What is Basel II?
Basel II is the second set of regulations on Minimum Capital Requirement, Supervisory Review, and Role and Market discipline and disclosure and were created for International Banks by the Basel Committee on Bank Supervision in order to maintain a transparent and risk-free banking environment.
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 in such a way that there are regulations that prevent banks to take risk on their own and don’t respect depositor’s 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 is the inflow vs the outflow of capital. Basel 2 norms focus on the minimum capital requirement of the banks as well as on other areas.
Objectives of Basel II
- To save investor’s money in case of any risk, banks will have to set aside capital based on the assets they hold. Bank’s assets are the investments that the bank does, such as issuing a loan. Basel 2’s objective is to make sure 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. 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. Now 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., 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 to calculate on their own as to whether the bank is maintaining proper capital as per their asset. The objective is to make things open, so that if something is missed by the regulators, then 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 earlier 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 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. keep for default be the same for both the assets? Not. It should be higher for risky assets and lower for less risky assets. So this pillar ensures that 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.. 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. associated with the assets and decide the capital requirement. As per Basel 2, the minimum capital requirement is 8% of the risk-weighted assets.
#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. of the assets that the bank has invested in. So the supervisor can intervene in the daily operations to make sure that capital doesn’t fall the desired threshold. 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 2 has stated banks to make full and timely disclosures.
Effects of Basel II
BASEL II main objective is to make the banking sector extra cautious while handling highly risky assets. As 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 by 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 3 is built upon Basel 2. 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 2.
- Basel 3 is considering 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 3 has tightened the capital Ratio requirements.
- Banks’ capital that is 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..
- The overall requirement of capital consisting of all three segments was 8% in Basel 2, 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 to be more secure due to the strict capital requirement norms.
- Strict supervisory has helped many banks to not deviate from the stipulated minimum capital requirement. This practice has helped banks to save themselves from the worst scenarios.
- Disclosure requirement has helped the banking sector to be more transparent and has allowed investors from all over the world to make an informed decision.
Disadvantages of Basel II
- Importance was lacking on the very crucial capital ratios which help to predict the shortfall.
- Minimum capital requirements were not set considering the extreme outcomes. In case of extreme crisis, even BASEL II regulations can’t save a bank. If a bank has invested too much on risky assets and the entire market drops, then capital reserve will be of no use. There will be a bank run.
Basel II norms are developed to make the banking sector more secured. 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 try to follow the best practice and invest in less risky assets. Banks are handling other’s money, so that responsibility should be there.
This has been a guide to what is Basel II and it’s a definition. Here we discuss the objectives and pillars of Basel II along with their effects and differences. You may learn more about financing from the following articles –