What is Basel II?

Explanation

The banking system depends totally on trust. Investors can only gain trust when they know that their money is secured. Basel II norms are designed to prevent banks from taking risks independently and don’t respect depositors’ money. The business model of any bank is to accept deposits in the form of savings or fixed deposits and to use this capital to issue loans to individuals or businesses. So the main focus of regulators should be to check how much the inflow is vs. the outflow of capital. Basel 2 norms focus on the minimum capital requirement of the banks and other areas.

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Objectives of Basel II

  • To save investors’ money in case of any risk, banks will have to set aside capital based on the assets they hold. Bank’s assets are the bank’s investments, such as issuing a loan. Basel II’s objective is to ensure that the bank does a thorough risk analysisRisk AnalysisRisk analysis refers to the process of identifying, measuring, and mitigating the uncertainties involved in a project, investment, or business. There are two types of risk analysis - quantitative and qualitative risk analysis.read more of the asset on which they are planning to invest. So capital should be allocated considering the risk factor involved in assets.Earlier, Basel’s objective was to make banks concentrate only on the credit risk of the individual or organization that the bank is issuing the loan to. Nowadays, along with credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower’s failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt’s principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more, a bank must also concentrate on operational and market risk.The disclosure requirement of the banks has been increased, which will help any market participant calculate on their own as to whether the bank is maintaining proper capital as per their asset. The objective is to open things so that if the regulators miss something, other participants can find it out.

Pillars of Basel II

The pillars of Basel II are the Minimum Capital Requirement, Supervisory Review and role, and Market Discipline and Disclosure.

#1 – Minimum Capital Requirement

The one-time capital requirement was based on the asset that the bank used to hold. Each asset is not equal, risk-wise. So if you think practically, if the bank is holding a very risky asset and a very safe asset, should the capital capital reserveCapital ReserveCapital reserve is a reserve that is formed from the company’s profits earned from its non-operating activities during a period of time and is retained for the purpose of financing the company’s long-term projects or writing off its capital expenses in the future.read more kept for default be the same for both the assets? No. It should be higher for risky investments and lower for less risky assets. So this pillar ensures that the bank calculates assets based on risk, also known as risk-weighted assetsRisk-weighted AssetsRisk-weighted asset refers to the minimum amount that a bank or any other financial institution must maintain to avoid insolvency or bankruptcy risk. The risk associated with each bank asset is analyzed individually to figure out the total capital requirement.read more. Now the bank will not consider only credit risk, but also operational riskOperational RiskOperational risk is the business uncertainty a company comes across in the industry while executing its everyday business operations. Such risks arise due to internal system breakdown, technical issues, external factors, managerial problems, human errors or information gap. read more associated with the assets and decide the capital requirement. The minimum capital requirement is 8% of the risk-weighted assets per Basel II.

#2 – Supervisory Review and Role

Regulations are of no use if proper supervision is not done. As per Basel II, it is the primary duty of the supervisor to ascertain that the bank has covered enough capital that will deal with operational, credit, and market riskMarket RiskMarket risk is the risk that an investor faces due to the decrease in the market value of a financial product that affects the whole market and is not limited to a particular economic commodity. It is often called systematic risk.read more of the assets that the bank has invested in. So the supervisor can intervene in the daily operations to ensure that capital doesn’t fall the desired threshold. Therefore, the review role of the supervisor should be extremely strong and should always try to maintain the capital above the required level.

#3 – Market Discipline and Disclosure

Nowadays, markets are extremely disciplined. There are informed market participants who are well informed about the minimum requirement of capital by the banks. So if any time bank drops below the desired level of capital requirement, then market participants can identify it with the disclosures made by the banks. So this helps investors to make informed decisions. Basel II has stated banks to make full and timely disclosures.

Effects of Basel II

Basel II’s main objective is to make the banking sector extra cautious while handling highly risky assets. The capital requirement is based on risk-weighted assets now, so banks will have to charge extra spread while issuing loans to lower rating individuals/businesses. So now it will be really difficult to raise money from risky businesses. Depositors will be more confident in the banking sector, and they will start to save more instead of spending. This will increase the capital base of the banking sector even more.

Basel 2 vs Basel 3

  • Basel III is built upon Basel II. So areas where the regulators thought that more care should be taken, those areas were made stricter. The capital requirement is even stricter as compared to BASEL II.Basel III considers the credit ratings of the assets that the bank is planning to invest to set up a relation between the market risk and the risk of the asset.Capital ratios are extremely important to find the capital status of banks. Basel III has tightened the capital ratio requirements.Banks’ capital kept for risky times is divided into common equity tier 1 capital, tier 1 capital, and Tier 2 capitalTier 2 CapitalTier 2 capital, also known as supplementary capital, is the second layer of bank capital requirements. It consists of hybrid instruments, general provisions and revaluation reserves. Uneasy to liquidate; Tier 2 capital is considered less secure.read more.The overall requirement of capital consisting of all three segments was 8% in Basel II. It remains the same. The changes are made inside the common equity tier 1 capital and tier 1 capital.The minimum common equity tier 1 capital changed from 4% to 4.5%, and minimum tier capital changed from 4% to 6%.

Advantages of Basel II

  • It has helped the banking sector be more secure due to the strict capital requirement norms.Strict supervision has helped many banks not deviate from the stipulated minimum capital requirement. This practice has helped banks to save themselves from the worst scenarios.Disclosure requirements have helped the banking sector be more transparent and have allowed investors from all over the world to make informed decisions.

Disadvantages of Basel II

  • Importance was lacking on the crucial capital ratios that help predict the shortfall.Minimum capital requirements were not set considering the extreme outcomes. Even Basel II regulations can’t save a bank in a severe crisis. The capital reserve will be useless if a bank has invested too much in risky assets and the entire market drops. There will be a bank run.

Conclusion

Basel II norms are developed to make the banking sector more secure. The entire financial sector must understand that everything is dependent on trust. So it shouldn’t be that a best practice will only be followed if it is made as a rule. Banks should always follow the best approach and invest in less risky assets. Banks are handling others’ money, so that responsibility should be there.

This has been a guide to what Basel II is and its definition. Here we discuss Basel II’s objectives and pillars and their effects and differences. You may learn more about financing from the following articles –

  • Tier 1 Capital RatioBank CapitalCapital Adequacy RatioReserve Requirement