What is Basel II?
Basel II is the second of the Basel Accords, (now extended and partially superseded by Basel III), which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision.
The Basel II Accord was published initially in June 2004 and was intended to amend international banking standards that controlled how much capital banks were required to hold to guard against the financial and operational risks banks face. These regulations aimed to ensure that the more significant the risk a bank is exposed to, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability. Basel II attempted to accomplish this by establishing risk and capital management requirements to ensure that a bank has adequate capital for the risk the bank exposes itself to through its lending, investment, and trading activities. One focus was to maintain sufficient consistency of regulations to limit competitive inequality amongst internationally active banks.
Basel II was implemented in the years prior to 2008, and was only to be implemented in early 2008 in most major economies; that year's Financial crisis intervened before Basel II could become fully effective. As Basel III was negotiated, the crisis was top of mind and accordingly more stringent standards were contemplated and quickly adopted in some key countries including Europe and the US.
Purpose, Goals, and Influence of Basel II
The purpose of Basel II is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. The goals of Basel II are:
- Ensuring that capital allocation reflects the level of risk
- Separating operational risk from credit risk, and quantifying both
- Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage
The influence of implementing Basel II on IT mainly relates to the security of operations. Focus areas are:
- Preventing improper disclosure of information
- Preventing execution of unauthorized transactions as well as providing means of transmission that will allow neither modifications nor access to confidential data
- Preventing system outages and unauthorized changes in the system that would compromise existing security measures
It should be noted that banks implement country-specific regulations based on Basel II rather than Basel II itself.
The practice has shown that financial institutions use Basel II requirements/methods when rating their customers. Hence, although Basel II originally concerns financial institutions, it has high relevance for all kinds of sectors either for rating credit risks or by means of supply chains.
Basel II Requirements
Building on Basel I, Basel II provided guidelines for the calculation of minimum regulatory capital ratios and confirmed the requirement that banks maintain a capital reserve equal to at least 8% of their risk-weighted assets.
Basel II divides the eligible regulatory capital of a bank into three tiers. The higher the tier, the more secure and liquid it's assets.
- Tier 1 capital represents the bank's core capital and is composed of common stock, as well as disclosed reserves and certain other assets. At least 4% of the bank's capital reserve must be in the form of Tier 1 assets.
- Tier 2 is considered supplementary capital and consists of items such as revaluation reserves, hybrid instruments, and medium- and long-term subordinated loans.
- Tier 3 consists of lower-quality unsecured, subordinated debt.
Basel II also refined the definition of risk-weighted assets, used in calculating whether a bank meets its capital reserve requirements. Risk weighting is intended to discourage banks from taking on excessive amounts of risk in terms of the assets they hold. The main innovation of Basel II in comparison to Basel I is that it takes into account the credit rating of assets in determining their risk weights. The higher the credit rating, the lower the risk weight.
The Three Pillars under Basel II
- Pillar 1: Capital Adequacy Requirements: Pillar 1 improves on the policies of Basel I by taking into consideration operational risks in addition to credit risks associated with risk-weighted assets (RWA). It requires banks to maintain a minimum capital adequacy requirement of 8% of their RWA. Basel II also provides banks with more informed approaches to calculating capital requirements based on credit risk, while taking into account each type of asset’s risk profile and specific characteristics. The two main approaches include the:
- Standardized approach: The standardized approach is suitable for banks with a smaller volume of operations and a simpler control structure. It involves the use of credit ratings from external credit assessment institutions for the evaluation of the creditworthiness of a bank’s debtor.
- Internal ratings-based approach: The internal ratings-based approach is suitable for banks engaged in more complex operations, with more developed risk management systems. There are two IRB approaches for calculating capital requirements for credit risk based on internal ratings:
- Foundation Internal Ratings-based approach (FIRB): In FIRB, banks use their own assessments of parameters such as the Probability of Default, while the assessment methods of other parameters, mainly risk components such as Loss Given Default and Exposure at Default, are determined by the supervisor.
- Advanced Internal Ratings-based approach (AIRB): Under the AIRB approach, banks use their own assessments for all risk components and other parameters.
- Pillar 2: Supervisory Review: Pillar 2 was added owing to the necessity of efficient supervision and lack thereof in Basel I, pertaining to the assessment of a bank’s internal capital adequacy. Under Pillar 2, banks are obligated to assess the internal capital adequacy for covering all risks they can potentially face in the course of their operations. The supervisor is responsible for ascertaining whether the bank uses appropriate assessment approaches and covers all risks associated.
- Internal Capital Adequacy Assessment Process (ICAAP): A bank must conduct periodic internal capital adequacy assessments in accordance with its risk profile and determine a strategy for maintaining the necessary capital level.
- Supervisory Review and Evaluation Process (SREP): Supervisors are obligated to review and evaluate the internal capital adequacy assessments and strategies of banks, as well as their ability to monitor their compliance with the regulatory capital ratios.
- Capital above the minimum level: One of the added features of the framework Basel II is the requirement of supervisors to ensure banks maintain their capital structure above the minimum level defined by Pillar 1.
- Supervisor’s interventions: Supervisors must seek to intervene in the daily decision-making process in order to prevent capital from falling below the minimum level.
- Pillar 3: Market Discipline: Pillar 3 aims to ensure market discipline by making it mandatory to disclose relevant market information. This is done to make sure that the users of financial information receive the relevant information to make informed trading decisions and ensure market discipline.
Pros and cons of Basel II
Basel II expanded upon Basel I to help regulators handle the financial innovations and new financial products that came about since the inception of Basel I in the 1980s. For example, Basel II required that banks maintain a capital reserve equal to at least 8% of their risk-weighted assets.
Basel II attempted to discourage risky behavior, but it also resulted in several strategies banks used to make risky investments. Among these strategies were ones that resulted in the emergence of the subprime mortgage market and moving higher-risk assets to unregulated parts of holding or parent companies. Another tactic was to transfer the risk directly to investors by securitization, which is the process of taking a nonliquid asset or groups of assets and transforming them into a security that can be traded on open markets.
Some experts contend that the risky behavior Basel II enabled was in part responsible for the subprime mortgage meltdown and accompanying Great Recession of 2008.