The Lowdown on Basel II

Its No. 1 goal is to smooth out financial crises, and its main method is fine-tuning banks' capital requirements

WHAT BASEL II IS

A 2004 international agreement to close loopholes in banking regulation and put banks around the world on a similar footing. National regulators can adopt it in whole or in part.

HOW IT WORKS

It governs how much capital banks need to hold as a buffer against unexpected losses. Capital is the amount by which the bank's assets exceed its liabilities--in other words, the value of the bank to shareholders. When a bank suffers big losses, the capital is supposed to get wiped out before depositors and taxpayers are harmed. How much capital each loan requires depends on its riskiness.

WHAT MAKES IT DIFFERENT

Basel I, which was conceived in 1988, made rough estimates of the riskiness of broad categories of loans and other assets. Banks learned how to game the system to minimize their required capital. Basel II forces banks to assess the true risks to their portfolios and hold an appropriate amount of capital against them. It also requires more regulatory supervision and financial disclosure.

THE CONSEQUENCES

If the riskiness of a bank's portfolio gets too high, the bank has two choices: Raise more capital to boost the size of its buffer or shed risky assets by, say, selling off loans.

WHEN IT TAKES EFFECT

Japanese banks implemented Basel II in 2007, and European banks at the start of 2008. U.S. regulators will begin switching over in 2009. Only the 10 or 12 largest U.S. banks will use their own risk assessments. Smaller banks will use a system more like BaselI, with regulator-determined estimates of assets' riskiness.

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