Basel II Accord: 3 Pillar Framework
Basel II is the second of the Basel Accords, which are banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II, which was initially published in June 2004, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face.
Unlike Basel I, where focus was mainly on credit risk, Basel II creates standards and regulations on how much capital banks must have put aside. Banks need store capital to reduce the risks associated with investing and lending practices. Basel II is built on a three-pillar system.
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. Minimum capital requirements are:
Tier 1 capital ratio - 4%
Core Tier 1 capital ratio - 2%
The difference between the total capital requirement of 8.0% and the Tier 1 requirement can be met with Tier 2 capital.
Pillar 2: Supervisory Review Process
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, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk and legal risk, which the accord combines under the title of residual risk. It gives banks a power to review their risk management system.
Pillar 3: Disclosure & Market Discipline
The aim of pillar 3 is to allow market discipline to operate by requiring lenders to publicly provide details of their risk management activities, risk rating processes and risk distributions. It sets out the public disclosures that banks must make that lend greater insight into the adequacy of their capitalisation.