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The Basel Committee on Banking Supervision

Author: Christopher Alessi
July 11, 2012
This publication is now archived.

Introduction

The global financial crisis of 2007 to 2009 generated fresh pressure for international regulations to protect against future meltdowns. One body that took on a more wide-reaching role was the Basel Committee on Banking Supervision, long considered a private club for the world's leading central bankers. The committee's most sweeping accomplishments have been the Basel rules on banks' capital requirements, which culminated in 2010 with the development of the Basel III accord on capital and liquidity standards. However, many national governments are facing significant resistance from the international financial sector, which has argued that the Basel standards will slow growth and damage the fragile global economic recovery. Other critics say the framework does not go far enough to stem risk in the international banking system.

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History of the Basel Committee

Situated in the Bank for International Settlements in Basel, Switzerland, the committee was designed primarily to provide nonbinding recommendations to member countries for strengthening an increasingly interconnected international financial system. The Basel Committee first and foremost grew out of the "growing globalization of financial intermediation" in the 1960s, explains the London School of Economics' Charles Goodhart in his book, "The Basel Committee on Banking Supervision." At the same time that financial markets became more global, monetary control and regulation remained situated at the national level, highlighting the "need to establish communication networks among national authorities, where consequential common problems could be discussed, and cooperation sought," Goodhart writes.

Two pivotal events in the early 1970s directly facilitated the creation of the Basel Committee. During the Arab-Israeli Yom Kippur War in October 1973, Arab states significantly cut oil production, causing the price of oil to quadruple. This created large international financial imbalances, while begging the question, Goodhart explains, of "whether, and how, the international banking system could recycle the flow of funds between oil producers (creditors) and oil importers (debtors)." The second development was the dissolution of Germany's Bankhaus Herstatt in June 1974.The collapse of the small bank, which had foreign exchange dealings around the world, caused significant losses for associated financial institutions, while "roiling financial exchange markets for months," explains former CFR fellow Marc Levinson in a 2010 essay for Foreign Affairs.

The Basel Committee was established at the end of 1974 by the G10 countries--Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, the United Kingdom, and the United States--along with Switzerland and Luxembourg. The central aim of the new committee was to provide a "forum for regular cooperation between member countries on banking supervisory matters" and improving the "quality of banking supervision worldwide." Crucially, the committee "does not possess any formal supranational supervisory authority, and its conclusions do not, and were never intended to, have legal force."

Structure of the Basel Committee

The committee's governing body is comprised of member states' central bankers and, in some cases, banking sector supervisors. Membership of the committee was expanded significantly in 2009 and now includes Argentina, Australia, Brazil, China, Hong Kong SAR, India, Indonesia, South Korea, Mexico, Russia, Saudi Arabia, Singapore, South Africa, and Turkey.

The committee is chaired by one of the central bankers or supervisors of member states, who operates largely out of his or her home country. Meanwhile, the committee's secretariat is located at the Bank for International Settlements and comprises staff from member institutions that are on temporary assignment. The work of the committee, which meets approximately four times per year, is divided into four main subcommittees: the Standards Implementation Group, the Policy Development Group, the Accounting Task Force, and the Basel Consultative Group.

Goodhart says that the structure of the committee and its subgroups was initially quite informal, noting, "there was a conscious aim to instill a 'club'-like atmosphere" by which compromises could be achieved. However, by the end of the 1980s, the committee became more formalized, and its attendant subcommittees more "technical" and "specialized."

Early Risk Management Efforts

The committee issued its first major document in 1975. The Basel Concordat outlined a "set of principles for sharing supervisory responsibility for bank activities between host and home countries," explains U.S. Federal Reserve Board member Daniel K. Tarullo in his 2008 book "Banking on Basel." The document was revised in 1983 following the Latin American sovereign debt crisis and the collapse of Italian bank Banco Ambrosiano. The committee sought to address "jurisdictional gaps by amending the Concordat to ensure that consolidated supervision could occur on a transnational basis," Kern Alexander, John Eatwell, and Rahul Dhumale explain in their 2006 book "Global Governance of Financial Systems." However, the revised Concordat failed to define for the home country "precisely when an international bank was registered with a particular jurisdiction." This "major supervisory gap" fueled a scandal in 1991 (BBC) at the Bank of Credit and Commerce International, which had essentially been set up to evade international regulation. The case of BCCI triggered another round of revisions to the Concordat in 1992 that called on home and host country supervisors to agree in advance of establishing cross-border banking operations.

In the 1980s, the committee's work increasingly focused on issues of bank capital adequacy, which led, in 1988, to the Basel Accord on capital requirements, or Basel I. It 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," explains Tarullo. The accord called for banks to maintain two minimum capital ratios: A bank's "tier one" core capital, which had to be at least 4 percent of risk-weighted assets, and a bank's "tier two" total capital, which had to be at least 8 percent of risk-weighted assets.

In 1998, the committee began to revise the Basel Accord to address banking risks beyond credit risk, paving the way for the issuance of a revised Basel framework--Basel II--in June 2004. Tarullo identifies two developments in the banking industry that led the committee to overhaul the original accord: the increase in securitizations of mortgages and other loans by U.S. banks, and advances in internal risk management techniques at global banks.

Basel II divided bank regulation into three pillars: minimum capital requirements that expanded those outlined in the 1988 accord; regulatory supervision and risk management; and harnessing market forces through effective disclosure to encourage sound banking practices. The major changes stipulated by Basel II included refining the "risk buckets for the capital adequacy calculations" for small banks, and permitting large banks "to base their minimum capital requirements on inputs from their own internal credit risk models," explains Tarullo.

However, when the global financial crisis erupted, Basel II proved in many ways to be insufficient. As Levinson notes in his Foreign Affairs essay, "Inadequate capital is only one of the problems that can beset a financial institution during a crisis. Some institutions that seemed well positioned when the recent crisis struck suffered not from a lack of capital but from a lack of ready cash--what bankers refer to as 'liquidity.'"

"There is an inherent problem in that capital requirements are very static" -- Viral V. Acharya, NYU

Viral V. Acharya, a professor at New York University's Stern School of Business, contends that the Basel accords focused too much on capital requirements at the expense of other issues--he points out that investment bank Bear Stearns was well-capitalized, but nonetheless failed in 2008--such as resolution authority and forbearance. Moreover, Acharya told CFR.org, there is an "inherent problem in that capital requirements are very static," whereas asset risks "don't stay static forever." He recommends Basel adopt a banking stress-test approach--which is being increasingly mandated at the national level, including by the United States--as a "more dynamic way of dampening the cycle if a credit bubble is building up."

The Global Meltdown and Basel III

The 2007-2009 financial crisis prompted the Basel Committee to once again revise its accord on capital requirements, while placing a new emphasis on the importance of liquidity standards. In December 2010, the committee issued a new document on global regulatory standards--Basel III-- to limit the kind of risk-taking at global financial institutions that had precipitated the crisis, and which the original two Basel accords had failed to prevent.

Levinson argues the previous Basel rules may have even contributed to the crisis. Basel capital requirements "destabilized the financial system by giving banks an incentive to get loans off their books by securitizing them rather than setting aside more capital to back them," Levinson writes.

The G20 endorsed the Basel III framework at the group's summit in Seoul in November 2010. Basel III is expected to be phased in by national governments between 2013 and 2019. The revised accord "establishes tougher capital standards through more restrictive capital definitions, higher risk-weighted assets, additional capital buffers, and higher requirements for minimum capital ratios. It also introduces new strict liquidity requirements," explains this PricewaterhouseCoopers report (PDF).

Basel III raises the key capital ratio from 2 percent to 4.5 percent, while adding a new buffer of a further 2.5 percent (FT). At the same time, the accord now calls for banks to triple core tier one capital ratios from 2 percent to 7 percent by 2019.

The Debate Over Basel

Many question whether Basel does enough to limit bank risk. "In principle, it's a good thing, but in practice the Basel Committee has failed," says the London School of Economics' Andrew Walter. He notes that the Basel rules are based on internal risk-based models for banks, while arguing that such a system is "essentially outsourcing the risk-weighing process to the banking sector itself." Therefore, banks have a "vested interest" in promoting the current system, while "no one really understands how risky a bank is," Walter argues.

The international banking industry has argued that the additional capital requirements mandated by Basel III will hurt economic growth. Indeed, the Institute of International Finance estimated in 2010 that the economies of the United States and Europe would shrink by 3 percent over five years under Basel III.

"In principle, it's a good thing, but in practice the Basel Committee has failed" – Andrew Walter, LSE

Conversely, Simon Johnson, the former chief economist at the International Monetary Fund, has argued for capital requirements beyond those laid out by Basel III. He has rebutted the banking industry's claim that higher capital requirements will hurt the struggling global economic recovery. "Capital requirements do not hold anyone or anything hostage--they merely require financial institutions to fund themselves more with equity relative to debt. Capital requirements are a restriction on the liability side of the balance sheet--they have nothing to do with the asset side," he wrote on the New York Times' Economix blog last year.

Douglas J. Elliott of the Brookings Institution says that the new capital requirements will make credit more expensive and somewhat less available, but that the "relative effect is not so big." Overall, the "increased safety" that comes with higher capital and liquidity requirements "outweighs" the somewhat slower economic growth that may ensue in the short term, Elliott says.

"A lot of progress has been made in terms of the international approach to regulation" – Richard Reid, International Center for Financial Regulation

"A lot of progress has been made in terms of the international approach to regulation," says Richard Reid of the International Center for Financial Regulation told CFR.org. Still, Reid says, there remain many details of Basel III to be worked out, in large part because "individual jurisdictions" have their own priorities--the United States' Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 among them. At the same time, Reid says, the "Basel process is complementary" to efforts in the EU to create a banking union that would centralize regulatory control over the eurozone's beleaguered banks.

The widening banking scandal in Britain over the manipulation by Barclays of a key lending rate known as the Libor adds a new dimension to the bank regulation debate. While Basel does not address issues such as interest rates, "this whole [Libor] episode is likely to stiffen the resolve of governments and regulators to press for not just adoption of the Basel recommendations, but their implementation and compliance," Reid says.

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