Basel II represents a substantial improvement on Basel I because of its more extensive integration of the capital requirement within the prudential supervision framework through its greater risk-sensitivity and comprehensive coverage of banking risks. Shortcomings (particularly in the modelling of credit risk) revealed by the GFC are being addressed, which should ultimately strengthen Basel II.

Of the concerns debated during the development of Basel II the main outstanding issue is its pro-cyclical effect. It is unlikely to be evident during the current economic crisis because of the greater effects of the GFC; illiquidity of markets and the tightening of lending standards by banks. But Basel II should be modified to counter its pro-cyclical effect.

The main lesson of the GFC for Basel II is that bank capital is a necessary but not sufficient requirement for a bank’s stability. Prudential regulators need to be vigilant because the intended influence of the capital requirement on banks’ risk-taking behaviour can be outweighed when competing institutions profit from their greater risk appetite, especially when there is a too-ready acceptance of financial innovation.