Basel II: three pillars · RiskAtoms Academy

By the end you will be able to

1Describe Basel II's three pillars: minimum capital, supervisory review and market discipline.
2Explain the move from fixed weights to external ratings and banks' internal models, and the new charge for operational risk.
3Compare the capital a loan needs under Basel I and under Basel II's standardised approach.
4Explain why Basel II was criticised after the 2007–09 crisis.

Why it matters

Under Basel I, a loan to a top-rated multinational needed the same capital as a loan to a struggling start-up. Basel II set out to fix that, and in doing so handed some of the measuring to the banks themselves.

Core explanation

Three pillars, not one ratio

L2.7.02: The Basel Committee and Basel I ended with Basel I's weaknesses: flat weights that ignored credit quality, and no charge for operational risk. After a first consultation in June 1999 and years of testing, the Basel Committee published A Revised Framework in June 2004: Basel II. A comprehensive version, which folded in the market risk rules, followed in June 2006. The minimum stayed at 8% of risk-weighted assets. What changed was how risk is measured, and the idea that one ratio is not enough. Basel II stands on three pillars.

Pillar 1

Minimum capital

Formulas for credit, market and operational risk. Capital ≥ 8% of RWA.

Pillar 2

Supervisory review

The bank judges all its risks and the capital they need; the supervisor reviews that judgement and can ask for more.

Pillar 3

Market discipline

The bank publishes its risks and capital, so investors and creditors can judge it and price it.

Pillar 1: more risk-sensitive capital

For credit risk, banks could choose from a menu. The standardised approach keeps weights set by the rules but varies them with external credit ratings: 20% for a company rated AA, 150% for one rated below BB−. Home mortgages fell from 50% to 35%. The internal ratings-based (IRB) approaches go further: with the supervisor's approval, the bank estimates each borrower's probability of default (PD), and in the advanced version also the loss given default (LGD) and exposure at default (EAD). A formula set by Basel turns them into a capital charge. Basel II also added a charge for operational risk for the first time, and kept the 1996 market risk rules with their internal models.

ExploreThe menu of approaches

Click an approach to see who measures what. Simpler approaches sit on the left.

Standardised

Weights from a table, linked to ratings by approved agencies. Unrated companies take 100%. It is the simplest choice, and the usual one for smaller banks.

Pillar 2: the supervisor's judgement

Formulas cannot capture everything: a loan book concentrated on one industry, interest rate risk in the banking book, liquidity, strategy. Pillar 2 asks each bank to run its own internal capital adequacy assessment process (ICAAP). The supervisor reviews it (in the EU this is the Supervisory Review and Evaluation Process, SREP), expects banks to hold more than the minimum, and steps in early if capital looks thin.

Pillar 3: daylight

If banks measure their own risks, outsiders need to see how. Pillar 3 sets out what banks must publish about their capital, risk exposures and methods, so that shareholders and creditors can reward caution and punish recklessness. These are the Pillar 3 reports you met in L1.8.08: Reading an annual report.

Sort itWhich pillar?

Place each requirement under the pillar it belongs to.

A bank estimates the PD of each corporate borrower for its IRB capital charge.
A bank publishes a table of its exposures by risk weight.
A supervisor asks a bank with heavy lending to one region to hold extra capital.
Capital of 15% of average gross income for operational risk.
The board approves the bank's own assessment of how much capital all its risks need.
A bank discloses how it validates its internal models.

The formal version

The headline test is unchanged from L2.7.02: The Basel Committee and Basel I, but RWA now has three parts. Market and operational risk are measured as capital charges and turned into an RWA equivalent by multiplying by 12.5, which is 1 ÷ 8%:

\frac{\text{Total capital}}{\text{RWA}_{\text{credit}} + 12.5\,(K_{\text{market}} + K_{\text{op}})} \;\ge\; 8\%

Under the basic indicator approach, with gross income GI in each of the last three years:

K_{\text{op}} = 15\% \times \frac{\text{GI}_1 + \text{GI}_2 + \text{GI}_3}{3}

Shown in full: both build directly on the Basel I ratio. Years with negative gross income are left out of the average. The IRB formula itself belongs to Level 4: Regulation, Capital & Accounting.

Try it

Pick a borrower and compare the capital under the two rulebooks. Which borrowers win under Basel II, and which lose?

Try itOne loan, two rulebooks

Borrower

Loan amount€100m

Basel I weight100%

Basel II weight20%

Capital, Basel I (8%)€8.00m

Capital, Basel II (8%)€1.60m

Basel II asks for €6.40m less: it sees this exposure as safer than Basel I's flat weight did.

Worked example

Alpine Bank moves to Basel II

Alpine Bank, a made-up European lender, has €90bn of exposures. It moves from Basel I to Basel II's standardised approach for credit risk and the basic indicator approach for operational risk. Its gross income in the last three years was €2.0bn, €2.4bn, €2.2bn.

Basel I against Basel II

Step 1 of 5

1

Credit risk, line by line

Exposure	€bn	Basel I	Basel II	RWA I	RWA II
Government rated AAA to AA−	20	0%	0%	0.0	0.0
Company rated AAA to AA−	10	100%	20%	10.0	2.0
Company rated BBB+ to BB−	15	100%	100%	15.0	15.0
Company rated below BB−	5	100%	150%	5.0	7.5
Residential mortgage	30	50%	35%	15.0	10.5
Small loan to a household or small firm (retail)	10	100%	75%	10.0	7.5
Total	90			55.0	42.5

Regulatory lens

The EU put Basel II into law for all its banks and investment firms through the Capital Requirements Directive of 2006, applying from 2007 and 2008. In the United States, the agencies applied it only to the largest banks, through the advanced approaches, and the crisis struck before it was fully in place.

The crisis exposed its weak points:

Too little, too weak capital. 8% of RWA, much of it not common equity, could not absorb the losses.
Models and ratings. Internal models drove some banks' RWA down, and rating agencies had given top ratings to securities that later collapsed.
Trading books. Market risk charges were far too low; the committee raised them in July 2009 in a package known as Basel 2.5.
Liquidity. Basel II had no liquidity rules. Banks failed for lack of cash as well as capital.
Procyclicality. Risk-sensitive weights rise as ratings and PDs worsen in a downturn, so capital needs grow just when capital is scarce: a side effect explored in L2.7.08: How regulation shapes risk management.

The three pillars survived: Basel III (L2.7.04: Basel III and its finalisation) and Solvency II (L2.7.05: Solvency I to Solvency II) are both built on them.

Sparks

SparkA dividend rise, two months before a run

In June 2007, Northern Rock received approval to use the IRB approach. Its interim results that summer said its lower capital requirement would allow it to pay a higher dividend. In September 2007 it faced the first run on a British bank in well over a century. Its problem was funding, not the capital formula, but the episode became a symbol of how far measured capital had drifted from real resilience.

SparkWhere the 99.9% comes from

The IRB formula is calibrated so that, if the model is right, capital covers credit losses in all but one year in a thousand. That sounds very safe, but it assumes the PD, LGD and correlation inputs are right, which in a crisis they often are not.

Key takeaways

Basel II (June 2004) kept the 8% minimum but rebuilt the measurement of risk around three pillars.
Pillar 1: risk-sensitive capital for credit (standardised or IRB), market and, for the first time, operational risk.
Pillar 2: the bank's own assessment (ICAAP) and the supervisor's review, which can require more capital.
Pillar 3: public disclosure, so markets can discipline banks.
The crisis showed too little high-quality capital, over-reliance on models and ratings, no liquidity rules and procyclical requirements.

Reaction

Check what stuck

Glossary

Pillar 1: Minimum capital requirements: the formulas for credit, market and operational risk.
Pillar 2: Supervisory review: the bank assesses all its risks and its capital; the supervisor reviews and can demand more.
Pillar 3: Market discipline: public disclosure of risks and capital, so investors and creditors can judge the bank.
Standardised approach: Risk weights set by the rules, using external credit ratings where they exist.
IRB approach: Internal ratings-based approach: the bank's own estimates of default risk feed a formula set by the rules.
PD: Probability of default: the chance a borrower defaults within a year.
LGD: Loss given default: the share of the exposure lost if the borrower defaults.
EAD: Exposure at default: how much is owed when the borrower defaults.
Operational risk: The risk of loss from failed processes, people or systems, or from external events such as fraud or a fire.
ICAAP: Internal capital adequacy assessment process: the bank's own judgement of how much capital its risks need.
Procyclical: Moving with the economic cycle in a way that amplifies it: here, capital needs rising just as times turn bad.

Deep Dives & Origins

Deep Dives

Hull, Risk Management and Financial Institutions, Wiley, the chapter on Basel I, Basel II and Solvency II. Intermediate.
Basel Committee on Banking Supervision, An Explanatory Note on the Basel II IRB Risk Weight Functions, BIS, July 2005. Advanced.

Origins

Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards: A Revised Framework, BIS, June 2004; comprehensive version, June 2006.
Basel Committee on Banking Supervision, Enhancements to the Basel II framework and Revisions to the Basel II market risk framework, BIS, July 2009.
Directives 2006/48/EC and 2006/49/EC (the EU Capital Requirements Directive).
House of Commons Treasury Committee, The run on the Rock, Fifth Report of Session 2007–08, January 2008.

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