Basel II: flexible capital requirements and market discipline

The Basel II Accord in 2006 reformed the overall regime to the direction of flexibility and heavy use of meta-regulation. Basel II consists of three pillars. Under Pillar 1, banks have to maintain minimum capital equivalent to 8% of their total risk exposure, which consists of credit risk, market risk and operational risk. As under Basel I, half of the capital ought to be Tier 1 capital, i.e. shareholders’ equity and disclosed reserves, while the rest could be Tier 2 capital. Credit risk is the risk that borrowers may default; market risk is the risk

Regulation of bank capital and liquidity 213 that financial assets traded by a bank, such as securities, may suffer a reduction in value; and operational risk is the risk of losses due to failed internal processes and systems, rogue employees and external events. Credit risk is calculated as a percentage of the actual value of a bank’s relevant assets, whereas market risk consists of a risk-weighted market risk measurement, and operational risk is calculated by reference to a bank’s income. Pillar 2 requires banks to have in place internal processes to assess their own capital adequacy regarding any residual risks not covered by Pillar 1, and gives regulators the duty to supervise banks’ processes and the power to demand banks to hold additional capital and to intervene early in cases of breach.[1] Pillar 3 requires banks to disclose relevant information to enable market participants to assess banks’ capital adequacy, thus reinforcing market discipline.

The following paragraphs will set out the Basel II framework to calculate banks’ exposures to credit, market and operational risk. These rules continue to be important as they form the basis of the Basel III framework - with certain crucial modifications that will be examined in Section 12.7. Basel II introduced two methodologies to assess credit risk, namely, the Standardised Approach and the Internal Ratings-Based (IRB) Approach, the latter being available for banks, only with the explicit consent of their regulator. A similar approach was taken with regard to the other two types of risk. We will first examine the standardised approaches for the three types of risk and then the more flexible approaches.

Under the Standardised Approach for credit risk, assets are risk-weighted based on their falling within broad categories prescribed by Basel II, i.e. claims on sovereigns, public bodies, banks, companies, mortgages, etc. The multiplier to be used for certain traded assets (e.g. bonds) depends on their credit rating. So, sovereign bonds can be weighted at 0%, 20%, 50%, 100% or 150%, while corporate bonds can be weighted at 20%, 50%, 100% or 150%. Residential mortgages are weighted at 35%. Non-performing loans are weighted at 150%. It is notable that Basel II introduced risk weightings of 150%, exceeding the actual exposure of banks in the cases of particularly high-risk debt.

The Standardised Approach for market risk remained the same as under the 1996 amendment for equities trading risk, foreign exchange risk and commodities risk, but was amended in relation to interest rate risk. While before Basel II interest rate risk-weightings for each type of loan depended only on the type of borrower and ranged from 0% to 8%, under Basel II, they also depend on the credit rating of the borrower and ranged from 0% to 12%. Equities trading risk is calculated by reference to the value of a bank’s equities portfolio, applying a weighting of 8% to account for general market risk and an additional weighting of either 4% or 8% to account for specific portfolio risk (4% if the portfolio is fully diversified and liquid). Foreign exchange risk is calculated at 8% of a bank’s net long currency positions, or net short currency positions or net gold positions, whichever the higher. Commodities risk comprises two components: 15% of the net position of the bank in each commodity and 3% of the gross long and gross short positions of the bank on each commodity.

Regarding operational risk there are two off-the-shelf approaches. The Basic Indicator Approach, suitable for smaller banks with few lines of business, prescribes a weighting of 15% of a bank’s annual gross revenues, averaged over a period of three years.[2] The Standardised Approach, suitable for banks with multiple business lines, distinguishes between eight different lines of business and assigns a separate weighting to the average revenue from each line of business, with weightings ranging from 12% to 18%. In particular, corporate finance activities, trading and sales, and payments and settlement are weighted at 18%; commercial banking and agency services are weighted at 15%; and retail banking, retail brokerage and asset management at 12%.

Turning to meta-regulatory measuring approaches, for credit risk, there are two versions of the IRB Approach: the foundation and the advanced. Under the former, banks themselves calculate the probability of default of loans, but rely on their regulators for other factors, such as loss given default, exposure and maturity. Under the latter, banks autonomously calculate all of the above factors. Banks were therefore given discretion, wider in the case of the advanced version, to calculate their own capital adequacy relating to credit risk. An Internal Models Approach is also available to calculate market risk, insofar as banks can convince their regulators that their models are robust. In the case of operational risk, the equivalent approach was branded the Advanced Measurement Approach. In all cases, banks following such approaches are required to set up an independent internal risk management department, to have a robust compliance policy, to ensure that there is board oversight and to have these systems independently reviewed, normally by external audit. They are also required to satisfy minimum technical parameters when constructing their methodologies for calculating the relevant risks. Furthermore, regulatory approval of these approaches and continuous supervision were relied on to place limits on banks’ ability to bypass capital adequacy requirements, although with hindsight it is now evident that regulatory scrutiny of banks’ internal models in the period before the global financial crisis was not sufficient.

A significant feature of the Basel II framework - both under standardised approaches and within banks’ own risk calculation models - was heavy reliance on credit ratings. Nevertheless, recent evidence suggests that Credit Rating Agencies (CRAs) may be consistently under-valuing the riskiness of certain debts, due to the presence of conflicts of interest and the inherent limits of human rationality. The Eurozone sovereign debt crisis, for

Regulation of bank capital and liquidity 215 instance, illustrates that borrowers who appear to be risk-free or of low risk (such as highly rated OECD countries) and hence banks face incentives to lend heavily to them may turn out not to be creditworthy, the most notable example being the government of Greece. Capital adequacy rules thus had negative unintended consequences and failed to influence banks’ risk profiles to the intended direction. In addition, the requirement to keep capital against RWAs created incentives for banks to remove assets from their balance sheets. Extensive use of securitisation, for instance, was widely used before the global financial crisis to circumvent capital adequacy ratios by removing assets from banks’ balance sheets.[3] In Section 11.7, we will see that certain steps have been taken, particularly at the EU level, to improve the quality of credit ratings and reduce reliance on them, but the extent to which they have mitigated the problem remains unclear.

  • [1] See Basel II, Part 3: The Second Pillar - Supervisory Review Process. 2 See Basel II, Part 4: The Third Pillar - Market Discipline. 3 Basel II, paras 50-51. 4 See Basel II, Part 2,11. Credit Risk - The Standardised Approach. 5 See Basel II, Part 2, VI. C. Market risk - The standardised measurement method: 1. Interest rate risk. 6 See Basel II, Part 2, VI. C. Market risk - The standardised measurement method: 2. Equity position risk; 3. Foreign exchange risk; and 4. Commodities risk.
  • [2] Basel II, paras 649-651. 2 Basel II, paras 652-654. 3 Basel II, para 245. 4 See Basel II, Part 2, VI. D. Market Risk - The Internal Models Approach. 5 Basel II, paras 655-659. 6 On this, see Michael McAleer, Juan-Angel Jimenez-Martin and Teodosio Perez-Amaral, ‘What Happened to Risk Management during the 2008-2009 Financial Crisis’ in Robert W Kolb (ed), Lessons from the Financial Crisis (John Wiley 2010) 307. Several UK official reports on failed banks take similar views: Parliamentary Commission on Banking Standards, An Accident Waiting to Happen: The Failure of HBOS (2012-2013, HL 144, HC 705) 3-4; ibid., Changing Banking for Good (2013-2014, HL 27-11, HC 175-11) 82-83; and FSA, ‘The Failure of the Royal Bank of Scotland: Financial Services Authority Board Report’ (December 2011) 62-63, (accessed 21 June 2020). 7 An analysis of the role and incentives of Credit Rating Agencies can be found in John P. Hunt, ‘Credit Rating Agencies and the “Worldwide Credit Crisis”: The Limits of Reputation, the Insufficiency of Reform, and a Proposal for Improvement’ (2009) 2009 Columbia Business Law Review 109. For a detailed examination of the business model and conflicts of interest faced by CRAs, see Andrea Miglionico, The Governance of Credit Rating Agencies: Regulatory Regimes and Liability Issues (Edward Elgar 2019) Chapters 1-2.
  • [3] Orkun Akseli, ‘Was Securitisation the Culprit? Explanation of Legal Processes Behind Creation of Mortgage-Backed Sub-prime Securities’ in Joanna Gray and Orkun Akseli (eds), Financial Regulation in Crisis? The Role of Law and the Failure of Northern Rock (Edward Elgar 2011) 2-3. 2 On the limitations of market discipline and traditional shareholder governance to safeguard financial stability, see Emilios Avgouleas, ‘The Global Financial Crisis and the Disclosure Paradigm in European Financial Regulation: The Case for Reform’ (2009) 6 European Company and Financial Law Review 440; and Emilios Avgouleas and Jay Cullen, ‘Market Discipline and EU Corporate Governance Reform in the Banking Sector: Merits, Fallacies, and Cognitive Boundaries’ (2014) 41 Journal of Law and Society 28. For a comprehensive examination of the relationship between shareholder-centric corporate governance and financial stability, see Andreas Kokkinis, Corporate Law and Financial Instability (Routledge 2018). 3 Basel Committee on Banking Supervision, Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems (rev edn, Bank of International Settlements Publications 2011). From now on, it will be referred to as ‘Basel I IT. 4 Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC [2013] OJ L176/338. From now on, it will be referred to as ‘CRD IV’. 5 Regulation (EU) No. 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No. 648/2012 [2013] OJ L176/1. From now on it will be referred to as ‘CRR’. The CRR has been amended by the EU Regulation 2019/876 amending Regulation (EU) No. 575/2013 as regards the leverage ratio, the net stable funding ratio, requirements for own funds and eligible liabilities, counterparty credit risk, market risk, exposures to central counterparties, exposures to collective investment undertakings, large exposures, reporting and disclosure requirements, and Regulation (EU) No. 648/2012 (‘CRR 2’).
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