An extension of the regulations for minimum capital requirements as defined under Basel I
Over 2 million + professionals use CFI to learn accounting, financial analysis, modeling and more. Unlock the essentials of corporate finance with our free resources and get an exclusive sneak peek at the first module of each course. Start Free
What is Basel II?
Basel II is the second set of international banking regulations defined by the Basel Committee on Bank Supervision (BCBS). It is an extension of the regulations for minimum capital requirements as defined under Basel I. The Basel II framework operates under three pillars:
- Capital adequacy requirements
- Supervisory review
- Market discipline
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 its RWA.
Basel II also provides banks with more informed approaches to calculate 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:
1. 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.
2. 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 their 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.
Related Readings
Thank you for reading CFI’s guide to Basel II. To keep advancing your career, the additional CFI resources below will be useful:
FAQs
Basel II is an international business standard that requires financial institutions to maintain enough cash reserves to cover risks incurred by their operations. The Basel accords are a series of recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision.
What is the difference between Basel II and Basel III? ›
The Basel III accord raised the minimum capital requirements for banks from 2% in Basel II to 4.5% of common equity, as a percentage of the bank's risk-weighted assets. There is also an additional 2.5% buffer capital requirement that brings the total minimum requirement to 7%.
What are the three pillars of Basel II? ›
It is based on three main "pillars": minimum capital requirements, regulatory supervision, and market discipline.
What is the difference between Basel 1 and Basel 2? ›
The main difference between Basel I, II, and III was the different objectives they were established to achieve. Basel I was formed to explain a minimum capital requirement for the banks. Basel II introduced supervisory responsibilities and further improved the minimum capital requirements.
Why did Basel 2 fail? ›
Basel II's failure, I argue, lies in regulatory capture, 'de facto control of the state and its regulatory agencies by the 'regulated' interests, enabling these interests to transfer wealth to themselves at the expense of society'.
What are the disadvantages of Basel II? ›
The disadvantages of Basel II Accord revealed by the international crises can be: the internal rating method of risks evaluation is so complex, that is very difficult to be applied by countries in East and Central Europe, the responsibilities for bank supervisors are very high and the capital markets are full of ...
What are the Basel Accords for dummies? ›
The Basel Accords were formed with the goal of creating an international regulatory framework for managing credit risk and market risk. Their key function is to ensure that banks hold enough cash reserves to meet their financial obligations and survive in financial and economic distress.
What Basel III means for banks? ›
Basel III is an internationally agreed set of measures developed by the Basel Committee on Banking Supervision in response to the financial crisis of 2007-09. The measures aim to strengthen the regulation, supervision and risk management of banks.
What are examples of risk-weighted assets? ›
Examples include debentures, treasury bills, and government bonds. Investors use this ratio to assess a bank's financial stability. The RBI sets specific capital requirements for different types of assets.
Why is it called Basel? ›
Name. The name of Basel is first recorded as Basilia in the 3rd century (237/8), at the time referring to the Roman castle. This name is mostly interpreted as deriving from the personal name Basilius, from a toponym villa Basilia ("estate of Basilius") or similar.
Meaning of Basel in English
a city in northwestern Switzerland, the third largest in the country after Zürich and Geneva: The Congress was held in Basel, Switzerland.
Why did Basel 1 fail? ›
Criticism of Basel I
Another critique of Basel I was its simplistic approach to risk weighting. Basel I assigned fixed risk weights to different types of assets, but these weights could seen as arbitrary and not reflective of the actual risk. For example, corporate loans would be given a risk weight.
What is Basel in simple terms? ›
Basel I is a set of international banking regulations established by the Basel Committee on Banking Supervision (BCBS). It prescribes minimum capital requirements for financial institutions, with the goal of minimizing credit risk.
What are the highlights of Basel II? ›
Basel II guidelines were originally published in 2004 with the objective of creating standards and regulations around how much capital banks must hold. The regulation is divided into three pillars concerned with minimum capital requirements, supervisory review and market discipline.
What is the equivalent of Basel 2 in insurance? ›
For insurance companies, the regulatory framework Solvency II is being final- ized and is scheduled for implementation after 2013. At the same time, the regula- tory regime for banking, Basel II, has been revised in response to the financial cri- sis; the new version is Basel III.
What are the three countries in Basel? ›
At the meeting point between France, Germany and Switzerland lies the Three Country Region. A surprising mixture of gentle living and urban excitement!
