Basel II: Understanding International Banking Regulations

Basel II is the second set of international banking regulations defined by the Basel Committee on Bank Supervision (BCBS). It is an extension of the regulations for minimum capital requirements as defined under Basel I. The Basel II framework operates under three pillars:

• Capital adequacy requirements
• Supervisory review
• Market discipline

The Three Pillars under Basel II

Pillar 1: Capital Adequacy Requirements

Pillar 1 improves on the policies of Basel I by taking into consideration operational risks in addition to credit risksCredit RiskCredit risk is the risk of loss that may occur from the failure of any party to abide by the terms and conditions of any financial contract, principally, associated with risk-weighted assets (RWA). It requires banks to maintain a minimum capital adequacy requirement of 8% of its RWA. Basel II also provides banks with more informed approaches to calculate capital requirements based on credit risk, while taking into account each type of asset’s risk profile and specific characteristics. The two main approaches include the:

1. Standardized approach

The standardized approach is suitable for banks with a smaller volume of operations and a simpler control structure. It involves the use of credit ratings from external credit assessment institutionsRating AgencyA rating agency assesses the financial strength of companies and government entities, especially their ability to meet principal and interest payments for the evaluation of the creditworthiness of a bank’s debtor.

2. Internal ratings-based approach

The internal ratings-based approach is suitable for banks engaged in more complex operations, with more developed risk management systems. There are two IRB approaches for calculating capital requirements for credit risk based on internal ratings:

• Foundation Internal Ratings-based approach (FIRB): In FIRB, banks use their own assessments of parameters such as the Probability of DefaultProbability of DefaultProbability of Default (PD) is the probability of a borrower defaulting on loan repayments and is used to calculate the expected loss from an investment., while the assessment methods of other parameters, mainly risk components such as Loss Given Default and Exposure at Default, are determined by the supervisor.
• Advanced Internal Ratings-based approach (AIRB): Under the AIRB approach, banks use their own assessments for all risk components and other parameters.

Pillar 2: Supervisory Review

Pillar 2 was added owing to the necessity of efficient supervision and lack thereof in Basel I, pertaining to the assessment of a bank’s internal capital adequacy. Under Pillar 2, banks are obligated to assess the internal capital adequacy for covering all risks they can potentially face in the course of their operations. The supervisor is responsible for ascertaining whether the bank uses appropriate assessment approaches and covers all risks associated.

• Internal Capital Adequacy Assessment Process (ICAAP): A bank must conduct periodic internal capital adequacy assessments in accordance with their risk profile and determine a strategy for maintaining the necessary capital level.
• Supervisory Review and Evaluation Process (SREP): Supervisors are obligated to review and evaluate the internal capital adequacy assessments and strategies of banks, as well as their ability to monitor their compliance with the regulatory capital ratios.
• Capital above the minimum level: One of the added features of the framework Basel II is the requirement of supervisors to ensure banks maintain their capital structureCapital StructureCapital structure refers to the amount of debt and/or equity employed by a firm to fund its operations and finance its assets. A firm's capital structure above the minimum level defined by Pillar 1.
• Supervisor’s interventions: Supervisors must seek to intervene in the daily decision-making process in order to prevent capital from falling below the minimum level.

Pillar 3: Market Discipline

Pillar 3 aims to ensure market discipline by making it mandatory to disclose relevant market information. This is done to make sure that the users of financial information receive the relevant information to make informed trading decisions and ensure market discipline.

Related Readings

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• WACC GuideWACCWACC is a firm’s Weighted Average Cost of Capital and represents its blended cost of capital including equity and debt.