Friday, May 9, 2008

A quick overview of Basel II

This summary was written to provide a concise overview of Basel II for anyone researching the subject. If it is of use to you e-mail and comments are appreciated.

What is Basel II?

By Ted Chan and Victoria Slingerland

Basel II is a set of standards and best practices recommended by bank supervisors and central bankers from Basel Committee on Banking Supervision. The accords, named after the city in Switzerland where the committee meets sets the adequacy standards for a bank’s capital, thereby placing restrictions on the types of transactions and required operational standards in place. Basel II is an updated version of the original accord from 1988. The Basel Accords essentially are risk management guidelines for the banking industry established to enhance accountability and limit the amount of risk taken on by banks. Overall, Basel II enhances the reliability of the bank by helping to ensure it will not go out of business due to poor risk management. (Chaudhary et al., 2005, Wikipedia)

Basel I primarily focused on market and credit risk. Basel II differs in that it enhances the broadens the risks that banks need to monitor into a model that is more or less, requires enterprise risk management for a banking institution, as it broadens out from market and credit risk into operational risk. Overall, a much stronger framework is provided for regulators to monitor this, including a requirement far more detailed disclosures. Many describe the Basel II approach as being based on three pillars. The first is to limit market, credit and operational risk as related to the bank’s capital. The second ensures that they employ improved risk management practices and do not allow capital to be used as a substitute for inadequate risk management. The third pillar provides the regulatory tools for governments and central banks to monitor the first two pillars. These consist of required disclosures related to capital, balance sheet and risks. (Chaudhary et al., 2005)

The Basel Accords by themselves have little clout. The accords themselves set standards for regulations to be implemented by countries and regulatory zones. The standards can be adopted into banking law and are enforced to varying degrees in various locales. However, non-compliance by a regulatory locale implies that doing business within the financial system and capital markets in the region is riskier. The wealthier members of the G-10 (the 13 leading banking nations) will likely adopt them stringently. In other countries, with varying degrees of capital to invest into the require improvement and governance, the standards will vary.

Many banks have made or will require substantial investments in technology and personnel in order to meet Basel guidelines for risk measurement and new reporting standards to meet the end of 2006 deadlines that have been set. Some of the more complex models requiring more advanced approaches will need to be in place by the end of 2007. Both are fairly tight timeframes given the complexity of the accords. (Bank for International Settlements, 2004)


Bibliography:

“Basel II norms: Strength from three pillars”, by Dinesh Chaudhary, Paramdeep Singh and Pawan Prabhat; Business Line, February 13, 2005.

“Consensus achieived on Basel II proposals”, Bank for International Settlements website, May 11, 2004

Federal Reserve Online Basel II Website: http://www.federalreserve.gov/generalinfo/basel2/default.htm

Wikipedia Basel I entry: http://en.wikipedia.org/wiki/Basel_I

Wikipedia Basel II entry: http://en.wikipedia.org/wiki/Basel_II

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