Basel II
Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision.
The purpose of Basel II, which was initially published in June 2004, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks that banks face. Advocates of Basel II believe that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank, or a series of banks, collapse.
In practice, Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability
The objective of Basel II is to:
- constitute a more comprehensive and more sensitive approach to addressing risks
- encourage banks to improve risk management
- enhance competitive equality;
- promote safety and soundness in the financial systems;
- provide better alignment of regulatory capital to underlying risk;
The risk categories in Basel II are:
- credit risk - the risk that a borrower or counterparty might not honour its contractual obligations;
- market risk - the risk of adverse price movements such as exchange rates, the value of securities, and interest rates;
- operational risk - the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events
The underlying principles of Basel II (the three 'pillars' that support 'capital adequacy') are:
- minimum capital requirements - rules to calculate required capital;
- supervisory review process - increased supervisory power;
- market discipline requirements - increased disclosure requirements.
These three 'Pillars' together are intended to achieve a level of capital commensurate with a bank's overall risk profile;
By creating Pillars 2 (supervisory review) and 3 (market discipline), the Committee is trying to reduce emphasis on Pillar 1, although the Pillar 1 culture remains strong, Pillar 2 is there, partly to protect in case Pillar 1 throws up suspiciously low numbers - but it should not be considered an automatic add-on