Content of Basel II Less comprehensive and over-simplified capital adequacy framework in Basel I result a change in 2004 where Basel II was adopted. Basel II is merely a voluntary agreement between the banking authorities of the major developed countries which is not binding until the country ratifies it. Basel II expands beyond its predecessor by establishing the so-called three pillars which enshrine the key principles of the new regime.
Three Pillars of Basel II Pillar I associates with maintenance of three tiered regulatory capital calculated for the banks’ actual underlying risk: credit risk, operational risk and market risk. First of all, credit risk is the risk of loss where borrowers default at payment. Banks have two options in determine credit risk component: to be assessed by external rating agencies or supervisors (Standardised Approach) or rely on the bank’s own bespoke measures of the degree of risk inherent in various businesses (Internal Ratings-Based Approach). Operational risk is referred to the risk of loss resulting from failure or inadequate external and internal events. Banks are encouraged to use more refined and complex practice for operational risk in order to increase risk sensitivity. There are three methods available in this spectrum: Basic Indicator Approach, Standardised Approach and Advanced Measurement Approaches. Last but not least, market risk is the risk of losses in on and off-balance-sheet position arising from movements in market prices. The capital requirements for market risk are applied on a global