Bank International Settlement (BIS) was formed in 1930 by the Governor of The Bank of England, Montagu Norman, and a German counterpart Hjalmar Schact, later Adolf Hitler’s finance minister. The Bank for International Settlement (BIS) is the institutional home of the Basel Committee on Banking Supervision. Headquartered in Basel, Switzerland, and the organization’s mandates are to promote international monetary and financial cooperation and to serve as a bank for central bank. The BIS also houses the secretariats of several committees and organizations focusing on the international financial system, including the Basel Committee, although these entities are not formally a part of the BIS. BIS membership currently totals 55 central banks. (BIS History-Overview)

The BIS was created in 1930 within the framework of Young Plan to address the issue of German reparations. Its focus soon shifted to the promotion of international financial cooperation and monetary stability. These goals were initially pursued through regular meeting of central bank officials and economic experts directed toward promoting discussion and facilitating decision-making processes, as well as through the development of a research staff to compile and distribute financial statistics. The BIS also played a role in implementing and sustaining the Bretton Woods system. (BIS History-Overview)

Throughout its history, the BIS has retained its role as a bank for central banks, acting as an agent or trustee in connection with international financial operations and a prime counterparty for central banks in their financial transactions and proving or organizing emergency financing to support the international monetary system. The BIS assists central banks in their management of foreign currency reserves and itself holds about 6 percent of global foreign exchange reserves invested by central banks. (BIS History-Overview)

Introduction of Basel Committee on Banking Supervision

The Basel Committee on Banking Supervision states its objective as “improving supervisory understanding and the quality of banking supervision worldwide” (Basel Committee, 2007). Originally the Committee on Regulations and Supervisory Practices, it was created by the Group of Ten Countries (G-10) at the end of 1974, after the failure of Herstatt Banks caused significant disturbances in currency markets throughout the world. National representation on the committee comes from central banks and other agencies with responsibility for supervision of bank.

The committee has no formal legal existence or permanent staff, and the results of its activities do not have the force of international law. It provides a forum for exchanges of views several times a year in Basel, Switzerland, where it is housed at the headquarters of the Bank for International Settlements. The Committee’s members come from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. Its proceedings are neither open to the public nor- as with some entities like the Executive Board of the International Monetary Fund – memorialized in publicly available summaries (About the Basel Committee). However, it releases and maintains on its website a steady stream of documents on standards, recommendations, guidelines, and best practices for supervision of internationally active banks. The Committee encourages contacts and cooperation among its members and other banking supervisory authorities. It circulates to supervisors throughout the world both published and unpublished papers providing guidance on banking supervisory matters. Contacts have been further strengthened by an International Conference of Banking Supervisors (ICBS) which takes place every two years (About the Basel Committee).

The committee’s works is organized under four principal subcommittees: the Accord Implementation Group (dealing specifically with Basel II), the Policy Development Group (dealing with new and emerging issues), the Accounting Task Force, and the International Liaison Group (which structures interactions between the Basel Committee and non- Basel Committee supervisors).

Introduction of Basel I

Basel I was motivated by two interacting concerns – the risk posed to the stability of the global financial system by low capital levels of internationally active banks and the competitive advantages accruing to banks subject to lower capital requirements (Danniel. K. Tarrulo). These interacting concerns made the Basel I process a kind of hybrid of an international trade negotiation and a regulatory exercise. Although national competitiveness concerns became more dominant as time went on, the Basel I process never departed from the premise that capital ratios of internationally active banks needed to rise. The Basel I accord and its implementation largely fulfilled this situation.(About the Basel Committee)

There are three scopes of Basel I, which are: (a) to promote the harmonization of regulatory and capital adequacy standards only within the member states of the Basel Committee; (b) to provide adequate capital to guard against risk in the creditworthiness of a bank’s loan book; (c) proposes minimum capital requirements for internationally active banks, and invites sovereign authorities and central banks alike to be more conservative in their banking regulations (Balin, 2008).

The accord, by its own terms, addressed only credit risk, while acknowledging that banks must guard against other kinds of risk as well (Danniel. K Tarullo). The basic approach was to assign each asset or off-balance-sheet item held by a bank to one of five risk categories, calculate the capital required for each asset or item based on the risk weighting, and then add all these amounts together to produce the total minimum capital ratios: a bank’s core capital, called “tier 1” capital by the committee, which was to be at least 4 percent of risk-weighted assets, and a bank’s total capital, which included so-called tier 2 components and was to be at least 8 percent of risk-weighted assets. Core, or tier 1, capital consisted of the universally recognized elements of shareholders’ equity, retained earnings, and noncumulative perpetual preferred stock. Other elements, such as revaluation reserves, subordinated debt, general loan-loss reserves, and certain hybrid capital instruments were designated as tier 2 capital.

The accord endorsed and consolidated the movement toward risk weighting of assets that had been advancing in the preceding decade. Five risk categories encompass all assets on a bank’s balance sheet.

0 Percent

Cash

Claims on central governments and central banks denominated in national currency and funded in that currency

Other claims on OECD countries, central governments, and central banks

Claims collateralized by cash of OECD central government securities or guaranteed by OECD central government

0, 10, 20, or 50 Percent (at National Discretion)

Claims on domestic public sector entities, excluding central governments, and loans guaranteed by securities issued by such entities

20 Percent²

Claims on multilateral development banks and claims guaranteed or collateralized by securities issued by such banks

Claims on, or guaranteed by, banks incorporated in the OECD

Claims on, or guaranteed by, banks incorporated in countries outside the OECD with a residual maturity of up to one year

Claims on nondomestic OECD public-sector entities, excluding central government, and claims on guaranteed securities issued by such entities¹

Cash items in process of collection

50 Percent

Loans fully secured by mortgage on residential property that is or will be occupied by the borrower or that is rented

100 Percent

Claims on the private sector

Claims on banks incorporated outside the OECD with a residual maturity of over one year

Claims on central governments outside the OECD (unless denominated and funded in national currency)

Claims on commercial companies owned by the public sector

Premises, plant and equipment, and other fixed assets

Real estates and other investments

Capital instruments issued by other banks (unless deducted from capital)

All other assets

Amended in 1994 to include claims collateralized by securities of public-sector entities other than central government.

A 1998 amendment added to the 20 percent risk-weight category claims on securities firms incorporated in the OECD subject to comparable supervisory and regulatory arrangements

Source: Basel Committee (1988)

Development of Basel I

Basel’s adaptation and implementation occurred rather smoothly in the Basel Committee states. With the exception of Japan (which, due to the severity of its banking crisis in the late 1980s, could not immediately adopt Basel I’s recommendations), all Basel Committee members implemented Basel I’s recommendations including the 8% capital adequacy target by the end of 1992. Japan later harmonized its policies with those if Basel I in 1996. Although they were not intended to be included in the Basel I framework, other emerging market economies also adopted its recommendations. In contrast to the pointed warnings written into Basel I against implementation in industrializing countries, the adoption of Basel I standards was seen by large investment banks as a sign of regulatory strength and financial stability in emerging markets, causing capital-hungry states such as Mexico to assuage to Basel I in order to receive cheaper bank financing. By 1999, nearly all countries, including China, Russia, and India, had at least on paper implemented the Basel Accord (Balin, 2008).

As concluded, Basel I was an impressive accomplishment in purely institutional terms. However, there are several criticisms in Basel I. The most important criticisms of Basel I were that it had gaps in its coverage and that the opportunities it created for regulatory arbitrage became progressively more serious as the mix of bank activities shifted toward securitization, writing derivatives, and other financial products that had comprised much smaller segments of major bank activity during the period in which Basel I was drafted. In response to the banking crises of the 1990s and the aforementioned criticisms of Basel I, the Basel Committee decided in 1999 to propose a new, more comprehensive capital adequacy accord, known formally as A Revised Framework on International Convergence of Capital Measurement and Capital Standards and informally as “Basel II” (Daniel. K Tarullo)

Introduction of Basel II

The Basel II Framework (the official name is International Convergence of Capital Measurement and Capital Standards: a Revised Framework) is a new set of international standards and best practices prepared by the Basel Committee on Banking Supervision that define the minimum capital requirements for internationally active banks (Allen & Overy, 2008). Banks have to maintain a minimum level of capital, to ensure that they can meet their obligations; they can cover unexpected losses, and can promote public confidence (which is of paramount importance for the international banking system). Banks like to invest their money, not keep them for future risks. Regulatory capital (the minimum capital required) is an obligation. A low level of capital is a threat for the banking system itself: Banks may fail, depositors may lose their money, or they may not trust banks any more. This framework establishes an international minimum standard (Lekatis, 2009). Basel II will be applied on a consolidated basis (combining the bank’s activities in the home country and in the host countries).

There are three pillar of Basel II, as stated in the followings:

Pillar 1 Minimum Capital requirement

Credit Risk

Standardized Approach

Addition of a 150 percent risk category to the 0, 20, 50, and 100 percent Basel I categories

Risk ratings may be based on evaluation of external credit assessment institutions; corporate exposures may thus be as low as 20 percent

Credit conversion factor approach retained for off-balance-sheet exposures; conversion factor for commitment with maturity under one year increased from 0 percent under Basel I to 20 percent

Internal Ratings – Based Approaches

Exposures allocated to risk categories based on internal bank assessments of probability of default and – in the advanced internal ratings – based(IRB) approach – loss given default, exposure at default, and maturity

Extensive requirements for IRB eligibility – e.g. rating system design, validation of internal estimates, disclosure requirements

Securitization Exposures

Standardized Approach

External ratings used to risk-weight exposures

Deductions from capital generally required for unrated exposures

Originating banks required to deduct retained exposures below investment grade

Internal Ratings – Based Approach

For externally rated exposures, IRB banks must use ratings – based approach, similar to standardized approach but taking into account seniority and granularity of exposure

Unrated exposures generally risk weighted through highly complex supervisory formula that incorporates certain bank-supplied inputs

Operational Risk

Basic indicator approach requires capital charge of 15 percent of bank’s average annual gross income in preceding three years

Standardized approach requires capital charge between 12 and 18 percent of bank’s average annual gross income in preceding three years for each of eight lines of business

Advanced measurement approach requires capital charge equal to risk measure generated by bank’s internal operational risk measurement system

Market risk

Conforming changes to 1996 Market Risk Amendment to minimize arbitrage possibilities between assets held in banking book and those held in trading book

Pillar 2 Supervisory Review

Four Principles for Supervisory Review

Bank process for assessing overall capital adequacy in light of its risk profile

Supervisory ability to monitor and enforce regulatory capital requirements

Supervisors should expect banks to operate above minimum regulatory capital levels and have ability to require banks to hold capital above minimum

Supervisors should seek to intervene at an early stage to prevent capital from falling below minimum levels and should require remedial action

Selected Specific Issues

Supervisors must take action to deal with “outlier” banks, defined as those whose capital could decline by more than 20 percent in response to an interest rate shock of 200 basis points

Supervisors should assess bank credit risk concentration and management

Supervisors should adapt to securitization innovations

Pillar 3 Market Disciplines

Banks should have a formal disclosure policy and internal controls to implement it

Specific disclosure requirements on scope of application of revised framework in the banking group, capital structure, capital adequacy, credit risk, credit risk mitigation, counterparty credit risk, securitization, market risk, operational risks, equities, and interest rate risk

Credit risk disclosure requirements include explanation and description of internal ratings system for portfolios subject to IRB approach

Sources: Basel Committee (2004)

Development of Basel II

After its drafting in 1999, Basel II underwent seven years o deliberation and two revisions before a final agreement was agreed upon by all G-10 nations and representative from Spain in July 2006. Over the course of the Accord’s deliberation, the size of the agreement ballooned to 347 pages. The development process of the Basel II and the proposed changes on the Basel II during the process are stated in the following (Tarullo, 2008):

1999

Release of the First Consultative Paper

Orientation of Basel II policy development

The committee placed all the quantitative capital requirements in the context of what it described as a “three-pillar” approach

One additional risk bucket would be created (a 150 percent risk weighting)

Proposed special rules to deal with retained interests following securitizations, adjustments to capital requirements for certain risk mitigation measures taken by banks, consolidation requirements intended to reduce “double gearing”

2001

Second Consultative Paper issued on Basel II

Promote domestic implementation by establishment of IRB, which envisioned two distinct approaches:

“foundational” internal rating – based (F-IRB) approach

A-IRB approach

Proposed the addition of a fourth 50 percent risk bucket for corporate exposures, a preferential risk weight for short-term exposures to other banks denominated in the local currency, and the possibility that a bank or corporation could have a lower risk weighting than the sovereign in its country of incorporation.

Introduction of three separate methodologies for banks of varying risk management capabilities

Issued guidelines for supervisory review of the minimum standards for IRB eligibility, supervisory transparency and accountability, and the review of interest rate risk

Specified disclosures that would facilitate the exercise of market discipline on risk-taking by banks. These requirements, divided into core and supplementary disclosures, were grouped into 10 topical areas

Modification of treatment of expected and unexpected losses (July 2001)

Proposed on internal ratings – based (IRB) treatment of equity exposures (August 2001)

Changes in credit risk mitigation techniques, reduction in number of disclosures required under pillar 3, changes and elaborations in operational risk proposal (September 2001)

Proposal on IRB treatment of securitizations and proposed on IRB approach to specialized lending exposure (October 2001)

2002

Major changes in previously announced proposals, including creation of new risk-weigh curve for credit card exposures, more favourable risk weightings for exposures to SME, elimination of floor capital requirement under an advanced management approach to operational risk, changes in floor capital requirements (July 2002)

Second set of proposals on treatment of asset securitization (October 2002)

2003

Release of the Third Consultative Paper

Guidelines for management of operational risk (February 2003)

Principles for cross-border implementation of new accord (August 2003)

Proposal on treatment of expected losses and statement of intention to simplify treatment of asset securitization, to revisit treatment of credit card exposures, and to modify certain credit risk mitigation techniques (October 2003)

2004

Modification for expected losses, changes to the securitization framework, principles for home-host recognition of advanced management approach operational risk capital, clarifications on implementations of pillar 2 (January 2004)

Release of comprehensive consultative paper on Basel II implementation

Submission of Banks’ Basel II rollout plan

2005

Finalization of the Basel Framework

Development of formal draft guidance (“CAR”)

Expansion of supervisory review related to pillar 1

Development of data reporting requirements (“BCAR”)

2006

A-IRB applications and on-site reviews of A-IRB system

Finalization of supervisory guidance

The start of parallel reporting

2007

Rollout of Basel II implementation and approval reviews

Basel II started on November 1, 2007

Additionally, there are several changes to Basel II following the subprime crisis, including strengthened capital requirements for assets held in the trading book, higher capital requirements for complex structured credit products, new guidance on risk management practices (e.g. capital planning, stress testing, management of firmwide risks), and enhanced disclosures relating to complex securitizations, asset-backed commercial paper conduits, and the sponsorship of off-balance-sheet entities (Tarullo, 2008).

In conclusion from the analysis of Basel II is that capital regulation cannot bear as much of the weight of prudential regulation as has been placed upon it. Uncertainty about the efficacy of capital regulation – whether based on an IRB, standardized, or some other approach – counsels greater attention to other prudential tools. The subprime crisis has dramatically reinforced this conclusion by revealing the extent of liquidity and reputational risks associated with certain banks that were, under prevailing regulations, “well capitalized”. Basel II, in all intents and purposes, never came properly into effect. In July 2009 the Basel Committee proposed a new framework, Basel III.

Introduction of Basel III

Basel III is a new global regulatory standard on bank capital adequacy and liquidity, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector. This framework aimed to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, improve risk management and governance, and strengthen banks’ transparency and disclosures (International regulatory framework for banks (Basel III)). Basel III issued by the Basel Committee in December 2009 aims to fix several problems noted in Basel II. Below are the proposed changes from Basel II to Basel III:

Raise the quality, consistency and transparency of the capital base

The predominant form of Tier 1 capital must be common shares and retained earnings, Tier 2 capital instruments will be harmonized, and Tier 3 capital will be eliminated.

Enhancing risk coverage

Strengthen the capital requirements for counterparty credit exposures arising from banks’ derivatives, REPO and securities financing transactions and raise the capital buffers backing these exposures.

Provide incentives to strengthen the risk management of counterparty credit exposures.

Introduction of leverage ratio requirement

Put a floor under the build-up of leverage in the banking sector and introduce additional safeguards against model risk and measurement error.

Pro-cyclicality

The Committee is introducing a series of measures to address pro-cyclicality: (i) dampen any excess cyclicality of the minimum capital requirement; (ii) promote more forward looking supervisions; (iii) conserve capital to build buffers at individual banks and the banking sector that can be used in stress; and (iv) achieve the broader macro prudential goal of protecting the banking sector from periods of excess credit growth.

Introduction of a global minimum liquidity standard for internationally active bank

A 30-day liquidity coverage ratio requirement underpinned by longer-term structural liquidity ratio called the Net Stable Funding Ratio.

Review the need for additional capital, liquidity or other supervisory measures to reduce the externalities created by systematically important institutions.

Development of Basel III

In December 2009, the Basel Committee on Banking Supervision (BCBS) issued a consultative document setting out proposals for strengthening regulation of banks’ capital and liquidity (Basel III) in the light of lessons learnt from recent experience, especially that of the current financial crisis, with the goal of improving the resilience of the financial system. In the case of capital, the proposals build on the framework of Basel II as set out in the 2006 draft. But Basel II has now been extended to include rules for the management of liquidity risk.

This extension is justified by the fact that crises or serious threats to banks’ solvency (and thus to the adequacy of their capital) are typically triggered by pressures on their liquidity positions in the form of difficulties over financing their portfolios of assets. Thus, the measurement and management of banks’ capital is indissolubly linked to the successful management of their liquidity, a link graphically illustrated by events during the current financial crisis.

In August 2010, the Basel Committee and the Financial Stability Board (FSB) issued two reports assessing the impact of Basel III. These followed the publication of estimates of this impact by other bodies, including one by the Institute of International Finance (IIF), an industry body of international banks.

One of the two official reports is concerned with the impact during the transition period when the new requirements for capital and liquidity were being phased in and focussed exclusively on the costs of introduction of the new requirements. The other report of a working group of the BCBS analyses the long-term economic impact (LEI) of Basel III. Long-term is defined by the assumption that banks have completed the transition to the new regulations on capital and liquidity. The LEI report assesses the economic benefits as well as the costs of the regulations. The conclusions of these two reports are that the costs in terms of lost output due to the changes in capital and liquidity requirements are likely to be moderate and less than those estimated by the banking sector itself in the parallel exercise of the Institute of International Finance. Moreover, the LEI report concludes that there will be significant benefits from these changes due to the lower incidence of financial crises and that these benefits outweigh the costs by a significant amount.

Conclusions and Recommendations

Before concluding, one very important fact to assess is the achievements and limitations of each Basel Accord. The first Basel Accord, Basel I, was a groundbreaking accord in its time, and did much to promote regulatory harmony and the growth of international banking across the borders of the G-10 and the world alike. However, its limited scope and rather general language gives banks excessive freedom in their interpretation of its rules, and, in the end, allows financial institutions to take improper risks and hold extremely low capital reserves. Basel II, on the other hand, seeks to extend the breath and precision of Basel I, bringing in factors such as market and operational risk, market-based discipline and surveillance, and regulatory mandates. Alternatively, in the words of Evan Hawke, the U.S. Comptroller of the Currency under George W. Bush, Basel II is “complex beyond reason” (Jones, 2000), extending to nearly four hundred pages without indices, and, in total, encompassing nearly one thousands pages of regulation.

The drawbacks of both accords, interestingly enough, are remarkably similar. Both effectively ignore the implications of their rules on emerging market banks. Although each states that its positions are not recommended for application in emerging market economies, the use of Basel I and II by most private and public organizations as truly international banking standards predicates the inclusion of emerging markets in each accord. The failure of this inclusion has put emerging markets in an awkward position—they can either adopt Basel I and II, receive international capital flows, or face excessive risk-taking and an overwhelmed central bank, or they can be cut off from most international capital. Therefore, it is highly beneficial to the safety and stability of the international financial system—and moreover, the international economy—to include emerging market economies in future revisions of the Basel Accords.

The advent of the subprime crisis triggered a debate over whether a fully implemented Basel II would have mitigated the risk associated with securities backed by subprime mortgages. Important as the merits of this debate are, the most significant argument is one that neither side can make credibly – that any capital regulation regime could have sufficiently contained these risks so that the subprime situation would have been merely a problem rather than a crisis. The OECD has identified the hallmarks of the crisis as: (a) too-big-to-fail institutions that took on too much risk; (b) insolvency resulting from contagion and counterparty risk, driven mainly by the capital market activities of banks; (c) lack of regulatory and supervisory integration; and (d) lack of efficient resolution regime to remove insolvent firms from the system (Blundell-Wignal & Atkinson, 2010).

How do the Basel III proposals bear on these issues, in the sense of helping to ensure that the chance of another crisis like the current one can be greatly reduced? The Basel III capital proposals have some very useful elements – notably the support for a leverage ratio, a capital buffer and the proposal to deal with pro-cyclicality through dynamic provisioning based on expected losses. Adopting the buffer capital proposal to ensure the leverage ratio was not compromised in crisis situations seems especially important – so that in good times, dividends, share buyback policies and bonuses would be restrained as necessary to build back buffers used up in bad times – seems very important.

Perhaps most significantly, the cumulative experience of the subprime crisis and other instances of financial distress in recent year suggests that more attention must be paid to the systemic risks that arise from the interactions among financial participants and that cannot be measured or contained solely by a focus on each individual institution’s balance sheet (US Department of the Treasury. 2008).

Finally, Basel II rules have been incorporated into domestic banking regulation in the Basel Committee countries and will be implemented by many non-committee countries as well. Thus, the recommendations here begin from this fact bur urge changes to both the substantive capital rules and to the institutional mechanisms for overseeing those rules. The focus should be on principles, straightforward common rules, peer review, and coordinated procedures for enforcement of domestic laws. Specifically with respect to capital regulation, the Basel Committee should (Tarullo, 2008):

Accelerate its work on redefining capital. Capital regulation means little if the definition of capital is not limited to the kinds of buffets that will actually protect a bank from insolvency. The definition of capital was a subject of compromise in the original Basel I negotiations and has been subsequently expanded excessively.

Institute a requirement that complex, internationally active banks issue subordinated debt with specific, harmonized characteristics. While not an assured income, there is a reasonable chance that the market pricing of this debt would serve a “canary in a coal mine” role in alerting supervisors to potential problems at bank.

Strengthen the monitoring role of the Basel Committee. This should include regular and substantially more robust peer review of national regulatory activity to implement Basel rules and principles. The committee should regularly report on bank capital positions and capital supervision. Finally, and most importantly, the committee should establish a special inspection unit – a supranational team of experts that conducts in-bank validations of the credit risk models used by internationally active banks in the Basel Committee countries. This unit would serve both to disseminate expertise among the various national supervisors and to provide some monitoring of their own validation of their banks’ models and attendant risk management.