Banking Regulations

Bank regulation is a form of government regulation which subjects banks to certain requirements, restrictions and guidelines, designed to create market transparency between banking institutions and the individuals and corporations with whom they conduct business, among other things. As regulation focusing on key actors in the financial markets, it forms one of the three components of financial law, the other two being case law and self-regulating market practices.

Bank regulation was solidified by the Bank of International Settlements’ Basel Committee on Banking Supervision through the Basel Accords. Basel Accords are an official treaty among representative central banks and regulatory authorities on regulation of banks. Their main is to enhance financial stability by improving supervisory role of the banking sector worldwide. The Accords are classified into Basel I, II, and III.

Basel I focuses on the capital adequacy of financial institutions to improve stability. It also defines banks capital ratio and sets standards for solvency monitoring and reporting. This accord categorizes assets of financial into five risk categories, i.e.0%, 10%, 20%, 50% and 100%.

The Shortcomings of this Accord include:

i. Categorization of credit risk was very generic as the risk was simply assigned to one of the 5 categories;

ii. A static measure of 8% for the multinational banks did not consider the changing nature of the default risk of financial institutions;

iii. The maturity of credit exposure was not considered and duration of credit instruments was not accounted for;

iv. There was no differentiation of counterparty risk for different kinds of borrowers; and

v. Did not provide any relaxation for diversification of portfolio.

Basel II revised the capital framework and focused on:

i. minimum capital requirements which categorizes the requirements into tier i and ii;

ii. Supervisory review- deals with risks such as systematic, liquidity and legal; and

iii. Market discipline- disclose on risks exposure and capital adequacy.

Basel III was developed after the 2008 financial crisis with the main pillars being:

i. Banks should have a minimum capital requirement;

ii. leverage and liquidity- an upper limit of 3% was introduced for the leverage ratio;

iii. counter cyclical measures- banks can set aside additional capital during times credit expansion and relax capital requirements during contractions;

iv. Bucketing system- banks are grouped together and assigned to the buckets according to their size, complexity and importance to the overall economy.

In summary the 3 accords can be broken down as shown in the table below according to the risk addressed and tools used.

	Risks	Tools
Basel I	Credit risk Market risk	Capital Adequacy Ratio (CAR)
Basel II	Credit risk Market risk Operational risk	CAR Supervisory review Market discipline
Basel III	Credit risk Market risk Operational risk Countercyclical risk Liquidity risk	CAR Supervisory review Market discipline Liquidity coverage ratio Counter cycle buffer Leverage ratio