Basel Accords
The Basel Committee comprises the Central Bank governance of the larger nations. The committee publishes regulatory and supervisory standards and guidelines on best practice. Its principles are reflected in European Union law.
The late 1980s and early 1990s saw a shift from detail rules-based regulation to the principles-based regulation of credit institutions and other financial service providers. This approach required management to apply principles on a largely self-regulatory basis. As the financial services industry grew more complex the self-regulatory principle-based approach commended itself.
The first Basel Accord was agreed in 1988 as the standard for regulation of bank capital and reserve. In 2004 a revised capital adequacy standard Basel II was agreed.
Basel II sought to provide risk-based capital requirements. It proposed that banks would have considerable flexibility in deciding the nature of its risk management policy.
Basel III was approved in 2010 and is to be implemented by 2019.
Pillars
The first aspect or pillar relates to the capital requirements required for various types of risk which the bank runs. Risk is divided into different types including credit risk, market risk, and operational risk. Capital requirements are linked to the risk and different requirements are tied to the types of risks. Regulators are allowed considerable freedom in assessing the risk.
The second pillar is a regulatory response to the first pillar, giving regulators ‘tools’ and powers It also provides a framework for dealing with systemic risk, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk, and legal risk, which the accord combines under the title of residual risk.
The supervisors must consider how banks assess their capital needs relative to their risks and regulate accordingly. Banks must be in a position to appraise their overall capital requirements, with reference to the risks in their business. Regulators must be in a position to review these assessments and strategies and monitor compliance. They will require banks to operate above minimum capital ratios and have requisite capital.
A third pillar aims to complement the minimum capital requirements and supervisory review process by developing a set of disclosure requirements which will allow the market participants to gauge the capital adequacy of an institution. It requires the disclosure by financial institutions of their capital adequacy assessment. This should allow institutions to assess other institutions.
Capital Adequacy and Basel II
The European Union Capital Adequacy Directive follows the Basel II principle. It set standards for the capital adequacy and prudential regulation of credit institutions and investment firms. The capital adequacy directive has been amended and is likely to be supplemented or replaces by a single directly effective EU regulation n the near future.
The capital adequacy directive applies to banks which hold deposits and other repayable funds and grant credit on their own account. The first pillar sets out the principles for ascertaining the required capital. This may be determined under n external rating based approach or an internal rating based approach, where the latter is permitted by the regulator. There is provision for risk rating in relation to credit, operational and market risk.
The second supervisory pillar requires the regulator to review the institution’s risk appraisal. Recent amendments require remuneration policy principles in relation to certain senior management. The third pillar requires the disclosure in public of certain information.
Post Financial Crisis
The Basel rules proved hopelessly ineffective in the financial crisis. The Basel III system grew out of the failures of the Basel II in the economic banking and financial crisis. It raised the required equity relative to risk-weighted assets progressively by 2015.
Banks were required to have additional capital buffers to withstand adverse shocks. The total equity capital is to be increased and tier 1 capital is to increase from 4 to 6 per cent. The definition of capital is amended.
International standards have recommended the modification of the systems of remuneration linked to undue risk-taking. The financial crisis has reminded regulators that the critical role of banking in the economy is such that banks ought not to be allowed to take risks and be subject to moral hazard.
Mechanisms have been recommended for the resolution of insolvency in financial institutions without destabilizing the financial system. Strategically important financial institutions should have increased capacity to withstand risk due to their systematic importance. They should be more intensely supervised.
Post Crisis Institutions
Following the financial crisis, the European Union has modified the overall supervisory approach.
The European Systematic Risk Board is responsible for overall oversight of the financial system in order to prevent systematic risks in financial stability. It has the function of collecting information, identifying risk, issuing warnings and recommendations, following up the warnings, cooperating with other authorities and liaison with the IMF. The ESRB consists of members of the ECB and central banks of the states together with a range of other representatives.
The ESRB provides national regulators with information on risks relevant to their own requirements and responsibilities. The ESRB may issue recommendations to national authorities and warnings. It does not have legal power, but national regulators must respond and give justification if they do not follow the direction or recommendation.
The European supervisory authorities comprise the European Banking Authority, European Insurance, and Occupational Pension authority and the European Securities and Market Authority. They are comprised of national regulators of the states.
The European Banking Authority consists of the representatives of the supervisory authorities
The European Banking Authority is to
- establish a common regulatory and supervisory standards:
- contribute to the consistent application of binding EU rules.
- organise and conduct peer review.
- consider capital adequacy.