Basel II

Basel II is the second of the Basel Accords, (now extended and effectively superseded by Basel III), which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. Basel II was initially published in June 2004.

Three-Pillars of Basel-II
minimum capital requirements, supervisory review process market discipline Its three-pillar approach offers a more comprehensive framework for banking regulation and supervision, while the revision of minimum capital requirements allows for both a menu of choices and a migration to more risk-sensitive methodologies.

Pillar 1 (Minimum Capital Requirements)

The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk, and market risk.

Under Pillar 1, regulators and banks may choose between a Standardized Approach (SA), which constitutes a revision of Basel I, and an entirely new internal ratings-based approach (IRB), whose two methodologies (Foundation and Advanced) are intended for banks with more sophisticated risk management.

 The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach, Foundation IRB and Advanced IRB. IRB stands for "Internal Rating-Based Approach". For operational risk, there are three different approaches - basic indicator approach or BIA, standardized approach or STA, and the internal measurement approach (an advanced form of which is the advanced measurement approach or AMA). For market risk the preferred approach is VaR (value at risk).

 Deals with the regulatory response to the first pillar, Gives regulators much improved 'tools' over those available to them under Basel I. Provides a framework for dealing with all the other risks a bank may face, such as
systemic risk, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk and legal risk, which the accord combines under the title of residual risk.

The Second Pillar (Supervisory Review Process)

 Gives banks a power to review their risk management system. Internal Capital Adequacy Assessment Process (ICAAP) is the result of Pillar II of Basel II accords.

Pillar 3 (Market Discipline)

Complements the minimum capital requirements and supervisory review process by developing a set of disclosure requirements which will allow the market participants to gauge the capital adequacy of an institution.

Objectives
to create an international standard for banking regulators to control how much capital, banks need to put aside to guard against the types of financial and operational risks banks (and the whole economy) face. to maintain sufficient consistency of regulations so that this does not become a source of competitive inequality amongst internationally active banks. To ensure that capital allocation is more risk sensitive;

 to enhance disclosure requirements which will allow market participants to assess the capital adequacy of an institution; to ensure that credit risk, operational risk and market risk are quantified based on data and formal techniques; to attempt to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.