Basel II

Basel II is the second of the Basel Accords, which are recommendations on banking laws and
regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II,
which was initially published in June 2004, is to create an international standard that banking
regulators can use when creating regulations about how much capital banks need to put aside to
guard against the types of financial and operational risks banks face. Advocates of Basel II
believe that such an international standard can help protect the international financial system
from the types of problems that might arise should a major bank or a series of banks collapse. In
practice, Basel II attempts to accomplish this by setting up rigorous risk and capital management
requirements designed to ensure that a bank holds capital reserves appropriate to the risk the
bank exposes itself to through its lending and investment practices. Generally speaking, these
rules mean that the greater risk to which the bank is exposed, the greater the amount of capital
the bank needs to hold to safeguard its solvency and overall economic stability.

Contents
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 1 Objective
 2 The Accord in operation
o 2.1 The first pillar
o 2.2 The second pillar
 3 Recent chronological updates
o 3.1 September 2005 update
o 3.2 November 2005 update
o 3.3 July 2006 update
o 3.4 November 2007 update
o 3.5 July 16, 2008 update
o 3.6 January 16, 2009 update
o 3.7 July 8-9, 2009 update
 4 Basel II and the regulators
o 4.1 Implementation progress
 5 See also
 6 References
 7 External links

[edit] Objective
The final version aims at:

1. Ensuring that capital allocation is more risk sensitive;

2. Separating operational risk from credit risk, and quantifying both;
 3. Attempting to align economic and regulatory capital more closely to reduce the scope for
regulatory arbitrage.

While the final accord has largely addressed the regulatory arbitrage issue, there are still areas
where regulatory capital requirements will diverge from the economic.

Basel II has largely left unchanged the question of how to actually define bank capital, which
diverges from accounting equity in important respects. The Basel I definition, as modified up to
the present, remains in place.

[edit] The Accord in operation

Basel II uses a "three pillars" concept – (1) minimum capital requirements (addressing risk),
(2) supervisory review and (3) market discipline – to promote greater stability in the financial
system.

The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the
first Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market
risk was an afterthought; operational risk was not dealt with at all.

[edit] The first pillar

The first pillar deals with maintenance of regulatory capital calculated for three major
components of risk that a bank faces: credit risk, operational risk, and market risk. Other risks
are not considered fully quantifiable at this stage.

The credit risk component can be calculated in three different ways of varying degree of
sophistication, namely standardized approach, Foundation IRB and Advanced IRB. IRB stands
for "Internal Rating-Based Approach".

For operational risk, there are three different approaches - basic indicator approach or BIA,
standardized approach or TSA, and the internal measurement approach (an advanced form of
which is the advanced measurement approach or AMA).

For market risk the preferred approach is VaR (value at risk).

As the Basel 2 recommendations are phased in by the banking industry it will move from
standardised requirements to more refined and specific requirements that have been developed
for each risk category by each individual bank. The upside for banks that do develop their own
bespoke risk measurement systems is that they will be rewarded with potentially lower risk
capital requirements. In future there will be closer links between the concepts of economic profit
and regulatory capital.

Credit Risk can be calculated by using one of three approaches:

1. Standardised Approach
2. Foundation IRB (Internal Ratings Based) Approach

3. Advanced IRB Approach

The standardised approach sets out specific risk weights for certain types of credit risk. The
standard risk weight categories are used under Basel 1 and are 0% for short term government
bonds, 20% for exposures to OECD Banks, 50% for residential mortgages and 100% weighting
on unsecured commercial loans. A new 150% rating comes in for borrowers with poor credit
ratings. The minimum capital requirement (the percentage of risk weighted assets to be held as
capital) remains at 8%.

For those Banks that decide to adopt the standardised ratings approach they will be forced to rely
on the ratings generated by external agencies. Certain Banks are developing the IRB approach as
a result.

[edit] The second pillar

The second pillar deals with the regulatory response to the first pillar, giving regulators much
improved 'tools' over those available to them under Basel I. It also provides a framework for
dealing with all the other risks a bank may face, such as systemic risk, pension risk,
concentration risk, strategic risk, reputational risk, liquidity risk and legal risk, which the accord
combines under the title of residual risk. It gives banks a power to review their risk management
system.

[edit] Recent chronological updates

[edit] September 2005 update

On September 30, 2005, the four US Federal banking agencies (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) announced their revised plans for
the U.S. implementation of the Basel II accord. This delays implementation of the accord for US
banks by 12 months.[1]

[edit] November 2005 update

On November 15, 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 had been flagged well in advance, as part of a paper released in July 2005.[2]

[edit] July 2006 update

On July 4, 2006, the committee released a comprehensive version of the Accord, 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: International Convergence of Capital Measurement
and Capital Standards: A Revised Framework. No new elements have been introduced in this
compilation. This version is now the current version.[3]

[edit] November 2007 update

On November 1, 2007, the Office of the Comptroller of the Currency (U.S. Department of the
Treasury) approved a final rule implementing the advanced approaches of the Basel II Capital
Accord. This rule establishes regulatory and supervisory expectations for credit risk, through the
Internal Ratings Based Approach (IRB), and operational risk, through the Advanced
Measurement Approach (AMA), and articulates enhanced standards for the supervisory review
of capital adequacy and public disclosures for the largest U.S. banks.[4]

[edit] July 16, 2008 update

On July 16, 2008 The federal banking and thrift agencies ( 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 a final guidance
outlining the supervisory review process for the banking institutions that are implementing the
new advanced capital adequacy framework (known as Basel II). The final guidance, relating to
the supervisory review, is aimed at helping banking institutions meet certain qualification
requirements in the advanced approaches rule, which took effect on April 1, 2008. [5]

[edit] January 16, 2009 update

For public consultation, a series of proposals to enhance the Basel II framework was announced
by the Basel Committee. It releases a consultative package that includes: the revisions to the
Basel II market risk framework; the guidelines for computing capital for incremental risk in the
trading book; and the proposed enhancements to the Basel II framework.[6]

[edit] July 8-9, 2009 update

A final package of measures to enhance the three pillars of the Basel II framework and to
strengthen the 1996 rules governing trading book capital was issued by the newly expanded
Basel Committee. These measures include the enhancements to the Basel II framework, the
revisions to the Basel II market-risk framework and the guidelines for computing capital for
incremental risk in the trading book.[7]

[edit] Basel II and the regulators

One of the most difficult aspects of implementing an international agreement is the need to
accommodate differing cultures, varying structural models, and the complexities of public policy
and existing regulation. 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 Basel II is
ultimately interpreted by various countries' legislatures and regulators.
To assist banks operating with multiple reporting requirements for different regulators according
to geographic location, there are several software applications available. These include capital
calculation engines and extend to automated reporting solutions which include the reports
required under COREP/FINREP.

For example, U.S. FDIC Chair Sheila Bair explained in June 2007 the purpose of capital
adequacy requirements for banks, such as the accord: "There are strong reasons for believing that
banks left to their own devices would maintain less capital -- not more -- than would be prudent.
The fact is, banks do benefit from implicit and explicit government safety nets. Investing in a
bank is perceived as a safe bet. Without proper capital regulation, banks can operate in the
marketplace with little or no capital. And governments and deposit insurers end up holding the
bag, bearing much of the risk and cost of failure. History shows this problem is very real … as
we saw with the U.S. banking and S & L crisis in the late 1980s and 1990s. The final bill for
inadequate capital regulation can be very heavy. In short, regulators can't leave capital decisions
totally to the banks. We wouldn't be doing our jobs or serving the public interest if we did.[8]

[edit] Implementation progress

Regulators in most jurisdictions around the world plan to implement the new Accord, but with
widely varying timelines and use of the varying methodologies being restricted. The United
States of America's various regulators have agreed on a final approach.[9] They have required the
Internal Ratings-Based approach for the largest banks, and the standardized approach will not be
available to anyone.(See http://www.federalreserve.gov/newsevents/press/bcreg/20080626b.htm
for an update on proposed Standardized Approach)

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

In response to a questionnaire released by the Financial Stability Institute (FSI), 95 national

regulators indicated they were to implement Basel II, in some form or another, by 2015.[10]

The European Union has already implemented the Accord via the EU Capital Requirements
Directives and many European banks already report their capital adequacy ratios according to the
new system. All the credit institutions adopted it by 2008.

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