Basel II is the second Basel banking framework, designed to make bank capital rules more sensitive to actual risk than the original Basel Agreement.
The three-pillar structure
Basel II is usually summarized by three pillars:
- Minimum capital requirements: banks must hold capital against credit, market, and operational risk.
- Supervisory review: regulators assess whether a bank’s own risk controls and capital planning are credible.
- Market discipline: disclosure requirements let investors and counterparties monitor the bank more closely.
What changed from Basel I
Basel II moved beyond broad risk buckets and tried to align regulatory capital more closely with measured risk. It let some banks use internal models, subject to regulatory approval, and explicitly added operational risk to the framework.
That improved risk sensitivity, but it also made the system more complex and more dependent on model assumptions.
Economic interpretation
The framework reflects a policy trade-off. If capital rules are too weak, banks can expand balance sheets aggressively and amplify crises. If rules are too strict or procyclical, lending can contract sharply in downturns. Basel II tried to improve pricing of bank risk, but the global financial crisis exposed how vulnerable model-based systems can be when measured risk looks low during a boom.