Account for why the Basel regulations were introduced, including the main risk exposures they target, and for why they were revised over the years.
The idea
The Basel Committee was set up by the G10 central bank governors at the end of 1974, after the failure of Bankhaus Herstatt showed how a bank problem could spread across borders. By the 1980s capital ratios had been falling and the Latin American debt crisis exposed thin equity. Supervisors therefore wanted a common minimum standard that would also give internationally active banks a level playing field. The 1988 Accord targeted credit risk, then the dominant exposure. Revisions followed because the rules were crude and exploitable. Every corporate loan carried the same 100 percent weight, so banks used securitization and guarantees to cut required capital without cutting risk. Trading positions were uncovered, which led to the 1996 market risk amendment. Basel II then added operational risk and more risk-sensitive credit weights. Exam point: tie each revision to the gap it closed.
A practice question
The Basel Committee on Banking Supervision was established at the end of 1974 by the central bank governors of the G10. Which event is most directly associated with its creation?
- The 1974 failure of Bankhaus Herstatt, which disrupted foreign exchange settlement across borders - correct
- The collapse of Long-Term Capital Management, the hedge fund, in 1998 after the Russian defaultWhy not: LTCM came more than two decades after the Committee was formed; it is an event of the late 1990s.
- The Latin American sovereign debt crisis of the early 1980s, which weakened bank capitalWhy not: That crisis helped motivate the 1988 capital Accord, but the Committee already existed by then.
- The failure of Barings Bank in 1995Why not: Barings occurred after Basel I and fed later concern about operational risk, not the founding of the Committee.
The Committee was formed after the Herstatt failure in 1974 showed how a single bank's problems could spread internationally. The Latin American debt crisis motivated the 1988 Accord; LTCM and Barings came later.
A harder one
By the early 1990s banks had built large trading books of bonds, equities, currencies and derivatives whose price risk was not covered by the Basel I credit risk charge. Which revision responded to this gap?
- The 1995 amendment, which introduced rules on netting of credit exposuresWhy not: The 1995 amendment concerned credit exposure on derivatives with a counterparty, not price risk of trading positions.
- Basel II Pillar 3, which introduced market discipline through public disclosureWhy not: Pillar 3 is about disclosure, and Basel II came in 2004, well after the market risk gap was closed.
- Basel II's operational risk chargeWhy not: Operational risk is a separate exposure; it has nothing to do with price changes in trading positions.
- The 1996 amendment, which introduced capital for market risk in the trading book - correct
The 1996 amendment (effective 1998) added capital for market risk in the trading book, using either a standardized method or the bank's own 10-day 99 percent VaR. The 1995 amendment dealt with netting of credit exposures.
The hardest tier
A bank holds USD 200 million of corporate loans risk-weighted at 100 percent under Basel I. It obtains guarantees from an OECD bank covering USD 120 million of the loans, which Basel I lets it treat as claims on the guarantor. The guarantees do not remove all the credit risk (the guarantor can default and there may be a maturity mismatch). By how much does required capital at 8 percent fall (closest to), and what does the result illustrate?
- USD 7.68 million, illustrating that Basel I gave large capital relief for risk transfer that was not fully effective - correct
- USD 9.60 million, illustrating that guarantees correctly remove the credit risk of the covered loans entirelyWhy not: Treats the protected loans as carrying a 0 percent weight; Basel I assigns the OECD bank's 20 percent weight, and the residual risk remains.
- USD 4.80 million, illustrating that guarantees receive half the credit reliefWhy not: Uses a 50 percent weight on the protected amount; Basel I gives claims on OECD banks a 20 percent weight, not 50 percent.
- USD 12.80 million, illustrating that every loan in the book benefits from the guaranteeWhy not: Applies the 20 percent weight to the whole USD 200 million instead of only the USD 120 million that is guaranteed.
Before: 200 x 100% x 8% = 16.00. After: unprotected 80 x 100% + protected 120 x 20% = 104 of RWA, capital 8.32. Saving = 7.68. The relief is large relative to the economic risk reduction, a form of arbitrage that motivated revision.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Capital Regulation Before the Global Financial Crisis
- Explain how Basel I's original guidelines arrive at risk-weighted assets and at the capital a bank must hold.
- Outline what the 1995 and 1996 amendments brought in, namely rules on netting credit exposures and ways to compute market risk capital for trading book assets.
- Set out what Basel II changed, including its three pillars.
- Contrast how Basel II derives credit risk capital under the standardized approach, under the foundation IRB approach and under the advanced IRB approach.
- Work out Basel II credit risk capital with the internal ratings-based (IRB) approach.
- Contrast how Basel II's basic indicator approach, standardized approach and AMA (advanced measurement approach) each produce a charge for operational risk.
- Give a summary of what the Solvency II framework requires of insurance companies in terms of capital.