Basel II Summary – What is Important to Know About the Basel II Framework By George J Lekatis
What is Basel II? Who is behind it? Who has developed it? Is it an international law? Do we have to comply? Who has to comply? May I have a Basel II Summary? These are very important questions, and it is good to start from their answers.
The Basel II Framework (the official name is “International Convergence of Capital Measurement and Capital Standards: a Revised Framework”) is a new set of international standards and best practices that define the minimum capital requirements for internationally active banks. Banks have to maintain a minimum level of capital, to ensure that they can meet their obligations, they can cover unexpected losses, and can promote public confidence (which is of paramount importance for the international banking system).
Banks like to invest their money, not keep them for future risks. Regulatory capital (the minimum capital required) is an obligation. A low level of capital is a threat for the banking system itself: Banks may fail, depositors may lose their money, or they may not trust banks any more. This framework establishes an international minimum standard.
Basel II will be applied on a consolidated basis (combining the bank’s activities in the home country and in the host countries).
The framework has been developed by the Basel Committee on Banking Supervision (BCBS), which is a committee in the Bank for International Settlements (BIS), the world’s oldest international financial organization (established on 17 May 1930).
The Basel Committee on Banking Supervision was established by the G10 (Group of Ten countries) in 1974. These 10 countries (have become 11) are the rich and developed countries: Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States.
The G10 were behind the development of the previous (Basel i) framework, and now they have endorsed the new Basel II set of papers (the main paper and the many explanatory papers). Only banks in the G10 countries have to implement the framework, but more than 100 countries have volunteered to adopt these principles, or to take these principles into account, and use them as the basis for their national rulemaking process.
Basel i was not risk sensitive. All loans given to corporate borrowers were subject to the same capital requirement, without taking into account the ability of the counterparties to repay. We ignored the credit rating, the credit history, the risk management and the corporate governance structure of all corporate borrowers. They were all the same: Private corporations.
Basel II is much more risk sensitive, as it is aligning capital requirements to the risks of loss. Better risk management in a bank means that the bank may be able to allocate less regulatory capital.
In Basel II we have three Pillars:
Pillar 1 has to do with the calculation of the minimum capital requirements. There are different approaches:
The standardized approach to credit risk: Banks rely on external measures of credit risk (like the credit rating agencies) to assess the credit quality of their borrowers.
The Internal Ratings-Based (IRB) approaches too credit risk: Banks rely partly or fully on their own measures of a counterparty’s credit risk, and determine their capital requirements using internal models.
Banks have to allocate capital to cover the Operational Risk (risk of loss because of errors, fraud, disruption of IT systems, external events, litigation etc.). This can be a difficult exercise.
The Basic Indicator Approach links the capital charge to the gross income of the bank. In the Standardized Approach, we split the bank into 7 business lines, and we have 7 different capital allocations, one per business line. The Advanced Measurement Approaches are based on internal models and years of loss experience.
Pillar 2 covers the Supervisory Review Process. It describes the principles for effective supervision.
Supervisors have the obligation to evaluate the activities, corporate governance, risk management and risk profiles of banks to determine whether they have to change or to allocate more capital for their risks (called Pillar 2 capital).
Pillar 3 covers transparency and the obligation of banks to disclose meaningful information to all stakeholders. Clients and shareholders should have a sufficient understanding of the activities of banks, and the way they manage their risks.
Here is a simple video to follow: By bionicturtledotcom
Quick overview of Basel II framework that sets capital requirements for banks. Three pillars contains the rules & support (supervisor review, market discipline) that say how much eligible regulatory capital must be held against risk-weighted assets.