Basel II History

The special role of banks in today’s economies has already been discussed, as have the competing economic demands of risk provisioning and maintaining a strong position in international competition among banks. In the mid-1980s, when the capital ratios of the world’s largest banks fell to dangerously low levels due to competitive pressure, the Basel Committee on Banking Supervision felt compelled to take action: From the mid-1970s onward, the committee had mainly been making efforts to close gaps in international supervision and to develop suitable supervisory standards, and at that point they decided to publish capital adequacy recommendations. The result was the Basel Capital Accord, which was applied to international banks in G-10 countries. This system of capital measurement (called "Basel I" in retrospect), which is still in force today, was a milestone in the international harmonization of regulatory capital requirements. The accord first concentrated on credit risk and required a minimum capital ratio of 8% of a bank’s risk-weighted assets. This level of capital adequacy was implicitly meant to cover other risks as well.

Although the new capital adequacy framework at first only applied to banks which operated internationally, in the 1990s it gained recognition as the worldwide standard for capital adequacy in banking and is now applied in over 100 countries around the world. The corresponding EU directives – and consequently also the corresponding national legal regulations such as the Austrian Banking Act (BWG) – have likewise been influenced heavily by the Basel Capital Accord.

Naturally, banking has changed dramatically since the original accord was introduced in 1988, as in recent years banks have increasingly become providers of broad-based (financial) services. Risk management practices in the banking business – especially on the financial markets themselves – have also seen significant changes. The new capital adequacy framework was expanded several times, mainly to cover banks’ off-balance-sheet activities and risks. Due to the growing significance of trading activities at banks, the accord was amended in 1996 to include market risk. The risks arising from trading positions in bonds, equities, foreign exchange, and commodities were separated from credit risk calculations and combined in a new risk category with explicit capital requirements based on positions outstanding in each instrument. For the first time, this allowed many banks to use their own systems for measuring market risk (market risk models) and for determining the capital required to cover this risk.

However, the contrast between capital requirements (such as the uniform 8% capital charge for the private sector), which were still clearly defined but increasingly considered to be too general and imprecise, and the increasingly complex internal methods used by banks to determine their economic capital requirements was becoming more and more evident. New financial instruments and credit risk management methods as well as risk mitigation techniqueswere practically not covered by Basel I.

In June 1999, the Basel Committee on Banking Supervision began the process of replacing the 11-year-old accord with a more up-to-date framework and published the first consultation paper, which was (intentionally) rather vague in its details as it was intended to encourage early international discussions on this topic. In this context, three measures were introduced to help achieve the goal of increased risk sensitivity:

• expanding the quantitative standards used to date (minimum capital requirements) and adding two additional "pillars" (supervisory review process and market discipline),
• allowing banks to use ratings from approved external rating agencies to classify exposures to sovereigns, corporates and banks in risk classes, and
• allowing banks with more sophisticated risk management mechanisms to use internal ratings, that is, in-house systems for assessing credit risks.

The consultation paper published in June 1999 also introduced a capital requirement for "other risks."

Based on the comments received from banks and supervisory authorities as well as the dialog with banking practitioners, it was possible to specify the new framework further; as a result, the second consultation paper appeared in January 2001. This paper was also changed in the course of ongoing discussions in the ensuing consultation stage; an overview of the ideas and approaches used in the current version of the new capital accord can be found under Basel II Basics.