Understanding corporate finance: the legal and regulatory framework: regulatory capital: the Basel Accord
The Basel Accord
The UK’s rules on regulatory capital for banks operate within the framework of an international agreement known as the Basel Accord. The Basel Committee on banking supervision is a committee of the Bank for International Settlements, which is based in Switzerland and was originally set up to deal with war reparations after World War I. In 1988 the committee produced the Basel Accord in response to concerns that banks operating internationally were not always adequately capitalised. The Accord was a voluntary agreement that aimed to strengthen the stability of the international banking system and introduce consistency of regulatory treatment around the world. The Accord was legislated by directives issued by the EU. The most important of these, the Capital Adequacy Directive (CAD) was introduced in 1993 and amended in 1998 (CAD2).
The committee issued Basel II, the successor to the Basel Accord in June 2004. Basel II came partly into effect in the EU on 1 January 2007 as required by the Capital Requirements Directive (CRD) and was extended to all lenders to which the CRD applies on 1 January 2008.
The Basel II regulatory framework is intended to reflect risk more accurately. Banks felt that the risk weight approach in the original Basel Accord required too much capital to be set aside to cover certain risks. This was because there was not enough differentiation between the risks of default by different borrowers - a brand new company would attract the same risk weight as a long established household name (100%). This meant that the bank’s own assessment of capital at risk differed from the amount they were required to hold.
The new rules in Basel II are not intended to change the level of regulatory capital in the banking system. The rules aim to allocate capital more accurately so that higher risk business is backed by more capital and lower risk capital is backed by less. CFM14160 has more detail on Basel II.
In December 2010 the Bank for International Settlements announced a comprehensive reform package to address the lessons of the global financial crisis and promote a more resilient banking sector.
These fundamental new measures, known collectively as Basel III, will broadly require banks to improve the quality and quantity of their capital base, and feature a new liquidity coverage ratio. Implementation is due to begin on 1 January 2012 with gradual introduction of the new measures over the following six years.
In the 23 March 2011 Budget the Government asked HMRC to set up an industry working group to explore tax issues associated with the development of new capital instruments in light of the Basel III proposals. In May 2011 HMRC issued a discussion document (HMRC discussion paper: The tax treatment of regulatory capital instruments) and announced a series of open meetings to discuss aspects of the Basel III proposals and forthcoming EU Capital Requirements Directive (CRD4).