1. Basel I and Basel II (Chapter 15)
An agreement in 1988, known as the Basel Accord, marked the start of international standards for
bank regulation. Since 1988, bank regulation has been an evolutionary process. New regulations have
modified previous regulations, but many of the approaches used in previous regulations have usually
been preserved. In order to understand the current regulatory environment, it is therefore necessary
to understand historical developments. This chapter explains the evolution of the regulatory
environment prior to the 2007 credit crisis. Chapter 16 will cover developments since the crisis, and
Chapter 17 will cover a planned future development.
This chapter starts by reviewing the evolution of bank regulation between the 1980s and 2000. It
explains the 1988 Basel Accord (now known as Basel I), netting provisions, and the 1996 Amendment.
It then moves on to discuss Basel II, which is a major overhaul of the regulations and was implemented
by many banks throughout the world in about 2007. Finally, it reviews Solvency II, a new regulatory
framework for insurance companies, which is broadly similar to Basel II and is expected to be
implemented by the European Union in 2016.
Why? Because if you have more than that,
e.g. 2 mil., it’s not reasonable to put it in
1.1. The reasons for regulating banks a bank account, there are other places to
invest properly (mutual funds, stock,…)
Why regulatory capital?
• Does the banking sector self-regulate? =>Lecture: no, not ‘self’, maybe only in journalism sector
• Systemic risk =>Lecture: e.g. Lehman brothers during the banking crisis (2008/9)
Deposit insurance
• Most countries have some type of state operated guarantee scheme for bank deposits
(up to some amount)
• Why is deposit insurance needed?
▪ Lecture: To avoid a run on the bank (when <too much> people want their money back because
they lose trust in the bank, but they can’t do this because the bank hands out loans)
• What could be a possible unwanted effect of deposit insurance?
▪ Lecture: If we all know that our money in the bank is safe because we have deposit insurance
(€100 000 ) then banks might start taking too much risk
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. By doing this, they hope to create a stable
economic environment where private individuals and businesses have confidence in the banking system.
It is tempting to argue: “Bank regulation is unnecessary. Even if there were no regulations, banks would
manage their risks prudently and would strive to keep a level of capital that is commensurate with the
risks they are taking.” Unfortunately, history does not support this view. There is little doubt that
regulation has played an important role in increasing bank capital and making banks more aware of
the risks they are taking.
As discussed in Section 2.3, governments provide deposit insurance programs to protect depositors.
Without deposit insurance, banks that took excessive risks relative to their capital base would find
it difficult to attract deposits. However, the impact of deposit insurance is to create an environment
where depositors are less discriminating. A bank can take large risks without losing its deposit base1.
1
As mentioned in Chapter 3, this is an example of what insurance companies term moral hazard. The existence
of an insurance contract changes the behaviour of the insured party.
,The last thing a government wants is to create a deposit insurance program that results in banks taking
more risks. It is therefore essential that deposit insurance be accompanied by regulation concerned
with capital requirements.
A major concern of governments is what is known as systemic risk. This is the risk that a failure by a
large bank will lead to failures by other large banks and a collapse of the financial system. The way
this can happen is described in Business Snapshot 15.1. 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.
During the market turmoil of 2007 and 2008, the decision was taken to bail out many large financial
institutions in the United States and Europe. However, Lehman Brothers was allowed to fail in
September, 2008. Possibly, the United States government wanted to make it clear to the market that
bailouts for large financial institutions were not automatic. However, the decision to let Lehman
Brothers fail has been criticized because arguably it made the credit crisis worse.
A. Basel I
History of Bank Regulation
• Pre-1988
• 1988: BIS Accord (Basel I)
• 1996: Amendment to BIS Accord
• 1999: Basel II first proposed
1.2. Bank regulation Pre-1988
• Banks were regulated using balance sheet measures such as the ratio of capital to assets
• Definitions and required ratios varied from country to country
• Enforcement of regulations varied from country to country
Lecture: globalization started to pick up and the need for something international arised
Also it is not a requirement (like Solvency II for EU), companies signed up to this because they decide to do so
• Bank leverage increased in 1980s
• Off-balance sheet derivatives trading increased
Lecture: existing rules looked at the balance sheet but derivatives had become much more
important and a lot of them are off balance sheet (e.g. all swaps). Because initially they have the
value of zero. E.g. compared to a bank buying a bond, it takes cash from its balance sheet, buys the
bond and the bond gets on the balance sheet, if you enter into a swap, you don’t spend any cash,
no impact on balance sheet, e.g. CDS the spreads are set such that the contract has a zero value at
the start.
• LDC debt was a major problem (less developed countries)
• Basel Committee on Bank Supervision set up
,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. 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 (see Business
Snapshot 2.3) 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. Consider, for example, an interest rate swap. If the counterparty in the
interest rate swap transaction defaults when the swap has a positive value to the bank and a negative
value to the counterparty, the bank is liable to lose money. The potential future exposure on
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 committee consisted of representatives from Belgium,
Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Sweden, Switzerland, the United
Kingdom, and the United States. It met regularly in Basel, Switzerland, under the patronage of the Bank
for International Settlements. The first major result of these meetings was a document entitled
“International Convergence of Capital Measurement and Capital Standards.” This was referred to as
“The 1988 BIS Accord” or just “The Accord.” Later it became known as Basel I.
1.3. 1988: BIS Accord (page 327-330)
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.
Main Provisions:
• Capital must be 8% of risk weighted assets.
▪ So a bank is obliged to hold capital for at least 8% of its risk-weighted assets (see later)
• At least 50% of capital held must be Tier 1 (that is, 4% of the risk-weighted assets)
• Applies to both banking and trading book, but some assets of the trading book are excluded, such
as traded securities.
5.3.1. The Cooke Ratio
1.3.1.
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:
1. Those arising from on-balance sheet assets (excluding derivatives)
2. Those arising for off-balance sheet items (excluding derivatives)
3. Those arising from over-the-counter derivatives
,Consider the first category. Each on-balance-sheet asset is assigned a risk weight reflecting its credit
risk. A sample of the risk weights specified in the Accord is shown in Table below. Cash and securities
issued by governments of OECD countries (members of the Organisation of Economic Co-operation
and Development) are considered to have virtually zero risk and have a risk weight of zero. Loans to
corporations have a risk weight of 100%. Loans to banks and government agencies in OECD countries
have a risk weight of 20%. Uninsured residential mortgages have a risk weight of 50%. µ
The total of the risk-weighted assets for N on-balance-sheet items equals:
=>where Li is the principal amount of the ith item and wi is its risk weight.
1.3.2. Risk-Weighted Capital (Credit risk)
• A risk weight is applied to each on-balance- sheet asset according to its risk, e.g.:
▪ 0% to cash, gold bullion, and govt bonds (claims on OECD governments such as Treasury bonds
or insured residential mortgages);
▪ 20% to claims on OECD banks and OECD public sector entities such as securities issued by U.S.
government agencies or claims on municipalities);
▪ 50% to uninsured residential mortgages;
▪ 100% All other claims: corporate loans, corporate bonds, non-OECD banks, less developed country debt…
• For bilateral OTC derivatives and off-balance sheet commitments, first calculate a credit equivalent
amount is calculated and then a risk weight is applied
• Risk weighted amount (RWA) consists of
▪ Sum of products of risk weight times asset amount for on-balance sheet items
▪ Sum of products of risk weight times credit equivalent amount for derivatives and off-balance
sheet commitments
If this were the entire
bank, then what would the
capital requirement be?
Capital requirement
= 8% of 125 million
= 10 million
1.3.3. Credit Equivalent Amount for Derivatives
• The credit equivalent amount is calculated as the current replacement cost (if positive) plus an
add-on factor (Applies to notional amount)
▪ “Lecture: current replacement costs (so the market value), at the really start of a swap it is zero, if it’s not a derivative,
an option, even at the start there will be a positive value, but derivatives can change a lot in value over time, therefore
that current market value / replacement cost, is not sufficient, you have to add an element, an add on factor.”
• The add-on amount varies from instrument to instrument
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.
,Consider next the third category. For an over-the-counter derivative such as an interest rate swap or
a forward contract the credit equivalent amount is calculated as max(V, 0) + aL where V is the current
value of the derivative to the bank, a is an add-on factor, and L is the principal amount. The first term
in the equation is the current exposure. If the counterparty defaults today and V is positive, the
contract is an asset to the bank and the bank is liable to lose V. If the counterparty defaults today and
V is negative, the contract is an asset to the counterparty and there will be neither a gain nor a loss to
the bank. The bank’s exposure is therefore max(V, 0). The add-on amount, aL, is an allowance for the
possibility of the exposure increasing in the future. Examples of the add-on factor, a, are shown in
Table 15.2.
1.3.4. Add-on Factors as a % of Principal for Derivatives - Table 15.2, page 329
Add-on depends on the
underlying type + remaining
maturity of the contract.
e.g. If you have a swap that
is going to end this year it
cannot change that much in
value anymore, it’s not that
sensitive LT contracts are
• Example: A $100 million swap with 3 years to maturity worth $5 million would
have a credit equivalent amount of $5.5 million
1.3.5. Example with off-balance sheet items
A negative market value
is floored at zero & only
the add on is left
• Wat are the risk-weighted assets/amount (RWA) for this swap?
▪ If the client is an OECD bank? → 20% x 2.5 million = 0.5 million
▪ If the client is a corporate? → 50% x 2.5 million= 1.25 million
,1.3.6. Final formula for RWA
Putting all this together, the total
risk-weighted assets for a bank
with N on-balance-sheet items and
M off-balance-sheet items is…
(wj* is the risk weight of the
counterparty for this jth item)
1.3.7. Types of Capital (p.330) – Lecture: he said we won’t go into too much detail on this
Capital Requirement: The Accord required banks to keep capital equal to at least 8% of the risk-
weighted assets. The capital had two components:
• Tier 1 Capital: this consists of items such as common equity, non-cumulative perpetual preferred
shares2 (Goodwill is subtracted from equity.)
▪ Lecture: bond-like instruments that companies can issue, they are fixed income, so there is a coupon
attached but they can not pay it if they want to. Maybe this sounds weird but… if you don’t pay the
coupon on these preferred shares, you cannot pay any dividend to your ‘real’ shareholders (and of
course they want to get paid). & it has to be perpetual, with no maturity date
• Tier 2 Capital: This is sometimes referred to as Supplementary Capital. It includes instruments such
as cumulative preferred stock3, certain types of 99-year debentures, debt subordinated to
depositors with an original life of more than 5 years
• If losses are larger than Tier 1 capital the banks is insolvent. Tier 2 capital will absorb further losses,
protecting depositors
Equity capital is the most important type of capital because it absorbs losses. If equity capital is greater than
losses, a bank can continue as a going concern. If equity capital is less than losses, the bank is insolvent. In the
latter case, Tier 2 capital becomes relevant. Because it is subordinate to depositors, it provides a cushion for
depositors. If a bank is wound up after its Tier I capital has been used up, losses should be borne first by the Tier
2 capital and, only if that is insufficient, by depositors.
The Accord required at least 50% of the required capital (that is, 4% of the risk-weighted assets) to be in Tier
1. Furthermore, the Accord required 2% of risk weighted assets to be common equity. (Note that the Basel
committee has updated its definition of instruments that are eligible for Tier 1 capital and its definition of
common equity in Basel III.)
The bank supervisors in some countries require banks to hold more capital than the minimum specified by the
Basel Committee and some banks themselves have a target for the capital they will hold that is higher than that
specified by their bank supervisors.
2
Noncumulative perpetual preferred stock is preferred stock lasting forever where there is a predetermined dividend
rate. Unpaid dividends do not cumulate (that is, the dividends for one year are not carried forward to the next year).
3
In cumulative preferred stock, unpaid dividends cumulate. Any backlog of dividends must be paid before
dividends are paid on the common stock.
, Lecture: As Basel 1 was implemented & used, they observed that some improvements could be made
The 1996 Amendment
1.4. G-30 Policy Recommendations (page 330-331)
In 1993, a working group consisting of end-users, dealers, academics, accountants, and lawyers
involved in derivatives published a report that contained 20 risk management recommendations for
dealers and end-users of derivatives and four recommendations for legislators, regulators, and
supervisors. The report is not a regulatory document, but it has been influential in the development of
risk management practices. A brief summary of the important recommendations is as follows:
Basel I only
covers credit risk
(L: B1 does not
care about market
risk at all)
Basel I does not
account much for risk
mitigation or netting
1.5. Netting (p. 331-333)
• Netting refers to a clause in Master Agreements, (ISDA4) which states that all OTC derivatives with
a counterparty are treated as a single transaction in the event of a default
• In 1995 the 1988 accord was modified to allow banks to reduce their credit equivalent totals when
bilateral netting agreements were in place
4
International Swaps and Derivatives Association
,Netting (continued)
Participants in the over-the-counter derivatives market have traditionally signed an International
Swaps and Derivatives Association (ISDA) master agreement covering their derivatives trades. The
word netting refers to a clause in the master agreement, which states that in the event of a default all
transactions are considered as a single transaction. Effectively, this means that, if a company defaults
on one transaction that is covered by the master agreement, it must default on all transactions covered
by the master agreement.
At this stage, we note that netting can have the effect of substantially reducing credit risk. Consider a
bank that has three swap transactions outstanding with a particular counterparty. The transactions are
worth +$24 million, –$17 million, and +$8 million to the bank. Suppose that the counterparty
experiences financial difficulties and defaults on its outstanding obligations. To the counterparty the
three transactions have values of –$24 million, +$17 million, and –$8 million, respectively. Without
netting, the counterparty would default on the first transaction, keep the second transaction, and
default on the third transaction. Assuming no recovery, the loss to the bank would be $32 (= 24 + 8)
million. With netting, the counterparty is required to default on the second transaction as well. The
loss to the bank is then $15 (= 24 − 17 + 8) million.
More generally, suppose that a financial institution has a portfolio of N derivatives outstanding with a
particular counterparty and that the current value of the ith derivative is Vi. Without netting, the
financial institution’s exposure in the event of a default today is
“your exposure towards the counterparty,
the market value, is the maximum of
the market value and zero (floored at zero)”
With netting, it is
Here you take all the positive & negative
amounts into account
Without netting, the exposure is the payoff from a portfolio of options. With netting, the exposure is
the payoff from an option on a portfolio.
The 1988 Basel Accord did not take netting into account in setting capital requirements. From equation
(15.1) the credit equivalent amount for a portfolio of derivatives with a counterparty under the Accord
was
where ai is the add-on factor for the ith transaction and Li is the principal for the ith transaction.
By 1995, netting had been successfully tested in the courts in many jurisdictions. As a result, the 1988
Accord was modified to allow banks to reduce their credit equivalent totals when enforceable bilateral
netting agreements were in place. The first step was to calculate the net replacement ratio, NRR. This
is the ratio of the current exposure with netting to the current exposure without netting:
The credit equivalent amount was modified to:
, Netting Example
(p.57 SV)
• What is the NRR?
• What is the total add on?
• What is the credit equivalent amount with and without netting
• Suppose that the counterparty is an OECD bank, and therefore the risk weight is 0.2.
What is the RWA with and without netting?
1.6. 1996 Amendment The original version only cared about credit risk
The activities of a bank are seen to exist out of two different types of transactions:
Credit risk • Banking book
▪ Long term positions which the bank intends to hold until maturity
▪ Typically loans and some debt securities
▪ No fair value accounting, but accounted for at amortized cost
Market risk • Trading book:
▪ Assets held for trading purposes
▪ Includes most derivatives, equity securities, commodities,…
▪ Fair value accounting required, with daily mark-to-market
Implemented in 1998
, In 1995, the Basel Committee issued a consultative proposal to amend the 1988 Accord. This became
known as the “1996 Amendment.” It was implemented in 1998 and was then sometimes referred to as
“BIS 98.” The amendment involves keeping capital for the market risks associated with trading activities.
Marking to market is the practice of revaluing assets and liabilities daily using a model that is calibrated
to current market prices. It is also known as fair value accounting.
Banks are required to use fair value accounting for all assets and liabilities that are held for trading
purposes. This includes most derivatives, marketable equity securities, foreign currencies, and
commodities. These items constitute what is referred to as the bank’s trading book.
Banks are not required to use fair value accounting for assets that are expected to be held for the
whole of their life for investment purposes. These assets, which include loans and some debt securities,
constitute what is referred to as the banking book. Unless there is reason to believe that repayment
of the principal will not be made, they are held at historical cost.
1.6.1. The 1996 Amendment - Market Risk Capital (1996)
Market risk (new)
The Amendment introduced a capital charge for the market risk associated with all items in the trading book.
• Requires banks to hold capital for market risk for all instruments in the trading book including
those off balance sheet (This is in addition to the BIS Accord credit risk capital)
Credit risk (changed)
Under the 1996 Amendment, the credit risk capital charge in the 1988 Accord continued to apply to all
on-balance-sheet and off-balance-sheet items in the trading and banking book, except…
• Credit risk capital charge no longer applies to:
▪ Traded debt and equity securities in the trading book
▪ Commodities and foreign exchange positions in the trading book
• For banks NOT using an internal model for market risk, the new capital requirement for market
risk is to be calculated with the “standardized” approach.
• The standardized approach is based on a system of haircuts (percentages) to be applied to the
different assets, and combinations of assets on the trading book
• The calculation for market risk with the standardized approach has two components
▪ Market risk (relating to individual issuers), to be calculated with very little netting
▪ General market risk (related to movements of the market as a whole), with more netting being
allowed in the calculation
The 1996 Amendment outlined a standardized approach for measuring the capital charge for market
risk. The standardized approach assigned capital separately to each of debt securities, equity
securities, foreign exchange risk, commodities risk, and options. No account was taken of correlations
between different types of instruments.
The more sophisticated banks with well-established risk management functions were allowed to use
an “internal model-based approach” for setting market risk capital. This involved calculating a value-
at-risk measure and converting it into a capital requirement using a formula specified in the 1996
Amendment. Most large banks preferred to use the internal model-based approach because it better
reflected the benefits of diversification and led to lower capital requirements.
