The breakdown of the Bretton Woods system of managed exchange rates in 1973 soon led to casualties. On 26 June 1974, West Germany's Federal Banking Supervisory Office withdrew Bankhaus Herstatt's banking licence after finding that the bank's foreign exchange exposures amounted to three times its capital. Banks outside Germany took heavy losses on their unsettled trades with Herstatt, adding an international dimension to the debacle.
In October the same year, the Franklin National Bank of New York also closed its doors after racking up huge foreign exchange losses. Three months later, in response to these and other disruptions in the international financial markets, the central bank governors of the G10 countries established a Committee on Banking Regulations and Supervisory Practices.
Later renamed as the Basel Committee on Banking Supervision, the Committee was designed as a forum for regular cooperation between its member countries on banking supervisory matters. Its aim was and is to enhance financial stability by improving supervisory knowhow and the quality of banking supervision worldwide.
The Committee seeks to achieve its aims by setting minimum supervisory standards; by improving the effectiveness of techniques for supervising international banking business; and by exchanging information on national supervisory arrangements. And, to engage with the challenges presented by diversified financial conglomerates, the Committee also works with other standard-setting bodies, including those of the securities and insurance industries.
Since the first meeting in February 1975, meetings have been held regularly three or four times a year. After starting life as a G10 body, the Committee expanded its membership in 2009 and now includes 27 jurisdictions. The Committee now reports to an oversight body, the Group of Central Bank Governors and Heads of Supervision (GHOS), which comprises central bank governors and (non-central bank) heads of supervision from member countries.
Countries are represented on the Committee by their central bank and also by the authority with formal responsibility for the prudential supervision of banking business where this is not the central bank. The present Chairman of the Committee is Stefan Ingves, Governor of the Riksbank, Sweden's central bank. (See list of past Basel Committee chairmen.)
The Committee's decisions have no legal force. Rather, the Committee formulates supervisory standards and guidelines and recommends statements of best practice in the expectation that individual national authorities will implement them. In this way, the Committee encourages convergence towards common standards and monitors their implementation, but without attempting detailed harmonisation of member countries' supervisory approaches.
At the outset, one important aim of the Committee's work was to close gaps in international supervisory coverage so that (i) no foreign banking establishment would escape supervision; and (ii) that supervision would be adequate and consistent across member jurisdictions. A first step in this direction was the paper issued in 1975 that came to be known as the "Concordat", which set out principles by which supervisory responsibility should be shared for banks' foreign branches, subsidiaries and joint ventures between host and parent (or home) supervisory authorities. In May 1983, the Concordat was revised and re-issued as Principles for the supervision of banks' foreign establishments .
In April 1990, a supplement to the 1983 Concordat was issued with the aim of improving the cross-border flow of prudential information between banking supervisors. In June 1992, certain principles of the Concordat were reformulated as minimum standards. These standards were communicated to other banking supervisory authorities, who were invited to endorse them, and published in July 1992.
In October 1996, the Committee released a report on The supervision of cross-border banking, drawn up by a joint working group that included supervisors from non-G10 jurisdictions and offshore centres. The document presented proposals for overcoming the impediments to effective consolidated supervision of the cross-border operations of international banks. Subsequently endorsed by supervisors from 140 countries, the report helped to forge relationships between supervisors in home and host countries.
The involvement of non-G10 supervisors also played a vital part in the formulation of the Committee's Core principles for effective banking supervision in the following year. The impetus for this document came from a 1996 report by the G7 finance ministers that had called for effective supervision in all important financial marketplaces, including those of emerging economies.
As published in September 1997, the paper set out 25 basic principles that the Basel Committee believed should be in place for a supervisory system to be effective. After several revisions, most recently in September 2012, the document now embraces 29 principles, covering supervisory powers, the need for early intervention and timely supervisory actions; supervisory expectations of banks, and compliance with supervisory standards.
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Capital adequacy soon became the main focus of the Committee's activities. In the early 1980s, the onset of the Latin American debt crisis heightened the Committee's concerns that the capital ratios of the main international banks were deteriorating at a time of growing international risks. Backed by the G10 Governors, the Committee members resolved to halt the erosion of capital standards in their banking systems and to work towards greater convergence in the measurement of capital adequacy. This resulted in a broad consensus on a weighted approach to the measurement of risk, both on and off banks' balance sheets.
There was a strong recognition within the Committee of the overriding need for a multinational accord to strengthen the stability of the international banking system and to remove a source of competitive inequality arising from differences in national capital requirements. Following comments on a consultative paper published in December 1987, a capital measurement system commonly referred to as the Basel Capital Accord (or the 1988 Accord) was approved by the G10 Governors and released to banks in July 1988.
The Accord called for a minimum capital ratio of capital to risk-weighted assets of 8% to be implemented by the end of 1992. Ultimately, this framework was introduced not only in member countries but also in virtually all other countries with active international banks. In September 1993, a statement was issued confirming that all the banks in the G10 countries with material international banking business were meeting the minimum requirements set out in the 1988 Accord.
The 1988 capital framework was always intended to evolve over time. In November 1991, it was amended to give greater precision to the definition of general provisions or general loan-loss reserves that could be included in the capital adequacy calculation. In April 1995, the Committee issued an amendment to the Capital Accord, to take effect at end-1995, to recognise the effects of bilateral netting of banks' credit exposures in derivative products and to expand the matrix of add-on factors. In April 1996, another document was issued explaining how Committee members intended to recognise the effects of multilateral netting.
The Committee also refined the framework to address risks other than credit risk, which was the focus of the 1988 Accord. In January 1996, following two consultative processes, the Committee issued the so-called Market Risk Amendment to the Capital Accord to take effect at the end of 1997 at the latest.
This was designed to incorporate within the Accord a capital requirement for the market risks arising from banks' exposures to foreign exchange, traded debt securities, equities, commodities and options. An important aspect of this amendment is that banks are allowed to use internal value-at-risk models as a basis for measuring their market risk capital requirements, subject to strict quantitative and qualitative standards. Much of the preparatory work for the market risk package was undertaken jointly with securities regulators.
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In June 1999, the Committee issued a proposal for a new capital adequacy framework to replace the 1988 Accord. This led to the release of the Revised Capital Framework in June 2004. Generally known as "Basel II", the revised framework comprised three pillars, namely:
The new framework was designed to improve the way regulatory capital requirements reflect underlying risks and to better address the financial innovation that had occurred in recent years. The changes aimed at rewarding and encouraging continued improvements in risk measurement and control.
The framework's publication in June 2004 followed almost six years of intensive preparation. During this period, the Basel Committee had consulted extensively with banking sector representatives, supervisory agencies, central banks and outside observers in an attempt to develop significantly more risk-sensitive capital requirements.
Following the June 2004 release, which focused primarily on the banking book, the Committee turned its attention to the trading book. In close cooperation with the International Organization of Securities Commissions (IOSCO), the international body of securities regulators, the Committee published in July 2005 a consensus document governing the treatment of banks' trading books under the new framework. For ease of reference, this new text was integrated with the June 2004 text in a comprehensive document released in June 2006.
Both Committee member countries and several non-member countries agreed to adopt the new rules, albeit on varying timescales. Thus, consistent implementation of the new framework across borders has become a challenging task for the Committee. To encourage collaboration and shared approaches, the Committee's Supervision and Implementation Group (SIG) serves as a forum on implementation matters. The SIG discusses issues of mutual concern with supervisors outside the Committee's membership through its contacts with regional associations. In January 2009, its mandate was broadened to concentrate on implementation of Basel Committee guidance and standards more generally.
One challenge that supervisors worldwide faced under Basel II was the need to approve the use of certain approaches to risk measurement in multiple jurisdictions. While this is not a new concept for the supervisory community - the Market Risk Amendment of 1996 involved a similar requirement - Basel II extended the scope of such approvals and demanded an even greater degree of cooperation between home and host supervisors. To help address this issue, the Committee issued guidance on information-sharing and supervisory cooperation and allocation mechanisms in the context of Advanced Measurement Approaches in 2006 and 2007, respectively.
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Even before Lehman Brothers collapsed in September 2008, the need for a fundamental strengthening of the Basel II framework had become apparent. The banking sector had entered the crisis with too much leverage and inadequate liquidity buffers. These defects were accompanied by poor governance and risk management, as well as inappropriate incentive structures. The combination of these factors was manifest in the mispricing of credit and liquidity risk, and excess credit growth.
Responding to these risk factors, the Basel Committee issued Principles for sound liquidity risk management and supervision in the same month that Lehman Brothers failed. In July 2009, the Committee issued a further package of documents to strengthen the Basel II capital framework, notably with regard to the treatment of certain complex securitisation positions, off-balance sheet vehicles and trading book exposures. These enhancements were part of a broader effort to strengthen the regulation and supervision of internationally active banks, in the light of weaknesses revealed by the financial market crisis.
In September 2010, the Group of Governors and Heads of Supervision announced higher global minimum capital standards for commercial banks. This followed an agreement reached in July regarding the overall design of the capital and liquidity reform package, now referred to as "Basel III". In November 2010, the new capital and liquidity standards were endorsed at the G20 Leaders Summit in Seoul.
The new proposed standards were set out in Basel III: International framework for liquidity risk measurement, standards and monitoring , issued by the Committee in mid-December 2010. A new capital framework revises and strengthens the three pillars established by Basel II. The accord is also extended with several innovations, namely:
In January 2012, the Group of Central Bank Governors and Heads of Supervision (GHOS) endorsed the comprehensive process proposed by the Committee to monitor members' implementation of Basel III. The process consists of the following three levels of review:
The Basel Committee has worked in close collaboration with the Financial Stability Board (FSB) given the FSB's role in coordinating the monitoring of implementation of regulatory reforms. The Committee designed its programme to be consistent with the FSB's Coordination Framework for Monitoring the Implementation of Financial Reforms (CFIM) as agreed by the G20.
These tightened definitions of capital, significantly higher minimum ratios and the introduction of a macroprudential overlay represent a fundamental overhaul for banking regulation. At the same time, the Basel Committee, its governing body and the G20 Leaders have emphasised that the reforms will be introduced in a way that does not impede the recovery of the real economy.
In addition, time is needed to translate the new internationally agreed standards into national legislation. To reflect these concerns, a set of transitional arrangements for the new standards was announced as early as September 2010, although national authorities are free to impose higher standards and shorten transition periods where appropriate.
The new, strengthened definition of capital will be phased in over five years: the requirements were introduced in 2013 and will be fully implemented by the end of 2017. Capital instruments that no longer qualify as non-common equity Tier 1 capital or Tier 2 capital will be phased out over 10 years beginning 1 January 2013.
Turning to the minimum capital requirements, the higher minimums for common equity and Tier 1 capital are being phased in from 2013, and will become effective at the beginning of 2015. The schedule will be as follows:
The 2.5% capital conservation buffer, which will comprise common equity and is in addition to the 4.5% minimum requirement, will be phased in progressively starting on 1 January 2016, and will become fully effective by 1 January 2019.
The leverage ratio will also be phased in gradually. The test (the so-called "parallel run period") began in 2013 and run until 2017, with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on review and appropriate calibration.
The liquidity coverage ratio (LCR) will be phased in from 1 January 2015 and will require banks to hold a buffer of high-quality liquid assets sufficient to deal with the cash outflows encountered in an acute short-term stress scenario as specified by supervisors. To ensure that banks can implement the LCR without disruption to their financing activities, the minimum LCR requirement will begin at 60% in 2015, rising in equal annual steps of 10 percentage points to reach 100% on 1 January 2019.
The other minimum liquidity standard introduced by Basel III is the net stable funding ratio. This requirement, which will be introduced as a minimum standard by 1 January 2018, will address funding mismatches and provide incentives for banks to use stable sources to fund their activities.
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Basel Committee on Banking Supervision (2013): Basel Committee on Banking Supervision (BCBS) Charter.
Goodhart, C (2011): The Basel Committee on Banking Supervision: A history of the early years 1974-1997, Cambridge University Press.
Toniolo, G (2005): Central bank cooperation at the Bank for International Settlements 1930-1973, Cambridge University Press.