Basel II

Basel II is a set of international banking regulations released in 2004 by Basel Committee on Banking Supervision (BCBS) to expand the rules for minimum capital requirements established under Basel I. Basel II had three main pillars which are minimum capital requirements, regulatory supervision, and market discipline.

Pillar I — Building on Basel I, the minimum capital reserve ratio of 8%, Basel II provided guidelines for calculation of regulatory capital ratios. Basel II divided the eligible regulatory capital of a bank into three tiers with higher tier being more secure and liquid.

Tier 1 capital represents the bank’s core capital and is composed of common stock, as well as disclosed reserves and certain other assets. At least 4% of the bank’s capital reserve must be in the form of Tier 1 assets. Tier 2 is considered supplementary capital and consists of items such as revaluation reserves, hybrid instruments, and medium-term and long-term subordinated loans. Tier3 consists of lower-quality unsecured, subordinated debt.

The definition of risk-weighted assets was further refined in Basel II. To discourage banks taking on excessive amounts of risk in terms of assets held, credit rating of assets was accounted in determining their risk weights.

Pillar II — The second pillar provides framework for national regulatory bodies to deal with systemic risk, liquidity risk, and legal risk.

Pillar III — Market discipline introduces various disclosure requirements for banks’ risk exposures, assessment processes, and capital adequacy. It is intended to provide transparency into the soundness of business practices.

Basel II refined and expanded the regulations and helped address some of the new financial products. Though Basel II discouraged banks taking on excessive credit risk, it failed to correctly estimate the risks during the subprime mortgage meltdown and Great Recession of 2008.