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The Basel Capital accords were first established in 1988 by the Bank of International Settlements in Basel, Switzerland, to provide a global definition of capital, and set minimum capital requirement for banks in over 100 countries. At the time the world’s financial system was running close to over-drive, and the intention of the Basel Capital accords was to enhance competitive equality for international banks, strengthen the overall stability of the banking system, and standardise the risk management practices banks adopt when determining how much they can afford to borrow against their reserves. In short, to prevent banks biting more than they can chew.

Despite the overall prosperity of the decade, the 1990s were marked by accelerating globalisation, cross-border capital flows, political instability, complacency in regulatory reform and contagious financial meltdowns. The world’s financial system became vulnerable to new threats. The Basel Capital Accords of 1988 became an overly simplistic tool for calculating minimum regulatory capital. Instead, it was recommended that the risk management methods banks adopt be used as a template for assessing lending capacity. This led to the development of the Basel II Capital Accord.

The Basel II Capital Accord is described as three pillars:

  • Pillar I defines minimum regulatory capital requirements, i.e.: the amount of capital banks must hold against risks
  • Pillar II defines the process for supervisory review of a bank’s risk management framework and its capital adequacy.
  • Pillar III defines bank disclosure requirements, which includes the methods banks adopt in calculating its capital adequacy and risk assessment framework.

    The Bank of International Settlements can then accredit banks according to these ratings:

  • Credit Risk Capital: How well can a bank withstand losses from its creditors defaulting. There are three measures: Standardised (calibrated from a few simple measures of creditworthiness), Internal Ratings Based Foundation (the Basel Committee determines the minimum size of a loan that requires supervision while the bank works out the probability of default), and Internal Ratings Based Advanced (as before, but with more stringent criteria).
  • Operational Risk Capital: How well can a bank withstand direct or indirect losses from inadequate/failed internal processes, people and systems, or external events. There are three measures: Basic Indicator Approach (basically how much money the bank has plus a percentage), Standardised Approach for Operational Risk (like the Basic Indicator Approach, but weighted different for each business line and activity), and Advanced Measurement Approaches (even more complicated than before, including balanced scorecards).

    So if you keep extending indefinite lines of credit to shady characters, or their cousins keep holding up your branches with shotties, don't expect your bank to pass Basel II.

    In many countries the local financial regulatory authorities will require banks to be compliant with Basel II (usually with some modifications to suit local conditions). The more established a bank is, the more likely they will attempt to be compliant with the Internal Ratings Based Advanced and the Advanced Measurement Approaches ratings.

    Banks themselves are motivated to obtain advanced Credit Risk and Operational Risk accreditation since it will reduce their own borrowing costs and improve the efficiency and effectiveness of their own operations.

  • From a U.S. perspective, the Basel II Accords can also be interpreted as a triumph of globalization over domestic politics. Following on the heels of the U.S. savings and loan meltdown and subsequent bailout, the Federal Reserve would have preferred to more aggressively regulate American banks. However, this proved to be an incredibly difficult endeavor, as it would have required the support of Congress - and since the Basel Accords are most definitely not in any particular bank's short-term interest (particularly if that bank is likely to run afoul of the regulators), there was little hope of getting the heavily-subsidized Congressional delegations to write and pass comprehensive banking reform legislation.

    However, since the Basel Accords are an international agreement, entering into their provisions is a matter for the Executive branch and the State Department, not the industry-captured Congress. As a result, the United States approached its traditional fiscal partner, the central bank of the U.K., and proposed the new banking regime. The Bank of England agreed in principle, but had their own concerns - namely, that the U.K., whose currency and hence banking was not fully integrated into the European Union, would suffer from the availability of cheap money from mainland European banks. The BoE agreed to the plan if the European banks (Germany, especially) could be included, since signing would preclude them from making inflationary capital available within the U.K. at low rates, which the U.K. couldn't otherwise legally preclude. The capital reserve requirements of Basel II would ensure that.

    Once that was settled, the next problem was that the European banks wanted the Pacific Rim banks (Japan in particular) brought on board. If the European banks were unable to provide paper at the low reserve ratios they had come to enjoy, the Japanese banks with their traditional easy availability of government capital through extremely low central bank rates would be able to simply take over the credit markets the European banks were servicing, either directly or through the new and burgeoning area of interest rate swaps and other synthetic financial products. And thus the Basel II accords swept eastwards.

    Looked at with this particular jaundiced eye, Basel II can be seen as a domestic American banking regulatory end-run that went a bit mad.

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