Basel II is an international business standard that requires financial institutions to maintain enough cash reserves to cover risks incurred by operations. The Basel accords are a series of recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision (BSBS). The name for the accords is derived from Basel, Switzerland, where the committee that maintains the accords meets.
Basel II improved on Basel I, first enacted in the 1980s, by offering more complex models for calculating regulatory capital. Essentially, the accord mandates that banks holding riskier assets should be required to have more capital on hand than those maintaining safer portfolios. Basel II also requires companies to publish both the details of risky investments and risk management practices. The full title of the accord is Basel II: The International Convergence of Capital Measurement and Capital Standards - A Revised Framework.
The three essential requirements of Basel II are:
- Mandating that capital allocations by institutional managers are more risk sensitive.
- Separating credit risks from operational risks and quantifying both.
- Reducing the scope or possibility of regulatory arbitrage by attempting to align the real or economic risk precisely with regulatory assessment.
Basel II has resulted in the evolution of a number of strategies to allow banks to make risky investments, such as the subprime mortgage market. Higher risks assets are moved to unregulated parts of holding companies. Alternatively, the risk can be transferred directly to investors by securitization, the process of taking a non-liquid asset or groups of assets and transforming them into a security that can be traded on open markets.