Basel II is a banking supervision accord which was created to serve as an international standard which banking regulators can apply when creating policies regarding the minimum capital requirements banks need to set aside to serve as protection against underlying financial and operational risks that banks face. Basel II is the second of Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision.
According to supporters of Basel II, such international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse.
As prevention, Basel II utilizes rigorous risk and capital management requirements which are intended to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. This generally means that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to protect its solvency and overall economic stability.
The Basel II intends to:
1. Ensure that capital allocation is more risk sensitive;
2. Separate operational risk from credit risk, and quantify both;
3. Attempt to closely align economic and regulatory capital to decrease the scope for regulatory arbitrage.
While the final agreement has largely addressed the regulatory arbitrage issue, there are still areas where regulatory capital requirements will diverge from the economic.
Basel II has largely left unchanged the question of how to actually define bank capital, which diverges from accounting equity in important respects. The Basel I definition, as modified up to the present, remains in place.
Basel II in Action
To promote greater stability in the financial system, Basel II utilizes a Three Pillar concept:
The First Pillar deals with safeguarding of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk and market risk.
Credit Risk can be calculated in three different ways of varying degree of sophistication: Standardized Approach, Foundation IRB and Advanced IRB. (IRB stands for Internal Rating-Based Approach.)
Operational Risk uses three different approaches: Basic Indicator Approach (BIA), Standardized Approach (TSA), and the Internal Measurement Approach (an advanced form of advanced measurement approach or AMA).
Market Risk uses the preferred approach of Value at Risk (VaR), which is used to measure in financial services to assess the risk associated with a portfolio of assets and liabilities.
The Second Pillar deals with the regulatory response to the first pillar, giving regulators much improved tools over those available under Basel I. It provides a structure for dealing with other risks a bank may face, as in reference to systems, pension, concentration, strategy, reputation, liquidity and legality, which the agreement combines under the title of Residual Risk. It provides the banks with the power to review their risk management system.
The Third Pillar requires that bank activities be transparent to the general public. The bank is supposed to release relevant financial data (financial statements) to the public (such as through its webpage). This aims to enable depositors to better evaluate bank condition and diversify their portfolio accordingly. It is believed that this pillar will enhance the role of market discipline in financial markets.