‘Basel II’ – the revision of the Basel Accords was published in June 2004 at first. It is a proposal on banking laws and regulations and the Basel Committee on Banking Supervision carried it out in 2007,. It is trying to amend the crude risk buckets and differentiate risks in more detail Under Basel II. For instance, a loan to a large and creditworthy company is typically less risky than a loan to a local and small firm.
This can help banks keep the level of capital requirements and encourage banks to use the more advanced risk-sensitive approaches. Basel II is believed by its supporters to be an international standard that could help protect the soundness and stability of the international financial system and avoid problems that may cause banks to collapse. With most of the other elements of Basel I unchanged, Basel II changes the constituents of Risk Weighted Assets, which is the denominator of the CAR. The definition of core and supplementary capital and the 8% minimum CAR requirement are unchanged under Basel II.
Basel II is composed of a set of supervisory standards to enhance risk management practices and uses a “three pillars” concept:
Pillar 1: deals with maintenance of minimum requirements for credit, market risk and operational risk. Pillar I enables banks to highly differentiate risk factors and their magnitude without increasing the overall capital burden, or even a reduction in it. If the bank’s own internal model or approach indicates that they have highly risky, loss-prone loans that produce high internal capital charges, their risk-based capital charges should also be high. Likewise, lower risk loans should have lower risk-based capital charges.
Pillar 2, which offers guidance on the supervisory review. According to Basel accords, banks are suggested to develop an internal capital assessment process and set objectives for capital to accord with the bank’s risk features. In addition, Supervisory authority has the responsibility for evaluating how well banks are assessing their capital adequacy. Supervisory Review Process allows banks to review the risk management system and also offers a framework for addressing legal risk, concentration risk, pension risk, reputational risk, strategic risk, liquidity risk, and systemic risk.
Pillar 3: market discipline. Under Basel II, banks are requested to publicly disclose pivotal detail on their risk exposures and capitalization that will help the market participants evaluate the capital adequacy of an bank. This can be regarded as a means to improve market discipline. It is an indirect method, that presumes adequate competition within the banking industry and must be in line with how the way the senior management evaluate and manage the risks of the banks.
In contrast to Basel I, the scope of application is much more extensive. The Basel I only focused on parts of one of these pillars. For instance: concerning the first Basel II pillar, there was only credit risk, which was addressed in a simple way. Besides, operational risk and market risk were not included at all. In addition, Basel II is trying to combine regulatory and economic capital more closely to lower regulatory arbitrage.