The Basel Committee has played a leading role in standardizing bank regulations across jurisdictions. Its origins can be traced to June 26, 1974, when German regulators forced the troubled Bank Herstatt into liquidation. That day, a number of banks had released payment of DEM to Herstatt in Frankfurt in exchange for USD that was to be delivered in New York. Because of time-zone differences, Herstatt ceased operations between the times of the respective payments. The counterparty banks did not receive their USD payments.
Responding to the cross-jurisdictional implications of the Herstatt debacle, the G-10 countries (the G-10 was actually eleven countries: Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States) and Luxembourg formed a standing committee under the auspices of the Bank for International Settlements (BIS). Called the Basel Committee on Banking Supervision, the committee comprises representatives from central banks and regulatory authorities. Over time, the focus of the committee has evolved, embracing initiatives designed to:
define roles of regulators in cross-jurisdictional situations;
ensure that international banks or bank holding companies do not escape comprehensive supervision by a "home" regulatory authority;
promote uniform capital requirements so banks from different countries may compete with one another on a "level playing field."
The Basel Committee's does not have legislative authority, but participant countries are implicitly bound to implement its recommendations. Usually, the committee has allowed for some flexibility in how local authorities implement recommendations, so national laws vary.
In 1988, the Basel Committee proposed a set of minimal capital requirements for banks. These became law in G-10 countries in 1992, with Japanese banks permitted an extended transition period. The requirements have come to be known as the 1988 Basel Accord.
To understand the scope of the 1988 accord, we need to clarify what we mean by "bank." Some jurisdictions distinguish between banks and securities firms, and the Basel accord applied only to the former.
Under its Glass-Steagall Act, the United States had long distinguished between commercial banks and securities firms (investment banks or broker-dealers). Following World War II, Japan adopted a similar legal distinction. The United Kingdom also distinguished between banks and securities firms, although this was more a matter of custom than law. By comparison, Germany and other European countries had a tradition of universal banking, which made no distinction between banks and securities firms.
The 1988 Basel Accord primarily addressed banking in the sense of deposit taking and lending (commercial banking under US law), so its focus was credit risk. Banks were subject to an 8% capital requirement. Specifically, they would calculate metrics for:
with a requirement that:
A bank's capital was defined as comprising two tiers. Tier 1 ("core") capital included the book value of common stock, non-cumulative perpetual preferred stock and published reserves from post-tax retained earnings. Tier 2 ("supplementary") capital was deemed of lower quality. It included, subject to various conditions, general loan loss reserves, long-term subordinated debt and cumulative and/or redeemable preferred stock. A maximum of 50% of a bank's capital could comprise tier 2 capital.
Credit risk was calculated as the sum of risk-weighted asset values. Generally, G-10 government debt was weighted 0%, G-10 bank debt was weighted 20%, and other debt, including corporate debt and the debt of non-G-10 governments, was weighted 100%. Additional rules applied to mortgages, local government debt in G-10 countries, and contingent obligations, such as letters of credit or derivatives.
In the early 1990s, the Basel Committee decided to update the 1988 accord to include bank capital requirements for market risk. This would have implications for non-bank securities firms.
Any capital requirements the Basel Committee adopted for banks' market risk would be incorporated into future updates of Europe's Capital Adequacy Directive (CAD) and thereby apply to Britain's non-bank securities firms. If the same framework were extended to non-bank securities firms outside Europe, then market risk capital requirements for banks and securities firms could be harmonized globally. In 1991, the Basel Committee entered discussions with the International Organization of Securities Commissions (IOSCO) to jointly develop such a framework. IOSCO is the primary international organization representing securities regulators. The two organizations formed a technical committee, and work commenced in January 1992.
Because of the fundamental differences between banks and securities firms (see this glossary's article regulatory capital), the initiative soon ran into trouble. Europe's draft CAD regulations already applied uniform capital standards to banks and securities firms. They had to because Europe's universal banks were both banks and securities firms. Many European regulators wanted the Basel-IOSCO initiative to adopt rules similar to the draft CAD. This would have required that the SEC abandon its own long-established Uniform Net Capital Rule (UNCR) for securities firms in favor of the weaker European rules.
Richard Breeden was chairman of the SEC and chairman of the Basel-IOSCO technical committee. Ultimately, he balked at discarding the SEC's rules. An analysis by the SEC indicated that the European approach might reduce capital requirements for US securities firms by 70% or more. Permitting such a reduction, simply to harmonize banking and securities regulations, seemed imprudent. The Basel-IOSCO initiative had failed. In the United States, banking and securities capital requirements were to remain distinct.
In April 1993, following the failure of the Basel-IOSCO initiative, the Basel Committee released a package of proposed amendments to the 1988 accord. Primarily, these proposed minimum capital requirements for banks' market risk. The proposal generally conformed to Europe's CAD. Banks would be required to identify a trading book and hold capital for trading book market risks and organization-wide foreign exchange exposures. Capital charges for the trading book would be based upon a crude value-at-risk (VaR) measure loosely consistent with a 10-day 95% VaR metric. Similar to a "building block" VaR measure used by Europe's CAD, this partially recognized hedging effects but ignored diversification effects.
In addition to capital for credit risk, banks would now be required to hold capital equal to the calculated VaR. If we define market risk as VaR/8%, the proposed amendment required that banks hold capital such that:
The proposal also liberalized the definition of capital by adding a third tier. Tier 3 capital comprised short-term subordinated debt, but it could only be used to cover market risk.
The committee received numerous comments on this proposal. Commentators perceived the crude VaR measure as a step backwards. Many banks were already using proprietary VaR measures. Most of these modeled diversification effects, and some recognized portfolio non-linearities. Commentators wondered if, by embracing a crude VaR measure, regulators might stifle innovation in risk measurement technology.
In April 1995, the Basel Committee released a revised proposal. This made a number of changes, including the extension of market risk capital requirements to cover organization-wide commodities exposures. An important provision allowed banks to use either a regulatory building-block VaR measure or their own proprietary VaR measure for computing capital requirements. Use of a proprietary measure required approval of regulators. A bank would have to have an independent risk management function and satisfy regulators that it was following acceptable risk management practices. Regulators would also need to be satisfied that the proprietary VaR measure was sound. Proprietary measures would need to support a 10-day 99% VaR metric and be able to address the non-linear exposures of options. Diversification effects could be recognized within broad asset categories—fixed income, equity, foreign exchange and commodities—but not across asset categories. Market risk capital requirements were set equal to the greater of:
the previous day's VaR, or
the average VaR over the previous sixty business days, multiplied by a factor of at least 3.
The original VaR measure—which was now called the "standardized" measure—was changed modestly from the 1993 proposal. It may reasonably be interpreted as still reflecting a 10-day 95% VaR metric. Extra capital charges were added in an attempt to recognize non-linear exposures.
The Basel Committee's new proposal was adopted in 1996 as an amendment to the 1988 accord. It is known as the 1996 amendment. It went into effect in 1998.
By this time, shortcomings with the original accord's treatment of credit risk were becoming evident. The simple system of risk weightings provided an incentive for banks to hold the 0% risk-weighted debt of G-10 governments (a fact viewed with some cynicism, since those same governments were largely responsible for the original accord). However, such debt tended to be unprofitable. Far more profitable for banks was corporate debt, which was weighted 100%. With all corporate debt being weighted equally, it made sense for banks to hold the most risky corporate debt. Higher quality corporate debt incurred exactly the same capital charges but was less profitable.
During this period, markets for credit derivatives and securitizations grew explosively. It was an open secret that banks were employing these to take advantage of shortcomings in the 1988 Accord's crude system of risk weights. This practice is called regulatory arbitrage.
Another issue during this period was operational risk. Operational risk poses significant risk for banks. It includes a variety of contingencies including fraud, which is routinely a factor in bank failures. Neither the original Basel Accord nor the 1996 Amendment required capital for operational risk.
In January 1999, the Basel Committee proposed a new capital accord, which has come to be known as Basel II. There followed an extensive consultative period, with the committee releasing additional proposals for consultation in January 2001 and April 2003. It also conducting three quantitative impact studies to assess those proposals. The finalized Basel II Accord was released in June 2004.
Originally, it was planned that Basel II would be based on three pillars:
minimum capital requirements,
supervisory review, and
However, the final accord relied primarily on minimal capital requirements with only brief, largely aspirational specifications of the second and third pillars.
Generally, Basel II retains the definition of bank capital and the market risk provisions of the 1996 Amendment. It largely replaces the old treatment of credit risk, and it requires capital for operational risk. With some juggling, the basic capital requirement for banks might be expressed as:
As with market risk under the 1996 Amendment, banks had options as to how they valued their credit risk and market risk. For credit risk, they could choose from among:
a Standardized Approach,
a Foundation Internal Rating-Based (IRB) Approach, and
an Advanced IRB Approach.
For operational risk, their choices were:
a Basic Indicator Approach
a Standardized Approach, and
an Internal Measurement Approach.
Basel II was supposed to become effective in December 2006. It was not as widely implemented as the earlier Accord. Basel II largely achieved European regulators' objectives of addressing shortcomings in the original accord's treatment of credit risk, incorporating operational risk and harmonizing capital requirements for banks and securities firms. Europe applied Basel II to all their banks with CAD III. US regulators were less enthusiastic. While they shared the goal of addressing shortcomings in the original accord's treatment of credit risk, they felt that existing bank supervision in the United States already addressed operational risk. Also, harmonization was never a priority for US regulators. They perceived Basel II as primarily relevant for internationally active banks. They applied it to just ten of the largest US banks. Another ten had the option to opt-in. Other US banks remained subject to existing US regulations, including those adopted under the original Basel Accord.
The 2008 financial crisis forced numerous banks around the world to seek government bailouts. Due to delays, Basel II had been only partially implemented, but that was little excuse. The Basel approach to bank regulation had failed catastrophically. Regulators scrambled to cobble together enhanced capital standards, largely within the Basel II framework. These increased required capital levels and improved the quality of assets that would be considered capital. Tier 3 capital was eliminated. Regulators also introduced new requirements relating to bank liquidity and bank leverage. Extra capital charges apply to "systemically important" (i.e. "too big to fail") financial institutions. The new regime, called Basel III, has a gradual phase-in period extending through 2019.