Why Basel II.5 corrected Basel II to improve banking regulations

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Sep. 10 2014, Updated 5:00 p.m. ET

Basel II.5

Basel II.5 was essentially a revision of Basel II norms, as the existing norms often failed to correctly address the market risks that banks took on their trading books. Basel II.5’s main aim was to strengthen the capital base, and so the banks’ ability to withstand risk, by increasing the banks’ capital requirements.

Basel II.5’s four main features

  1. An additional charge—incremental risk charge (or IRC)—was introduced. This was introduced to estimate and capture default and credit migration risk. Credit migration risk is when a customer moves his loan from one bank to another bank.
  2. An additional charge for comprehensive risk measure was introduced. This was introduced to correctly measure how one risk related to other risks. Often, a rise in one risk also leads to a rise in another risk, although the effects may show later. In finance, this risk is also known as correlational risk.
  3. Basel II.5 introduced stressed value at risk (or SVaR) as an additional requirement to calculate capital requirements. The idea behind SVaR was that under stressed conditions, banks may require more capital, and such capital requirements aren’t fully captured in normal value-at-risk calculations. So to include capital requirements under stressed conditions, SVaR was included.
  4. Basel II.5 also introduces standardized charges for securitization and re-securitization positions. Securitization and re-securitization were problems for all regulators, as the popularity of these instruments was leading to loans being incorrectly classified.

Basel II.5 tried to cover market risk for investment banks like Morgan Stanley (MS) and Goldman Sachs (GS), banks with major investment banking arms like JPMorgan (JPM) and Citibank (C), and other investment banks in an ETF like the Financial Select Sector SPDR Fund (XLF).

The banking industry was evolving at a rapid pace, so there was a need for a completely new look at regulations. For this, Basel III was introduced as we shall see in our next part of the series.

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