Basel II

What Is Basel II?

Understanding Basel II

Basel II is a second international banking regulatory accord that is based on three main pillars: minimal capital requirements, regulatory supervision, and market discipline. Minimal capital requirements play the most important role in Basel II and obligate banks to maintain minimum capital ratios of regulatory capital over risk-weighted assets. Because banking regulations significantly varied among countries before the introduction of Basel accords, a unified framework of Basel I and, subsequently, Basel II helped countries alleviate anxiety over regulatory competitiveness and drastically different national capital requirements for banks.

Minimum Capital Requirements

Basel II provides guidelines for calculation of minimum regulatory capital ratios and confirms the definition of regulatory capital and an 8% minimum coefficient for regulatory capital over risk-weighted assets. Basel II divides the eligible regulatory capital of a bank into three tiers. The higher the tier, the less subordinated securities a bank is allowed to include in it. Each tier must be of a certain minimum percentage of the total regulatory capital and is used as a numerator in the calculation of regulatory capital ratios.

Tier 1 capital is the most strict definition of regulatory capital that is subordinate to all other capital instruments, and includes shareholders' equity, disclosed reserves, retained earnings and certain innovative capital instruments. Tier 2 is Tier 1 instruments plus various other bank reserves, hybrid instruments, and medium- and long-term subordinated loans. Tier 3 consists of Tier 2 plus short-term subordinated loans.

Another important part in Basel II is refining the definition of risk-weighted assets, which are used as a denominator in regulatory capital ratios, and are calculated by using the sum of assets that are multiplied by respective risk weights for each asset type. The riskier the asset, the higher its weight. The notion of risk-weighted assets is intended to punish banks for holding risky assets, which significantly increases risk-weighted assets and lowers regulatory capital ratios. The main innovation of Basel II in comparison to Basel I is that it takes into account the credit rating of assets in determining risk weights. The higher the credit rating, the lower the risk weight.

Regulatory Supervision and Market Discipline

Regulatory supervision is the second pillar of Basel II that provides the framework for national regulatory bodies to deal with various types of risks, including systemic risk, liquidity risk, and legal risks. The market discipline pillar provides various disclosure requirements for banks' risk exposures, risk assessment processes, and capital adequacy, which are helpful for users of financial statements.