Basel II is an international business standard that requires financial institutions to maintain enough cash reserves to cover risks incurred by operations. The Basel accords are a series of recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The name for the accords is derived from Basel, Switzerland, where the committee that maintains the accords meets.

Basel II improved on Basel I, first enacted in the 1980s, by offering more complex models for calculating regulatory capital. Essentially, the accord mandates that banks holding riskier assets should be required to have more capital on hand than those maintaining safer portfolios. Basel II also requires companies to publish both the details of risky investments and risk management practices. The full title of the accord is Basel II: The International Convergence of Capital Measurement and Capital Standards – A Revised Framework.

The three essential requirements of Basel II are:

• Mandating that capital allocations by institutional managers are more risk-sensitive.
• Separating credit risks from operational risks and quantifying both.
• Reducing the scope or possibility of regulatory arbitrage by attempting to align the real or economic risk precisely with regulatory assessment.

Basel II has resulted in the evolution of a number of strategies to allow banks to make risky investments, such as the subprime mortgage market. Higher risks assets are moved to unregulated parts of holding companies. Alternatively, the risk can be transferred directly to investors by securitization, the process of taking a non-liquid asset or groups of assets and transforming them into a security that can be traded on open markets.

Pillars of BASEL II

• Pillar 1 (Minimum Capital Requirement): Minimum capital is the technical, quantitative heart of the accord. Banks must hold capital against 8% of their assets, after adjusting their assets for risk.
• Pillar 2 (Supervisory ReviewProcess): Supervisor review is the process whereby national regulators ensure their home country banks are following the rules. If minimum capital is the rulebook, the second pillar is the referee system.
• Pillar 3 (Market Discipline): market discipline is based on enhanced disclosure of risk. This may be an important pillar due to the complexity of Basel. Under Basel II, banks may use their internal models (and gain lower capital requirements) but the price of this is transparency.

Key Highlights of BASEL II

• Classification of bank risk as credit risk, operational risk, and market risk
• Suggested methods for measuring credit risk are standardized approach, foundation IRB (Internal Rating Based) approach, and advanced IRB approach
• Operational risk is to be measured using a standardized approach, basic indicator approach, and advanced measurement approach
• Standardized approach and internal VAR (Value At Risk) are the two methods suggested for measuring market risk
• Capital Adequacy Ratio (CAR) =
• Tier 1 Capital is the core capital of banks including equity capital and retained earnings
• Tier 2 Capital is the supplementary capital of banks including some undisclosed reserves by banks, loan loss reserves, and subordinated term debts (maturity period of more than 5 years)
• Tier 3 Capital is the tertiary capital allocated for covering market risk including short term subordinated debts (maturity less than 2 years) undisclosed reserves by banks
• For a minimum CAR of 8%, tier 1 capital has to contribute 4.5% to 6%, tier 2 capital has to be 50% to 100% of maintained tier 1 capital and tier 3 capital has to be maintained at 100% to 200% of maintained tier 1 capital
• Risk-weighted assets consist of not just credit risk related assets but also operation and market risk related assets

Limitations of BASRL II

• A complex phenomenon to understand and implement. Thus, it requires skilled supervisors to ensure the success of BASEL II implementation
• Too much regulatory compliance different types of capital, items to be included under such capitals, a minimum requirement of different tiers of capitals, items to be included and excluded in risk-weighted assets etc. making it a complicated calculative model
• BASEL II is still over-focused on credit risk as in BASEL I though it adds operation and market risk into its framework
• It demands the disclosure of all qualitative and quantitative aspects of the bank which the bank is not willing to disclose in other circumstances
• Excessive dependency on data available which might not be accurate and reliable all the time