Basel II is an international banking accord that regulates how much capital banks must set aside to cover their assets. It was introduced in 2004 and revised in 2006 and 2007. Basel II requires banks to use more sophisticated methods for calculating their risks, which in turn requires them to hold more capital against those risks. The goal of Basel II is to ensure that banks have enough capital to absorb losses, without requiring a taxpayer-funded bailout.
Basel II works by setting minimum standards for the amount of capital that banks must hold against certain assets. These standards are based on the riskiness of the asset, as well as the likelihood that it will lose value. For example, an asset that is considered to be very risky, such as a subprime mortgage, will require a higher level of capital than a less risky asset, such as a government bond.
The Basel II accord is divided into three “pillars”:
Pillar 1: Minimum Capital Requirements
This pillar sets out the minimum amount of capital that banks must hold against certain types of risk. The most important risks covered by Pillar 1 are credit risk and market risk.
Pillar 2: Supervisory Review
This pillar requires banks to periodically assess their overall risk profile and to hold additional capital if they are deemed to be at higher risk.
Pillar 3: Market Discipline
This pillar is designed to enhance market discipline by requiring banks to disclose information about their risks and capital levels. This information helps investors and regulators to better understand the risks associated with a particular bank, and to make informed decisions about whether or not to invest in that bank.
Basel II has been generally successful in achieving its goals. However, some critics have argued that it does not do enough to address the problem of “too big to fail” banks. In addition, Basel II has been blamed for exacerbating the global financial crisis of 2007-2008 by encouraging banks to take on too much risk.