free qr code reader for .net Development of an International Framework for Risk Regulation in Software

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Development of an International Framework for Risk Regulation
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The Basel Committee on Banking Supervision was founded in 1975; it is the driving force for harmonization of banking supervision regulation on an international level, and it substantially supports cross-border enforcement of cooperation among national regulators. The committee s recommendations have no internal binding power, but based on the material power of persuasion and the implementation of its recommendations at the local level by the members of the Committee, it has a worldwide impact.72 Capital adequacy is the primary focus of the committee, as capital calculation has a central role in all local regulations, and the standards of the BIS are broadly implemented. The standards are intended to strengthen the international finance system and reduce the distortion of normal trading conditions by arbitrary national requirements. The BIS
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recommendations apply only to international banks and consolidated banking groups. They are minimum standards, allowing local regulators to set or introduce higher requirements. The Basel Committee intends to develop and enhance an international regulatory network to increase the quality of banking supervision worldwide. 2.5.2 Framework of the 1988 BIS Capital Adequacy Calculation
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Since its inception, the Basel Committee has been very active on the issue of capital adequacy. A landmark financial agreement was reached with the Basel accord, concluded on July 15, 1988, by the central bankers of the G-10 countries.73 The regulators announced that the accord would result in international convergence of supervisory regulations governing the capital adequacy of international banks. Though minimal, these capital adequacy standards increase the quality and stability of the international banking system, and thus help to reduce distortion between international banks. The main purpose of the 1988 Basel accord was to provide general terms and conditions for commercial banks by means of a minimum standard of capital requirements to be applied in all member countries. The accord contained minimal capital standards for the support of credit risks in balance and off-balance positions, as well as a definition of the countable equity capital. The Basel capital accord was modified in 1994 and 1995 with regard to derivatives instruments and recognition of bilateral netting agreements.74 With the Cooke defined ratio, the 1988 accord created a common measure of solvency. However, it covers only credit risks and thus deals solely with the identity of banks debtors. The new ratios became binding by regulation in 1993, covering all insured banks of the signatory countries. 2.5.2.1 The Cooke Ratio The Basel accord requires that banks hold capital equal to at least 8 percent of their total risk-weighted assets. Capital, however, is interpreted more broadly than the usual definition of equity, because its goal is to protect deposits. It consists of two components:
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Tier 1 capital. Tier 1 capital, or core capital, includes stock issues and disclosed reserves. General loan loss reserves constitute capital that has been dedicated to funds to absorb potential future losses. Real losses in the future are funded from the reserve account rather than through limitation of earnings, smoothing out income over time. Tier 2 capital. Tier 2 capital, or supplementary capital, includes perpetual securities, undisclosed reserves, subordinated debt
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with maturity longer than five years, and shares redeemable at the option of the issuer. Because long-term debt has a junior status relative to deposits, debt acts as a buffer to protect depositors (and the deposit insurer). The Cooke ratio requires an 8 percent capital charge, at least 50 percent of which must be covered by Tier 1 capital. The general 8 percent capital charge is multiplied by risk capital weights according to predetermined asset classes. Government bonds, such as Treasuries, Bundesobligationen, Eidgenossen, and so forth are obligations allocated to the Organization for Economic Cooperation and Development (OECD) government papers, which have a risk weight of zero. In the same class fall cash and gold held by banks. As the perceived credit risk increases (nominally), so does the risk weight. Other asset classes, such as claims on corporations (including loans, bonds, and equities), receive a 100 percent weight, resulting in the required coverage of 8 percent of capital. Signatories of the Basel accord are free to impose higher local capital requirements in their home countries.75 For example, under the newly established bank capital requirements, U.S. regulators have added a capital restriction which requires that Tier 1 capital must comprise no less than 3 percent of total assets. 2.5.2.2 Activity Restrictions In addition to the weights for the capital adequacy calculation, the Basel accord set limits on excessive risk taking. These restrictions relate to large risks, defined as positions exceeding 10 percent of the bank s capital. Large risks must be reported to regulatory authorities on a formal basis. Positions exceeding 25 percent of the bank s capital are not allowed (unless a bank has the approval of the local regulator). The sum of all largerisk exposures may not exceed 800 percent of the capital. 2.5.3 Criticisms of the 1988 Approach
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The 1988 Basel accord had several drawbacks, which became obvious with implementation. The main criticisms were the lack of accommodation of the portfolio approach, the lack of netting possibilities, and the way in which market risks were incorporated.
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The portfolio approach was not accommodated. Thus, correlations between different positions of the bank s portfolio did not account for the portfolio risk of the bank s activities. The Basel accord increased the capital requirements resulting from hedging strategies, as offsetting hedging positions were not allowed. Netting was not allowed. If a bank nets corresponding lenders and borrowers, the total net exposure may be small. If a
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