Basel II in Review | 21 Years of Successes, not Failures, and Lessons Learned (2025)

Basel II in review

The Basel II framework was a significant advancement in global banking regulation. More than two decades after its introduction, a reassessment offers an opportunity to revisit its legacy, and reflect on its regulatory impact and the lessons it left behind.

The uneven implementation

Before drawing conclusions about the effectiveness of Basel II, it is essential to first examine the uneven implementation that significantly shaped its global footprint and, ultimately, its impact.

Although the framework introduced a more sophisticated and risk-sensitive approach to capital regulation, the discretion it afforded to national regulators led to wide disparities in how it was adopted and enforced across jurisdictions.

Some countries moved swiftly to implement the advanced approaches, while others lagged behind or opted for simpler, less risk-sensitive methods. These inconsistencies not only weakened the harmonization of global banking standards but also made it difficult to evaluate Basel II’s success or failure on a level playing field. To understand what Basel II achieved, or failed to achieve, we must first consider the fragmented way in which it was translated into practice worldwide.

Was this a Basel II mistake? No, the discretion afforded to national regulators under Basel II was both intentional and necessary. When Basel II was introduced, it was designed to be a flexible framework that could be adapted by jurisdictions with different levels of financial system maturity, regulatory capacity, and institutional sophistication. The Basel Committee, aware of the vast differences among its member countries, deliberately left room for national discretion to ensure that implementation would be feasible across diverse regulatory environments.

For example, the more advanced approaches required a high degree of internal risk modeling sophistication, and extensive historical data, capabilities that were present in some jurisdictions but not in others. National discretion allowed less advanced regulators or smaller banking systems to adopt the more basic approaches instead, preventing unnecessary disruption or exclusion. In this way, the flexibility helped promote wider participation in the Basel framework rather than a rigid, one-size-fits-all model that could have alienated many countries.

However, this same flexibility also led to fragmentation and regulatory arbitrage, as countries interpreted and applied the rules differently, sometimes in ways that diluted the original intent. Larger banks in more lenient jurisdictions were able to benefit from reduced capital requirements by exploiting differences in how models were approved or risk weights assigned. So, while national discretion was necessary, it came with trade-offs: it enabled adoption but also undermined consistency and comparability.

What about Basel III? Like its predecessor, Basel III has been adopted with significant variation across jurisdictions. Differences in political will, regulatory capacity, economic priorities, and pressure from domestic industries have led to delays, exemptions, and modifications in how the rules are applied.

In some regions, the framework has been embraced in full, with robust supervisory enforcement and commitment to the spirit of the reforms. In others, only parts have been adopted or timelines have been extended well beyond the original Basel Committee expectations.

These inconsistencies raise the question: are we judging Basel II and Basel III as global standards, or are we judging the ways they have been selectively applied? Any fair evaluation must distinguish between flaws in the design and shortcomings in the implementation.

The Transitional Framework: Basel II’s Place in Regulatory Evolution — Bridging Basel I and Basel III

Basel I, finalized in 1988, was a remarkably concise document (only about 30 pages in length). This is the agreement among the G-10 central banks to apply common minimum capital standards to their banking industries, to be achieved by end-year 1992. The framework focused almost entirely on credit risk, which at the time was widely recognized as the principal risk faced by banks. The simplicity of Basel I was one of its strengths. It required banks to maintain a minimum capital ratio of 8%. While basic, it was a groundbreaking first step toward international regulatory cooperation.

Basel II was a much more ambitious and complex endeavor. It sought not just to refine the measurement of credit risk, but also to expand the regulatory framework to include other risks, like operational risk. Through its three-pillar structure (minimum capital requirements, supervisory review, and market discipline), Basel II aimed to tailor capital requirements more closely to the actual risk profile of each bank, encourage stronger internal risk management practices, and enhance transparency.

However, this pursuit of precision and flexibility came at a cost. Basel II could not achieve the broad, consistent adoption that Basel I had managed. Advanced approaches required resources, expertise, and data that were not universally available. While Basel I set a foundational baseline with a simple, enforceable standard, Basel II’s attempt to achieve more risk sensitivity was less successful.

In seeking to improve the measurement of risk, Basel II lost the simplicity and universality that had given Basel I its practical strength. And while many critics have since accused Basel II of being weak compared to Basel III, such comparisons often overlook the historical context. Expecting Basel II to meet standards that were only defined after the global financial crisis is not only unfair but also anachronistic. Basel II was a product of its time, reflecting the regulatory thinking and priorities of the early 2000s, not the post-crisis resilience efforts.

Basel II ultimately achieved what was possible to be achieved at the time, given the regulatory thinking, data availability, and risk management practices of the early 2000s. It represented a genuine effort to move beyond Basel I.

Basel II promoted a more refined and risk-sensitive approach to banking regulation.

Basel II moved beyond the static, one-size-fits-all capital requirements of Basel I. It introduced a framework that allowed banks, especially larger, more sophisticated institutions, to align regulatory capital more closely with their actual risk profiles.

Through the Internal Ratings-Based (IRB) approaches, banks could use their own models to calculate capital requirements, subject to supervisory approval. This shift incentivized improved risk management practices, deeper analytical capabilities, and a more dynamic understanding of credit, operational, and market risk.

Moreover, Basel II’s three-pillar structure integrated regulatory oversight (Pillar 2) and market transparency (Pillar 3) into the capital framework, creating a broader and more nuanced system of risk governance. The core principle of Basel II, linking capital adequacy to the true underlying risk faced by banks, marked a major conceptual advancement in global financial regulation. Unlike its predecessor, which applied uniform risk weights regardless of borrower quality or institutional sophistication, Basel II sought to tailor capital requirements to the actual riskiness of a bank’s exposures.

This shift reflected a deeper understanding of the nature of financial risk and acknowledged the importance of incentivizing banks to improve their internal risk assessment models. By allowing more advanced institutions to use their own data and methodologies, Basel II aimed to reward sound risk management while encouraging regulatory systems to evolve beyond static capital rules. Though this principle introduced complexity and required significant supervisory oversight, it laid the intellectual foundation for modern risk-based regulation and influenced how financial institutions worldwide began to integrate risk sensitivity into their core operations and strategic decision-making.

However, what did not work was the over-reliance on banks’ internal models. While flexibility was theoretically sound, in practice it opened the door to model manipulation and regulatory arbitrage. Banks, motivated by profit and market competition, had incentives to optimize models to reduce capital charges rather than to reflect genuine risk. Supervisors, in many jurisdictions, were under-resourced or insufficiently trained to challenge the assumptions behind these models, leading to a dangerous reliance on what were sometimes flawed inputs or outputs.

An international standard, such as those developed by the Basel Committee, can establish a common framework, create peer pressure, and promote best practices, but it cannot fully prevent banks from gaining an advantage when they are supported by governments that actively seek national or geopolitical advantage. The effectiveness of an international standard relies heavily on the willingness of national authorities to implement and enforce them faithfully. When governments prioritize domestic economic or strategic interests over global consistency, they may apply international rules selectively, delay implementation, or exploit grey areas to benefit their own institutions.

Regulatory arbitrage becomes particularly potent when governments use their influence to give their domestic banks a competitive edge, whether through favorable capital treatment, state guarantees, or relaxed supervisory oversight. This is especially true in countries where large banks are closely tied to national economic policy, or where financial institutions play a role in state-directed lending and strategic investment.

In theory, international standards aim to minimize these discrepancies by encouraging convergence and exposing non-compliance to global scrutiny. But in practice, they lack enforcement power. The Basel Committee, for instance, has no legal authority, it depends on voluntary adoption and moral suasion. Mechanisms like peer reviews and public assessments (e.g., through the Regulatory Consistency Assessment Programme, or RCAP) can highlight divergences, but they cannot compel governments to comply.

An international standard sets the rules, but it cannot neutralize the political will of a sovereign state that chooses to bend them. Even after Basel III, the playing field remains uneven, especially when national interest overshadows collective responsibility.

It was not possible for Basel II to introduce macroprudential regulation.

Basel II was fundamentally microprudential in nature. Its core objective was to improve the way individual banks assessed and managed their own risk exposures through more refined capital requirements. It focused on the solvency and resilience of each institution, not the stability of the financial system as a whole.

At the time Basel II was developed, macroprudential regulation was not yet part of the global regulatory vocabulary. The concept of safeguarding the financial system as a whole, rather than focusing solely on the soundness of individual banks, was still in its infancy. Basel I, finalized in 1988, was a foundational step that introduced uniform capital requirements, but it was simple and entirely microprudential in scope.

When Basel II was being designed, the regulatory focus remained largely on refining the measurement of individual bank risk, especially credit risk, and improving alignment between regulatory capital and internal risk models. The global financial community had not yet fully appreciated the importance of systemic risk, interconnectedness, and procyclicality, core elements of what we now call macroprudential oversight.

Moreover, the necessary tools, data, and modeling techniques to support system-wide supervision were still underdeveloped. There was no political or institutional mandate for regulators to manage the financial system's collective behavior. The prevailing assumption was that if each bank managed its risks properly, the system as a whole would remain stable.

In that context, it would have been unrealistic to expect Basel II, just after the basic framework of Basel I, to leap ahead and incorporate principles of macroprudential policy. That evolution only gained momentum after the 2007–2008 financial crisis, when the global regulatory community recognized that micro-level soundness does not automatically translate into macro-level stability. Basel III, built on the lessons of that crisis, introduced macroprudential elements.

It was not possible for Basel II to address interconnectedness or contagion.

Basel II could not address interconnectedness or contagion because it was built on a microprudential foundation, focusing on the soundness of individual institutions, not the financial system as a whole.

Interconnectedness refers to the complex web of financial relationships between institutions, through interbank lending, derivative exposures, and shared asset holdings. Contagion is the mechanism by which distress in one institution or market spreads to others, even if those others are individually sound. Basel II lacked tools to measure or limit these dynamics, as there was no political or institutional mandate for regulators to manage the financial system's collective behavior.

Data limitations and modeling capabilities of the early 2000s made it extremely difficult to quantify systemic risk. Regulators did not have the infrastructure to monitor cross-institution dependencies in real time, and macroprudential thinking had not yet developed into a regulatory doctrine.

Only after the crisis did global regulators, through Basel III and other reforms, begin to introduce system-wide safeguards, such as capital surcharges for systemically important banks, liquidity coverage ratios, and stress testing that incorporates network effects.

Basel II could not address interconnectedness or contagion not because it ignored them deliberately, but because it was built in a time when these systemic dimensions were neither well-understood nor prioritized in regulatory design. It was a product of its era, an era still operating under the belief that strong parts naturally make a strong whole.

Was Basel II a good framework?

Basel II was, in many respects, a very good forward-thinking framework for its time. When it was developed in the late 1990s and finalized in 2004, it represented a major leap forward from Basel I. It introduced a far more refined and risk-sensitive approach to capital adequacy, recognizing that not all credit exposures carry the same risk and that more sophisticated banks should be allowed (and encouraged) to model risk internally. It also expanded the regulatory focus to include operational risk and introduced the three-pillar structure, integrating supervisory review and market discipline alongside capital requirements.

At that moment in history, the global banking system had not yet experienced a systemic crisis rooted in interconnectedness, procyclicality, or shadow banking. The prevailing regulatory mindset was largely microprudential: Ensure each bank is sound, and the system will be sound. Basel II reflected the best available knowledge and the tools regulators had at their disposal. To expect it to solve problems that were not yet fully understood or widely acknowledged is to apply hindsight unfairly.

Basel II didn't fail and it was not poorly designed. It was designed in an era that had not yet confronted the realities of systemic contagion and global financial complexity. Judging Basel II solely through the lens of post-crisis knowledge is like blaming a 19th-century doctor for not prescribing antibiotics, they simply hadn’t been discovered yet.

Will Basel III fail? No, it won’t. But of course, sooner or later, we will have a Basel IV. That's how regulation evolves: not because the previous framework failed, but because the world keeps changing. You may visit: