Provision, Capital Requirements and Basel II

This concluding chapter discusses provision and capital requirements. These are two measures credit granting organizations need to calculate to comply with national and international banking regulations. Provision is an amount set aside to cover expected losses in the future; that is, losses which have not been incurred yet, but which are expected to arise at some future time. For example, some of an organization’s outstanding loans will be written-off due to customers’ defaulting on their repayments. An estimate of future write-off will therefore be made and this amount set aside as provision so that funds are available to cover the loss when it occurs. Capital requirements are reserves, in addition to provision, that organizations maintain to cover unexpected losses; that is, costs arising from unexpected events that have not been accounted for by provision. For example, if the economy takes a sudden downturn, the provision estimate is likely to underestimate the actual write-off that occurs, as more people become unemployed and can no longer meet their loan repayments. The more capital that an organization puts aside, the better able it is to cover losses arising from unforeseen events, and therefore, the more likely it is to remain solvent. The Basel II capital accord is an international agreement drawn up by the bank of international settlements based in Basel, Switzerland. The accord specifies the minimum capital banking organizations need to maintain to keep their risk of insolvency below acceptable levels. At the time of writing the accord is due to be implemented in all OECD (Organization for Economic Cooperation and Development) countries by 2009.