Basel II represents recommendations by bank supervisors and central bankers from the 13 countries making up the Basel Committee on Banking Supervision (BCBS) to revise the international standards for measuring the adequacy of a bank's capital. It was created to promote greater consistency in the way banks and banking regulators approach risk management across national borders.

Implementation of the Accord is expected by 2008 in many of the over 100 countries currently using the Basel I accord.

The final version aims at:

• Ensuring that capital allocation is more risk sensitive;
• Separating operational risk from credit risk, and quantifying both;
• Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.

Bank´s risk can be measured and controlled more precisely

This should lead to a more stable financial market

Basel II uses a "three pillars" concept - (1) minimum capital requirements; (2) supervisory review; and (3) market discipline - to promote greater stability in the financial system.

• The First Pillar
• The first pillar provides improved risk sensitivity in the way that capital requirements are calculated for three major components of risk that a bank faces: credit risk, operational risk and market risk. In turn, each of these components can be calculated in two or three ways of varying sophistication. Other risks are not considered fully quantifiable at this stage.
• Technical terms in the more sophisticated measures of credit risk include VaR (Value at Risk), EL (Loss function) whose components are PD (Probability of Default), LGD (Loss Given Default), and EAD (Exposure At Default). Calculation of these components requires advanced data collection and sophisticated risk management techniques.
• The Second Pillar
• 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 that a bank faces, such as name risk, liquidity risk and legal risk, which the accord combines under the title of residual risk.
• The Third Pillar
• 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.

Basel Committee

The Basel Committee on Banking Supervision (BCBS) consists of representatives from central banks and regulatory authorities of the G10 countries, plus others (specifically Luxembourg and Spain). The committee does not have the authority to enforce recommendations, although most member countries (and others) tend to implement the Committee's policies. This means that recommendations are enforced through national (or EU-wide) laws and regulations, rather than as a result of the committee's recommendations - thus some time may pass between recommendations and implementation as law at the national level. The Basel Committee is named for the Swiss town of Basel. The Bank for International Settlements (often confused with the BCBS) supplies the secretariat for the BCBS and is not itself the BCBS.

"Accord"

The key Accord to come from the Basel Committee refers to capital adequacy - ensuring that financial institutions retain enough capital to protect themselves against unexpected losses.

The first Basel Accord was issued in 1988 and sets out the basics - such as credit risk. This was updated in 1996 to cover market risk and to clarify and extend the first Accord.

The second Basel Accord was finalized in 2004 after an extensive consultation process. It is aimed at making the capital measures much more risk sensitive and itemizing and quantifying several more categories of risk (enhanced credit risk and operational risk).