Basel II

Introduction

Basel II is the second set of international banking regulations set up by the Basel Committee on Banking Supervision and is a part of Basel accords, including Basel I and Basel III. The accord’s goal was to standardise banking practices all over the world. The Basel II record was initially published in June 2004. Basel II regulation aimed to amend international banking standards that controlled how much capital banks were required to hold to guard against the strategic and operational risks they faced. These regulations’ goal was to ensure that the more significant the risk a bank is exposed to, the greater the amount of capital the bank needed to hold for the overall economy.

Basel II Norms and Objectives

Basel II’s objective was to ensure that capital risk is more sensitive. It also had an objective of separating operational risk and calculating both based on data and formal technique. It also aimed to reduce the scope for regulatory arbitrage. Basel II uses a three-pillar concept to implement the regulations. The three pillars are, Minimum Capital Requirements, Supervisory review and Market Discipline.

The first pillar, also known as Minimum Capital Requirement, deals with capital maintenance for three major risks that a bank faces: credit, market, and operational risks. Other risks were not quantified at this stage. The minimum capital adequacy ratio of 8% was prescribed, taking into account the credit risk. However, in India, the reserve bank of India has prescribed the minimum capital adequacy rate of 8% for risk-weighted assets.

The Pillar II, also known as supervisory review, sets out a new supervisory process. It also provides a framework to deal with systematic risk, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk, and legal risks, which the accord combines under the title of residue risk. Banks have their internal risk management model. Banks were expected to work above the minimum capital requirements. The supervisor intervention will take place if the capital is not sufficient.

Pillar III, also known as Market Discipline, ensures that discipline is revoked by making it mandatory to disclose some of the market information. Its role was to ensure capital adequacy in the market and close coordination with the International Accounting Standard Board.

The key difference between Basel II and III

 The key difference between Basel II and Basel III are that in comparison to Basel II, the Basel III framework provides a more enhanced framework. Basel II was introduced in 2004, which laid down the guidelines for capital adequacy, risk management and disclosure policies. Many believed the shortcomings of the Basel II norms led to a financial crisis in 2008. Basel II did not have any explicit regulations on the debt banks can take on their books and focused more on individual financial institutions, ignoring the systematic risk. To ensure that banks do not take excessive debts and do not rely much on short term funds, Basel III norms were proposed in 2010.

Basel III guidelines aimed to promote a more resilient banking system by focusing on the four important banking parameters, which were capital, leverage, funding and liquidity. Basel III was proposed to strengthen bank capital requirements by increasing minimum capital requirements, holding high-quality liquid assets and decreasing bank leverage.

Basel II Operation Risks

Basel II and III defined operational risk as the risk of loss from internal and inadequate issues, failure from people or systems, human errors or external events. Under operation risk, Basel II broadly gave three methods to calculate the capital required for operational risks, Basic Indicator Approach, which was based on the annual revenue of the financial departments, Standardised Approach which was based on the annual revenue of each of the broad business lines of the financial departments, and advanced measurement approach which was based on the internally developed risk management framework for the banks to adhere to a standard process.

Conclusion

Basel II was the second set of regulations made after looking at the criticisms of Basel I. This set of regulations focused not only on credit risk but also market risk and operational risk. Basel II regulations seek to improve the existing Basel accord. Basel II norms were defined using the three-pillar concept, including Capital Adequacy Requirement, Supervisory Review, and Market Discipline. Basel II’s objective was to modernise the existing capital requirement framework concept to make it more sensitive and risk-free.