1.0 Introduction

Bank of International Settlement (BIS) is an international organization fostering the cooperation of central banks. In other words, it serves as a bank for central banks. The BIS is located in Basel, Switzerland, and has representative offices in Mexico City and Hong Kong. Its member banks include the Bank of Canada, the Federal Reserve Bank and the European Central Bank.

It was formed on 27 May 1930 and regarded as the world’s oldest international financial organization. The idea for this establishment was from Young Committee in 1930 in order to facilitate the reparation payments imposed on Germany by the Treaty of Versailles after the First World War. Afterward, it took over the functions previously performed by the Agent General for Reparations in Berlin. Its main roles were including collection, administration and distribution of the annuities payable as reparations. Therefore, the Bank’s name is derived due to this reason. Besides, another purpose of the BIS was to stimulate the development of and cooperation between central banks.

Subsequently, the BIS developed into a bank in order to coordinate the cooperation between central banks and promoting their financial and monetary stability.  Its main goals are to promote information sharing and become a center for economic research.

Until the early 1970s, the main activities of the BIS were the Bretton Woods system implementation. In 1970s and 1980s, it focused on managing cross-border capital flows due to oil crisis and the debt crisis. These crises have resulted in the need for international banking supervision and standards. Thus, the first Basel Capital Accord was adopted in 1988. Its fundamental purpose was to require banks to pledge sufficient capital to protect them from financial distress.

The Basel Capital Accord was then found posses some serious weaknesses and failed to regulate the banks. Consequently, it was replaced by a new set of guidelines which known as Basel II issued by Basel Committee on Banking Supervision (BCBS) in 2007. Under Basel II, the banks were required to make adjustment to their capital according relative to the type and amount of risk.

2.0

Basel IEven though the Basel II has some advantages over the Basel Capital Accord, however, its deficiencies in financial regulation were revealed by the Global Financial Crisis. As a result, the Basel Committee carries out the broad framework and concrete proposal of the Basel III in 2009. It is a comprehensive set of reform measures aims to strengthen the bank capital requirements. It also set up new regulatory requirements especially on bank liquidity and leverage (History of the, 2009).

Basel I was the first accord and was introduced in 1988 by the Basel Committee on Banking Supervision (BCBS). It was established to promote the stability of regulatory (Balin, 2008) and to create minimum levels of capital for international active banks (Ahmed & Khalidi, 2007). In addition, Basel I also cooperates with sovereign authorities and central banks alike, thus to become more conservative in their banking regulations. Moreover, the capital adequacy ratios are prohibited to be viewed in separation and as the crucial arbiters of a bank’s solvency (Balin, 2008).

Besides, Basel I was designed only to provide adequate capital to protect against risk in the bank’s creditworthiness. It does not mandate the capital to guard against risks including fluctuations in a country’s currency as well as interest rates (Balin, 2008).

The Basel I consists of four “pillars”. The first “pillar” known as “The Constituents of Capital” and it defines the kinds of capital held as a bank’s reserves and the amount they can hold it. The capital reserves are divided into two tiers. The first tier is “Tier 1 Capital,” for instances, common stock and preferred shares. The second tier is “Tier 2 Capital”. This capital incorporates reserves created to cover potential loan losses, holdings of subordinated debt, hybrid debt or equity instrument holdings, and potential gains from the sale of assets purchased through the sale of bank stock (Balin, 2008).

The second “pillar” is “Risk Weighting”, which creates a comprehensive system to risk-weight a bank’s assets. Furthermore, it was aimed at setting standards based on relatively crude method of assigning risk weights to balance sheet and off balance sheet asset categories and focused mainly on the credit risks (Balin, 2008). There are five risk categories contain all assets on a bank’s balance sheet which are 0% -cash, OECD government debt, 20% -mortgage-backed bonds and government obligation (GO) municipal bonds, 50% -home, loans and municipal revenue bonds and 100% -private sector debt, non-OECD bank and bank premises.

The third “pillar” is “A Target Standard Ratio”. It combines the first and second pillars of the Basel I Accord. A universal standard is set, so that Tier 1 and Tier 2 capital reserves are able to cover 8% of a bank’s risk-weighted assets. For Tier 1 capital, there must be at least 4% of a bank’s risk-weighted assets to be covered. This ratio is perceived as “minimally adequate” to prevent credit risk in deposit insurance-backed in all Basel Committee banks (Balin, 2008).

The last “pillar” is “Transitional and Implementing Agreements”, which facilitates the implementation of the Basel Accords. Each country’s central bank is required to build strong surveillance as well as enforcement mechanisms to ensure the compliance of Basel Accords (Balin, 2008).

2.1

In 1999, the Basel Committee proposed a new and a more comprehensive capital adequacy accord in order to improve the criticisms of the Basel I. This accord is known as A Revised Framework on International Convergence of Capital Measurement and Capital Standards (Basel II). Besides, the “pillar” framework of Basel I is still maintaining but Basel II covers a broader range of approaches to credit risk, adapts to the securitization of bank assets, covers market, operational, and interest rate risk, as well as incorporates market based on surveillance and regulation (Balin, 2008).

Basel II consists of three pillars. The first “pillar” contains the minimum capital requirements for credit risk, market risk and also operational risk. This “pillar” involves three methodologies to measure the riskiness of a bank’s assets. The standardized approach is the simplest method. The risk weights are derived from ratings set by external credit assessment institutions or export credit agencies (Valova, 2007). Beyond the standardized approach, two alternate approaches are suggested in Basel II toward risk-weighting capital. One of them is known as an Internal Ratings Based Approach (IRB), which encourage banks to create their own internal systems to analyse risk with the assistance of regulators. The second internal ratings based approach is Advanced Internal Ratings Based Approach. The main difference is that the banks themselves to make assumptions of their credit default models. Hence, this standard is suitable for the largest banks with the complex modes (Balin, 2008).

Secondly, Basel II takes the assessment of and protection against operational risks into consideration. Basel II proposes three mutually exclusive methods (Balin, 2008). The first method is the Basic Indicator Approach. This approach used to calculate for the capital charge as a fixed percentage (Valova, 2007). The second method, namely Standardized Approach, categorizes banks according to their business lines to determine the volume of cash a bank must hold to protect itself against operational risk. The third method, known as Advanced Measurement Approach, is much less arbitrary than other approaches (Balin, 2008). On the other hand, banks are allowed to use their own various internal methods and models. The methods and models have to be approved by the supervisory authority (Valova, 2007).

Lastly, market risk evaluated in Pillar I of Basel II attempts to measure the reserves needed to be held by banks, for instance, the risk of loss due to changes in asset prices. Basel II also differentiates the fixed income and other products such as equity and commodity. It also divides into interest rate and volatility risk, which are the two principal risks that contribute to overall market risk (Balin, 2008).

In addition, Pillar II is the supervisory review process. This “pillar” seeks to strengthen and reinforce the role that national supervisors play to guarantee the effectiveness of the accord (Elizalde, 2006). The supervisors will evaluate bank measurement techniques with respect to credit and operational risks. It is important to consider the soundness and quality of the bank’s management and control mechanisms. It is necessary for bank to have internal processes in place to assess called Capital Adequacy Assessment Process (CAAP). The absolute minimum of capital adequacy is still 8% of the value of risk-weighted assets (Valova, 2007).

Pillar III will be the market disciplined. It seeks to enhance disclosure and transparency by strengthening banks’ financial reporting system and by encouraging market discipline and allowing the key stakeholders to assess key pieces of information in the scope of application, capital risk exposures, and capital adequacy of the institution (Ahmed & Khalidi, 2007). On the other hands, Basel II aims to authorize shareholders to emphasize discipline in the risk-taking activities (Balin, 2008).

Basic differences between the Basel I and II