Basel II

Active since: 2008
Successor of: Basel I
Succeeded by: Basel III
Succeeded per: January 2022
Target: All financial institutions world-wide
Goal: Make capital allocation more risk-sensitive, enhance reporting requirements and align economic and regulatory capital more closely.

With Basel I in place a basic risk model was implemented accross financial institutions around the world. However this model used a standardized approach which did not justice to specific portfolios of customers and products. The unintended concequence of Basel I was that it encouraged risk-seeking to receive more revenue within the same risk profile.

The new accord is based on three pillars:

  1. Minimum capital requirements
  2. Supervisory review
  3. Market discepline

The minimum capital requirements form the heart of Basel II it means that banks must hold 8% capital against their assets after adjusting these assets with the risk ran on it.
Most of the document describes how to determine the adjustment of value with the risk ran on it.

Banks can now choose to follow the standardized approach (basically Basel I) or the Internal rating based approach (IRB). The Internal rating based approach has two flavours: foundation and advanced. Foundation means that the bank determines the risk run on the customer (probability of default), but uses the supervisor determined parameters used for the collateral value, while the advanced method means the bank applied their own proofed parameters on both the customer as the collateral risk.

The supervisory review is introduced in Basel II in order to ascertain whether the bank uses the correct assessments and covers all risks associated.
It describes the Internal Capital Adequacy Assessment Process (ICAAP) and the Supervisory Review and Evaluation Process (SREP).
It basically set the rules on how banks must prove their used parameters in the IRB-foundation and IRB-advanced approach as report on their risk weighted assets and capital levels.

The market discipline means that the bank is open to the public about relevant market information so the public can make informed trading decisions.


Full text of Basel II