THE BASEL ACCORDS
The origins of the Basel Accords begins with the UK’s Secondary Banking Crisis of 1973-75. Suddenly, the Bank of England, the City of London regulator was forced to create a supervisory regime the like of which had never existed in the UK before. The “Governor’s eyebrows” had somehow kept the City in line for decades without supervisors.
Alongside supervision came a new debate about bank capital and about how much a bank should be required to have. Nobody seemed to know and the matter was further confused by the fact that British banks were allowed to maintain secret reserves and smooth out their reported profits.
The Secondary Banking Crisis was a relatively small affair compared to the Global Financial Crisis that hit the world in 2007. At its heart was a UK property crash, an oil crisis, a three-day week and a less than impressive market culture in the City of London. Dozens of small (secondary) banks faced bankruptcy and had to be “rescued” by the Bank of England “lifeboat”. Among them were secondary banks with names such as London and County Securities, Cedar Holdings, Keyser Ullmann and Forward Trust.
One of the most high-prolife secondary banks was FNFC, a secondary mortgage lender led by Pat Matthews that at one stage explored a merger with Chase Manhattan Bank of the US. Many decades later in 1995 it was acquired by Abbey National, a former large building society that is now the core of Santander UK. Like FNFC, all the former secondary banks are long since gone.
The Secondary Banking crisis also forced the Bank of England to create a supervision department for the first time, having previously relied on meetings between the BOE Governor and bank CEOs to keep order in the City. (It was said at the time that the Governor’s eyebrows were his main vehicle for conveying his views!)
But these times were long before globalisation. The challenge of the Secondary Banking Crisis and the fact that large numbers of foreign banks had activities in London led the Bank of England and the other nine central banks that were then members of the Bank for International Settlements (the central banks’ bank) to create the Basel Committee on Banking Supervision (BCBS) in 1974.
BIS member countries now include Australia, Argentina, Belgium, Canada, Brazil, China, France, Hong Kong, Italy, Germany, Indonesia, India, Korea, the United States, the United Kingdom, Luxembourg, Japan, Mexico, Russia, Saudi Arabia, Switzerland, Sweden, the Netherlands, Singapore, South Africa, Turkey, and Spain.
The BCBS describes its original aim as the enhancement of “financial stability by improving supervisory know-how and the quality of banking supervision worldwide.” Later, it turned its attention to monitoring and ensuring the capital adequacy of banks and the banking system.
Of particular interest to bankers are the BCBS recommendations on banking and financial regulations concerning capital risk, market risk, and operational risk. The so-called Basel Accords (each updating the previous Accord) were to follow and are referred to as:
- Basel I – issued in 1988
- Basel II – Issued between 2004 and 2006
- Basel III – issued between 2010 and 2017
Basel I
The first Accord, known as Basel I, was issued in 1988 and focused on the capital adequacy of financial institutions. The capital adequacy risk (the risk that an unexpected loss would cause to a financial institution), categorizes the assets of financial institutions into five risk categories—0%, 10%, 20%, 50%, and 100%.
Under Basel I, banks that operate internationally must maintain capital (Tier 1 and Tier 2) equal to at least 8% of their risk-weighted assets.
For example, if a bank has risk-weighted assets of $100 million, it is required to maintain capital of at least $8 million. Tier 1 capital is the most liquid and primary funding source of the bank, and tier 2 capital includes less liquid hybrid capital instruments, loan-losses, and revaluation reserves as well as secret/inner reserves.
Basel II
The second Accord known as Basel II, updates the original Accord. The main difference from Basel I is that Basel II incorporates credit risk of assets in calculating regulatory capital.
Basel III
The Global Financial Crisis (GFC) of 2007 demonstrated that the Basel Accords had serious shortcomings and required major reform – particularly in the calculation of Risk-weighted assets (RWAs). According to the BCBS, the 2017 reforms seek to restore credibility in the calculation of (RWAs) and improve the comparability of banks’ capital ratios. RWAs are an estimate of risk that determines the minimum level of regulatory capital a bank must maintain to deal with unexpected losses.
The BCBS concluded that poor governance and risk management, inappropriate incentive structures, and an overleveraged banking industry were the reasons for the 2007crisis. In November 2010, an agreement was reached regarding the overall design of the capital and liquidity reform package. This agreement is now known as Basel III.
The reforms also introduce constraints on the estimates banks make when they use their internal models for regulatory capital purposes, and in some cases, ban the use of internal models.
Basel III is a continuation of the three pillars along with additional requirements and safeguards. For example, Basel III requires banks to have a minimum amount of common equity and a minimum liquidity ratio. It also includes additional requirements for what the Accord calls “systemically important banks,” or those financial institutions that are considered “too big to fail”. In doing so, it got rid of tier 3 capital considerations.
The terms of Basel III were eventually finalized in December 2017. However, its implementation has been delayed, due to the impact of the 2020 global crisis, and the reforms are now expected to take effect in January 2023.