Reason For The Development Of Basel II

Credit models - grading or options - based

The increasing use of quantitative methods by banks to calculate and report credit risk in their asset portfolios at the peak publicated Market Risk Amendment, which allows banks to use internal models to calculate the credit risk.
The development of this quantitative method provides a strong foundation for Basel II. Two problems that must be resolved before the Committee, Basel II can process.

Determining the type of 'credit model' will be allowed on Pillar 1. Committee to consider 2 alternatives:
'Full portfolio model' is a technique → option pricing model was developed by Robert Merton in determining prices and calculate the portfolio option.
'grading models' in which risk calculations are based on 'individual obligor base' and portfolio risk is the total of these individual risk → model was also used by rating agencies like S & P and Moody's. It should be noted that the Basel II uses the term 'grades' and not 'rated' even if it means the same.
At the end of the 1990 Committee decided to use a 'credit grading models'. However, there is a trend in the banking sector to use these 2 techniques together.

The extent to which quantitative techniques can be used to cover 'other risks' particularly operational risk. There are some arguments whether these risks should be included in Pillar 2 because very few banks that use quantitative calculations to compute and manage these risks. Concern of bank supervisors that the risk is very significant and if only depend on Pillar 2 will cause 'under capitalization' or 'inconsistent capitalization' of risk.
As a result Committee decided:
Include operational risk as a quantitative calculation of Pillar 1
Defining the broader operational risk but not including the risk of reputation, business and strategic.
Credit risk models in Pillar 1 is 'credit grading techniques'.