9.   INTERNATIONAL BANKING AND FINANCIAL REGULATION

 

 

Many national banking and financial laws are based on international standards agreed at the international level through various technical committees. The main body in the banking area is the Basel Committee on Banking Supervision which was set up in 1974 and is based at the offices of the Bank for International Settlements (BIS) in Basel, Switzerland. The technical committees in other key financial sectors are considered separately subsequently The significance of the measures adopted is that they are have been prepared by technical committees made up of representatives from the national authorities in the largest financial centres in cooperation with officials from emerging markets. They have then able to produce expert and technically relevant papers although only in the form of informal standards (sometimes referred to as ‘soft law’) rather than formal international laws, treaties or conventions which would have been highly difficult to agree in light of the sensitivity of the matters covered and differences in underlying national laws and practices. These standards are then dependent on national adoption and implementation or transplantation through such regional systems as the EU.

 

(a)       Bretton Woods

 

The Basel Committee was set up in September 1974 following the collapse of the Bretton Woods system of managed exchange rates which had stabilised international currencies since the end of the Second World War. All of the currencies had been fixed to the dollar with the dollar being fixed to gold at US$35 per ounce. President Richard Nixon announced the closure of the ‘Gold Window’ in a radio address on 15 August 1971 which led to the abandonment of the fixed exchange rate mechanism and move to floating currencies. This resulted in substantial losses to many international banks with market instability arising in the US especially with the closure of the Franklin National in summer 1974 and Bankhaus Herstatt in Cologne, Germany on 26 June 1974. This led to a crisis in the international financial system with the G10 having to issue a support Communiqué in September 1974 and with the Basel Committee being set up to attempt to develop international standards and practices to prevent similar crises arising in future.

 

(b)       Basel Committee Supervisory Programme

 

The Committee initially prepared a series of general standards to improve the cross-border supervision of major banking groups. These were based on an allocation of supervisory responsibility between the parent and host authorities and for the exchange of information and co-operation and co-ordination of action. A First Concordat was issued in 1974 following the Bankhaus Herstatt crisis. A Revised Concordat was produced in 1983 after the collapse of Banco Ambrosiano in Italy with a further Information Supplement being released in 1990. A set of absolute minimum provisions was then created under the 1992 Statement of Minimum Standards following the closure of BCCI in July 1991 with a further Report on the Implementation of Minimum Standards in 1996.

 

(c)       Basel I, II and III

 

While the Committee had not originally been set up to produce regulatory standards rather than supervisory principles, it began to consider the issue during the early 1980s following the Third World Debt Crisis beginning in Mexico in 1982. The Committee recognised that the capital standards of international banks had fallen to dangerously low levels with the US and UK authorities agreeing a separate  Bilateral Capital Accord in 1986. This was presented to the Committee with the threat of applying this to all banks in New York and London unless the Committee produced its own global standards. The Committee released a first Basel I Capital Accord in July 1988 which established the 8% minimum capital to risk adjusted assets ratio calculated on the basis of government and corporate borrowers from OECD or non-OECD countries. (Cash is generally given a 0% weighting, OECD debt in the local currency 10%, non-OECD debt 20%, secured lending 50% and all other borrowing 100% with all items on a bank’s balance sheet being multiplied by these ratios to create a lower ‘risk-adjusted figure’ and with separate rules applying with regard to the conversion of off-balance sheet items into on-balance sheet equivalent values.)

 

Despite its non-legally binding nature, these provisions were accepted as the de facto global standards for a decade despite their simplicity and only crude approximation of actual risk. The Basel Committee agreed separate international standards for capital for securities activities under its 1986 Market Risk Amendment which were generally based on the EU Capital Adequacy Directive 1993 (93/6/EEC of 15 March 1993).

 

A revised set of Basel II standards was subsequently agreed in July 2004 after five years of negotiation to create a more sophisticated and risk sensitive measurement framework. This was based on three Pillars with minimum capital requirements in Pillar 1 (for credit risk, market risk and a new operational risk charge), Minimum supervisory review standards in Pillar 2 and Market discipline (based on market disclosure) in Pillar 3. The 8% minimum figure was retained within Pillar 1 although this was made more risk sensitive using the ratings produced by approved Credit Rating Agencies (CRAs) and with alternative Foundation and Advanced Internal Ratings Base (IRB) methods being provided for more sophisticated institutions using banks’ internal rather than external CRA ratings. Basel II was much more risk sensitive although problems remained with regard to the low capital levels permitted under the market risk trading book sections for securities activities and for specific operations, such as securitisation. Basel II was implemented in the EU under the Capital Requirements Directive in 2006 (2006/48/EC of 14 June 2006) although it had not been implemented fully in many countries before the global financial crisis beginning in summer 2007.

 

The most recent Basel III requirements were agreed after the global financial crisis by the Committee in December 2010. This generally provides for the core tier 1 (CET1) capital figure of 2% to be increased to 4.5% with a separate Conservation Buffer of 2.5% which increases this to 7% (section 9(1)(e) below). A discretionary counter-cyclical buffer of between 0-2.5% is to be applied with a further systemic buffer of around 2-3% to follow after final agreement by the Financial Stability Board in 2011. A separate leverage ratio (of 3% tier 1 capital) is also to be imposed with two new liquidity ratios for the first time (the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR)).

 

 

(d)       Core Principles for Effective Banking Supervision

 

While the Basel Committee’s work had generally either focused on supervisory or regulatory matters until the mid-1990s, the Committee was directed by the G7/8 governments to prepare a fully integrated set of Core Principles for Effective Banking following the Asian Financial Crisis beginning in Thailand in July 1997. 25 Core Principles were subsequently produced in September 1997 and then revised in October 2006. A separate implementation of the Core Principles Methodology was produced in October 1999 and then reissued in October 2006. The Core Principles were significant in that they combined supervisory and regulatory matters, were designed to apply at the national and cross-border levels and applied to G10 and non-G10 country banks. They also became the model for other similar sets of core principles in other sectors including securities, insurance and payment and settlement.

 

 

 

(e)       International Financial Crisis Response

 

The Basel Committee standards were criticised following the global financial crisis for allowing banks to maintain inadequately low levels of capital and with no international liquidity standards having been agreed. The Committee produced over 30 documents following the crisis in a number of core areas (Section 9(1)(c) above). The most important result was the Basel III capital amendments agreed in December 2010 with supporting new global liquidity standards with a minimum Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). The main difficulty was the delayed eight year implementation period until 2018. The Basel III capital rules consist of:

 

(a)    Core tier 1 capital (essentially paid up share capital and retained earnings) is increased from 2% to 4.5%;

(b)   Supplemented by a protective Conservation Buffer of 2.5% which increases the core tier 1 ratio to 7%:

(c)   A discretionary 0-2.5% counter-cyclical buffer (to be applied during ‘boom’ periods when markets were rising to create additional capital reserves);

(d)   A further Systemic Risk buffer of approximately 2-3% for larger banks and financial groups which create

additional systemic risks (referred to as ‘Systemically Important Financial Institutions’ (SIFIs) or ‘Global SIFIs’ (G-SIFIs)); and

 (e)  A new 3% tier 1 leverage ratio.

 

The Committee has also developed a number of other sets of basic principles in key areas related to the global financial crisis as part of its larger crisis response. The most important other documents include:

 

1. Nineteen principles on bank governance and supervisory oversight under the Principles for Enhancing Corporate Governance (March 2010);

2. Nine principles on remuneration under Compensation Principles and Standards Assessment Methodology (January 2010) with a further Range of Methodologies for Risk and Performance Alignment of Remuneration (May 2011);

3. Ten recommendations on Cross-border Bank Resolution (March 2010);

4. Eight principles on the operation of Good Practice Principles on Supervisory Colleges (October 2010); and

5. The Committee has also attempted to include a macro-prudential oversight component within its Basel III framework under The Basel Committee’s Response to the Financial Crisis: Report to the G20 (October 2010).

 

The Committee has been criticised for the length of the time that it has taken to produce its crisis response documents and for succumbing both to industry lobbying and to government pressure, such as with the delayed implementation period until 2019. The Committee has nevertheless had to conduct a full and proper consultation process and take into account all relevant opinions. The Committee has consequently produced a targeted, informed, balanced and proportionate as well as inclusive and co-operative new agenda which includes measures in all key post- crisis reform areas within the scope of the Committee's competence and mandate.