Basel II: Three Pillars

Definition

What is Basel II: Three Pillars?

While Basel I improved the way capital requirements were determined for banks worldwide, it had some major limitations. To improve the framework, Basel II was launched in 2004 and implemented in 2007, correcting a number of deficiencies in Basel I. The rules applied to “internationally active” banks and thus many small regional banks in the United States were not subject to the requirements but fell under Basel IA, similar to Basel I, instead. All European banks are regulated under Basel II. There are three pillars under Basel II: (1) minimum capital requirements, (2) supervisory review, and (3) market discipline.

Example of Basel II: Three Pillars:

Pillar 1: Minimum Capital Requirements

The key element of Basel II regarding capital requirements is to consider the credit ratings of counterparties. Capital charges for market risk remained unchanged from the 1996 Amendment. Basel II added capital charges for operational risk. Banks must hold total capital equal to 8% of RWA under Basel II, as under Basel I. Total capital under Basel II is calculated as:
total capital = 0.08 × (credit risk RWA + market risk RWA + operational risk RWA)

Pillar 2: Supervisory Review

Basel II is an international standard governing internationally active banks across the world. A primary goal of Basel II is to achieve overall consistency in the application of capital requirements. However, Pillar 2 allows regulators from different countries some discretion in how they apply the rules. This allows regulatory authorities to consider local conditions when implementing rules. Supervisors must also encourage banks to develop better risk management functions and must evaluate bank risks that are outside the scope of Pillar 1, working with banks to identify and manage all types of risk. Banks were also required to have internal capital adequacy and assessment processes (ICAAP) that take their risk profiles into account.

Pillar 3: Market Discipline

The goal of Pillar 3 is to increase transparency. Banks are required to disclose more information about the risks they take and the capital allocated to these risks. Information about other bank risks.

Why is Basel II: Three pillars important?

The BASEL norms have three aims: Make the banking sector strong enough to withstand economic and financial stress; reduce risk in the system and improve transparency in banks.