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value would require a higher capital level still, of $4 million. The capital calculations for derivatives have detail differences between them, depending on the instrument that is being traded. For example for interest-rate swaps the exposure includes an “add-on factor” to what is termed the instruments “current exposure.” This add-on fac- tor is a percentage of the nominal value, and is shown in Exhibit 14.3.     THE PROPOSED BASEL II ACCORD   The perceived shortcomings of the 1988 Basel capital accord attracted much comment from academics and practitioners alike, almost as soon as they were adopted. The main criticism was that the requirements made no allowance for the credit risk ratings of different corporate borrowers, and was too rigid in its application of the risk weightings. That these were valid issues was recognized when, on June 3, 1999 the BIS published pro- posals to update the capital requirements rules. The new guidelines are designed “to promote safety and soundness in the financial system, to provide a more comprehensive approach for addressing risks, and to enhance competitive equality.” The proposals also are intended to apply to all banks worldwide, and not simply those that are active across inter- national borders. The 1988 accord was based on very broad counterparty credit require- ments, and despite an amendment introduced in 1996 to cover trading book requirements, remained open to the criticism of inflexibility. The pro- posed new Basel II rules have three pillars, and are designed to be more closely related to the risk levels of particular credit exposures. These are:   ■ Pillar 1: A new capital requirement for credit risk, as well as a charge for the new category of operational risk. ■ Pillar 2: The requirement for supervisors to take action if a banks risk profile is high compared to the level of capital held. ■ Pillar 3: The requirement for greater disclosure from banks than before to enhance market discipline.   The markets have developed to a much greater level of sophistication since the original rules were drafted, and the Committee has considered a wide range of issues related to the determinants of credit risk.       ELEMENTS OF THE PROPOSED NEW BASEL II RULES   In this section we consider the main points of the Basel II proposal and also assess market reaction to it at the time of writing. As just noted, as they currently stand the new Basel accord is split into three approaches or Pillars, which we consider in more detail in this section.

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