New capital adequacy rules - Basel 2

The rules on capital adequacy - the regulatory capital - express legislators’ opinion of how much capital (capital base) a credit institution, such as a bank, must have in relation to the size of its risk taking expressed in the form of riskweighted assets. The most important part of the capital base is the shareholders’ equity. In addition to equity the institution may issue certain liabilities such as subordinated loans to be included in the capital base. The legal minimum requirement stipulates that the capital base must correspond to at least 8 percent of the risk-weighted assets.

The Swedish parliament has adopted a new law on capital adequacy and large exposures that came into effect on February 1st, 2007. Since the new law entails major changes compared to previous law, it is implemented in stages (the transition period) over a three-year period through 2009. The transition rules require - among other things - that the capital base must at least correspond to 95 percent (2007), 90 percent (2008) and 80 percent (2009) respectively of the capital required for credit and market risks calculated according to the previous capital adequacy rules, Basel 1.

According to the new rules, there are two main methods to calculate the capital requirement for credit risks: the standardized approach and the IRB approach. In the IRB approach the capital requirement, to a greater degree than before, is linked to the bank’s current and future risk profi le, its own riskmeasures and an assessment of risk capital needs. The IRB approach applies to banks with sophisticated and well developed risk measurement processes. Before applying the IRB approach, the banks are required to seek approval from the Swedish Financial Supervisory Authority. For banks that do not meet the required standard, the capital requirement will be based on the standardized approach which is very similar to the previous rules, Basel 1. In addition to the capital requirement for credit and market risks, which was present in Basel 1, a capital requirement is also introduced for operational risks.

Another of the most important changes in the new rules is the requirement that the institutions prepare and document their own internal capital adequacy assessment process (Pillar 2). All relevant sources of risk must be taken into account when assessing the total capital needed, i.e. not only those already included when calculating the capital requirement for credit, market and operational risks (Pillar 1). Moreover, the new rules include requirements on the institution to disclose comprehensive information about its risks, risk management and associated capital requirements (Pillar 3).