Basel II is an international regulatory framework for banking supervision developed by the Basel Committee on Banking Supervision. It was introduced in 2004 as an update to the original Basel Accord, commonly known as Basel I, which was implemented in 1988.
The primary objective of Basel II is to establish minimum capital requirements that are more risk-sensitive and reflective of the actual risks faced by banks. It provides a comprehensive framework for assessing and managing various risks faced by banks, including credit risk, market risk, and operational risk.
Minimum capital requirements: Similar to Basel I, Basel II requires banks to maintain a minimum level of capital based on a percentage of their risk-weighted assets. However, Basel II introduces a more sophisticated approach to determine the risk weights, taking into account the creditworthiness of borrowers and the risk mitigation techniques employed by banks.
Three-pillar structure: Basel II introduces a three-pillar structure that comprises minimum capital requirements, supervisory review, and market discipline. The first pillar focuses on minimum capital standards, the second pillar emphasises the importance of effective supervision by regulatory authorities, and the third pillar promotes market discipline through enhanced disclosure requirements.
Internal ratings-based (IRB) approach: Basel II allows banks to use their internal models to calculate risk weights for credit risk, known as the IRB approach. This approach enables banks to tailor the risk weights to their specific portfolios based on their own assessment of credit risk. However, it requires banks to meet certain criteria and obtain regulatory approval to use the IRB approach.
Operational risk management: Basel II recognises operational risk as a distinct risk category and provides guidelines for banks to measure and manage it. Operational risk includes risks arising from internal processes, systems, human error, and external events. Banks are required to develop robust risk management frameworks and allocate sufficient capital to cover potential operational losses.
Supervisory review process: The second pillar of Basel II emphasises the role of supervisory authorities in evaluating banks' risk management practices, internal controls, and capital adequacy. It requires regulators to conduct regular assessments of banks' risk profiles and to intervene if necessary to address any deficiencies or risks.
Market discipline and disclosure: The third pillar aims to enhance market discipline by requiring banks to disclose key information about their risk profiles, capital adequacy, and risk management practices. This promotes transparency and enables market participants to make informed decisions about the banks they engage with.
Basel II represents a significant shift from the simpler capital adequacy framework of Basel I by incorporating a more nuanced and risk-sensitive approach. It provides a more comprehensive framework for managing risks and promotes better alignment between capital requirements and actual risk exposures for banks.
