Under Pillar 2 of the Basel II Accord, the bank needs to have in place internal procedures and processes to ensure that it possesses adequate capital resources in the long term to cover all of its material risks. These processes and procedures together are known as the Internal Capital Adequacy and Assessment Process or ICAAP for short. The following post gives an overview of the regulations that preceded the Basel II Accord.
The Great Depression and Regulation Q
The great depression circa 1929 was a watershed event for bank regulators because it showed, though not for the first time, how bank failures impacted society. A number of lessons came out of that event; the two most relevant to this course were:
- The critical role the banking sector played in providing credit and access to capital at regional, national and global levels and its effect on economic growth.
- The scale of human misery when the banking system failed and was no longer in a position to play that role.
The first attempt post depression to regulate banks came from the liability side. If there was a cap on the maximum rate a bank could pay to its depositors there was no longer an incentive for it to invest in increasingly risky assets. As long as an investment earned a reasonable spread over the cost of bank funds, a bank would stick to safer products and solutions. The culprit, in the thinking of that time, was rate-based competition for deposits – leading to increasingly risky behaviour on the part of banks. If you could control cost of deposits, you could control rate based competition and control risky behaviour. The thinking stayed in vogue for more than 50 years after it first came into being as Regulation Q- a part of the Banking Act, 1933 that authorized the Federal Reserve to impose ceilings on the interest rates paid on time and savings deposits by member banks.
It was in the high-inflation, high-yield 80’s that this thinking was first challenged by emerging non-banking deposit products. Why earn a miserly two to four percent before taxes when your money market account could easily credit three to five times that amount. Challenged by non-banking sector products that changed the dynamics of the deposit market, banks could no longer compete as long as they were held back by regulation Q. One side effect was non price competition for deposits including over supply of branches, automated teller machines, additional banking hours, free toasters, subsidized cash and exchange management services. The other more well known side effect was the growth and development of the offshore Euro Dollar market. The time was now ripe for a more risk sensitive regulatory standard.
Basel I & Amendments to the Capital Accord
Basel I marked the shift towards linking capital with risk taking behavior when it introduced minimum capital requirements dependent on the risk profile of a bank’s credit portfolio. Introduced in 1988 as the Basel I capital accord or BIS 88, the regulatory framework took the first step towards supporting risk based pricing and creating a level playing field as far as capital was concerned in member countries.
Once the Capital Accord was rolled out, it became evident that credit was not the only source of risk on the balance sheet of a bank. Proprietary trading profits represented another source of volatility that banks could use to exploit risk-based gaps in the capital accord and sidestep the intent of the regulatory framework. Amendments to the capital accord followed in 1996 and became the basis for BIS 98. The revised standard now provided for calculation of market risk capital based on the profile of the trading book and a total capital adequacy ratio that factored both credit and price risk.
In this post, we covered the predecessor regulations to Basel II, in particular, Regulation Q which placed ceilings on deposit rates and Basel I and its amendments which introduced the first version of risk-based minimum capital requirements. In the next post, we will look at the principal features of the Basel II Accord.