Loading the player...

What is 'Basel II'

Basel II is a set of international banking regulations put forth by the Basel Committee on Bank Supervision, which leveled the international regulation field with uniform rules and guidelines. Basel II expanded rules for minimum capital requirements established under Basel I, the first international regulatory accord, and provided framework for regulatory review, as well as set disclosure requirements for assessment of capital adequacy of banks. The main difference between Basel II and Basel I is that Basel II incorporates credit risk of assets held by financial institutions to determine regulatory capital ratios.

BREAKING DOWN 'Basel II'

Basel II is a second international banking regulatory accord that is based on three main pillars: minimal capital requirements, regulatory supervision and market discipline. Minimal capital requirements play the most important role in Basel II and obligate banks to maintain minimum capital ratios of regulatory capital over risk-weighted assets. Because banking regulations significantly varied among countries before the introduction of Basel accords, a unified framework of Basel I and, subsequently, Basel II helped countries alleviate anxiety over regulatory competitiveness and drastically different national capital requirements for banks.

Minimum Capital Requirements

Basel II provides guidelines for calculation of minimum regulatory capital ratios and confirms the definition of regulatory capital and 8% minimum coefficient for regulatory capital over risk-weighted assets. Basel II divides the eligible regulatory capital of a bank into three tiers. The higher the tier, the less subordinated securities a bank is allowed to include in it. Each tier must be of certain minimum percentage of the total regulatory capital and is used as a numerator in the calculation of regulatory capital ratios.

Tier 1 capital is the most strict definition of regulatory capital that is subordinate to all other capital instruments, and includes shareholders' equity, disclosed reserves, retained earnings and certain innovative capital instruments. Tier 2 is Tier 1 instruments plus various other bank reserves, hybrid instruments, and medium- and long-term subordinated loans. Tier 3 consists of Tier 2 plus short-term subordinated loans.

Another important part in Basel II is refining the definition of risk-weighted assets, which are used as a denominator in regulatory capital ratios, and are calculated by using the sum of assets that are multiplied by respective risk weights for each asset type. The riskier the asset, the higher its weight. The notion of risk-weighted assets is intended to punish banks for holding risky assets, which significantly increases risk-weighted assets and lowers regulatory capital ratios. The main innovation of Basel II in comparison to Basel I is that it takes into account the credit rating of assets in determining risk weights. The higher the credit rating, the lower risk weight.

Regulatory Supervision and Market Discipline

Regulatory supervision is the second pillar of Basel II that provides the framework for national regulatory bodies to deal with various types of risks, including systemic risk, liquidity risk and legal risks. The market discipline pillar provides various disclosure requirements for banks' risk exposures, risk assessment processes and capital adequacy, which are helpful for users of financial statements.

RELATED TERMS
  1. Basel Accord

    The Basel Accord is a set of agreements on banking regulations, ...
  2. Tier 1 Capital

    Tier 1 capital is a term used to describe the capital adequacy ...
  3. Basel I

    Basel I is a set of bank regulations laid out by the BCBS which ...
  4. Cooke Ratio

    The Cooke Ratio is a capital adequacy ratio that expresses the ...
  5. Tier 2 Capital

    Tier 2 capital is supplementary capital including items like ...
  6. Common Equity Tier 1 (CET1)

    Common Equity Tier 1 (CET1) is a component of Tier 1 capital ...
Related Articles
  1. Personal Finance

    How Basel 1 Affected Banks

    The 1988 Basel 1 agreement sought to decrease bankruptcies among major international banks.
  2. Insights

    Banks Could Unlock Over $200 Billion for Investors

    Passage of a recently introduced Republican bill could free up $200 billion in bank capital.
  3. Insights

    The New Global Banking Regulations To Avert Future Crisis

    These are the types of policies that are being developed to minimize the risks posed to the global financial system by banks which are too big to fail.
  4. Personal Finance

    What Is the Bank for International Settlements?

    Headquartered in Basel, Switzerland, Founded in the 1930's the Bank for International Settlements (BIS), is a bank for central banks.
  5. Managing Wealth

    An Investor's Guide To Bank Stress-Testing

    Just how are bank stress tests performed and what is the logic behind them? And is a stress test useful for evaluating a bank's stock?
  6. Financial Advisor

    Why Banks Don't Need Your Money to Make Loans

    Contrary to the story told in most economics textbooks, banks don't need your money to make loans, but they do want it to make those loans more profitable.
  7. Investing

    Understanding Bank of America's Capital Structure (BAC)

    For banks, especially large banks such as Bank of America, capital structure has to both meet funding needs and satisfy the regulator's capital requirements.
  8. Investing

    The Biggest Risks of Investing in Bank of America Stock

    Learn the largest risks to owning Bank of America stock. Discover its outlook through fundamental analysis and external risks to the company and its industry.
  9. Managing Wealth

    The International Money Market

    Banks, corporations, traders and speculators all use the IMM to borrow, lend, trade, profit, finance, speculate and hedge risks.
RELATED FAQS
  1. How are risk weighted assets used to calculate the solvency ratio in regulatory capital ...

    Learn how risk-weighted assets are used to determine solvency ratio requirements under the Basel III accord, and see how ... Read Answer >>
  2. What is the minimum capital adequacy ratio that must be attained under Basel III?

    Find out more about the capital adequacy ratio, or CAR, and the minimum capital adequacy ratio that banks must attain under ... Read Answer >>
  3. How can I calculate the tier 1 capital ratio?

    Learn about the tier 1 capital ratio, what the ratio indicates about a firm's capital adequacy and how to calculate a firm's ... Read Answer >>
  4. What Is the Difference between Tier 1 Capital and Tier 2 Capital?

    Tier 1 capital is a bank's core capital, whereas tier 2 capital is a bank's supplementary capital. Read Answer >>
  5. What is the formula for calculating the capital-to-risk-weighted assets ratio for ...

    Find out more about the capital-to-risk-weighted assets ratio, what the ratio measures, and the formula used to calculate ... Read Answer >>
Trading Center