Basel II

Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision.

The final version of Basel II aims to ensure that capital allocation is more risk sensitive; separate operational risk from credit risk, quantifying both; align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage. 

Basel II uses a three pillars concept: minimum capital requirements, supervisory review and market discipline, to promote greater stability in the financial system.

• 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.
• The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, strategic risk, reputation risk, liquidity risk and legal risk, which the accord combines under the title of residual risk.
• The third pillar greatly increases the disclosures that the bank must make. This is designed to allow the market to have a better picture of the overall risk position of the bank and to allow the counterparties of the bank to price and deal appropriately.