Basel II: International Banking Standards and Reforms

Basel II introduced a new framework for credit risk assessment, which shifted the focus from a one-size-fits-all approach to a more tailored approach based on a bank's specific risk profile.

The Basel Committee on Banking Supervision (BCBS) developed this framework, which was first introduced in 1999 and finalized in 2004.

This new framework required banks to hold more capital against higher-risk assets, such as commercial mortgages and consumer loans.

Consider reading: Standardized Approach (operational Risk)

Basel II is a set of international banking regulations first released in 2004 by the Basel Committee on Banking Supervision. It expanded the rules for minimum capital requirements established under Basel I.

The Basel accords are a series of recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. They were named after Basel, Switzerland, where the committee that maintains the accords meets.

Basel II improved on Basel I, which was released in 1988, by offering more complex models for calculating regulatory capital.

Banks holding riskier assets should have higher capital requirements than those maintaining safer portfolios, according to Basel II.

Intriguing read: Basel Accords

Basel II has three main tenets: minimum capital requirements, regulatory supervision, and market discipline.

These tenets are built on the foundation of Basel I, which provided guidelines for the calculation of minimum regulatory capital ratios. Basel II confirmed the requirement that banks maintain a capital reserve equal to at least 8% of their risk-weighted assets.

Regulatory supervision is the second pillar of Basel II, providing a framework for national regulatory bodies to deal with systemic risk, liquidity risk, and legal risks, among others.

One of the key weaknesses of Basel II became apparent during the subprime mortgage meltdown and Great Recession of 2008. It underestimated the risks involved in current banking practices and showed that the financial system was overleveraged and undercapitalized.

Suggestion: Basel Committee on Banking Supervision

The updates and revisions to the Basel II accord were a gradual process that spanned several years. The first major revision was announced in September 2005, when the four US Federal banking agencies delayed the implementation of the accord by 12 months.

Curious to learn more? Check out: Basel Iii Accord

In November 2005, the committee released a revised version of the Accord, incorporating changes to the calculations for market risk and the treatment of double default effects. These changes were flagged well in advance, as part of a paper released in July 2005.

A comprehensive version of the Accord was released in July 2006, incorporating the June 2004 Basel II Framework, the elements of the 1988 Accord that were not revised during the Basel II process, the 1996 Amendment to the Capital Accord to Incorporate Market Risks, and the November 2005 paper on Basel II.

In September 2005, the US Federal banking agencies announced a revised plan for implementing the Basel II accord.

The four US Federal banking agencies involved in the announcement were the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision.

Implementation of the accord for US banks was delayed by 12 months, from an unspecified original date to a new date that is not specified in the article.

This delay was a significant change from the original plan, and it had important implications for banks and financial institutions in the US.

Worth a look: Basel 4 Impact on Banks

In July 2008, the federal banking and thrift agencies issued a final guidance on the supervisory review process for banking institutions implementing the new advanced capital adequacy framework, known as Basel II.

This guidance aimed to help institutions meet qualification requirements in the advanced approaches rule, which took effect on April 1, 2008.

The federal banking and thrift agencies involved were 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.

They issued this guidance to ensure that banking institutions were meeting the necessary standards for the supervisory review process.

The final guidance was a crucial step in the implementation of Basel II, as it provided clarity on the supervisory review process and helped institutions prepare for the new framework.

Consider reading: Advanced Measurement Approach

The Basel I and Basel II reforms were implemented to regulate the banking industry, but they ultimately failed to prevent the financial crisis of 2007 to 2009.

One of the main criticisms of Basel I was that it adopted a too simple approach to risk weighting, focusing solely on credit risk and overlooking other critical risks.

The Basel II regulations were also found to be inadequate in curtailing the risks that some banks were taking, leading to the subprime mortgage meltdown in 2007.

The Basel Committee, established by the Bank for International Settlements, is responsible for developing and implementing these regulations.

The Basel Committee's charter emphasizes the importance of international cooperation and coordination in regulating the banking industry.

The failures of Basel I and Basel II led to the introduction of Basel III, which aims to better address the risks posed by banks to the worldwide financial system.

Basel III is still being phased in, but it represents a significant improvement over its predecessors.

The first pillar of Basel II deals with maintaining regulatory capital, calculated for three major components of risk: credit risk, operational risk, and market risk.

Credit risk can be calculated using three different approaches: the standardized approach, Foundation IRB, and Advanced IRB.

For operational risk, there are three approaches: basic indicator approach (BIA), standardized approach (TSA), and the internal measurement approach.

Market risk is typically calculated using VaR (value at risk).

Basel II divides eligible regulatory capital into three tiers, with Tier 1 representing the bank's core capital, composed of common stock, disclosed reserves, and certain other assets.

At least 4% of the bank's capital reserve must be in the form of Tier 1 assets.

Tier 2 is supplementary capital, consisting of revaluation reserves, hybrid instruments, and medium- and long-term subordinated loans.

Tier 3 consists of lower-quality unsecured, subordinated debt.

Here's a breakdown of the three approaches for credit risk calculation:

Risk weighting is used to discourage banks from taking on excessive amounts of risk, and the main innovation of Basel II is that it takes into account the credit rating of assets in determining their risk weights.

Regulatory supervision is a key component of Basel II, providing a framework for national regulatory bodies to deal with various types of risks, including systemic risk and liquidity risk.

The market discipline pillar introduces various disclosure requirements for banks' risk exposures and risk assessment processes, fostering greater transparency and allowing investors to compare banks on equal footing.

Banks can review their risk management system as part of the supervisory review process, which provides a framework for dealing with residual risk, including pension risk, concentration risk, and reputational risk.

The Internal Capital Adequacy Assessment Process (ICAAP) is a result of Pillar 2 of Basel II accords, allowing banks to assess their own capital adequacy and risk management systems.

Basel II divided the eligible regulatory capital of a bank into three tiers, with each tier having a minimum percentage of the total regulatory capital and used as a numerator in the calculation of regulatory capital ratios.

Curious to learn more? Check out: Basel Framework

The implementation of the new accord is a complex process, with regulators worldwide adopting different approaches and timelines.

Regulators in most jurisdictions plan to implement the new accord, but with varying timelines and methodologies. The United States' regulators have agreed on a final approach, requiring the Internal Ratings-Based approach for the largest banks and the standardized approach for smaller banks.

In India, the Reserve Bank of India implemented the Basel II standardized norms on 31 March 2009 and is moving to internal ratings in credit and AMA norms for operational risks in banks.

The RBI's existing norms for banks in India require a common equity of 3.6%, Tier 1 requirement of 6%, and total capital of 9% of risk-weighted assets.

By 2015, 95 national regulators indicated they would implement Basel II in some form, according to a questionnaire released by the Financial Stability Institute.

The European Union implemented the Accord via the EU Capital Requirements Directives, with many European banks already reporting their capital adequacy ratios according to the new system.

Australia implemented the Basel II Framework on 1 January 2008, through its Australian Prudential Regulation Authority.

A different take: Internal Ratings-based Approach (credit Risk)

Regulatory supervision is a crucial part of risk management, providing a framework for national regulatory bodies to deal with various types of risks, including systemic risk, liquidity risk, and legal risks.

Regulatory supervision is the second pillar of Basel II, which gives regulators better tools to assess and manage risks.

The market discipline pillar introduces various disclosure requirements for banks' risk exposures, risk assessment processes, and capital adequacy, fostering greater transparency and allowing investors and others to compare banks on equal footing.

This transparency is essential for sound banking practices, as it enables market participants to gauge the capital adequacy of an institution.

The Internal Capital Adequacy Assessment Process (ICAAP) is a result of Pillar 2 of Basel II accords, allowing banks to review their risk management system.

Banks can use the ICAAP to identify and manage risks more effectively, reducing the likelihood of financial instability.

Market discipline supplements regulation by sharing information, facilitating the assessment of a bank's capital adequacy by investors, analysts, customers, other banks, and rating agencies.

This sharing of information leads to good corporate governance, as market participants can reward banks that manage their risks prudently and penalize those that do not.

Institutions are required to create a formal policy on what will be disclosed and controls around them, along with the validation and frequency of these disclosures.

The disclosures under Pillar 3 apply to the top consolidated level of the banking group to which the Basel II framework applies.

Regulatory supervision and market discipline are essential for maintaining a stable financial system, and banks must comply with the requirements of both pillars to ensure sound risk management practices.

The Basel Accords were developed over several years beginning in the 1980s, and the Basel Committee on Bank Supervision (BCBS) was founded in 1974 as a forum for cooperation between its member countries on banking supervisory matters.

The BCBS is headquartered in Basel, Switzerland, and its original aim was to enhance financial stability worldwide. The committee turned its attention to monitoring and ensuring the capital adequacy of banks and the banking system.

The Basel Accords were set up by the central bank governors of the G10 countries in response to bank failures in Germany and the U.S. in the 1970s.

The BCBS has 45 members from 28 countries and other jurisdictions, representing central banks and supervisory authorities.

International Consistency is a crucial aspect of implementing an international agreement. Banks' senior management will determine corporate strategy, as well as the country in which to base a particular type of business, based in part on how the agreement is ultimately interpreted by various countries' legislatures and regulators.

Accommodating differing cultures, varying structural models, complexities of public policy, and existing regulation can be a significant challenge. This is especially true for banks operating in multiple countries, with multiple reporting requirements for different regulators according to geographic location.

Software applications can assist banks in meeting these diverse requirements. These applications include capital calculation engines and automated reporting solutions which include the reports required under COREP/FINREP.

Banks need to carefully consider the varying regulatory requirements when deciding where to base a particular type of business. This will ultimately affect their corporate strategy and overall operations.

The Basel Accords were set up by the Basel Committee on Bank Supervision (BCBS), created by central bank governors of the G10 countries in response to bank failures in Germany and the U.S. in the 1970s.

The BCBS was founded in 1974 as a forum for regular cooperation between its member countries on banking supervisory matters. Its original aim was the enhancement of "financial stability by improving supervisory knowhow and the quality of banking supervision worldwide."

The Basel Accords are named after the city of Basel, Switzerland, where the Bank for International Settlements (BIS) is headquartered. This is where the BCBS is also located.

The BCBS has 45 members from 28 countries and other jurisdictions, representing central banks and supervisory authorities. These members are responsible for implementing the Basel rules in their respective countries.

Here's a list of some of the countries that are part of the BCBS: