# Basel II

The term Basel II refers to a set of capital requirements that were proposed by the Basel Committee on Banking Supervision between Basel I and Basel III . The original version of the framework agreement was published in June 2004. According to the EU directives Directive 2006/48 / EC and Directive 2006/49 / EC, the rules must be applied in the member states of the European Union for all credit institutions and financial services institutions (for short: institutions). While implementation in Switzerland is managed by FINMA , in Germany it is implemented through the Banking Act , the Solvency Ordinance and the Minimum Requirements for Risk Management (MaRisk).

Although originally suggested and initiated by the USA, Basel II was not implemented in the United States with the same emphasis as in Europe. The US government initially intended to introduce the regulations gradually from 2008 onwards. In the meantime, a postponement has also been announced due to the current financial situation (see also implementation below). Since 2013, Basel III has been gradually replacing the previous rules called Basel II.

## Motifs

The three pillars of Basel II

As with Basel I , the objectives are to ensure that institutions have adequate capital adequacy and to create uniform competitive conditions for both lending and loan trading . The main objective of the changes made in Basel II compared with Basel I is to align the regulatory capital requirements required by the state more closely with the actual risk and thus to approximate the capital requirements determined internally by institutions. This is intended to reduce the so-called regulatory arbitrage. If all the regulations of Basel II are consistently implemented, the granting of risky and possibly “non-performing loans” on a large scale is relatively unlikely.

The criticism of Basel I is based on three points:

1. Misallocation of regulatory capital (taken into account in Pillar 1 of Basel II). Since, under Basel I, the equity backing for loans to a customer segment (e.g. corporate customers) was independent of the borrower's creditworthiness, there was an incentive to grant loans to customers with a poor creditworthiness because they could enforce higher interest rates, and thus a larger one Profit could be achieved on the underlying capital.
2. Inclusion of further risks (taken into account in Pillar 1 of Basel II). Under Basel I, only market price risks and credit risks had to be backed with equity. Experience over the past few years shows, however, that a large number of banking crises were triggered not by these risks but by operational risks , for example the bankruptcy of the British bank Barings due to incorrect controls of the activities of the trader Nick Leeson in Singapore. It is also unofficially known that - in addition to the factual relevance of operational risks - the expectation of lower capital requirements for credit risks led to the need to back operational risks.
3. Lack of conformity with regulatory review and publication of risk information (taken into account in Pillar 2 and 3 of Basel II). So far there have been no international standards for regulatory audits in various countries. There were also no uniform standards regulating the company's own publication of risk-relevant information.

## content

Basel II consists of three mutually complementary pillars:

1. Minimum Capital Requirements
2. Banking regulatory review process
3. Extended Disclosure

### Pillar 1: minimum capital requirements

The aim of the first pillar is now to take into account a bank's risks more precisely and more appropriately when assessing its capital adequacy. To calculate the total capital to be backed, the following applies under Basel II:

${\ displaystyle {\ text {Regulatory capital}} \ geq 8 \, \% \ times \ left [{\ text {Total risk-weighted assets}} + 12 {,} 5 \ times \ left (\ mathrm {market risk} + { \ text {Operational risk}} \ right) \ right]}$

#### Credit default risks

The determination of the risk-weighted assets (and their backing with own funds) is carried out in accordance with the minimum capital requirements for credit risks . The credit risk is determined using an internal or external rating . The external rating ( standard approach ) is carried out by a rating agency ( above all Standard & Poor’s , Moody’s and Fitch Ratings ). However, there is also the option of leaving credit claims unrated. With internal ratings, the bank assesses the risk itself ( IRB approaches : “internal rating based” - based on internal ratings). However, this requires acceptance and approval by the banking supervisory authority. The bank must be able to demonstrate that it has met certain methodological and disclosure requirements. There is a simplified procedure for private customers, the scoring . Furthermore, here there are provisions for receivables securitization (English asset securitization ).

The maxim of Basel II on the credit risk is that expected losses (English expected loss are) priced in risk premiums and go as risk provisions at the expense of existing shareholders' equity at concretely anticipated losses. In contrast, unexpected losses (English unexpected loss ) to be backed by capital. In the approaches based on internal procedures for risk measurement, a security level of 99.9% is specified by the supervisory authority and, in the standard approach, the calibration is also aimed for. At the time Basel II was created, this security level corresponded to a triple B rating (BBB). The banking supervisory authority opted for this confidence level because, in their opinion, no sustainable business model is conceivable that would get by with a lower level of security.

The more progressive and therefore more risk-sensitive the valuation method used by the bank (standard approach, basic IRB approach, advanced IRB approach), the greater the potential savings in capital backing: For example, additional types of collateral can be recognized to reduce risk. So that u. a. an incentive for banks to use the most advanced methods possible.

#### Market price risks

The market risk was in 1996 added to the original agreements. Little changes in these regulations. In Germany, for example, the market risk under the Solvency Regulation of 2007 consisted of the interest rate and share price risk in the trading book , the foreign currency risk , the commodity risk and other market price risks.

Market price risks in accordance with Basel II include unforeseen changes in the exchange rate, changes in interest rates and all other changes in capital market prices that have a negative impact on the expected result of the bank. Since it is only one of the many options for the bank to obtain liquid funds through money market transactions (theory of money market financing), the bank can dispense with proprietary and trading transactions in financial derivatives. However, it is not practicable for the bank to forego transformation services. The bank is therefore constantly exposed to price risks and has to quantify and control them after the price risks have been identified.

1. Quantification of price risks
• Determination of net exposures (only auxiliary construct)
• Sensitivity analyzes (only auxiliary construct)
• Value-at-risk approaches (concept for determining the amount of loss that will not be exceeded with a certain probability ( confidence level ) in a certain period (risk horizon))
2. Control of price risks
1. Avoidance
• Refraining from transformation services (not practicable)
• Avoiding proprietary / trading transactions with derivatives (possible)
2. reduction
• Risk limit systems: Fixing a target value through value-at-risk procedures in order to limit the overall risk of a bank
3. compensation
• Additional transaction, the value of which reacts to the same market price change, which has a negative impact on the position to be hedged, as precisely as possible in the opposite way, so that the loss in value is compensated for, for example through interest rate swaps
• Interest limitation contracts ( cap, floor, collar )

#### Operational Risks

The inclusion of operational risk is new . It represents the risk of direct or indirect losses as a result of inadequate or failing internal processes, employees and systems or as a result of events outside the bank. It is taken into account using the basic indicator approach , the standardized approach and the advanced measurement approach .

### Pillar 2: banking supervisory review process

Requirements for the banks

Pillar 2 places two requirements on banks:

• First, they need to have a process by which they can assess whether their capital adequacy is appropriate in relation to their risk profile. They also need to have a strategy in place to maintain their equity level. This strategy is called Internal Capital Adequacy Assessment Process briefly ICAAP and internal capital referred.
• Second, Pillar 2 requires the supervisory authority to subject all banks to an evaluation process. On the basis of this process, supervisory measures may be required.

The internal capital adequacy procedure comprises all procedures and measures of a bank that ensure the following points:

• Appropriate identification and measurement of risks.
• Appropriate provision of internal capital in relation to the risk profile.
• Application and further development of suitable risk management systems.

Pillar 2 is intended to ensure that all major risks that a bank takes are taken into account. This also applies to risks that are not recorded in Pillar 1 (e.g. interest rate risks in the banking book).

#### Supervision requirements

##### Ongoing regular review by the banking supervisory authority

The banking supervisory authority (in Germany: BaFin together with the Deutsche Bundesbank , in Switzerland: FINMA , in Austria: FMA together with the Oesterreichische Nationalbank ) assesses and monitors compliance with the methodology and disclosure requirements that are necessary for the bank to have internal ratings may use. See: special test .

##### Review of risk management and reporting

The supervisory review and evaluation process (SREP) requires the establishment of adequate risk management systems - such as management risk controlling (MRC) - at banks and investment firms and their monitoring by a supervisory authority.

The basis is the principle of double proportionality, which states that both the control instruments in a bank and the intensity of monitoring by the banking supervisory authority should be proportional to the risks taken by a bank. However, it is difficult to understand the real risks. Loan commitments that had not been used for a long time and had a term of less than one year were not considered credit and were therefore risk-free. The same still applies to the forward selling of assets.

### Pillar 3: Extended Disclosure / Market Discipline

The aim of the third pillar is to strengthen market discipline by increasing the disclosure of information as part of the banks' external accounting (e.g. in the annual financial statements, in quarterly reports or in management reports). The discipline follows z. B. from feared price reactions of the own share or risk premiums to be paid . The possible reactions from the disclosure are an incentive for the banks to pay attention to a reasonable equity and risk capital structure.

There are extensive disclosure requirements about:

#### Equity structure

1. Qualitative disclosure
• Summarized information on the terms and conditions of the most important characteristics of all equity instruments, especially for innovative, complex or hybrid equity instruments.
2. Quantitative disclosure
1. The amount of core capital, with the following to be disclosed separately:
• Paid-in share capital
• Reserves
• Minority interests in the equity of subsidiaries
• innovative core capital instruments
• other tier 1 capital instruments
• Insurance excess capital
• Regulatory calculation differences that are deducted from core capital and
• Other amounts that are deducted from Tier 1 capital, including goodwill and equity investments
2. Total amount of Tier 2 capital and Tier 3 funds
3. Further capital deduction options
4. Total amount of eligible own funds

#### Risks taken and their assessment

In order to enable other market participants to assess the credit institution's risk positions, the techniques that the bank uses to measure, monitor and control risks must be disclosed.

For this purpose, credit institutions must describe the internal goals and principles of risk management in each individual risk area (e.g. credit , market , operational risk , interest rate risk in the banking book and equity positions) . This includes:

• Strategies and processes
• Structure and organization of the relevant risk management function
• Type and scope of risk reports and / or risk measurement systems
• Principles of hedging and / or mitigation of risks as well as strategies and processes for monitoring the continued effectiveness of these safeguards / risk mitigation .

Effective disclosure is designed to ensure that market participants gain better insight into a bank's risk profile and adequacy of capital adequacy. In detail, it concerns the following aspects:

1. Qualitative disclosure
• An overall discussion of the bank's own approach to assessing the adequacy of the equity base for backing current and future business.
2. Quantitative disclosure
1. Capital requirements for credit risk:
• Portfolios according to the standard and simplified standardized approach , for each portfolio individually
• Portfolios in accordance with the IRB approaches , separately for each portfolio in accordance with the basic IRB approach and for each portfolio in accordance with the advanced IRB approach:
• Corporations (including specialty finance that does not meet relevant regulatory criteria), banks and sovereigns
• Mortgage lending
• Qualified Revolving Retail Receivables
• other retail claims
• Securitisations
2. Capital requirements for equity positions in the IRB approach:
• Participations according to the market approaches:
• Holdings according to the simple risk weight approach; and
• Investments in the banking book according to the internal model approach (for banks that use the IMA for investments in the banking book)
• Participations in accordance with PD / LGD approaches
3. Capital requirements for market risk:
• Standard approach
• Internal models approach - trading book
4. Capital requirements for operational risk:
5. Total and core capital ratio :
• of the consolidated group as a whole
• the major banking subsidiaries (individually or sub-consolidated depending on the application of the framework agreement).

## Effects

### QIS studies

In order to assess the impact of Basel II on German banks, the Deutsche Bundesbank carried out a series of impact studies ( QIS , Quantitative Impact Study ). The results of QIS4 are available. The fifth study ( QIS5 ) was carried out in spring 2006 .

According to this, the banks' capital requirements increase slightly in the standardized approach , while the capital requirements decrease slightly in the two IRB approaches . It is more interesting to look at the individual customer groups:

The capital requirements for mortgage loans are falling sharply. In the area of ​​corporate lending, particularly for small and medium-sized enterprises, relief can be seen. The burdens on loans to banks and in particular to governments are increasing sharply.

### General consequences

The general rule is that higher risks result in higher interest rates. If the bank has to back more equity in the event of a poor rating , its own funds costs also increase. These increased costs may be passed on to the borrower via higher (loan) interest rates. Conversely, a borrower with a good rating benefits from lower lending rates because the bank has to deposit less equity for the loan. However, there are no regulations on credit pricing in the Basel framework itself. In other words, whether the bank charges interest in line with its own funds costs depends on the banks' income and other considerations (competitive position, etc.).

According to Basel I , every loan had to be backed with a uniform 8% equity. Basically nothing has changed in this procedure with Basel II. However, depending on the rating of the business partner, the bank's outstanding receivables are now weighted with a percentage between 0% ( e.g. receivables from OECD countries) and 1250%. The resulting “risk-weighted assets” must each be backed with 8% equity. The statements made here relate to the standardized approach. The procedure in the IRB approaches is much more complex.

## criticism

• The regulations can turn out to be problematic for medium- sized companies, as they are typically short of equity. This means that a bad rating can be expected for them. In order to take this peculiarity of the German economy into account, an agreement was reached with the Basel Committee in which the capital adequacy requirement for small and medium-sized enterprises (SMEs) is significantly lower. From the banks' point of view, this makes SME loans an inexpensive group of borrowers that saves their own resources. At the same time, the same creditworthiness claims are applied as to the other companies (e.g. scoring procedure), so that access to the credit market is made more difficult for them.
• However, modern refinancing products such as securitization might offer a way out of this dilemma . This enables SMEs to certify their claims. The entrepreneur can use the liquidity thus freed up, for example in accordance with a loan. However, the small and medium-sized enterprises would be bound directly to the unpredictable international capital markets. This would threaten the existence of the farms.
• Banks are also able to remove an existing equity burden from a loan portfolio through securitization or forward selling of the same from the balance sheet and thus release equity. However, this would endanger the banks if the buyer of the receivables can no longer meet his obligations. This is not uncommon due to the unpredictable international capital markets.
• Basel II has an economic structure-preserving effect. Companies with the best rating, i.e. the best creditworthiness , receive the most favorable credit terms . Naturally, however, these companies are also the companies that require the least amount of credit.
• Basel II causes credit rationing, since credit applications are no longer related to individual cases but are assessed statistically. The relationship between the bank and the borrower becomes anonymous.
• Basel II puts small banks at a disadvantage, as they cannot build up portfolios that can be statistically evaluated and their individual valuation causes increased costs of equity.
• Basel II has a pro-cyclical effect on the economy, since, for example, increasing banks' credit default rates also lead to a higher capital requirement, which on the one hand leads to rising interest rates and on the other hand leads to fewer financing options for the banks.

### Regulations for small and medium-sized businesses

As part of the consultation process on Basel II, regulations were introduced to reduce the risk weight of small and medium-sized companies:

• Loans to traders and smaller companies are assigned to the IRB retail approach if the total loan exposure is less than EUR 1 million per borrower unit with a banking group. In this approach, a different risk weighting function is used, which leads to lower risk weights in the IRB approach for “corporates” with the same probability of default and the same collateral.
• The IRB risk weights are reduced for companies with an annual turnover of 5 to 50 million euros by being able to combine them in an SME portfolio. The relief is dependent on sales and can reach up to 20% compared to the equity backing in large companies. On average, the relief should amount to 10% (so-called SME package ).
• There is the option of suspending the maturity adjustment for loans to groups of companies with an annual turnover of less than EUR 500 million by national banking supervisory authorities.

## implementation

The EU legal requirements on the minimum equity base of credit institutions for credit and counterparty default risk as well as operational risk can be found in the revised Directive 2006/48 / EC ( Banking Directive ) of June 14, 2006, those on the minimum equity base of credit institutions and certain financial services institutions for the Market price risk as well as the expansion of the regulations regarding counterparty default and operational risk for financial services institutions in the revised Directive 2006/49 / EC ( Capital Adequacy Directive ) of June 14, 2006. The implementation in Germany was supported by the "Law for the Implementation of the Revised Banking Directive and of the revised Capital Adequacy Directive ”of November 17, 2006, which laid down extensive adjustments to the Banking Act and which came into force mainly on January 1, 2007.

The legal changes are supplemented by two ordinances:

The Solvency Regulation replaces the former capital and reserves principle I from. The SolvV essentially regulates the more detailed provisions on the adequate capital adequacy ( solvency ) of credit institutions, groups of institutions and financial holding groups. The ordinance also regulates the composition, management and administration of the banks' trading book and contains rules on the application of regulations on the trading book in groups of institutes and financial holding groups.

The GroMiKV contains more detailed regulations

• to determine the credit offset amounts and the borrower,
• to mitigate credit risk,
• organizational obligations and measures,
• on decision-making obligations and on the backing of exceeding large exposure limits,
• for the overall trading book position of a trading book institute and for evaluating positions in the trading book,
• for notification in the context of the million dollar credit process, and
• to display the large loans and million loans granted by the institutes.

The new GroMiKV is intended to replace the previous large loan and million dollar loan ordinance.

Once the legislative process has been completed, the application of the new capital adequacy regulations is to become mandatory by all institutions on January 1, 2007. The floor regulations begin. The additional regulatory areas of Pillar II and the disclosure requirements come into force. On January 1st, 2008 the new GroMiKV came into force.

### Delays

In September 2006, the US tried to postpone the enactment of the rules planned for January 1, 2007 to January 1, 2009. This was seen by various bank representatives in Europe as a critical factor for the entire package and even a failure of Basel II was not excluded.

### Basel III

As a result of the financial and global economic crisis and based on the experience gained, the supervisory framework was further developed. In December 2009, the Basel Committee on Banking Supervision initially presented a draft (Consultative Document). The measures presented are complex and interactive. An impact study was carried out in 2010 in order to get an overview of the modes of action of the individual proposed rules.

Under the heading Basel III, a new set of rules was published in December 2010, which has been an international standard since the beginning of 2013. While Basel II is primarily concerned with risk measurement, the new regulations deal with the definition of equity capital and the required minimum ratios. The previous Basel II regulations will be revised and supplemented by the new package. Even if new subject areas have been included with a minimum requirement for the unweighted equity ratio (“ leverage ratio ”) and regulations for minimum liquidity, Basel III is a further development of Basel II, which remains fundamentally valid.

In the European Union , Basel III was implemented through the Capital Adequacy Ordinance and the Equity Directive. Due to delays in political decision-making, the new law did not come into force until the beginning of 2014.

## literature

• Beck, Samm, Kokemoor: Law on the Credit System . CF Müller Verlag, Heidelberg, commentary in loose-leaf collection, 129th update February 2008, ISBN 978-3-8114-5670-9 .
• Bieg, Krämer, Waschbusch: Banking supervision in theory and practice Frankfurt School Verlag, Frankfurt, 3rd updated and expanded edition 2009, ISBN 978-3-933165-87-9 .
• Cluse, Engels (ed.): Basel II - Handbook for the practical implementation of the new banking supervision law, Erich Schmidt Verlag, Berlin, 2005, ISBN 3-503-08346-4 .

## Individual evidence

1. Information on Basel II on the FINMA website
2. http://www.manager-magazin.de/unternehmen/mittelstand/0,2828,438330,00.html Managermagazin from Sept. 21, 2006
3. Archive link ( Memento from February 1, 2008 in the Internet Archive ) Banking Association sees Basel II on the brink
4. Guide to overall bank management: Internal Capital Adequacy Assessment Process (ICAAP), Austrian National Bank and Financial Market Authority, January 2006
5. Archive link ( Memento from January 5, 2010 in the Internet Archive )
6. Federal Ministry of Finance: The Federal Ministry of Finance on the success of the negotiations on Basel II. ( Memento of May 7, 2005 in the Internet Archive ) July 10, 2002
7. Mark Schieritz, Birgit Jennen, Heike Buchter, Rolf Lebert: Basel II threatens to fail due to the USA. In: Financial Times Germany. September 19, 2006, archived from the original on October 3, 2006 ; accessed on June 6, 2017 .
8. Basel Committee on Banking Supervision (Ed.): Consultative Document. Strengthening the resilience of the banking sector . December 2009 (English, online [PDF; 282 kB ]).
9. CRD IV: New regulatory package for banks in force. Retrieved May 19, 2017 .