Basel II

Basel II is an international banking regulatory framework developed by the Basel Committee on Banking Supervision (BCBS) to enhance the regulation, supervision, and risk management of the banking sector. It builds on the original Basel I framework and introduces more sophisticated risk management requirements.
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Updated: May 31, 2024

3 key takeaways

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  • Basel II introduced a three-pillar approach to banking regulation: minimum capital requirements, supervisory review, and market discipline.
  • It aims to align capital requirements more closely with the actual risks faced by banks.
  • The framework encourages better risk management practices and greater transparency in the banking sector.

What is Basel II?

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Basel II is a set of international banking regulations that provide guidelines for risk management and capital adequacy. It was developed by the Basel Committee on Banking Supervision and implemented in 2004. The goal of Basel II is to create a more comprehensive and risk-sensitive framework for banking supervision, improving upon the simpler and less risk-sensitive Basel I framework.

The Basel II framework is based on three pillars:

Pillar 1: Minimum Capital Requirements

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  • Objective: Ensure banks hold sufficient capital to cover credit risk, market risk, and operational risk.
  • Credit Risk: Banks must hold capital based on the riskiness of their loans and other credit exposures. They can use the standardized approach, the foundation internal ratings-based (IRB) approach, or the advanced IRB approach.
  • Market Risk: Banks must hold capital for potential losses from changes in market prices, including interest rates, foreign exchange rates, and equity prices. This is often measured using value-at-risk (VaR) models.
  • Operational Risk: Banks must hold capital to cover losses resulting from inadequate or failed internal processes, people, systems, or external events. They can use the basic indicator approach, the standardized approach, or the advanced measurement approach.

Pillar 2: Supervisory Review Process

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  • Objective: Provide a framework for regulators to evaluate the risk management practices and capital adequacy of banks.
  • Supervisory Review: Regulators assess the internal risk management processes of banks and ensure that they have adequate capital to cover all risks, including those not fully captured under Pillar 1.
  • Internal Capital Adequacy Assessment Process (ICAAP): Banks must develop and use ICAAP to evaluate their overall capital adequacy in relation to their risk profile and ensure they have strategies in place to maintain sufficient capital levels.

Pillar 3: Market Discipline

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  • Objective: Enhance transparency and market discipline through disclosure requirements.
  • Disclosure Requirements: Banks must publicly disclose key information about their risk exposures, risk assessment processes, and capital adequacy. This transparency allows market participants to better assess the bank’s risk profile and management practices, promoting discipline and accountability.

Importance of Basel II

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  • Risk Sensitivity: Aligns capital requirements more closely with the actual risks faced by banks, leading to a more risk-sensitive regulatory framework.
  • Enhanced Risk Management: Encourages banks to adopt more advanced risk management practices and improve their internal processes.
  • Transparency: Increases transparency and market discipline, allowing investors and stakeholders to make more informed decisions about banks’ risk profiles and financial health.

Real-world application

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Example: A commercial bank needs to comply with Basel II regulations by holding adequate capital for its credit, market, and operational risks.

Credit Risk: The bank adopts the foundation IRB approach to assess the riskiness of its loan portfolio. It uses internal ratings to estimate the probability of default and loss given default for each borrower, calculating the required capital based on these estimates.

Market Risk: The bank uses a VaR model to measure potential losses from changes in interest rates and foreign exchange rates. It holds capital based on the estimated VaR to cover these market risks.

Operational Risk: The bank implements the standardized approach to assess its operational risks. It calculates the required capital based on the gross income from its various business lines and holds sufficient capital to cover potential operational losses.

Supervisory Review: The bank’s regulators review its ICAAP, ensuring that the bank has adequate capital to cover all risks and that its risk management processes are robust and effective.

Market Discipline: The bank publicly discloses information about its risk exposures, capital adequacy, and risk management practices in its annual report, promoting transparency and accountability.



Sources & references
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Arti
AI Financial Assistant
Arti is a specialized AI Financial Assistant at Invezz, created to support the editorial team. He leverages both AI and the Invezz.com knowledge base, understands over 100,000... read more.