Basel II Compliance: Risk Management

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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.

Basel II Compliance in Financial Institutions

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.

Pillars of Basel II Compliance

There are three pillars of Basel II:

  • Minimum Capital: A bank must have a substantial capital against at least 8% of the assets to ensure best practices with risk management and Basel II compliance.
  • Supervisor Review: This is a system which is set up by national regulators to ensure that the country banks abide by the banking regulations in compliance with Basel II. In other words, this is more of a referee system.
  • Market Discipline: This is a critical requirement for banks. Under compliance with Basel II banks are allowed to use their internal models to ensure low capital requirement. However, there is a catch. The banks must provide transparency as a best practice.

Risks Attached to Basel II

There are risks attached to Basel II and these include:

  • Credit Risk: Risk of losses when a borrower fails to pay back a credit.
  • Market Risk: This is a risk of loss inherent to the entire market. Also known as Systemic Risk.
  • Operational Risk: This form of risk is not always associated with financial or market risk, rather it is the consequences of these risks. It results from breakdowns in systems or even internal procedures in a financial institution or bank.

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.

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