Unit-02, PPT-03
International Banking Law
Establishment of Basel Committee-
Herstatt Crisis- Losses caused by unauthorised foreign exchange
dealings were particularly heavy in the earlier stage of the floating
exchange rate regime which begin in 1973. The risk of default by the
counterparty in a spot foreign exchange transaction was highlighted
for the first time by the Herstatt Bank collapse.
In the Herstatt Bank case German mark was sold to Bankhaus
Herstatt on 24th June 1974 by at least a dozen of banks.
Settlement was due in Dollars on 26 June 1974
Herstatt Bank- Germany
Background
Herstatt Bank was founded in 1955 by Ivan David Herstatt, with financial
assistance from Herbert Quandt, and Hans Gerling, the head of an
insurance company who took a majority share.
By 1974 the bank had assets of over DM2 billion, making it the 35th largest
bank in Germany.
Herstatt Bank became a significant participant in the foreign exchange
markets. During 1973 and 1974, the U.S. dollar experienced significant
volatility. The bank made wrong bets on the direction of the dollar, and by
June 1974 had accumulated DM470 million in losses, compared with capital
of only DM44 million.
Liquidation
On 26 June 1974, German regulators forced the troubled Bank Herstatt into
liquidation. That day, a number of banks had released payment
of Deutsche Marks (DEM) to Herstatt in Frankfurt in exchange for US
dollars (USD) that were to be delivered in New York. The bank was closed at
16:30 German time, which was 10:30 New York time. Because of time
zone differences, Herstatt ceased operations between the times of the
respective payments. The counterparty banks did not receive their USD
payments.
Responding to the cross-jurisdictional implications of the Herstatt debacle,
the G-10 countries (the G-10 is actually eleven countries:
…Belgium, Canada, France, Germany, Italy, Japan,
the Netherlands, Sweden, Switzerland, the United Kingdom and the
United States), Luxembourg and Spain formed a standing committee
under the auspices of the Bank for International Settlements (BIS).
Called the Basel Committee on Banking Supervision, the committee
comprises representatives from central banks and regulatory
authorities. This type of settlement risk, in which one party in
a foreign exchange trade pays out the currency it sold but does not
receive the currency it bought, is sometimes called Herstatt risk.
The failure of Herstatt Bank was a key factor that led to the
worldwide implementation of real-time gross settlement (RTGS)
systems, which ensure that payments between one bank and another
are executed in real-time and are considered final. The work on these
issues was coordinated by the Basel Committee on Banking
Supervision under the Bank for International Settlements.
The Basel Committee
initially named the Committee on Banking Regulations and
Supervisory Practices - was established by the central bank
Governors of the Group of Ten countries at the end of 1974 in the
aftermath of serious disturbances in international currency and
banking markets (notably the failure of Bankhaus Herstatt in West
Germany).
The Committee, headquartered at the Bank for International
Settlements in Basel, was established to enhance financial stability by
improving the quality of banking supervision worldwide, and to
serve as a forum for regular cooperation between its member
countries on banking supervisory matters. The Committee's first
meeting took place in February 1975, and meetings have been held
regularly three or four times a year since.
Since its inception, the Basel Committee has expanded its
membership from the G10 to 45 institutions from 28 jurisdictions.
Starting with the Basel Concordat, first issued in 1975 and revised
several times since, the Committee has established a series of
international standards for bank
regulation, most notably its landmark publications of the accords on
capital adequacy which are commonly known as Basel I, Basel II and, most
recently, Basel III.
Basel Concordat of 1974- The following key principles were embedded
in the original Concordat-
the supervision of foreign banking establishment is the joint responsibility
of parent and host authorities
no foreign banking establishment should skip supervision
the supervision of liquidity should be the primary responsibility of the host
authorities
the supervision of solvency is essentially a matter for the parent
authority in the case of foreign branches and primarily the
responsibility of the host authorities in case of foreign subsidiary.
practical cooperation should be promoted by exchange of
information between host and parent authorities and by the
authorisation of bank inspection by or on behalf of parent authorities
on the territory of the host authorities.
BASEL - I
Basel I is the round of deliberations by central bankers from around
the world, and in 1988, the Basel Committee on Banking
Supervision (BCBS) in Basel, Switzerland, published a set of
minimum capital requirements for banks. This is also known as the
1988 Basel Accord, and was enforced by law in the Group of Ten (G-
10) countries in 1992.
A new set of rules known as Basel II was later developed with the
intent to supersede the Basel I accords. However they were criticized
by some for allowing banks to take on additional types of risk, which
was considered part of the cause of the US subprime financial
crisis that started in 2008.
The BCBS was founded in 1974 as an international forum where
members could cooperate on banking supervision matters. The BCBS
aims to enhance "financial stability by improving supervisory know-
how and the quality of banking supervision worldwide." This is done
through regulations known as accords.
Basel I was the BCBS' first accord. It was issued in 1988 and focused
mainly on credit risk by creating a bank asset classification system.
Main framework:-
Basel I, that is, the 1988 Basel Accord, is primarily focused on credit
risk and appropriate risk-weighting of assets.
Assets of banks were classified and grouped in five categories
according to credit risk, carrying risk weights of 0% (for example
cash, bullion, home country debt like Treasuries), 20% (securitisations
such as mortgage-backed securities (MBS) with the highest
AAA rating), 50% (municipal revenue bonds, residential mortgages),
100% (for example, most corporate debt), and some assets given No
rating.
Banks with an international presence are required to hold capital
equal to 8% of their risk-weighted assets (RWA).
CR of State Bank- Example
Loan to Government- 10 Cr – Risk 0% = 00 Rs
Loan to Reliance security Backed- 50 Cr- Risk 10%= 5 Cr Rs
Loan to Vijay Malya unsecured- 100 Cr- Risk 100%- 100 Cr Rs
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CR= 8% of 5+100 Cr
From 1988 this framework was progressively introduced in member
countries of G-10, comprising 13 countries as of
2013: Belgium, Canada, France, Germany, Italy, Japan, Luxembourg,
Netherlands, Spain, Sweden, Switzerland, United Kingdom and
the United States of America.
Over 100 other countries also adopted, at least in name, the
principles prescribed under Basel I. The efficacy with which the
principles are enforced varies, even within nations of the Group.
Basel II: the new capital framework
Basel II is the second of the Basel Accords, (now extended and partially
superseded by Basel III) which are recommendations on banking laws
and regulations issued by the Basel Committee on Banking Supervision.
The Basel II Accord was published initially in June 2004 and was intended
to amend international banking standards that controlled how much
capital banks were required to hold to guard against the financial and
operational risks banks face.
These regulations aimed to ensure that the more significant the risk a
bank is exposed to, the greater the amount of capital the bank
needs to hold to safeguard its solvency and overall economic
stability.
Basel II attempted to accomplish this by establishing risk and capital
management requirements to ensure that a bank has adequate
capital for the risk the bank exposes itself to through its lending,
investment and trading activities. One focus was to maintain
sufficient consistency of regulations so to limit competitive inequality
amongst internationally active banks.
Objective-
The final version aims at:
Ensuring that capital allocation is more risk-sensitive;
Enhancing disclosure requirements which would allow market
participants to assess the capital adequacy of an institution;
Ensuring that credit risk, operational risk and market risk are
quantified based on data and formal techniques;
Attempting to align economic and regulatory capital more closely to
reduce the scope for regulatory arbitrage.
the revised framework comprised three pillars:
minimum capital requirements, which sought to develop and
expand the standardised rules set out in the 1988 Accord
supervisory review of an institution's capital adequacy and internal
assessment process
effective use of disclosure as a lever to strengthen market discipline
and encourage sound banking practices
Minimum Capital Requirement-
Generally, Basel II retains the definition of bank capital and the
market risk provisions of the 1996 amendment. It largely replace the
old treatment of credit risk, and it requires capital for operational risk.
It formalized the methods for calculating the quantifiable risk
recognized.
1- There are three methods for calculating credit risk.
A- standardize approach
B- Foundation Internal Rating Based approach
C- Advanced Internal rating based approach
2. Operational risk calculation methods are-
A- Basic Indicator Approach
B- Standardized Approach
C- Advanced Measurement Approach
3- Market Risk is calculated by using duration value at risk method. In India
standardise duration approach is being used for computing capital
requirement for market risk.
The idea is to move from basic model to more sophisticated models for
calculating risk that will reward the banks with lower capital requirement
and optimization of the available capital.
The basic capital requirement for banks can be expressed as under:-
Capital / Credit Risk + Market Risk + Operational Risk = 8 percent
Pillar II Supervisory review – based on four
principle
Bank should have a process for assessing their overall capital
adequacy
Supervisor should review bank’s assessment
Banks are expressed to operate above minimum
Supervisor’s intervention if capital is not sufficient
Pillar- III- Market Discipline-
Pillar 3 aims to ensure market discipline by making it mandatory to
disclose relevant market information. This is done to make sure that
the users of financial information receive the relevant information to
make informed trading decisions and ensure market discipline.
Thank You
