Events such as the Enron bankruptcy and the trading losses have increased the awareness of risk. Basel II, primarily focuses on the internal methodologies for better risk management in the financial sector, with special emphasis on banks. In essence, it aims to ensure effective risk management and security systems in the financial sector.
For an orderly functioning of the markets, it is essential that participants have confidence in each other`s ability to transact business. Among others, capital rules help foster the confidence, that if banks hold appropriate capital, they can absorb reasonable level of losses before becoming insolvent. Accordingly, Basel II in 1988 came out with a set of rules, which recommended minimum capital or capital adequacy ratio to be maintained. Here, capital adequacy ratio is a measure of the amount of a bank's capital expressed as a percentage of risk weighted exposures.
At the time of introduction of the capital accord itself, it was widely recognized that prescribed capital standards were good indicators of the financial condition of a financial institution. In the sense, the accord adopted a "broad brush approach," i.e., the accord was not sensitive to risk. For maintaining capital adequacy or regulatory capital, there was no distinction, whether one lent money to AAA or BB rated client, thereby leading to "capital arbitrage." Here "capital arbitrage" in the words of the Federal Reserve Board Governor, Laurence H Meyer refers to the strategies that reduce a bank's regulatory capital requirements without a commensurate reduction in the bank's risk exposure.
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