The world financial market is an extremely complex system that involves many different participants from local banks 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 between the world's banking regulators, 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, when a faltering capital market might hurt the real economy.
In this article, we will take a look at the intent of the Basel Accords and see how the Basel II accord affected the financial system before the 2008 financial crisis. We'll also see how later accords attempted to shore up the weaknesses of the Basel II regulatory framework.
- The Basel Accords are a set of regulatory standards established by an agreement between central banks and financial regulators.
- The Basel II Accord intended to protect the banking system with a three-pillared approach: minimum capital requirements, supervisory review and enhanced market discipline.
- Basel II was expected to take full effect in 2008, but was interrupted by the 2007 financial crisis.
- Basel II was quickly replaced by Basel III, a new set of regulatory standards intended to reduce system-wide risks to the banking sector.
Basel Accords Establish Minimum Capital Requirements
The Basel Accords determine how much equity capital—known as regulatory capital—a bank must hold to buffer unexpected losses. In the Basel I accord, adopted in 1988, the Basel Committee on Banking Supervision established that international banks must keep liquid assets equivalent to 8% of their risk-weighted assets.
The regulatory justification for this is about the system: if a big bank fails, it could have a domino effect on the rest of the banking system, causing losses to depositors, creditors, and, ultimately, taxpayers. So, Basel attempts to protect the system in much the same way that the Federal Deposit Insurance Corporation (FDIC) protects the domestic banking system.
Why Basel II Was Needed
The Basel I Accord succeeded in raising the minimum capital requirements across the international banking system. However, it also had some unintended consequences. Because it did not differentiate risks very well, it perversely encouraged risk-seeking behavior. It also promoted the loan securitization that would later lead to the unwinding in the subprime market.
Recognizing that the original accord did not effectively guard against credit risk, the Basel Committee continued to discuss ways to shore up the financial system. In 2004, the Committee published a new set of regulatory standards to shore up the system against potential threats.
The Basel Committee
The Basel Accords are established by the Basel Committeee on Banking Supervision, an intergovernmental body of central banks and financial regulators from 28 jurisdictions.
The 3 Pillars of Basel II
Basel II is vastly more complex than the original accord, with multiple approaches for different types of risk. It also has multiple approaches for securitization and for credit risk mitigants (such as collateral).
The new agreement consists of three pillars: minimum capital requirements, supervisory review process, and market discipline.
- Minimum capital is the technical, quantitative heart of the accord. As in Basel I, the new standard required banks to hold capital against 8% of their risk-weighted assets. But Basel II also introduced a tiered system for different types of capital. Tier 1 capital is the highest quality of capital, such as shareholder equity and retained earnings, and tier 3 includes lower-quality assets such as subordinated loans. Basel II sets regulatory minimums for all three tiers.
- Supervisor review is the process whereby national regulators ensure their home country banks are following the rules. This pillar required banks to implement internal risk ratings and capital assessment processes, with oversight by their boards and senior members.
- Market discipline refers to the disclosure requirements for individual banks, allowing other market players to assess each banks capital and risk exposures. Under this framework, banks are required to disclose all material information relating to their risk management policies, but enforcement is left to the individual regulators.
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.
Basel II Transition Interrupted by Crisis
Following the publication of the Basel II framework, regulators began to slowly adopt the new standards, with full implementation expected by 2008. However, the partial rollout did not prevent the financial system from crashing in 2007, due largely to the credit risk factors that Basel II was intended to address.
As the crisis continued, financial regulators began discussing additional ways to shore up banking regulations and prevent another crash. The result was Basel III, a new set of regulatory standards announced in 2009. The new standards introduced leverage and liquidity requirements to prevent reckless borrowing and changed the tiered structure of regulatory capital. Tier 3 capital was eliminated, and the reforms introduced a 2.5% capital buffer requirement in addition to the 8% minimum capital requirements.
The Basel III reforms were finalized in 2017, with full implementation expected to be complete by 2023.
The Bottom Line
The Basel II Accord attempted to fix the problems with the original accord. It did this by more accurately defining risk, but at the cost of considerable rule complexity. However, the reforms arrived too late to prevent reckless borrowing from destabilizing the global banking sector. The Basel III reforms further enhanced regulatory safeguards and oversight, but it remains to be seen if these reforms will be effective. This is particularly the case in the era of fintech, cryptocurrencies, and blockchain. A decade ago, regulators faced the challenges of derivative reckless modeling; now, they face those of cryptography.