Basel II

The second accord of the Basel framework concerned with banking regulations, rules, and laws established by the Basel Committee on Banking Supervision.

Author: Christy Grimste
Christy Grimste
Christy Grimste
Real Estate | Investment Property Sales

Christy currently works as a senior associate for EdR Trust, a publicly traded multi-family REIT. Prior to joining EdR Trust, Christy works for CBRE in investment property sales. Before completing her MBA and breaking into finance, Christy founded and education startup in which she actively pursued for seven years and works as an internal auditor for the U.S. Department of State and CIA.

Christy has a Bachelor of Arts from the University of Maryland and a Master of Business Administrations from the University of London.

Reviewed By: Osman Ahmed
Osman Ahmed
Osman Ahmed
Investment Banking | Private Equity

Osman started his career as an investment banking analyst at Thomas Weisel Partners where he spent just over two years before moving into a growth equity investing role at Scale Venture Partners, focused on technology. He's currently a VP at KCK Group, the private equity arm of a middle eastern family office. Osman has a generalist industry focus on lower middle market growth equity and buyout transactions.

Osman holds a Bachelor of Science in Computer Science from the University of Southern California and a Master of Business Administration with concentrations in Finance, Entrepreneurship, and Economics from the University of Chicago Booth School of Business.

Last Updated:November 8, 2022

Basel II is the second accord of the Basel framework concerned with banking regulations, rules, and laws established by the Basel Committee on Banking Supervision- BCBS in Basel, Switzerland. 

It was published in 2004 and implemented in 2008 in the most significant countries, yet it was not implemented fully due to the financial crisis in 2007-2008. The European Union-EU adopted it in 2008, and by the U.S.A in late 2009.

It was a new framework offering international banking standards that replaced and added to the Basel I accord. Its focus is determining the minimum capital requirement a bank should hold in its reserves to guard itself against any financial loss. 

Its regulations are designed to ensure that a bank can protect its solvency and perform stability in the long term. Solvency refers to a bank having a sufficient level of current assets that exceed the current liabilities and its ability to meet its fixed long-term expenses.  

Because when a bank's exposure to risk is high, the amount of capital needed to hold and avoid default is more significant. This can be achieved by setting requirements for managing capital and risk to guarantee that a bank has considerable money to operate. 

This new framework existed because of the deficiencies, discrepancies, and inadequacy of rules and regulations included in Basel I, as financial analysts and experts saw it. 

Although banks implementing Basel I had some positive outcomes, their actions were far from the set rules and regulations due to the simplicity of protocol. Nevertheless, it gave rapid rise to the pioneering financial products and services to be gotten around the most robust of its rules.

Thus, the thought of just setting Capital Ratios was not appropriate anymore. After all, there was a requirement for something robust to give insights into a bank's performance when assessing its potential exposure to different risks; like Basel, I ignored the aspect of managing risk. 

Timeline Updates of Basel II

Basel II has been updated and enhanced multiple times, and here is a brief illustration of the chronological updates among different years, starting from 2005 and ending in 2010.

  • In November of 2005, the BCBS issued a revised framework of Basel II providing extra guidelines in a document called: "The Application of Basel II to Trading Activities and the Treatment of Double Default Effects."
  • It was developed jointly with the International Organization of Securities Commissions- IOSCO by adjusting the specific treatments when calculating variables like credit risk. 
  • In May 2006, the committee released a press about the measurements and scales required for this framework that would be taken from the outcome of the "fifth Quantitative Impact Study” -QIS5 and QIS4.
  • In June of 2006, the committee issued a document, "Home-host information sharing for effective Basel II implementation," intending to set standards for the shared information between host and home countries as it was issued with the help of the Core Principles Liaison Group.
  • In July 2006, the Basel Committee issued a comprehensive document for this framework that includes other published papers for the readers' comfort. 
  • In July 2008, the committee issued two documents for public comment concerning risk exposure and calculating Value At Risk-VAR models, as it will accept these comments by October 2008. 

  • In January 2009, the committee issued a series of proposals to improve Basel II, including five different documents.
  • In July 2009, the committee issued a finalized package of measures to improve the three pillars and boost up the rules given in 1996 regarding training book capital. 
  • Finally, in December 2009, the Basel Committee announced consultative proposals and welcomed comments from the public by April 2010 to enhance the banking sector's resilience and capability, including three different papers. 

Basel II.5

Additionally, the Basel II accord was further developed and enhanced to Basel II.5, for which several discrepancies were found, especially after the financial crisis in 2007-2008. As a result, it was published in 2009. 

It concerns improving the framework in weak areas in terms of risk and increasing capital requirements, including trading instruments with high credit risk.  

The reason for this enhancement is that during the chaotic period of the financial crisis of 2007-2008, the committee and regulators started to be aware of the immense risk exposure for each country and the financial world. 

They saw the need for a more strengthened and comprehensive version of Basel II and its protocols. In addition, they were focused on addressing the concerns regarding the capital requirement and the associated most risky products in terms of credit risk.

It provides more robust regulations regarding the increased amount of capital a bank should hold against the market risk exposure due to its trading activities.

From the paper shared by the committee, the enhancements included the use of Incremental Risk Charge-IRC to capture default risk and credit margin, and it obliged new charges for securitization or re-securitization. 

Also, using the Stressed Value At Risk-SVAR model instead of VAR for measuring capital requirement and the Comprehensive Risk Measure-CRM to assess the exposure of default and migration risks in measuring what is called: correlated trading activities. 

These enhancements were intended for the three pillars and only for the measures that already existed in the guidelines that were established before.  

Objective and Requirements

It aimed to reduce inequality among international banks by providing consistent regulations and rules. In addition, it seeks to reduce the scope for regulatory arbitrage by aligning the economic and regulatory capital. 

The final version's objectives are :

  • To enhance the disclosure requirements,
  • Ensure that credit, operational, and
  • market risk is measured using formal techniques and data and allocates more risk-sensitive capital.

The aim is to offer banks guidelines by maintaining specific capital ratios to risk-weighted assets, and the minimum required capital is a crucial element under this framework. 

It helps to ensure and provide other advanced risk management approaches to maintain the capital requirement at its stated level by encouraging and bringing awareness to supervisory agencies and financial institutions to implement these rules and enhance their performance.

It is through assuring that the amount of capital reflects the level of risk to avoid bankruptcy and assessing each risk properly to understand better the degree of the riskier type to a bank and take corrective action.

The focal point is to restrain any bank from unauthorized activities and transactions beyond the stated scope of the guidelines. 


As bank disclosure would be enhanced and reflect more transparency, that implies strengthening market discipline. Moreover, it helps investors and interested financial information users to benefit from published reports.

The requirements guidelines are based on Basel I to calculate the minimum capital ratios and confirm that banks must maintain a capital reserve equal to at least 8% of risk-weighted assets.

The Three Pillars

Its focus extends in terms of managing and assessing risk through implementing the three pillars approach for evaluating capital. 

1. Capital Requirements: 

A bank is required to maintain an acceptable capital amount. It aims to improve the regulations in Basel I by adding operational and market risks to the credit risk connected with Risk Weighted Assets-RWA.

Two approaches were included in calculating the capital based on the credit risk concerning each asset’s type and characteristics. 

  •  A standardized approach - uses external credit ratings to evaluate the debtor's creditworthiness. It is a good approach to be followed by a bank that has a smaller number of activities.    
  •  The internal Rating based -IRB approach refers to the inner bank's evaluation process for the creditworthiness of a debtor. It is suitable for a bank with a more significant and complicated number of activities. 

It has two approaches: the foundation and the advanced. The main difference between both is that the first follows standardized techniques in calculating the risk, while the latter is usually based on each bank's treatments for calculating it.

Three approaches were implemented in calculating the capital based on the operational risk.

  • The basic Indicator approach - BIA refers to the amount of capital a bank must hold equal to the average over the previous three years of a fixed percentage, usually by alpha, of positive annual gross. 
  • Internal Measurement Approach - It’s an evolved measurement of Advanced Measurement Approach-AMA- has a complicated approach that requires a bank to calculate the capital charge by using internal models of internal risk variables.  
  •  Standardized Approach - TSA is an intermediate between BIA and AMA, requiring a bank to divide the total Gross Income-GI into eight business lines.  

The capital is calculated as a sum of the products of GI of each business line with its respective coefficient, indicated by beta. 

2. Supervisory Review 

A bank must evaluate its solvency concerning its profile's risk as an additional guideline for banks in calculating capital requirements.

It helps banks and regulatory bodies in the ability to foresee the adequate level of capital before it decreases, so it acts as a response to what is drafted in the first pillar. 

It gives a view of other financial risks, including systematic, reputational, legal, and strategic risks. Finally, it urges a bank to develop and use enhanced risk management techniques to control and oversee its risks. 

It has four principles; each has its specific focus and denotes the party's responsibilities. For example, principle one is specified for bank responsibility, and Principles 2-4 are intended for supervisory responsibilities. 

  • Principle 1- necessitates a bank to have a process to evaluate capital adequacy for its risk characteristics.  
    It encourages using the Internal Capital Adequacy Assessment Process- ICAAP as an integrated approach for risk and capital management, including the level of risk and appetite for it, to assure that the quality of capital is adequate.
  • Principle 2- obliges supervisors to review a bank's internal capital adequacy assessments and maintain regular follow-up. 
  • Principle 3- obliges supervisors to indicate their opinion and expectations for a bank to operate regularly above the minimum capital ratios.
  • Principle 4- urges supervisors to intervene in a bank at an earlier stage to prevent any failure and exposure of capital going below the minimum requirement, ensuring its risk profile.

3. Market Disciplines 

A bank requires a different enhanced level of disclosure regarding its risk, risk management, capital structure, capital adequacy, and general management practices.

By obliging a bank to disclose the relevant information about the market, the aim is to ensure the quality of published information for its users to make decisions based on accurate and reliable data and to ensure that there is a market discipline to the rules. 

It should reflect senior and top management practices. These disclosures should be done at least twice a year except for qualitative parts, including a summary of risk management and its objectives that can be done annually.  

It complements the previous two pillars by ensuring minimum capital requirements and the supervisory review.

Advantages and Disadvantages

On the one hand, Basel II came with expanded and clarified regulations originally founded in Basel I. But on the other hand, it helped regulators know and address some of the new financial products and innovations established since Basel I.

It helped reduce the discrepancy between the regulatory and economic capital, allowing a bank to depend on its risk methodology.

Also, as it has taken a broader scope for assessing the different types of risks, it gives a bank the ability to foresee and control the risk exposure by any of these types.  

Economic capital refers to a bank's amount of capital estimation needed to maintain its solvency for any risk exposure. In contrast, economic regulation refers to the capital estimated by regulators necessary for a bank.

On the other hand, Basel II was not that successful because of its inability to manage the banking sector, especially during the Great Financial Crisis and Subprime Mortgage Meltdown

Thus, it was rigorously criticized and not well-welcomed by many analysts because its associated 2.5 enhancements were insufficient to stand out and prevent failures. 

One reason to illustrate such failure is that the underlying requirements for capital adequacy and assessment of risks were poorly structured.

It primarily resulted in a misestimation of risks that a bank and banking sector was involved in its daily operations, leaving the financial system unleveraged and undercapitalized.

It left the banking sector with an immense amount of leverage with inadequate liquidity cushions that would protect it from such cruises, as well as poor governance practices for risk management, which led to improper pricing of credit and liquidity risks.

Also, it was criticized that it helped banks hide a bank's risky exposures on their balance sheet instead of disclosing them.

Researched and Authored by Noor H | LinkedIn 

Reviewed & edited by Aditya Salunke and Ankit Sinha I LinkedIn | LinkedIn

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