Basel II set up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk it exposes itself to through its lending and investment practices. The greater risk a bank has, the greater the amount of capital it needs to hold to safeguard its solvency and overall stability.
The final version of Basel II seeks to:
- ensure that capital allocation is more risk sensitive;
- separate operational risk from credit risk and quantify both; and
- align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.
Though the final Accord has largely addressed the regulatory arbitrage issue, there are still areas where regulatory capital requirements will diverge from the economics. Basel II has left largely untouched the question of how to actually define bank capital, which diverges from accounting equity in important respects.
Basel II (effective March 2008) required, among...