Written by Basel II is an international regulatory framework for banking institutions developed by the Basel Committee on Banking Supervision.
The framework was released in 2004. It introduced a set of more comprehensive and risk-sensitive capital requirements for banks.
It is a more comprehensive measure and standard for capital adequacy that seeks to improve on the existing Basel I rules by aligning regulatory capital requirements more closely to the underlying risks that banks face.
It seeks to ensure that risks inherent in banks’ portfolios are better reflected in the minimum capital requirements, risk management practices and accompanying disclosures to the public.
Pillars of Basel II
The Basel II framework is comprised of three pillars:
- Pillar 1: Minimum Capital Requirements – This pillar specifies the minimum amount of capital that banks must hold, based on the risks they face. It specifies minimum capital requirements that banks must meet to ensure that they have enough capital to cover their risk exposure.
- Pillar 2: Supervisory Review Process – This pillar requires banks to have a supervisory review process in place to assess their overall risk profile and determine whether they have adequate capital to cover their risks. This process involves continuous monitoring and evaluation by banking supervisors, who may require the bank to increase its capital reserves or take other measures to reduce its risk.
- Pillar 3: Market Discipline – This pillar seeks to promote greater transparency and accountability in the banking sector. Banks are required to disclose information about their risk management practices and the adequacy of their capital reserves. This may involve publishing information about their risk management policies and procedures, as well as their capital adequacy and risk profile.
According to Basel 2, banks are required to hold a minimum of 8% of their risk-weighted assets as capital.
Basel II divides the eligible regulatory capital of a bank into three tiers.
The higher the tier, the less subordinated securities a bank is allowed to include in it.
Tier 3 consists of lower-quality unsecured, subordinated debt, such as short-term subordinated loans.
Tier 1 capital represents the bank’s core capital. It include shareholders’ equity, disclosed reserves, retained earnings and certain innovative capital instruments.
Tier 2 represent the supplementary capital of the bank. It consists of hybrid instruments, revaluation reserves, and medium and long-term subordinated loans.
Advantages of Basel II
1. Increased transparency: The Basel 2 framework requires banks to disclose more information about their risk management practices, which increases transparency and helps investors make more informed decisions.
2. Reduced discrepancy between economic and regulatory capital: Basel II reduce the discrepancy between regulatory capital and economic capital.
The regulatory capital requirement for banks under Basel I was based on a one-size-fits-all approach, where all banks had to hold a fixed percentage of capital against their assets.
Basel II provides a framework that allows banks to use their own internal risk models to determine the amount of regulatory capital they need to hold based on their risk profile.
By using banks’ own risk models, the regulatory requirements will better reflect the actual risks faced by each bank.
3. Recognition of credit risk mitigation:
Basel II provides wider recognition of credit risk mitigation techniques.
Under Basel I, banks were not given credit for the risk-mitigating effects of collateral, guarantees, or other risk mitigation devices
However, Basel II recognizes the significance of risk mitigants and how they can significantly reduce the risk of loss.
By recognizing the importance of risk mitigants, the framework allows banks to take them into account when calculating their regulatory capital requirements.
This approach encourages banks to adopt risk-mitigating strategies, which ultimately helps to make the financial system more stable and less prone to systemic risk.
4. Better risk management: Under Basel II, banks must assess the risk of their assets using internal models that take into account a wide range of factors, such as the likelihood of default, loss given default, and exposure at default.
This more sophisticated approach enables banks to allocate capital more efficiently, which reduces their overall risk and makes them more resilient to financial shocks.
Disadvantages of Basel II
1. Too much regulatory compliance: Basel 2 requires banks to comply with a lot of regulatory requirements, such as risk measurement and management, capital adequacy, and disclosure.
This means that banks have to spend a lot of time, effort, and money to comply with these regulations, which can be a burden for small and medium-sized banks who may not have the required resources to do so
2. Complexity: The Basel 2 framework is more complex and demanding than the previous version, which makes it harder for supervisors and unsophisticated banks to understand and comply with.
The framework is made up of three pillars, which are the minimum capital requirements, the supervisory review process, and the market discipline.
Each pillar is complex and requires a lot of expertise to implement. This means that smaller banks may struggle to comply with the Accord.
Moreover, the complexity of Basel 2 framework may make it difficult for regulators to assess whether banks are accurately assessing and managing their risks.
3. Over-focus on credit risk: Basel 2 places a lot of emphasis on credit risk, which is the risk of default by borrowers.
While credit risk is an important risk, it is not the only risk that banks face.
Other risks, such as market risk, liquidity risk, and operational risk, are also important, but they are not given as much attention in Basel II.
Therefore, Basel II do not adequately cover certain types of risks, such as liquidity risk, operational risk, and systemic risk, which an average banks faces.
Summary
To conclude, Basel II is a regulatory framework that introduced a comprehensive and risk-sensitive capital requirement for banks.
It seeks to align regulatory capital requirements with the underlying risks that banks face.
Basel II is aimed at ensuring that risks inherent in banks’ portfolios are better reflected in the minimum capital requirements, risk management practices, and accompanying disclosures to the public.
The Basel II framework comprises three pillars, namely; minimum capital requirements, supervisory review process, and market discipline.
The advantages of Basel II include increased transparency, reduced discrepancy between economic and regulatory capital, recognition of credit risk mitigation, and better risk management.
On the flip side, Basel II put too much focus on credit risk and is very complex compared to Basel I.
