Basel Agreements

The Basel Agreements are a set of documents issued by the Basel Committee on Banking Supervision (BCBS) defining methods to calculate capital levels banks should be required to maintain given the risks they accept on the assets they record within their balance sheets. The first agreement was signed in 1988, amended in 1995, rewritten in 2004, and is currently in its third version, known as Basel III.

These agreements were a response to two concerns that emerged in the 1970s. On the one hand, there was increasing discomfort among regulators, government authorities and conservative academic economists with what was seen as a growing problem of moral hazard created by the existence of safety nets for the banking sector. It was believed that safety nets created an environment where banks were stimulated to seek riskier assets because eventual losses would be borne by the authorities rather than by banks themselves. The second concern related to the increasing internationalization of banking activity, which made it difficult for national regulators to monitor properly the risks to which banks under their jurisdiction were exposed.

The 1970s witnessed a number of episodes of banking crises that quickly became or threatened to become global problems, like the cases of the Franklin National Bank in the United States and Herstatt Bank in Germany. As a result, the BCBS was created as an informal "club" of national financial supervisors to discuss and coordinate joint initiatives to improve systemic safety. The BCBS is hosted by the Bank for International Settlements (BIS) in Basel, Switzerland, but works independently of the BIS. As an informal group, the BCBS has no formal powers. Its members do not have the mandate to commit their countries to decisions taken by the BCBS, so that partial or total adherence to its directives is strictly voluntary and in the terms that are chosen by each country's political authorities.

The Basel Agreements are known mostly because of the principle they put forward that, for prudential reasons, banks should maintain capital levels that are proportional to the value of assets they hold weighted by their risk. During most of the twentieth century, prudential regulation aimed at guaranteeing the liquidity of bank deposits to avoid bank runs like those that led the US banking system to collapse in the early 1930s. By the 1970s, however, it was believed that the most important piece of that regulation, deposit insurance schemes, had created a situation where banks would seek riskier assets to increase their profitability, trusting that clients would be complacent because their deposits were insured by government institutions. Moral hazard created by the existence of deposit insurance schemes, however, were causing the banking sector to become more, instead of less, risky. The idea of demanding banks to maintain capital in proportion to their risk-weighted assets, in theory, should correct the problem, as banks would now be risking their own capital in case their loans were non-performing. As a result, banks would be more cautious (or so was expected) when selecting assets to purchase and hold in their balance sheets.

The first agreement, Basel I, stated that banks should maintain capital to the propor- tion of 8 per cent of their risk-weighted loans. Risk weights were provided by the BCBS, aggregated in five "buckets". The agreement was adopted by a surprisingly large number of countries, much beyond what the BCBS itself expected. Two criticisms, however, were almost immediately raised. First, Basel I dealt with credit risks only, neglecting all other risks, particularly market risks - that is, risks created by the variation of marketable securities prices - when banks were increasingly diversifying their activities worldwide. Second, grouping risks into five "buckets" seemed to gloss over fundamental risk differ- ences between assets within the same category. As a result, Basel I was amended in 1995 in order (i) to include market risks and (ii) to allow that qualified banks could calculate their risks themselves. The extension of this freedom to calculate risks to credit risks (as well as considering another class of risk, operational risk), besides other adjustments, led to a new version of the agreement, Basel II, signed in 2004.

Basel II turned out to be an exceedingly complex strategy and its implementation faced many difficulties, including the refusal of the United States to comply with some of its key recommendations (recall that adherence to the Basel Agreements is voluntary). The global financial crisis that burst in 2008, in addition, showed that banks' own risk calcu- lations were irremediably flawed. A large majority of those banks that were either shut down or had to be bailed out exhibited appropriate levels of regulatory capital before the meltdown. The use of risk weights calculated by banks themselves, besides the pos- sibilities it opens of fraud and manipulation, cannot capture systemic risks, which have the nature of externalities. Risk measurements that individual banks take as parameters are in fact endogenous to the banking sector and to the economy. Moreover, as pointed out by post-Keynesians, risk calculations are only useful if one assumes that the future will replicate the past. Under fundamental uncertainty, as Keynes argued, one can be sure only that this assumption is wrong. Both financial institutions and regulators were reminded of this basic truth yet again when all risk calculations prescribed by Basel II turned out to be wrong.

The realization that Basel II was a failure led the G20 group of countries to command the BCBS to rethink Basel rules. Hence, the BCBS came up with Basel III, a new set of measures where, on the one hand, Basel-II-required capital levels were increased, and, on the other hand, new demands were made, of which two are the most important: banks should now calculate a direct leverage ratio - that is, the ratio between total assets and net worth - to be limited at 33; and banks should also respect liquidity requirements, defined in two ways: a certain share of assets held should consist of very liquid assets to avoid forced asset sales like those that happened in 2007 and 2008 in the United States; and access to financing lines should be guaranteed. While it is doubtful whether more of the same - that is to say, strengthening Basel II's demands - can work, the new regulatory framework promises to reach more solid systemic safety.

As one would expect, banks reacted to Basel III by stating that it would reduce the supply of credit and choke incipient recoveries in countries hit by the global financial crisis. Many national governments endorsed this concern, so that some measures were watered down to some extent or had their implementation postponed. As adherence to the Basel Agreements is voluntary, even countries that decided to implement Basel III may choose which measures should be introduced and when. As a hybrid instrument, containing the market-friendly inept measures proposed in Basel II and introducing time-tested demands in terms of direct leverage and liquidity, Basel III seems at this point to contribute not much more than marginally to the improvement of global financial systemic safety.

See also:

Bank capital and the new credit multiplier; Bank deposits; BIS macro-prudential approach; Capital requirements; Financial crisis; Systemically important financial institutions.