Basel II
Encyclopedia
Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision
Basel Committee on Banking Supervision
The Basel Committee on Banking Supervision is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten countries in 1975. It provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance...

. The purpose of Basel II, which was initially published in June 2004, 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 while maintaining sufficient consistency so that this does not become a source of competitive inequality amongst internationally active banks. Advocates of Basel II believe that such an 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. In theory, Basel II attempted to accomplish this by setting up risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency
Solvency
Solvency, in finance or business, is the degree to which the current assets of an individual or entity exceed the current liabilities of that individual or entity. Solvency can also be described as the ability of a corporation to meet its long-term fixed expenses and to accomplish long-term...

 and overall economic stability.

Objective

The final version aims at:
  1. Ensuring that capital allocation
    Capital requirement
    Capital requirement refers to -The standardized requirements in place for banks and other depository institutions, which determines how much capital is required to be held for a certain level of assets through regulatory agencies such as the Bank for International Settlements, Federal Deposit...

     is more risk sensitive;
  2. Enhance disclosure requirements which will allow market participants to assess the capital adequacy of an institution;
  3. Ensuring that credit risk
    Credit risk
    Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....

    , operational risk
    Operational risk
    An operational risk is, as the name suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates...

     and market risk
    Market risk
    Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices...

     are quantified based on data and formal techniques;
  4. Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.


While the final accord has largely addressed the regulatory arbitrage issue, there are still areas where regulatory capital requirement
Capital requirement
Capital requirement refers to -The standardized requirements in place for banks and other depository institutions, which determines how much capital is required to be held for a certain level of assets through regulatory agencies such as the Bank for International Settlements, Federal Deposit...

s will diverge from the economic capital
Economic capital
-Finance and Economics:In financial services firms, economic capital can be thought of as the capital level shareholders would choose in absence of capital regulation....

.

Basel II has largely left unchanged the question of how to actually define bank capital
Capital requirement
Capital requirement refers to -The standardized requirements in place for banks and other depository institutions, which determines how much capital is required to be held for a certain level of assets through regulatory agencies such as the Bank for International Settlements, Federal Deposit...

, which diverges from accounting equity in important respects. The Basel I definition, as modified up to the present, remains in place.

The accord in operation

Basel II uses a "three pillars" concept – (1) minimum capital requirements
Capital requirement
Capital requirement refers to -The standardized requirements in place for banks and other depository institutions, which determines how much capital is required to be held for a certain level of assets through regulatory agencies such as the Bank for International Settlements, Federal Deposit...

 (addressing risk), (2) supervisory review and (3) market discipline
Market discipline
Buyers and sellers in a market are said to be constrained by market discipline in setting prices because they have strong incentives to generate revenues and avoid bankruptcy...

.

The Basel I
Basel I
Basel I is the round of deliberations by central bankers from around the world, and in 1988, the Basel Committee in Basel, Switzerland, published a set of minimal capital requirements for banks. This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten countries...

 accord dealt with only parts of each of these pillars. For example: with respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk was not dealt with at all.

The first pillar

The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....

, operational risk
Operational risk
An operational risk is, as the name suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates...

, and market risk
Market risk
Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices...

. Other risks are not considered fully quantifiable at this stage.

The credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....

 component can be calculated in three different ways of varying degree of sophistication, namely standardized approach
Standardized approach (credit risk)
The term standardized approach refers to a set of credit risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions....

, Foundation IRB
Foundation IRB
The term Foundation IRB or F-IRB is an abbreviation of foundation internal ratings-based approach and it refers to a set of credit risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions....

 and Advanced IRB
Advanced IRB
The term Advanced IRB or A-IRB is an abbreviation of advanced internal ratings-based approach and it refers to a set of credit risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions....

. IRB stands for "Internal Rating-Based Approach".

For operational risk
Operational risk
An operational risk is, as the name suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates...

, there are three different approaches - basic indicator approach
Basic indicator approach
The basic approach or basic indicator approach is a set of operational risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions....

 or BIA, standardized approach
Standardized approach (operational risk)
In the context of operational risk, the standardized approach or standardised approach is a set of operational risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions....

 or STA, and the internal measurement approach (an advanced form of which is the advanced measurement approach
Advanced measurement approach
Under Basel II, operational risk charges can be calculated by using one of the three methods that increase in sophistication and risk sensitivity: the Basic Indicator Approach; the Standardised Approach; and Advanced Measurement Approaches .Under AMA the banks are allowed to develop their own...

 or AMA).

For market risk
Market risk
Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices...

 the preferred approach is VaR (value at risk
Value at risk
In financial mathematics and financial risk management, Value at Risk is a widely used risk measure of the risk of loss on a specific portfolio of financial assets...

).

As the Basel 2 recommendations are phased in by the banking industry it will move from standardised requirements to more refined and specific requirements that have been developed for each risk category by each individual bank. The upside for banks that do develop their own bespoke risk measurement systems is that they will be rewarded with potentially lower risk capital requirements. In future there will be closer links between the concepts of economic profit and regulatory capital.

Credit Risk can be calculated by using one of three approaches:

1. Standardised Approach

2. Foundation IRB 3. Advanced IRB Approach

The standardized approach sets out specific risk weights
Risk-weighted asset
Risk-weighted asset is a bank's assets or off-balance sheet exposures, weighted according to risk. This sort of asset calculation is used in determining the capital requirement or Capital Adequacy Ratio for a financial institution...

 for certain types of credit risk. The standard risk weight categories used under Basel 1 were 0% for government bonds, 20% for exposures to OECD Banks, 50% for first line residential mortgages and 100% weighting on consumer loans and unsecured commercial loans. Basel II introduced a new 150% weighting for borrowers with lower credit ratings. The minimum capital required remained at 8% of risk weighted assets, with Tier 1 capital making up not less than half of this amount.

Banks that decide to adopt the standardised ratings approach must rely on the ratings generated by external agencies. Certain banks used the IRB approach as a result.

The second pillar

The second pillar deals with the regulatory response to the first pillar, giving regulators
Bank regulation
Bank regulations are a form of government regulation which subject banks to certain requirements, restrictions and guidelines. This regulatory structure creates transparency between banking institutions and the individuals and corporations with whom they conduct business, among other things...

 much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk
Systemic risk
In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by...

, pension risk, concentration risk
Concentration risk
Concentration risk is a banking term denoting the overall spread of a bank's outstanding accounts over the number or variety of debtors to whom the bank has lent money. This risk is calculated using a "concentration ratio" which explains what percentage of the outstanding accounts each bank loan...

, strategic risk, reputational risk
Reputational risk
Reputational risk, often called reputation risk, is a type of risk related to the trustworthiness of business. Damage to a firm's reputation can result in lost revenue or destruction of shareholder value, even if the company is not found guilty of a crime...

, liquidity risk
Liquidity risk
In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss .-Types of Liquidity Risk:...

 and legal risk
Legal risk
Legal risk is risks that counterparty are not legally able to enter into a contract. Another legal risk relates to regulatory risk, i.e., that a transaction could conflict with a regulator's policy or, more generally, that legislation might change during the life of a financial contract.-The Risk...

, which the accord combines under the title of residual risk. It gives banks a power to review their risk management system.

Internal Capital Adequacy Assessment Process (ICAAP) is the result of Pillar II of Basel II accords

The third pillar

This pillar aims to complement the minimum capital requirements and supervisory review process by developing a set of disclosure requirements which will allow the market participants to gauge the capital adequacy of an institution.

Market discipline
Market discipline
Buyers and sellers in a market are said to be constrained by market discipline in setting prices because they have strong incentives to generate revenues and avoid bankruptcy...

 supplements regulation as sharing of information facilitates assessment of the bank by others including investors, analysts, customers, other banks and rating agencies which leads to good corporate governance. The aim of pillar 3 is to allow market discipline to operate by requiring institutions to disclose details on the scope of application, capital, risk exposures, risk assessment processes and the capital adequacy of the institution. It must be consistent with how the senior management including the board assess and manage the risks of the institution.

When market participants have a sufficient understanding of a bank’s activities and the controls it has in place to manage its exposures, they are better able to distinguish between banking organisations so that they can reward those that manage their risks prudently and penalise those that do not.

These disclosures are required to be made at least twice a year, except qualitative disclosures providing a summary of the general risk management objectives and policies which can be made annually. Institutions are also required to create a formal policy on what will be disclosed, controls around them along with the validation and frequency of these disclosures. In general, the disclosures under Pillar 3 apply to the top consolidated level of the banking group to which the Basel II framework applies.

September 2005 update

On September 30, 2005, the four US Federal
United States Department of the Treasury
The Department of the Treasury is an executive department and the treasury of the United States federal government. It was established by an Act of Congress in 1789 to manage government revenue...

 banking agencies (the Office of the Comptroller of the Currency
Office of the Comptroller of the Currency
The Office of the Comptroller of the Currency is a US federal agency established by the National Currency Act of 1863 and serves to charter, regulate, and supervise all national banks and the federal branches and agencies of foreign banks in the United States...

, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation
Federal Deposit Insurance Corporation
The Federal Deposit Insurance Corporation is a United States government corporation created by the Glass–Steagall Act of 1933. It provides deposit insurance, which guarantees the safety of deposits in member banks, currently up to $250,000 per depositor per bank. , the FDIC insures deposits at...

, and the Office of Thrift Supervision
Office of Thrift Supervision
The Office of Thrift Supervision was a United States federal agency under the Department of the Treasury that charters, supervises, and regulates all federally- and state-chartered savings banks and savings and loans associations. It was created in 1989 as a renamed version of another federal agency...

) announced their revised plans for the U.S. implementation of the Basel II accord. This delays implementation of the accord for US banks by 12 months.

November 2005 update

On November 15, 2005, the committee released a revised version of the Accord, incorporating changes to the calculations for market risk and the treatment of double default effects. These changes had been flagged well in advance, as part of a paper released in July 2005.

July 2006 update

On July 4, 2006, the committee released a comprehensive version of the Accord, incorporating the June 2004 Basel II Framework, the elements of the 1988 Accord that were not revised during the Basel II process, the 1996 Amendment to the Capital Accord to Incorporate Market Risks, and the November 2005 paper on Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework. No new elements have been introduced in this compilation. This version is now the current version.

November 2007 update

On November 1, 2007, the Office of the Comptroller of the Currency
Office of the Comptroller of the Currency
The Office of the Comptroller of the Currency is a US federal agency established by the National Currency Act of 1863 and serves to charter, regulate, and supervise all national banks and the federal branches and agencies of foreign banks in the United States...

 (U.S. Department of the Treasury) approved a final rule implementing the advanced approaches of the Basel II Capital Accord. This rule establishes regulatory and supervisory expectations for credit risk, through the Internal Ratings Based Approach (IRB), and operational risk, through the Advanced Measurement Approach (AMA), and articulates enhanced standards for the supervisory review of capital adequacy and public disclosures for the largest U.S. banks.

July 16, 2008 update

On July 16, 2008 the federal banking and thrift agencies (the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision) issued a final guidance outlining the supervisory review process for the banking institutions that are implementing the new advanced capital adequacy framework (known as Basel II). The final guidance, relating to the supervisory review, is aimed at helping banking institutions meet certain qualification requirements in the advanced approaches rule, which took effect on April 1, 2008.

January 16, 2009 update

For public consultation, a series of proposals to enhance the Basel II framework was announced by the Basel Committee. It releases a consultative package that includes: the revisions to the Basel II market risk framework; the guidelines for computing capital for incremental risk in the trading book; and the proposed enhancements to the Basel II framework.

July 8–9, 2009 update

A final package of measures to enhance the three pillars of the Basel II framework and to strengthen the 1996 rules governing trading book capital was issued by the newly expanded Basel Committee. These measures include the enhancements to the Basel II framework, the revisions to the Basel II market-risk framework and the guidelines for computing capital for incremental risk in the trading book.

Basel II and the regulators

One of the most difficult aspects of implementing an international agreement is the need to accommodate differing cultures, varying
structural models, and the complexities of public policy and existing regulation. Banks’ senior management will determine corporate strategy, as well as the country in which to base a particular type of business, based in part on how Basel II is ultimately interpreted by various countries' legislatures and regulators.

To assist banks operating with multiple reporting requirements for different regulators according to geographic location, there are several software applications available. These include capital calculation engines and extend to automated reporting solutions which include the reports required under COREP/FINREP.

For example, U.S. Federal Deposit Insurance Corporation
Federal Deposit Insurance Corporation
The Federal Deposit Insurance Corporation is a United States government corporation created by the Glass–Steagall Act of 1933. It provides deposit insurance, which guarantees the safety of deposits in member banks, currently up to $250,000 per depositor per bank. , the FDIC insures deposits at...

 Chair Sheila Bair explained in June 2007 the purpose of capital adequacy requirements for banks, such as the accord:
There are strong reasons for believing that banks left to their own devices would maintain less capital—not more—than would be prudent. The fact is, banks do benefit from implicit and explicit government safety nets. Investing in a bank is perceived as a safe bet. Without proper capital regulation, banks can operate in the marketplace with little or no capital. And governments and deposit insurers end up holding the bag, bearing much of the risk and cost of failure. History shows this problem is very real … as we saw with the U.S. banking and S & L crisis in the late 1980s and 1990s. The final bill for inadequate capital regulation can be very heavy. In short, regulators can't leave capital decisions totally to the banks. We wouldn't be doing our jobs or serving the public interest if we did.

Implementation progress

Regulators in most jurisdictions around the world plan to implement the new accord, but with widely varying timelines and use of the varying methodologies being restricted. The United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...

' various regulators have agreed on a final approach. They have required the Internal Ratings-Based approach for the largest banks, and the standardized approach will be available for smaller banks.

In India, Reserve Bank of India
Reserve Bank of India
The Reserve Bank of India is the central banking institution of India and controls the monetary policy of the rupee as well as US$300.21 billion of currency reserves. The institution was established on 1 April 1935 during the British Raj in accordance with the provisions of the Reserve Bank of...

 has implemented the Basel II standardized norms on 31 March 2009 and is moving to internal ratings in credit and AMA norms for operational risks in banks.

Existing RBI norms for banks in India (as of September 2010): Common equity (incl of buffer): 3.6%(Buffer Basel 2 requirement requirements are zero.); Tier 1 requirement: 6%. Total Capital : 9 % of risk weighted assets.

Basel III asks for those ratios as 7-8.5%(4.5% +2.5%(conservation buffer) + 0-2.5%(seasonal buffer)) and 8.5-11% for tier 1 cap and 10.5 to 13.5 for total capital (Proposed Basel III Guidelines: A Credit Positive for Indian Banks)

In response to a questionnaire released by the Financial Stability Institute
Financial Stability Institute
The Financial Stability Institute , is one of the bodies hosted by the Bank of International Settlements at its headquarters in Basel...

 (FSI), 95 national regulators indicated they were to implement Basel II, in some form or another, by 2015.

The European Union has already implemented the Accord via the EU Capital Requirements Directive
Capital Requirements Directive
The Capital Requirements Directive for the financial services industry will introduce a supervisory framework in the EU which reflects the Basel II rules on capital measurement and capital standards....

s and many European banks already report their capital adequacy ratios according to the new system. All the credit institutions adopted it by 2008.

Australia, through its Australian Prudential Regulation Authority
Australian Prudential Regulation Authority
The Australian Prudential Regulation Authority is a statutory authority and the prudential regulator of the Australian financial services industry.-Regulatory scope:...

, implemented the Basel II Framework on 1 January 2008.

See also

  • Basel III
    Basel III
    BASEL III is a new global regulatory standard on bank capital adequacy and liquidity agreed upon by the members of the Basel Committee on Banking Supervision. The third of the Basel Accords was developed in a response to the deficiencies in financial regulation revealed by the global financial...

  • Credit risk
    Credit risk
    Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....

  • Operational risk
    Operational risk
    An operational risk is, as the name suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates...

  • Market risk
    Market risk
    Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices...

  • Capital adequacy
  • Solvency II
    Solvency II
    The Solvency II Directive is an EU Directive that codifies and harmonises the EU insurance regulation. Primarily this concerns the amount of capital that EU insurance companies must hold to reduce the risk of insolvency....

  • Procyclical
    Procyclical
    Procyclical is a term used in economics to describe how an economic quantity is related to economic fluctuations. It is the opposite of countercyclical. However, it has more than one meaning.-Meaning in business cycle theory:...

  • Data governance
    Data governance
    Data governance is an emerging discipline with an evolving definition. The discipline embodies a convergence of data quality, data management, data policies, business process management, and risk management surrounding the handling of data in an organization...


External links

Bank for International Settlements (BIS)

Office of the Comptroller of the Currency (United States)

UK government

Hong Kong Monetary Authority (HKMA)
Hong Kong Monetary Authority
The Hong Kong Monetary Authority or HKMA is Hong Kong's central banking institution . It is a government authority founded on 1 April 1993 via the consolidation of "Office of the Exchange Fund" and the "Office of the Commissioner of Banking"...



Others
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