What is Basel II? Who is behind this? Who has developed it? Is it an international law? Do we have to comply? Who has to comply? Can I have a summary of Basel II? These are very important questions and it is good to start with your 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 banks with international activity. Banks must maintain a minimum level of capital, to ensure that they can meet their obligations, can cover unexpected losses, and can promote public confidence (which is of utmost importance to the international banking system).
Banks like to invest their money, not save it for future risk. Regulatory capital (the minimum capital required) is an obligation. A low level of capital is a threat to the banking system itself: banks can fail, depositors can lose their money or they can stop trusting banks. This framework establishes a minimum international 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 of the Bank for International Settlements (BIS), the world’s oldest international financial organization (established on May 17, 1930).
The Basel Committee on Banking Supervision was established by the G10 (Group of Ten countries) in 1974. These 10 countries (now 11) are the rich and developed countries: Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and USA. .
The G10 was behind the development of the previous framework (Basel i), and has now endorsed the new set of Basel II documents (the main document and the many explanatory documents). Only banks in G10 countries have to implement the framework, but more than 100 countries have volunteered adopt these principles, or take them into account, and use them as the basis for your national standard-setting process.
Basel i was not risk sensitive. All loans made to corporate borrowers were subject to the same capital requirement, regardless of the repayment capacity of the counterparties. We ignore the credit rating, credit history, risk management and 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 with risks of loss. Better risk management in a bank means that the bank can allocate less regulatory capital.
In Basel II we have three Pillars:
Pillar 1 it has to do with calculating the minimum capital requirements. There are different approaches:
The standardized approach to credit risk: Banks rely on external measures of credit risk (such as credit rating agencies) to assess the credit quality of their borrowers.
Internal Ratings-Based (IRB) gets too close to credit risk: banks rely partially or totally 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 Operational Risk (risk of loss due to errors, fraud, disruption of IT systems, external events, litigation, etc.). This can be a difficult exercise.
The core indicator approach links the capital requirement to the bank’s gross income. In the Standard Approach, we divide the bank into 7 lines of business and we have 7 different capital allocations, one per line of business. Advanced measurement approaches are based on internal models and years of loss experience.
Pillar 2 covers the supervisory review process. Describes the principles for effective supervision.
Supervisors are required to assess banks’ activities, corporate governance, risk management, and risk profiles to determine whether they should shift or 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 interested parties. Clients and shareholders must have sufficient knowledge of the activities of banks and the way in which they manage their risks.