasingly integrated global financial system, establishing and maintaining a minimum capital cushion sufficient to foster financial stability in periods of adversity and uncertainty, and grounding risk measurement and management in actual data and formal quantitative techniques. let me emphasize that last objective, since it is often overlooked. critical to basel ii is the effort to improve risk measurement and management, especially at our largest, most complex organizations. ” 1 thus, it would be reasonable to infer that the main focus of the new framework is on providing the right incentives to the banks to adopt data - based, quantitative risk management systems to be able to adopt the advanced risk - sensitive approaches of the revised framework, which, in turn, would contribute to systemic and financial stability. hence, inducing the adoption of advanced risk management systems by the banking institutions would seem to lie at the heart of the new framework. select aspects of basel ii framework 8. given the foregoing objectives of the new framework, it may be useful to take a brief stock of the salient aspects of this dispensation, which could be of particular interest to this audience. a comprehensive approach 9. one of the unique aspects of basel ii is its comprehensive approach to risk measurement in the banking entities, by adopting the now - familiar three - pillar structure, which goes far beyond the first basel accord. to recapitulate, these are : pillar 1 – the minimum capital ratio, pillar 2 – the supervisory review process and pillar 3 – the market discipline. the pillar 1 provides a menu of alternative approaches, from simple to advanced ones, for determining the regulatory capital towards credit risk, market risk and operational risk, to cater to the wide diversity in the banking system across the world. pillar 2 requires the banks to establish an internal capital adequacy assessment process ( icaa