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Definition:

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.

What is Basel II?

• Basel II is the recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision.
• It is essentially a guideline to the international regulator about how much capital banks need to put aside against the types of financial and operational risk.
• Ensures that a bank hold capital reserve appropriate to the risk of the bank exposure itself through its lending and investment practice.
• Greater the risk greater is the amount of capital requirement.

The final version aims at:

• Ensuring that capital allocation is more risk sensitive;
• Separating operational risk from credit risk, and quantifying both;
• 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.

Basel II: Managing Enterprise Risk

Addressing the Three Pillars

Types of Risks:

As of now 3 types of major risks are addressed in Basel II:

• Credit Risk: Default by the borrower to repay the borrowings.
• Market Risk: Volatility in the banks’ portfolio due to change in market factors.
• Operational risk: Risk arising out of banks’ inefficient internal processes, systems, people or external events like natural disasters, robbery etc.

Minimum Capital Allocation for credit risk

To allocate the capital for any of the above risk, it should be quantitatively measured. Currently banks follow two methods to measure credit risk and allocate the capital for credit risk.

1) Standardized Approach (Varies country to country; Indian Context):

External credit rating agencies like CARE, ICRA will assign the ratings for the assets of the banks and then capital is allocated for each of the assets. Credit rating and capital allocation is inversely proportional.

2) Internal Rating (IR) Approach:

In both methods, capital is allocated based on the following 3 factors:

• Exposure at default (EAD) –amount of facility that is likely to be drawn in default.
• Loss given at default (LGD) – Measures the proportion of lost exposure in default.
• Probability of default (PD) – chances of default in terms of percentage (Default – fails to repay borrowings)