The Basel Committee on Banking Supervision had established the Basel I and Basel II. The purpose of Basel II was to create international banking regulations and standards in 2004. The Basel II compliance requires banks to put aside a certain capital to guard themselves against losses and solvency. Compliance with Basel II is especially important during time of economic instability. Therefore, Basel II compliance ensures risk management which is a best practice for banks.
According to advocates of Basel II, these international standards can protect the international financial system from problems incase a central bank or series of banks collapses. The Basel II accomplished this by enforcing certain requirements to protect banks by ensuring that it holds capital reserves. The simple rule with Basel II compliance is that the greater the risks the greater the capital reserves the bank needs.
Additionally, compliance with Basel II has its own effect on financial institutions. These include:
Determination of Bank Equity Capital: In banks traditionally assets are loans and liabilities are customer deposits. Even then the ratio of debt to equity is very high in banks. Therefore, for protection against losses Basel II compliance ensures that a bank used the equity as a backup in case the assets declined. This provides the depositors protection through best practices and risk management and Basel II compliance.
Protection through Bank Loans: Recently banks have moved away from long term illiquid assets and instead look towards tradable assets. Banks therefore take it as best practice to sell assets or purchase credit protection from third parties to ensure risk transfer. This indirectly means hedge funding which is a best practice for risk management in financial institutions.
However, Basel II compliance involves certain complex procedures such as securitization, credit risk management and involves complex formulas. This makes compliance with it a bit difficult and demanding. Therefore, it is not appreciated by most banking systems. Nonetheless, it is part of the best practices in global banking and cannot be taken lightly.
There are three pillars of Basel II:
There are risks attached to Basel II and these include:
Therefore, Basel II protects banks and other financial institutions by defining the risks. It is in the best of interests that Basel II compliance is implemented as best practice.