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Summary Chapter 15 - Basel I, Basel II and Solvency
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Only the formulas included in this chapter have to be known for the exam.
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3. Basel I, Basel II and Solvency II3.1.The reason for regulating banks
The main purpose of bank regulation is to ensure that a bank keeps enough capital for the risks it
takes. It is not possible to eliminate altogether the possibility of a bank failing, but governments
want to make the probability of default for any given bank very small.
A major concern of governments is what is known as systemic risk11. When a bank or other large
financial institution does get into financial difficulties, governments have a difficult decision to
make. If they allow the financial institution to fail, they are putting the financial system at risk. If
they bail out the financial institution, they are sending the wrong signals to the market.There is a
danger that large financial institutions will be less vigilant in controlling risks if they know that they
are “too big to fail” and the government will always bail them out.
Because capital requirements are put in place to guarantee the stability of the financial system,
national banks play an important role in setting these requirements.
3.2.Bank regulation pre-1988
Prior to 1988, bank regulators within a country tended to regulate bank capital by setting
minimum levels for the ratio of capital to total assets. However, definitions of capital and the ratios
considered acceptable varied from country to country. And some countries enforced their
regulations more diligently than other countries.
Increasingly, banks were competing globally and a bank operating in a country where capital
regulations were slack was considered to have a competitive edge over one operating in a
country with tighter, more strictly enforced capital regulations. In addition, the huge exposures
created by loans from the major international banks to less developed countries such as Mexico,
Brazil, and Argentina, as well as the accounting games sometimes used for those exposures were
starting to raise questions about the adequacy of capital levels.
Another problem was that the types of transactions entered into by banks were becoming more
complicated.The over-the-counter derivatives market for products such as interest rate swaps,
currency swaps, and foreign exchange options was growing fast. These contracts increase the
credit risks being taken by a bank. The potential future exposure from derivatives was not
reflected in the bank’s reported assets. As a result, it had no effect on the level of assets reported
by a bank and therefore no effect on the amount of capital the bank was required to keep. It
became apparent to regulators that the value of total assets was no longer a good indicator of the
total risks being taken.A more sophisticated approach than that of setting minimum levels for the
ratio of capital to total balance-sheet assets was needed.
The Basel Committee was formed in 1974:
The Basel Committee for Bank Regulation: Committee of the central banks and banking
supervisors of the main industrial countries Established in 1974: Belgium, Germany, France, Italy,
Japan, Canada, Luxembourg, the Netherlands, Sweden, Switzerland, USA, and the United
Kingdom
- The Basel Committee governs fundamental aspects of bank supervision
11Systemic risk is the risk that a default by one financial institution will create a “ripple effect” that
leads to defaults by other financial institutions and threatens the stability of the financial system.
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, - The Bank for International Settlements (BIS), in Basel, serves as a meeting location for the Basel
Committee, and provides administrative support. The BIS is itself not involved in drawing up
the regulatory requirements.
- The BIS is owned by, and provides services to central banks. It is the lender of last resort for
central banks.
3.3.The 1988 BIS accord
The 1988 BIS Accord was the first attempt to set international risk-based standards for capital
adequacy. It has been subject to much criticism as being too simple and somewhat arbitrary. In
fact, the Accord was a huge achievement. It was signed by all 12 members of the Basel
Committee and paved the way for significant increases in the resources banks devote to
measuring, understanding, and managing risks. The key innovation in the 1988 Accord was the
Cooke ratio.
3.3.1.The Cooke Ratio
The Cooke ratio considers credit risk exposures that are both on-balance-sheet and off-balance-
sheet. It is based on what is known as the bank’s total risk-weighted assets (also sometimes
referred to as the risk-weighted amount). This is a measure of the bank’s total credit exposure.
Credit risk exposures can be divided into three categories:
I. Those arising from on-balance sheet assets (excluding derivatives)
II. Those arising for off-balance sheet items (excluding derivatives)
III. Those arising from over-the-counter derivatives
Each on-balance-sheet asset is assigned a risk weight reflecting its credit risk:
- 0% on cash, gold bullion, claims on OECD governments such as Treasury bonds or insured
residential mortgages
- 20% on claims on OECD banks and OECD public-sector entities such as securities issued by
U.S. government agencies or claims on municipalities
- 50% on uninsured residential mortgage loans
- 100% on all other claims such as corporate bonds and less developed country debt, claims on
non-OECD banks
Consider next the second category. This includes bankers’ acceptances, guarantees, and loan
commitments.
A credit equivalent amount is calculated by applying a conversion factor to the principal amount
of the instrument. Instruments that from a credit perspective are considered to be similar to loans,
such as bankers’ acceptances, have a conversion factor of 100%. Others, such as note issuance
facilities (where a bank agrees that a company can issue short-term paper on pre-agreed terms in
the future), have lower conversion factors.
Finally, consider the third category. For an over-the-counter derivative
such as an interest rate swap or a forward contract, the credit V = the current value of
equivalent amount is calculated as: the derivative to the
max(V, 0) + aL bank
The first term in equation is the current exposure (current replacement a = an add-on factor
cost). L = the principal
If the counter-party defaults today and V is positive, the contract is an
asset to the bank and the bank is liable to lose V. If the counter-party
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