Basel II
January 20, 2025
What is Basel II?
Basel II was developed by the Basel Committee on Banking Supervision (BCBS) in 2004 with full implementation required by 2008. Its aim was to improve the mandate of Basel I and create a more sophisticated and nuanced approach to calculating risk-weighted assets.
These would be used to regulate credit risk using methodologies defined by the regulator, as well as allowing banks to determine their own internal calculations of credit risk-weighted assets.
Key Learning Points
- Basel II introduced a more sophisticated system for calculating risk-weighted assets for credit risk
- Basel II was developed to address the shortcomings of Basel I, which had a simplistic risk-weighting system that penalized high-quality lending and benefited weaker credit quality counterparties
- It allowed banks to use both regulatory-defined methodologies and their own internal calculations
- Three Pillars Framework: Basel II is structured around three pillars:
- Pillar 1 focuses on minimum capital requirements for credit, market, and operational risks
- Pillar 2 requires banks to assess the adequacy of their capital to cover all risks they face
- Pillar 3 mandates increased public disclosure about the risks banks face and how they manage them
History of Basel II
Basel I was established in 1988 by the Basel Committee on Banking Supervision (BCBS), when it recognized the need for a consistent regulatory approach to enable banks to compete internationally on an equal footing. Basel I focused on the credit risk that banks faced from their loan portfolio.
The main criticism of Basel I was its risk weighting was too simplistic. It ended up penalizing banks who engaged in high quality lending to corporates and benefiting banks who lent to much weaker credit quality counterparties, since most loans had the same risk weighting and attracted the same capital charge. Basel II announced to introduce improvements to the methodology and put more emphasis on banks and financial institutions being responsible for their own risk calculations.
Basel II Requirements
Pillar 1
Basel II introduced risk-weighted asset requirements for both market risk and operational risk, in addition to credit risk. These risks together with credit risk are referred to as pillar one – it summarizes risks that all banks face.
Pillar 2
Pillar two of Basel II introduced the need for banks and other financial institutions to carry out ongoing assessments of the adequacy of the capital they were holding. It had to meet all risks faced, whether included in pillar one or not
Pillar 3
Pillar three required banks to increase the amount of public disclosure regarding the risks being faced and as well as details on how these risks were quantified and managed internally. Pillar three effectively delegated some of the regulation responsibility to the stock market and the credit market by the rating agencies to assess the information that is publicly disclosed by banks.
Basel III
The implementation of Basel II was superseded by the 2008 global financial crisis. Basel III then became the updated response by regulators as the crisis highlighted a number of further risk-related issues which would require immediate attention. So, Basel II was swiftly overtaken by new directives aimed at further mitigating risk in the markets.
Basel III includes enhanced capital requirements and more rainy-day capital for when there is a downturn in the economic cycle, as well as a charge for being a too big to fail bank and funding and liquidity regulation, which were critical factors in the failure of firms like Lehman Brothers and Northern Rock.
Download a free Financial Edge cheat sheet showing the key metrics of the three pillars plus details of Basel III objectives.
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Conclusion
Basel II represents a significant advancement in the regulatory framework for banking, addressing the limitations of Basel I by introducing a more nuanced approach to risk management. The three pillars of Basel II—minimum capital requirements, supervisory review, and market discipline—provide a comprehensive structure for banks to manage credit, market, and operational risks more effectively.
This framework not only enhances the stability of the financial system but also promotes transparency and accountability through increased public disclosure. As the financial landscape continues to evolve, the principles established by Basel II remain foundational in guiding banks toward more robust and resilient risk management practices.