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This chapter presents a detailed overview on the Basel II Capital Accord. The capital accord consists of three mutually reinforcing pillars. Pillar 1 defines the minimum capital requirements for credit, market, and operational risk. Pillar 2 describes the supervisory review process to verify whether the bank holds sufficient capital to cover all its risks. Pillar 3 defines the market disclosure to catalyze prudential risk management and sufficient capitalization. The new capital accord has important implications for the bank's information and communication technology: data needs to be collected on various levels: risk information, exposure, loss measures; computation engines calculate the risk on transactions and portfolios; data needs to be transferred correctly between different levels; and risk reports need to be communicated to regulators, senior management and the financial markets. The Basel II rules make capital requirements more risk sensitive, which will impact, amongst others, the credit pricing, and capital needs for banks with different risk profiles. The chapter concludes with a discussion on future evolutions.

The previous chapters in the book have concentrated on modelling decisions and uncertainties on one consumer loan. This chapter concentrates on models related to portfolios of such loans. In particular it looks at the economic capital and regulatory capital needed to cope with the credit risk in a portfolio of consumer loans. It concentrates on how the Basel Capital Accord, in place since 2007, impacts on credit scoring and is in turn dependent on credit scoring. The chapter reviews what the Accord requires and how the minimum capital requirement formula can be derived. It then looks at the impact it has on credit scoring with the increased importance in validating the prediction probabilities of the default scores, and the need to calculate long run average probability of default rates from credit scores. Models are developed to show how the Basel regulations will change the optimal cut-off scores in the application process. The various portfolio credit risk models for corporate loans and whether there are equivalent models appropriate for assessing the credit risk for portfolios of consumer loans are discussed. These are useful for stress testing as required in the Basel Accord.

This chapter analyzes international harmonization of financial regulation. This is a relatively new regulatory area, with international harmonization efforts starting only in the 1980s. Sector-specific regulatory coordination and harmonization efforts are traced in the fields of banking regulation (Basel Concordat, Basel Accord and Basel II), securities regulation (IOSCO MOUs and the Objectives and Principles of Securities Regulation) and insurance regulation. Cross-sector regulatory coordination and harmonization by the Joint Forum are also analyzed. The chapter concludes with detailed analyses of developments after the Lehman Shock, notably activities of the G20 toward the formulation of Basel III.

Following the financial crisis, UK preferences shifted decisively in favour of trading up bank capital and liquidity requirements. To reassure voters, elected officials intervened in the regulatory process by strengthening the domestic institutional architecture for banking regulation. Financial regulators leveraged this political support to overcome resistance from the financial industry, but also pushed for international/EU harmonization of capital requirements to avoid damaging the UK’s competitiveness. Internationally, UK regulators therefore acted as pace-setters and exerted significant influence over the design of the Basel III Accord. However, at the EU level, the UK was forced to act as a foot-dragger by prolonging negotiations over the Capital Requirements Directive IV (CRD IV) in an attempt to resist Franco-German efforts to water down the rules. But UK negotiators were more successful in leveraging domestic constraints to oppose the Commission’s attempt to impose the ‘maximum’ harmonization of bank capital.

The purpose of this chapter is to analyse whether a European banking system, which consists of smaller and more specialised banking firms and is regulated with a larger set of prudential rules than present, is likely to better withstand systemic shocks. The chapter adopts a novel empirical approach that relates the changes in the risk that a bank fails to changes in the degree of systemic stability. Also, the role of liquidity is examined in protecting banks against these shocks only when the banking system is under stress. While the results show that restrictions on a bank’s leverage ratio and the imposition of liquidity requirements, as in the Basel III Accord, may improve the resilience of a bank to systemic events, they also demonstrate that bank size, the share of non-interest income and asset growth (none of which are at the centre of the new regulatory landscape) are key determinants of a bank’s risk exposure. In particular, the introduction of a cap on bank absolute size appears the most effective tool, ceteris paribus, to reduce the default risk of a bank given systemic events.

If bank managers and shareholders under-price the risks attached to the bank’s business model, there is a potential role for regulation to address this market failure. The core idea behind capital rules for banks is that shareholders’ equity should fund a minimum proportion of the current value of the bank’s assets in order to increase the chances that a bank will be able to absorb losses on the assets side of its balance sheet without becoming insolvent and, more importantly, without triggering a run on its deposits or other short-term funding. The implementation of this simple idea requires, however, a series of further decisions to be taken: (i) Against which risks should capital be held? (ii) How should the capital requirement be formulated? (iii) How much capital should be required? After the financial crisis, answers were also sought to additional questions: (iv) How can procyclical consequences of capital requirements be avoided? (v) Should higher capital charges be imposed on systemically important banks? This chapter examines how the Basel Committee decided these central policy questions and how those decisions changed over time as the limitations of the initial policy choices became apparent. It also considers the arguments in favour of different choices.

Financial markets have experienced many financial crises across time. Although each boom and crisis has some distinctive features, several recurring themes and common patterns emerge. While the technologies and methodologies to measure risks have reached impressive levels of sophistication and complexity, the financial crisis of 2007‒2008 clearly demonstrates that substantial improvements in the way financial institutions measure and manage risks are still urgently needed. This chapter provides an analysis and discussion of recurring themes and patterns that increase the likelihood of financial crises and disasters. It also proposes how the financial industry should evolve to mitigate their impact on the world economy. In particular, financial institutions play a fundamental role in mitigating systemic risk. To increase the soundness of financial institutions, regulatory and supervisory oversight are essential in defining new rules that can lead to improving capital allocation strategies by defining a clear risk-appetite framework, implementing a true enterprise risk management program, which measures and aggregates all risk types, and redefining the role of the risk function within the governance of financial organizations. Improving methods used to measure risks and implementing the proposed changes in risk management would allow financial institutions to reduce the systemic risk and restore the trust of markets and customers to mitigate the impact of the next financial crises

This chapter returns to the institutional blueprint that was described in the Introduction, which represents a particular form of the more generic PPP system from chapter 8. Much of the chapter is concerned with the regulatory challenge of confining money-creation to the licensed banking system. In practice, this would mean establishing and enforcing a generalized prohibition on the issuance of cash equivalents (private money) by nonbanks, subject to de minimis exceptions. This is less radical than it sounds: we already prohibit “deposit” funding in the absence of a special charter. Many financial firms that currently rely heavily on short-term “wholesale” funding, such as the major Wall Street firms, would be precluded from doing so under the proposed design. The problem of “regulatory arbitrage” is discussed in some detail. The chapter then discusses the international dimensions of the institutional design. Ideally, the reformed system would be accompanied by a modification to the Basel Accord (the central international accord on financial regulation). Essentially, the modification would recognize the issuance of monetary instruments as a sovereign prerogative.

This chapter returns to the institutional blueprint that was described in the Introduction, which represents a particular form of the more generic PPP system from chapter 8. Much of the chapter is concerned with the regulatory challenge of confining money-creation to the licensed banking system. In practice, this would mean establishing and enforcing a generalized prohibition on the issuance of cash equivalents (private money) by nonbanks, subject to de minimis exceptions. This is less radical than it sounds: we already prohibit “deposit” funding in the absence of a special charter. Many financial firms that currently rely heavily on short-term “wholesale” funding, such as the major Wall Street firms, would be precluded from doing so under the proposed design. The problem of “regulatory arbitrage” is discussed in some detail. The chapter then discusses the international dimensions of the institutional design. Ideally, the reformed system would be accompanied by a modification to the Basel Accord (the central international accord on financial regulation). Essentially, the modification would recognize the issuance of monetary instruments as a sovereign prerogative.