'Basel II'

Our understanding of the risks faced by the banks, and how they manage them, is set to improve.

The international banking accord known as 'Basel II' took another step forward last week, after US regulators agreed to hammer out a uniform rule enabling the country's eleven largest banks to comply with the accord.  The Basel II framework is often referred to as a 'capital adequacy standard' for internationally active banks.  In other words, it tells banks how much capital they need to hold.  However, that is only part of the story.  More precisely, it is one-third of the story.

The previous accord, Basel I, only regulated minimum capital requirements. But Basel II adds another two 'pillars': supervisory review and market discipline.  Supervisory review means that national authorities are supposed to not only make sure that banks actually hold the amounts of capital they are supposed to be holding; but also to encourage banks to develop and use better techniques to manage risk.

Market discipline is all about disclosure and complements the first and the second pillars. By making banks adhere to a set of disclosure requirements, Basel II enables other market participants, as well as regulators, to get a better picture of the risks faced by the banks and also how they manage them. In a sense, the market discipline-pillar ties the other two together in that it allows outsiders to judge whether banks are handling their risks in the best possible way –- and to act in case they do not.

Basel III?

Work is apparently already underway on Basel III, which will refine the definition of bank capital, quantify additional classes of risk and further improve the sensitivity of the risk measures.