Basel II was an international accord on bank capital requirements drafted by the Basel Committee to supersede the earlier Basel I accord. Implementation commenced in the mid 2000s and was almost complete at the time of the 2008 financial crisis, which revealed Basel II to be woefully inadequate. The Basel Committee rushed adoption of stopgap measures, commonly referred to as Basel 2.5. Longer-term, a new Basel III accord replaced Basel II and Basel 2.5.
Work on Basel II commenced in the late 1990s, by which time shortcomings in how the original Basel I accord treated credit risk were becoming evident. Basel I’s simple system of risk weightings provided an incentive for banks to hold the 0% risk-weighted debt of G-10 governments (a fact viewed with some cynicism, since those same governments were largely responsible for the original accord). However, such debt tended to be unprofitable. Far more profitable for banks was corporate debt, which was weighted 100%. With all corporate debt being weighted equally, it made sense for banks to hold the most risky corporate debt. Higher quality corporate debt incurred exactly the same capital charges but was less profitable.
During this period, markets for credit derivatives and securitizations grew explosively. It was an open secret that banks were employing these to take advantage of shortcomings in the 1988 Accord’s system of risk weights. Such practices are called regulatory arbitrage.
Another issue during this period was operational risk. Operational risk poses significant risk for banks. It includes a variety of contingencies including fraud, which is routinely a factor in bank failures. Neither the original Basel I accord nor the 1996 amendment to Basel I required capital for operational risk.
In January 1999, the Basel Committee proposed a new capital accord. There followed an extensive consultative period, with the committee releasing additional proposals for consultation in January 2001 and April 2003. It also conducting three quantitative impact studies to assess those proposals. The finalized Basel II Accord was released in June 2004.
Originally, it was planned that Basel II would be based on three pillars:
- minimum capital requirements,
- supervisory review, and
- market discipline.
However, the final accord relied primarily on minimal capital requirements with only brief, largely aspirational specifications of the second and third pillars.
Generally, Basel II retained the definition of bank capital and the market risk provisions of the 1996 amendment. It largely replaced the old treatment of credit risk, and it required capital for operational risk. With some juggling, the basic capital requirement for banks might be expressed as:
As with market risk under the 1996 amendment, banks had options as to how they valued their credit risk and market risk. For credit risk, they could choose from among:
- a standardized approach,
- a foundation internal rating-based (IRB) approach, and
- an advanced IRB approach.
For operational risk, their choices were:
- a basic indicator approach
- a standardized approach, and
- an internal measurement approach.
Basel II was supposed to become effective in December 2006. It was not as widely implemented as the earlier Accord. Basel II largely achieved European regulators’ objectives of addressing shortcomings in the Basel I treatment of credit risk, incorporating operational risk and harmonizing capital requirements for banks and securities firms. Europe applied Basel II to all their banks with CAD III. US regulators were less enthusiastic. While they shared the goal of addressing shortcomings in the original accord’s treatment of credit risk, they felt that existing bank supervision in the United States already addressed operational risk. Also, harmonization was never a priority for US regulators. They perceived Basel II as primarily relevant for internationally active banks. They applied it to just ten of the largest US banks. Another ten had the option to opt-in. Other US banks remained subject to existing US regulations, including those adopted under the Basel I.