Prudential requirements

Introduction

Of all financial industry legislation, banking legislation is the most multifaceted and wide-ranging. This is a reflection of the central role played by banks in the financial system, and the inventiveness of bankers, given their need to stay ahead of competitors. Consequently, the regulators have difficulty in staying ahead of developments, i.e. they tend to be a hop and a skip behind their private sector banking counterparts.

In the past it was fashionable to say that banking legislation is primarily aimed at the protection of the depositor, and specifically the small proverbial man in the street who does not have the skills to protect himself / herself from the odd unscrupulous banker. Nowadays, this is seen as a narrow focus. Banking legislation worldwide is focused increasingly on the integrity of the financial system, i.e. financial stability, discussed earlier.

The US subprime banking crisis, which had international repercussions, showed how interconnected the financial systems of the world are, and therefore the importance of international financial stability.

This crisis is not the first one; it follows many others, such as the Japanese bank crisis, the Asian crisis, and so on. These led to a number of international financial-stability proposals. One example is the G20 initiative, the Financial Stability Forum (FSF), through which these countries adopted 12 key standards for sound financial systems. These standards are issued by various standard-setting bodies (such as the IMF, the World Bank, the OECD, the Basel Committee), and cover the following areas/issues:

• Monetary and financial policy transparency.

• Fiscal policy transparency.

• Data dissemination.

• Insolvency.

• Corporate governance.

• Accounting and auditing.

• Payments and settlement.

• Market integrity.

• Banking supervision.

• Securities regulation.

• Insurance supervision.

• Public debt management.

In conclusion, it is useful to quote from the keynote speech of President and CEO of the Federal Reserve Bank of New York40:

"In a world of instantaneous communication, interconnected markets, and more complex instruments and risks, effective supervision is more important than ever to maintaining financial stability, both locally and globally. To remain effective and relevant, supervisors must understand how and to what extent the 'wired' economy and other technologies are changing banking and finance...we must take care that our efforts to ensure the safe and sound operation of the financial markets do not stifle the innovation and creative energy that is changing banking and finance -indeed the world - for the better."

The key word in this text is risk. Ultimately, bank management, and bank regulation and supervision are about the management and regulation of risk. The broad strokes of bank regulation and supervision for the G-20 (and generally accepted by the world) are set out in the Basel Accords. We discuss the Accords briefly, before moving on to the prudential requirements.

Basel accords

The term Basel Accords (German spelling, also referred to as the Basle Accords, British spelling) refers to the banking regulation / supervision Accords of the Basel Committee on Banking Supervision (BCBS). The BCBS is situated at the Bank of International Settlements (BIS) in Basel, Switzerland. The G-20 economies, as well as some other major banking locales such as Turkey and Singapore, are represented on the BCBS.

Essentially, the Accords are recommendations on banking laws and regulations, and there are three: Basel I, Basel II and Basel III (in progress).The BCBS, as an informal forum of countries, creates broad supervisory standards / guidelines / statements of best practice in banking, in the expectation that member and other countries' supervisory authorities will implement them. It therefore encourages countries to adopt common approaches to and standards of supervision.

Basel I was published by the BCBS (then populated by the G-10 countries' banking supervision representatives) in 1988 and enforced in 1992. It published a set of minimum capital requirements for banks, primarily focused on credit risk. The assets of banks were placed in five categories according to credit risk, carrying risk weights of 0% (government securities) in steps up to 100% (unsecured corporate debt). Banks with international presence were required to hold capital equal to 8% of the risk-weighted assets.

Basel I is now generally regarded as outmoded. As financial conglomerates and product innovation spread, risk management had to change Therefore, a more comprehensive set of guidelines, known as Basel II, was developed by BCBS; these have been implemented by the G-20 and most other countries. Basel III, a response to the financial crisis, following the "Great Recession" of 2007-09, is being phased in over a long period (see below). Basel III builds on Basel II.