by Basel II is the second set of international banking regulations issued by the Basel Committee on Banking Supervision (BCBS). Introduced in 2004, its official title is the International Convergence of Capital Measurement and Capital Standards. It was developed to create a more risk-sensitive and comprehensive framework than its predecessor, Basel I. The framework is built on Three Pillars: Pillar 1 (Minimum Capital Requirements with refined risk-weighting), Pillar 2 (Supervisory Review Process), and Pillar 3 (Market Discipline through disclosure). Its core goal is to strengthen global banking stability by better aligning regulatory capital with the underlying economic risk of a bank’s assets.
Functions of Basel II:
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Pillar 1: Minimum Capital Requirements
Pillar 1 refines the calculation of minimum regulatory capital a bank must hold against its risk-weighted assets (RWA). It introduces three key risk types: Credit Risk (calculated via Standardised Approach or Internal Ratings-Based (IRB) Approach), Operational Risk (via Basic Indicator, Standardised, or Advanced Measurement Approaches), and Market Risk. By moving from a one-size-fits-all approach to risk-sensitive weightings, it ensures capital reserves are more accurately aligned with the actual risk profile of a bank’s portfolio, making the banking system more resilient to unexpected losses.
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Pillar 2: Supervisory Review Process
Pillar 2 establishes the regulator’s active role in ensuring each bank has adequate capital to cover all material risks, including those not fully captured under Pillar 1 (e.g., concentration risk, interest rate risk in the banking book). It mandates banks to develop an Internal Capital Adequacy Assessment Process (ICAAP) and subjects them to a Supervisory Review and Evaluation Process (SREP). This pillar enhances dialogue between banks and supervisors, promoting proactive, forward-looking risk management and ensuring banks hold capital buffers above the Pillar 1 minimum.
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Pillar 3: Market Discipline
Pillar 3 aims to strengthen market discipline by requiring banks to publicly disclose detailed, consistent information about their risk exposures, capital adequacy, and risk management practices. This transparency allows investors, analysts, and counterparties to make better-informed assessments of the bank’s risk profile and financial health. The resulting market pressure incentivizes banks to maintain sound risk management and adequate capital, complementing regulatory and supervisory oversight. It transforms risk data from an internal metric into a tool for external accountability.
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Enhanced Risk Sensitivity & Management
A core function of Basel II is to make capital requirements highly sensitive to underlying risk. By offering advanced approaches (like IRB for credit risk), it incentivizes banks to develop sophisticated internal risk measurement and management systems. This creates a direct link between a bank’s risk management quality and its regulatory capital cost, encouraging a cultural shift towards embedding robust risk assessment into all business decisions, thereby fostering greater internal discipline and a deeper understanding of risk across the institution.
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Promoting Global Consistency & Financial Stability
Basel II functions as a harmonizing global standard, aiming to create a level playing field for internationally active banks. By setting common definitions and methodologies for risk and capital, it reduces regulatory arbitrage (where banks shift activities to jurisdictions with weaker rules). This enhanced consistency strengthens the stability of the global financial system by ensuring that banks worldwide operate under a comparable, robust prudential framework, reducing the risk of contagion from weaknesses in any single national banking system.
