Basel II, implemented in the European Union in 2006 and 2007 through Directives 2006/48/EC and 2006/49/EC, structures banking regulation in three pillars:

Pillar 1 – Minimum capital requirements

Pillar 1 was established in order to make the prudential framework created by Basel I more sensitive to risk, changing the rules for the calculation of minimum capital requirements. 

In addition to calculating minimum capital requirements for credit risk and market risk (including minimum capital requirements regarding foreign exchange risk and commodities risk), it specifies the definition of capital requirements for operational risk.

It enables more sophisticated institutions, under certain conditions and when authorised by their respective supervisory authorities, to use their own management and risk assessment methodologies to calculate minimum capital requirements.

Simplified illustration of Pillar 1

Pillar 2 – Supervisory Review and Evaluation Process

Pillar 2 sets out the ‘supervisory process’ concept, which combines a set of principles essentially intended to reinforce the interaction between institutions under supervision and the respective supervisors.

On the one hand, these principles encourage institutions to adopt strategies, procedures and control mechanisms designed to calculate and maintain levels of internal capital appropriate to the nature and size of the risks incurred.  

On the other hand, supervisory authorities (including Banco de Portugal and the European Central Bank, in the SSM context) are responsible for assessing the quality of such strategies, procedures and control mechanisms, and for imposing corrective measures where the capital held is deemed inconsistent with the risk profile of these institutions – see the Supervisory Review and Evaluation Process (SREP). 

These principles cover the risks that are not covered or are only partially covered by Pillar 1 requirements, namely credit concentration risk and interest rate risk in the banking book.

Pillar 3 – Market discipline

Pillar 3 introduced requirements for the disclosure of information by institutions to the public (i.e. customers, counterparties, investors, analysts) regarding solvency and other items describing the respective risk profiles, in order to ensure effective market discipline.

In particular, market participants shall have at their disposal information to reward or penalise the institutions’ management practices, through their influence on costs/borrowing capacity and capital valuation.

Improvements to Basel II

From Basel II to Basel III a number of improvements were introduced, particularly as regards Pillar 1’s treatment of securitisations and the supervisor’s analysis and review process (Pillar 2). 

As regards Pillar 2, the Basel Committee guidelines aimed to remedy a number of deficiencies observed during the financial crisis in areas of the institutions’ risk management processes. They cover internal governance and risk management of institutions, capturing off-balance-sheet risk exposures due to securitisation activities, credit concentration risk management, incentives for better management of risks and returns in the long term and best practice in compensation packages. 

Pillar 3 requirements (market discipline) were also strengthened in some key areas.

Basel III arose with the purpose of improving the banking sector’s capacity to absorb shocks due to adverse economic and financial scenarios.

For this purpose, it introduced a stricter definition of regulatory capital (own funds), defined for the first time harmonised liquidity requirements at international level, by means of two new metrics – one short-term (liquidity coverage ratio) and the other medium-term (net stable funding ratio) – and added to the list of prudential measures a prudential requirement complementary to the capital adequacy ratio based on risk-weighted assets, translated into a forecast of the leverage ratio.

Basel III also introduced capital buffer requirements, of both a structural and countercyclical nature, in order to strengthen the resilience of institutions and promote the internalisation of possible costs for the financial system.

Basel II standards and the most recent Basel III standards were adopted in the European Union through a Regulation and a Directive that are known as CRR and CRD IV respectively:

• Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June, (Capital Requirements Regulation or CRR);
• Directive 2013/36/UE, of the European Parliament and of the Council of 26 June (Capital Requirements Directive or CRD IV).

The Regulation must be applied in its entirety across the EU. In Portugal, CRD IV was transposed through Decree-Law No 157/2014 of 23 October 2014, whose provisions were included in the Legal Framework of Credit Institutions and Financial Companies.