Whilst banks are regulated by laws implemented at a national level, the global nature of financial institutions and capital markets has increasingly required an international perspective involving an integrated approach across national boundaries by law makers and regulators. The Basel Committee on Banking Supervision supported by heads of state of the worlds major economies (the expanded members of which are now known as the Group of Twenty (or G20) has led the development of minimum requirements for banking regulation at the global level. At the European level, harmonization of the laws of European Member States relating to securities, banking and capital markets activities has been a key driving force in the development of national legislation with the focus of bank regulatory capital being derived from a series of directives under the umbrella of the Capital Requirements Directive described below.

The Basel Committee on Banking Supervision

The Basel Committee on banking supervision provides a high level industry focused forum for the development of cooperation and supervisory oversight of the banking sector on a worldwide basis.

The Basel Committee was formed as a result of the liquidation of a Colognebased bank (Herstaff) in 1994 which prompted the then Group of ten (G-10) nations to form the Basel Committee on Banking Supervision, under the auspices of the Bank of International Settlements (BIS) located in Basel, Switzerland.

The Basel Committee's members include most of the major nations of the world and the importance of the Committee reflects the cross border and interconnected nature of banking business in the world today. Originally focussed on the Group of Ten (G-10) countries, the new membership incorporates the G-20 nations plus certain other countries.

The Committee's secretariat is located at the Bank for International Settlements in Basel, Switzerland, and is staffed mainly by professional supervisors on temporary secondment from member institutions.

Basel I

In 1988, the Basel Committee published a set of minimal capital requirements for banks which was known as the 1988 Basel Accord and which was enforced by law in each of the G-10 countries in 1992. The 1988 Basel Accord primarily focused on credit risk. The approach was relatively simplistic requiring banks to categorise assets into five sub-groups and apply a capital weighting against the perceived credit risk applicable to counterparties in each respective subgroup. Weightings ranged from zero percent (in respect of holdings of cash or home country sovereign debt) through ten, twenty, fifty and one hundred percent. Banks were required to hold capital equal to not less than 8% of the aggregate assets weighted for risk on the above basis. As a later add-on, the 1988 Basel Accord was supplemented by measures to address market risk in addition to credit risk in respect of the required holding of regulatory capital.

Basel II

Whilst the 1988 Basel I provided the groundwork for global recognition of minimum capital requirements, it was recognised even before the rules were implemented that further development of a risk based supervisory approach to banking regulation would require a more comprehensive and detailed approach to the management of risk in the banking sector.

In June 2004, the Basel II Accord was published to provide a mechanism for establishing risk and capital management requirements designed to ensure that banks hold capital reserves more specific and appropriate to the wide range of risk a bank exposes itself to through its lending and investment practices. Basel II aimed to make the supervisory process of capital allocation more risk sensitive, separate operational risk from credit risk and to align more closely regulatory capital with economic capital to avoid the scope for regulatory arbitrage.

Basel II broadened the scope of the regulatory regime based on a three pillars concept:

  • the first pillar addressed minimum capital requirements;  
  • the second pillar provided for supervisory review; and  
  • the third pillar applied market discipline.  

Pillar One

This applied a formulaic approach to minimum capital requirements in respect of credit risk, operating risk and market risk perceived to be the three major risks banks face. Methodologies were laid out for each of these depending on the nature and sophistication of the bank involved. Credit risk could be calculated based on one of three approaches:  

  • the standardised approach;  
  • the Foundation IRB approach ; or  
  • the Advanced IRB approach.  

Where the standardised approach would be based on criteria set by the regulator and the IRB approach based on criteria established from data provided by the organisations own "internal ratings based" models.  

Operating risk again could be calculated based on one of three methodologies:

  • basic indicator approach (BIA);  
  • standardised approach (TSA); or  
  • internal measurement approach (an advanced form of which is the advanced measurement approach MMA).

Market risk is measured by "value at risk" or VaR.

The standardised approach is still based on weighting of risk in accordance with categorisations of risk profile relating to the assets involved but Basel II introduced additional levels of risk category including weightings above 100% for assets considered to be more risky and requiring banks applying the standardised ratings approach to apply weightings based on ratings provided by external rating agencies.

Pillar Two

This provides for a regulatory response to Pillar One providing regulators with a greater range of tools to address perceived weaknesses in Pillar One. It provides also a framework for dealing with other risks a bank may face.  

Pillar Three

This pillar aims to promote market discipline.

Basel III

Basel III introduces additional and more onerous capital requirements for credit institutions and introduces a number of new measures to establish counter cyclical capital buffers which can be called on when a market has overheated. Basel III also looks to establish a gross assets leverage ratio to avoid concerns that arose from the financial crisis that risk weightings may be inadequate in certain circumstances to avoid over leverage across the bank's balance sheet. A schedule of the new capital model for credit institutions and the timing of the introduction of the various elements of the new model are set out below.

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The principles and methodologies developed by the Basel Committee are implemented into regional and national legislation through the legislative bodies responsible for implementation of banking legislation and regulation in the applicable regions or counties. This may be under the oversight of multi-state bodies or by direct implementation in law. A diagram of the legal infrastructure and potential national or multi-national bodies that may be involved is set out below:

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EU Regulation

Capital adequacy requirements for banks and other credit institutions have long been enshrined in European law. The Capital Requirements Directive: 2006/49/EC and 2006/48/EC (the "CRD"), was implemented in 2006 and was itself written as a recast of Directive 93/6/EEC on the capital adequacy of investment firms and credit institutions and Directive 2000/12/EC relating to the taking up and pursuit of business of credit institutions, both of which had been amended so many times that they needed restating in order to consolidate and clarify the matters they concerned.  

The CRD was also introduced following the finalisation of the Basel Committee on Banking Supervision's 'Basel II' in 2004 and was drafted to implement the Basel II framework into European law.  

Application

The CRD is made up of two different directives:

Directive 2006/48/EC ("CRD 48") applies to "credit institutions" including banks and building societies; and

Directive 2006/49/EC ("CRD 49") applies to "investment firms" including those within Article 4(1) of MiFID.

How the CRD works

The CRD works on the same principles as Basel II. The authorities consider that firms are exposed to three main types of risk – credit risk, market risk and operational risk.

In relation to credit risk (the risk that a counterparty to a transaction will default), CRD 48 introduced new and more sophisticated methods by which firms can calculate the capital they are required to hold.

CRD 48 also introduced new provisions requiring firms to hold capital to cover operational risk (loss resulting from inadequate or failed internal processes, people or systems or from external events, including legal risk).  

In relation to market risk, CRD 49 redefined the "trading book" and introduced new approaches in relation to the capital required to be held against the positions in that book.

Since it was initially established as the Capital Requirements Directive, the process of regulation of bank capital has gone through a series of changes and amendments.  

The effect of the implementation of these changes (known as CRD II, CRD III and CRD IV and V) to the capital requirements for each of the risk sectors are reviewed further in Orrick Viewpoint.