This checklist describes Basel II, and outlines its aims and purpose.
The Basel Accords are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. Basel II, drafted initially in June 2004 and intended to replace Basel I in due course, aims to create an international standard for regulators to use when creating regulations on how much capital banks must set aside to guard against the types of financial and operational risks they face. The theory is that the Basel II international standard would help protect global financial systems from the types of problems that might arise should a major bank, or a series of banks, collapse. This would be achieved by designing and implementing rigorous risk and capital management requirements to ensure a bank holds sufficient capital reserves appropriate to the risk it is exposed to through its lending and investment practices. This implies that the greater the risk to which the bank is exposed, the greater the amount of capital the bank must reserve to safeguard its solvency and overall economic stability.
Basel II aims to ensure that capital allocation is more risk sensitive, to separate operational risk from credit risk and quantify both, and to attempt to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage. There are three pillars to Basel II.
Pillar I covers the maintenance of regulatory capital (minimum capital requirements) calculated for the three major components of risk that a bank faces: Credit risk, operational risk, and market risk. The credit risk component can be calculated using one of three methods that vary in their degree of sophistication: The standardized approach, the foundation IRB (internal ratings-based) approach, and the advanced IRB approach. Similarly, there are three different approaches for operational risk: The basic indicator approach (BIA), the standardized approach (TSA), and the advanced measurement approach (AMA). For market risk, the preferred approach is value-at-risk (VaR).
Pillar II not only deals with the regulatory response to the first pillar and gives regulators better tools for implementing regulations, it also provides a framework for dealing with the residual risks a financial institution may face, such as systemic, concentration, strategic, reputational, liquidity, and legal risks. This pillar gives a financial institution the power to review its risk management system.
The third pillar concerns market discipline and the promotion of stability in the financial system. The number of disclosures that a financial institution must make is greatly increased, in order to give the market a better picture of the overall risk position of the financial institution, and enables its counterparties to price and deal appropriately.
Since 2004, Basel II has gone through a number of revisions. In July 2008, the US federal banking and thrift agencies (comprising the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision) issued final guidance outlining the supervisory review process for financial institutions implementing Basel II. This guidance aims to help financial institutions meet certain qualification requirements in the advanced approach rules, which took effect on April 1, 2008.
The implementation of an international agreement such as Basel II can be very complex, requiring the need to accommodate differing cultures, varying structural models, and the complexities of public policy and existing regulation. Basel II is open to interpretation by various countries’ legislatures and regulators during implementation. As banks now must deal with multiple reporting requirements for different regulators, including Basel II, according to their geographic location, a number of software applications have been developed to assist, including capital calculation engines and automated reporting solutions.
Regulators around the world are working on implementing Basel II. US regulators have agreed on a joint final approach that enforces the IRB approach for the largest banks, while agreeing that the standardized approach will not be available to anyone. The European Union (EU) has already implemented the accord via the EU Capital Requirements Directives. Many European financial institutions are already reporting their capital adequacy ratios under Basel II requirements. All European credit institutions within the EU were due to have adopted it by 2008. In response to a questionnaire drafted by the Financial Stability Institute (FSI) in 2006, 95 national regulators indicated they would implement Basel II, in one form or another, by 2015.