The third pillar – it’s pretty simply – it requires banks to be more translucent with their reporting, allowing markets to get a better grasp of what’s going on inside the bank.

Let’s take a step back on the topic – why do I care?  Not just because banking is a rather important topic of conversation lately.  This is an international document that lacks the ability to be enforced.  Different cultures, different government regulations that affect banking more directly rather than an elusive, global document.  It’s worth talking about, getting familiar with, just as international accounting standards are being adapted to global companies. 

But overall – this is pertinent to current times.  I’d like a clearer definition of what a bank considers its assets before I invest.  I’d like to know how Lehman Brothers developed its CDOs and derivative products. Or how banks managed their risks, what they were exposed to, what to expect for risk in the future and how it’s pieced together.  

Smart people can develop complicated financial models to outsmart the market, to dissipate risk and create a win-win situation.  But let’s have regulations that piece together all of these, to understand CDOs and what-if situations of unwinding them.  Of conceiving irresponsible rating agencies inflating MBSs or plain company bonds.  Well, I guess I’m getting a little ahead of myself.

But a clearer presentation to the market of internal activities would allow the possibility of smart people to conceive these possibilities of failing banks, poor loan practices and the overall ripple effect on others.

I don’t think it’s too much to ask for a free market with free information.

From what I know up front, there are two and provide guidelines for capital requirements for banks.  And that Basel is in Switzerland.

The second Basel agreement is more pertinent, yet still only recommendations.  It provides recommendations for capital adequacy…sound relevant?  

-side note – banks in Europe have more of a liberal accounting system, with the ability to write off non-performing assets to look like they’re profitable (e.g. Deutsche Bank in 4Q07 I believe, maybe 1Q08).  

Sparing myself from reading 350 pages, there are three pillars of the agreement: capital allocation is more risk sensitive, separating operational risk from credit risk, and align economic and regulatory capital to reduce the possibility of regulatory arbitrage.

Let’s look at the first pillar for now (as I don’t have the focus after work for all three at once!) – capital allocation being more risk sensitive – it outlines capital adequacy for credit, operational and market risk.  It also aligns itself with a minimum capital requirement.  When banks take deposits and turn it around for investments, they can choose investments or loans, and the Basel accord rates this on a scale from least to most risky, starting with government bonds at 0%, OECD countries at 20%, mortgages at 50%, commercial loans at 100% and now something new – subprime borrowers at 150%.  The minimum capital requirement that the Basel accord lays out is 8% with the risk weighted assets.  I believe this is to encourage banks to even out their risk – but I wonder why there isn’t a maximum.  Perhaps I’m not understanding this fully.  Lastly – the first pillar says that banks basically can evaluate credit risk by their own means: the “Standard Approach”, or the foundation/advance “Internal Ratings Based Approach.” 

So returning to that side note – the IRB approach? huh? so you have the power to rate your own credit risk, even right it down so much that you create the illusion to have a profit?  I hope this approach is moderated…or at least looked after.

next to come: pillar 2 of the 2nd Basel accord.