The world financial market is an extremely complex system that involves many different participants from your local bank to the central banks of each nation and even you, the investor. Due to its importance on the global economy and our everyday lives it is vital that it is functioning properly.

One tool that helps the financial markets run smoothly is a set of international banking agreements called the Basel Accords. These accords coordinate the regulation of global banks, and are "an international framework for internationally active banks". The accords are obscure to people outside banking, but they are the backbone of the financial system; the Basel Accords were created to guard against financial shocks, which is when a faltering capital market hurts the real economy, as opposed to a mere disturbance.

In this article, we will take a look at intent of the Basel Accords and see where the markets are headed with the formation of the Basel Accord II. (For background reading, see Does The Basel Accord Strengthen Banks? and What Is The Bank For International Settlements?)

Basel Accords Determine Bank Equity Capital
The Basel Accords determine how much equity capital - known as regulatory capital - a bank must hold to buffer unexpected losses. Equity is assets minus liabilities. For a traditional bank, assets are loans and liabilities are customer deposits. But even a traditional bank is highly leveraged (i.e., the debt-to-equity or debt-to-capital ratio is much higher than for a corporation). If the assets decline in value, the equity can quickly evaporate. So, in simple terms, the Basel Accord requires banks to have an equity cushion in the event that assets decline, providing depositors with protection.

The regulatory justification for this is about the system: If big banks fail, it spells systematic trouble. If not for this, we would let banks set their own levels of equity -known as economic capital - and let the market do the disciplining. So, Basel attempts to protect the system in much the same way that the Federal Deposit Insurance Corporation (FDIC) protects individual investors. (For more insight, read Are Your Bank Deposits Insured?)

Bank Loans - Then and Now
The traditional "loan and hold" bank may now only exist in a museum. Modern banks "originate and distribute" and they have astonishingly complex balance sheets. For example, many banks have been tilting away from long-term illiquid assets and toward tradable assets. In addition, many banks routinely securitize. That is, they sell loan assets off of their balance sheets, or achieve a similar risk transfer by purchasing credit protection from a third party, often a hedge fund indirectly. This is a called a synthetic securitization. (To learn more, read Behind The Scenes Of Your Mortgage and What is securitization?)

The Original Accord Is Broken
The Basel I Accord, issued in 1988, has succeeded in raising the total level of equity capital in the system. Like many regulations, it also pushed unintended consequences; because it does not differentiate risks very well, it perversely encouraged risk seeking. It also promoted the loan securitization that led to the unwinding in the subprime market. (For more on the subprime crisis, check out our Subprime Mortgage Feature page.)

In short, Basel I has several shortcomings. And, although some people are mistakenly implicating all of Basel in some of the problems it has created, it is too early to tell whether Basel II will fail in regard to credit derivatives and securitizations. Basel II does try to address new innovations in risk but the cost is complexity.

Basel II Is Complicated
The new accord is called Basel II. Its goal is to better align the required regulatory capital with actual bank risk. This makes it vastly more complex than the original accord. Basel II has multiple approaches for different types of risk. It has multiple approaches for securitization and for credit risk mitigants (such as collateral). It also contains formulas that require a financial engineer.

Some countries have implemented basic versions of the new accord, but in the United States, Basel II is seeing a painful, controversial and prolonged deployment (even as large banks have been working for years to meet its terms). Many of the problems are inevitable: The agreement tries to coordinate bank capital requirements across countries and across bank sizes. International coherence is hard enough, but so is scaling the requirements - in other words, it is very hard to design a plan that does not give advantage to a banking giant over a smaller regional bank.

Basel II is Three Pillars
Basel II has three pillars: minimum capital, supervisor review and market discipline.

Copyright © 2007 Investopedia.com
Figure 1

Minimum capital is the technical, quantitative heart of the accord. Banks must hold capital against 8% of their assets, after adjusting their assets for risk.

Supervisor review is the process whereby national regulators ensure their home country banks are following the rules. If minimum capital is the rulebook, the second pillar is the referee system.

Market discipline is based on enhanced disclosure of risk. This may be an important pillar due to the complexity of Basel. Under Basel II, banks may use their own internal models (and gain lower capital requirements) but the price of this is transparency.

Basel II Charges for Three Risks
The accord recognizes three big risk buckets: credit risk, market risk and operational risk. In other words, a bank must hold capital against all three types of risks. A charge for market risk was introduced in 1998. The charge for operational risk is new and controversial because it is hard to define, not to mention quantify, operational risk (The basic approach uses a bank's gross income as a proxy for operational risk. It is not hard to challenge this idea.)

Copyright © 2007 Investopedia.com
Figure 2

The Basel II Transition
Not only is the implementation staggered globally, but the accord itself contains tiered approaches. For example, credit risk has three approaches: standardized, foundation internal ratings-based (IRB), and advanced IRB. Roughly, a more advanced approach relies more on a bank's internal assumptions. A more advanced approach will also generally require less capital, but most banks will need to transition to more advanced approaches over time.

Summary
The Basel II Accord attempts to fix the glaring problems with the original accord. It does this by more accurately defining risk, but at the cost of considerable rule complexity. The technical rules will be importantly supported by supervisor review (Pillar 2) and market discipline (Pillar 3). The goal remains: Maintain enough capital in the banking system to guard against the damage of financial shocks.

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