The Basel Accord (Basel II)

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  1. The Origins of Basel II

The Basel Accord, also known as Basel I is a very basic model used for calculating a bank’s capital requirement given the types of risks faced and the variations in the riskiness of the bank’s assets (Hunt & Terry, 2008). Basel was an attempt to reduce the number of bank failures by tying a bank’s Capital Adequacy Ratio to the risk of the loans it makes (Nath, 2006). Basel I refers to round deliberations by central bankers from around the world, and in the year 1988, a set of minimal capital requirements for banks were published by the Basel Committee (BCBS) in Basel, Switzerland. The 1998 Basel Accord was first enforced by law in the Group of Ten (G-10) countries in 1992 (Cornford, 2004).

The Basel Accord was widely accepted and in response to this, BCBS came up with the initiation of work on Basel II As part of the regulatory consensus on the direction of work on Basel II, the BCBS decided to pick up the major banks’ gauntlet and to include in the new agreement rules which would challenge banks to upgrade their rating systems to the point at which they could be accepted as an integral part of setting the weights for credit risk (Cornford, 2004). In the year 1998, a more comprehensive set of guidelines, known as  was proposed, which uses much more sophisticated risk classifications (Nath, 2006). Therefore, Basel I is now widely viewed as outmoded, while the Basel II is currently still in the process of implementation by several countries.


2.0 The Original Intentions of Basel II

According to Cornford (2004), the initial purpose of Basel II, which was published in June 2004, was to create an international standard that banking regulators can use when creating regulations on how much capital banks need to put aside to guard against the types of financial and operational risks banks face. Advocates of Basel II believe that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse (Cornford, 2004). In practice, Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability (Basel Committee on Bank Supervision, 2003).

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        However, according to Nath (2006), in the latest and final version of Basel II, the intentions are to ensure that the capital allocation is more risk sensitive. Besides, it also aims at separating operational risks from credit risk, but at the same time quantifying both. The Basel II is also attempting to align economic and regulatory capital more closely in order to reduce the scope for regulatory arbitrage.

The difference between Basel I and Basel II is that Basel I only involved parts from each of these pillars. For example, as seen in the figure above, ...

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