Basel II

What is Basel II?

Basel II is an international banking regulatory framework published in 2004 by the Basel Committee on Banking Supervision. It serves as an improvement and update to the earlier Basel I agreement.

The aim of Basel II is to enhance the effectiveness of banking supervision and the quality of risk management, adjusting to the evolving financial market environment. The primary objective is to encourage banks to better manage risks, including credit risk, market risk, and operational risk, and to more accurately calculate and allocate capital to cover these risks.

Key Components of Basel II

Basel II, released in 2004 and implemented starting in 2007, is a set of international banking regulatory standards designed to improve banks' risk management and capital adequacy requirements. The main contents of Basel II include:

1. Capital Adequacy Requirements: Basel II emphasizes that banks should determine capital adequacy requirements based on the risks they bear. The agreement introduces more precise and detailed methods for calculating capital, including specific requirements for credit risk, market risk, and operational risk.
2. Risk Assessment Methods: Basel II encourages banks to adopt more advanced risk assessment methods, including the Internal Ratings-Based (IRB) approach and the Standardized Approach. These methods allow for more accurate assessment and measurement of the levels of risk banks face.
3. Market Risk Requirements: Basel II highlights the more comprehensive and detailed management of banks' market risk. It requires banks to consider the intrinsic risk exposure of market risk when calculating capital adequacy and to use more accurate methods for measuring market risk.
4. Operational Risk Requirements: Basel II emphasizes the comprehensive and accurate management of banks' operational risk. It requires banks to consider the intrinsic risk exposure of operational risk when calculating capital adequacy and to use more precise methods for measuring operational risk.
5. Regulatory Prudential Review: Basel II encourages regulatory authorities to conduct more prudent and comprehensive audits of banks' risk management and capital adequacy. Regulators should regularly assess banks' risk management systems to ensure compliance with the agreement.
6. Transparency and Market Discipline: Basel II stresses that banks should provide more risk-related information to increase transparency and promote market discipline. Banks are required to disclose their risk management and capital adequacy status to regulators and market participants, allowing the market to better assess the risk conditions of banks.

Market Risks in Basel II

In Basel II, market risk is defined as the potential losses that banks face from fluctuations in the financial markets during their trading, investment, and asset management activities. Market risk primarily includes three aspects:

1. Equity Risk: Involves the risk of value fluctuations of stocks and stock-related derivatives held by banks. Fluctuations in the stock market could lead to losses in stock investments for banks.
2. Interest Rate Risk: Involves the risk of value fluctuations of bonds and interest rate-related derivatives held by banks. Rising or falling interest rates could lead to losses or gains in bond investments, affecting banks' capital adequacy.
3. Foreign Exchange Risk: Involves the risk associated with banks' transactions and holdings in foreign exchange assets or liabilities. Fluctuations in the foreign exchange market could result in losses in forex transactions for banks.

Requirements of Basel II

Building on Basel I, Basel II provides guidelines for calculating the minimum regulatory capital ratio and confirms the requirement for banks to maintain capital reserves equivalent to at least 8% of their risk-weighted assets.

Basel II classifies banks' eligible regulatory capital into three tiers. The higher the tier, the safer and more liquid the assets.

• Tier 1 capital represents the core capital of banks, consisting of common shares, disclosed reserves, and certain other assets. At least 4% of banks' capital reserves must be in the form of tier 1 assets.
• Tier 2 capital is considered supplementary capital, including items like revaluation reserves, hybrid instruments, and subordinated term debts.
• Tier 3 capital consists of lower quality, unsecured, subordinated debts.

Basel II also refined the definition of risk-weighted assets used to calculate whether banks meet their capital reserve requirements. Risk weighting aims to prevent banks from taking on excessive risks in their asset holdings. Compared to Basel I, a major innovation of Basel II is its consideration of assets' credit ratings in determining their risk weights. The higher the credit rating, the lower the risk weight.

Differences Between Basel II and Basel I

Basel II and Basel I are two different international financial standards, with the following main differences:

1. Risk Classification: Basel I used a simplified risk classification method, assigning assets to specific risk categories and allocating corresponding risk weights. Basel II, on the other hand, introduced a more complex and detailed risk classification method, allowing banks to more accurately measure and assess different risks using internal assessment models.
2. Capital Requirements: Basel I employed a simple capital adequacy requirement, linking capital requirements to banks' risk exposures but only considering credit risk. Basel II introduced more risk categories, including credit risk, market risk, and operational risk, and required banks to calculate capital requirements based on their risk levels.
3. Internal Rating Models: Basel II encourages banks to use internal rating models to assess credit risk, allowing banks to more accurately evaluate a borrower's credit risk level and determine the appropriate level of capital. In contrast, Basel I relied mainly on standardized risk weights and external ratings.
4. Regulatory Prudence: Basel II places greater emphasis on regulatory prudence, requiring closer cooperation and information exchange between regulators and banks to ensure effective risk management and adequate capital provisioning. In contrast, Basel I focused more on absolute capital adequacy requirements.

The Role of Basel II

The main role of Basel II is to improve banks' risk management and capital adequacy requirements, ensuring that financial institutions can operate more robustly in the face of risks and enhancing the stability of the financial system. The main roles of Basel II include:

1. Enhancing Risk Management: Basel II encourages banks to use more accurate and comprehensive risk assessment methods, including internal rating models and advanced measurement approaches, to better assess credit risk, market risk, and operational risk. This enables banks to more accurately measure and manage their risk exposures and develop appropriate risk management strategies.
2. Strengthening Capital Adequacy: Basel II requires banks to ensure they have sufficient capital reserves based on the levels of risk they undertake. By more precisely calculating and provisioning capital, banks can better withstand risks and cope with the uncertainties of financial markets, enhancing their ability to absorb potential losses.
3. Promoting Market Discipline: Basel II encourages banks to disclose more risk-related information, increasing transparency and enabling market participants to better evaluate and understand banks' risk conditions. This helps promote market discipline, encouraging banks, management, and regulatory authorities to more effectively monitor and manage financial institutions.
4. Strengthening Regulatory Cooperation: Basel II requires closer cooperation and information exchange between regulatory authorities and banks, ensuring that regulators can thoroughly understand banks' risk conditions and provide necessary guidance and supervision. This enhances the effectiveness and consistency of regulation and increases the overall stability of the financial system.