CHAPTER SIX

FINANCIAL REGULATION AND PRELIMINARY INTRODUCTION TO

THE BASEL ACCORDS

Financial regulations are laws and rules that govern financial institutions. Regulations of
financial institutions focus on providing stability to the financial system, fair competition,
consumer protection, and prevention and reduction of financial crimes. By the mid-1970s, the
global financial system witnessed market-oriented reforms that led to liberalization in the
financial system, such as the reduction of interest rate controls, removal of investment
restrictions on financial institutions and a line of business restrictions, and control on
international capital movements.

The modern trend observed is that financial sector regulation is moving toward a greater cross-
sector integration of financial supervision. In 1998, the adoption of the Basel Accord, which
required international banks to attain an 8% capital adequacy ratio was a major significant
milestone in banking regulations. The collapse of the global financial system that led to the
global crisis can be attributed to the systemic failure of financial regulation. Basel I defined bank
capital and bank capital ratio based on two-tier systems. The Basel II framework consisted of
Part 1, the scope of application and three pillars, the first one being minimum capital
requirements, the second one a supervisory review process, and the third pillar is market
discipline. The Basel III framework prepared new capital and liquidity requirements for banks.

Impact of Regulatory Activity

Successful financial regulation prevents market failure, promotes macroeconomic stability,

protects investors, and mitigates the effects of financial failures on the real economy. Financial
regulation can also be used to improve market transparency and to protect investors. However,
financial regulation also imposes a variety of costs on regulated firms and the economy:

Direct costs: Costs of regulation administration and enforcement, which might be complicated by
having multiple agencies enforce regulation. These costs might be financed by some
combination of taxes and fees imposed on regulated institutions and their clients as well as taxes

1
imposed on the general public. These costs might also be absorbed by regulated firms through
self-regulation.

Indirect costs: Costs of compliance, such as those associated with maintaining records, hiring
compliance officers, making payments to auditors and ratings agencies, and so on.

Distortions to financial markets: Reactions to regulation often cause institutions to conduct

business sub-optimally, and can cause firms to leave or restrict their entry into the marketplace.
Regulated firms often seek operating jurisdictions with the least restrictive regulations.

What are the Basel Accords? The Basel Committee

The BCBS was founded in 1974 as an international forum where members could cooperate on
banking supervision matters. The BCBS says it aims to enhance "financial stability by improving
supervisory know-how and the quality of banking supervision worldwide. “This is done through
regulations known as accords.

The Basel Accords refers to a set of banking supervision regulations set by the Basel Committee
on Banking Supervision (BCBS). They were developed over several years between 1980 and
2011, undergoing several modifications over the years.

The Basel Accords were formed with the goal of creating an international regulatory framework
for managing credit risk and market risk. Their key function is to ensure that banks hold enough
cash reserves to meet their financial obligations and survive in financial and economic distress.
They also aim to strengthen corporate governance, risk management, and transparency.

The regulations are considered to be the most comprehensive set of regulations governing the
international banking system. The Basel Accords can be broken down into Basel I, Basel II, and
Basel III.

What Is Basel I?

Basel I is a set of international banking regulations established by the Basel Committee on

Banking Supervision (BCBS). It prescribes minimum capital requirements for financial
institutions, with the goal of minimizing credit risk. Under Basel I, banks that operate
internationally were required to maintain at least a minimum amount of capital (8%) based on

2
their risk-weighted assets. Basel I is the first of three sets of regulations known individually as
Basel I, II, and III, and collectively as the Basel Accords.

Basel I, also known as the Basel Capital Accord, was formed in 1988. It was created in response
to the growing number of international banks and the increasing integration and interdependence
of financial markets. Regulators in several countries were concerned that international banks
were not carrying enough cash reserves. Since international financial markets were deeply
integrated at that time, the failure of one large bank could cause a crisis in multiple countries.

Basel I was enforced by law in G10 countries in 1992, but more than 100 countries implemented
the regulations with minor customizations. The regulations aimed to improve the stability of the
financial system by setting minimum reserve requirements for international banks.

Benefits of Basel I

Basel I was developed to mitigate risk to consumers, financial institutions, and the economy at
large. Basel II, brought forth some years later, lessened the capital reserve requirements for
banks. That came under some criticism, but because Basel II did not supersede Basel I, many
banks continued to operate under the original Basel I framework, later supplemented by Basel III
addendums.

Perhaps the greatest legacy of Basel I was that it contributed to the ongoing adjustment of
banking regulations and best practices, paving the way for further protective measures.

Criticism of Basel I

Basel I has been criticized for hampering bank activity and slowing growth in the overall world
economy by making less capital available for lending. Critics on the other side of that argument
maintain that the Basel I reforms did not go far enough. Both Basel I and Basel II were faulted
for their failure to avert the financial crisis and Great Recession of 2007 to 2009, events that
became a catalyst for Basel III.

Basel II

Basel II, an extension of Basel I, was introduced in 2004. Basel II included new regulatory
additions and was centered on improving three key issues – minimum capital requirements,
supervisory mechanisms and transparency, and market discipline.

3
Basel II created a more comprehensive risk management framework. It did so by creating
standardized measures for credit, operational, and market risk. It was mandatory for banks to
use these measures to determine their minimum capital requirements.

A key limitation of Basel I was that the minimum capital requirements were determined by
looking at credit risk only. It provided a partial risk management system, as both operational
and market risks were ignored.

Basel II created standardized measures for measuring operational risk. It also focused on
market values, instead of book values, when looking at credit exposure. Additionally, it
strengthened supervisory mechanisms and market transparency by developing disclosure
requirements to oversee regulations. Finally, it ensured that market participants obtained
better access to information.

Basel II Requirements

Building on Basel I, Basel II provided guidelines for the calculation of minimum regulatory
capital ratios and confirmed the requirement that banks maintain a capital reserve equal to at
least 8% of their risk-weighted assets.

Basel II divides the eligible regulatory capital of a bank into three tiers. The higher the tier,
the more secure and liquid its assets.

Tier 1 capital represents the bank's core capital and is composed of common stock, as well as
disclosed reserves and certain other assets. At least 4% of the bank's capital reserve must be
in the form of Tier 1 assets.

Tier 2 is considered supplementary capital and consists of items such as revaluation reserves,
hybrid instruments, and medium- and long-term subordinated loans. Tier 3 consists of lower-
quality unsecured, subordinated debt.

Basel II also refined the definition of risk-weighted assets, used in calculating whether a bank
meets its capital reserve requirements. Risk weighting is intended to discourage banks from
taking on excessive amounts of risk in terms of the assets they hold. The main innovation of
Basel II in comparison to Basel I is that it takes into account the credit rating of assets in
determining their risk weights. The higher the credit rating, the lower the risk weight.

4
Regulatory Supervision and Market Discipline

Regulatory supervision is the second pillar of Basel II and provides a framework for national
regulatory bodies to deal with various types of risks, including systemic risk, liquidity risk,
and legal risks.

The market discipline pillar introduces various disclosure requirements for banks' risk
exposures, risk assessment processes, and capital adequacy. It is intended to foster greater
transparency into the soundness of a bank's business practices and allow investors and others
to compare banks on equal footing.

Pros and Cons of Basel II

On the plus side, Basel II clarified and expanded the regulations introduced by the original
Basel I Accord. It also helped regulators begin to address some of the financial innovations
and new financial products that had come along since Basel I's debut in 1988.

Basel II was not entirely successful, however, and has even been called a miserable failure in
its central mission of making the financial world safer.

The subprime mortgage meltdown and Great Recession of 2008 showed that Basel II
underestimated the risks involved in current banking practices and that the financial system
was overleveraged and undercapitalized, despite Basel II's requirements.

Overleveraging occurs when a business has borrowed too much money and is unable to pay
interest payments, principal repayments, or maintain payments for its operating expenses due
to the debt burden.

Even the Bank for International Settlements, the organization behind the Basel Committee on
Banking Supervision, today acknowledges, "The banking sector entered the financial crisis
with too much leverage and inadequate liquidity buffers. These weaknesses were
accompanied by poor governance and risk management, as well as inappropriate incentive
structures. The dangerous combination of these factors was demonstrated by the mispricing
of credit and liquidity risks and excess credit growth."

Responding to the financial crisis, the Basel Committee issued new risk management and
supervision guidelines to strengthen Basel II in 2008 and 2009. Those reforms and others

5
 issued in 2010 and later represented the beginnings of the next Basel Accord, Basel III,
which, as of 2022, is still being phased in.

Basel III

The Global Financial Crisis of 2008 exposed the weaknesses of the international financial
system and led to the creation of Basel III. The Basel III regulations were created in
November 2010 after the financial crisis; however, they are yet to be implemented. Their
implementation’s constantly been delayed in recent years and is expected to occur in January
2022.

Basel III identified the key reasons that caused the financial crisis. They include poor
corporate governance and liquidity management, over-levered capital structures due to lack
of regulatory restrictions, and misaligned incentives in Basel I and II.

Basel III strengthened the minimum capital requirements outlined in Basel I and II. In
addition, it introduced various capital, leverage, and liquidity ratio requirements.

Under Basel III, the minimum capital adequacy ratio that banks must maintain is 8%. 1 The
capital adequacy ratio measures a bank's capital in relation to its risk-weighted assets.

Basel III introduced a minimum "leverage ratio". The leverage ratio was calculated by
dividing Tier 1 capital by the bank's average total consolidated assets; the banks were
expected to maintain a leverage ratio in excess of 3% (a minimum of 4 %) under Basel III.
leverage ratio relates a bank's core capital to its total assets in order to judge liquidity.

The LCR (Liquidity coverage ratio) is a requirement under Basel III whereby banks are
required to hold an amount of high-quality liquid assets that's enough to fund cash outflows
for 30 days.

The liquidity coverage ratio (LCR) refers to the proportion of highly liquid assets held by
financial institutions, to ensure their ongoing ability to meet short-term obligations.

The minimum liquidity coverage ratio that banks must have under the new Basel III standards
are phased in beginning at 70% in 2016 and steadily increasing to 100% by 2019. The year-by-
year liquidity coverage ratio requirements for 2016, 2017, 2018 and 2019 are 70%, 80%, 90%
and 100%, respectively.

6
7