In January 2001 the Basel Committee on Banking Supervision issued a proposal for a New Basel Capital Accord that, once finalised, will replace the current 1988 Capital Accord. The proposal is based on three mutually reinforcing pillars that allow banks and supervisors to evaluate properly the various risks that banks face. The New Basel Capital Accord focuses on:

• minimum capital requirements, which seek to refine the measurement framework set out in the 1988 Accord

• supervisory review of an institution's capital adequacy and internal assessment process

• market discipline through effective disclosure to encourage safe and sound banking practices.

The Basel Committee received more than 250 comments on its January 2001 proposals. In April 2001 the Committee initiated a Quantitative Impact Study (QIS) of banks to gather the data necessary to allow the Committee to gauge the impact of the proposals for capital requirements. A further study, QIS 2.5, was undertaken in November 2001 to gain industry feedback about potential modifications to the Committee's proposals.

In December 2001 the Basel Committee announced a revised approach to finalising the New Basel Capital Accord and the establishment of an Accord Implementation Group. Previously, in June 2001 the Committee released an update on its progress and highlighted several important ways in which it had agreed to modify some of its earlier proposals based, in part, on industry comments.

During its 10 July 2002 meeting, members of the Basel Committee reached agreement on a number of important issues related to the New Basel Capital Accord that the Committee has been exploring since releasing its January 2001 consultative paper.

The Basel Committee on Banking Supervision has issued a third consultative paper on the New Basel Capital Accord during April 2003. Comments are due by 31 July 2003, and will be helpful to the Committee as it makes the final modifications to its proposal for a new capital adequacy framework. The goal of the Committee continues to be to complete the New Accord by the fourth quarter of this year, with implementation to take effect in member countries by year-end 2006. To that end, work already has begun in a number of countries on draft rules that would integrate Basel capital standards with national capital regimes.

Since release of the QIS 3 Technical Guidance, the Committee has spent considerable time refining its proposals for the New Accord. Each round of industry consultation has led to modifications aimed at enhancing the risk sensitivity of the new framework and at producing capital requirements that are broadly consistent with the Committee's stated objectives. The changes reflected in CP3 also are provided in this spirit.

The Committee believes that important public policy benefits can be obtained by improving the capital adequacy framework along two important dimensions. First, by developing capital regulation that encompasses not only minimum capital requirements, but also supervisory review and market discipline. Second, by increasing substantially the risk sensitivity of the minimum capital requirements.

An improved capital adequacy framework is intended to foster a strong emphasis on risk management and to encourage ongoing improvements in banks' risk assessment capabilities. The Committee believes this can be accomplished by closely aligning banks' capital requirements with prevailing modern risk management practices, and by ensuring that this emphasis on risk makes its way into supervisory practices and into market discipline through enhanced risk- and capital-related disclosures.

The new accord is widely hailed for its comprehensive approach. An extract from an article titled "Basel II: New Wine in an Old Bottle" from the website of Pinnacle Systems, Inc is reproduced hereunder, conveying informative comments on the accord.

"Basel II is designed to be more flexible and risk-sensitive than its predecessor. It affects all banks and other financial institutions including bankers, custodians, fund managers and brokers to name just a few. The accord provides a draft set of regulations that is set to modify notably, the way that banks are capitalized.

"The new framework is set to improve the trustworthiness of the financial system by aligning capital adequacy assessment more closely with the fundamental risks in the banking industry. Moreover, it will also provide incentives for banks to enhance their risk measurement and management capabilities. It will thereby augment market discipline.

"An improved capital adequacy framework is aimed to foster a strong emphasis on risk management and to encourage ongoing improvement in risk assessment capabilities of banks. It further seeks to maintain the current overall level of capital in the system and boost competitive equality.

"In the final form, Basel II will establish the basic capital frameworks for Committee member countries and will enforce that banks have a risk management strategy. For example a commercial bank�s greatest risk 15 years ago was its loan portfolio but due to innovative financial instruments today such as derivatives, a bank's capital is exposed to credit risk, interest and market risk, as well as operational risk. Once Basel II is implemented, operational risk will feature directly in the assessment of capital adequacy for the first time.

"Basel II defines Operational Risk as �The risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events.�

"Though this will include legal risk, it is worth noting that strategic and reputation risks are currently out of scope. International banks will be required by regulators to set aside capital against operational risk for the first time. Banks are being asked to set aside approximately 20 per cent of their regulatory funds against unexpected disasters.

"The next 3 years will be strenuous for finance organizations since they will have to implement changes for the Basel II Accord"

The Committee believes the proposals contained in CP3 are suitable for a wide range of banks in different countries. Within the G10, Committee members have agreed to a common implementation date for the New Accord of year-end 2006. In these countries, the implementation of the new Accord is intended to encompass internationally active banks, and other significant banks as national supervisors deem appropriate. In a number of G10 countries, the Basel II framework will be applied to the entire banking system. National supervisors in the G10 will ensure that banks not implementing Basel II will be subject to prudent capital adequacy regulation.

While the New Accord has been designed to provide options for banks and banking systems worldwide, the Committee acknowledges that outside the G10 moving to the new framework in full in the near future may not be the first priority for all supervisors in terms of what they need to do to strengthen their supervision. Where this is the case, each national supervisor should consider carefully the benefits of the new framework in the context of its domestic banking system when developing a timetable and approach to implementation.

Given resource constraints and other priorities, it should be neither surprising nor inappropriate for these timetables, particularly in non-G10 countries, to extend beyond 2006. That said, supervisors should consider implementing key elements of the supervisory review and market discipline components of the New Accord even if the Basel II minimum capital requirements will be implemented after year-end 2006.

Many national supervisors have already begun to plan for the transition to Basel II. To assist in this process, the Committee has asked a group of supervisors from around the world, with IMF and World Bank participation, to develop a framework for assisting non-G10 supervisors and banks in the transition to both the standardised and foundation IRB approaches of the New Accord. The Committee believes that continued co-operation along these lines is essential to ensuring a successful transition to the New Accord.

The Committee sees frequent exchanges of information between banks and supervisors and between supervisors in different jurisdictions as critical for the successful implementation of Basel II. To promote consistency in the implementation of the New Accord across jurisdictions, the Committee established the Accord Implementation Group (AIG) for national supervisors to exchange information on the practical implementation challenges of Basel II and on the strategies they are using to address these issues. The AIG also will work closely with the Committee's Capital Task Force (CTF), the body responsible for considering substantive modifications to and interpretations of the New Accord.

The Committee believes that the Accord will continue to evolve following the implementation of Basel II. This evolution is necessary to ensure that the framework keeps pace with emerging market developments and advances in risk management practices. Nonetheless, it is not the intent of the Committee for the New Accord to be a moving target prior to implementation. Priorities in the period prior to end-2006 will include reconciling any major, unintended inconsistencies in the treatment of similar exposures across the approaches for determining capital for a given risk. Additionally, the Committee will seek to close any loopholes and unintended effects of the new framework.

The Committee recognises that the need for such actions may only come to light after banks have begun to rely on the Basel II requirements. Those banks adopting the more advanced approaches to risk assessment (the IRB approach for credit risk and the AMA for operational risk) will be required to run them in parallel with the existing Accord for one year prior to the implementation of Basel II. The Committee believes that this parallel calculation will provide banks and supervisors with valuable information on the potential impact of the New Accord and allow issues to be brought up prior to formal implementation.

The CTF will take responsibility for considering new banking products and implications of advances in risk management processes on the new framework beyond year end 2006. The Committee is aware that industry practices change over time with some areas evolving more rapidly than others do. In particular, the IRB approaches and the AMA are meant to reflect sound industry practice. Other areas of the new framework, for example, the capital treatment of securitisation should be flexible enough to adapt to new developments when necessary. The Committee also intends to consider issues, such as a revised treatment of potential exposures associated with OTC derivatives, that it was unable to include in Basel II.

The Committee has benefited greatly from its ongoing and extensive dialogue with industry participants. As a means of continuing this productive interaction, it will look for enhanced opportunities for the industry to assist in the development of proposals for aligning regulatory capital requirements with sound industry practice. Future exchanges of views between banks and supervisors on developments in risk management will help the Committee to make decisions that will keep the new framework relevant for years to come.

Effective supervision of large banking organisations necessarily entails a closer more co-operative partnership between industry participants and supervisors. Under the New Accord, cross-border issues are likely to receive even greater attention than they do today.The Committee believes existing cross-border responsibilities of supervisors, as set out in the Basel Concordat and Minimum Standards documents will continue to apply as the New Accord is being implemented. Nevertheless, the New Accord will require enhanced cooperation between supervisors on a practical basis, especially for the cross-border supervision of complex international banking groups. In particular, the Committee believes that, wherever possible, supervisors should avoid performing redundant and uncoordinated approval and validation work in order to reduce the implementation burden for banks, and to conserve supervisory resources. Consequently, in implementing the New Accord, the Committee believes that supervisors should communicate as clearly as possible to affected banking groups about the respective roles of home- and host-country supervisors so that practical arrangements are understood.

Cross-border implementation of the New Accord will not change the legal responsibilities of supervisors for the regulation of their domestic banking organisations and the arrangements of consolidated supervision. This said, the Committee recognises that home country supervisors may not have the ability alone to gather the information necessary for effective implementation of the revised Accord. Consequently, the AIG is developing a set of principles to facilitate closer practical co-operation and information exchange among supervisors.

The Committee broadly supports the principle of "mutual recognition" for internationally active banks as a key basis for international supervisory co-operation. This principle implies the need for recognising common capital adequacy approaches when considering the branching of internationally-active banks into host jurisdictions, as well as the desirability of minimising differences in the national capital adequacy regulations between home and host jurisdictions so that subsidiary banks are not subjected to excessive burden.

The Committee is issuing the current package of proposals for a three-month comment period. Comments on CP3 should be submitted by 31 July 2003 to relevant national supervisory authorities and central banks and may also be sent to the Basel Committee on Banking Supervision at the Bank for International Settlements, CH-4002, Basel, Switzerland. It anticipates that this process will again provide valuable input and will contribute to an improved Accord that enhances the stability of the international banking system. The Committee aims to finalise the Basel II framework in the fourth quarter 2003, so that member countries will be able to implement it on the envisioned timetable.

An overview of the Accord as set out in the document CP3 of Basel Committee published during April 2003 is reproduced in the succeeding pages