The Basel Committee on Banking Supervision: A History of the Early Years 1974-1997

The Basel Committee on Banking Supervision

The Basel Committee on Banking Supervision (BCBS) sets the guidelines for worldwide regulation of banks. It is the forum for agreeing international regulation on the conduct of banking. Based on special access to the archives of the BCBS and interviews with many of its key players, this book tells the story of the early years of the Committee from its foundation in 1974/5 right through until 1997€– the year that marks the watershed between the Basel I Accord on Capital Adequacy and the start of work on Basel II. In addition, the book covers the Concordat, the Market Risk Amendment, the Core Principles of Banking and all other facets of the work of the BCBS. While the book is primarily a record of the history of the BCBS, it also provides an assessment of its actions and efficacy. It is a major contribution to the historical record on banking supervision. c h a r l e s g o o d h a r t CBE, FBA is Emeritus Professor of Banking and Finance and a member of the Financial Markets Group at the London School of Economics and Political Science, having previously served as the Group’s Deputy Director from 1987 to 2005. From 1985 until his retirement in 2002 he was the Norman Sosnow Professor of Banking and Finance at LSE. Before moving into academia he worked at the Bank of England for seventeen years as a monetary advisor, becoming a chief advisor in 1980.

The Basel Committee on Banking Supervision A History of the Early Years, 1974–1997 Charles Goodhart

ca mbr idge u ni v ersit y pr ess

Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, São Paulo, Delhi, Tokyo, Mexico City Cambridge University Press The Edinburgh Building, Cambridge CB2 8RU, UK Published in the United States of America by Cambridge University Press, New York www.cambridge.org Information on this title: www.cambridge.org/9781107007239 © Charles Goodhart 2011 This publication is in copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press. First published 2011 Printed in the United Kingdom at the University Press, Cambridge A catalogue record for this publication is available from the British Library Library of Congress Cataloguing in Publication data Goodhart, C. A. E. (Charles Albert Eric) The Basel Committee on Banking Supervision : a history of the early years, 1974–1997 / Charles Goodhart. p.â•… cm. Includes bibliographical references and index. ISBN 978-1-107-00723-9 1.╇ Banks and banking–State supervision.â•… I.╇ Title. HG1725.G66 2011 332.1–dc23â•…â•…â•… 2011017975 ISBN 978-1-107-00723-9 Hardback Cambridge University Press has no responsibility for the persistence or accuracy of URLs for external or third-party internet websites referred to in this publication, and does not guarantee that any content on such websites is, or will remain, accurate or appropriate.

Contents

List of figures page vii List of tables viii Foreword by Dr Nout Wellink, President of De Nederlandsche Bank, and Chairman of the BCBS ix Preface xi 1 Introduction

1

2 The antecedents of the BCBS

10

3 Modus operandi: Chairmen; Secretariat; members; structure of meetings

51

4 The Concordat

96

5 External and foreign exchange issues

127

6 Capital adequacy and the Basel Accord of 1988

146

7 The Market Risk Amendment

224

8 The Core Principles of Banking Supervision

286

9 Liquidity

317

10 Off-balance-sheet exposures and derivatives

351

11 Other topics addressed by the BCBS

372

12 The relationship of the BCBS with banks and other banking regulators

413

13 Relationships with other non-bank oversight and supervisory bodies

465

14 The legal position of the BCBS

542

15 The international relations of the BCBS

560 v

vi

Contents



16 The BCBS and the social sciences

572



17 Epilogue

581

Bibliography Index

583 589

Figures

3.1 Participation record 3.2 Number of participants at each meeting 9.1 The changing composition of the UK banking system’s assets

page 66 71 334

vii

Tables

3.1 Long-serving members of the BCBS page 65 3.2 Number of BCBS meetings each year 73 3.3 External issues 79 3.4 Discussions on own regulatory practices 80 3.5 Measuring and influencing bank practices 81 3.6 Scheduled discussions of bank failures 82 3.7 Relationships with other groups connected with financial oversight 82 3.8 Infrastructural issues 83 3.9 General issues 83 4.1 Matrix of suggestions for sharing of responsibilities 98 6.1 Elements of capital in a tiered framework 161 6.2 Suggested tabular format for submitting responses to Secretariat 162

viii

Foreword

In May 2004 Professor Charles Goodhart wrote to the then General Manager of the Bank for International Settlements (BIS), Dr Malcolm Knight, proposing that he would compose a history of the early years of the Basel Committee on Banking Supervision (BCBS), 1975–97, with the cut-off date excluding all discussions on Basel II. He asked for permission to see the files from the archives in the BIS for these years, while at the same time offering to show all his drafts to the relevant central banks and supervisory experts prior to publication, and to take into account their comments. This was, in several respects, a difficult issue. While the BIS is, in principle, in favour of providing such historical assessments, in practice it does not control the copyright to the archives of the BCBS. The BCBS is a standing committee of the central bank Governors of the G10 countries, who meet at the BIS in Basel. Copyright and access to the archives rests with the BCBS itself and through it to the G10 Governors and central banks. In the event these central banks, and members of the BCBS, were willing to give permission to view the relevant archives, subject to having the opportunity to review the archives beforehand and to remove from them such documents as they regarded as still being inappropriate for historical reporting in public, as well as having the opportunity to review and to comment on the draft in advance of publication. Some papers were thus winnowed, but only a very small minority. When reading the early drafts, every attempt has been made to ensure the accuracy of the factual reporting. The interpretation of such facts, and the judgements about the merits, or otherwise, of the work of the BCBS remain, however, with the individual author, that is Professor Goodhart. The fact that the author has been given (restricted) access to these archives, and support by the BIS, does not imply that the BIS, BCBS or the member central banks would necessarily share those interpretations and judgements. Indeed in a few cases they almost certainly would not do so. Even so, we believe that this work will provide ix

x

Foreword

a useful background and extension to the understanding of the history and conduct of financial regulation in general, and of the work of the BCBS in particular. nou t w el l i n k

Chairman of the Basel Committee on Banking Supervision

Preface

I became 65 in October 2001 and retired from my position, as Norman Sosnow Professor of Banking and Finance at the London School of Economics (LSE), in July 2002. By 2004 I was beginning to wonder how I might usefully fill the many prospective years of retirement that enhanced life expectancy indicated might lie ahead. So in 2004 I took the initiative of writing to the then General Manager, Malcolm Knight, of the Bank for International Settlements (BIS) to propose that I prepare a history of the early years of the Basel Committee on Banking Supervision (BCBS). I had always been fascinÂ� ated by financial history; my Harvard PhD had been about the 1907 banking crisis in the USA. The historical development of financial Â�regulation in general and of the BCBS in particular were important topics that had not, in my view, been sufficiently researched. Malcolm Knight was both welcoming and supportive and my first thanks are to him. Indeed all the staff of the BIS were equally welcoming and I was even given a room there for my work. I am particularly grateful to Elizabeth Koehl for handling the administration details so efficiently. But there was a problem. The archives of the BCBS were not the property of the BIS. The BCBS was a standing subcommittee of the G10 governors of central banks, who meet regularly at the BIS at Basel (see Toniolo and Clement 2005). While the BIS provided the meeting place and administrative and secretarial support functions, the BCBS’ papers and archive belonged to the BCBS itself and through them to the G10 central banks. My request to access their papers needed to be passed on to the BCBS itself and to their parent central banks. So my second set of thanks is to the BCBS itself, its chairmen, Jaime Caruana and Nout Wellink, and its Chief Secretary, Stefan Walter, and through them also to the parent central banks. I had promised to send all the central banks a copy of my text, which I did in July 2009, though only a few came back to me with any comments. There was, however, one proviso, that all members of the BCBS could preview the archives and remove, in advance of my use xi

xii

Preface

of them, any which were felt, by any one of them, to be too sensational or still too confidential for my eyes. This turned out to be a blessing in disguise for me. The reports of BCBS meetings virtually all had both a ‘Short Report’, setting out what was decided and why, and an ‘Informal Record’, giving a brief account of what everyone said at each, usually two-day, meeting. These latter had all been winnowed. The Short Reports were usually about 4–5 pages long, whereas the Informal Records were often over 50, or even 100 pages long. Since there were some 83 BCBS meetings during this period, such winnowing reduced my necessary reading load dramatically, perhaps halving it, without obscuring, I believe, my ability to follow the main lines of development and their rationale significantly. Even so, going through the BCBS’ (winnowed) archives was quite an effort and I was privileged to have been accorded that opportunity. So, I thought it behoven to the BIS, to the BCBS and to future historians to make it less necessary for others to follow my path in this respect by reproducing what I have felt to be the key documents from the archives, mostly in long Appendices to each chapter. Future historians can read it here rather than need to go to the BIS themselves. Similarly, in the chapters themselves I have tried to present the main story as the BCBS saw it themselves. So there is much ‘cut and paste’. While I do not hide my own views, I did not want them to obtrude in the main text (except in Chapters 14–17, and at the end of most of the previous chapters). One of the reasons for writing this history now is that most of the main protagonists are still alive and in good shape. A few had died earlier, Huib Muller and Chris Thompson, and Michael Dealtry died in 2006; and a few were in no shape to talk to me. Like most committees, the BCBS has been run by its Chairmen and secretaries. My next set of thanks is to the BCBS’ Chairmen in these years, George Blunden, Peter Cooke, Gerald Corrigan, Tommaso Padoa-Schioppa and Tom de Swaan, all of whom I bludgeoned into part-writing their own short biographies in Chapter 3, and particularly to Peter Cooke. I also got much valuable assistance from the BCBS’ Secretariat, especially Michael Dealtry before he died, Erik Musch, and especially and particularly from Charles Freeland, who really should have written this instead of me. I would like to dedicate this book to the memory of Huib Muller and Michael Dealtry, two outstanding public officials. Being an ex Bank of England official myself and living in London, it was easiest for me to discuss the BCBS’ history with other Bank and British officials who had participated in the establishment or activities of the BCBS. In this category I am grateful to Sir Kit McMahon, Rodney Galpin, Robin Hutton, who died in 2007, Colin Powell (of Jersey) and

Preface

xiii

Brian Quinn for sharing their insights with me. If this book has an excessively British slant, so be it. Archives do not just open up for the historian at the right page. They need to be carefully prepared. Here my thanks go to the set of archivists who helped me on my way, first and foremost to Edward Atkinson and Piet Clement at the BIS, but also to Sarah Millard at the Bank of England, to Arnoud Glaudemans of the Nedelandsche Bank and to Danielle Mander of the Commission de Surveillance du Secteur Financier in Luxembourg. I am also grateful to Barry Johnston and his publisher Macmillan for permission to publish excerpts from his book on The Economics of the Euromarket (1983) in Chapter 2; to Steve Solomon and Caitlin McKenna for permission to publish excerpts from Steve’s book, The Confidence Game (1995) in Chapter 6; to Dick Herring and Bob Litan and the Brookings Institute for permission to publish excerpts from Financial Regulation in the Global Economy (1994) in Chapter 14; to George Walker and Kluwer Law International for permission to publish excerpts from his book on International Banking Regulation (2001) also in Chapter 14; to Ethan Kapstein and Princeton University for permission to publish an excerpt from his 1991 paper, ‘Supervising International Banks’ in Chapter 15. Finally my thanks go to those whom I asked to read and comment on some, or all, of the text, notably Kern Alexander and Rosa Lastra, especially on legal issues, and to Ethan Kapstein on international relations, and also to Ian Bond, Ivo Maes and Brian Quinn. I must also thank my research assistant, Burc Tuger, for checking on factual details, my secretary, Marina Emond, for the herculean task of preparing this book for publication, and my wife, Miffy, for almost everything other than this book. It goes without saying that all errors of fact and judgement remain my own responsibility.

1

Introduction

Most people working in the financial sector have heard of the Basel Committee on Banking Supervision (BCBS), and have a reasonably good idea what it does, notably its responsibility for the Accords on Capital Adequacy, commonly known as Basel I and Basel II. Not so many know that the BCBS is a Standing Committee set up by, and reporting to, the central bank Governors of the G10 group of countries. Few would probably be able to name any of the other (in 2008 three) Standing Committees of the G10 Governors, or be able to describe what they did. Indeed, the name of each current Chairman of the BCBS has become probably better known worldwide than is the identity of the contemporaneous President of the G10 governors, and possibly better known than that of the contemporaneous General Manager of the Bank for International Settlements, at whose headquarters in Basel, Switzerland, the BCBS, G10 governors, and so on, meet, and which provides the Secretariat for all these groups. The names of the consecutive Chairmen of the BCBS, the Presidents of the G10 governors’ committee and the General Managers of the BIS during the years covered by this book (1974–97) are recorded in Appendix A of this chapter. In short, the BCBS has become publicly well known, even famous; in some respects it is now perhaps the best-known member of the collection of BIS groups and institutions. How did this happen? It is a truism that finance and financial markets have become international, global, in scope whereas the regulation, supervision and control of financial systems have remained national, subject to national legislation and jurisdiction. This basic contrast has inevitably caused, and continues to cause, all kinds of tensions about competition between financial institutions headquartered in different countries (the ‘level playing field’ issue), about the coverage of supervision of international banks, about the relative responsibilities of home v. host regulators/supervisors, and so on. In particular, the level playing field issue meant that no single country could tighten its own financial regulations unilaterally without finding that its own banks might lose their competitive edge vis-à-vis 1

2

Introduction

their international rivals, certainly abroad and even possibly at home. The domestic banks could then become subject to a process known as disintermediation, whereby the more toughly regulated institutions lose business to their more lightly regulated competitors. This has meant that unilateral domestic regulation would normally be vehemently opposed by that country’s (international) banks. Since regulation, to be effective, does generally need the acquiescence of the regulated, at least up to a point, this has meant that financial regulation has to be coordinated on an international basis. This tension between the need for international harmonisation and national jurisdiction has been particularly marked within the European Union, and finding ways to overcome this tension has been a leitmotif of the European Commission. So the BCBS has usually operated in tandem, at least since the mid-1980s, as will be described subsequently in Chapter 5, with complementary groups acting at the EU level, such as the Groupe de Contact and the Banking Advisory Committee (BAC). Nevertheless, given the leading role of US financial intermediaries in the world’s financial system, and the large role of those from Japan, it was clearly preferable to agree on a common regulatory basis between Europe, North America and Japan, rather than for the Europeans to follow an entirely separate approach that might be unacceptable to their American and Asian colleagues. While the various strictly European bodies, such as the BAC, would most often be discussing identical issues simultaneously with the BCBS, for example on supervisory consolidation, capital adequacy, maturity mismatch in the Euromarkets, and so on, it became in practice the BCBS where the main decisions were taken, with the EC Directives transcribing the positions agreed within the BCBS. This is not to suggest that the BCBS overrode European concerns; rather the reverse. Seven of the ten members of the G10 were European (Belgium, France, Germany, Italy, Netherlands, Sweden and the UK). Switzerland also became a member of the G10 governors, not only as host country to the BIS but also as a contributor to the International Monetary Fund’s (IMF) General Agreement to Borrow (GAB), and so participated in all the Standing Committees. Finally, for special reasons that will be recorded in Chapter€2, Luxembourg, although not a member of the G10 governÂ� ors, did send a participant to both the BCBS and to the Euro-currency Standing Committee. So the European contingent was numerically dominant on the BCBS (nine out of twelve, the other three being Canada, Japan and the USA). European concerns were always fully voiced. The initial emergence of the global financial system, following decades when exchange controls and other restrictions confined and

Introduction

3

constrained financial institutions to operate primarily within their own domestic economy, appeared in the guise of the rapidly developing euro-currency market in the 1960s. This free and international market frightened many, including economists, central bankers and politicians, concerned that they might lose the control that they had previously wielded. Some economists feared that a system of deposits without any required reserve base might spiral out of control; some central bankers feared that the resulting monetary expansion would be inflationary; some politicians (and central bankers) feared that this huge and internationally mobile stock of funds could threaten the maintenance of the Bretton Woods system of pegged (but occasionally adjustable) exchange rates. All this is set out in greater detail in Chapter€2. Be that as it may, the central bank Governors were sufficiently concerned about all this to set up the special, separate Euro-currency Standing Committee, one of the first such committees, in April 1971.1 The remit of this Committee was to study the macro-economic and international financial implications of this new, fast-growing market. This Committee has continued to this day to explore and to report to the G10 governors on international macro and financial developments. As such international markets have changed, so has the formal name of this Committee, and it is now known as the Committee on the Global Financial System. The years 1973/4 were among the most disturbed in the second half of the twentieth century. The Arab/Israeli war in 1973 led to a quadrupling in the price of oil, and raised the question of how the sudden huge oil revenues could be recycled to the oil-importing countries. This led to a reconsideration of the role of the Eurodollar system. It was now viewed, not so much as a threat to macro-stability, but as a vital component of the necessary global recycling process. But was the Eurodollar market, and the banks that ran it, structurally strong and sound enough to do this without putting the whole system at risk? That question was given immediacy and greater urgency by the failure of a (smallish) German bank (Bankhaus Herstatt) on 26 June The Euro-currency Standing Committee was the first BIS-based G10 committee to be set up explicitly by a decision of the Governors at their meeting of April 1971. However, the Gold and Foreign Exchange Committee (now:€ Markets Committee) predates the Euro-currency Standing Committee. It evolved from the gold and foreign exchange experts’ group created in 1961 to monitor the gold market (and administer the Gold Pool), and in fact became a G10 committee when representatives from Canada, Japan and Sweden joined the group. So although there was no formal Board decision creating the Gold and Foreign Exchange Committee as a G10 committee, it has in practice been operating as a G10 committee since 1964 (see Toniolo and Clement 2005, p. 365). 1

4

Introduction

1974.2 This was not a major player in the Euromarkets, but had taken out large positions in the foreign exchange market, which was one of the reasons for its collapse. By misadventure, it was closed in Germany before its foreign exchange (fx) positions in New York were settled. The liquidator of Herstatt then refused to make payments on its spot US$ positions. This badly rattled the fx market, which almost closed for several days. Although this debacle related to the structure of the fx market (where the basic problem became known as Herstatt risk and was not finally settled until almost thirty years later with the establishment then of the Continuously Linked Settlement (CLS) system), rather than to the structure of Euromarkets and international capital transfers, it forcibly reminded everyone of the inherent fragility of these latter systems, on which the world’s economy was now becoming so reliant. Under strong prodding from leading politicians (outlined in Chapter 2), the central bank Governors, in some cases somewhat unwillingly, were put under pressure to come up with mechanisms and procedures to maintain stability in the international financial system. The focus of this new commitment and work was to be on the systemic stability front, concerned with the structure of institutions and their supervision, in effect micro-focused. This required a different focus from the macro approach of the existing Euro-currency Standing Committee, and, in particular, a different cast of specialists, notably including bank supervisors. In many countries in the G10 group bank supervision was carried out by a different authority than the central bank. This was then so in Belgium, Canada, Japan, Sweden and Switzerland, and to a degree in France, Germany and the USA. The institutions represented in the BCBS at the end of our period, 1997, are recorded in Appendix B of this chapter; there is further discussion of such representation in Chapter 3. This would be the first time that noncentral bank representatives would serve on a G10 governors’ standing committee. For all these reasons the G10 governors set up a new separate committee to handle this remit. Having played quite a large role in prodding the G10 governors into setting up the BCBS, the politicians then largely retired from the scene, apparently content that there had been an international expert body established to deal with the complex technical issues of handling the 2 The concurrent problems of the Fringe Banks in the UK (see Reid 1982) and of Franklin National, earlier in May 1974, in the USA added to the general ambience of concern about financial stability but were less germane to the specific international issues.

Introduction

5

interface between international and domestic financial stability issues. Indeed, the politicians thrust the arising problems in the direction of the BCBS. In particular, the 1982 crisis, when Mexico, Argentina and Brazil all threatened to default, revealed the insufficiency of (US) money-centre banks’ capital reserves, and Congress passed an International Lending Supervision Act (ILSA 1983) to tighten up on banks’ procedures, to enhance supervision and to raise capital standards (see, for example, Solomon 1995, pp. 247, 418–19; Markham 2002; and Tomz 2007). But Congress was made well aware that unilateral action to raise US banks’ required capital ratios, on their own, could act as a competitive penalty in their international business, especially vis-à-vis the Japanese banks, which were seen as a major competitive threat at that juncture. So Chairman Volcker of the Federal Reserve Board (Fed) was effectively mandated to go to the G10 governors’ meeting to seek the establishment of some internationally ‘functionally equivalent’ capital adequacy requirement (CAR). The search for an international agreement on CARs was, naturally, passed on to the BCBS, who had been working on this subject, on and off, already for several years (see Chapter 6). This remit had both disadvantages and advantages. The disadvantage was that, hitherto, the BCBS had operated by achieving consensus on best practice, for example on consolidated supervision; once such agreement was reached, the BCBS would advise the G10 governors to recommend the adoption of such practices domestically. The problem with the new remit was that existing practices and attitudes towards CARs were sufficiently distinct in a few key respects in several major countries to make the achievement of a general consensus well nigh impossible; and the ethos of the BCBS was always to try to find such common ground. That meant that progress there was slow; this was one reason for the separate adoption of a common UK/US accord on CARs in the autumn of 1986, which had the (intended) effect of putting considerable extra pressure on the BCBS to agree to a compromise solution, which involved several of those concerned giving up some ground on their own previously preferred positions. The advantage to the BCBS (if it can, indeed, really be considered such) was that it subtly shifted its role from being a body which made recommendations to its respective Governors, to being a body which formulated regulations to be applied to banking systems both within the G10 and much more widely, especially throughout the whole of the European Union. The BCBS always emphasised that it had no formal legal role whatsoever, and especially that it could apply no sanctions to

6

Introduction

any country failing to implement its proposals (the question of sanctions for any such failures appears never to have been discussed in the BCBS during these years€– it was outside the locus of the Committee). That said, the 1988 Basel Accord on capital adequacy, or Basel I as it is now normally known, involved regulations that needed to be transposed by the various national and regional authorities, for example in the EU, into law. The whole question of the legal position of the BCBS is reviewed further in Chapter 14. Be that as it may, questions concerning the interface between the international nature of banking and the domestic character of financial regulation/supervision otherwise faced a political/economic/legal vacuum at this time. It was this vacuum that the BCBS filled, and between the BCBS’ foundation in 1975 and 1995, it was largely left without much outside political direction. In 1995 the politicians revisited this subject, with expressions of growing concern on the financial stability of emerging economies, starting with the Halifax G7 summit, but continuing through to the end of the period of this book (1997). By 1997 the BCBS was well established with several striking successes to its name, for example the Concordat, and had become, following the successful adoption of Basel I, the primary source for international banking regulations. Moreover, the BCBS had encouraged and facilitated the formation of satellite groups of regional banking supervisors, many from emerging economies, in various parts of the world (see Chapter 5) and had begun to run training programmes for them. Even so, the BCBS tended then to see its core function as providing a regulatory structure for the international role of banks from the developed world. So, when the call first came from the G7 politicians to devise a regulatory/supervisory framework for the wider, emerging economies, there was initially some reluctance within the BCBS to see this as part of its own role. No doubt in part because the alternative was for the IMF to take over this role, views within the BCBS changed rapidly. Indeed, the compilation and agreement on ‘The Core Principles of Banking Supervision’ was achieved in record time in 1996/7 (see Chapter 8). The end of 1997 is the date at which this history ends. It represents a high point for the BCBS. The Concordat and Basel I had been fully and successfully implemented. The Market Risk addendum to Basel I, allowing banks to use their own models to assess market risk in their Trading Books, had been introduced in 1996, to general applause, (see Chapter 7). The Core Principles had been promulgated, and a division of responsibilities (tacitly) agreed with the IMF/World Bank (WB), whereby the BCBS would formulate the proposed regulations while the IMF/WB would undertake checks on their implementation via the Financial Sector Assessment Programmes (FSAPs).

Introduction

7

In 1997 a new subcommittee of the BCBS was established with the remit of thinking about the next stage of credit risk and capital adequacy regulation. But the Basel II exercise, which was to become the focus of so much of BCBS work in subsequent years, had yet to start. This latter is too recent, and for the time being too contentious, to become the subject of a historical study such as this. So for all these reasons the end of 1997 has seemed a good finishing date. The Basel Committee on Banking Supervision did not carry that same name throughout its history. Like several of the other Standing Committees of the G10 governors, its nomenclature changed over time. At its inception it was given the title of the Basle Committee on Banking Regulations and Supervisory Practices. This was rather a mouthful, and there was no accompanying catchy acronym. So, the Committee came to be known by other shorter names. In the UK certainly, and perhaps in other countries, it was better known in its earlier years by the name of its (British) Chairmen, first the Blunden Committee (1975–77) and then the Cooke Committee (1978–88). More neutrally, it increasingly began to be referred to as the Basle Supervisors Committee, or the Basle Committee on Supervision.3 In 1985 the Committee discussed a note proposing that the name be shortened to the Basle Supervisors’ Committee, but took no action. Then in 1989 the (BIS) Secretariat put forward a note to the Committee, now under the chairmanship of H. Muller of the Nederlandsche Bank, proposing some alternative names, to replace the original longer name, and the Basle Committee on Banking Supervision emerged as the generally agreed choice (see ‘Report on International Developments in Banking Supervision’, BCBS, September 1990, Chapter 1, Footnote 1). Notice that the spelling of Basle was Anglophone. The good burghers of Basel, which is in the German-speaking part of Switzerland, preferred, however, that Basel be spelt according to local custom, and so, in 1998, during negotiations (of the tax treaty) with the local government, it was agreed to do that, and so the name changed once again to its present and current form. Rather than confuse matters by referring to the Committee by the title currently in use at each moment, this record will try to simplify matters by calling it by its latest, and current, name, the Basel Committee on Banking Supervision, or even shorter by its acronym, the BCBS. The way in which this book is organised is as follows. It starts with two chapters setting the scene, Chapter 2 on how and why the BCBS was set up, and what went before, and then Chapter 3 on its membership As Rosa Lastra has reminded me, the BCBS has become above all a regulatory body, a standard-setting institution. Hence, the word ‘regulation’ in its title (as at its inception) would have been more appropriate to define its role than the word ‘supervision’. 3

8

Introduction

and operations. This is followed by eight chapters on what the BCBS did, its main work. The chapters each focus on a main topic, but each chapter then follows its own separate chronological order. In recording what the BCBS did, I aim intentionally to allow it to speak for itself. So, as already noted in the Preface, there is much ‘cut and paste’ here, and even longer Appendices. No committee operates in a void, so Chapters 12 and 13 cover the BCBS’ interactions with counterparties, first with banks and other banking regulators and then with non-bank oversight and supervisory bodies. In a sense Chapters 2 to 13 are meant to be a quasi-official historical record. In contrast, the last four chapters, which are also much shorter, are commentaries, from a legal perspective (Chapter 14), from an international relations viewpoint (Chapter 15) and from an economics, social science, stance (Chapter 16), ending with a brief epilogue (Chapter 17).

Appendix A 1975–1997 Chairman of the BCBS 1975 76

President of G10 governors’ committee

General Manager of the BIS

Zijlstra (Nederlandsche Bank)

Larre

Richardson (Bank of England)

Schlieminger

Blunden (Bank of England)

77 78 79 1980 81

Cooke (Bank of England)

82 83 84 85

Pohl (Deutsche Bundesbank)

86 87 88

Lamfalussy

89 1990 91 92

Muller (Nederlandsche Bank) Corrigan (FRBNY)

De Larosière (Banque de France)

Appendix B Chairman of the BCBS 93 94 95

President of G10 governors’ committee

General Manager of the BIS

Crow (Bank of Canada) Padoa-Schioppa (Banca d’Italia)

96 97

9

Tietmeyer (Deutsche Bundesbank)

Crockett

De Swaan (Nederlandsche Bank)

Handover date to the nearest calendar year.

Appendix B List of member institutions in 1997 Belgium€ – Central Bank Commission Bancaire, Financière et des Assurances Canada€ – Central Bank Office of the Superintendant of Financial Institutions (OSFI) France€– Central Bank Commission Bancaire Germany€ – Central Bank Bundesaufsichtsamt für das Kreditwesen (BaKred) Italy€– Central Bank Japan€– Central Bank Ministry of Finance Luxembourg€– Institut Monétaire Luxembourgeois Netherlands€– Central Bank Sweden€– Central Bank Financial Supervisory Authority Switzerland€– Central Bank Eidgenössische Bankenkommission (EBK) (Swiss Federal Banking Commission) UK€– Central Bank USA€– Board Fed NY Office of the Comptroller of the Currency (OCC) Federal Deposit Insurance Corporation (FDIC)

2

The antecedents of the BCBS

A

Introduction

The primary reason for the foundation of the BCBS was the implications for the monetary authorities of the growing globalisation of financial intermediation. This occurred slowly, but steadily, in the aftermath of World War II, as exchange controls and other direct restrictions on financial flows were removed, eroded or evaded, and as international communication improved. Whereas financial markets and intermediation became international (monetary) control and regulatory systems remained national, if only because legal systems and powers remained nationally based. So there was a need to establish communication networks among national authorities, where consequential common problems could be discussed, and cooperation sought, perhaps leading on to convergence of policies. At the beginning of the 1970s this generated two separate strands of international cooperation on financial regulation. The first, and less well known, is the Groupe de Contact, established in 1972 to discuss common cross-border problems for banking regulations within the Common Market, the EEC (European Economic Community). The most eye-catching manifestation of financial globalisation during the 1960s was, however, the Eurodollar market. This international, amorphous market was seen by many as a threat to national monetary and regulatory control, especially in view of its explosive growth in these years. So concerned about this phenomenon were the G10 Governors1 that they established a special subcommittee, The The origins of the Group of 10 have to do with the borrowing powers of the IMF. The first credit lines established by the Fund to supplement its quota-based resources were the General Arrangements to Borrow or GAB. This was an agreement negotiated by the Fund with eight of the major industrial countries (United States, United Kingdom, France, Japan, Italy, Canada, Netherlands, Belgium) and the central banks of two others (Deutsche Bundesbank and Sveriges Riksbank) in 1962. (See Lastra 2006, pp. 386–7. See Decision of the Executive Board No. 1289-(62/1) of 5 January 1962 with effect from 24 October 1962. The decision, as amended, 1

10

Introduction

11

� Euro-currency Standing Committee, in April 1971, to monitor and report on Euromarket developments. Moreover, the Bretton Woods system of pegged exchange rates was progressively collapsing at the start of the 1970s, leading to uncertainty about how the international financial system would work in the context of (relatively uncontrolled) floating. Then in 1973/4 two events occurred. The first was the Arab/Israeli Yom Kippur Fourth War. This led to a cutback in oil production by the Gulf States and then to a quadrupling of the price of oil, which in turn brought about huge financial imbalances. The question then was whether, and how, the international banking system, and the Euromarkets, could recycle the flow of funds between oil producers (creditors) and oil importers (debtors). The second event was the collapse of Bankhaus Herstatt in June 1974. This raised the question of whether the international banking system was safe and secure, just at the time when its role had become essential for recycling the oil moneys. This question needed analysis and assessment by a group including officials expert in the micro-economics of prudential regulation and also of foreign exchange operations. But this could not be provided by the existing Euro-currency Standing Committee; the members of this Committee were all central bank officials, and in many of the G10 countries, such as Germany and France, such banking regulation was primarily undertaken by other (non-Central-Bank) bodies. Moreover, the focus of this Committee was towards macro-economics and general monetary policy, whereas the focus of the newly formed Committee on Banking Regulation and Supervisory Practices (as the BCBS was then termed), was to be, as its name indicates, more micro in outlook and focussed on regulation/supervision. While the chain of developments leading from Euromarket events up to the formation of the BCBS is much better known, the actual pro�cedures, activities and approach of the BCBS emerged much more closely as a continuation and extension of the Groupe de Contact (than as the micro, regulatory arm of the Euro-currency Standing Committee). So it is to the Groupe de Contact that we turn first.

is published in Selected Decisions of the International Monetary Fund (International Monetary Fund 2000)). The G10 or Group of Ten refers to the group of countries that agreed to participate in the General Arrangements to Borrow. Under this agreement, the members would consider supplementing the Fund’s resources if further resources were necessary in order to finance the transactions of any of them with the Fund.

12

The antecedents of the BCBS

B

The Groupe de Contact

The Groupe de Contact was established as a result of an individual initiative by a small number of (then) upper/middle-ranking officials in the banking supervisory authorities of the initial six EEC countries, in mid1972 (Belgium, France, Germany, Italy, Luxembourg, Netherlands). The leading personalities involved were Albert Dondelinger, the Commissaire au Contrôle des Banques€ – Luxembourg, Huib Muller, Head of Credit Control Service of the Nederlandsche Bank, and Herman Baeyens, Director of the Department for the Control of Banks, Commission Bancaire, Belgium. As this indicates, the initiative came from the Benelux countries, especially the Netherlands. The other participants at the first Conference meeting in Amsterdam were:

• Manfred Schneider, President of the Department of the Bundesaufsichtsamt; • Giuliano Monterastelli, Head of the General Affairs Credit Control Services, Banca d’Italia; • Pierre Fanet, Deputy General Secretary, Commission for the Control of Banks, France.

As will be noted from this list, only two of the initial participants, from the Nederlandsche Bank and the Banca d’Italia, came from within central banks; the other four from specialised bank regulatory/supervisory authorities, though the French Commission de Controle des Banques was closely associated with the Banque de France. Perhaps in some part just because this was a mixed group of officials from differing kinds of institutions, it was not formally established.2 It was a personal/private In personal correspondence with me, Robin Hutton raised the question why it took so long to set up such a group. Thus he wrote that ‘By the early 1970s it was, I believe, pretty clear to both bank managements and their national supervisors that the responsibility of the supervisors had to become more extensive and complex€ – and more internationally cooperative€– if the scope for disaster was to be minimised.’ One reason, on which we agree, is that the heterogeneous structure of banking supervision, with some supervisors being within central banks and some without, complicated the process of international coordination. One possible additional reason for the slow process was the existence of doubts and uncertainty about the proper role of the EC itself in such an exercise. As detailed at some length in the body of this Section, this vexed question continued to trouble the Groupe. Another possible cause for hesitation, at least for EEC member authorities, might have been the juxtaposition of their need for greater openness with each other with the efforts of national governments to move towards a Common Market in Banking (see also footnote 4, later). The Directives on Banking had been launched by the Commission of the Six, before the enlargement of the EEC to nine Member States in 1973, as part of a programme aimed at harmonising existing national legislations into a single body of Community Law. The drafting was, I understand, done by German lawyers on the Commission staff and negotiated among civil servants of national 2

The Groupe de Contact

13

initiative among consenting officials, though it had the goodwill, support and blessing of the participants’ respective institutions, which were prepared to pay the expenses of the Conference meetings. The circumstances leading up to the formation of the Groupe were as follows. On 25 February 1972 there was a telephone call between Herman Baeyens, then Deputy Director of the Commission Bancaire in Belgium, and Huib Muller, a young but middle-ranking official in the banking supervisory department of the Nederlandsche Bank. Baeyens wanted to discuss how to handle the proposals of an American commercial bank, which wanted to establish simultaneously in Belgium a subsidiary for managing domestic business and a representative office for dealing with non-domiciled international business. ‘Towards the end of this discussion Baeyens noted that it was a pity that there was no place where international supervisory issues could be discussed by those concerned.’3 Muller was of the same opinion, as he wrote in his note for the record on the telephone discussion, dated 28 February. In this he remarked that someone should take the initiative to set up such meetings. He was as good as his word. On 2 March he wrote a note to his Executive Director in the Bank, Postumus Meyjes, offering an outline for such a group to hold discussions about international supervisory issues. Muller noted that, ‘in the context of the coordination guidelines of the European Community, and of the European Commission (EC), there is some consideration being given to setting up an informal working group of official supervisors. Several member state delegations would like this as soon as possible. Someone has to arrange its take-off.’ Muller went on to suggest that if the Dutch took the initiative, the first meeting could be held that October. He was typically broad and inclusive in his outline proposals for membership. This should involve two members each from the existing six original EC countries, plus the four then candidate countries (UK, Denmark, Ireland and Norway), plus two experts from the EC (which would also, Muller suggested, provide the Secretariat). Moreover, at some subsequent date he envisaged government departments rather than banking supervisors€– though some of the latter may have been consulted from time to time. This process may have given rise to a suspicion among several supervisory authorities that the Directives and their implementation might be too legalistic in both text and practice, restricting the fleetness of foot supervisors could often require. Thus there could have been some suspicion that politics might get in the way of proper action by supervisory authorities, especially when some prominent banks were state-owned. 3 Translated from the original Dutch of the records in the archives of the Nederlandsche Bank for me by the archivist/historian Arnoud Glaudemans, to whom I am most grateful.

14

The antecedents of the BCBS

extending membership to Switzerland and the USA; official languages to be English/French; meetings quarterly for one or two days each; the host Bank to pay expenses. The proposed original agenda was: 1. Liquidity and solvency regulations 2. Capital requirements (e.g. treatment of hidden reserves) 3. Limitations on large exposures 4. Philosophy on treatment of minority interests 5. Handling of external (overseas) commercial bank offices 6. Continuation of Groupe discussions on a permanent basis. The goal was to be a general, informal exchange of views, with a view towards encouraging convergence on best practice, but with absolutely no binding commitment. Muller suggested that, if the Executive Board should take a positive view of this proposal, then the European Commission should be contacted first, alongside Baeyens. The EC could then advise whom to invite. The Dutch Ministry of Finance should be informed, but on no account invited to participate. From the very outset, the question of whether, when and how to involve the EC in the Groupe became contentious. In one of the early internal comments on Muller’s note, van Kats, a senior official, argued that such a group should not aim to become an official EC working group. The Groupe would be more inclusive of outsiders (whose experiences were just as valuable), such as Switzerland and the USA, if the EC were kept at arm’s length. The question of EC representation cropped up regularly at subsequent meetings. The general arguments against inviting an EC representative included: 1. Result could be greater formality;4 2. Could inhibit discussion of individual bank cases, on account of secrecy requirements;

4 Shortly before his death in 2007, Robin Hutton, who became the EC’s Director of Financial Institutions, prepared the following comment for me, as follows: [There was] hesitation amongst national supervisory authorities about taking practical steps to learn in greater detail about techniques used in other countries to measure risks, and determine responsibilities for monitoring exposures and providing last resort facilities. Several people later involved in the work both of the Groupe de Contact and of the Brussels Commission made this point to me. It may be that one aspect of the hesitation arose from the juxtaposition of the work of the supervisors with the efforts of national governments in the EEC to move towards a Common Market in Banking. The Directives launched by the Commission of the Six, before the enlargement to nine Member States in 1973, [were] part of a programme

The Groupe de Contact

15

3. Would tend to keep the Groupe narrow, excluding non-EU participants; 4. Some worries about the abilities and characteristics of potential EC representatives. Whereas the arguments in favour were: 1. The whole exercise was being carried out in an EU context; 2. The effective international basis and context for these countries would be EC Directives; 3. So any attempt at (formal) convergence would have to involve the EC.5 of measures aimed at harmonising existing national legislations into a single body of Community Law. The drafting was done by German lawyers on the Commission staff, and negotiated amongst civil servants of the national government departments involved€– not amongst banking supervisors, though some supervisors may have been consulted by the civil servants from time to time. This has undoubtedly given rise to a suspicion among several supervisory authorities that the Directives and their implementation might be too legalistic in both text and practice, and could well restrict the fleetness of foot which bank micro supervision could often require. By the time that the Liaison Committee [mentioned later on p. 24] came into existence, I had been the Director of Financial Institutions (i.e. banking, insurance, stockmarkets and financial services in general) in the European Commission since the UK joined the EEC in 1973. The legalistic German authors of the Directives had left the scene and the Commission became much keener on close cooperation with the banking supervisors, as I believe the latter were with the Commission. This was, as always, a delicate issue; so much so that one member of the Groupe circulated the following letter to his colleagues, in December 1973, on a personal basis: 5

At our next meeting in Brussels on February 7 and 8, 1974, we shall discuss the eventuality of Mr Hutton joining our group in a personal capacity. With great interest I read the letter of November 16, 1973, from our friend Albert Dondelinger about his meeting with Mr Hutton. Having carefully reconsidered my original feelings on the subject, I can’t help being worried about the proposal to accept Mr Hutton as a member of the Club. I hope, therefore, you don’t mind my setting out below some thoughts on the matter for further reflection and for discussion in Brussels. Let me start by saying that I have recently met Mr Hutton and that we had a most pleasant chat. If I have any doubts about the desirability of the participation of a topofficer of the European Commission, there is nothing in my remarks that is levelled against Mr Hutton personally. My doubts are based on the following considerations: (a) Each supervisory authority, acting in its own country as the confidante of both the banking system and the Government, maintains a delicate balance. A prerequisite for successfully occupying this valuable position is in my view the absence of direct government representation in the national authority. One wonders why this requirement should not be maintained strictly with regard to the European ‘executive’. (b)╇A lthough it may still seem rather far away, one could envisage our informal ‘Club’ as the nucleus of a future European Bank-controlling authority. However remote this may be, it seems wise to maintain right from the beginning the separation

16

The antecedents of the BCBS

Be that as it may, having received a generally favourable response from the Directors of the Board of the Nederlandsche Bank, the next step was for Muller to hold an informal, personal discussion on 10 April at the Commission Bancaire in Belgium, with Baeyens and Gelders there, and also Albert Dondelinger from Luxembourg. Dondelinger, the Commissaire au Contrôle des Banques, was the senior both in terms of official position and experience. Although the original initiative came from Muller, Dondelinger rapidly assumed the position of (unofficial) leading spokesman. Anyhow, all, including de Barsy, the then Head of the Belgian Commission Bancaire, who joined them at lunch, agreed to go forward. Eight points were made: 1. The Groupe (club) should be very informal, with only one regular participant per country (plus a pre-announced substitute). 2. Start should be immediate in June with only the existing EC countries; the candidates could come on the next occasion. The Swiss and Americans should not be invited. 3. Invitations should be sent to named persons. between the executive (the European Commission) and the Bank controlling authority. (c) The issues raised under (a)€– and perhaps also those under (b)€– involve an important practical point:€bank secrecy. To maintain access to all the files of the banking system it is necessary for the controlling authority to be able to observe absolute secrecy. But if one recalls the exchange of views in our ‘Club’, one knows that, now and then, very confidential information comes up on any subject. It will be very difficult, if not impossible, to gather all confidential information into one specific unofficial item on the agenda that could be discussed in the absence of the new member (in itself it is not a very pleasant idea to declare a certain part of every meeting as ‘out of bounds’ for one of the ‘Club’ members). (d) Simultaneously with the ‘Club’, the group of experts on banking legislation is working in Brussels on a draft directive dealing with bank control. The group is chaired by a member of the Commission and any Commission officer may attend its meetings. In this group on legislation, also practical problems of control of a more general kind are discussed (e.g. ratios for solvency and liquidity and reporting procedures). One might feel that the borderlines between the activities of the group of experts and the ‘Club’, or between legislation and implementation of control, threaten to be blurred by admitting a top officer of the Commission to the ‘Club’. Would we feel as free as before to express our opinions? If not, the essential value of the ‘Club’ would be seriously impaired. (e) Finally the question might arise whether comparisons can be made between our ‘Club’ and the group of supervisors of investment funds. I’m not an expert on the control of investment funds, but I would be highly surprised if all points mentioned before (in particular the secrecy and the dual role of confidante) would be equally important for the supervision of investment funds. I trust that you will consider this letter as the expression of my personal opinion. Please keep it only in your personal file. I would appreciate your returning the letter to me after our discussion on this item in Brussels.

The Groupe de Contact

17

4. Groupe to meet quarterly. 5. Host organisation picks up the bill; original language, French. 6. EC should be informed (by telephone) and invited to send a single ‘observer’, with no reference to be made to any official EC advisory committee to be organised in future. 7. Informal organisation allows Ministries to be informed, but prevented them from any participation. Also need to preserve bank secrecy. 8. The tentative agenda should begin with a discussion of the character of the Groupe (club), and then continue with a Tour de Table of its members, before launching into the various subjects outlined already by Muller, in his internal note of 28 February. This was followed by a letter from Muller to Dondelinger,6 dated 16€May 1972, setting down on paper the arrangements for the first meeting of the Groupe to be held in Amsterdam on 29–30 June, which they had previously discussed over the telephone and at the meeting in Brussels on 10 April. The purpose of the exercise was ‘de pouvoir échanger des idées en ce qui concerne la réalisation du contrôle économique privé des banques dans les pays intéressés. Comme vous le savez, il s’agit ici d’un échange d’idées officieux (NB this means unofficial in English) où l’on s’abstiendra de prendre des “décisions”.’ Muller notes that the idea is to have a series of such meetings. He then sets out a suggested agenda, as follows: 1. Initial discussion on the purpose and ‘character’ of such conferences. 2. Tour de table (half hour by each participant) on their own regulatory framework and problems. 3. Consideration of position of branches of banks from other countries. 4. Limitations on large exposures. 5. Composition of capital funds (subordinated debt? hidden reserves?). 6. Philosophy relating to the future development of directives on private-sector banking [in the EEC]. 7. Reciprocity in the establishment of banks vis-à-vis countries outside the EEC. 8. The effect of euro-currency transactions on bank liquidity, and to set out conditions concerning the examination of credits extended to euro-borrowers. 9. Requirements for establishing a new bank. My thanks are due to Danielle Mander and Jean-Nicolas Schaus of the Commission de Surveillance du Secteur Financier for making this, and other documents, relating to the early years of the Groupe de Contact available. 6

18

The antecedents of the BCBS

Among the points to note are the importance attached to sharing information on what each country was currently doing internally, the emphasis on cross-border issues, some concern (but not a major focus) on the Euromarket, early worries about the appropriate definition of capital, and an ambitious agenda. Indeed, most of the elements in this agenda would reappear time after time at subsequent conferences (as would also later become the norm with the BCBS). In fact, the actual agenda for the first conference became even longer. Extra items included were: (a)╇ the position of representative offices of foreign banks, and their distinction from branches. (b) the bank-like activities of non-banks, both persons and enterprises, and how to control these. (c) territorial extension of the number of places where a bank is established. The minutes of this conference, held as planned, indicated the conference opened with a statement reinforcing its informal character (‘un caractère strictement informel’). In the opening discussion, Dondelinger suggested that the conferences should be treated as having the nature of ‘réunions informelles d’un “club”’. There was a lengthy tour de table, in which the role of the European Commission, notably in the 1967 Directive on ‘Droit d’Établissement et Services’ was mentioned, followed by a discussion on (1) the regulatory/supervisory position in each country of branches of foreign banks, (2) representative offices and (3) reciprocity in the establishment of banks with countries outside the EEC (primarily the USA). The meeting concluded with a discussion of the next steps to be taken. The participants were unanimous that the exercise had been useful and should be continued. At this juncture it appeared that Denmark, Ireland, Norway and the UK would shortly be admitted as new members into the EEC. The Groupe decided to invite representatives from all these countries to its next meeting, to be held in November 1972 in Luxembourg. The name of Rodney Galpin, Deputy Director of the Discount Office at the Bank of England, was already known to the existing participants, and was proposed. It was suggested that soundings would be taken about appropriate persons to invite from the other three countries. Such invitations largely depended on the relevant position of each invitee in his home institution, but also to some extent on personal contacts. There was a conscious effort to make the meetings into reunions of like-minded

The Groupe de Contact

19

individuals rather than an official committee. Thus it was decided that ‘chaque pays aura seulement un représentant dans le “club” qui sera toujours la même personne’. One of the unresolved issues, as already noted, was what should be the relationship between the Groupe and the European Commission. Membership of the EEC was the unifying feature of the ‘club’, and financial regulation was progressively coming under the umbrella of EC directives. But there were concerns whether the participation of an EC official at such meetings might alter the nature of the Â�discussions; it might be better to wait until the ‘club’ was more firmly established before making any such invitation; it might also make it difficult to invite a Swiss representative. Nevertheless Muller was mandated to discuss such possible participation with Schwartz of the EC. In the event Norway did not proceed towards entry into the EEC, but invitations to the next meeting (in Luxembourg) were sent to Bjorn Jensen, Inspector at the Tilsynet med Banker og Sparekasser in Copenhagen, and to Michael Cleere, Manager of the Central Bank of Ireland, in addition to that sent to Rodney Galpin. The agenda grew even longer (14 items). In addition to the items carried over from Amsterdam, and the regular introductory subjects (approval of agenda, tour de table, introduction of new members, etc.), the following were added: 1. How best to present bank accounts. 2. What bank ratios are enforced in each country. 3. Ability of the home supervisor to undertake examination of branches in host countries (NB the home/host terminology had not been adopted by then, but that was what was meant). 4. Credit insurance. 5. Mergers between banks and insurance companies. It is at this stage worth remarking on how the meetings were Â�organised. There was no chairman7 and no regular secretariat. Instead, each meeting was chaired by the local representative in whose country the meeting was held. This revolved among the members. The list of early meetings was as follows:

It was, however, tacitly appreciated by all concerned that Dondelinger and Muller were the prime movers in the exercise, and the Committee was sometimes known as the Dondelinger or Muller Committee. 7

20

The antecedents of the BCBS 29–30 June 1972 9–10 November 1972 22–23 February 1973 14–15 June 1973 8–9 October 1973 7–8 February 1974 6–7 June 1974 12–13 September 1974 13–14 February 1975

Amsterdam Luxembourg Paris Dublin Rome Brussels Berlin Copenhagen London

The secretariat from the host country was primarily there to record the minutes, which were quite extensive (about fifteen pages generally). There was hardly any circulation of other papers beforehand, apart from the agenda. Each participant was expected to come briefed and able to speak on his own country’s position. The discussion was in either French or English, as were the agenda and minutes, depending on which was the host country. Perhaps partly to reinforce the personal ‘club’ nature of the conferences, wives were regularly invited. The members did bond together, so much so that they continued to hold reunions of the ‘Fathers and Mothers’8 [of cross-border financial regulatory cooperation.] Although the Groupe often had a long list of topics on its agenda, it did try to focus on what it then perceived as the most urgent and immediate issue, though following the standard tour de table on recent changes in regulatory practices. Thus, it focussed on the following topics: Luxembourg:€Publication and presentation of bank balance sheets and accounts (following which Dondelinger wrote a paper). Paris:€Discussion of the Dondelinger paper on ‘La presentation et la publicité des comptes annuels des banques dans la CEE.’ Dublin:€ Whether bank supervisory agencies could carry out examinations in the foreign branches of a national bank. This covered both directions, for example US regulators examining US bank branches in Italy, and vice versa; AND Euro-currency transactions and their effect on bank liquidity; examination of credits granted in the Euro-currency market. Rome:€O verbanking and the allocation of branches (also involving some discussion of a paper by Giusani of the Banca d’Italia); AND Criteria for the establishment of new banks; AND (briefly) Bank secrecy and transfers of information to the judiciary and to other members of the Groupe. Brussels:€Overlaps (mergers) between banks and life assurance companies. Personal comment from Rodney Galpin. 8

The Groupe de Contact

21

Berlin:€Intended US legislation on foreign credit institutions; AND Limitations on consumer credits.

The relatively calm conduct of the procedures of the Groupe at these initial seven meetings was then disturbed, just before the occasion of the eighth Copenhagen meeting, by the communiqué of the G10 Governors at the BIS on 10 September 1974 (which will be reported in Section C of this chapter), which one newspaper (Börsen-Zeitung, 11 September) (incorrectly) related to the forthcoming meeting of the Groupe in Copenhagen. The succession of events in 1974 would change the character of the Groupe, but before coming on to these, we may note some of its practices that were maintained and extended in the early years of the BCBS. First, included in the agenda for the Brussels meeting was a possible discussion (of the implications for financial regulators) of the earlier failure of the National Bank of San Diego (in the USA)€– despite having no American representative to guide them. Thus the principle of running a post-mortem to examine the lessons of banking crises had been set. Second, the discussions were not only informal, but specifically not intended to lead to any decisions. Nevertheless, following a round table on individual national practices, there might be a summation, often by Muller, on what seemed to be common (or best) practice; each national representative could feed that back into their own domestic discussions (on bank regulation) as seemed appropriate. Third, the agenda, and discussions, occasionally stimulated participants, notably Albert Dondelinger, to circulate personal papers. All these precedents fed through into the early years of the BCBS. Be that as it may, the Copenhagen meeting agreed that Dondelinger, in a personal letter to the Chairman of the G10 Governors, might state the attitude of the Groupe to the BIS communiqué. Following what was, apparently, a long discussion, it was ‘agreed that the following might be expressed: 1. The contact group held a meeting in Copenhagen on the 12th and 13th September, 1974. It was the eighth meeting since 1972. 2. The problems referred to in the BIS communiqué dealing with the supervision of banking activities and the possibilities of international cooperation in this field were discussed. 3. The group has to a large extent exchanged views on current legislation and practice in the EEC countries; the new measures that are or will be adopted in these countries have been noticed. At the same time rules of solvency have been discussed, and also, to the extent considered necessary, the rules of procedure applying to banks.

22

The antecedents of the BCBS

4. The group agreed to further without delay a thorough study of the following items: (a) rules of security concerning the internal supervision of banks, particularly with regard to foreign exchange dealers, etc. (b) the most adequate informal line of action permitting the exchange of confidential information about events that may jeopardize the solvency of banks, especially those established in more than one country. 5. The group has had its first exchange of views on the possibility of improving its internal function without ruining the confidential character of the deliberations. The usefulness of exchanging qualified executive officers between the competent authorities with the purpose of permitting the officers to become acquainted with their colleagues’ methods and supervision rules has been emphasised in particular. 6. It was the opinion that it might be useful for the group to be in contact with supervision authorities outside the Community, for instance by a meeting once a year. 7. Finally the contact group offer the Governors of the Central Banks to set to work on technical studies as expressed in the BIS communiqué.’ Dondelinger wrote such a letter (19 September 1974), and also in that letter asked to have a reference to the work of the Groupe placed on the agenda for the subsequent meeting of the G10 Governors. Meanwhile the Americans had also become alerted to the work of the Groupe. George Mitchell, a Governor of the Federal Reserve Board (FRB), had discussed common regulatory issues in his European visit in Spring 1974, and he (and Wallich and Dahl of the FRB) had taken the opportunity of the IMF/World Bank meeting in Washington in September 1974 to discuss holding a meeting of banking authorities with Dondelinger and Muller. This envisaged attendance by representatives of the Common Market countries plus Canada, Japan, Switzerland and the USA. If the meeting is to be productive, a suitable agenda will have to be prepared. As I have already indicated, we believe that a major item for discussion should be the types and forms of consultative arrangements that might be put in place on a continuing basis. On more substantive matters, we have tentatively thought of the following topics from which agenda items might be drawn:€(1) reporting systems as a means of surveillance; (2) examination practices; (3) capital requirements; (4) controls on foreign exchange exposures; and (5) control of intermediation exposure. We would welcome suggestions for agenda items and

The Groupe de Contact

23

perhaps at the next meeting of your group, which I understand is scheduled for mid-November, consideration could be given to agenda suggestions.9

This was rather a high-profile exposure for what was initially set up as an informal group of (upper/middle ranking) officials. There were some in the group who felt that such an exercise would be inconsistent with its informal status. Given the disparity of views, the decision taken was to play for time, to refuse the initial American invitation to go to Washington for 5–7 December 1974 (on grounds of insufficient time), and to propose instead a later date of 26–28 February. This latter would have given the Groupe a chance to meet again on its own (which it did in London on 13–14 February). But by then the issue had been largely overtaken by the G10 Governors’ decision, at its December meeting, to set up the BCBS as a separate subcommittee to the G10 Governors at the BIS in Basel. Nevertheless there was a meeting of the Groupe in Washington DC, prior to the first meeting of the BCBS, in February 1975. After its normal meeting, the Groupe met with Dahl of the FRB and some other US officials, to exchange views on current systems of banking regulation in Europe and the USA, and also touched on issues of cooperation between banking supervisors in their respective countries.10 Once the BCBS had been established at the December meeting of the G10 Governors, a question arose of where that might leave the regional role of the EEC and the Commission in international cross-border regulatory issues relating to banking. So in the course of its meeting on 11 March 1975, the Committee of Central Bank Governors of the EEC discussed, in the presence of M Henri Simonet, Vice President of the Commission, a proposal to establish a new official committee to advise the Commission on Directives relating to the harmonisation of banking regulation.11 The relationship of the Groupe de Contact with the Commission had been felt to be complex and difficult from the start. As noted earlier, it was discussed at the very first Amsterdam meeting; and whether an EC representative should attend was discussed again in Dublin. The main argument for having an EC representative was that any changes to legal arrangements that might flow (eventually) from the discussions of the Groupe, and be adopted by all the members, would need to be done under the aegis of the EC. The arguments against were that the 9 Letter Mitchell to Galpin, 23 October 1974. 10 I am grateful to Rodney Galpin for this account. 11 This had been foreshadowed in proposals emanating from the European Commission in December 1974.

24

The antecedents of the BCBS

presence of the EC might change the informal nature of the ‘club’. The conclusion of the Dublin discussion was that ‘it appeared too early yet for a definite decision but that the observer would possibly be welcomed provided the character of our group did not change and a suitable person was appointed’. Once, however, the EEC Governors had agreed to establish a new official Committee to advise the EC, initially entitled the Liaison Committee, Dondelinger proposed that Robin Hutton, Director of the Banking Directorate of DGXV, the Financial Services Directorate General at the Commission, be invited to attend the meeting12 (after lunch on the first day, before which ‘sundry items’, i.e. individual banking cases, would be discussed). Thus, from having been the sole (European) group to discuss common cross-border regulatory issues, albeit in an informal fashion, the Groupe de Contact suddenly found itself buttressed, in early 1975, with two newly established official groups, the BCBS on one side and the EC’s Advisory (initially Liaison) Committee on the other. That raised questions of how, and whether, the Groupe should continue, and Dondelinger and Baeyens wrote papers about its future structure.13 It has continued to the present day because its members have found opportunities for informal discussions on such subjects (including the provision of confidential warnings about certain named banking institutions) to be useful. Although overshadowed, in the public eye, by the higher profile official Committees, especially the BCBS (and because the Groupe has never sought publicity), the Groupe was the first in the field. The practices that it adopted fed through into the procedures of the BCBS (see Chapter 3). Moreover, the membership of the Groupe, the BCBS and the Advisory Committee was extremely incestuous in the sense that the same official, from one of the participating EEC countries, would often represent his institution on two, or even all, these groups at the same time. Thus initial representatives on the BCBS of Belgium (Baeyens), France (Fanet), Italy (Monterastelli), Luxembourg (Dondelinger), 12 At this same second Amsterdam meeting, 5–6 June 1975, the Bundesbank asked to participate on the grounds that it was ‘actively engaged in bank supervision’, alongside the Bundesaufsichtsamt. Discussion was postponed. 13 Galpin wrote to me (personal correspondence) that he did not: recall any serious move to argue for the latter’s closure and indeed felt personally that the BCBS and the Liaison Committee were no more than the logical and desirable outcome to the initiative taken in the formation of the Groupe. An important role for the Groupe, as it turned out, was the establishment of very close relationships with other European supervisors.

Eurodollar market, Herstatt, international financial stability

25

Netherlands (Muller) and the UK (Galpin), all had been, and continued on, the Groupe de Contact. The BCBS did not emerge as a pristine organisation; it had behind it in the background the prior experience of the Groupe de Contact. C

The Eurodollar market, Herstatt and international financial stability

Both domestic and international financial systems had become subject to tight controls by the end of World War II. Uncontrolled international capital flows had been blamed for exacerbating exchange rate disturbÂ� ances in the 1930s, and had become subject to widespread exchange controls. These controls were intended to be long-lasting, if not permanent. During World War II, bank lending to the private sector had been restricted, in order to divert funds to the public sector. After the war the needs of rearmament for the cold war (and the Korean War), combined with a desire to construct a welfare state, led to such needs persisting. Moreover, the application of socialism led governments in many countries to believe that they could allocate such private sector credits as were allowed more efficiently than private markets. So in many countries credit expansion was directly controlled, and/or interest rates regulated. In this context the development of an offshore, unregulated, international euro-currency market appeared a serious threat both to the maintenance of the (pegged but adjustable) international Bretton Woods system, and to domestic monetary control. Barry Johnston, in his book The Economics of the Euro-Market (1983),14 writes as follows (pp. 11–16): Throughout the 1960s, and indeed the 1970s, the Euro-currency market grew at a remarkable pace. In September 1963€– the earliest date for which systematic data are available on the foreign currency activities of European banks€– the total short-term foreign currency assets of the commercial banks of nine countries reporting to the Bank for International Settlements was $12.4 billion (of which $9.3 billion was in US dollars). By the end of the decade this aggregate had grown by over 500 per cent to $63.4 billion (of which $53 billion were US dollars), i.e. at an annual compounded rate of around 31 per cent per annum … [The] internationalisation of banking and the growth of the Euro-currency market was importantly stimulated by national controls and regulations introduced in the 1960s and early 1970s to restrict the international flow of shortand longer-term capital. These controls shifted the locus of international 14 See also Dale (1984), especially Chapters 1 and 2.

26

The antecedents of the BCBS

transactions to the Euro-currency markets and away from national banking systems. In early 1965 the introduction of the Voluntary Foreign Credit Restraint Program (VFCR) in the USA severely limited the ability of US domestic banks to lend directly to foreigners. The VFCR, which was part of a larger programme, including the Interest Equalization Tax (IET), introduced in July 1963, and the Foreign Direct Investment regulations (FDI), aimed at improving the worsening US balance of payments by curbing capital outflows. Under the VFCR banks (and other non-bank financial intermediaries) in the USA were asked to keep their loans to foreigners and other foreign assets within a certain ceiling limitation, and during the period up to 1970 the foreign credits of US banks varied within a narrow range of $9.25 billion to $9.75 billion. However, as the programme applied only to the operation of US-based banks and not their foreign branches, it had the effect of shifting the foreign operations of US banks to their foreign branches and the demand for international finance to overseas markets, particularly the Eurocurrency market. Brimmer and Dahl (1975) document the very rapid expansion of the foreign branches of US banks which accompanied these controls. As shown in Table 2.1, at end-1964 only 11 US banks had established branches abroad, operating 181 foreign branches; however, by end-1973, just before the controls were taken off, there were 125 banks with a total of 699 foreign branches, and the total assets of these branches had risen from $7 billion to $118 billion. There was also a sharp increase in the so-called ‘Edge Act and Agreement’ corporations, which are domestically organised subsidiaries that serve as a vehicle for foreign banking and investment. The number of these rose from 38 in 1964 to 104 in 1973 and their assets from $0.9 billion to $6.9 billion.

International operations of US banks:€Selected indicators, 1964–73 Category I. II.

III.

US offices Bank Credit to Foreigners ($ bn) Overseas branches of US banks Number of banks with overseas branches Number of overseas branches Asset of overseas branches ($ bn) ‘Edge Act/and Agreement’ Corporations Number Assets ($ bn)

1964

1970

1973

9.4

9.7

17.2

11 181 6.9

79 536 52.6

125 699 118

38

77

104

0.9

4.6

6.9

Source:€Brimmer and Dahl (1975)

… In the USA, under Regulation Q, ceilings were imposed on the level of interest rates banks were permitted to pay on deposits in the USA (but not their

Eurodollar market, Herstatt, international financial stability

27

branches abroad). When credit was tight in the USA and market interest rates moved above the Regulation Q ceilings, banks in the Euro-currency market had an interest-rate advantage in attracting dollar deposits. The impact of these ceilings on the growth of the Euro-dollar market was particularly marked in 1968 and 1969 as interest rates rose during a period of credit restraint … Western Europe domestic corporations also used Euro-markets as a source of funds when the supply of domestic credit was restricted. Under tight monetary conditions West German enterprises were reported to have obtained about one-third of their total borrowing needs from abroad in 1970; and UK business firms borrowed heavily in the Euro-currency market during 1969–70 when there were quantitative limitations on the supply of domestic bank credit. In both countries controls on the import of capital had to be tightened to insulate the domestic market from external flows. On the other hand, the Italian authorities gave active encouragement to Euro-dollar borrowing by Italian corporations as a way of financing Italy’s external payments deficit and as a supplement to domestic savings. Other monetary regulations favoured the growth of the Euro-currency market. Unlike the situation in the US and West German domestic markets, Eurobanks were free from the requirement of holding non-interest-bearing reserve balances against deposits. These balances are held primarily for the purpose of domestic monetary control in these countries. The absence of these domestic regulations in the Euro-market enabled banks to offer higher deposit rates, and short-term Euro-dollar interest rates were usually some 0.5 per cent higher than in the US domestic market. Moreover, while it was illegal in the USA to pay interest on demand deposits and time deposits of less than thirty days, there were no such restrictions in the Euro-market. It was also reported that in making loans Euro-banks could operate on narrower lending margins, determined in a freely competitive market, than in national markets, where lending rates tended to be partly administered. This general freedom that the Euromarket enjoyed from regulatory constraints and the associated advantageous interest-rate terms it offered to both depositors and borrowers, the different constellation of geographical, sovereign and institutional risks in the Euromarket compared with national money markets, the relative freedom of capital movements and an emerging desire by wealth-holders to internationalise their investments, all added to the attractiveness of the Euro-currency markets to depositors and thus to the supply of foreign currency deposits to banks.

Some more general statistics are given in Dale (1984), The Regulation of International Banking, Table 1, p. 5: There was a discussion of the Euromarkets in the Groupe de Contact’s Dublin meeting in June 1973; at that time the respective participants noted that the following percentages of banking assets in their countries (roughly) were held in euro-currency assets: Netherlands Belgium Luxembourg

40% 30% to 40% up to 80%

2.8 38.7 193.5

US Dollars (bn) 20.3 187.6 751.2

Average Annual Rates of Growth (%) 29.4 35.4 37.4 45.6 21.9 25.8

1966 1973 1980

1966–80 1966–73 1973–80

28.4 33.6 23.4

17.4 132.0 575.0

3. Euro�currency Market, Net Size

28.4 31.6 25.2

51.8 354.5 1,711.3

4. Deposit Banks’ Foreign Assets

27.2 30.0 24.4

61.3 384.7 1,777.8

5. Deposit Banks’ Foreign Liabilities

NA NA 27.0

NA 31 165.0

6. Net New International Bank Lending

NA NA 26.5**

NA 10 41*

7. Net New International Bank Lending To Non-Oil LDCs

Notes:€* 1979; **1973–9. Sources:€Columns 1–3, BIS Annual Reports; Columns 4 and 5, IMF, International Financial Statistics; Columns 6 and 7, BIS and IMF International Capital Markets (Occasional Paper), September 1980. Columns 4 and 5 refer to IMF ‘world’ aggregates (all countries). Reproduced from A. K. Swoboda, ‘International Banking:€ Current Issues in Perspective’, Journal of Banking and Finance, September 1982.

2. Eurocurrency Claims on NonBanks

1. Eurocurrency Assets, Total

Table 1. Indicators of international banking and lending growth

Eurodollar market, Herstatt, international financial stability

29

(though one needs to remember that these were unofficial and, possibly unprepared, comments). Be that as it may, by the early 1970s the Euromarkets had become a major feature in the international financial system. From its earliest days the Eurocurrency market had developed as a means of evading, and thereby profiting from, direct domestic controls. Thus, as Dale (1984, pp. 9–10) notes: The modern evolution of the Eurocurrency market may be said to have begun in the early 1950s when the Soviet Union, allegedly fearing that the United States might block its dollar reserves, decided to deposit dollars in a Sovietowned Paris bank, Banque Commerciale pour l’Europe du Nord (known as ‘Euro-bank’€– hence the term Eurodollars). In September 1957 the market was given a major stimulus on the demand side when the UK authorities imposed a ban on sterling credits to finance trade between third countries, the result being that London-based banks began to bid for dollars as a new source of funding for this business. It is significant that the post-war development of the Eurocurrency market should have begun in the first place in anticipation of a US regulatory initiative and in the second place as a positive response to UK restrictions on the use of sterling; for it is a basic contention of this book that both multinational banking and the Eurocurrency market on which it feeds are to a large extent the creation of national regulatory arrangements.

Since much of the rationale and profitability of the euro-currency markets arose from exploiting and bypassing domestic monetary controls, it is not surprising that (most of) the monetary authorities (initially at least) viewed this development with suspicion, if not downright hostility. This was particularly so for the Americans, where the effect of the Euromarkets in neutering their controls has already been noted, and for the Germans, where the Euromarkets made it much harder for the Bundesbank to combine adherence to the pegged exchange rate with tight domestic monetary policies (to control inflation). The discussion was also spiced by an accompanying, somewhat esoteric, theoretical debate about the proclivity of the euro-currency system to lead to a significant expansion of the world’s money supply. One facet of monetarist analysis (at that time in conflict with traditional Keynesian theory), was that the money stock was determined by the money multiplier, connecting the money stock to the high-powered monetary base and a multiplier dependent on two ratios, the deposit/ reserve ratios and the deposit/currency ratio. The formula is: M = H.

D/R(1+D/C) D/R+D/C

Indeed Friedman and Schwartz’s great book A Monetary History of the United States (1963) is largely built around an analysis of the factors causing changes in each of these variables; see pages 50–53 in particular.

30

The antecedents of the BCBS

A key feature of the euro-currency market was that, as already noted, there was no required reserve ratio at all. Moreover, most banks reckoned that they could always attract more euro-currency funds (to meet outflows) by bidding for them (or by selling domestic cash reserves for foreign currency in the foreign exchange market). Thus, in the Eurocurrency markets the D/R ratio, the deposit reserve ratio, appeared to approach infinity, implying (to some) that an injection of new dollars, say, into the euro-dollar market could multiply without limit. The counter-argument, however, was that the Euromarket was not a closed system, so that injections of new funds would normally be matched by leakages, leading to very little net expansion. This issue is discussed at length in Johnston (1983, Chapter 9), who concludes on pp. 242–3 that: There is a broad range of estimates about the size of the Euro-currency multiplier, particularly where a fractional reserve multiplier theory is concerned. Most, if not all, approaches which recognise that the Euro-market is an open banking system strongly indicate, however, that its endogenous credit-Â�creating ability is very small. These conclusions are based on plausible judgements about the size of leakages from the market into other assets. Allowing for leakages to markets outside the USA and for central bank redepositing could raise the multiplier estimate, but even under extreme assumptions it is by no means huge and many qualifications have to be made.

Even assuming that this latter argument is correct, as I believe it to be, the absence of any required reserve ratio gave the offshore Euromarket a marked advantage over onshore banking markets subject to such required ratios. For such reasons campaigns to curb the growth of the Euromarkets commonly involved attempts to impose (common) required reserve ratios on all deposits, whether on or offshore. This discussion came to the fore in 1979/80; see Johnston (1983, Chapter 10). In the early 1970s, however, the main concern of the authorities was to prevent the Euromarkets from disturbing the maintenance and/or restoration of the Bretton Woods fixed exchange rate system. As Johnston notes (1983, Chapter 10, pp. 248–9): The regular meetings of central banks at the BIS in Basle had long provided a forum for the discussion of macroeconomic and prudential issues raised by the growth of international banking, and in April 1971 a Euro-currency Standing Committee was formed to examine and make recommendations on policy questions arising in relation to the Euro-currency market. One result of consultations was the agreement reached among the Group of Ten central banks in June 1971 not to increase official placements of foreign exchange reserves in the Euro-currency market€– the so-called ‘self-denying ordinance’. The underlying reason for this agreement was that in a world of fixed exchange rates and restrictions on capital outflows from the USA central bank placements were a potentially important source of deposit growth in the Euro-currency market.

Eurodollar market, Herstatt, international financial stability

31

However, since the agreement only covered the Group of Ten central banks, it did not affect reserve placements by other countries that were quantitatively more important. In the early 1970s there were also discussions about the need for general measures to curb the rapid expansion of the Euro-currency market. Following the 1973 oil crisis, the focus of attention shifted to the adequacy of Euro-market liquidity and the ability of the markets to withstand the recycling pressures imposed by the OPEC surplus.

The world was, indeed, turned upside-down by the fourth Arab-Israeli war in October 1973, by the subsequent cut-back in oil production by the Arab Gulf States, and then the quadrupling of oil prices from $5–6 to over $20 per barrel over the course of the next year. All this had the effect of reversing (official) concerns about the Euromarket, from worries about whether it was too expansionary (to be consistent with the Bretton Woods pegged exchange rate system), to worries about whether it was too anaemic and unstable to play a major role in recycling petrodollars from oil-exporting (OPEC) countries to oil importers. By June 1974, The Economist (1 June) had a lead article entitled ‘The approaching depression’, pp. 69–70, where it stated that ‘The problem is to recycle the money from the strongest economies, where it will be invested, to the weakest where it will be needed.’ This concern was given particular emphasis by the subsequent collapse of the private German bank, Bankhaus Herstatt on 26 June 1974. Although quite small, it had taken large speculative positions in the foreign exchange market. The foreign exchange market was then settled in two legs; thus a Dm/$ trade would have the Dm leg of the final transfer settled in Germany during German market open hours, and the American counterpart transfer of dollars in New York during its later opening hours. When Herstatt became clearly insolvent, the German authorities shut the bank and appointed a receiver after German markets had closed but before the US markets had closed. Once a receiver is appointed, he insists on all due payments inward being made, but refuses to make payments out, until bankruptcy proceedings are concluded. Consequently, banks which had sold Dm to Herstatt, and expected dollars back, had already transferred the Dm to Herstatt in Germany, but were left high and dry with no counterpart transfer to them of counterpart dollars in the USA. This led to some sizeable losses.15 This debacle led to a sudden realisation among the authorities of the risks involved in foreign exchange (fx) 15 The Economist, 6 July 1974b, reported on p. 104 as follows: The collapse of Germany’s largest private bank, I.€D.€Herstatt, has not spread into a financial panic; the Bundesbank has calmed the fearful. Other banks have been helped out with fairly unorthodox measures:€they can borrow from the central bank at 9% instead of 10%. The losers so far include Morgan Guaranty Trust Company of New

32

The antecedents of the BCBS

dealing. A new term, Herstatt risk, was coined to connote the risk involved in the temporal separation between the two legs of fx deals (a risk that was only eliminated recently with the foundation of the CLS settlement system enabling fx deals to be settled on a payments vs. payment (pvp) basis). This shock led to a temporary cutback in trades, deals and settlements in the fx market, the world’s biggest and most important market. As, or even more, important than the disturbance to the fx market, this failure led to a general reassessment of the risks inherent in Euromarkets. Even though Herstatt was not a major player in the Euromarkets itself, its failure was a catalyst for revisions of risk assessment, much more so than the earlier failure of Franklin National (13 May 1974) despite the fact that the latter was much bigger; ‘at that time Franklin was New York’s largest commercial bank and twenty-third largest in the USA’ (Johnston 1983, p. 29). The Economist, on 3 August 1974c, pp. 55–7, wondered aloud whether there might be ‘A world banking crisis?’ in the aftermath of Herstatt. This had three interconnected facets: The three big international banking problems of the moment are the dangerous curb in foreign exchange markets, the uncertainty about how oil money will move in the two usual crisis months of August and September, and the way in which fears of crashes are causing money to be withdrawn from small banks all round the world.

On the foreign exchange (fx) side: The mishandling of the Herstatt bank’s recent failure has caused the big New York banks to curb foreign exchange deals, with the result that there is now no properly operating forward market anywhere. The lion’s share of international money€– and thus more and more control over foreign exchange markets€– is going to certain big and Arab-favoured New York banks (especially Citibank, Morgan Guaranty and Chase). After their losses from Herstatt the big banks in New York are delaying foreign exchange deals for any suspect European or Asian banks, for many smaller banks and for most French and Italian banks.

On the recycling of oil money: The Arabs are at present believed to be pouring their billions of dollars into just two main forms of investment:€into short-term deposits at the biggest New York banks (such as Citibank, Morgan Guaranty and Chase) and into shortterm Eurodollar deposits with big London and European banks. Note that a Eurodollar deposit even in a London bank does not help sterling. There are York, down for £5.4m, the First National Bank of Seattle, which shelled out £9m and did not get the D-marks in exchange and Hill Samuel, which, unable to complete the second half of a £9m exchange transaction because the Herstatt banking licence was revoked plumb in the middle of American banking hours, stands to lose £1m or so unless the Germans do the decent thing.

Eurodollar market, Herstatt, international financial stability

33

two urgent questions about recycling for the next few weeks. One concerns sterling … The other urgent question about recycling is whether the short-term Arab deposits going into a handful of the world’s biggest banks can continue to be Â�re-lent. The banks concerned are not willing to lend long what they have borrowed short, they are often nearing their self-set limits on how much they will lend to any particular country or sector, or deposit in any particular other bank, or indeed how much they will lend to anybody because their capital-to-asset ratios are strained. Optimists say that this Arab desire to put money only in short-term deposits will be corrected by market forces, because short-term interest rates will fall as the big banks try to discourage the short-term money they cannot use, so the Arabs will try to get higher returns by stretching out their maturities and investing in longer-term assets. But if the Arabs are putting so much of the world’s money into unusable deposits, the fall in world demand thus caused may precipitate financial crashes, and the Arabs’ reaction to these crashes may be to insist on even shorter-term deposits with the biggest institutions only.

The third worry related to increasing risk premia, especially for smaller banks, and banks from weaker countries: There are dangers of current losses in the Eurodollar market because banks that are not on the Arabs’ favoured list are sometimes having to pay premium rates to get funds to refinance roll-over loan contracts at lower rates than the premium deposit rate costs them, which could be very serious. And all of these strains on smaller- or medium-sized banks (or banks in countries whose governments’ economic policies are suspect) are occurring at a time when some of their customers are going to go bust, when post-Herstatt jitters mean that foreign exchange deals may be delayed for them, when the first whiff of even a false rumour is liable to cause a run. Central banks need to learn again the right policy for a situation of this sort. The right policy is not to say ‘we must tighten controls on Euromarkets’. It is now in some respect the reverse:€to make sure that money supply is not cut by large amounts by accident.

Likewise the monetary authorities had, prior to Herstatt, been reasonably relaxed about the euro-currency market. Following the oil shock, it was now seen as a key element in the process of recycling the oil money (that could not be spent in the OPEC countries), but in some ways that was even quite a relief for the centres of the euro-currency market, in London, Luxembourg and Switzerland, who were no longer having to fend off attempts by Germany and the USA to impose (common, ratio) controls on the market.16 16 In a UK briefing note written later that summer, the following Sections were written about the Euromarket: The Euromarkets have so far absorbed oil money without serious mishap. The rise in deposits was probably more than $20 billion in the first half of 1974. The UK, France

34

The antecedents of the BCBS

The increased use of the euro-currency markets for recycling led, however, to a perceived need for more data and information. Thus, on 10 May 1974 Gordon Richardson, the new (since 1973) Governor of the Bank of England, wrote to René Larre at the BIS about exchanging information on these markets that: I understand from Kit McMahon [of the BoE] that there was some discussion on this subject at the Working Party 3 meeting in Tokyo; and that Emminger suggested a regular exchange of information on developments each month at Basle. This seems to us a useful idea, although€– as Kit pointed out€– banker/ customer confidentiality would, of course, have to be preserved. In fact, a note summarising recent developments in the Euro-markets, and based entirely on published information, is prepared here in the Bank each month for our own purposes. It occurs to me that my colleagues, and yours, might find it a useful background document.

Similarly there was a, relatively relaxed, discussion of the Euromarkets and recycling at the G10 Governors, at that time chaired by J. Zijlstra of the Nederlandsche Bank, meeting in Basel on Monday 10 June, shortly after the Herstatt collapse. The British record of the meeting (Overseas Information and Records Section, 3A 162/5) indicates that four items were discussed. There was first a brief discussion on the rules and guidelines for their Euromarket operations of banks headquartered in each country,

and Italy have all borrowed substantial sums through this market. Some recent signs of strain have had nothing to do with the state of the market generally; the failure of Herstatt and Israel-British, for example, were due to mismanagement and speculative foreign exchange activities, rather than to any inherent instability in the market. However, the markets’ capacity for intermediation may be strained from now on. Partly as a result of possible over-prudence on the part of oil producers, deposits are mainly short-term and are being concentrated very heavily with a relatively small number of prime banks. The capital base of these banks is being severely strained as a result. And there is a problem of maturity transformation, since much of the demand is for medium term loans. But the constraints being felt on this account are not just due to the influx of oil money. Liquidity problems, high interest rates, inflation and unmarketable investments are all causing difficulties. But we must not be complacent about the situation. There is a danger that the failure of one or two banks, even if not as a direct result of their operations in the Euromarket, might have a domino effect and lead to a general loss of confidence. Governments and central banks must make it crystal clear that they will not stand by and let a major institution collapse. And the UK must insist that the country of the head office must be responsible for bailing out a bank which has failed. We insisted on this line with the Israel-British Bank and we know that the US are thinking on the same lines. We must avoid having to foot the bill for any failures of foreign banks operating in London. At the same time, the fact that the few large banks are at their capital ratio limits has important implications. The oil producers have tended to place deposits with them partly because they are familiar, and so presumably safe, names. They should now be encouraged to place deposits with slightly smaller, but still thoroughly reputable

Eurodollar market, Herstatt, international financial stability

35

and ‘everyone agreed that they would try to answer a questionnaire on the subject which Larre (BIS General Manager) is to send out’. The second issue was where lay the responsibility for decisions on Lender of Last Resort. Governor Richardson opened the discussion with: a statement of our belief that while prime responsibility should be deemed, a priori, to lie with the central bank of the parent organisation, the initial responsibility for mustering support would probably fall on the host central bank; and a plea that there should be no attempt to formulate hard and fast rules€– banks should be neither automatically bailed out nor automatically abandoned on any general criterion:€we should be concerned above all with the health of the system as a whole and willing to co-operate to the utmost. This view was repeated by Zijlstra in his summing up; nobody controverted it and it may be deemed to have received general assent.

This led on, naturally enough, to a discussion of the Herstatt affair. There were three strands to this. First, much of the fx dealing by Herstatt that led to its collapse had been done in Luxembourg. There was some ‘controversy’ over whether Luxembourg banking secrecy may have contributed to the debacle, an issue which was later ‘resolved’ by Dondelinger, the Luxembourg banking commissioner, who offered to assist other central banks, as far as possible, on a confidential basis. Second there was some discussion on how to handle ‘Herstatt risk’, that is the time lag between the two legs of the fx (spot) transaction: The third strand of discussion, arising from the Herstatt affair but going much wider, was the growing split between the very big banks and the rest. Virtually all governors adduced evidence from their own centres of the increasing difficulty which medium and smaller banks, however solvent and well-run, were having in getting hold of money. The Governor pointed out that the danger we confronted now was not of lax banking, but of ‘over-prudence’. The potential seriousness of the problem was accepted by all; and it was agreed that it underlined the importance of continued close collaboration and interchange of information between the main central banks.

The fourth main subject was whether it was still sensible to continue the earlier self-denying ordinance whereby central banks were to refrain banks. But they will not do so unless confidence generally is high€– so Governments should do all they can to bolster confidence in the Euromarket as a whole. The BIS may also have a useful role to play. Agreement has been reached that they should be ready to accept and, indeed, seek to attract, deposits from oil producers, if possible on a medium term basis. Operations of this sort might need to be guaranteed by governments. Developments on these lines would be a useful complement to the Eurodollar market generally, but the BIS itself comes up against capital ratio problems so the possibilities for intermediation through this channel are limited.

36

The antecedents of the BCBS

from investing funds into the Euromarkets. Richardson and Carli (Italy) could see circumstances in which some injection of liquidity into these markets could be useful, but Klasen (Germany) was still worried about its inflationary implications. Later, at the dinner that night there was some further (but preliminary) discussion whether the BIS might itself act as a ‘recycling agent’ in the Euromarkets. Prudential worries about the Euromarkets and their ability to act as a recycling channel, however, increased during the summer months17; and reached the highest political levels€– Chancellor Schmidt of Germany, in particular, was reported as being concerned about the issue€– so much so that a series of three meetings, primarily focussed on Euromarket issues, was held in early September 1974. These were, in order: 1. A meeting of G6 Officials18 at the Banque de France, Friday, 6€September. 17 Kapstein (2007, also see 1994, Chapter 2) attributes some of this worsening to a failure of the G10 central bank Governors to issue a (calming) press statement after their June meeting. Whether or not he is correct in so doing, I do not know; the relevant paragraphs are reproduced below: If we return to June 1974, when the G-10 central bankers gathered in Basel for one of their regular meetings at the BIS, the health of the international financial system was poor, and the prospects for international cooperation to revive it seemed negligible. Financial markets were reeling under the strain of the oil price shock, the collapse of Bankhaus Herstatt, and the implosion of Franklin National. In Britain, a number of ‘fringe’ banks had fallen, requiring a Bank of England lifeboat operation. Financial intermediation in the Euromarkets was grinding to a halt as banks sought to reduce their risk profiles, and many banks were being squeezed out of the interbank lending market altogether, threatening credit availability worldwide. The question of how central bankers ought to respond to this financial instability was the topic of the day. And vociferous disagreements were expressed around the table. The United States argued that central bankers should send an explicit signal that they were prepared to provide lender of last resort service to banks operating in the Euromarkets. The Germans refused to make such an explicit statement, for several reasons. First, they said that they had no mandate to announce such a policy. Second, they thought that banks that had failed due to managerial incompetence ought to be allowed to collapse and not be bailed out. Finally, they said that any blanket assurances would create severe moral hazard problems for the financial community. The meeting thus broke up without a G-10 agreement, suggesting the limits of models of international cooperation among financial supervisors that parsimoniously emphasize only collective concerns with stability. But the central bankers were not let off the hook by their domestic financial intermediaries. As word spread of the disagreement, small banks started to be shut out of the interbank markets, leading them to place strong political pressure on their financial supervisors. Influenced by these domestic actors for a stronger statement, the central bankers returned in September for another gathering. This time, their views converged and they were able to make a formal announcement about their market intentions. 18 G6 was a slight misnomer. It had been the G5 group (France, Germany, Japan, UK and USA), but Italy had lobbied for inclusion. But the Italians were only (at the last minute) invited to part of the ministerial meeting, and so, in dudgeon, pulled out of the prior official meeting.

Eurodollar market, Herstatt, international financial stability

37

2. A meeting of the G6 ministers of finance and central bank Governors, Weekend, 7–8 September. 3. Basel meeting of G10 Governors, 9–10 September. In the first official meeting, the Americans (Bennett, US Treasury): began the discussion on supervision and surveillance in the Euromarkets by saying in firm terms that the Central Bank Governors would have to agree a joint public position on the question of lender of last resort by the Annual Meetings at the latest. As the discussion proceeded, Mitchell [UK, HMT], de Larosière [France] and Weber [Germany] gave general support to this view.

But exactly which central bank should be responsible for foreign bank subsidiaries, branches or, even worse, consortium banks? It was generally agreed that foreign branches of banks should involve no ambiguity of responsibility:€as an integral part of the parent bank the branch should be clearly the responsibility of the parent, and if the parent itself were in difficulties any responsibility to help it lay squarely with its central bank. Wallich [USA] pointed out that if the parent itself were insolvent, the central bank might be legally prevented from providing support … Bennett then asked Emminger and McMahon whether their central banks would provide support to a subsidiary of a German or British bank elsewhere. Emminger produced a moment of consternation when he said flatly:€ No. However, what he meant was that the Bundesbank would not and probably could not provide support directly to a subsidiary of a German bank in London:€but he gave a quite firm assurance that they would provide assistance to a parent which needed it€– and would also be prepared to put some pressure on the parent bank if it appeared to be reluctant to help out its subsidiary. McMahon said the Bank of England would behave similarly … It was left that the Central Bank Governors would consider these questions and the possibility of a statement further at the forthcoming Basle meeting. Wallich and McMahon warned that a statement which appeared to show more agreement than actually existed or could be represented as too limited in what it promised could do more harm than good.

The official caravan now rolled forward to the Chateau de Champs, for the weekend ministerial meeting chaired by M Fourcade, the French Minister of Finance. In his summary of the first session on Euromarkets and recycling, M Fourcade: said that he thought there was general agreement on the following points: (i) The massive increase in the price of oil had created grave economic and political problems. Arrangements were required that would ease the situation by ensuring the orderly recycling of funds. (ii)╇T he Finance Ministers were agreed that Governors of central banks should make progress, and be seen to make progress, at Basle on arrangements to

38

The antecedents of the BCBS improve the organisation of the international money markets. The govern� ors should work during dinner on a form of words which could be used in press guidance at the end of the present meeting.19

Earlier in that same session: The Chancellor [Mr Barber] expressed the hope that the central bankers would agree at their immediately following meeting in Basle on adequate systems of information and effective surveillance, and also on rules about acceptance of responsibility if banks found themselves in temporary liquidity difficulties. Burns thought that all this could only be of limited usefulness, but Fourcade and Simon underlined the need to define, and perhaps enhance, the responsibilities of central bankers. Clappier suggested that the objectives should be to improve the flow of information between central banks; to devise measures that would reduce the risk of failures; and to define the responsibilities of central banks for their banking systems. But he added that any formulae should not be too precise, so as to avoid the risk of creating an excess of confidence among bankers. This statement of the objectives received general assent.

In the event, M Fourcade went somewhat further in his press conference than had been anticipated, and gave the impression that the G10 central bank Governors would be making an announcement at their subsequent Basel meeting, on the following two days, of measures to monitor and support the Euromarkets. So, the Governors found themselves under intense pressure to come up with some form of words to that general effect. Not surprisingly in these circumstances, the G10 Governors meeting on 9–10 September (1974) was ‘entirely dominated by the question of the euro-markets’ (C. W. McMahon, Note for the Record,

19 Agreed Press Guidance Within the framework of their periodic meetings, the Finance Ministers of the Federal Republic of Germany, Great Britain, United States, France and Japan, who were joined by the Finance Minister of Italy, have met at Champs-sur-Marne on 7th and 8th September 1974. They had asked the Governors of the Central Banks of their country to attend the meeting … With regard to the movement of capital, they agreed on the necessity of reinforcing and of diversifying the recycling mechanisms … The Finance Ministers agreed on the necessity for monetary authorities to intensify exchange of information on the situation in the international markets and the operations of the Eurobanks. They agreed on the desirability of the strengthening the surveillance of bank foreign operations. They noted with satisfaction the responsibility which is being generally assumed by the Central Banks here represented to come to the assistance of domestic or foreign banks in temporary liquidity difficulties.

Eurodollar market, Herstatt, international financial stability

39

12€September, Bank of England, BAMMS file 6A. 115/5). The British line at this meeting: was broadly, as hitherto, that the only workable solution was a general understanding of the shared responsibility by parents. Schemes for harmonisation, or elaborate ratio controls, etc., would not only involve massive delays and immense technical complexities but would prove irrelevant to the problems in hand. However, he [Gordon Richardson] recognised two kinds of difficulties€– 1. that there was an awkwardness for a central bank to assume even indirectly responsibility for an institution in another centre where the central bank had not only no power to impose rules, but might not have access to information about an institution; and 2. that there were in some countries (especially the US) legal restrictions on the powers of the central bank formally to help parent banks or force those banks to support their subsidiaries.

As to the need for some public press communiqué: most Governors expressed the view that though they would prefer not to do so because of the risks, they felt their hands had now been forced by the restricted meeting in Paris and Fourcade’s press conference … [Leutwiler (Switzerland) was concerned with] the legal restrictions on his power to help:€ he could only provide liquidity against money-market paper or Lombard assets and many banks that might get into trouble would have neither, or would already have used them as collateral to other banks. [Much the same complication existed in Germany, which was the reason for their establishing a new Liquidity (Liko) bank.] However, in the end he was convinced that in all the circumstances it would be now worse not to issue a statement than to issue one, and was prepared, somewhat reluctantly, to go along with the statement at issue. All the Governors agreed to go no further than the terms of the press announcement in dealing with journalists in their own capitals.

The press communiqué (10 September 1974) read as follows: At their regular meeting in Basle on 9th September, the Central-Bank Governors from the countries of the Group of Ten and Switzerland discussed the working of the international banking system. They took stock of the existing mechanisms for supervision and regulation and noted recent improvements made in these fields in a number of major countries. They agreed to intensify the exchange of information between central banks20 on the activities of banks operating in international markets and, where appropriate, to tighten further the regulations governing foreign exchange positions. 20 One could well ask why the IMF was not brought in to this. The answer, I believe, is that the Fund answers to political masters, and the central banks wanted to keep the politicians at bay on such issues.

40

The antecedents of the BCBS

The Governors also had an exchange of views on the problem of the lender of last resort in the Euro-markets. They recognized that it would not be practical to lay down in advance detailed rules and procedures for the provision of temporary liquidity. But they were satisfied that means are available for that purpose and will be used if and when necessary.

Most attention was attracted to the gnomic final paragraph, whose exact meaning was (intentionally) opaque.21 In practice, however, it was the middle paragraph that had the greater operational effect. Much, perhaps most, of Euromarket activities was undertaken by branches, or subsidiaries, of banks headquartered abroad (or, even trickier, by consortium banks). Now that the central banks had accepted responsibility for maintaining oversight of systemic stability in this (international) arena, the question was how this could be done? What would be each central bank’s responsibilities, and how could they 21 In November 1974, Euromoney asked six well-known financial experts to take part in ‘Controlling the Euro-dollar market€– a debate’, pp. 18–24. Those taking part were: Alberto Weissmüller, managing director, United International Bank, London; Harold van B. Cleveland, vice-president, First National City Bank, New York; Dr Walter Seipp, member of the managing board, Westdeutsche Landesbank Girozentrale, Düsseldorf; Herbert Baschnagel, manager, Swiss Bank Corporation, Zürich; André Coussement, general manager, Kredietbank Luxembourgoise, Luxembourg, and Takamasa Matsuda, chief manager, research department, Fuji Bank, Tokyo. In response to a question: Do you consider that the recent Basle agreement on support for banks in trouble is likely to prove of any great practical importance? Weissmüller:€ I am not aware of any specific and concrete agreement at Basle to support banks in trouble. What is clear, particularly after the recent IMF meetings in Washington, is that central banks appear more willing to co-ordinate their actions in case of need within their respective banking communities. This increased co-operation is a very positive step forward in re-establishing confidence in financial markets. Seipp:€T he Basle agreement, no doubt, left many questions unanswered, and there is still not yet any official confirmation of the results of the conference. Above all it has not yet been clarified who should intervene to back up the numerous consortium banks in the Euromarket in case of liquidity difficulties. However, the psychological effect of the Basle agreement should not be underestimated. An agreement in which for the first time the central banks indicate in unison their willingness to take on the role of ‘lender of last resort’ on the Euromarket must be an important factor in Â�re-establishing confidence in this market. Baschnagel:€ To my knowledge, very little has been agreed upon. However, I believe the central banks were right in avoiding being specific, first because it is almost impossible to specify in advance who would come to the rescue of whom and under what circumstances, and second because it was realized that a bank can get into trouble for a variety of reasons, such as bad management, not all of them meriting outside help to the same degree. Coussement:€I hope that there will never be a need for the Basle agreement to be of practical importance, but the mere fact that it exists will no doubt help to bolster confidence, and that is what we need …

Eurodollar market, Herstatt, international financial stability

41

obtain the information to carry out such responsibilities (especially given the legal requirements for bank secrecy in such key countries as Luxembourg and Switzerland)? McMahon’s Note for the Record of the September meeting (BAMMS file 6A. 115/5) gives no indication that the Governors were yet thinking of establishing a new subcommittee to pursue such issues; though he does note that ‘Future developments that may be helpful here are the forthcoming meeting of Dondelinger’s Groupe de Contact of supervisory people from a number of major countries in Copenhagen’. Dondelinger, himself, though not a governor, participated in some of the Basel sessions, and was instrumental in subsequently composing a letter to the President of the G10 Governors (Zijlstra, Netherlands) on the current and potential future work of the Groupe. Moreover, the Governors would in most cases have become aware of the American approach to the Groupe to widen it to include representatives from the USA, Canada and Japan. But the Dondelinger Groupe de Contact was not only unofficial, it also included representatives from prudential authorities, which were not central banks. About half of its participants came from such specialised prudential authorities. It could not, in its existing form, simply be transmuted into a subcommittee of the G10 Governors. There must have been an exchange of letters, and/or numerous telephone calls, on how to adapt the Groupe de Contact into a format that would be more appropriate for an official committee under the aegis of the G10 Governors (though I have not found such records to date). The solution was quite elegant, which was that each country should have two representatives, of which one would be a prudential expert, who in several countries concerned would be from the prudential authority, not from the central bank, while the second would have to be from the central bank. But what was the second central bank representative to do? The Herstatt collapse had caused major problems for, and severe losses in, the foreign exchange market.22 Moreover, any banking crisis in the euro-currency markets could well be accompanied by instability, if not Matsuda:€ The Basle agreement seems to me to have helped to dispel the credit uneasiness in the Euromarket and to that extent has been of practical significance. 22 At almost the same time as the BCBS was founded, Gordon Richardson circulated a note to the other G10 Governors on improving standards in the fx market (20 December 1974). It read: Dear Mr Governor, The losses suffered this year by banks in a number of countries as a result of imprudent, often unauthorised, foreign exchange operations have naturally caused concern, not least because of their serious impact on confidence in the markets.

42

The antecedents of the BCBS

worse, in currency markets. So, it was proposed that the second (central bank) representative should (normally) be a foreign exchange expert. The next question to be answered was which countries would participate in this new committee. The G10 countries were Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, UK and USA, plus (as already noted earlier) Switzerland. They became members as of right. But this excluded Ireland, Luxembourg and Denmark, who already had seats on the Groupe de Contact. The most difficult question related to Luxembourg, partly because of its key role as a major international/Euromarket centre in Europe, and partly because of the central role of Dondelinger himself. Earlier in December 1974, it had been agreed that Dondelinger could be admitted as a member of the EuroCurrency Standing Committee, as an offshoot of Belgium23 (he sat next to the Belgian representative). Given his even greater role in founding the Groupe de Contact, it seemed churlish to deny a place on the BCBS to him, and/or to another Luxembourg representative. But the compromise was made that, since Luxembourg had no independent central bank, they would have only one representative, compared to everyone else with two (or in some cases, e.g. the USA, more than two). Trying to get agreement on the respective responsibilities of parent (commercial) banks for their respective branches, subsidiaries and joint consortia, and thence on their home and host central banks for crisis management (and (possible) Lender of Last Resort support), had for many years been a prime concern of the Bank of England. As usual, there was more than a little self-interest involved. With London being the main centre for the euro-currency market, and host to a large I am sure that all banks have been rigorously reviewing their own practices. But we consider that there are a number of points which it is particularly important should be included in such reviews; and there are some gaps in our knowledge of the foreign exchange activities of banks over which we exercise supervision. Accordingly I have today sent a note on these matters, or have arranged for it to be sent, to all banks registered in this country which are authorised by the Exchange Control to conduct operations in foreign exchange. It is also being sent for information to branches here of overseas banks which are similarly authorised. I thought that it might be of interest to you to see the note, and so I enclose a copy which I hope you will find selfexplanatory. You may like to know that in my covering letter to British banks I have told them that it follows from the undertakings about ultimate responsibility, which the Bank have recently sought from banks which are shareholders in banks registered in this country, that British banks must be expected to accept like responsibility for banks overseas in which they have shareholdings. It is therefore incumbent on such shareholding banks to satisfy themselves, in their own interests, that the foreign exchange activities of the relevant overseas banks are conducted to high standards. 23 At that time Luxembourg was in a monetary union with Belgium and did not have a separate central bank.

Eurodollar market, Herstatt, international financial stability

43

number of foreign bank branches and subsidiaries, the Bank did not want to be left with sole responsibility for picking up the pieces if anything went wrong. So Gordon Richardson was a leading proponent of this prospective new committee. Moreover, having previously been head of a London investment bank (Schroders), he was seen by his confrères as knowÂ� ledgeable on such prudential issues. With the Europeans having already had a track record on cross-border regulatory joint discussion, the Chairman really had to come from a European country, and ideally a country in which the central bank was involved in prudential supervision. That narrowed the field down to Italy, Netherlands and the UK. The effective choice probably (though this is surmise) lay between Huib Muller of the Netherlands and a nominee of the Bank of England. At that time J. Zijlstra of the Nederlandsche Bank was also President of the G10 Governors, and, as such, could not press his own candidate, although Muller had more experience in the field. Be that as it may, it was agreed by the other G10 Governors that the Bank of England should nominate the first chairman of this new committee. After the fringe bank crisis in 1973/4 (see Reid, 1982), the Bank had become aware of the need to give many more resources, personnel and effort to banking supervision (than had been employed in the old Discount Office, which had only employed a handful of officials). A whole new department, for Banking and Money Market Services (BAMMS) had been formed earlier in 1974, and George Blunden was appointed its head. (The previous Principal of the Discount Office, P.J. Keogh (see Goodhart 2004), had taken much of the blame for the fringe bank crisis, and retired early.) His Deputy, Rodney Galpin, was not implicated in the same way, and moved over into BAMMS to serve under Blunden. Anyhow, early in December 1974 Richardson warned Blunden24 that he would be the first chairman of this new committee. The first BIS Secretary to the new committee was also English, Michael Dealtry, who had been seconded to the BIS initially from the Bank, but had by then become a permanent official in Basel. Dealtry’s appointment was not connected to his nationality. He was then a senior official in the BIS’s economic and statistics department, headed by Milton Gilbert. All the other managers in the BIS were working in operational posts, and were therefore not natural candidates for an analytical secretarial role. Michael was also by this time known for his exceptionally good drafting 24 George records, in a personal conversation, that the Governor did so casually as they were leaving a cocktail party together.

44

The antecedents of the BCBS

abilities.25 So the BCBS, or the Committee on Banking Regulation and Supervisory Practices (as it was initially known), had a strong British character at the outset. At this stage, 1 January 1975, the Bank of England prepared a ‘Note on the BIS Governors’ activities vis-à-vis the Euro-currency market’, giving a careful, but succinct, account of the history of G10 Governors’ involvement with the Euromarkets to that date. It was clearly intended for wider circulation, though I have not been able to ascertain its exact intended use. It is a useful document, and is attached, in full, as Appendix A to this chapter. D

First steps

As the Bank of England’s Note reported, this new Committee, the BCBS was not intended to supplant the existing Euro-currency Standing Committee. Nevertheless the division of responsibilities between the two needed to be clarified. There was some discussion of this in the Bank (an exchange of notes between Blunden, McMahon and M. J. Balfour in mid-December 1974). One issue was whether the ECSC might act as a higher-level committee, ‘filtering’ reports from the BCBS before they reached the G10 Governors (the answer was ‘no’; the two committees were to be complementary,26 not hierarchical). Perhaps a more difficult question was the division of responsibility for collecting euro-currency statistics. In the event each committee took on responsibility for the data relating to its own area of enquiries (not perhaps necessarily the best practice, since sometimes the BCBS failed to get the benefit of expert statisticians’ advice at the outset of complicated exercises). A related question was what was to be the relationship between this new committee and more narrowly European groups, the Groupe de Contact and the European Commission. The G10 Governors excluded certain members of the EEC (Ireland and Denmark at that time; and subsequent entrants to the EU). The British argued, unavailingly, to widen membership of the BCBS to include all EEC members, so that all cross-border international issues could be primarily discussed in that forum (briefing paper by M. J. Balfour, 3 January 1975, in advance 25 I am grateful to Sir Kit McMahon for this comment. 26 Balfour noted that the ECSC would become ‘a passive body; but since its previous activity has not achieved anything very concrete€– though admittedly paving the way for the Governors’ decisions which have been taken€– I daresay that this would not matter too much.’

First steps

45

of Richardson’s dinner with other EEC Governors, 7 January 1975). But the Governors were unwilling to dilute BCBS membership further, beyond the extra place for Luxembourg. That gave the EC, and the EEC Governors, additional grounds for establishing their own separate Banking Advisory (initially Liaison) Committee, whose memberships, as already noted, overlapped extensively with the continuing Groupe de Contact. With membership issues having been settled, and Chairman and Secretariat appointed, the Committee met for the first time at Basel in February 1975. The list of members at all meetings, including this first meeting, is attached as Appendix B of Chapter 3. Blunden prepared his opening remarks carefully, writing them out in full and circulating them in advance to his close Bank colleagues and to Michael Dealtry at the BIS. The draft of 24 January reads: You have all received a copy of the record of the Governors’ decision to establish this Committee. Five important points emerge from that record: (i)╇ Our main objective is to help ensure the solvency and liquidity of banks. (ii)╇Our work should lead to further discussions among the Governors themselves. (iii)╇We should take as our starting point the summary report on existing regulations and supervisory practices already prepared by the BIS. (iv) We should give particular attention to the need for an early warning system. (v) We should remember that the quality of work done in supervision is at least as important as the regulations themselves. Before discussing how we have applied these five points to our agenda for this meeting, I would like to amplify them by drawing your attention to one or two further points which I understand were made during the discussions which led up to the Governors’ decision. First, we have not been given any instruction to find answers to specific questions or to conclude our discussions by any specific date. We are intended to be a standing committee meeting from time to time, as and when and where we ourselves think appropriate, and discussing issues of current importance in the field of supervision.27

27 It is apocryphally claimed that, at this point in the meeting itself, George Blunden joked that he did not expect the material in the mandate to occupy the Committee for more than a short time (perhaps only a few meetings). But George cannot now recall making that quip. Peter Cooke, however, notes (in personal conversation) that he can: recall George saying to me, and I think he has referred to it publicly, that he said to Michael Dealtry at the beginning of the meeting, ‘Do you think we have enough to talk about to take the meeting beyond lunchtime’. He also said and I have repeated

46

The antecedents of the BCBS

Secondly, we are not intended to attempt to harmonise supervising techniques, riding roughshod over existing practices and legislation in the separate countries represented here. It is appreciated that we cannot commit our countries to such changes. In words which I understand were used by the President of the BIS at a Governors’ meeting, our aim should be ‘to learn from each other rather than to make far-fetched attempts to harmonise everything we do’. We have to try to understand how things are done in each of the countries represented here and why they are done as they are and to see whether there are techniques in other countries which could usefully be adopted in, or adapted for, our own systems; we should also consider whether there are techniques which we could recommend to the Governors for general adoption, irrespective of the legislative framework against which they would be applied.28 Thirdly, I understand that we are encouraged to be quite frank in expressing doubts and criticisms and asking questions about how supervision is carried out in other countries. If, for example, any one of you is worried that the systems in use in the United Kingdom have gaps in them which create risks of allowing practices to develop which could have undesirable effects on the international banking scene, I hope that you will raise them, and, in my neutral position on this side of the table, I shall take much enjoyment in hearing how Mr Galpin and Mr Byatt deal with your comments. And I hope that all other representatives will feel equally ready to deal with any criticisms or questions that others may raise about their systems. If this Committee is to be effective in the way the Governors desire, it is essential that we all be frank with each other and that we do not object to sensible criticism. Fourthly, it was clearly the wish of the Governors that we should concentrate on problems affecting external, international markets. Matters of purely domestic import and techniques for dealing with them may be of interest but it many times in my speeches that he noted that none/hardly any of those round the table had ever met each other before€– a measure of the small beginnings to international supervisory cooperation. 28 As Kapstein (2007 and 1994) has noted: At this time, the objectives of the Basel Committee were appropriately modest. The central bank governors emphasized that the Committee’s objective ‘should not be to make far-fetched attempts to harmonize the twelve countries’ individual systems of supervision, but should be to enable its members to learn from each other and to apply the knowledge so acquired to improving their own systems of supervision, so indirectly enhancing the likelihood of overall stability in the international banking system’ (cited in Kapstein 1994). Thus, the Basel Committee was charged with the tasks of education about bank supervision; information sharing about banking practices; the establishment of an ‘early warning system’€– how often that idea has been repeated by financial supervisors ever since!€– to detect problems within international banks; research on international bank supervision; and finally, policy coordination in supervising international and consortium banks. In sum, as the first head of the Basel Committee, George Blunden, once stated, ‘There is agreement that the basic aim of international cooperation in this field is to ensure that no foreign banking establishment escapes supervision.’ It is probably fair to say that the level and scope of regulatory harmonization that this cooperative process has subsequently induced was unimaginable when the Committee first began to meet.

Appendix A

47

are not of direct relevance to the problems with which we are primarily concerned round this table. They are already, for many of the countries represented here, subject to discussion in the informal EEC Groupe de Contact, known to many of us as the Dondelinger Group, and I understand that it is now intended that representatives of the non-EEC countries belonging to this Committee should in future meet from time to time with that group to discuss such questions.

George Blunden (1977, pp. 195–6) subsequently wrote in a paper, delivered at a SUERF (Société Universitaire Européenne de Recherches Financières) Conference, that: The committee was established as a permanent standing committee, meeting periodically throughout the year, and not as an ad hoc committee to perform a particular task against a time limit. Dr Zijlstra, the President of the Nederlandsche Bank, who is also President of the Bank for International Settlements and Chairman of the Group of Ten Governors’ Committee, laid down that the committee’s objective should not be to make far-fetched attempts to harmonise the twelve countries’ individual systems of supervision, but should be to enable its members to learn from each other and to apply the knowledge so acquired to improving their own systems of supervision, so indirectly enhancing the likelihood of overall stability in the international banking system. And the committee was particularly charged to bear constantly in mind the need for means of improving international early warnings of potential troubles in banking systems where these troubles might cross frontiers.

Appendix A Note on the BIS Governors’ activities vis-à-vis the euro-currency market The central-bank Governors who meet regularly at the Bank for International Settlements in Basle interested themselves in the Eurocurrency market early in its development. (a)

Statistics

The first thing needed was a statistical picture of the market. This was initiated at the beginning of 1963, with the data collected by the central banks and put together and circulated by the BIS. The data were improved in the course of time and became the �authoritative information on the evolution of Euro-banking. The question of �central-bank policy with regard to the market was discussed from time to time, but no general problems had shown themselves and it was left to each central bank to control the Euro-currency transactions in its own market.

48

The antecedents of the BCBS

(b)

Supervision

Early in 1971, as the strains on the international monetary system were growing severe, the Governors set up a Standing Committee of senior central-bank officials to study developments in the market and to report to the Governors on possible policy actions. The Standing Committee had the advantage of including not only the main European countries but also the Federal Reserve System and the Central Banks of Canada and Japan. (c)

Regulations and controls:€national vs. international measures

The question before the Governors at this time was whether the Eurocurrency market was significantly aggravating the problems of the international monetary system and whether joint action by the central banks was desirable. Opinions differed on these questions. Some of the central banks favoured coordinated controls over the Euro-banks so as to dampen international influences. Other central banks did not share this view. They considered that the added money and credit flows were marginal, in the sense that they were substitutions for flows that would otherwise have been financed through different channels; that the Euro-market had its useful aspects, not only in activating bank competition but also in facilitating the management of the domestic money supply and of external reserves by the central bank; and finally that any effective overall controls would be hard to devise and more apt to drive the market to unregulated areas than to reduce significantly the volume of its activities. In view of those divergences of opinion, studies of a possible scheme of reserve requirement to be applied to the Euro-banks had to be abandoned. It was recognized, instead, that the control of private transactions in the market would remain on a national basis. All the monetary authorities exercised some controls, varying in severity with changing conditions. (d)

Official deposits

Another aspect of the Euro-market’s development was the growing volume of official deposits. Our group of central banks agreed that this official supply of funds to the market was not appropriate in the circumstances. The governors therefore decided not to increase such deposits, through the BIS and otherwise, and indeed to reduce them as market conditions might allow. We considered the possibility of drawing other central banks into this agreement, but their known views did not

Appendix A

49

suggest that a significant response could be expected€– particularly as we had no quid pro quo to offer. (e)

Diagnosis of the market crisis

During the past year the concerns of the Governors and their Standing Committee about the Euro-currency markets have been changed completely. This was, firstly, because of the financing requirements arising out of the oil situation and, secondly, because of the difficulties that a few banks got themselves into under the new conditions of floating exchange rates and tight monetary policies. In the first half of the year the Euro-market was the major channel both for financing oil-induced deficits and for investing the oil countries’ surpluses. As the volume of transactions mounted, the market became hesitant about the burden being assumed€ – from the standpoint both of the maturity transformation involved and of the credit standing of a number of borrowing countries. Confidence in the international banking structure was weakened also by the failure of a few banks and large foreign exchange losses by some others. The Standing Committee came to the conclusion that, although a major crisis of liquidity of the euromarket did not seem probable, action should be taken in two directions: 1. To strengthen confidence in the international banking system, and 2. To fortify the existing mechanisms for supervising and regulating international banking operations so as to assure sound practices. (f )

The September communiqué on the lender of last resort

At their September 1974 meeting the Governors agreed to intensify the exchange of information between central banks on the international activities of their commercial banks and to tighten up further, where appropriate, the supervision and regulation of the banks. A number of improvements have been made in this respect during recent months, and it may be added that the banks themselves have acted to reinforce their own internal checks and directives. A press communiqué was issued, in which the Governors publicly clarified at the same time their role as lenders of last resort in the Euromarkets. They noted that it would not be practical to lay down in advance detailed rules and procedures for the provision of temporary liquidity. But they expressed themselves as satisfied that means are available for that purpose and that they will be used if and when necessary.

50

The antecedents of the BCBS

(g)

The Blunden Committee

At their December meeting in Basle the Governors returned to the problems of assuring the solvency and liquidity of banks. They had before them a report prepared by the BIS staff which summarised existing regulations and supervisory practices in the member countries of the Group of Ten. To carry further the work in this field and to prepare for future discussions among themselves, they established a new committee made up of experts from the banking supervision and foreign exchange departments of Group of Ten monetary authorities. It was decided to appoint Mr Blunden from the Bank of England as the Chairman of the new committee. The committee is to take as its starting point the BIS summary report and to look into the possibility of introducing into certain national markets measures of supervision and control which have proved to be fruitful in other countries. The need for an early warning system in case of banking difficulties is also to be considered. It was stressed in the course of the discussion that the quality of supervision is at least as important as the regulations themselves. The new Committee will not take the place of the Euro-currency Standing Committee, which will continue to discuss Euro-currency policy problems, either at the request of the Governors or whenever the Chairman or members of the Committee consider it necessary.

3

Modus operandi: Chairmen; Secretariat; members; structure of meetings

A

Introduction

The most important person in any committee is the chairman; during these years all the chairs of the Basel Committee on Banking Supervision were men. The chairman sets the agenda and drives the committee forward. The choice of direction by the chair is particularly important when the mandate is broad, rather than narrowly defined, and when the superior body to which the committee reports, the G10 central bank Governors in the case of the BCBS, gives it a loose rein. As will become clear in the course of the remaining chapters of this book, this was the case with the BCBS, so the involvement and leadership of the Chairmen were crucial. There were six Chairmen during our period, excluding the acting role of Danielsson (Swedish Riksbank) who took over for one meeting after Muller’s death when in office as Chairman, and before Corrigan was appointed. Potted biographies of each of them are presented in Section B. They were:€ Blunden (Bank of England), Cooke (Bank of England), Muller (Nederlandsche Bank), Corrigan (Federal Reserve Bank of New York), Padoa-Schioppa (Banca d’Italia) and de Swaan (Nederlandsche Bank). The latter, Tom de Swaan was only in office for a very short period, for the last three BCBS meetings in 1997, at the tail-end of the years covered here. The BCBS met three or four times a year generally, and the role of Chairman was not full-time. Each remained primarily doing his normal national central banking job, as well as acting as BCBS Chairman. On average, Chairmen probably devoted about 20–25 per cent of their time to BCBS work, representing the better part of a fortnight around each BCBS meeting, and occasional work at their home national central bank during the rest of the year. This varied between Chairmen, depending in part on the scale and scope of their other duties. During the last few years of his long period in office as BCBS Chairman, Peter Cooke gave this role more of his time and effort than any other Chairman, 51

52

Modus operandi

particularly in the fraught year and a half (December 1986 to June 1988) leading up to the Basel Accord on Capital Adequacy; during this period his role as BCBS Chairman took up the majority of his time. The earlier Chairmen, Cooke and Muller,1 were specialists in the field of bank regulation. Blunden was more of a generalist; during his spell as Chairman, he allowed the specialist members of the Committee, especially the Dutch, Muller and his successor Coljé, to make much of the running while he held the ring. After Basel I, the work of the BCBS came to be more widely recognised as of major importance, and that led to the appointment of higher profile Chairmen, Corrigan and then PadoaSchioppa. Naturally they had a wider range of other duties and commitments, and could give less time personally to the affairs of the BCBS. On the other hand, unlike the other Chairmen, they both had personal assistants (Spindler in the case of Corrigan, Donati, among others, for Padoa-Schioppa) who could help them with their BCBS work. The earlier Chairmen, partly perhaps because of their role as experts in banking supervision, tended to interpret the remit for the BCBS quite narrowly, as a specialist group advising the G10 central bank Governors on what was accepted, consensually, as best practice among themselves and which the Governors might wish to implement in their own countries. With the advent of Corrigan and Padoa-Schioppa, the BCBS’ function began to be interpreted more widely, as providing direction, soft law, for banks’ risk management worldwide. The transition was never abrupt, being much more gradual, and there were many other factors involved beyond the personalities and leadership of the Chairmen. Even so, they made a difference. After the chairman, the next most important person on any committee is its (chief) secretary. So in Section C we turn to an account of who these were, and how they operated. Then in Section D (and Appendix B) we move on to record the membership of the Committee, before turning finally to a description of how the BCBS typically operated. B

Chairmen



George Blunden

George joined the Bank of England in 1947, straight from University (Oxford, University College), having served in the army during the Muller was the most considerate to the secretariat, taking time to keep them in touch with his conversations with others, via Notes for the Record, which not all other chairmen did so assiduously. 1

Chairmen

53

World War II. Apart from a brief spell (1955–8) on secondment to the Balance of Payments Division of the IMF, a role held successively by three secondees from the Bank of England, and a couple of years between leaving the Bank to work in the City of London in 1984 and being recalled as Deputy Governor in 1986, he worked in the Bank all his working life (1947–90). He was knighted in 1987. He served mainly in operational roles (rather than on research or economic analysis). He had been a Deputy Chief Cashier in 1968–73 in charge of the Bank’s operations in the money markets and then was made Chief of Management Services in 1973–4 (an important role since this was the time when the Bank was introducing computers throughout). In 1974 the new Banking and Money Market Services (BAMMS) was established, largely to expand the Bank’s role in banking supervision. The prior Principal of the Discount Office, Jim Keogh, was tarred by his failure to anticipate the 1973/4 fringe bank crisis; and Rodney Galpin, his deputy, was not senior enough. The then Deputy Governor, Sir Jasper Hollom, had done much of the work in steering the Bank through that crisis, and Blunden is sure (personal discussion) that it was Hollom’s support that got Blunden his position as Head of BAMMS (Banking Supervision). Blunden was sharp-witted, a skilful operator, with a wicked but often self-deprecating wit. He felt that the other participants on the new Committee would be wary about the nature of the new Committee. So he began at his most emollient, in so far as that was in his character. He went out of his way to emphasise the following points: (a) As Chairman he would be neutral, not representing the UK. Galpin would be the lead UK representative and Blunden said that he would watch his performance in that role with considerable interest. (b) The Committee would not be executive, nor legislative, but rather advisory on the basis of learning from each other. (c) The Committee should, as far as possible, be kept quite small and collegiate in approach. A problem of succession (to the chair of the BCBS) arose too soon for comfort. George was promoted (again) from Head of BAMMS to being Executive Director in charge of all personnel matters in early 1976, though it was known that this would not take place until late Autumn 1975; there were then four such Executive Directors in charge respectively of Home Finance, External Finance, Economic Analysis and Personnel. The problem was that his replacement as Head of BAMMS (Peter Cooke) was probably then too new to be acceptable to the other participants in the BCBS (or to the G10 Governors) as the

54

Modus operandi

new Chairman. The Bank of England did not want to cede command of the chair at that stage; they wanted to be able to continue to shape the agenda. So the decision was taken in the Bank for George to seek to soldier on as Chairman of the BCBS for the time being, despite his change of role, on the (plausible) grounds that there was a need for continuity. Blunden’s speaking notes for the December 1975 meeting (File 6A.115/2) read: Personal position. Dismissed.2 But, recognising often-expressed views on desirability of continuity of membership in order to enhance mutual confidence, etc., Governor has seen disruptive effect of change of Chairman so early and has agreed I may continue. Reported to other Governors this week who agreed. But does present opportunity for change if they want it. If so, speak to secretariat.

By early 1977, however, Peter Cooke had been both in his position as head of BAMMS and a member of the BCBS itself for long enough to be an acceptable candidate as a new Chairman, and Blunden wanted to step down. Accordingly Richardson wrote to Zijlstra to that effect (the letter is attached as Appendix A to this chapter). As noted earlier, the BCBS did not start from scratch, but had before it the example of the earlier Groupe de Contact. Much of the procedures adopted did follow on quite naturally from that precedent. Nevertheless Blunden (and Dealtry) did establish the working procedures of the Committee, which are described in more detail later in this chapter.

Peter Cooke

Peter Cooke followed a rather similar career pattern to Blunden. He entered the Bank of England directly from University (Oxford again:€ Merton College) at age 23 in 1955. Like Blunden, in his early years he was seconded abroad, first to the BIS in 1958–9 and to the International Monetary Fund from 1961–5 as personal assistant to the Managing Director (first Jacobsson in his final years as Managing Director, followed by Schweitzer). On his return from Washington, he was appointed to mainly operational jobs, including a period on the foreign exchange side of the Bank (1965–8) and a year as the first Secretary of the City Panel on Takeover and Mergers (1968–9). He then became Assistant Chief of the Overseas Department, before moving to the Chief Cashier’s Department as First Deputy Chief Cashier It was typical of Blunden to describe his promotion to a more senior job in the Bank of England as a ‘dismissal’ from his current position. 2

Chairmen

55

in 1970. In 1973 he became an adviser to the Governors, with special reference to European (EEC) and City affairs. When Blunden was promoted to Executive Director in 1976, Peter was made Head of BAMMS in his place. Peter Cooke was by far the longest-serving Chairman, presiding over 38 consecutive meetings from 1977 (second meeting) to 1988 (third meeting); the next two longest serving were Padoa-Schioppa (thirteen meetings) and Blunden (nine meetings). During his period in office, the Concordat was refined (see Chapter 4) and the first Capital Accord (Basel I) was concluded (see Chapter 6). It was largely due to his effective and persuasive leadership that the BCBS developed its role as the world authority on cross-border financial regulatory issues. Alongside, but linked to the work of the Committee, he worked hard over a period of years to bring supervisory authorities around the world into regional groupings to encourage a cooperative relationship between supervisors in non-G10 countries and the Basel Committee. As a member of the EEC Banking Advisory Committee, he worked to promote a productive debate between Brussels and Basel on banking supervisory and regulatory matters. He would commonly describe his own approach, both within and beyond the Committee, as an iterative process to achieve the four Cs:€Contact, Cooperation, Co-ordination, Convergence. Peter had admirable personal qualities for this role, being attentive, calm, considerate, intelligent (without overt personal ambition or any trace of arrogance). His was a measured approach, recognising that achieving agreement by mutual consent rather than through the imposition of some external authority was a delicate process involving above all else a sense of national and collective benefit (although there were those who felt that some of the Committee’s goals might have been achieved faster with a more forceful approach). He had good personal relationships with his colleagues on the Committee. Indeed, throughout his tenure, he encouraged a collegiate environment and a common approach to building a global regulatory consensus. He ran into difficult circumstances in the latter years of his chairmanship, following the threatened insolvency of a London bank, Johnson Matthey Bankers (JMB), in 1984. Its rescue by the Bank raised controversy with the then Chancellor, Nigel Lawson, over it being a potential call on taxpayers’ money without securing prior Treasury approval. Cooke, as Head of Banking Supervision, took some of the blame for the supervisors’ failure to pick up the deteriorating state of JMB. In September 1985 he ceased to have responsibility for the domestic banking system in the UK. He continued, however, with his international supervisory work€– arguably, this move assisted his work in Basel in two

56

Modus operandi

ways. It gave him more time to devote to the work of the Committee and, without any continuing domestic supervisory responsibilities, it helped to emphasise his independence as Chairman of the Committee free from national ties. By 1985 the major thrust of the Committee’s work was directed toward attempting to arrive at agreement among the G10 governors to try to arrive at a common basis among the G10 for a Capital Adequacy Requirement (CAR). Peter had been given a personal mandate by the G10 Governors to try to achieve an agreement on a common standard. Not surprisingly, however, progress toward consensus within the BCBS was not easily or speedily achieved and the Americans wanted to move faster. (The story of the US/British separate démarche is told in Chapter€ 5). The awkwardness of this development for Peter was that he himself was excluded from these separate bilateral discussions between the US regulatory authorities and the Bank and, when the US/UK bilateral agreement became known, it placed Peter in an invidious position€ – a British Chairman who was not privy to what his own central bank was hatching! Someone who was less transparently honest and straightforward could well have lost credibility. Peter handÂ�led the difficult situation admirably (see Chapter 5), emphasising his Â�independence, and steered the difficult negotiations on Basel I through 1987 to agreement and promulgation in 1988. After that mammoth task was successfully completed in Tokyo, in October 1988 he retired both as Chairman of the BCBS and from the Bank. He recommended Huib Muller of the Nederlandsche Bank, whose credentials for the job were second to none, as his successor.

Huib Muller

The Basel Committee on Banking Supervision had many ‘founding fathers’, but Huib Johan Muller has a strong claim to be the foremost among them. As already outlined in Chapter 2, he took the lead in organising the Groupe de Contact (although Dondelinger subsequently became its senior spokesman), which set the pattern for the BCBS. There were a variety of reasons why he was not chosen as the first (or second) Chairman of the BCBS:€he was too young (only 38 in 1975) and junior in the Nederlandsche Bank; Gordon Richardson was the driving force behind the establishment of the BCBS, and, as President of the G10 Governors of the time, Jelle Zijlstra may have felt constrained from pushing his own candidate. Nevertheless Muller was appointed one of the two initial Dutch members; although he only served on the BCBS in this capacity until the third meeting of 1976, he drafted the initial

Chairmen

57

formative note from which the Concordat emerged (reproduced in full in Chapter 4). He was an obvious, and much acclaimed, candidate to take over as Chairman from Peter Cooke, once the latter stood down after the Basel Accord on Capital Adequacy (Basel I) had been negotiated in 1988. Muller was born in Surabaya in Indonesia in December 1936. He took a doctoral degree in law from the University of Leiden in 1961 and, after military service, went for a year to Michigan State University’s macro-economics program. He joined the Nederlandsche Bank in 1964. After a variety of posts, in the General Secretariat and the Foreign Department, he went to the Supervisory Department as Chief of the Banking Supervision System in 1968, becoming Signatory General in 1972, an Alternative Deputy Director in 1973, Deputy Director in 1976 (after which promotion he left the BCBS, being replaced by Coljé), and Executive Director in 1976. He then became a member of the Bank’s governing board, with a special brief for (prudential) supervision of the credit system. From January 1977 until June 1985 he was a member, and (from June 1982 until June 1985) the Chairman of the EEC Banking Advisory Committee. He played a prominent role in Amsterdam charitable and artistic activities, and was made a Knight of the Order of the Netherlands Lion. During his three years as Chairman of the BCBS, 1988–91, he oversaw the initial implementation of Basel I, and the further Â�development of studies of the management of various aspects of banking risk. Although struck down by cancer of the liver, he insisted on staying at his post until very shortly before his death in 1991, becoming the only Chairman, to date, to die in office. He was a great servant of the cause of good banking regulation (in the Netherlands, Europe and the world), and all those who met him in this role have emphasised how helpful and constructive he was.

Gerald Corrigan

E. Gerald Corrigan (Jerry) obtained a BS degree in economics from Fairfield University in 1963. He received an MA in 1965 and a PhD in 1971, both in economics, from Fordham University. He joined the New York Fed in 1968. From 1968 to 1979 Mr Corrigan served in a variety of staff and official positions, including as Vice President for Planning and Domestic Open Market Operations, at the New York Fed. In August 1979 he went on leave from the Bank to become special assistant to Federal Reserve

58

Modus operandi

Board Chairman Paul Volcker in Washington DC. In September 1980 he became President of the Federal Reserve Bank of Minneapolis, a position in which Mr Corrigan served for four years until his return to the New York Fed in 1984. Mr Corrigan became the seventh Chief Executive Officer (CEO) of the Federal Reserve Bank of New York on 1 January 1985. In that capacity, he became a permanent voting member of the Federal Open Market Committee (FOMC). He was also named Vice Chairman of the FOMC, a position traditionally held by the President of the New York Fed. In July 1991 he was appointed Chairman of the Basel Committee on Banking Supervision by the Governors of the central banks of the Group of Ten countries. He held this post until 1993. Mr Corrigan ended his twenty-five-year career with the Federal Reserve System when he stepped down from his position as President and CEO of the Federal Reserve Bank of New York on 18 July 1993. Mr Corrigan joined Goldman Sachs on 3 January 1994 as Chairman, International Advisors and Senior Advisor to the Executive Committee. He was later named Managing Director and Partner at Goldman, Sachs & Co., effective 30 November 1996. Mr Corrigan maintains an association with a wide range of public policy and non-profit organizations. Among others, he is a member or a trustee of:€The Bretton Woods Committee; the Group of Thirty; The Trilateral Commission; the Aspen Institute, Program on World Economy; and the American Academy of Arts and Sciences.

Tommaso Padoa-Schioppa

Tommaso Padoa-Schioppa graduated from the Luigi Bocconi University, Milan, Italy, in 1966 and received an MSc from MIT in 1970. He joined the Banca d’Italia in 1968, where he spent ten years in the Research Department and was a Vice Director General from 1984 to 1997. In 1979–83 he was at the European Commission as Director General for Economic and Financial Affairs. Between 1988 and 1989 he served as Joint Secretary to the Delors Committee for the study of European Economic and Monetary Union. Later he chaired the Banking Advisory Committee of the Commission of the European Communities (1988–91). He also created and chaired the Working Group on Payment Systems of the Central Banks of the European Community (European Monetary Institute) (1991–5). He was appointed Chairman of the Basel Committee on Banking Supervision in 1993, succeeding Jerry Corrigan, and holding that role until 1997.

Chairmen

59

On leaving the BCBS in 1997 Mr Padoa-Schioppa became Chairman of Commissione Nazionale per le Società e la Borsa (CONSOB, 1997–8), Italy’s stock market supervision agency. In that capacity he created and chaired FESCO (Forum of European Securities Commissions), which later became the Committee of European Securities Regulators (CESR). In May 1998, at the foundation of the European Central Bank, he was appointed to its first six-member Executive Board until the end of May 2005. He was Chairman of the IASC Foundation (International Accounting Standard Committee) in 2005–6. On 17 May 2006 he became Economy and Finance Minister in the government of Romano Prodi, serving in that post until May 2008. From October 2007 until April 2008 he was Chairman of the IMFC (International Monetary and Financial Committee), the top policy steering committee of the International Monetary Fund (IMF). He was a Member of the Group of Thirty since 1979, President of the International Center for Monetary and Banking Studies (Geneva) and Senior Adviser and Advisory Board Member of Promontory Financial Group, LLC. He was Cavaliere di Gran Croce della Repubblica Italiana. He has published numerous books and articles, mostly relating to European finance. He died suddenly of a heart attack on 18 December 2010.

Tom de Swaan

Tom de Swaan became Chairman of the Basel Committee on Banking Supervision in the middle of 1997 and only stayed for one year in the chair. In the middle of 1998 he left the regulatory community to become Chief Financial Officer and Chief Risk Officer of ABN AMRO. Before his chairmanship he represented the Nederlandsche Bank in the Committee as a member from 1991. During his tenure as Chairman the ‘Core Principles’ for effective banking supervision were published, see Chapter 8. Then, in early 1998 in a speech in New York, he announced the start of the revision of the Basel I framework, which then led, much later, to Basel II. De Swaan was born in Amsterdam, the Netherlands in March 1946. He took a Masters Degree in Macro and Monetary Economics from the University of Amsterdam in 1972 before joining the Nederlandsche Bank in the Foreign Department, where he became acting chief in 1976. In 1978 he became Chief of the Export Credit Guarantee Department. In 1984 he became a Deputy Director responsible for the Payment Systems and Administrative Department. In 1986 he became a member

60

Modus operandi

of the Bank’s Governing Board with a brief for the payment systems and all internal departments. In 1991, following Muller’s death, he became responsible for supervision of the banking system and mutual funds. Internationally he was from 1993 the first Chairman of the Tripartite Group for the Supervision of Financial Conglomerates (the later Joint Forum) and became Chairman of the Banking Supervisory Subcommittee of the European Monetary Institute in 1995, a function he relinquished when he became Chairman of the BCBS in 1997. He was made a Knight of the Order of the Netherlands Lion in 1993. C

The Secretariat

After the Chairman, the most important member of any Committee is its (chief) secretary. I have already described in Chapter 2 how Michael Dealtry (d. 2006) came to be appointed the head of the Secretariat for the BCBS. He was supported by Helmut Mayer, an Austrian, and (from the end of 1975) by Bernhard Timm from Germany. Not surprisingly, since the BCBS was a new body, all three members of the initial Secretariat came from within the BIS’ own staff. Helmut Mayer was the BIS’ resident expert on the Euromarkets, and was appointed to the Secretariat as the specialist to help with the anticipated work on international (monetary) issues. As already described and will be further discussed in Chapter 5, the BCBS had a remit from the G10 Governors that suggested that they should take a major role in international crisis prevention. In practice, they focussed much more on supervisory issues (though such issues have an indirect effect on preventing cross-border crises). At first, in the first four meetings of 1975, there were only the two members (Dealtry and Mayer) who acted as the Secretariat. Right from the start, the volume of required drafting was large. Besides the agenda, and the short Minutes for the Record, which ran to about five or six pages, and had to be made ready within a week, or so, the members (later) received an Informal Record, which reported the main points made by each identified participant. The meetings were tape-recorded. Lasting for the better part of two days, transcribing the tapes (though this was only done for occasional excerpts) would have covered up to 500 pages. This was synthesised for the Informal Record to a document of around 50 pages detailing the main points made by each member of the Committee. This was done by the Secretariat, and took about three man-weeks. There was more than one attempt (initiated by the Chairman and Secretariat) to cease such detailed reporting of the proceedings, but the members of the BCBS (who obtained the

The Secretariat

61

benefit and did not face much of the cost), always insisted that these more extensive records were of value to them. Mayer was a professional economist, who joined the BIS in 1963 having completed a PhD in Economics at Stanford University earlier that same year, and became the BIS in-house expert on the Eurodollar market. His publications include a couple of Essays in International Finance (no. 79, 1970, and no. 104, 1974), five BIS economic papers (numbers 1, 5, 6, 15 and 16) between 1979 and 1986, and several academic papers, mostly on the Euromarkets and other aspects of international finance. Having him do all the drafting work was a waste of skilled resources. Michael Dealtry was a senior official in the Monetary and Economic Department at the BIS. He oversaw the drafting, and undertook the main administrative work, and the correspondence with the Chairman and the other members. He could not be expected to do the basic drafting, for example of the Informal Record, and write up the results of surveys of supervisory practices. So, there was a need for a third member. Timm was appointed to this position at the end of 1975. From the start, perhaps in part because the first Chairman and Chief Secretary were both British, the main papers emanating from the Secretariat were only produced in English.3 Papers sent to the group by the members, or provided by their central bank/supervisory authority, would at the outset often be in the other main languages, but would then be translated into English by the BIS translators. In the actual committee meetings of the BCBS there was simultan� eous translation (by interpreters)4 into English, French, German and initially Italian. If the subject matter involved negotiation and potential commitment, as occurred for example in the precession in 1987 to the Basel I (1988) accord, when the Japanese delegation asked for simul� taneous translation into Japanese, this was provided on an exceptional basis. Some of the Japanese supervisory experts who came to Basel for those discussions did not have as good a command of English as their usual delegates. Overall the cost of translation and interpretation for the BIS was large both absolutely and relative to the cost of the regular Secretariat. An exception to this general rule was in the case of papers proceeding upwards to the superior G10 Governors group. These would be translated into all the BIS regular languages, i.e. English, French, German and sometimes Italian as well. 4 Peter Cooke commented, in private correspondence, that some of the interpreters: 3

came meeting after meeting for years. They became very expert in translating the technical language. They made a real contribution to the smooth running of the meetings and I regularly acknowledged this to them saying that I sometimes thought they understood the issues better than the delegates.

62

Modus operandi

But Timm was inevitably handicapped in drafting English, and at the outset of 1978 a replacement was found in the person of Charles Freeland. Charles had come from the Overseas Department of the Bank of England. He was seconded from the International (Overseas) Department of the Bank in March 1975, for the particular purpose of acting as one of three Secretariat members supporting the Committee of European Central Bank Governors. Although this Committee should in principle have been meeting in the EU, its members for convenience decided to ask the BIS to host its monthly meetings, to discuss specifically European monetary and regulatory issues, around the occasion of the monthly G10 Governors meetings at the BIS. At this time it was chaired by Gordon Richardson, the Governor of the Bank of England, who wanted a native English speaker in its Secretariat as the new members (Denmark, Ireland and the UK) all required documents in English. Freeland, who had been in the European Division of the Overseas Department, fitted the bill. After three years his secondment was due to come to an end. For personal reasons he wanted to stay on in Basel, and transferred into the BIS permanent staff. Once this had taken place, on 1 April 1978, he was immediately appointed as the main drafter for the work of the BCBS in place of Timm. He was to hold this position until well after the closing date for the coverage of this book, that is, the end of 1997.5 He attended all the regular Committee meetings between 1978 and 1997 (72 meetings in all), though his overall attendance record during these years was outstripped by Vachon of Canada (77 between 1975 and 1997). This trio, Dealtry, Mayer and Freeland, then operated continuously as the Secretariat for the BCBS from the beginning of 1975 until after the second meeting in 1984:€Dealtry in overall charge, and main link with the Chairman (Blunden until mid-1977, Cooke thereafter), Mayer the economist and Euromarket expert, and Freeland the main draftsman. Then, simultaneously, but for differing reasons, the first two left. Dealtry had many other responsibilities in the BIS; the work of the BCBS was becoming more extensive and yet at the same time more specialised. Anyhow, after ten years in the role, it was time for a change.6 Mayer had also served for ten years, and in his case his particular expertise, on the international Euromarket aspects, was �becoming

I am indebted to him for almost all the information in this Section. Charles retired from the BIS at the end of 2006. He is a living (and fit) repository of the history of the BCBS. He has been, perhaps, too closely involved with it all to write this history himself, though I tried to persuade him to do so. 6 It may also be that he was promoted to the post of Manager at that time. 5

The Secretariat

63

increasingly peripheral to the focus of the BCBS, which by then was clearly shifting to specific supervisory topics such as capital adequacy. The then Chairman, Peter Cooke, needed an expert to help him handle such (capital adequacy) issues. So Peter took the opportunity of Dealtry’s cross-posting to other roles within the BIS to arrange for a Bank of England expert on this subject to be seconded to take over from Dealtry as head of the Secretariat. An internal note by the Chairman explaining this to the BCBS (BS/84/31) is reproduced as Appendix C to this chapter. Dealtry’s replacement was Chris Thompson. Shortly thereafter van Schaik of the Nederlandsche Bank (also an expert on such issues), no doubt on the advice and recommendation of Huib Muller, took up the third position. From then onwards the character of the Secretariat changed. Prior to 1984 the Secretariat consisted of permanent BIS staff members. From 1985 onwards the Secretariat, apart from the continuity provided by Freeland, consisted of persons temporarily seconded from the member bodies, for example Thompson, Hayward and Fisher from the Bank of England, Rohmann, Gehring, Harbrecht and Cordewener from the Bundesbank, Kos, Gilbert, Olson and Walter from the FRBNY, Betsy Roberts from the Federal Reserve Board (FRB), Pény and Carrère from the Commission Bancaire at the Banque de France. The initial term of each secondment was for two years but, if both sides were content, the term was often extended to three years. This was regarded by their home institutions as the maximum time that would still allow for efficient re-entry. Not only did the characteristics of the Secretariat change (i.e. from BIS general staff members to specialists seconded from member authorities), but also the numbers on duty at any time increased. Prior to the enhanced workload generated by the Basel I exercise (both before and afterwards), there had been a few, mostly ad hoc, working groups set up to pursue particular topics. Some of these are detailed in the next section. Because these were few, usually with a small number of members€– who had a particular knowledge or expertise in the subject€– they could be serviced by the existing basic secretariat. With the expansion of the BCBS’ work occasioned by Basel I, the number of subgroups increased; they became semi-permanent, and with a larger membership. These subgroups also became more technical and specialised in nature, for example dealing with definitions of capital and with differing aspects of risk.7 It ceased to be practical or possible for the BIS to service (what increasingly seemed to be) the plethora of Peter Cooke insisted that each subcommittee should be chaired by a member of the main Committee. Later this practice was dropped. 7

64

Modus operandi

subgroups from a basic core secretariat of three persons. Each subgroup had to have its own secretary, though one person on the Secretariat could handle two (or perhaps even more) subgroups€– though there must have been calendar clashes as each subgroup would often try to fix the date of its own meeting close to that of the main BCBS meeting. So there were some secondees at the BIS whose main responsibility was servicing BCBS subgroups, though only in a few cases were they specialists, and they were not only given a variety of tasks at the BIS, but were expected to pay close attention to the full spectrum of BCBS concerns and activities. Even if they had no responsibility or role in dealing with the main BCBS meetings, they still needed to be present at such meetings in order to hear what was said about their own more particular (subgroup) fields. So, as noted earlier, in the mid-1980s the number of BIS Secretariat personnel attending the BCBS main meeting systematically rose above the prior regular three, to around double that, with the most frequent number being six, and even on a couple of occasions as many as eight (though several were present purely to listen to discussions of topics relevant to their subgroup). The hierarchy and relative responsibilities within the BIS Secretariat were well known, but kept informal in the earlier years. Peter Hayward, another expert on banking supervision and on capital adequacy issues from the Bank of England, took over the top Secretariat position from Chris Thompson, when the latter left the BIS shortly after Peter Cooke stood down as Chairman. It was Peter Hayward’s role to steer the Basel I Accord through its implementation and teething stage. This had been largely accomplished by mid-1992, so Peter returned to the Bank of England, and was replaced by Fredrick (Erik) Musch of the Netherlands Bank. On this occasion the pre-existing hierarchy was formalised, with Musch being given the formal title of Secretary General, and his first lieutenant, Charles Freeland, awarded the title of Deputy Secretary General. In effect the sequence of Secretary Generals to the BCBS over these years was: Michael Dealtry Chris Thompson Peter Hayward Erik Musch Danièle Nouy

1975–84 1984–8 1988–92 1992–7 1997–

Apart from the first few years, Charles Freeland filled the role of Deputy Secretary General throughout.

Members and participation

D

65

Members and participation

A listing of all those who participated in the BCBS meetings between the first meeting in February 1975 and the final meeting of this history in December 1997 is given in Appendix B to this chapter, together with their affiliation, the overall number of meetings that each member attended, and the date of their first and final meetings (within this time period). The longest-serving member was Vachon of Canada; he came to the first meeting and was still there at the end of our period, clocking up no fewer than seventy-seven appearances overall, out of a possible total of eighty-three. The record for the largest number of consecutive attendances was, however, held by Freeland of the BIS Secretariat, who attended his first BCBS meeting in March 1978 and then remained present at every single other meeting until the final meeting of our period in December 1997 (seventy-two consecutive meetings, a tribute, inter alia, to his health and fitness). Those making twenty or more appearances during this period are shown in Table 3.1. Table 3.1. Long-serving members of the BCBS From Chairman Belgium

Canada France

Germany

Italy Luxembourg Netherlands Sweden

Cooke Vanleeuw Dubois Mme Lepoivre Vachon Aubanel Bonnardin Fort Kloft Schneider Lang Becker Sanio Lanciotti Carosio Schaus Philippe Coljé Musch Rodeback Danielsson

Number of Appearances

o/w Consecutive

38 20 40 33 77 26 35 24 34 51 20 44 27 52 40 39 30 33 26 32 58

38 11 24 9 21 26 15 15 11 41 20 22 26 31 38 39 18 22 24 14 54

66

Modus operandi

Table 3.1. (cont.) From Törnqvist Lind Müller Hauri Klauser Byatt Barnes Quinn Farrant Dahl Willey Sandberg Ms Krause Fèvre Dealtry Mayer Freeland Musch

Switzerland

UK

USA

EC Commission BIS Secretariat

Number of Appearances

o/w Consecutive

23 28 31 39 35 28 24 21 25 38 20 31 24 22 31 30 72 21

23 28 31 10 15 18 21 13 13 25 10 18 12 13 21 14 72 21

(a) Overall 60 50

Participant

40 30 20 10 0

1

2

3

4

5

6

7

8

9

10 11~15 16~20 21~25 26~30 31~40 41~50 51~

Number of meetings

Figure 3.1. Participation record (a) Overall (b) By country

Members and participation

67

(b) By country

1.0

Canada

Participant 2.5

1.0

Germany

1.0

Japan

1

1 2 3 4 5 6 7 8 9 10 11~15 16~20 21~25 26~30 31~40 41~50 51~

6.0 4.0 2.0 0.0

2 3 4 5 6 7 8 9 10 11~15 16~20 21~25 26~30 31~40 41~50 51~

Participant 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0

2 3 4 5 6 7 8 9 10 11~15 16~20 21~25 26~30 31~40 41~50 51~

0.5

0.0

1

0.5

1.5

Participant 12.0 10.0 8.0

France

1.5

2.0

0.0

Participant 2.5 2.0

2 3 4 5 6 7 8 9 10 11~15 16~20 21~25 26~30 31~40 41~50 51~

1

Participant 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0

Italy

1 2 3 4 5 6 7 8 9 10 11~15 16~20 21~25 26~30 31~40 41~50 51~

1

0.0

2 3 4 5 6 7 8 9 10 11~15 16~20 21~25 26~30 31~40 41~50 51~

0.5

1

1.5

Belgium

2 3 4 5 6 7 8 9 10 11~15 16~20 21~25 26~30 31~40 41~50 51~

2.0

Participant 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0

Participant 1.2 1.0 0.8 0.6 0.4 0.2 0.0

Luxembourg

1 2 3 4 5 6 7 8 9 10 11~15 16~20 21~25 26~30 31~40 41~50 51~

Participant 2.5

Chairmen

Figure 3.1. (cont.)

As in the case of the Groupe de Contact, there was a conscious aim to instil a ‘club’-like atmosphere, an esprit de corps, in which confidences could be shared, understandings reached and compromises achieved. Most of the Chairmen encouraged this. A consequence was that most countries appointed ‘regulars’ to attend the BCBS. Naturally prior commitments or ill health would from time to time prevent the ‘reguÂ� lars’ from attending (and promotion or retirement would eventually

68

Modus operandi Netherlands

Participant 6.0 5.0 4.0

Sweden

2.0 1.5 1.0

4 5 6 7 8 9 10 11~15 16~20 21~25 26~30 31~40 41~50 51~

1 2 3

4 5 6 7 8 9 10 11~15 16~20 21~25 26~30 31~40 41~50 51~ 4 5 6 7 8 9 10 11~15 16~20 21~25 26~30 31~40 41~50 51~ EC Commission

BIS

4 5 6 7 8 9 10 11~15 16~20 21~25 26~30 31~40 41~50 51~

1 2 3

Participant 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0

Participant 2.5 2.0 1.5 1.0 0.5 0.0

UK

4 5 6 7 8 9 10 11~15 16~20 21~25 26~30 31~40 41~50 51~

4 5 6 7 8 9 10 11~15 16~20 21~25 26~30 31~40 41~50 51~

1 2 3

USA

1 2 3

Participant 12.0 10.0 8.0 6.0 4.0 2.0 0.0

Participant 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0

1 2 3

Switzerland

Participant 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0

0.0

1 2 3

4 5 6 7 8 9 10 11~15 16~20 21~25 26~30 31~40 41~50 51~

0.5

1 2 3

3.0 2.0 1.0 0.0

Participant 2.5

Figure 3.1. (cont.)

terminate their appearance), so they would be replaced on such occasions by a (temporary) stand-in or subordinate. Thus the distribution of participants by country was distinctly Â�bi-modal, with many coming for only a few meetings, often as standins, but also quite a number of ‘regulars’ attending for long periods. See the Charts of Participation. There is one obvious outlier, Japan, which had no ‘regulars’. Its two longest-serving members were Aoki (ten attendances between 1983

Members and participation

69

and 1986) and Sekine (eleven attendances between 1986 and 1989). This was caused primarily by the conventional custom in both the Bank of Japan and Ministry of Finance that it is appropriate to reposition officials in new jobs at fairly short intervals on a regular basis, and this convention was maintained throughout our period, irrespective of its effect in constraining their ability to influence the work of the Committee. Alongside the language problem€– which they trained to overcome€– the rapid turnover of Japanese participants meant that they could hardly enter into the ‘club’ spirit of the Committee. No less than fifty-two Japanese representatives attended the BCBS during these twenty-two years, most for two years or less. No sooner had they become acquainted with their colleagues and the subject matter under discussion than they were recycled to new positions back home. The general impression of their colleagues on the BCBS was that this rapid turnover limited the contributions to the work of the Committee that the Japanese representatives could provide. Peter Cooke noted that he tried to arrange for Aoki to stay on as a ‘regular’ member of the BCBS (in 1986), but to no avail. A second country that became an outlier in terms of participation is the United States. This was due to the divided nature of its federal regulatory system, with not only the Federal Reserve System (FRS), but also the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC) and even the Federal Home Loan Board (FHLB) having roles. Even within the FRS, both the Federal Reserve Bank of New York (FRBNY) and the Federal Reserve Board (FRB) in Washington have traditionally maintained connections with the BIS and G10 Governors in Basel (and their heads have separate positions on the BIS Board and the G10 Committee of Central Bank Governors). Initially, until about 1987, US representation in the BCBS remained primarily within the FRS, but the joint roles of the FRBNY and FRB meant that the US representatives were more commonly three or four in number than the two which most other countries maintained.8 Nevertheless the USA followed much the same approach of sending ‘regulars’ (Dahl, Sandberg, Willey), interspersed by more occasional 8 Again there were a few exceptions. As already noted, Luxembourg was limited to one seat. In Germany regulation and supervision were (mostly) under the aegis of the Bundesaufsichtsamt, but the Bundesbank also had a major interest in this field. So the Germans normally sent three representatives, two from the Bundesbank and one from the Bundesaufsichtsamt. When a change in membership was in process, at the outgoing member’s last meeting, s/he was encouraged to be accompanied by her/his designated successor.

70

Modus operandi

appointees, in some cases ‘stand-ins’. From the date of the discussions leading up to Basel I in 1987/8, the BCBS, however, became much more high profile. With its existence and importance becoming more widely observed in the USA (and elsewhere), the other federal banking regulators sought representation, and got it. In 1978 the BCBS invited the Office of the Comptroller of the Currency to send a participant; its first member was Robert Bench. From 1984 onwards the FDIC also participated9; its first member was R. Shumway.10 The number of US participants at each meeting increased noticeably after 1987, with the mean rising from about three to about five. The charts showing the number of participants at each meeting of each country are shown in Figure 3.2. Not only the USA, but also the BIS Secretariat changed the form of their participation at meetings around the same point of time. Up until the end of 1986 the number of those in the Secretariat attending the meetings was never greater than three, and occasionally two. From 1987 onwards, however, the average size of the Secretariat at each meeting rose to six, with some meetings where there were no less than seven or eight. The reason for this change in approach was discussed earlier in Section C of this chapter. Two other points are, perhaps, worth noting briefly. First, the number of (extraneous) visitors invited to attend the meetings of the BCBS was kept (intentionally) very low; although the first visitor, Dr Huth11, from the Central Bank of Israel, was invited (to discuss the failure earlier in 1974 of the Israel/British bank) as early as the fourth meeting in September 1975, this was emphatically not considered to be a precedent. There were only three other occasions of outsiders attending (and one of these, C. J. Thompson, was hardly an outsider since he was a BIS official at the time, and the next appointed Secretary).12 The final point to note is that the European Commission was invited to send observers once discussions/negotiations on Basel I got underway in earnest in 1987, from the second meeting in 1987 onwards. 9 Peter Cooke, the Chairman, had previously resisted participation by the FDIC on the grounds that the FDIC was not much involved in the supervision of the large international banks and that US representation was already excessive. 10 Kapstein (1994, p. 108) records that ‘Saint-Germain [the Chairman of the Congressional House Banking Committee at this time] further demanded that the FDIC be given a seat on the Basle Committee, in order to check the growing power of the secretive Federal Reserve in regulatory affairs.’ This was, to say the least, highhanded, but when the prospective FDIC participant turned up, he was accepted with reasonably good grace. 11 In the archives, his name is sometimes spelt Heth. 12 The occasions are reported in Appendix B.

Members and participation

71 Canada No. of meetings

No. of meetings

Belgium 80 60 40 20 0

0

1

2 3 No. of people

4

80 60 40 20 0

5

0

1

60 40 20 0

0

1

2 3 No. of people

4

5

No. of meetings

No. of meetings

20 1

2 3 No. of people

4

5

0

0

1

1

2 3 No. of people

4

5

No. of meetings

No. of meetings

No. of meetings

40 20 1

4

5

2 3 4 No. of people

5

40 20 0

0

1

2 3 No. of people

80 60 40 20 0

0

1

2 3 4 No. of people

2 3 No. of people Switzerland

60

0

5

60

Sweden 80

0

4

2 3 No. of people

Netherlands No. of meetings

0

5

20

Luxembourg 100 80 60 40 20 0

4

40

Japan

40

0

5

60

Italy 60

0

4

Germany

80 No. of meetings

No. of meetings

France

2 3 No. of people

5

80 60 40 20 0

0

1

Figure 3.2. Number of participants at each meeting

72

Modus operandi EC Commission* 40

No. of meetings

No. of meetings

UK 80 60 40 20 0

0

1

2 3 4 No. of people

30 20 10 0

5

0

1

2 3 No. of people

4

5

* From 2nd meeting in 1987 USA (1970~1986) No. of meetings

No. of meetings

USA (Whole period) 40 30 20 10 0

0

1

2

3

4 5 6 No. of people

7

8

7

8

20 15 10 5 0

0

1

2

3

4 5 6 No. of people

7

8

7

8

No. of meetings

USA (1987~1997) 20 15 10 5 0

0

1

2

3

4 5 6 No. of people

BIS (1970~1986) No. of meetings

No. of meetings

BIS (Whole period) 40 30 20 10 0

0

1

2

3

4 5 6 No. of people

7

8

7

8

No. of meetings

BIS (1987~1997) 20 15 10 5 0

0

1

2

3

4 5 6 No. of people

Figure 3.2. (cont.)

40 30 20 10 0

0

1

2

3

4 5 6 No. of people

The structure of BCBS meetings

73

Their attendance, however, was sporadic, with no one coming from the EC on about one third of the subsequent meetings, depending on whether the agenda was likely to contain issues of relevance to them, or not. Relationships between the EC and the BCBS are discussed in more detail in Chapter 12. E

The structure of BCBS meetings

There were normally three or four BCBS meetings per year, as shown in Table 3.2: Table 3.2. Number of BCBS meetings each year Year

Number of Meetings

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

5 3 3 3 3 3 3 4 3 3 4 4

Year

Number of Meetings

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

3 4 4 5 4 4 3 4 4 3 4

Until the early 1980s the normal number was three per year. Thereafter the pace of work increased and the average rose to four per year. The meetings were usually held at the BIS in Basel, and lasted for most of two days (usually until 4–5 p.m. on the second day, when a rush to the airport ensued). The summer meeting was occasionally held outside Basel, usually in a member Central Bank, following an initiative of Chairman Peter Cooke in 1979.13 He did so for several reasons. It brought the BCBS to the attention of the host central bank. It continued the tradition of the Groupe de Contact (see Chapter 2), in particular of inviting spouses to such events and combining social activities with business. 13 Though he attributes this initiative to the Swedish delegation.

74

Modus operandi

By contrast Basel was seen as a bit monotonous, and spouses would not accompany members.14 In 1987 there were additional special meetings (not included in Table 3.2) devoted to the negotiation of Basel I held at Gerzensee, the Swiss National Bank conference centre near Berne, and in Brussels. The dates of the regular meetings would be set so as to fit in with the rest of the BIS, particularly the meetings of G10 Governors, and with the schedule and preferences of the Chairman. There were some other factors, such as holiday seasons, reports for G10 ministers and the biennial International Conference of Banking Supervisors (ICBS), which also imposed constraints. Ideally, the dates for the meetings in the subsequent year were pencilled in at the autumn meeting, but there were inevitable slippages and ad hoc rearrangements. The delegates who had far to travel would normally gather the previous evening for a 9 a.m. start on the next day. They would stay at one of the several hotels close to the Basel railway station, and a minute or two’s walking distance from the BIS. These hotels were the Euler, the Hilton, the Schweizerhof and more recently the Victoria. When the BCBS was founded, the BIS was still in its old building at Centralbahnstrasse 7 (opposite Basel’s main railway station), where the Committee met in the spacious Governors’ meeting room. When the new building was completed and ready for use in 1977, the BCBS moved there, holding its meeting in Room D on the first floor, a room which could comfortably hold thirty-four participants around the table and many more behind. When he became Chairman in 1993, Tommaso Padoa-Schioppa, however, shifted the locus of the meeting to Room B on the first floor, because he wanted a round table for the Committee, although the seating capacity was slightly less. In the intervals between the sittings of the Committee, those participants from central banks could use the offices allocated to their own central bank in the floors above. That produced a minor problem for those participants from non-central bank supervisory authorities, who did not have any specific office to use. But this could be, and was, resolved by the BIS, since there was invariably enough empty office space to give each participant access to a desk, a telephone and in due course a computer. Even so, the BIS was home-from-home for the central bankers, but less so for the specialist supervisors. As noted earlier in Chapter 2, the BCBS did not spring from a tabula rasa, since the Groupe de Contact had been its predecessor. The first 14 But from the point of view of the Secretariat there were offsetting disadvantages. It was more difficult and costly to arrange simultaneous interpretation and translation of documents into several languages at national central banks than at Basel.

The structure of BCBS meetings

75

agenda, shown below, devised by the new Chairman, George Blunden, and Chief Secretary, Michael Dealtry, followed the outlines of those adopted earlier by the Groupe: Agenda for 6–7 February 1975 I Chairman’s Introductory Statement on ‘The Objectives of the Committee’. II BIS report summarising existing regulations and supervisory practices: (a) tour de table for general comments on, and queries relating to, the report; (b) information by participants on new developments in this field since the writing of the report. III Supervision of the banks’ foreign exchange positions. (Section II of the BIS paper). IV Early Warning Systems:15 (a) information by participants on existing arrangements in their own countries …; (b) suggestions how an international early warning system could be developed. V Future work; identification of problems, other than those arising from III and IV for study by the Committee.

Subsequently, of course, the minutes of the previous meeting were introduced, and revisions noted and agreed, as the (second) item of each meeting. Thus the format of the early introductory meetings would start with the standard sequence of: 1. Chairman’s introductory statement. 2. Informal minutes of previous meeting. 3. Tour de table on existing regulations and supervisory practices. The Chairman’s introductory statement would cover the main issues affecting the work of the BCBS since the previous meeting, for example any communications he had had with the BCBS’ superior body, the G10 Governors, any major banking crises or crucial developments, and would set out the priorities, as he saw it, for discussion and decision at the current meeting. The first two Chairmen, Blunden and Cooke, emphasised the importance of the tour de table. To some considerable extent, regulation and supervisory practices had developed separately 15 As noted earlier in Chapter 2, the initial impetus and mandate for the Committee placed much more emphasis on foreign exchange and international financial issues, such as international capital flows, net and gross fx positions and early warning systems, than the Committee, in the event, felt able to handle. For further discussion of this see Chapter 5.

76

Modus operandi

in each country, prior to 1975, in response to their own particular history, notably local banking and financial crises, and political, social, cultural and financial traditions. Now, with the development of international banking and finance, the regulatory/supervisory authorities had to work together, to cooperate and, ultimately and in some respects, to converge. As Herring and Litan (1994), p. 9, note: The procedures of the Basel Committee are designed to facilitate consensus building. The regular, confidential, off-the-record exchanges of views, identification of best practices, and drafting of policy papers helps the authorities find common ground without the distractions of external pressures. Moreover, banking supervision is a relatively arcane subject, and so bank supervisory authorities probably have considerable scope for autonomous decision making. Many agreements negotiated by the Basel Committee could be implemented directly without amending domestic legislation. Finally, the Basel Committee benefited from the institutional infrastructure developed by the central bank governors of the Group of Ten, who have met monthly in Basel for many decades.

A necessary starting point was to learn what each other country’s practice was in dealing with regulatory and supervisory issues.16 When this had been done, it might then be possible to consider a secondary question:€ which national procedures seemed to be best (though the BCBS tended not to use cross-country quantitative analysis for any such exercise, preferring to rely on expert judgement). Moreover, such regulatory/supervisory practices were not static during these years, but responded to the events in each country. So there was a steady and frequent listing of new regulatory and supervisory initiatives and legislation reported by the various national delegates. Indeed a large proportion of the (earlier) papers in the archives of the BCBS represent documents submitted by national delegates on new legislation and procedural changes relating to their own country’s regulation (translated by the BIS interpreters into the main languages used, see above). One of the factors leading to the formation of the BCBS was the concern about the stability of the international financial system occasioned by the failure of Bankhaus Herstatt earlier in 1974. This was not, of course, the last such (bank) failure. Such failures, and financial crises

16 Regulation entails establishing certain procedures, e.g. capital adequacy or liquidity requirements, whereas supervision involves monitoring whether these procedures are being implemented by those subject to regulation, and, at times, imposing sanctions when they are not.

The structure of BCBS meetings

77

more generally, tended to reveal points of weakness in the regulatory structure. Thus, as will be described at greater length in Chapter 4, the Banco Ambrosiano failure in 1981 illustrated some gaps in the initial version of the Concordat, which required that this be revised, broadened and extended in the 1983 version. So the BCBS developed the practice of discussing each noteworthy banking failure shortly after it occurred. The first such failure, around the time of the start of work by the BCBS, was that of the Israel-British Bank in 1974. This failure was unusual in that the home supervisor, the Central Bank of Israel, was not a member of the BCBS. So its head of supervision, Dr Meir Huth, was invited to Basel to outline the facts of the case at the fourth meeting of the Committee in 1975. As noted earlier, in Section D of this chapter, this was one of the extremely rare (only four between 1975 and 1998) occasions on which an outsider was invited to attend (a limited part of) a BCBS meeting. Like any other wreck, the details of bank (financial) failures are exciting and sometimes lurid; but the BCBS did have a rationale for going over such details, apart from innate interest. This was that such failures could, and often did, throw up lessons about necessary regulatory responses, and how to patch up the regulatory protective defences, so that ‘that’ could not happen again. And on the whole the BCBS discussions did, indeed, focus on the potential implications of the crises for their own future work. So an occasional entry on the agenda would be a detailed discussion, led by the home supervisor in almost all cases, of the causes, conduct and regulatory implications of each major bank failure after it occurred. Some of the details were (and still are) confidential, and perhaps at the time even sub judice, so this is rather a sensitive area. This seemed to be particularly so to the American participants who would on occasions submit only prior written commentaries and evidence that was already available in the public domain in the USA. No doubt they and their colleagues were more forthcoming to each other privately in the corridors outside the formal sessions. This latter aperçu only goes to underline the more general point that much of the exchange of information, the building-up of mutual trust and the overall value of such meetings resides in the informal discussions held, owing to the existence of the formal meeting, but outside its regular meetings. Almost by definition there is no record of the extent or value of such informal channels of communication, but most of those present say that these discussions were a valuable additional feature to the formal sessions, a process much assisted by the mutual confidence and trust which had developed among delegates.

78

Modus operandi

Once past this regular list of Chairman’s introduction, minutes, tour de table, and (occasional, indeed infrequent) discussion of a prior bank crisis, the way was then open for substantive discussions of major issues. The number of potential topics for discussion was almost always too large for all of them to be properly discussed in the day and a half of each meeting. There was always a reserve army of subjects for discussion. It was quite rare to work through the main agenda at each meeting, let alone to make inroads into the subsidiary list of subjects for discussion, if time allowed. And even when there was time for a discussion of a paper on a topic, it was generally sent back either to the original drafter or to the Secretariat to be rewritten in the light of the discussion. The ultimate objective was to distil a paper on a topic, reaching some generally agreed conclusion that could be passed forward to the superior body, the G10 Governors. Reaching a consensus on such difficult and complex issues, and putting that into an agreed document for transmission to the G10 Governors was a difficult and time-consuming exercise (and was, of course, the main function of the Chairmen). Accordingly, even when agreement could be reached, as over the responsibility of home/host supervisors in the Concordat (Chapter€4), the same subject would come up for discussion repeatedly, before reaching a (temporary) finale with the despatch of a paper to the G10 Governors€– where the Chairman would present the paper himself. And even in such cases the Governors could (but rarely did), ask for reconsideration; or, more frequently, innovations, events and time forced the BCBS to think again, as with the Concordat and Capital Adequacy Requirements. And when agreement/consensus could not be reached, as in the case of liquidity requirements (see Chapter 9), the subject would be raised, discussions continue for several sessions (not necessarily consecutively) and then peter out, perhaps from exhaustion. It is said of university economics exams that ‘the questions remain the same over time. It is just the answers that change.’ Much the same is true of bank (financial) regulation. A regulator in 2011 is still wrestling with much the same issues as its predecessors in 1975, for example the relative responsibilities of home/host supervisors. So most of the agenda items remain largely familiar. During these years, 1975–97, there were eighty-four regular BCBS meetings. Below, the main subjects on the agenda at these meetings are listed in Tables 3.3 to 3.9. There were additional ad hoc meetings, primarily with other groups of supervisors, but their agendas are not included in the tables, though in some cases they are taken up again in Chapter 12. Also the regular elements (e.g. Chairman’s introduction; minutes; tour de table on regulatory and supervisory practices; any other

The structure of BCBS meetings

79

Table 3.3. External issues

1 2 3

4

5 6 7 8

9 10

Surveillance of banks’ external positions Early Warning Systems for International Bank Crises Roles of foreign exchange (fx) brokers and their relationships with banks Rules concerning liquidation of outstanding forward fx contracts if one of the parties becomes insolvent Comparative analysis of fx reporting forms Assessing country risks in international bank lending Treatment of roll-over credits Maturity structure of bank lending and borrowing on international markets Undisclosed subparticipations in syndicated international loans Bunching of roll-over dates on euro-currency loans

Start

Main Years

Last

1975 (1)

1989 (2)

1975 (1)

1979–80, 1989 1975

1975 (3)

1975 (2)

None

1975 (3)

1976 (1)

1976, 1978

1980 (3)

1976 (2)

1976

1976 (3)

1976 (3) 1976 (3) 1977 (3)

1977–9, 1981, 1989 (3) 1989* None 1977 (2) 1978–80 1985 (1)

1979 (3)

1980

1983 (3)

1982 (3)

None

1982 (3)

* The resumption of interest in 1989 was in the context of the Brady proposals, as contrasted with concern about defaults in the earlier years.

business, and future work) have been omitted, as have self-referential reports, for example on drafts of biennial reports, summaries of ICBS (International Conference of Banking Supervisors) meetings and other, for example joint forum, reports, and so on. I have divided the subjects into main headings, to wit: 1. Primarily external, covering foreign exchange positions, international lending (and maturity structure thereof), and so on. 2. Primarily relating to regulatory practices of BCBS members themselves. 3. Primarily relating to attempts to measure and to influence internal practices of banks, though chiefly the large international banks that were the main clientele of the BCBS. 4. Discussion of bank failures, with special reference to their influence on the future work of the BCBS itself.

80

Modus operandi

Table 3.4. Discussions on own regulatory practices

1 2 3 4

5 6 7 8 9 10

11

Techniques of support and rescue for troubled banks Use of banks’ P&L accounts to inform bank supervision Deposit protection schemes Concordat; use of consolidated balance sheets as a basis for supervision Bank secrecy and cross-border information flows Costs to international banks of regulation and supervision Supervision of banks’ trust business Problems arising from bankruptcies of international banks Authorisation procedures for banks’ foreign establishments Implementation of minimum standards for cross-border supervision and Core Principles Models task-force report

Start

Main Years

End

1975

1975

1975 (5)

1976 (3)

1977

1977 (3)

1977 (2) 1977 (3)

1977/8 1978–80, 1983/4

1978 (3) 1989 (4)

1978 (3)

1986 (2)

1980 (1)

1979–81, 1985/6 1980

1980 (2)

1980 (2)

1982

1982 (3)

1980 (3)

1981/2

1983 (3)

1981 (1)

1981/2

1983 (1)

1993 (2)

1997

1995 (2)

None

Continuing after 1997 Cont.

5. Relationships with other groups connected with financial oversight, for example accountants, auditors, other banking supervisors (e.g. in offshore and non-G10 countries), and with oversight of other financial intermediaries, for example securities companies (IOSCO€ – International Organisation of Securities Commissions) and insurance companies (IAIS€ – International Association of Insurance Supervisors). 6. Assessments of primarily infrastructure issues. 7. General, often for information, not classifiable into any of the above. In each case, I note the first date on which the subject came onto the agenda, and the final date. Years in which the topic was intensively discussed (i.e. at a majority of meetings in that year) are reported. If the subject is to be discussed further in a subsequent chapter, this is also remarked, and key issues that are the subjects of individual chapters are in italic.

The structure of BCBS meetings

81

Table 3.5. Measuring and influencing bank practices

1 2

3 4 5

6 7 8 9 10 11 12 13 14 15 16 17 18

Capital and CARs, definition, role, measurement, etc. Affiliations (ownership connections), between banks and non-banks Status of foreign bank branches, e.g. endowment capital Exchange of credit information among commercial banks Measures of bank profitability

Banks’ accounting procedures for rescheduled loans Possible establishment of an international credit risks office Interest rate and market risk Liquidity in international banks Bank provisioning Off-balance-sheet exposures and derivatives Double-gearing on capital Debt swaps Money laundering and crime prevention Securitisation of banking assets Large exposure limits Internal control systems Identification of extreme risktaking outliers

Start

Main Years

End

1975 (2)

1976, 1981–94

Cont.

1976 (1)

1976

1977 (1)

1976 (3)

None

1976 (3)

1977 (1)

1977

1977 (3)

1978 (1)

Cont.

1981 (2)

1978, annual reporting item 1982

1982 (3)

1982 (2)

1982

1982 (3)

1982 (2) 1983 (2) 1984 (2) 1985 (1)

1986, 1989–97 1983–6, 1988 1988–90 1985, 1992–5

Cont. 1992 (2) 1993 (3) 1996 (2)

1985 (3) 1982 (2) 1986 (2)

1985 1986 1986–8

1985 (4) 1986 (3) 1988 (5)

1987 (1) 1987 (2) 1988 (2) 1991 (2)

1987 1989 1988 1991

1993 (1) 1990 (4) 1988 (4) 1991 (3)

As can be seen from Table 3.3, the essentially external concerns of the BCBS started strongly, but faded away rapidly. All the relevant agenda items, except one minor entry, were initiated in the 1970s, and all were brought to a close by end 1989, mostly long before then. The external work of the BCBS is reported in Chapter 5. The Concordat is reviewed in Chapter 4, and the adoption of Core Principles in Chapter 8. The other major headings in Table 3.4 are reviewed in Chapter 11. The division between including headings in Table 3.4, as compared with Table 3.3, is obviously fuzzy and relatively arbitrary.

82

Modus operandi

Table 3.6. Scheduled discussions of bank failures

1 2 3 4 5 6 7

Failure of Israel/British Bank ‘Chiasso Affair’ and role of ‘brass plate’ companies in Liechtenstein Banco Ambrosiano BCCI Patrikis Report on insolvencies (relates to BCCI) Drexel, Burnham, Lambert Barings

Start

Main Years

End

1975 (4) 1977 (3)

None None

1975 (5) 1978 (1)

1982 (3) 1991 (3) 1993 (3)

None 1991–3 None

1984 (3) 1993 (2) 1994 (2)

1992 (4) 1995 (3)

None None

1992 (4) 1995 (3)

Table 3.7. Relationships with other groups connected with financial oversight

1

2 3 4 5 6

7 8 9

Relationships with accountants and auditors, notably IASC (International Accounting Standards Committee) Relationships with offshore bank supervisors Relationships between banks and insurance companies Role of public auditors in bank supervision Supervision of financial conglomerates Relationships with IOSCO (International Organisation of Securities Commission) and IAIS (International Association of Insurance Supervisors) Encouraging bank supervision in Eastern Europe Relationship with non-G10 supervisors Political concern on inter-agency regulatory relationships, G7 communiqués of Halifax, Lyons, Birmingham

Start

Main Years

End

1976 (1)

1976, 1997

Cont.

1978 (1)

1978/9

1983 (1)

1982 (2)

None

1982 (2)

1983 (3)

1984/5

1988 (4)

1986 (1)

1990/91, 1993/4 1988–90, 1996/7

Cont.

1991

None

1992

1993 (1)

1994

1996

1995 (3)

1996

Cont.

1987 (1)

Cont.

The structure of BCBS meetings

83

Table 3.8. Infrastructural issues

1

2 3 4 5 6

Netting:€topic began as supervisory attitudes to the interbank market, continued as interbank netting, and went on to consider Lamfalussy rules. Settlement risk Risks in electronic funds transfers Collaboration with CPSS and ECSC on payment and settlement systems: e-money Y 2000

Start

Main Years

End

1983 (20)

1991/2

1996 (3)

1986 (3) 1988 (5) 1994 (4)

None None 1997

1994 (2) 1989 (2) Cont.

1996 (1) 1997 (8)

None None

Cont. Cont.

Table 3.9. General issues

1 2 3 4 5 6 7 8 9

Changes in structure of banking industry Islamic banking World Bank co-financed lending Issues raised by European financial integration Revised name for the BCBS GATT Promisel Report on international interbank relationships A retrospective on the US banking system in the 1980s Banking statistics, initiative by IMF. BIS re-emerging countries

Start

Main Years

End

1983 (1) 1985 (1) 1985 (3) 1988 (5)

1983 None 1985 None

1983 (2) 1985 (1) 1985 (4) 1988 (5)

1989 (2) 1991 (2) 1992 (4)

None 1991 None

1989 (2) 1991 (3) 1992 (4)

1993 (2)

None

1993 (2)

1997 (1)

None

Cont.

Entries (1) capital and capital adequacy requirements, (5) measures of bank profitability, (6) rescheduled loans, (10) bank provisioning and (12) double gearing on capital in Table 3.5 are taken together in Chapter 6 on The 1988 Basel Accord. Entries (8) on market and interest rate risks, (11) on off-balance-sheet risks and derivatives and (15) on securitisation of banking assets are grouped together in Chapter 7 on The Market Risk Amendment of 1997. There is a separate section on

84

Modus operandi

the work of liquidity in Chapter 9. The remaining material in Table 3.5 is mostly discussed in Chapter 11. The headings in Table 3.6 were the discussions on bank failures tabled in the agenda; such failures being sensitive matters, no doubt much of the discussion on these, and other bank failures and crises, were held privately in the corridors. In some other cases, for example Franklin National (1975) and Gotabanken (Sweden, 1978), background papers were submitted, but not tabled for discussion in the agenda. We shall discuss these only as they impinged on the main work of the BCBS, for example (1) on forward exchange rate contracts, (2) on relationships with offshore supervisors, (3) on the Concordat, and so on. The one failure that took up a considerable amount of the time and effort of the BCBS was the BCCI fraud/failure; we discuss this in Chapters 4, 11 and 14. The cross-institutional issues in Table 3.7 form the subject matter of Chapters 12 and 13. The headings in Table 3.8 were something of a sideline for the BCBS; they are picked up briefly in Chapters 11 and 12, the latter on relationships with other organisation, in this case primarily two of the other G10 subcommittees, the CPSS (Committee on Payment and Settlement Systems) and the ECSC (Euro-currency Standing Committee). The topics in Table 3.9 were mostly for the information of BCBS members, and will be raised only tangentially in subsequent chapters. The mandate for the BCBS has already been described in Chapter 2. The two key sentences were:€ ‘The committee is … to look into the possibility of introducing into certain national markets measures of supervision and control which have proved to be fruitful in other countries. The need for an early warning system in case of banking difficulties is also to be considered.’ But the first proposed line of work was only set out in a very general and fuzzy way, and the second was considered (briefly), only to be rejected by the BCBS (see Chapter 5). In truth, the BCBS began and continued to operate as an internally self-starting body, devising its own agenda for itself. Potential subjects for discussion could be, and were raised by any participant (though each participant, being an official in a central bank/supervisory authority, would almost always have cleared any such initiative with their home superiors first). There was, moreover, the consequential that the proposer of a discussion on any such new subject could expect to be asked to prepare the first (and maybe some subsequent) draft(s) of such a paper, before (if successful) handing it over to the Secretariat for final polishing. Papers and subjects arose from discussions, events and individual initiatives, and were then given a priority ranking by the

The structure of BCBS meetings

85

Chairman and Secretary. Of course, some members were more active and helpful in this respect than others. Besides Huib Muller, George Blunden remembers Willey as being particularly helpful and Peter Cooke would also point to Dahl and Coljé. This general framework whereby the members of the BCBS selected their own agenda, prepared papers and, if a consensus could be reached, submitted that to the G10 Governors changed in the course of the 1980s. The 1982 MAB (Mexico, Argentina and Brazil) crisis, and the resulting move towards Basel I, the Capital Adequacy Accord in 1988, not only broadened and deepened the issues, but also led to the refocussing of political attention on the international financial architecture.17 The broadening and deepening of the issues, notably the attempt to advocate18 some common capital adequacy requirement, meant that the subjects became too detailed and complex to be handled in the occasional regular meetings of the BCBS. Instead, a series of working groups was set up to handle the crucial issues. The first working group established by the BCBS was set up in 1976 (but which finally reported in 1978) under the chairmanship of J. Fitzenreiter of Germany to study the somewhat arcane issue of ‘bank confirmation enquiries’; see Chapter 5, Section B. After that, there was an occasional use of subgroups for specialised topics, the next one being on maturity transformation in international bank lending (see Chapter 5, Section C), chaired by Michael Dealtry. But the number of such groups ramified in the mid-1980s with, and following, the work on CARs. Each Chairman would thenceforth tend, on arrival, to reorganise and to restructure the set of working groups, in an attempt to achieve efficiency and clarity. Naturally each working group had its own dynamic (and chairman and secretary). So the papers coming before the main BCBS meetings increasingly came to take the form of papers submitted upwards from the separate subgroups. From the mid-1980s onwards the politicians, particularly in the US Congress, once again turned their gaze upon the international financial architecture. From then onwards the published final statement of 17 After the political flurry in 1974, described in Chapter 2, until the MAB crisis in 1982, there was relatively little outside political interest in, or oversight of, what the BCBS was doing. It was largely left to get on under its own steam. 18 Note the use of the word ‘advocate’ rather than ‘impose’. The BCBS did not see itself at this time, anyhow, as a body which could introduce, or impose, a worldwide requirement. Instead, they saw themselves as proposing measures that the G10 Governors could individually recommend their own countries to adopt. If other countries wanted to abide by the same procedures, that would be good; but if not, that would be entirely their own choice.

86

Modus operandi

the meetings of the G7 heads of government would commonly include some (pious) proposal for improving such architecture. In many cases the remit for taking such general proposals forward into some practical form, as with the Core Principles for Banking Supervision, often got passed back to the BCBS (see Chapter 8). So, by the 1990s, the BCBS had moved some considerable distance from its original format, becoming both more bureaucratic with a complex structure of subgroups, and more subject to political attention and oversight. Besides the reawakening of political concern about the international financial architecture, there were a number of additional reasons for the increase in the BCBS’ workload during the 1980s and 1990s. First, the range and scale of subjects put before it were primarily determined by the demand for its services by its own member institutions. As the BCBS became better known, and as its potential in handling both home/host issues (the Concordat) and other international regulatory concerns (e.g. Basel I and capital adequacy) became more credibly established, so that demand increased. Moreover, the member institutions, mostly Central Banks, realised that they could at times evade awkward domestic political obstacles by invoking an international (BCBS) consensus. Also there was a strongly felt need from banking supervisors in jurisdictions not represented in the BCBS for guidance and technical advice, especially as and when their markets liberalised and they came under pressure to establish effective supervisory frameworks. Finally, there was gradually increasing recognition by the large, international commercial banks of the importance to themselves of the work of the BCBS, in particular of the need for a ‘level-playing-field’ and regulatory consistency in their major markets. Although they have continued to quibble at the national level, the big banks have generally accepted agreed and balanced international deals.19

Appendix A Letter from Governor Gordon Richardson to Chairman Jelle Zijlstra of the G10 central bank Governors I am writing about the Chairmanship of the Committee on Banking Regulations and Supervisory Practices. When it was announced late in 1975 that Mr Blunden would shortly cease to be Head of Banking Supervision here, the Committee had met only four times; it therefore seemed sensible that he should continue as Chairman for the time 19 While this whole section has benefited from discussions with Charles Freeland, the ideas in this final paragraph emanated directly from him. That noted, all errors of fact and interpretation remain my own responsibility, not his.

Appendix A

87

being, so that the Committee might be spared a change of leadership in its early days. The Committee has now had another eighteen months’ life and its next meeting will be its tenth; in these circumstances Mr€ Blunden sees less need for him to continue as Chairman and, indeed, for a variety of reasons wishes to give up the post at the Committee’s next meeting in June. First, he feels handicapped by the fact that he is no longer in daily touch with matters discussed in the Committee; it is clearly best for the Committee to be led by someone who is completely familiar with all topics discussed in it. Secondly, his multifarious other duties make it difficult for him to give as much time as is desirable to the work of the Committee, especially to the preparatory work which needs to be undertaken with the Secretariat in Basle. Thirdly, in contrast to the situation late in 1975 when continuity of leadership was important, he thinks that the Committee might benefit from the stimulus that a new Chairman would provide. I would like to suggest to you that the Governors of the Group of Ten be asked to approve the appointment of Mr W. P. Cooke, who succeeded Mr Blunden as Chief of Banking Supervision in the Bank of England, as the new Chairman. This is not because I want to claim that the original appointment gives a prescriptive right to the chairmanship of this Committee to the United Kingdom; nor do I wish to argue, as I could, the benefits to be gained from national continuity. Rather, it is because he appears to be the best candidate. It is self-evident that the Chairman of a committee established by the Governors needs to be a central banker, and not someone from one of the outside supervisory agencies; and in view of the nature of the Committee’s work he should be one of those central bankers on the Committee who are engaged in banking supervision rather than one of the foreign exchange experts. These requirements rule out the representatives of Sweden, Switzerland, Belgium, Luxembourg and Canada. Secondly, the degree of liaison necessary with the Secretariat in Basle and the need to attend periodic Governors’ meetings would make the chairmanship unacceptably burdensome for those members who come from outside Europe; this rules out Canada again and, in addition, the United States and Japan. So a new Chairman needs to come from the supervisory representatives on the Committee from Germany, the Netherlands, France, Italy or the United Kingdom. The chief representative of the Bundesbank, Dr Burger, would be an admirable Chairman but, unfortunately, he speaks only German; most of the rest of the Committee do not speak German and its working languages are basically English and French. This must rule him

88

Modus operandi

out. The supervisory representatives of your Bank and the Banca d’Italia, Mr Coljé and Mr Montanaro, are relatively new members of the Committee who have each attended only one meeting as sole supervisory spokesmen for their countries unaccompanied by their predecessors; in the circumstances they can hardly yet be well enough known to the Committee to be considered as candidates. This leaves Mr Cooke and M Bonnardin of the Bank of France. Mr Cooke has been attending the Committee longer than M Bonnardin, who has been to only two meetings without his predecessor, and Mr Cooke is of a higher status in his own bank than M Bonnardin, being in charge of Banking Supervision, whereas the latter is not the head of his department. It is also relevant that Mr Blunden and Mr Dealtry, the Secretary of the Committee, have taken informal soundings of each of the deleÂ� gations, although they were, of course, at pains to make clear that any decision on the chairmanship was a matter for the Governors and not for the Committee. However, Mr Blunden thought no proposition should be put to the Governors which would not be welcome to the Committee. The preliminary, informal reaction to all the delegations was that they would be happy to see Mr Cooke as Chairman. No other names received more than isolated support. I would not, of course, put Mr Cooke’s name forward to you unless I was personally confident that he would make an admirable Chairman who could be expected to continue the efficiency and effectiveness of the Committee.

Appendix B No. of Attendance

Starting from

Ending at

Chairmen

Blunden Cooke Muller Danielsson (Acting) Corrigan Padoa-Schioppa De Swaan

9 38 12 1 8 13 3

1st, 1975 2nd, 1977 3rd, 1988 2nd, 1991 3rd, 1991 3rd, 1993 2nd, 1997

1st, 1977 3rd, 1988 1st, 1991 2nd, 1991 2nd, 1993 1st, 1997 4th, 1997

Belgium

Andre Baeyens Vanleeuw Pille Heyvaert Dubois Mme Lepoivre Rey

11 16 20 13 1 40 33 1

1st, 1975 1st, 1975 1st, 1978 1st, 1980 2nd, 1982 1st, 1984 3rd, 1984 3rd, 1988

3rd, 1977 3rd, 1979 3rd, 1984 3rd, 1983 2nd, 1982 3rd, 1994 2nd, 1995 3rd, 1988

Appendix B

89 No. of Attendance

Starting from

Ending at

Vigneron Lefèvre Maes Servais Lichtbuer

3 1 12 9 1

2nd, 1990 1st, 1991 4th, 1994 3rd, 1995 3rd, 1990

1st, 1992 1st, 1991 4th, 1997 4th, 1997 3rd, 1990

Canada

Read Vachon Macpherson Kennett Ruxton Mackenzie Ms Labarge Hanna Palmer Thompson LePan

3 77 13 19 3 12 14 2 4 1 6

1st, 1975 1st, 1975 2nd, 1975 1st, 1978 3rd, 1985 2nd, 1987 1st, 1989 1st, 1995 3rd, 1995 4th, 1995 2nd, 1996

2nd, 1976 4th, 1997 1st, 1988 2nd, 1986 4th, 1986 3rd, 1991 4th, 1994 2nd, 1995 2nd, 1996 4th, 1995 4th, 1997

France

Aubanel Fanet Bonnardin Fèvre Icard Vienney Lieuze Pontet Fort Pujal Mme Nouy Cardona Mme Dambrine Thoraval du Quesne Pény

26 6 35 3 6 18 11 3 24 9 13 4 1 5 2 1

1st, 1975 1st, 1975 1st, 1976 1st, 1978 3rd, 1982 1st, 1985 3rd, 1987 4th, 1989 3rd, 1990 3rd, 1990 1st, 1993 2nd, 1994 4th, 1994 3rd, 1996 3rd, 1996 2nd, 1997

3rd, 1982 2nd, 1976 2nd, 1987 3rd, 1986 2nd, 1984 3rd, 1989 2nd, 1990 2nd, 1990 3rd, 1997 3rd, 1992 2nd, 1995 2nd, 1995 4th, 1994 4th, 1997 1st, 1997 2nd, 1997

Germany

Bürger Kloft Rinke Schneider Fitzenreiter Lang Becker Goertz Mayer Maurer Sanio

16 34 1 51 5 20 44 6 3 2 27

1st, 1975 1st, 1975 1st, 1975 2nd,1975 3rd, 1975 1st, 1980 1st, 1986 1st, 1987 2nd, 1988 2nd, 1989 3rd, 1990

3rd,1 979 4th, 1986 1st, 1975 2nd,1990 1st, 1977 4th, 1985 4th, 1997 4th, 1988 5th, 1990 4th, 1991 4th, 1997

Italy

Monterastelli Catalano Siclari Montanaro

8 19 1 5

1st, 1975 1st, 1975 2nd, 1976 2nd, 1976

3rd, 1976 1st, 1981 2nd, 1976 3rd, 1977

90

Modus operandi No. of Attendance

Japan

Starting from

Ending at

Lanciotti Manzelli Santini Carbonetti Saccomanni Pompili Conigliani Carosio Pontolillo Godano Zeloni Donato Bianchi

52 1 7 1 3 3 1 40 1 18 11 2 1

3rd, 1977 2nd, 1978 1st, 1982 3rd, 1982 3rd, 1985 4th, 1985 1st, 1987 2nd, 1987 3rd, 1990 1st, 1993 3rd, 1993 3rd, 1996 2nd, 1997

4th, 1992 2nd, 1978 3rd, 1984 3rd, 1982 2nd, 1987 1st, 1987 1st, 1987 4th, 1997 3rd, 1990 4th, 1997 2nd, 1996 1st, 1997 2nd, 1997

Shoda Masunaga Akiyama S. Nagashima Sato Shigehara Tarukawa Mayeda Yamashita T. Kubota Kawase Ikawa Aoki Yoshimura Kodaki Sekine Kato H. Iida Hosoya Watanabe Higashi Arai Ishii Anzai Okubo Kansaku Hosomi Homma Kato T. Sasaki Akiyama M. Nishimura Hatayama Endo

1 2 8 3 2 9 7 6 6 4 5 8 10 5 5 11 1 1 4 3 4 3 1 2 1 8 4 5 2 2 1 1 3 1

1st, 1975 1st, 1975 2nd, 1975 3rd, 1975 1st, 1976 3rd, 1976 1st, 1977 2nd, 1979 1st, 1980 1st, 1981 1st, 1982 2nd, 1982 2nd, 1983 3rd, 1984 3rd, 1985 2nd, 1986 4th, 1986 4th, 1986 2nd, 1987 1st, 1987 3rd, 1987 3rd, 1987 3rd, 1988 4th, 1988 2nd, 1989 3rd, 1989 3rd, 1989 3rd, 1990 3rd, 1990 4th, 1990 1st, 1991 2nd, 1991 2nd, 1991 2nd, 1991

1st, 1975 2nd, 1975 1st, 1977 5th, 1975 2nd, 1976 3rd, 1979 1st, 1979 1st, 1981 3rd, 1981 3rd, 1988 1st, 1983 2nd, 1984 1st, 1986 2nd, 1985 3rd, 1986 1st, 1989 4th, 1986 4th, 1986 2nd, 1988 3rd, 1987 3rd, 1988 4th, 1988 3rd,1 988 2nd,1 989 2nd, 1989 1st, 1991 2nd, 1990 1st, 1992 5th, 1990 5th, 1990 1st, 1991 2nd, 1991 4th, 1991 2nd, 1991

Appendix B

91 No. of Attendance

Starting from

Ending at

Maruyama Kuroda Himino Koyama Ninomiya Yamashita I. Ariyoshi Shibasaki Amaya Harada Murakami Miyahara Mutoh Isaka Okawa

4 7 3 2 2 6 2 4 2 3 4 1 7 5 1

3rd, 1991 2nd, 1992 3rd, 1992 4th, 1992 3rd, 1993 3rd, 1994 3rd, 1994 3rd, 1994 1st, 1995 3rd, 1995 3rd, 1995 4th, 1995 1st, 1996 3rd, 1996 4th, 1997

2nd, 1992 2nd, 1994 4th, 1992 1st, 1993 1st, 1994 4th, 1995 4th, 1994 2nd, 1995 2nd, 1995 2nd,1 996 2nd, 1996 4th, 1995 4th, 1997 4th, 1997 4th, 1997

Luxembourg

Jaans Dondelinger Schmit Schaus Philippe

1 2 10 39 30

1st, 1975 2nd, 1975 4th, 1975 3rd, 1978 1st, 1990

1st, 1975 3rd, 1975 2nd, 1978 4th, 1989 4th, 1997

Netherlands

Timmerman Muller Coljé De Boer De Heer Musch Benard van Dorssen Geerling De Swaan van Nieuwkerk Brockmeijer

16 8 33 18 1 26 18 14 7 17 17 3

1st, 1975 1st, 1975 2nd, 1976 2nd, 1979 1st, 1980 4th, 1982 3rd, 1985 4th, 1988 2nd, 1990 2nd, 1992 2nd, 1992 2nd, 1997

3rd,1 979 3rd, 1976 3rd, 1986 2nd, 1985 1st, 1980 2nd, 1992 1st, 1990 4th, 1997 4th, 1991 1st, 1997 3rd, 1996 4th, 1997

Sweden

Rodebäck Danielsson Erne Törnqvist Lind Josefsson Norgren

32 58 1 23 28 13 11

1st, 1975 1st, 1975 1st, 1978 1st, 1985 3rd, 1990 3rd, 1991 1st, 1995

1st, 1985 3rd, 1991 1st, 1978 4th, 1990 4th, 1997 4th, 1994 4th, 1997

Switzerland

Stahel Gutzwiller Bodmer Müller Ehrsam Tschudi Corti

14 9 1 31 5 1 15

1st, 1975 1st, 1975 5th, 1975 3rd, 1976 2nd, 1980 3rd, 1981 1st, 1982

2nd, 1980 1st, 1977 5th, 1975 1st, 1986 1st, 1982 3rd, 1981 2nd, 1986

92

Modus operandi No. of Attendance

Starting from

Ending at

Hauri Klauser Zuberbühler Merz Stirnimann Birchler

39 35 5 1 1 8

1st, 1986 3rd, 1986 3rd, 1986 3rd, 1990 3rd, 1990 2nd, 1994

4th, 1997 4th, 1995 3rd, 1995 3rd, 1990 3rd, 1990 4th, 1997

UK

Galpin Byatt Cooke Atkinson Coleby Barnes Nendick Beverly Quinn Farrant Pople Foot Smout Page Reid Evans

10 28 5 1 8 24 8 16 21 25 1 8 15 2 1 2

1st, 1975 1st, 1975 5th, 1975 2nd, 1977 3rd, 1977 1st, 1980 1st, 1981 4th, 1982 1st, 1983 1st, 1987 1st, 1988 3rd, 1993 3rd, 1993 1st, 1996 1st, 1997 3rd, 1997

3rd,1 977 2nd, 1984 1st, 1977 2nd, 1977 1st, 1980 2nd, 1993 1st, 1983 2nd, 1989 3rd, 1995 2nd, 1993 1st, 1988 4th, 1997 4th, 1997 2nd, 1997 1st,1 997 4th, 1997

USA

Gemmill Dahl Willey Bench Heimann Ryan Baer Wood Martin Cross Sandberg Conover Selby Shumway Patriarca Taylor Clarke Meadows Marriott Miailovitch Hope Ryback Spindler Fritts Rushton

6 38 20 5 4 2 1 9 4 9 31 1 5 8 3 12 1 3 17 6 1 15 8 16 1

1st, 1975 1st, 1975 2nd, 1975 1st, 1978 2nd, 1978 3rd, 1978 1st, 1979 2nd, 1979 1st, 1982 3rd, 1979 3rd, 1982 2nd, 1983 2nd, 1983 1st, 1984 1st, 1985 3rd, 1985 1st, 1986 1st, 1986 2nd, 1986 4th, 1986 2nd, 1987 1st, 1988 2nd, 1988 3rd, 1986 4th, 1988

1st, 1978 3rd, 1986 1st, 1982 1st, 1984 2nd, 1980 3rd, 1983 1st, 1979 1st, 1982 1st, 1983 2nd, 1982 2nd,1 991 2nd, 1983 1st, 1986 2nd, 1986 4th, 1985 3rd, 1991 1st, 1986 4th, 1988 1st, 1991 2nd, 1995 2nd, 1987 2nd, 1997 2nd, 1993 2nd, 1993 4th, 1988

Appendix B

Stum Ms Krause Feldberg Fitterman McCurdy Ms Godfrey McCauley Ms Solol Spillenkothen Hartzell Patrikis Stone Ludwig Ms Cumming Ketcha Mrs Helfer Sciacca Cole

93 No. of Attendance

Starting from

Ending at

2 24 17 1 1 1 1 5 17 3 3 4 12 3 9 2 1 1

1st, 1989 3rd, 1989 3rd, 1990 3rd, 1990 3rd, 1991 3rd, 1991 4th, 1991 3rd, 1992 3rd, 1992 4th, 1992 1st, 1993 3rd, 1993 1st, 1994 2nd, 1994 3rd, 1995 2nd, 1996 1st, 1997 3rd, 1997

3rd, 1989 4th, 1997 4th, 1997 3rd, 1990 3rd, 1991 3rd, 1991 4th, 1991 2nd, 1993 4th, 1997 4th, 1994 2nd, 1994 4th, 1994 3rd, 1997 4th, 1997 4th, 1997 3rd, 1996 1st, 1997 3rd, 1997

1 1 1 1

4th, 1975 3rd, 1976 2nd, 1983 1st, 1984

4th, 1975 3rd, 1976 2nd, 1983 1st, 1984

Other

Huth (Israel) Fitzenreiter (Germany) Finch (IMF) C. J. Thompson (BIS)

EC Comm

Fitchew Imbert Bader Lamb van Lovengreen Fèvre Clarotti

8 1 13 2 7 22 1

2nd, 1987 2nd, 1987 3rd, 1987 3rd, 1987 2nd, 1988 2nd, 1990 2nd, 1996

1st, 1992 2nd, 1987 4th, 1997 2nd, 1988 4th, 1992 3rd, 1997 2nd, 1996

BIS

Dealtry Mayer Timm Freeland Thompson van Schaik Giannetti Hayward Rohmann Kos Pény Gehring Watanabe Gilbert Musch Harbrecht Fisher Carrère

31 30 7 72 16 9 10 16 12 9 11 7 7 9 21 6 8 7

1st, 1975 1st, 1975 5th, 1975 1st, 1978 3rd, 1984 1st, 1985 1st, 1987 4th, 1988 2nd, 1989 4th, 1989 1st, 1990 2nd, 1990 4th, 1991 1st, 1992 2nd, 1992 3rd, 1992 3rd, 1992 3rd, 1994

2nd,1 984 2nd, 1984 3rd, 1977 4th, 1997 4th, 1988 1st, 1987 3rd, 1989 2nd, 1992 4th, 1991 3rd, 1991 2nd, 1992 3rd, 1991 2nd, 1993 2nd, 1994 4th, 1997 2nd, 1994 4th, 1994 1st, 1996

94

Modus operandi

Goddin Cordewener Walter Sicotte Sahuquet Ms Roberts Ms Olson Mrs D Nouy Orrell

No. of Attendance

Starting from

Ending at

6 13 7 7 4 5 4 4 4

3rd, 1994 3rd, 1994 4th, 1994 1st, 1995 2nd, 1996 3rd, 1996 3rd, 1996 1st, 1997 1st, 1997

2nd, 1996 4th, 1997 2nd, 1996 3rd, 1996 2nd, 1997 4th, 1997 3rd, 1997 4th, 1997 4th, 1997

Appendix C The Committee’s Secretariat I have been conscious for some time that with the increasing pressures of work in the Committee it has been necessary to generate more and more technical work in sub-committees or in individual countries’ supervisory institutions. The Secretariat has provided the Committee with an excellent service over the years but none of them reckon to have practical supervisory experience. Furthermore, Michael Dealtry and Helmut Mayer have increasingly been involved with work in other areas of the BIS’s responsibilities and Michael Dealtry as a Manager of the BIS is really too senior, in my view, to serve as the Secretary of a BIS Governors’ Committee. I have, therefore, as a number of you will know, been pursuing the possibility of introducing some supervisory expertise into the Secretariat so that more technical papers can more easily be drafted at the outset in Basle. In order to do this and to enable the Secretariat to maintain more frequent direct contact with members, I have concluded that the Committee needs a full-time Secretary. I have endeavoured to find someone who could undertake this role from among the English-speaking members of the Committee, for obvious linguistic reasons, and looked first for someone from Canada and the United States. It has, however, not proved possible to find a suitable candidate from North America and I have therefore asked Mr Christopher Thompson of the Bank of England to undertake this assignment and he will be coming to Basle in the summer for three years to take over as Secretary of the Committee. Charles Freeland will remain as the Assistant Secretary of the Committee, but both Michael Dealtry and Helmut Mayer will leave the Secretariat. Michael Dealtry will, however, continue to keep a watching brief over the Committee’s work and Â�represent its interests in the BIS management and I hope

Appendix C

95

that the Committee will continue to be able to turn to Helmut Mayer for help and advice, particularly in the area of the compilation, analysis and interpretation of international banking statistics. I believe it may well be both necessary and desirable to consider supplementing the Secretariat’s resources further from other member countries but I believe that the steps just outlined will in practice sustain the capacity of the Secretariat for the time being. I trust that members will be content with these proposed changes, which are designed to enhance the capacity of the Secretariat to serve the Committee. 29th March 1984

4

The Concordat

A

Home/host relationships, 1975

As already noted in Chapter 2, the main focus of the G10 governors’ communiqué, establishing the Basel Committee on Banking Supervision (BCBS), was on external financial issues, notably on ‘the need for an early warning system’ for potential future international financial crises. Nevertheless, besides a survey, a summary paper, produced by the BIS on ‘existing regulations and supervisory practices’ in the member countries, the agenda for the first meeting (BS/75/1)1 had as item V a discussion of ‘Future Work’ (also see Chapter 3). The four topics that were then (6–7 February 1975) (BS/75/5) selected for such further consideration, with further work to be commissioned on them, were: (a) relation of banks with foreign exchange brokers (see Chapter 5); (b) responsibility for supervision of banks’ overseas branches, subsidiaries and joint ventures; 1 The BCBS archives are filed under the initials BS (Banking Supervision), followed by the relevant year, in this case 1975, and then ordered numerically in chronological order of submission to the files. The number of filed documents in each year was: 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

81 67 60 43 59 59 52 86 103 88 95 91

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

94 124 120 116 109 117 62 101 124 128 140

Initially such papers were often filed not only in English (e), but also in French (f) and occasionally in German (d); in later years the files are predominantly only in English.

96

Home/host relationships, 1975

97

(c) techniques of support and rescue operations (see Chapter 11); and (d) definition of capital and its role (see Chapter 6). The question of what should be the relative responsibilities of home/ host supervisors had been a key concern that had led to the initiative for the foundation of the Groupe de Contact (see Chapter 2). So it was no surprise that Huib Muller of the Nederlandsche Bank, one of the founding fathers of the Groupe, and initially appointed to the BCBS, volunteered to produce a paper on this topic. Indeed, he must already have had such a paper ready for this purpose, since the first draft was available and circulated by the BIS on 17 March 1975 (BS/75/11). In this draft Muller distinguished between three main kinds of crossborder banking establishments, that is joint ventures (more commonly known at that time in the UK as consortium banks), subsidiaries and branches. Initially Muller subdivided subsidiaries into those with specific parental guarantees (with a letter of comfort or parental support) and those without, but this distinction was felt to be fuzzy and removed in subsequent discussion. He similarly distinguished three grounds for prudential concern:2 on liquidity, on solvency and on foreign exchange positions, Finally, he ascribed which of the two supervisory authorities, local/host or parent/home should have primary responsibility in each of the nine cases (three types of cross-border bank; three foci for supervisory oversight). That gave rise to an eighteen-cell matrix, and Muller ended his early drafts with such a matrix. Most of his fellow members on the BCBS primarily recall that matrix, since it was clear and simple. The example from the first draft is given in Table 4.1, since it was an important stage in the home/host (continuing) discussion. It was, in my own view unfortunately, struck out of the final document for circulation to the G10 governors (and thence to supervisory authorities both in the G10 countries and more widely), probably on the grounds that it was too stark and simple without sufficient qualifications for special cases and grey areas. Alternatively, some regulators/supervisors may have been so allergic to mathematics that a matrix presentation, even with words in the cells, may have been regarded as off-putting. Nowadays cross-border banking is, almost invariably, undertaken either by branches or subsidiaries, but during the 1970s joint venture, or consortium, banking had become temporarily quite important, 2 A further concern was whether there was a need to tighten up on authorisation for banks wanting to expand outwards from the home country, or inwards to the host country. There was a general perception that such authorisations had been granted too easily with insufficient prudential due diligence.

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Table 4.1. Matrix of suggestions for sharing of responsibilities

Liquidity

Solvency

Foreign exchange positions

Supervision by

Supervision by

Supervision by

host

host

host

parent authorities

parent

authorities

parent

authorities

Joint venture necessary

not necessary necessary

advisable necessary advisable

Subsidiaries Nonguaranteed necessary Guaranteed necessary Branches necessary

not necessary necessary not necessary advisable not necessary advisable

advisable necessary advisable necessary necessary necessary necessary necessary necessary

especially in London. Groups of banks, from one or more countries, would get together to share in the capitalisation, governance and management of a consortium bank, often established in London to operate in the new international wholesale markets there, for example providing syndicated credits in the Euromarkets. Orion bank was a prime example. The Bank of England was particularly worried about the prudential implications of such banks, because there was no single parent. How could the position of such banks ever be consolidated into a single entity since there were multiple parents? If the joint venture ran into trouble, what would be the relative responsibilities of its various parents, de jure and de facto? Indeed, the Bank (George Blunden) had already written to all such consortium banks operating in London in an attempt to clarify this position (letter reproduced as Appendix A to this chapter). Given these uncertainties, it was a relief, especially to the Bank of England, that the early enthusiasm for such joint venture (consortium) banks cooled, for reasons outside the remit of this exercise, to an extent that they have largely disappeared from the current scene. Anyhow, Muller’s paper was discussed at both the second (24–25 April) (BS/75/31) and third (19–20 June) (BS/75/29 and BS/75/40) meetings of the BCBS in 1975. The paper, as revised by Chairman George Blunden and the Committee’s Secretary (BS/75/44), was then put up to the G10 governors following the September meeting, and approved by the Governors. There was then a discussion in the BCBS

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(at its fifth meeting in 11–12 December) (BS/76/1) on the external circulation to be given to this report. Besides dropping this matrix, and also the distinction between guaranteed and non-guaranteed subsidiaries, what were the main changes introduced in the redrafting process? The main change was that Muller’s initial draft focussed almost entirely on the allocation of responsibilities between home and host supervisors.3 The BCBS as a group accepted the gist of Muller’s allocative proposal, though slightly softening its sharp edges to account for hard cases and individual country exceptionalism (i.e. no ‘rules’, just ‘guidelines’). But the final paper included much more discussion and emphasis on how such cooperative allocation could be achieved, by contact, agreements and information-sharing between home and host prudential authorities, in both directions. This latter had been touched upon in Muller’s initial draft, under Section II on Principles of Cooperation, but was given much more emphasis in the final paper. The whole final paper is reproduced in Appendix B. The key additional sections on ‘cooperation’ are the final section on ‘Aids to communication’ which raised, inter alia, the constraints on information transfers caused by banking secrecy laws (discussed further in Chapter€11), and the middle paragraph of page 2, reproduced below: For a variety of reasons, therefore, adequate supervision of foreign banking establishments, without unnecessary overlapping, calls for contact and Â�co-operation between host and parent supervisory authorities. It is one of the Committee’s purposes to foster co-operation of that kind among its member countries. In addition, the Committee considers that any guidelines for Â�co-operation it may agree on should be communicated to other countries with a significant rôle in international banking, in the hope of obtaining their Â�co-operation too. The Committee has already established contacts with the supervisory authorities of a number of such countries and, if the Governors accept this report, will consider which other countries it might approach.

The Governors did accept the report’s suggestion that supervisory authorities abroad might be approached with information on the BCBS guidelines for the allocation of home/host responsibilities. Consequently the Chairman (Blunden) wrote to thirty-seven non-G10 central banks and eleven non-G10 banking supervisors (not being central banks) to enclose a copy of the BCBS report. An example, in the form of the Kapstein (1994, especially Chapter 1 on ‘Government and Global Markets’, pp.€14–17) argues that, in principle, alternative approaches to that proposed by Muller were possible. But only the home country could oversee the consolidated entity, and supranational regulatory bodies do not exist; so, in practice, there was really no serious alternative possible. 3

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letter to the Governor of the Reserve Bank of Australia, is attached as Appendix C. The letter asked for comments and suggestions, and several (favourable) comments were received, often requesting to be kept in touch with the future work of the BCBS. In some cases, however, the supervisors in other countries had only heretofore supervised locally owned banks, and the idea that they might also be concerned with the conditions of foreign-owned banks operating in their countries was, apparently, new to them. B

Consolidation of banks’ balance sheets

The second stage of this ongoing exercise began in the autumn of 1977 when the BCBS discussed at its eleventh meeting (27–28 October) (BS/77/46 and BS/77/60) a paper by Coljé, also from the Nederlandsche Bank, on ‘Consolidation of banks’ balance sheets:€aggregation of riskbearing assets as a method of supervising bank solvency’ (BS/77/52). The background to the preparation of this paper was probably that the intended and proposed transfers of information between host and home supervisors now made the consolidation of balance sheet information, by and for the home supervisor, into a more realistic proposition. After his promotion in the Nederlandsche Bank, Huib Muller had ceased to be one of the Dutch representatives to the BCBS; he left after the third meeting in 1976. But there is little doubt that the author of the paper, Coljé, will have discussed it at length with Muller beforehand. The gist of the paper was that a bank could, ‘by establishing subsidiaries, create an equity capital pyramid which enables it to circumvent restrictions imposed by the supervisory authorities in the form of capital adequacy ratios’. An example, reproduced below, shows how equity of 1 could be levered up to support deposits of 999 and loans of 1,000, despite apparently abiding by capital ratios of 10 per cent, 1 to 10, at each stage of the ladder. Example 1 Parent bank A Holding in B 10

Own resources 1 Deposits 9

Subsidiary B Holding in C 100 Own resources 10 Deposits 90 Loans 1,000

Subsidiary C Own resources 100 Deposits 900

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There were two potential ways around this problem. The first was to impose a 100 per cent solvency requirement on such holdings (i.e. offsetting the full amount of the investment in a subsidiary against the parent’s capital before calculating the latter’s required risk ratio), or via the consolidation of balance sheets, in particular all of a banking group’s risk-bearing assets. For a variety of reasons, consolidation was the preferred option. In particular, if Capital Adequacy Requirements (CARs) were lower in subsidiaries abroad, or such subsidiaries could themselves establish subsidiaries, the 100 per cent offset would still fail to prevent capital leverage. Moreover, prudential assessment of crossborder banks, for solvency and capital adequacy requirement purposes, on a consolidated basis was becoming best practice in a growing number of G10 countries. Among its advantages were (BS/77/52): – the same solvency ratio is applied to all risks of the same type that are being run by a particular bank, regardless of where its different offices may be located; – it removes the incentive for banks to establish non-branch affiliates in countries simply in order to take advantage of lower solvency requirements; – it should reduce the risk of ceilings on the size of loans to individual customers being circumvented, through the head office of a bank and a subsidiary extending credit to the same institution or person; In addition, consolidation should be useful for banking supervision purposes in enabling the authorities to monitor banks’ aggregate exposure to exchange rate risks and country risks.

Nevertheless there were some difficult operational issues; for example, what should be done about non-financial interests, or quasi-financial involvements such as leasing companies, or personal loan companies, or temporary relationships, or minority interests (consolidate, or not?). Anyhow, revised versions of the paper on consolidation were again discussed at the twelfth and thirteenth meetings of the BCBS (2–3 March 1978 and 29–30 June) (BS/78/5, 10, 14 and 20) and it was agreed that the Secretariat would recast it to highlight the BCBS’ conclusions and recommendation of the principle of consolidation, with the more technical section and that on member state current practices (derived from a questionnaire) relegated to appendices. Concern was expressed by some that ‘parts were too technical for the Governors’, so the new Chairman, Peter Cooke, suggested sending it with a covering letter from himself, after the BCBS had one last look at the draft in October. This was agreed at the fourteenth BCBS meeting (26–27 October) (BS/78/41). Chairman Peter Cooke was then invited by the President of the G10 governors to introduce the BCBS’ note on consolidation at the G10

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governors’ meeting in November 1978 (BS/79/10). They ‘strongly’ endorsed the main conclusions, but invited the BCBS to prepare a further note€– for resubmission to them (para. 6 in BS/79/10)€– including a further consideration on how this principle could be extended to joint ventures and minority holdings (which had already been addressed in a rather general BCBS note by Frederick Dahl from the Fed in 1978) (BS/78/36). A new draft was prepared in March 1979, after discussions at the March meeting of the BCBS (fifteenth meeting, 2–3 March) (BS/79/18 and 27), and a revised report to the G10 governors on the principle of consolidation was submitted to them towards the end of March 1979 (BS/79/27). This is reproduced in Appendix D. Following the subsequent May meeting of the G10 governors, President Zijlstra wrote a letter to his colleagues (dated 15 June and attached at the end of BS/79/27, with responses filed as BS/79/38) expressing the wish that this principle of consolidation be universally applied;4 see Appendix E. Up until now the work on these issues had been discussed under the headings of ‘Responsibility for supervision of banks’ overseas branches, subsidiaries and joint ventures’ (Stage 1) and ‘Consolidation of bank balance sheets‘ (Stage 2). Now the work on improving principles for the supervision of cross-border international banks became swept up into a single unity, and given a new title, the Concordat. This title first surfaces in the archives of the BCBS in late 1979. It was coined by the new Chairman, Peter Cooke, a keen historian, to indicate a set of understandings between sovereign parties, but without being based on a common legal authority or being legally binding.5 At this stage the Committee, and particularly its Chairman, felt it was important to recognise the full extent of the international banking market and that wider circulation of President Zijlstra’s letter to

4 A further paper on the treatment of minority participations was prepared in November 1979 (BS/79/30). In that it was agreed that non-financial and de minimis holdings should be excluded (subject to disagreement on how to define de minimis). For the rest, the BCBS split between advocating a case-by-case approach and applying a pro rata guideline. So in their 8–9 November meeting (BS/79/57) the BCBS ‘agreed that by one means or another the capital of a bank with an investment in a financial company should be adjusted to reflect the risk associated with the investment’. A number of other minor adjustments and revisions to the Concordat were also discussed at this same meeting, mainly relating to distinguishing between the foreign and domestic currency liquidity holding of foreign bank branches and subsidiaries. 5 Deriving from the Concordat agreed in the sixteenth-century between Francis I of France and the Pope.

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authorities other than the G10 was therefore needed. This perception of the importance of the wider international financial community led to the holding of the first international conference of banking supervisors on 5–6 July 1979 (BS/79/20) in London. With 150 delegates from 80 countries coming, the BCBS could transmit the core message of the Concordat to a wider, but still a private and professional, audience. During the next two to three years, from mid-1979 until end of 1981, the Concordat was tidied up and increasingly implemented. It had become a flagship project for the BCBS. As already noted in footnote 4, the BCBS discussed further possible (though minor) improvements to the Concordat at its seventeenth meeting in November 1979. At its next meeting (the eighteenth, 28–29 February 1980) (BS/80/21) it was agreed that the Secretariat should draft a review and update on the workings of the Concordat after five years’ experience (1975–80), and on the progress of member countries towards consolidated supervision, for submission to the G10 governors. In this report (BS/80/24) it was concluded that ‘these guidelines … known as the Concordat, appear to be working well … At the same time, … developments over the past five years [imply] … that certain modifications or extensions … would be appropriate’. These included: (a) parental responsibility in cases of poorly supervised host countries; (b) review of home/host relative responsibilities for foreign currency (fc) and domestic currency liquidity; (c) procedures for authorisation of branching-in and branching-out; and (percipiently) (d) ‘Definition of the parent country of banking groups incorporated in one country but carrying out the bulk of their operations elsewhere.’ Further work was done throughout 1980 (e.g. BS/80/27, 42, 54 and 59) on the drafting of the review of the Concordat for the governors, and also on the substantive issues of authorising branching in, or out of, G10 countries depending on the perceived supervisory competence of the counterpart supervisor in the non G10 country. Finally Peter Cooke sent in a reasonably confident review€– ‘steady progress is being made’€– together with an annex on member country progress in implementing the consolidation principle, under cover of a letter dated 26 January 1981, but essentially relating to work done in 1980. Apart from some limited further work on authorisation, the BCBS paid no further attention to the Concordat in 1981. Attention turned instead to questions of country risk and capital adequacy.

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The Concordat

C

Reaction to events



Banco Ambrosiano, 1982

Until 1982 the BCBS had been taking the initiative in establishing guidelines for the conduct of international banking supervision on the front foot. From then on, the BCBS and the Concordat were forced more often to react to unforeseen crises.6 The first of these was the Banco Ambrosiano crisis in June 1982. This was a sensational event involving fraud, the refusal of the IOR (Istituto per le Opere di Religione), a Vatican financial institution, to repay its loans from Banco Ambrosiano (subsidiaries), and the (presumed) murder of its Manager and Chairman, Roberto Calvi, by hanging under Blackfriars Bridge in London. From the point of view of the BCBS the crucial issue, however, was how the parent supervisor of the bank, in this case the Banca d’Italia (a member of the BCBS), had failed to see the overall risks to the bank when carrying out consolidated supervision. The basic answer to this was that Banco Ambrosiano had set up a ‘non-bank holding company’ in Luxembourg, Banco Ambrosiano Holding, SA. One of the main purposes of this company was to obtain funds, mainly in the Euromarkets, to finance the operations of the group’s foreign subsidiaries. It did not, however, do banking business in Luxembourg, and hence was not characterised or supervised as a bank there. Moreover, the Banca d’Italia, which had not by then undertaken fully consolidated supervision, found it hard to obtain information on this holding company. Furthermore, the holding company had set up foreign banking subsidiaries, Banco Ambrosiano Andino in Peru and Ambrosiano Group Banco Commercial of Managua in Nicaragua. These subsidiaries were effectively supervised neither in the host country (the host country’s bank supervision being limited at that date), nor in Luxembourg, nor in Italy (because of the break in the chain via the non-bank holding company). So, not surprisingly, the dodgy loans (to IOR, IOR-connected bodies and to borrowers connected with unidentified shareholders of Banco Ambrosiano) were concentrated in these subsidiaries. So the insertion of a non-bank holding company in the chain between parent bank and subsidiary bank had become an obvious loophole 6 For academic commentary on these events, and academic reaction to them, see Dale (1984) Chapter 7, on ‘International Supervisory Co-ordination’, especially pp. 171–8, and Herring and Litan (1994), Chapter 4, ‘International Efforts in Financial Regulation to Date’, especially pp. 101–7.

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which needed closing. Given the lapse of time since the issue of the initial paper in 1975, and the adoption of the principle of consolidation in 1978, the opportunity was taken to revise the whole initial paper.7 The key new paragraphs were numbers 13 and 14 of the revised document (which itself was prepared in late 1982/early 1983) (BS/83/24). These read as follows: Thirdly, gaps in supervision can arise out of structural features of international banking groups. For example, the existence of holding companies either at the head, or in the middle, of such groups may constitute an impediment to adequate supervision. Furthermore, particular supervisory problems may arise where such holding companies, while not themselves banks, have substantial liabilities to the international banking system. Where holding companies are at the head of groups that include separately incorporated banks operating in different countries, the authorities responsible for supervising those banks should endeavour to Â�co-ordinate their supervision of those banks, taking account of the overall structure of the group in question. Where a bank is the parent company of a group that contains intermediate holding companies, the parent authority should make sure that such holding companies and their subsidiaries are covered by adequate supervision. Alternatively, the parent authority should not allow the parent bank to operate such intermediate holding companies. Where groups contain both banks and non-bank organisations, there should, where possible, be liaison between the banking supervisory authorities and any authorities which have responsibilities for supervising these non-banking organisations, particularly where the non-banking activities are of a financial In his letter of 21 April 1983 (BS/83/33) to the president of the G10 governors€– by that time Richardson€– Peter Cooke wrote that: 7

The report on principles for the supervision of banks’ foreign establishments is in effect a re-formulation of the 1975 Concordat. As that paper did, it sets out guidelines for the allocation of responsibility in that area between the host and parent supervisors. Some important additions and clarifications to the original text have been introduced, partly in the light of developments since 1975 in banking practice and banking supervisory techniques, and partly as a result of experience in applying the principles contained in the 1975 Concordat. However, the balance of responsibility between host and parent authorities has not, in my view, been altered to any significant extent. The report contains two major additions to the 1975 document. Firstly, it incorporates the principle of consolidated supervision, which the Governors endorsed in 1978. Paragraph 16 stresses the importance of consolidation as a technique to enable parent authorities to monitor the overall risk exposure of banking groups, but adds that that does not imply any lessening of host authorities’ responsibilities for supervising foreign banking establishments that operate in their territories. Indeed, the Committee explicitly recognises that parent and host supervisory responsibilities should overlap. Secondly, in paragraphs 10 to 14, it examines ways of preventing gaps in international banking supervision, in particular those which arise from inadequate supervisory standards in certain countries or from the existence of non-bank holding companies within banking groups. The paper stresses the importance of close co-operation between host and parent authorities in dealing with such cases.

106

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character. Banking supervisors, in their overall supervision of banking groups, should take account of these groups’ non-banking activities; and if these activÂ� ities cannot be adequately supervised, banking supervisors should aim at minÂ� imising the risks to the banking business from the non-banking activities of such groups.

As noted in the ‘Report on International Developments in Banking Supervision’, 1983 (BCBS, March 1984): The document was sent early in June 1983 to supervisory authorities throughout the world, together with a letter from the Chairman suggesting that it might, in the same way as its predecessor, continue to be an accepted basis for understandings between supervisors worldwide in their respective supervisory responsibilities for the conduct of the business of banks operating internationally. A large number of countries in replying to the Chairman’s letter have indicated their agreement with the document in general terms and it has been endorsed by the Offshore Group of Banking Supervisors as well as receiving the broad approval of the Commission of Latin American and Caribbean supervisors. The paper was released to commercial banks and made generally available to those interested (including the press) shortly after being distributed to supervisory authorities worldwide.

Not surprisingly given its sensational overtones, the Banco Ambrosiano affair attracted great publicity. There was much subsequent discussion about the relative responsibilities, if any, of the Vatican, the Banca d’Italia and the Italian government for recompensing the losses of nondomestic creditors of Banco Ambrosiano. Concern whether the (appropriate?) authorities were doing enough in this respect tended to become confused and mixed up with accusations that the Concordat had failed to lead to adequate cross-border oversight, so much so that Chairman Peter Cooke felt a need to respond. In his lecture at the Financial Times Conference, 9 December 1982 (BS/82/80), he stated, at para. 22, that: The absence of effective consolidation and the related circumstances, in the particular recent case of Banco Ambrosiano would, of course, be a matter of concern if the facts of that situation were repeated widely throughout the system. But they are not. There may be, indeed are, some lessons to be learnt from the particular circumstances in that case and some authorities have already reacted to them. There may also be a need to refine somewhat the application of the principle of consolidation to take account of the position of non-banking companies within banking groups. But, as I have said on other occasions, this affair does not, in my view, invalidate the general principles of the Concordat which, as has many times been emphasised, relate to supervisory not to lender of the last resort responsibilities. Nor does it represent any major structural weakness in the supervisory arrangements worldwide. The particular circumstances in which the main South American subsidiary bank of the Ambrosiano group had been established, for example, were quite exceptional, as was the structure of the Ambrosiano Group as a whole. It is not replicated, as far as I

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am aware, among any of the major 500 or so banks in the world which are those principally engaged in international business.



BCCI, 1991

The revised Concordat of June 1983 was circulated to supervisory authorities worldwide, and the intention was, certainly, that such guidelines/principles should be universally adopted. The immediate question then for the BCBS was how far it should go in encouraging such implementation? We defer this issue, which was the focus of much of the BCBS work on the Concordat, and the focus of the Coljé subcommittee, until Section D. Instead we fast-forward to the next main crisis event that had direct implications for the Concordat, which was the BCCI affair in 1991. The BCCI affair8 had several similarities to the prior Banco Ambrosiano failure, notably the utilisation of non-bank holding companies (one of them being in Luxembourg), and a conscious attempt by BCCI managers to use both loopholes and weaknesses in the Concordat principle of consolidated supervision to prevent any single effective G10 supervisor from obtaining a consolidated view of the totality of BCCI’s balance sheet. Effectively BCCI, under Middle Eastern, especially Abu Dhabi, control, divided itself into two parts, with separate non-bank holding companies in Luxembourg and Grand Cayman. The Luxembourg holding company (BCCI (Holdings) Luxembourg) did no banking business in Luxembourg, and hence was not supervised as a bank there;9 instead it established subsidiaries in several countries, including the UK. Indeed, much of its business was undertaken in London, even if booked abroad. The problem was that no single supervisor had both the capacity and the will to enforce effective consolidation. Even as suspicion and concern about BCCI grew, the separation between the auditing in Luxembourg and Grand Cayman stymied any proper consolidation for several years. Again, like the Banco Ambrosiano affair, the BCCI debacle generated reconsideration and soul-searching about the need to reconsider and to restructure the Concordat. Jerry Corrigan, by then the Chairman of the

On this, also see Kapstein (1994, Chapter 7), entitled ‘BCCI and Beyond’. 9 BCCI also did banking business in Luxembourg under the aegis of a separate, subsidiary Luxembourg bank, BCCI Bank SA Luxembourg, which was separate and distinct from the holding company. The bank, unlike the holding company, was supervised by the IML (Institut Monetaire Luxembourg). 8

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The Concordat

BCBS, immediately raised (BS/91/70) a number of issues pertaining to the Concordat: The first set of questions centre on the application of the principle of consolidated supervision within the framework of the Basle Concordat. The questions include the following: (1) As a general matter are we satisfied with the manner in which supervisory information is shared between home and host country supervisors, especially in times of stress? (2) Within the G-10 countries should there be an understanding as to what constitutes a minimally acceptable form of home country consolidated supervision? (3) What should be the attitude of the Committee toward supervisory jurisdictions outside the G-10 that have or are thought to have inadequate home country consolidated supervision? –╇Should the Committee go so far as to actively discourage banks from the G-10 countries from establishing or maintaining a banking presence in such jurisdictions? (4) Are certain forms of bank secrecy laws an inherent obstacle to effective consolidated supervision? (5) Should the Committee seek to foster arrangements within the G-10 whereby€– at least in exigent circumstances€– the home country supervisor could perform on-site audits or exams in banking offices located in other countries?

In order to provide answers to these, and associated, questions, in January 1992 the BCBS issued a ‘Questionnaire on issues raised by BCCI’ (BS/92/4), including queries for both host and parent regulators on their experience and conduct with authorisation procedures; for both suppliers and receivers of information on the perceived constraints on such sharing; and on inspection rights for parent supervisors. Armed with the responses to this questionnaire, received in February (BS/92/19), the BCBS moved quickly, in May 1992 (BS/92/41) to issue a paper on ‘Minimum standards for the supervision of international banking groups and their cross-border establishments’. This latter set out four minimum standards (see Chapter 3 in the ‘Report on International Developments in Banking Supervision’, BCBS Report 3 (BCBS, September 1992): 1. All international banking groups and international banks should be supervised by a home-country authority that capably performs consolidated supervision; 2. The creation of a cross-border banking establishment should receive the prior consent of both the host-country supervisory authority and the bank’s and, if different, the banking group’s home country supervisory authority;

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3. Supervisory authorities should possess the right to gather information from the cross-border banking establishments of the banks or banking group for which they are the home country supervisor; and 4. If a host country authority determines that any one of the foregoing minimum standards is not met to its satisfaction, that authority could impose restrictive measures necessary to satisfy its prudential concerns consistent with these minimum standards, including the prohibition of the creation of banking establishments. Note in particular the traverse from general guidelines/principles, which members should maintain, to minimum standards which members must uphold. Thus the Introduction to that same note states: While the principles of the Concordat and its supplement are still viewed as being sound, members of the Committee now recognise that there needs to be a greater effort to ensure that these principles can be applied in practice. Accordingly certain of these principles have been reformulated as minimum standards, set out below, which G-10 supervisory authorities expect each other to observe. The supervisory authorities represented on the Basle Committee will be taking the necessary steps to ensure that their own supervisory arrangements meet the standards as soon as possible.

But this statement of command was addressed only to the member (i.e. G10) states of the BCBS. The next question was what to request from non-member supervisory authorities. This was done in a somewhat softened manner, with a revised, shortened and more general paper, entitled ‘Strengthening of international cooperation between banking supervisors’, but covering the same above four standards. It was sent to other supervisory authorities on 16 June 1992, and publicly released on 6 July. It was covered by a letter (BS/92/67) from Chairman Gerald Corrigan, attached here as Appendix F. This further June 1992 revision of the Concordat embodied the immediate response of the BCBS to the BCCI affair, and thus concludes this section on reactions to bank crises events. It was not, of course, the end to reviews and reconsiderations of the need for consolidated supervision and of the relative roles of home/host supervisors. Indeed, following on from the promulgations of minimum standards in 1992, a working group comprised jointly of BCBS members and also of the Offshore Group of Banking Supervisors produced in March 1996 a large (25 page) paper on ‘The Supervision of Cross-Border Banking’ (BS/96/9). After internal redrafting, this was finally published in October 1996; the covering press statement is reproduced in Appendix G. The rationale for this additional paper was that supervisors, especially those in non-G10 countries, had found it difficult to understand

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how the 1992 revision to the Concordat might be implemented in their own countries. At the instigation of Colin Powell of the Offshore Group of Banking Supervisors (OGBS) (see further Chapter 12), the BCBS and the OGBS produced in this paper a manual for so doing. It also included three important annexes. The first on ‘Standard procedures for cross-border inspections’ effectively recorded the outcome of negotiations whereby host countries which previously had been unwilling to allow home-country regulators to do on-site examinations (e.g. Singapore, Switzerland) would now be prepared to do so; and the final annex provided an ‘On-site examination check list’. This was circulated to all those attending the next International Conference of Banking Supervisors (ICBS) in Stockholm in June 1996, and following a show of hands called for by Chairman Tommaso PadoaSchioppa was accepted with no opposition, nem. con. At the next ICBS, which lies outside our period, country representatives were to be asked whether they had complied and, if not, to explain why not. D

Worldwide implementation of principles, and then standards?



How could this be done?

The BCBS perceived itself as an advisory, not as an executive, committee. Its role was to advise the G10 governors’ committee on best Â�regulatory practice. If the G10 governors accepted BCBS recommendations, they would introduce them into their own individual countries, and if that required legal support or amendment, it was up to each Governor to lobby his (or more rarely her) own national legislature to that end. This common, and comfortable, stance was put under some pressure in the course of, and subsequent to, the revision of the Concordat in June 1982. The point was that the objective of this revised Concordat, that is to establish that no foreign banking establishment was escaping supervision, required contact with non-member countries. A subgroup, chaired by Mr Coljé, was established to consider the implementation of the revised Concordat. The subgroup reported to the main Committee in mid-1983 (BS/83/73). Its main recommendations to the BCBS, paragraphs 3–5, read as follows: The sub-group believes that it is appropriate for the Committee to discuss not only the principles of supervisory co-operation but its practical application too. Recognising that considerable duplication of effort would be involved if each authority strictly followed the guidelines laid down in the Concordat

Worldwide implementation of principles

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for bilateral approaches to other supervisors, the sub-group believes that a Â�co-ordinated approach by the Group of Ten countries would be very helpful. Such an approach would imply that the Committee discuss details of the exÂ�periences members have had in their contacts with other supervisory authorities; in the past there may not have been sufficient opportunity for interchanges of this nature. At the same time, the sub-group feels that great care needs to be taken when reviewing supervisory standards in other countries. In its report to the Governors on the problems raised by the existence of offshore centres (BS/78/2), the Committee concluded that a co-operative and educational approach was preferable to any form of confrontation. Now that the benefits of this approach are beginning to bear fruit, the sub-group believes that the Committee should be careful not to compromise that principle. In particular, if it became known that the Committee as a body was formally seeking to judge, and perhaps condemn, particular supervisory regimes, the sub-group fears that the Committee would become subject to publicity and political pressure which would make it more difficult for it to operate effectively. The sub-group began by considering exactly what information is required by member countries to enable them to judge the capability of other countries to carry out the principles of the Concordat. What members wish to know relates essentially to practical and not necessarily legal capabilities and falls into three main areas: – whether, and if so to what degree, supervision is exercised, as host authorities, over the branches, subsidiaries and joint ventures of Group of Ten banks in their territories; – whether, and if so to what degree, supervision is exercised, as parent authorities, over the branches, subsidiaries and joint ventures of their own banks operating in Group of Ten countries; – the capacity to permit information to be passed back from the foreign banks operating in their territories to enable the parent authority to supervise on a consolidated basis. The sub-group concluded that the best way to acquire the specific information needed is to prepare and to circulate a questionnaire to those countries which have either host or parental relationships with Group of Ten countries, or perhaps to all countries which act as either hosts or parents to international banks. Although the circulation of questionnaire responses could be presented in a non-judgmental manner, inevitably they would in practice be used by member states to assess relative capabilities, as Paragraph 7 of the above Report implicitly acknowledged. While the responses to an appropriate questionnaire would provide some basis for members to assess the legal and practical capability of other countries to operate the Concordat, the sub-group is of the view that they should ideally be supplemented by the judgements of those who have had practical experience of host or parental relationships with the countries concerned. To this end, a first step is for Committee members to notify each other of the different countries with whom they have had contacts, so that when individual members

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The Concordat

are confronted with an issue relating to a third country, they know to which Committee members they may turn for guidance.

All this led to considerable soul-searching, in particular in the BCBS discussion of the Coljé subgroup report (BS/84/10, 10 February). I reproduce below a sizeable portion of Mr Brian Quinn’s (a Bank of England representative at the time) comments on this since they outline the issue so nicely. Mr Quinn (United Kingdom) I should stress that I am fully in sympathy with the objectives of preventing new, and closing existing, gaps in international supervisory coverage. Improving the availability of information on the supervision exercised by other countries is a useful contribution to this end and to the formation of opinions on the adequacy of other countries’ system. The first issue which exercises me is who forms the opinion on receipt of this information; and, in particular, the role of the Committee in this connection. As I recall the discussion on this subject in November, there was a broad consensus that the committee should not itself take on the role of passing judgement on other supervisory systems. I shared that view. I am not entirely convinced, however, that it will be possible for the Committee to avoid giving the impression, at least to some, that it is in fact moving in the direction of a collective judgement once it starts to gather and disseminate the information upon which judgements about supervisory standards will be reached. The particular method chosen to start the exercise, the questionnaire on supervisory practices, might well convey the impression to respondents, especially those anxious to gain the approval of the Committee, that they are participating in some qualifying process. At the very least, we should take care to avoid any such impression. If, efforts to the contrary notwithstanding, or because it was felt that the object of meeting the Governors’ request to extend the ambit of the Concordat was otherwise unattainable, the Committee did move in the direction of making collective judgements, it would have important implications for the role of the Committee, its standing and the nature of its work. It has occasionally been suggested that, in the longer run, the Committee might develop into more of an executive body co-ordinating supervisory standards around the world. To fulfil such a role effectively the Committee would require some form of sanctions in order to enforce its decisions; otherwise the Committee could find itself in the awkward position of having responsibility without power. Such a development would almost certainly require it to broaden its membership, if it was to enjoy widespread support for its actions. These developments might appear to be desirable in the long run, and indeed I find them attractive in such a perspective; but they have ramifications which can be identified and assessed only after careful consideration. You may feel that in expressing these reservations I am looking further ahead than necessary, given the modest scope of the recommendations of the sub-group report. However, I do feel some unease at setting off along a route without looking ahead at the implications of the journey.

Conclusion

113

The circulation of the questionnaire went ahead under cover of an introductory note which concentrated ‘on the fact-finding aspects of the exercise and makes no reference to the adequacy of supervisory standards’. (The answers were reported in BS/84/8.) Nevertheless the issue remained on the table. On the one hand, the BCBS did not want to play an executive role in grading, or sanctioning, any individual supervisory authorities. Thus, when the Bingham Report on the BCCI affair was discussed at the sixty-fifth meeting of the BCBS (2–3 December 1992) (BS/92/114), ‘the Committee discussed the idea that some form of peer group review procedure should be adopted to assess the adequacy of supervisory standards in member countries or outside. In general, members were not in favour of the Committee playing any form of pivotal role.’ Yet, on the other hand, if the purpose of the BCBS was to raise worldwide standards, how could this possibly be done without some process of measurement, comparison and grading, and hence of implicit, if not explicit, sanctions? This was the philosophical conundrum which Brian Quinn had so clearly noted. As we shall see as we go on to discuss Basel I and Capital Adequacy Requirements (in Chapter 6), the BCBS would slowly, but surely, be forced to shift towards executive actions in subsequent years, a journey bringing mixed feelings to those involved. See also Chapter 14. E

Conclusion

The continuing exercise of the Concordat showed the work of the BCBS to best advantage. The basic principles involved, that every banking establishment should be supervised and that the parental (home) supervisor should do so on the basis of consolidated accounts, were largely uncontroversial and incontrovertible. What was needed was attention to detail, patient negotiation, and advocacy at high levels. The BCBS had these qualities.10 10 Kapstein (1994), Chapter 8, ‘Assessing the Response to Globalisation’, was less complimentary. Thus, on p. 181 he wrote: As I have shown in this book, three sources of tension are particularly apparent. First, home country rules and regulations continue to differ from one country to the next, and in a competitive environment such rules can have powerful implications for domestic firms. They alter the cost structure that enterprises face and, in turn, the prices they must charge for their products … Second, home and host states continue to debate the appropriate division of supervisory and regulatory responsibilities between them, as was painfully revealed during the BCCI debacle. In the aftermath, the Basle Committee and the European Community have made various attempts to resolve matters, but they have only produced more confusion, since their guidelines are not the same; this is all the more

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The Concordat

Some may have seen the Ambrosiano and the BCCI affairs as evidence of failings in the BCBS exercise. That would be harsh. Both Ambrosiano and BCCI were consciously looking to subvert and to evade the regulatory framework. The existence of crime does not of itself demonstrate that the police were incompetent and the laws unavailing. But the way that the crime is carried out may point to a need for reformulation of the legal framework and new approaches for the police. So it was that these two events triggered revisions of the Concordat, parts of which needed introduction or revision for reasons unconnected with the prior failure, but due instead to the passage of time and to new developments in banking practices.

Appendix A

Dear In the context of banking supervision we have recently been reviewing the position of consortium banks like yours which are registered in this country, but whose shareholding banks come from a number of different countries. We consider that the shareholders must accept full responsibility for such banks and must stand behind them at all times. We think that, whenever a consortium bank has been established here, that position has been made clear to, and generally accepted by, the banks involved; but we now consider that it should be explicitly recorded. We should, therefore, welcome your obtaining for us from your shareholding banks statements that they accept ultimate responsibility for your bank. In some cases we understand that the practical effect of such responsibility is already achieved by the shareholding banks providing standby facilities; should this apply to your bank, we should like such standbys, and any subsequent changes in them, to be formally notified to us. You will no doubt wish to discuss this request with me and I should certainly welcome such a discussion. Yours sincerely (signed) G. Blunden troubling in that their memberships have significant overlap. Furthermore, history provides us with additional reasons not to expect too much progress on this issue. The Basle Concordat, for example, which was originally promulgated by the G-10 central bankers in 1974 as a statement of their common understanding with respect to home and host country responsibilities, has been revised three times over the past twenty years as part of an ongoing effort to determine the roles of supervisory authorities. Maybe so, but it is difficult to see just what more, or different, the BCBS could have been expected to do.

Appendix B

115

Appendix B

BS/75/94

Committee on Banking Regulations and Supervisory Practices Report to the Governors on the supervision of banks’ foreign establishments

Introduction

The object of this report is to set out certain guidelines for co-operation between national authorities in the supervision of banks’ foreign establishments, and to suggest ways of improving its efficacy. Three types of foreign banking establishment are distinguished: branches, which are integral parts of a foreign parent bank; subsidiaries, which are legally independent institutions incorporated in the country of operation and controlled by one foreign parent bank; and joint ventures, which are legally independent banks incorporated in the country of operation and controlled by two or more parent institutions, most of which are foreign and not all of which are necessarily banks. In addition, banking supervision is considered in the report from three different aspects:€liquidity, solvency and foreign exchange operations and positions. The Committee recognises that these different aspects are to some extent overlapping. For instance, liquidity and solvency problems can shade into one another; and both liquidity and solvency considerations are among the reasons why countries supervise their banks’ foreign exchange operations.

The need for co-operation

The Committee is agreed that the basic aim of international co-�operation in this field should be to ensure that no foreign banking establishment escapes supervision. It is also agreed that each country has a duty to ensure that foreign banking establishments in its territory are supervised; and that in the case of joint ventures involving parent institutions in more than one country there is no practicable alternative to supervisions by host. Acceptance that supervisory authorities are responsible for ensuring that foreign banks in their territory are supervised will not, however, necessarily preclude there being gaps in the supervision of such establishments. Thus, owing to differences in definition, a particular foreign establishment may be classified as a bank by its parent, but not by its

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The Concordat

host supervisory authority; and in some countries not represented on the Committee there may be no supervision whatever of foreign banking establishments. Furthermore, it is desirable not only that all foreign banking establishments are supervised but that this supervision is adequate, judged by the standards of both host and parent authorities. In that connection the Committee noted that host authorities are interested in the foreign banks operating in their territories as individual institutions and from the point of view of what happens in their own markets, while parent authorities are interested in them as parts of larger institutions which they are responsible for supervising. For a variety of reasons, therefore, adequate supervision of foreign banking establishments, without unnecessary overlapping, calls for contact and co-operation between host and parent supervisory authorities. It is one of the Committee’s purposes to foster co-Â�operation of that kind among its member countries. In addition, the Committee considers that any guidelines for co-operation it may agree on should be communicated to other countries with a significant role in international banking, in the hope of obtaining their Â�co-operation too. The Committee has already established contacts with the supervisory authorities of a number of such countries and, if the Governors accept this report, will consider which other countries it might approach.

Supervisory responsibilities and interest of host and parent authorities

Having agreed on the need for contact and co-operations between supervisory authorities, the Committee went on to consider the extent to which the division of responsibilities for supervision could be codified. Their discussions showed that it is not possible to draw up clear-cut rules for determining exactly where the responsibility for supervision can best be placed in any particular situation. Nevertheless, the Committee was able to agree on a number of general guidelines in this field.

Liquidity

In managing their liquidity foreign banking establishments rely heavily on local practices and comply with local regulations, including those established for monetary policy purposes. Responsibility for supervising

Appendix B

117

their liquidity must therefore rest in the first place with the host authority. Moreover, in practice, only the authority on the spot can carry out the continuous supervision of liquidity which may from time to time be required. For the management of liquidity in foreign currencies, and especially in the currency of the parent bank, local practices and regulations may be less important and not all host authorities accept the same degree of responsibility. In the case of a foreign branch, liquidity cannot be judged in isolation from that of the whole bank to which it belongs. This applies particularly when a branch is free to deposit funds with its parent bank. Furthermore, the parent authority, in controlling the liquidity of the parent bank, must take account of calls that its foreign branches might make on its liquid resources. For these reasons the liquidity of foreign branches is a matter of concern to parent authorities also. In the case of foreign subsidiaries of joint ventures, too, parent authorities may be concerned. For example, such banks may have stand-by facilities available to them from their parent institutions. In such cases the parent supervisory authority concerned ought to be informed by the host authorities of the importance they attach to these. Moreover, though the legal position of foreign subsidiaries and joint ventures is different from that of foreign branches, parent authorities cannot be indifferent to the moral responsibilities of the parent institutions.

Solvency

In the case of solvency controls, there is again some sharing of responsibility for supervision between host and parent authorities, with the emphasis varying according to the type of establishment concerned. For foreign subsidiaries and joint ventures, primary responsibility rests with host authorities; but, in addition, parent authorities must take account of the exposure of their domestic banks’ foreign subsidiaries and joint ventures because of those parent banks’ moral commitments to those foreign establishments. For foreign branches, solvency is indistinguishable from that of the parent bank as a whole. It is therefore essentially a matter for parent supervisory authorities. The ‘dotation de capital’ imposed by the host authorities in certain countries on foreign branches is above all intended to do two things; to oblige foreign branches that set up in business in those countries to make a certain minimum investment in them; and to equalise competitive conditions between foreign branches and domestic banks.

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The Concordat



Foreign exchange positions

Banks’ foreign exchange positions are supervised partly for prudential reasons, partly for balance-of-payments reasons and partly for the purpose of maintaining orderly market conditions. So far as concerns prudential supervision the considerations set out in the previous paragraphs govern the division of responsibility, while the other matters are by definition the concern of host authorities.

Aids to co-operation

The Committee considers that, in seeking to improve the supervision of banks’ foreign establishments and to implement the guidelines for co-operation set out earlier in this report, efforts should be made to remove, or at any rate reduce, certain restraints which at present hamper such co-operation. In particular, it believes that actions could usefully be taken in the following areas: 1. Direct transfers of information between supervisory authorities. Parent authorities may wish to obtain copies of reports submitted to host authorities, particularly in cases where host authorities waive certain requirements in respect of foreign banks established in their territory, where their control requirements are less stringent than those of the parent authorities or where they take into account, for prudential purposes, commitments to such banks by their parent institutions. Normally they should obtain such reports direct from the banks concerned provided that host authorities are previously informed. At the same time it would be desirable that host authorities be permitted to transfer copies of such reports to parent authorities when circumstances so warrant. The Committee is aware that such transfers of information are often impossible because of banking secrecy laws in host countries; but many of its members consider that the operation of these laws should over time be modified so as to permit them. (This same point also applies in the case of the proposals in 2 and 3 below.) The Committee wishes to emphasise that the sole purpose of such transfers would be to facilitate prudential control of banks and that in no circumstances would they be directed to the affairs of individual customers. 2. Direct inspections by parent authorities of their domestic banks’ foreign establishments. These are likely to be particularly helpful for purposes of solvency control, including control of banks’ foreign exchange positions. Such inspections already take place, sometimes on an

Appendix C

119

informal basis and sometimes as a result of formal reciprocal agreements between pairs of countries. Wherever possible steps should be taken to facilitate such arrangements, if necessary by amendment of legislation. 3. Indirect inspections of foreign banking establishments by parent authorities through the agency of host authorities. Most authorities that do not allow direct inspections by parent authorities of their domestic banks’ foreign establishments should give favourable consideration to carrying out, at the request of the parent authorities concerned, specific inspections of foreign banks operating in their territory and to reporting their overall findings to them. The Committee believes that in seeking to remove restraints on transfers of information between, and foreign inspections by, supervisory authorities it would be wise to begin with foreign branches, where the problems presented appear less difficult than with subsidiaries and joint ventures. The Committee asks that the Governors, if they are in agreement with the recommendations of this report, should take advantage of any opportunities that present themselves to further the removal of restraints on co-operation. 26 September 1975

Appendix C Bank for International Settlements By air mail Basle 22 December 1975 Mr H. M. Knight Governor Reserve Bank of Australia GPO Box No. 1947 Sydney (NSW) 2001 Dear Mr Governor, Committee on Banking Regulations and Supervisory Practices At the request of the central-bank Governors of the Group of Ten, and as Chairman of the Committee on Banking Regulations and Supervisory Practices established by them a year ago, I am writing to send you a copy of a report which the Committee recently presented to the Governors on the supervision of banks’ foreign establishments. As indicated in the first paragraph, the object of this report is to set out certain guide-lines for co-operation between national authorities

120

The Concordat

in the supervision of banks’ foreign establishments, and to suggest ways in which such co-operation could be improved. The centralbank Governors of the Group of Ten countries accepted the report last month and some of them have already indicated that they hope to find opportunities to take action on one or more of the aids to cooperation set out on pages six and seven of it. Both the Governors and the members of my Committee are very well aware that a significant part of the international banking system lies outside the area of the Group of Ten. For that reason the committee has said, on page two of its report, that it considers any guidelines for co-operation that it might agree on should be communicated to other countries with a significant role in international banking, in the hope of obtaining their co-operation too. It is in that hope that I am sending you the report. My committee would, of course, be interested to receive any comments or suggestions which you or your staff may have on the report. We should also be glad to know if you would like to receive from us any future papers of the Committee which may have a general connotation. I am, dear Mr Governor, Yours sincerely, George Blunden Chairman

Appendix D

BS/79/27

Report to the Governors on the consolidation of banks’ international activities The Committee submitted a paper (BS/77/52, 3rd revision) to the Governors in November 1978 on the consolidation of banks’ international business. That paper’s main conclusion was that in monitoring the solvency of their banks supervisors should take fully into account the risk exposure of banks in all their international activities. The Governors endorsed this conclusion and the present note has been prepared as a basis for further consideration of the subject by them. It addresses itself particularly to the supervisory issues, but the Committee recognize that the effective use of consolidation techniques for supervisory purposes by all the principal countries whose banks engage in large-scale international business could have macroeconomic effects too, in the sense of influencing the overall growth rate of international bank lending.

Appendix D

121

Following the Governors’ endorsement of the earlier paper, the Committee re-examined the subject at its meeting in March and they strongly re-affirm the principal conclusion of that paper. In the light of the rapid increase over the past twenty years in the internationalisation of many banks’ operations, it should be a basic principle of banking supervision that the authorities responsible for carrying it out cannot be fully satisfied about the soundness of individual banks unless they are in a position to examine the totality of each bank’s business worldwide. At the same time they recognize that supervisors will also need to continue to look at banks’ accounts on a non-consolidated basis. So far as the foreign branches of banks are concerned, consolidation should follow naturally from the fact that branches are legally not independent of their head offices. Few problems should arise for parent supervisory authorities with regard to consolidating that category of their banks’ foreign establishments and all member countries whose banks currently operate branches abroad observe the principle that the risk assets of all branches should be aggregated for supervisory purposes with those of the parent bank. The problems associated with the consolidation of banking figures for supervisory purposes thus principally concern banks’ foreign subsidiaries, participations and joint ventures. For these establishments the position is different for at least two reasons:€first, such banks are legally independent from their parent institutions; secondly, they come under the jurisdiction of the country in which they are incorporated, which may have different features from those applying to the parent institution. As the Committee’s earlier report demonstrated, the establishment of foreign subsidiaries, participations and joint ventures can substantially gear up a parent bank’s overall lending capacity if the capital adequacy of such foreign establishments is judged separately from that of the parent institution and if solvency requirements in the host country are significantly lower than at home. The Committee are agreed therefore that it is essential for supervisors, in looking at a bank’s solvency, to be in a position to do so on the basis that the risk-bearing assets of all foreign establishments in which a bank has a controlling interest should be consolidated with those of the parent institution. This means that consolidation should be applied by one means or another not only to the figures of banks’ foreign branches but also to those of their whollyowned and majority-owned foreign subsidiaries. For minority participations and joint ventures no single parent institution may have the predominant responsibility, since none has a controlling interest. In such cases it is desirable that the parent supervisory

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The Concordat

authorities should satisfy themselves that the capital of the parent bank is adequate to sustain its commitment to these minority interests. Most members of the Committee are agreed that this assessment is best undertaken on a case-by-case basis, taking into account in particular the degree of effective control exercised by the parent bank and the extent of its involvement in the management, although some countries choose to consolidate such holdings on a pro-rata basis. It appears that the scale of international banking operations undertaken by member countries’ banks through minority interests located outside the countries represented on the Committee is small in relation to the total of international bank lending. Following the Governors’ endorsement of the Committee’s earlier report, continued progress has been made by a number of member countries to develop and improve their own supervisory procedures with a view to extending the effective implementation of the basic principles of consolidation set out above. While recognising that certain problems may arise, particularly of a statistical nature, the Committee believe that all member countries should continue their efforts to improve consolidation techniques. These are directed particularly to ensuring the adequacy of banks’ solvency in their international operation but it is recognized that they can also be important for the analysis of bank country risk exposure and of their exposure on large individual loans (although their application in the last-named area may give rise to banking secrecy problems). In conclusion, the Committee recognize that the practices of member countries with respect to consolidation vary considerably at present and that for a variety of reasons, it is not to be expected that they can readily be made uniform. The Committee recommend, however, that all parent supervisory authorities should, within the context of their own systems and present circumstances, be required to give effect to the agreed principle that the capital adequacy and the risk exposure of all their banks be examined and assessed on the basis of the totality of their international activities. Furthermore, host supervisory authorities should co-operate in all ways they can to facilitate the achievement of this objective. March 1979

Appendix E

BS/79/27

Bank for International Settlements Letter from President Zijlstra to other G10 Governors The President

CH-4002 BASLE, 15 June 1979

Appendix F

123

Dear Mr Governor, CONSOLIDATION At the May meeting of the Governors of the Group of Ten and Switzerland we considered the report of the Standing Committee of Banking Supervisors on the consolidation of banks’ international activities (BS/79/27) and accepted its recommendations. I feel that these recommendations are of sufficient importance for me to write to you to underline what we have agreed about the prudential supervision of international banks on a consolidated basis. The Committee recommended that notwithstanding differences of practice which cannot easily be made uniform it should be a basic principle for supervisory authorities that international banks’ business should be monitored on the basis of the totality of their international activities. We have thus agreed that parent supervisory authorities in our countries should be required to ensure that the capital adequacy and risk exposure of all our banks should be examined and assessed in respect of their overall business internationally. It would be my hope that early steps will be taken in all our countries to implement this principle and that host country supervisory authorities will Â�co-operate fully in facilitating the achievement of this objective. I am, dear Mr Governor,

Appendix F

BS/92/67

Transcript of the Chairman’s letter to non-G10 supervisors enclosing the report on minimum standards Basle Committee on Banking Supervision Bank for International Settlements, Ch-4002 Basle The Chairman 16 June 1992 Dear Sir, I am writing to send you a report prepared by the Basle Committee on Banking Supervision setting out proposed minimum standards for the supervision of International banking groups and their crossborder establishments. The report is the result of a review of the Basle Concordat which has taken place in the aftermath of a number of recent developments, including the BCCI affair and the events in the Atlanta branch of Banca Nazionale del Lavoro. The conclusion of the Committee is that the Basle Concordat and its supplement of 1990 are soundly based but that the time is right for supervisory authorities to strengthen their commitment to implement the principles contained in them. The Committee is thus reinforcing the

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The Concordat

Concordat, which as you know has a ‘best-efforts’ character, with the enclosed document setting out minimum standards to which the G-10 supervisory authorities are committed. Furthermore, the Committee intends to monitor their implementation in its ongoing review of the supervision of international banks. By so doing, the Committee believes it should be possible to increase assurances that in future no international bank can operate without being subject to effective consolidated supervision. Nonetheless, the standards do not and cannot anticipate each and every practical application. As is the tradition of understandings reached in the Committee, notably in the 1988 Capital Accord, the standards need to allow flexibility of implementation according to differing legal and structural circumstances in different countries. For this reason, the paper is deliberately couched in general terms. Moreover, the recommendations are addressed to individual supervisory authorities in their relations with others. It is, of course, also possible for groups of countries to apply the same standards through negotiated agreements for the harmonisation of supervisory rules and mutual recognition. This has, for example, already been achieved in the European Community’s banking legislation which comes into effect on 1st January 1993 and which is fully in keeping with the standards. I hope that one of the results of these standards will be that both G-10 and non-G-10 home-country authorities will review their supervisory capabilities with a view to ensuring that they are capably performing consolidated supervision in respect of banks and banking groups operating out of their jurisdictions. In addition, host-country authorities will wish to review their national arrangements in order to see that home-country supervisory authorities have the capability to gather information, either through on-site examination or through other means which satisfy them, from cross-border establishments of their banks. I would also encourage all supervisory authorities to ensure that they can prevent the creation of any cross-border establishment by a bank or banking group whose home-country authorities either do not meet the standards or are not taking measures to meet these standards over time. I hope your institution will be prepared to endorse these standards. I recognise that you will need time to assess how the standards can be implemented in the light of your own circumstances, so the second day of the seventh ICBS in Cannes in October will be devoted to this subject and there will be ample opportunity then to debate their implications and to make your views known. In the meantime, I

Appendix G

125

would be happy to receive comments on the standards as well as your endorsement of them. E. Gerald Corrigan

Appendix G BS/96/82 Basle Committee on Banking Supervision Bank for International Settlements, CH-4002 Basle Press statement The Basle Committee on Banking Supervision is today making public a report on the Supervision of Cross-border Banking that was endorsed by banking supervisors from 140 countries at the June 1996 International Conference of Banking Supervisors in Stockholm. The report, compiled by members of the Basle Committee on Banking Supervision and the Offshore Group of Banking Supervisors, contains twenty-nine recommendations designed to strengthen the effectiveness of the supervision by home and host-country authorities of banks which operate outside their national boundaries. It builds on an earlier Basle Committee report Minimum Standards for the Supervision of International Banking Groups and their Cross-border Establishments issued in July 1992. The report consists of two principal sections. A first section examines the means by which home-country supervisors can obtain the information they need to exercise effective consolidated supervision of an international banking group. The starting point is that home supervisors must be able to make an assessment of all significant aspects of their banks’ operations, using whatever techniques are central to their supervisory process, including the conduct of on-site inspections. Many of the recommendations address the relatively few, but nonetheless significant, impediments to effective consolidated supervision that can arise and suggest ways in which these may be overcome. In particular, the paper contains recommended procedures for the conduct of cross-border on-site inspections by home-country supervisors. It also recommends a set of conditions designed to ensure that information obtained by bank supervisors from their supervisory colleagues in other countries remains confidential. A second section of the paper addresses the need to ensure that all cross-border banking operations are subject to effective home and host country supervision. This section contains guidelines for determining the effectiveness of home-country supervision, for monitoring supervisory standards in host countries and for dealing with corporate structures which create potential supervisory gaps.

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The Concordat

It is recognized that some of the recommendations in the paper are in conflict with bank secrecy or similar legislation in certain countries. Where this is so, supervisors have agreed to use their best endeavours to have the conflicting legislation amended. In order to set some sort of target for legislative changes, it was agreed in Stockholm to review the evidence of individual countries’ compliance with the recommendations in time for the next ICBS in October 1998. 8 October 1996

5

External and foreign exchange issues

A

An early warning system?

As already discussed in Chapter 2, the concerns that were uppermost in the minds of the G10 governors when they established the BCBS in the autumn of 1974 related to the Herstatt collapse, the resulting turmoil in foreign exchange markets and the sustainability of international capital flows (rather than the home/host supervisory issues that had been the focus of the work of the Groupe de Contact). This is clear from the initial mandate that the Governors gave the Committee, as follows: The Governors of the Group of Ten, at their [1974] December meeting at the Bank for International Settlements, discussed the problems of assuring the solvency and liquidity of banks, basing themselves on a summary report prepared by the BIS on existing regulations and supervisory practices. To carry further the work in this field and to prepare for future discussions among themselves, the Governors decided to establish a new committee to be made up of two experts from each country, one from the supervisory and one from the foreign exchange side. The committee will take as its starting point the BIS summary report and will give particular attention to the need for an early warning system. It was noted that from this point of view the quality of supervision is at least as important as the regulations themselves.

So, the one specific task that the BCBS was asked to undertake was to explore the possibility of an early warning system (EWS) for international financial crises. The Committee turned to this immediately:€it was on the agenda for all five meetings in their first year (1975). Despite the fact that the BCBS had been invited to act on establishing an EWS, the members soon discovered, in their discussions, that they were unwilling to do so. After their first two meetings they agreed (BS/75/12, discussion draft of a report to the Governors on an international early warning system) that ‘An international early-warning system must be based on national early-warning systems.’ This, the BCBS claimed, ‘is self-evident; even if it were possible to duplicate all the national sources of information into an international system, there could be no justification for such 127

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External and foreign exchange issues

duplication’ (or in shorthand, the Governors were silly to suggest this). But, to sugar this pill, the draft paper, prepared after the second meeting, suggested that ‘the Committee should itself be the focal point for an international early-warning system’, and indicated some rather woolly studies on national procedures for predicting trouble ahead. By the third meeting, however, the BCBS had considered in more concrete detail what it might add. It indicated (BS/75/27) that: For obtaining early warning of banks’ potential liquidity and credit problems the authorities of the countries represented in the Committee rely essentially on one or more of the following three sources of information: – monitoring of the statistical reports by banks; – periodical examination of banks; – informal contacts with the market. From the discussion, three elements in a possible international early warning system emerged: – exchanges between countries of information, based on any of the three sources mentioned above, as and when signs of trouble appear in one country’s banking system that could have international repercussions; – inspection of banks’ foreign branches and subsidiaries by the supervisory authorities of the home country; – transmission by banks’ foreign branches and subsidiaries to their home supervisory authorities of the reports they make to the supervisory authorities of the countries in which they are located. Some members of the Committee indicated that their authorities would have no objection to one or more of these practices, provided that they took place on a reciprocal basis and were subject to appropriate safeguards of confidentiality. Other members of the Committee, however, thought that it might be difficult for their authorities to adopt some of them and they reserved their positions on the question.

By now, however, Muller’s paper (BS/75/11) on home/host responsibilÂ� ities, and ensuring that all banking establishments, wherever located, were supervised, had become available (see Chapter 4). The BCBS was keen on this, and thought it helpful to its own agenda to present it as a contribution to preventing international financial crises. Indeed in the third and fourth meetings of the BCBS in 1975 (BS/75/28 and 45) consideration of Muller’s paper is included as a subheading under early warning systems! Anyhow, by June 1975 the BCBS was ready to report back to the Governors on the EWS. The report (BS/75/39) began, in effect, by stating that the basic idea ‘would not be practicable’, but went on to identify four ways in which it could help. These were:

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1. to improve national regulatory and supervisory systems by identifying and recommending best practices among the member countries; 2. to ensure that no part of the international system fails to be supervised; 3. to improve access of home (parent) supervisors to information given by foreign bank branches/supervisors to host supervisors; and 4. by exchanges of confidential information on their own banking systems at, or around, BCBS meetings. By such means did the Committee transform the initial agenda that the Governors had set into a new version with which it felt more comfortable.1 In my own view, it was, almost certainly, right to do so. The IMF has subsequently struggled for decades to find similar EWS without notable success and employing (econometric) techniques which the BCBS was not equipped to use.2 So the BCBS, and Chairman George Blunden, neatly shunted the exercise into fields where the BCBS could make a difference. Even so, observation of this process is somewhat entertaining for students of bureaucracies. But there were other aspects of the international financial system,3 and of the foreign exchange market, that the BCBS could and did study at greater length. After all, as remarked at the outset of this section, each country’s representation (bar that of Luxembourg) was of two experts, with the second being required (in these early years) to come

Also see G. Blunden (1977). Thus he wrote there, on p. 196: 1

The Committee quickly reached the conclusion that it would not be practicable to establish a separate reporting system, operated by an international body, to cover all international banking operations and to provide early warnings by identifying potential danger spots. Such arrangements would inevitably in large part wastefully duplicate existing national arrangements, would in many countries be incompatible with existing legislation and would be very difficult to co-ordinate because of differences in individual banking and political systems. They therefore agreed that early warnings of potential danger spots must continue to be derived from national supervisory systems and that action to counter potential dangers, even when they could have an international impact, must be taken by the national authority most concerned. The committee does not, therefore, concern itself with individual cases; it does not, for example, discuss individual problem banks or try to reach agreement on classification of the degree of risk involved in lending to individual countries or companies. Nor does it attempt to impose uniformity of operation; for example, it does not try to persuade the individual supervisory authorities represented at its meetings to adopt uniform ratios in examining balance sheet relationships. Though H.€D.€Willey, of the US delegation, reported to the BCBS in 1977 (BS/77/13) a factor analysis developed by the FRBNY to give a numerical index of bank vulnerability. 3 Also see Dale (1984), especially Chapter 4, pp. 73–89, on ‘International Banking Risks’. 2

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from ‘the foreign exchange side’. These latter members had to justify their existence by putting forward issues to study. One such exercise involved the preparation of a general paper on the ‘Supervision of banks’ foreign exchange position’ (BS/80/6, and available in the Compendium of BCBS papers on the BIS website), whose purpose was ‘to consider the prudential aspects of banks’ foreign exchange activities’. This was a relatively straightforward, but worthy exercise, describing the types of risk involved (exchange rate, interest rate, credit counterparty, time zone, and sovereign, i.e. exchange control, risks), noting the role of, first, bank managers and then of supervisors. This was a brief and quite general paper, but nonetheless helpful. B

Supervision of the foreign exchange market, foreign currency brokers, the forward market, and so on

The Herstatt failure was largely due to speculative exposures by that bank’s traders in the fx market. It is normal for supervisors to react to any such failure by tightening up procedures in that same field. For example, the Bank of England circulated a note to all banks in London on ‘Control of Foreign Exchange Dealing’ in December 1974. Similarly, the first two papers received from outside in the BCBS files are entitled ‘Regulations governing the commercial banks’ foreign currency transactions:€summary of replies from the central banks’4 (BS/75/3 and 7), detailing responses to a questionnaire circulated to them in the previous year by René Larre, who was then the General Manager at the BIS. Subsequently, between February and October 1975 there were descriptive papers: by Derrick Byatt on ‘Relations of banks in the UK with foreign exchange brokers’ (BS/75/13); on ‘Agreement between the big three banks on relations with brokers in Switzerland’ (BS/75/18); two papers on the same subject from Luxembourg (BS/75/19 and 20); a further paper by the Swiss National Bank; one from Canada, submitted by Mr Vachon; and yet another from the Banque de France. But nothing came of these descriptive papers. What did galvanise the BCBS into more positive action was the joint failure of the Israel-British bank in both Tel Aviv and London in 1974. This was primarily a case of fraudulent interconnected lending, but did give rise to two specific issues:€one was the need for bank confirmation This title is really a misnomer since the responses primarily covered capital, liquidity and large exposure requirements in both domestic and foreign currencies, rather than concentrating on fc exposures alone. However, a subsequent note did distinguish the varying objectives, e.g. prudential, balance of payments and market management, of the fc exposure controls of the central banks in the G10 group. 4

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of audit reports on a second bank (with interbank relationships with the first bank)5; the second, more relevant to this section, concerned ‘Draft rules governing the liquidation of outstanding forward foreign contracts in case one of the contracting parties becomes insolvent’ (BS/75/75). This rather arcane question was initially pursued by Mr P.€Timmerman from the Nederlandsche Bank, who devised a questionnaire to be sent to all member central banks on the subject (at the end of 1975). The whole subject was then transferred to a joint working party, under the chairmanship of Fitzenreiter of Germany, comprising members of the International Chamber of Commerce (ICC) and the BCBS, which reported in December 1978. But this did not mark the end of this project. A subsequent subgroup, again primarily led by the ICC, and chaired by Dr Roesli from the ICC and a director of Bank Leu in Switzerland, but including members of the BCBS, notably David Willey, considered ‘Rules for foreign exchange contracts’ (BS/81/45 and BS/82/53). The contents were as follows: Foreword (text written by the Secretary General of the ICC) Introduction Uniform Rules for foreign exchange contracts

• General provisions • Definitions • Confirmation • Funds delivery instructions • Failure to meet contractual obligations • Failure due to insolvency Comments on the rules.6

Even these short extracts reveal that this exercise was dominated by the ICC, not the BCBS, and that it was primarily legalistic rather than prudential or supervisory in approach. Quite how and why the BCBS Such confirmations had not been sought, or received, in some instances in the case of IBB. But they also ran foul of bank secrecy requirements in some countries, notably in Switzerland. This subject is further discussed briefly in Chapter 11. 6 These final remarks were as follows: 5

ICC Arbitration Attention is drawn to the fact that disputes arising from forexcos can be settled under the rules of conciliation and arbitration of the ICC by one or more arbitrators. List of Banks Adhering to Uniform Rules for Forexcos The ICC will publish in regular intervals a list of the banks and bankers associations which have declared by principle their adherence to the uniform rules for forexcos. Committee of Experts The ICC will appoint a special committee of experts in order to review periodically the application of the uniform rules for forexcos and to amend them if the need arises.

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became involved in this, somewhat extraneous, exercise, and for so long, is at this elapse of time not clear. Meanwhile, there were sporadic attempts, mostly by the US delegates, to document the complexity and non-comparability of member country reports on fc assets, liabilities and net positions, an issue which was to complicate, for example, the BCBS’ attempt to measure bank maturity positions in international markets; see Section C below. Among these were two US papers, one prepared by the FRBNY, submitted by Mr€Willey in 1976 (BS/76/31), and the other by Henry Terrell and Robert Gemmill of the FRB on ‘Bank practices in monitoring foreign country exposure’, dated August 1976 but submitted to the BCBS in mid-1977 (BS/77/32). Presumably the purpose was to harness BCBS support for an attempt to achieve some harmonisation and common standards between countries for statistical reporting of bank fc positions. If so, the attempt failed, since the BCBS did not choose to venture into this field, or indeed into any purely statistical issues. Instead the Committee preferred to focus on questions relating to micro-level (large international) bank behaviour. As a result, its main forays into international financial relationships involved the topics described in the next Section C. C

Country risk exposure and maturity transformations in wholesale international markets

Concern about both the above issues began to surface in 1977. At the ninth BCBS meeting in March 1977 Willey and Dahl (USA) made oral remarks about the country risk exposures of US banks, who were the largest international lenders (BS/77/13 and 14). Shortly thereafter, in May 1977 M Bonnardin of the Commission de Controle des Banques in France submitted a paper on the ‘Analysis of the maturity structure of lending and borrowing on the international markets:€problems raised by the growth of roll-over credits’ (BS/77/16). Bonnardin stated that the question of any possible surveillance or limits (which he suggested was ‘premature’) must be preceded by the establishment of common principles for recording data. He suggested that, within the EEC at least, there would be common agreement on the need for: – a minimum uniform presentation of returns, – the uniform recording of transactions (final maturity for roll-over credits, closest maturity for borrowed funds), – a common policy with regard to the liquidity of the international markets.7 7 Charles Freeland suggests that this, somewhat gnomic, phrase meant the potential adoption of limits on fc maturity mismatching, effectively in the euro-dollar market.

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Bonnardin’s note was followed up by a note on this topic by the Secretariat (BS/77/45). This note covered: (a) the increasing scale of maturity transformation in wholesale international markets, partly owing to oil-payment recycling; (b) the desirability of having harmonised data, but the objections of some countries to the extra work that would be involved; (c) the need for exchange of information on such transformation; (d) the possibility of harmonising regulatory principles, but the wide range of views on doing so; and (e) the potential need to liaise on this with other supervisory authorities outside the Committee. This paper was discussed in the BCBS’ eleventh meeting in October 1977 (BS/77/46), and a report along much the same lines drafted in January 1978 (BS/78/3). This, I believe, was sent up to the governors in mid-1978. Similarly, sporadic progress was also made on the related, but different subject of country risk exposures in 1978. This was further discussed at the March and June (twelfth/thirteenth) meetings (BS/78/10 and 20), with a paper drafted by the Secretariat (BS/78/13). This covered: (a) Definition and measurement issues, and (b) Possible alternative roles for the supervisory authorities. Two approaches to this were considered: (i) Treating country risk as a manifestation of wider credit risk, or (ii)╇ Specific (and detailed) official regulation. This latter paper was discussed in June, alongside an article in the FRBNY Quarterly Review (Spring 1978) on ‘A new supervisory approach to foreign lending’. Even though the Committee did not have time to complete their discussion, it was agreed to return to this issue in October (at the fourteenth meeting), with a view to putting to the Governors a short paper, or Chairman’s letter, ‘stating the extent of the Committee’s range of interest in this subject’. At the same time country representatives were asked to put in short notes to the Secretariat on their respective approaches to the definitional and measurement issues raised in the first part of the Secretariat’s note; the French, Swiss, Swedish, Dutch, Italian, British and American representatives duly did so at the outset of 1979 (BS/79/4, 5, etc.).8 These were collated by the Secretariat (BS/79/17), together with an Annex on the Committee’s views on how such exposures should be measured, e.g. consolidated, or not; net or gross; when subject to guarantee; with respect to currency risk, etc. 8

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So, by late summer 1978 the Governors were informed by the BCBS Chairman of the Committee’s growing interest in these two subjects. This was pushing on an open door, because the Governors were becoming increasingly concerned about international bank lending and the state of the Euromarket. The Governors gave the BCBS marching orders to expand its work on (a) consolidation (see Chapter 4), (b) maturity transformation, and (c) country risk exposure.9 The Chairman’s note, of January 1979 (BS/79/10) is, in my view, a valuable historical document, since it shows the temper of the times and is, therefore, largely reproduced as Appendix A to this chapter. Given the importance, urgency and specialised features of such work on maturity transformation now attached to this exercise, it was delegated to a subgroup, chaired by Michael Dealtry, which reported in the summer of 1979 (BS/79/32). The subgroup noted that maturity transformation was a common feature of banking activities and could lead to liquidity problems whether such transformation was undertaken domestically or internationally. Nevertheless, there were some special concerns over international maturity transformation because: (a) it was less easy to measure, assess and supervise; (b) it was funded by large wholesale deposits, that is less diversification on the funding side; (c) relationships with international borrowers and lenders were less well established; and (d) there was less recourse to a lender of last resort in fc dealing. The micro-prudential liquidity risks to individual banks were thus greater in wholesale international business than in (retail) domestic activities. Furthermore, there was enhanced macro-prudential risk. The extent of maturity transformation of the system as a whole could be much greater than that of any individual bank. The system as a whole could be much more fragile than each of its constituent banks, Note that such concern about country risk exposure was expressed and considered well before the MAB crisis of 1982, or the response to that by the US regulatory authorities (FRS, OCC and FDIC) in their paper to Congress, entitled, ‘Program for improved supervision and regulation of international lending’ (US Congress 1983). Duncan Wood, Governing Global Banking (2005), noted, on p. 71, that the program set out there ‘called for a five-pronged response to the problems incurred by, and underlying the contemporary crisis in, American banking.’ The first two such prongs were: 9

1. improving country risk evaluation and examination; 2. greater disclosure of sovereign debt exposure; But the country risk exposure exercise at the BCBS was not a particularly US-driven initiative. It had been underway for some time already.

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and hence could be subject to systemic weakness in the face of adverse global economic shocks. Having, therefore, persuaded themselves that there was a prima facie case for carving out data on international maturity transformation separately from aggregate maturity transformation (consolidated over all currencies and all kinds of business), the next question was how to do so statistically. There were questions of coverage (e.g. residents in fc; non-residents in domestic currencies?); netting; aggregation over all fc business, or currency by currency; choice of fineness of maturity breakdown, that is how many categories; the periodicity of reporting, and so on. A major problem was that there was no uniformity among the G10 countries in their existing reporting. Indeed, given the difficulties involved, the subgroup was more negative about the whole exercise than the Chairman felt consistent with the explicit wishes of the Governors to get on with the project, and the draft was revised. The revised draft (BS/79/44) was sent on to the Governors in early 1980 (11 February) (BS/80/20) with a ‘recommendation that the GovernÂ� ors should, if they wished to give an impetus to the development of statistics on maturity transformations, convene a statistical group to examine the details of the Committee’s proposals’. Such a group was duly established, again under the chairmanship of Michael Dealtry, and with most of its members, but not all, from the BCBS. As was the wont of BCBS working practices, the first stage was to send out a questionnaire to all member central banks on existing statistical procedures in this field. The working party met in April 1980 with the answers to the questionnaire before them, reached (a tentative) agreement (BS/80/25) on nearly ten of the outstanding statistical issues, and referred four back to the full Committee. These latter were agreed at the BCBS (nineteenth) meeting in June (BS/80/33), and a revised document (BS/80/32), including an outline statistical reporting sheet for (international) banks prospectively to complete, was sent up to the G10 governors’ meeting in September, to request authorisation to approach commercial banks to fill in such six-monthly reports. Such authorisation was duly given, and a letter prepared to send to all national representatives, covering in turn a letter (BS/80/48) and a statistical schedule to go to all reporting banks in November 1980, for a first reporting date of 31 March 1981. All are asked to use their best endeavours to provide the most complete data possible within the framework of the agreed schedule and it is hoped that over time it will be possible to develop a common basis in all reporting countries for collecting regular data on banks’ international maturity transformation.

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External and foreign exchange issues

The template for such statistics is shown in Appendix B. Those hopes were soon dashed. Countries sent in their own data slowly; in a couple of cases not at all. The databases varied widely in coverage of transactions and establishments, for example foreign branches, subsidiaries and joint ventures (BS/81/41). Nevertheless, some rather limited and broad-brush comments on the international maturity transformation of some countries could be gleaned from the data (remarks of Dr€ H. Mayer at the meeting on 30 October 1981, BS/81/47). A second set of similar data was requested for end-September 1981. These data were no more consistent across countries, particularly the transactions and institutional coverage, though once again Mayer was able to extract some comments on general trends (BS/82/8 and 9), and the Bank of England could prepare a paper in June 1982 comparing the risks and vulnerabilities of differing countries should they be unable to roll over maturing short-dated liabilities (BS/82/35). Further returns, on the same disparate basis, were obtained for end-March and end-September 1982 (BS/82/56 and 83/18). There was no internal paper to comment on them,10 though the Bank of England (BS/83/45) once again tried to draw some conclusions, subject to the caveat that ‘certain imperfections and inconsistencies in individual countries’ data may hinder interpretation of these statistics and lead to false conclusions being drawn from inter-country comparisons’. So, in 1983 Michael Dealtry wrote to representatives (BS/83/71) Â�asking for: (a) indications whether there was any prospect of getting improvements to the data; (b) a fuller note on data coverage and definition; and (c) how best to avoid double-counting. The responses were not encouraging. Although the data collection (and brief comments on them) dragged on through 1984, by 1985 everyone involved had had enough. Thus (from BS/85/15): The collection of statistics at six-monthly intervals has involved the contributing banks, the central banks and the BIS (both the Committee’s Secretariat and statistical experts in the Monetary and Economic Department) in a considerable amount of work. However, there are serious reservations about the overall quality of the data and the statistics have been criticised by some members of the Committee for their lack of consistency. These inconsistencies affect the institutional coverage of different countries’ series, the maturity bands and the 10 The next such internal paper, BS/83/70, reviewed the data from March 1981 to March 1983.

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categories of transaction which are reported. (A review of the main differences in the basis of reporting was contained in BS/83/79.) As a result, it has been difficult to interpret the figures with any degree of confidence.

There were three options: (a) to improve the data; (b) to continue as at present; (c) to abandon the exercise. One extra consideration was that the BCBS had recently begun to address closer attention to the wider subject of liquidity, discussed Â�further in Chapter 9. None of the above three options looked enticing; (a) would involve a lot more work for uncertain benefit, (b) had been demonstrated to be unsatisfactory, and (c) was a confession of failure. So, in the best tradition of bureaucracies, the whole issue was passed on to a subgroup to reconsider€– Sandberg’s subgroup, which was also reviewing liquidity issues. The subcommittee was reluctant to abandon the whole exercise tout court, and suggested that the framework be modified and simplified (BS/85/37). Although this was proposed, what actually happened was akin to abandonment. The pre-existing template (Appendix B) was therewith dropped, and no further reports on international maturity transformation were sent to, or analysed by, the BCBS. The wider subject of maturity transformation in general, and liquidity in particular, did, of course continue further, as reported in Chapter 9. Overall, this exercise of trying to look at the maturity transformation of one segment of banks’ activities, that is their international business, must be recorded as a failure. Many countries were sufficiently dubious about the value of the exercise, either to themselves or to their own banks, that they put no pressure on their own banks to adjust existing data methodology in order to achieve international comparability. A couple of countries just failed to produce any data at all. Perhaps, the lesson/moral to be drawn is that non-statutory groups, like the BCBS, with no formal clout and limited statistical expertise, should not allow themselves to get involved in designing international statistical exercises. Let us return now to the country risk exposure exercise. The Governors were less concerned (in 1978) about the analysis and measurement of country risk than about how to reduce a risk level that they already regarded as excessively high. This was, of course, a macro rather than a prudential issue, so the running initially was made by the Euro Currency Standing Committee (ECSC) under the chairmanship of Alexandre Lamfalussy. In this context Chairman Peter Cooke

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warned BCBS members at its seventeenth meeting in November 1979 (BS/79/57) that: it would probably be invited, in the next few days, to respond to a questionnaire being drawn up by Professor Lamfalussy’s Working Party on possible approaches to constraining the growth of international bank lending. He suggested that it would be helpful if the Committee could signify its willingness, at this stage, to undertake the work required, which would probably consist of giving a preliminary response to the feasibility of proposals in two main areas:€firstly, the idea that banks should be required to make accounting provisions against involuntarily rescheduled loans; secondly, questions regarding the effects of capital ratios on the growth of banks’ international business.

When the BCBS did come to discuss these issues, on 17 January 1980 (BS/80/3), their response was robust and dismissive: The Committee agreed that its report should start with a clear statement that it was not appropriate for banking supervisory authorities to impose on their banks regulations for which there were no sound prudential reasons and, furthermore, that prudential measures should not be used to ‘compensate’ for other measures which effectively favoured international lending. The paper would then consider each of the two proposals from the three angles of techÂ� nical feasibility, prudential acceptability and possible effectiveness in constraining the growth of banks’ international lending. The conclusion of its discussion was that either proposal would be technically difficult for national supervisory authorities to implement on a uniform basis internationally; that both would appear to pose problems of conflict between macro-economic and prudential aims; and that neither proposal, unless applied very strongly, appeared likely to exercise much constraining influence on banks’ international lending. A final section of the paper would stress the importance of action by national superÂ� visory authorities in both the areas under consideration.

And exactly such a report was, indeed, prepared by the Secretariat (February 1980) (BS/80/5), effectively trashing both suggestions of enforcing common provisions against involuntarily rescheduled international loans and of applying specifically higher required capital adequacy requirements to such lending. Some will view this as the BCBS at its best, independent and principled; in particular, sticking up for the principle that regulation should be for (micro) prudential purposes only, and prepared to run counter to the preferences of their own central banks if they thought it right to do so. There is another view. The main concern of bank regulators, on this latter view, should be with (macro) prudential concerns relating to systemic stability. Subject to concern over (depositor) customer ignorance, the individual bank can, and should, be the best judge of its own micro-risk/return trade-off. The regulator then should have much more concern about macro than about micro-fragility. If the level and

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growth rate of international bank lending was, indeed, a macro threat to systemic stability (a hypothesis that begs a lot of questions), then it should properly be a remit for the Committee. Although the BCBS effectively killed off these two proposals from the ECSC, generalised concern about international lending and country risk exposure did not evaporate. The Chairman reverted to the subject in September 1980 (BS/80/43), effectively asking for an update on how countries defined, measured and handled the topic of country risk exposure from a supervisory standpoint. Not surprisingly, this provoked yet another questionnaire (BS/80/51) in November 1980, the responses to which were received and collated by the Secretariat at the outset of 1981 (BS/81/1). Going beyond the usual questionnaire to central banks, at the next BCBS meeting in February 1981 (BS/81/7): It was agreed that it would be useful to look at the techniques used by banks to assess country risk, as well as their policies with respect to country exposure limits. In order to clarify the areas in which it would be helpful to have a response, the Secretariat would shortly circulate a questionnaire on the main issues involved which members could follow in approaching a small sample of banks in their country. It was also agreed that Messrs Coljé, Schneider and Willey should form a sub-group to consider the replies to the questionnaire, which would be requested by the middle of April, and to draft a paper pulling together the elements of best practice which had been identified for consideration at the Committee’s next meeting.

The Willey subgroup produced a rather general (and slightly woolly), but sane and sensible, report in June 1981 (BS/81/22), the gist of which was that commercial banks should make their own decisions (here as elsewhere), but that supervisors should check on their internal control mechanisms. The key paragraph (p. 8) reads: In the same way that supervisors do not dictate to their banks what domestic loans banks should or should not undertake, supervisors do not dictate to banks decisions about international loans. At the same time, however, supervisors have a clear interest in country risk since it can affect the liquidity and profitability of banks, and ultimately their solvency too. For this reason supervisors have a duty to ensure that banks have adequate methods of measuring, assessing and controlling their country exposures.

The paper was then redrafted (BS/81/37 and 38), partly to make it appear rather more proactive, and was sent off to the Governors (in March 1982) (BS/82/19) with the following recommendations, asking the Governors to: – endorse the paper (BS/81/38) on sound practices for banks with respect to country risk analysis and the measurement and control

140

–

–

–

–

External and foreign exchange issues

of country exposure, and to agree that it be distributed (a) to the banking communities in member countries and (b) to supervisors not represented on the Committee, for distribution to their banks. endorse the principle that supervisors should monitor banks’ practices with respect to country risk assessment and exposure taking due account of the guidelines for sound practices set out in that paper. endorse the principle that parent authorities should accept primary responsibility for the supervision of banks’ country exposure worldwide (although it is recognised that this cannot be fully applied where consolidated supervision is not yet wholly operative). endorse the recommendations that (a) all member countries should work towards standardised reporting by their banks of country exposure data, along the lines indicated in this report, and (b) work should be undertaken within individual countries to examine the feasibility of combining in one system the reporting of banks’ country exposure data and of data on countries’ external indebtedness to banks. reiterate the importance of speedier reporting by certain countries of international banking data to the BIS.

This endorsement was received, and the paper on ‘Management of banks’ international lending:€country risk analysis and country exposure measurement and control’ was sent out to all non-G10 supervisors, and thence for onward submission to commercial banks, under cover of Chairman Peter Cooke’s letter of 4 June 1982 (BS/82/28). In a sense the principles being applied to the treatment of country risk exposures were consonant with those in the Concordat, so the subject became pulled into the larger framework. Both countries and commercial banks welcomed the combination of clear principles in the framework, aligned with flexibility in operation, that this paper provided. The Secretariat provided a summary of responses to the paper in June 1984 (BS/84/39). That effectively brought to an end discussions within the BCBS about how, in principle, country risk exposures should be defined, measured and controlled. In practice, however, country risk exposure remained a crucial concern, especially in 1982/83 with the MAB (Mexico, Argentina and Brazil) potential default crisis (see footnote 9 above). A key issue that arose was how banks should provision against such loans. This subject, however, became intimately caught up in the discussions surrounding the Basel Capital Adequacy Accord of 1988 (Basel I), and so is discussed in the next chapter. There was also some discussion, prompted

Appendix A

141

by the IMF, in 1989 of whether the Brady proposals for handling the MAB debt overhang issue had any general regulatory implications; the answer apparently was ‘no’. And that was the last occasion on which purely external issues, as I have defined them, appear in the agenda or papers of the BCBS, up until the end of our period, the end of 1997. D

Conclusion

The G10 governors, when they established it in 1974, initially intended the BCBS to focus on international foreign exchange issues. Every country (bar Luxembourg) was to have two representatives, one of which was to be a foreign exchange expert. The only specific task allocated to the BCBS was to design an early warning system. Yet the proposal for an EWS was rapidly rubbished. The IsraelBritish bank failure led to some arcane technical work on counterparty failure in forward fc markets, but otherwise the fx experts on the BCBS must have been left largely twiddling their thumbs, apart from completing the 1980 general paper on the ‘Supervision of banks’ foreign exchange positions’, and from the early 1980s onwards they became steadily phased out. The attempt to examine international maturity transformation expired in a statistical quagmire. While the country risk exposures exercise did reach a successful conclusion in the 1982 paper, it can be argued (and I would) that this was because the exercise became subsumed within the general principles of the Concordat, rather than being treated on a stand-alone basis. This shift of focus away from external issues, and towards matters relating to commercial bank behaviour and the regulators’ treatment of that, followed on much more closely with the earlier concerns of the Groupe de Contact, and the interests of the key figures in the early years of the BCBS, almost an Anglo-Dutch cabal, with Blunden, Cooke and Dealtry steering the Committee and Muller and Coljé injecting many of the key papers.

Appendix A Chairman’s note BS/79/10

1. Since the Committee last met at the end of October the Central Bank Governors, meeting in Basle, have discussed further a number of matters of concern to the Committee relating to international bank lending and the state of the Euro-markets.

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2. At the Governors’ meeting in November I was invited by President Zijlstra to introduce the Committee’s report on consolidation to the G.10 Governors. This paper was accepted and its main conclusion endorsed by them. On 15th November there followed the joint meeting of the Euro-Currency Standing Committee and the Committee of Bank Supervisors requested by the Governors at their September meeting. This joint meeting considered in particular the possibilities of controlling the growth of international bank lending by three different types of banking supervisory measures:€limits on the total international element in banks’ balance sheets; limits on banks’ lending to individual foreign countries and their residents; and limits on maturity transformation in banks’ international business. 3. The report of that meeting concluded that uniform limits even at the national level in individual banks’ international business were neither desirable nor possible. Country limits too were not regarded as an acceptable instrument for controlling the overall growth of international bank lending, although the importance of improving the information on country indebtedness available to banks was re-emphasised. Maturity transformation was generally agreed to be an area to which particular attention should be paid and here the first priority was to obtain better information. The Governors were invited to give their strong support individually and collectively to efforts to improve and extend the collection of data on maturity transformation by banks in their international business. In addition the meeting reaffirmed the view that the consolidation of bank accounts was important not only as a banking supervisory instrument but also from the macro-economic point of view. 4. One delegation mentioned two further areas which might merit consideration by the Committee of Banking Supervisors; firstly, the setting of limits on bank loans to individual borrowers and secondly, the use of powers to prevent banks opening foreign branches or subsidiaries (particularly in offshore centres). 5. The Governors considered the report at their meeting in December in Basle. 6. On consolidation, the Governors strongly endorsed the recommendation that the capital adequacy and international risk exposure of banks and their affiliates can most satisfactorily be monitored by supervisory authorities on the basis of consolidation of risk assets. General support was voiced for the view that supervisors in each country ought to take fully into account the risk exposure of their banks in all their international activities in regulating the solvency of their operations. The Governors invited the Committee of

Appendix A



143

Bank Supervisors to prepare a further note on consolidation as a basis for their re-examination of this whole subject at an early future date. 7. The Governors also expressed the view in this connection that the steps already taken to examine and improve the quality of country risk analysis should be further pursued and reinforced. 8 On maturity transformation, the Governors charged the Committee with the task of examining further the technical aspects of information collection in the hopes that it might prove possible in the near future to arrive at a measure of agreement on a common basis for the collation and publication of this [sic] statistical data from each country. 9. Two other matters referred to in the report of the joint meeting in November (limits on bank loans to individual borrowers and use of powers to withhold authorisation for opening new foreign branches or subsidiaries) were also briefly discussed but no recommendations were made. 10. The Committee is thus charged by the Governors with carrying forward its work in the three important and related areas of consolidation, country risk analysis and maturity transformation and we should give this work the highest priority. In order to expedite further work on these subjects I am therefore circulating this note well in advance of our next meeting at the beginning of March so that we may come well prepared on these matters. 11. On the question of consolidation for assessing capital adequacy and international risk exposure we have agreed in our first paper a broad general principle. The new paper which the Governors have requested should in my view re-emphasise the importance of this principle and of its general application in the supervisory processes internationally. At the same time there are a number of aspects of this subject to which the Committee still has to address itself€– particularly how to extend the general principle for branches and subsidiaries to minority holdings and joint ventures. In addressing ourselves to this aspect it would be helpful if members could seek to assess the relative importance of these minority participations to the totality of the international business of banks subject to their supervision. It would also be very useful to hear from member countries how their thinking may have been modified in the light of the initial paper produced last summer and in what ways they are taking steps to improve and develop their own systems in the light of the analysis made in that paper. I am asking the Secretariat to prepare for early circulation the draft of a possible further paper to

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the Governors on consolidation and also a short note which poses some questions the answers to which may provide some further material for the Governors’ paper. 12. As regards country risk exposure we need to carry forward the work already brought together in order to develop a further paper for the Governors. The Secretariat will shortly be circulating the draft of a new paper which I hope may form the basis of such a report to the Governors, setting out firstly what I believe are general areas of agreement and secondly, some of the difficult aspects of definition and measurement of country risk which our discussions have brought to light. I would be grateful if, in advance of our March meeting, members could consider this paper so that we can decide whether the main body of the paper is an acceptable summary of our views and whether any general agreement is possible on at least some of the difficult questions of measurement there discussed. 13. On maturity transformation we need to address ourselves particularly to ways of improving the information available both to the banks and to the supervisory authorities. We have had a number of discussions on this subject and I do not under-estimate the difficulties which have been expressed by many members, but the Governors have now enjoined us to make progress in this area and I suggest that each delegation re-examines its position in the light of their comments. I would be grateful if all members can come to the meeting in March prepared to look at this subject afresh and as positively as possible. It may be that we shall have to consider setting in train some work on information systems outside the Committee itself. January 1979

Total liabilities (of which liabilities of foreign establishments to local residents in local currencies)

Deposits or borrowing – of which vis-à-vis other banks Banks’ own marketable liabilities – of which vis-à-vis other banks Other liabilities – of which vis-à-vis other banks

Liabilities

Total claims (of which claims of foreign establishments on local residents in local currencies)

Loans or deposits – of which vis-à-vis other banks Marketable securities – of which vis-à-vis other banks Other assets – of which vis-à-vis other banks

Claims

Notes and definitions attached.

III Claims less liabilities

II

I

up to and including 3 months

over 3 months and up to 6 months

over 6 months and up to 1 year

over 1 year and up to 2 years

over 2 years and up to 5 years

over 5 years and up to 7 years

Maturity schedule on the basis of consolidated data

Pro-forma

Appendix B

over 7 years Unallocated

Total

BS/80/48

6

Capital adequacy and the Basel Accord of 1988

A

Early work

The very first papers that were circulated to the BCBS (in response to a letter from Rene Larre, the then General Manager of the BIS, in 1974) concerned the ‘Rules and practices to protect the banks’ solvency and liquidity’, notably included a report by several countries of their capital adequacy requirements.1 The methodology of such requirements varied considerably between countries, with Continental European countries tending to require risk-weighted ratios and the Anglo-Saxon countries having no formal ratio at all.2 It may be helpful, if only as an aidememoire, to recall what the diversity of requirements was at the start of 1975, and the page from the Secretariat’s Summary on this is reproduced as Appendix A to this chapter. In these early years, there were two main topics relating to capital that were discussed. The first was whether or not, and subject to what restrictions, subordinated debt could be used as part of capital for capital adequacy purposes; there was a wide range of answers, all the way from not at all in Germany, to up to 50% in Luxembourg and 40% in Denmark. The second was how far foreign bank branches, as contrasted with subsidiaries, should also have their own endowment, or dotation, of capital. This latter issue would seem to muddy the distinction between branch and subsidiary, and to be inconsistent with the legal convention that foreign branches formed an integral part of the domestic bank. Nevertheless, at this time several Continental countries did require such a dotation before authorising branches of foreign banks in their own countries. Although there was a description of countries’ differing approaches to subordinated debt, there was

Though filed under the heading of ‘Regulations governing the commercial banks’ foreign currency transactions’, since that had been the background subject. 2 Though the UK moved towards the adoption of a risk-weighted ratio in 1975; see the BEQB paper on ‘The capital and liquidity adequacy of banks’, September 1975. 1

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no attempt to come to a view on best practice, let alone to suggest a harmonised approach. A truly excellent paper on ‘Subordinated debt in bank capital structures in the United States’ was submitted by F. R. Dahl to the BCBS in 1976. Partly because it may not otherwise be publicly available, and partly because it provides such a nice potted history of changing US capital requirements up to that date, it is reproduced in Appendix€B. The question of capital adequacy began to move into the policy arena in 1979/80. The initial impetus for this came from the G10 governors’ general concern about the rate of growth of international lending, and their specific worry that capital adequacy requirements (CARs) bit tighter on domestic than on foreign loan extension, as already described in Chapter 5. This was expressed in the Governors’ press communiqué of 15 April, 1980, where in paragraph 5, recognising: that individual banks, or the international banking system as a whole, could in future be exposed to greater risks than in the past, the Governors re-affirm the cardinal importance which they attach to the maintenance of sound banking standards€– particularly with regard to capital adequacy, liquidity and concentration of risks.

The Governors were already concerned about ‘level-playing-field’ issues, but just as much about the relative effects of regulation, notably CARs, on inducing banks to expand into international, as contrasted with domestic, business. Hence, they added in paragraph 6 that: The Governors note that differences in competitive conditions between domestic and international banking that arise out of official regulations and policies stimulate growth of international bank lending in general; and that transactions channelled through the Euro-currency market can pose problems for the effectiveness of domestic monetary policy in those countries where such differences are particularly significant. The Governors will continue efforts already being made to reduce the differences of competitive conditions, fully recognising the difficulties arising from differences in the national structure and traditions of banking systems.

We have already noted in Chapter 5 the abortive attempt to use the BCBS to attach higher CARs to international than to domestic business. Peter Cooke, however, returned to the issue of CARs in a more general context in his Chairman’s note of 10 February 1981 (BS/81/5), probably prompted in part by the growing and widespread concern with the general decline in commercial banks’ capital ratios, and because his thinking was already turning to his prospective Lausanne speech in June. After referring back to the Governors’ communiqué

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of April 1980, Peter noted that the Committee had not yet ‘addressed itself to this subject in a comprehensive manner’, although a number of earlier papers were relevant to the subject. His note raised: a number of issues for possible discussion:€firstly, on the measurement of capital adequacy on an internationally comparable basis; and secondly, on the consequences of different national capital requirements for banks in international markets.

The particular concerns raised in this note are reproduced in Appendix€ C. This note was discussed, briefly, at the next BCBS (twenty-Â�first) meeting at the end of February, and, in line with its usual procedures, a questionnaire was sent out to member central banks, in April, asking how they each defined capital for the purposes of their own national CARs and what ratios were used (BS/81/12). (The replies were collected together in BS/81/18.) Peter then expanded on these issues in a public speech at an International Monetary Conference at Lausanne, 3–5 June 1981, but in a rather general, philosophical manner (filed as BS/81/27). Thus he noted that: There is no objective basis for ex cathedra statements about levels of capital. There can be no certainty, no dogma about capital adequacy:€it is therefore an area, par excellence, where the supervisors have to play a role in setting standards to fill what could otherwise be a vacuum. It may be argued market forces should be allowed full rein to bring about necessary restraint on banks’ businesses. The trouble with that view is that the perception in the market of capital inadequacy is likely to arrive for some banks at a time when they are no longer in a position to remedy the situation. Conversely, others€– perhaps most of the world’s major banks€– could probably all too easily expand their business a good way beyond the level which supervisors would consider acceptable without provoking any market reaction … It may be argued that the logic of this position … suggests that capital adequacy tests may need to be applied relatively uniformly internationally if competitive imbalances in national markets are to be avoided. Too much should not be made of this, as there are many other factors affecting competitiveness, but it may be that some moves towards a convergence of national capital adequacy guidelines would be useful to form at least one of the bases of a more coherent framework for the conduct of international banking business, and to keep the pressures to expand such business within reasonable bounds. Recently, competitive pressures have squeezed margins for a lot of business in international markets. One aspect of this squeeze may well have been the capacity of banks with relatively liberal capital requirements to expand their book.

At this stage there was, however, little urgency exhibited in taking the issue forward. Again at the BCBS (twenty-second) meeting in June 1981, there was once more only a ‘very brief discussion’ of these issues

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(Item VI, BS/81/31) (perhaps because the answers to the questionnaires had not all been received), and the possibility of a fuller discussion was deferred to the next September meeting.3 When this latter meeting, the twenty-third, delayed until 29–30 October, took place, the Secretariat was asked to draft a paper with two parts:€first a technical report on definitions and ratios and the second a more general (macro) discussion of the role of capital, recent trends and the question of possible convergence in capital ratios. By now, with global pressures rising from the recession of 1980–82 and the accompanying high and volatile interest rates impinging on banking systems everywhere, the pace of work on capital adequacy speeded up. The Secretariat produced its draft paper on ‘Capital adequacy and international banking activity’ quickly (by the end of January 1982, BS/82/4). This covered five main topics (plus a couple of country-specific statistical annexes), being: (a) a general passage on the role of capital; (b) a more detailed account of the definition (constituents) of capital; (c) another detailed account of the ratios in use in various countries; (d) a general passage on the current declining trends of capital ratios; and (e) an essay on the possibility of adopting ‘a more systematic treatment of capital adequacy’, that is convergence. This paper was then discussed at the next (twenty-fourth) meeting of the BCBS (25–26 February 1982, BS/82/16). And, after discussion: the Chairman suggested that a draft report to the Governors on this question should be drawn up before the Committee’s next meeting covering four main points: – an endorsement of the principle (with appropriate qualifications) of no further erosion of capital ratios; – a statement of the desirability in principle of greater convergence in capital requirements; 3 In the meantime, following a suggestion by Mr Pille (Belgium), members were invited to comment on some of the chairman’s more general questions (from BS/81/5). Only five (and not including Belgium!) did so (Canada, France, Germany, Luxembourg and Switzerland). Their replies were (BS/81/39): Have capital ratios declined excessively? 3 Yes; 1 (Lux) Perhaps; Swiss, no answer. Have margins eroded too much? Canada, Yes; 4 Perhaps. Have banks in countries with low CARs become overexposed? Canada, No; France, in some cases; Germany and Lux, perhaps; Swiss, no answer. Are banks avoiding capital restraints by off-balance-sheet expansion? 5 No. The rise in such business was due to other factors. Should there be more international convergence in CARs? 3 Yes; Canada, Yes, but transitional problems; Swiss, no answer.

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– the expression of a preference for the risk assets ratio as the most important capital adequacy ratio; – a brief statement of the desirability of a common definition of capital internationally, together with some allusion to the work the Committee proposed to undertake in that context.

This was done in time for the (twenty-fifth) BCBS meeting (24–25 June) (BS/82/39). The revised paper by the Secretariat (BS/82/23) was shortened, and most of the technical details about differing definitions and ratios excised. Instead it concentrated on ‘The undesirability of any further erosion of banks’ capital ratios’ (however nationally measured) and ‘The desirability of greater homogeneity in the levels of capital employed by major banks operating internationally’.4 The paper noted the wide range of differentials between international banks’ capital requirements. It noted that the BCBS regarded these as too wide, but expressed hope that work could usefully be pursued on: a. The achievement of some greater convergence in national definitions of bank capital Work undertaken by the Committee has shown that there already exist a number of common elements in national definitions of capital for supervisory purposes. While not underestimating the technical difficulties or philosophical differences involved, the Committee believes that there would be great advantage in seeking to bring member countries’ understandings and practice with regard to the constituents of capital for supervisory purposes closer together. It is therefore exploring the possibility of arriving at a common view about the main constituent elements of capital. Some work in this area is also being pursued within the framework of European Economic Community institutions with which a number of Committee members are closely associated. b. The refinement of techniques of capital adequacy measurement While capital adequacy tests are found in all supervisory systems, their particular form and detailed application differ from country to country. There are a number of useful and widely practised techniques for assessing banks’ capital adequacy€– for example, gearing ratios, large loan limitations and risk assets ratios, but some form of risk assets measure is now one of the most widely considered ratios, frequently incorporating constraints on concentration of lending. This measure consists of a weighting of different categories of balance-sheet assets according to perceptions of the relative risks attaching to them. The main value of the risk assets ratio is that it enables supervisors to relate banks’ capital directly to the character and relative quality of their assets and thus to the risk of loss which exists in their business. 4 It was also clearly noted that if ‘capital adequacy levels generally should not be allowed to be further eroded, it has to be recognised that such a convergence would have to involve some upward movement of capital ratios in those countries where the requirements are most liberal’.

The attempt by the BCBS to achieve consensus

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The paper was put to the Governors’ July meeting, and was endorsed by them, as the Chairman recorded (BS/82/52): The question was raised of giving the report a wider distribution … My present view would be to favour wider distribution of the report, but only to supervisory authorities.5 Some Governors expressed an interest in having the report published.

So, by the end of 1982 the BCBS had reached agreement on a Â�general framework for moving towards an accord on capital adequacy. There was agreement, en principe, that there should be convergence towards a rather higher common level, on a consolidated balance sheet, (Concordat principle) and using a risk-related assets ratio. In that case, why did it take the BCBS so long, and require so much external Â�pressure (of various kinds), to move from outline, general agreement to a specific itemised Accord? There are three parts to the answer:€the first is that ‘the devil is in the detail’6; the second is that the BCBS was not, and has never held itself up to be, an effective body for forcing recalcitrant members to alter positions, especially when such readjustment might adversely affect the competitiveness, or the profitability, of that member’s banks. The BCBS (neither its Chairman, Secretariat, nor a majority of members) had little ability (or wish) to threaten such recalcitrant members. If (important) member countries dug in their toes, there was not much that the BCBS could do about that; nor should it have been expected of it. The most it could do was to note the problems and to report to the Governors, and encourage them to knock heads together. Finally it was not until 1984 that Volcker injected a real sense of urgency into the timetable. B

The attempt by the BCBS to achieve consensus

Although there was general agreement on the need for a common framework, and the broadly desired outcomes for CARs, by the end of 1982, it was appreciated that there was a massive amount of detailed, nitty-gritty work on definitions, risk ratios, and so on, to be done. It was not suitable to try to do this in full BCBS meetings, and yet was both too specialised and country-specific to hand over to the Secretariat. So at the June 1982 meeting the Chairman proposed setting up a subgroup to work on such technical issues (BS/82/39). Prior to the subsequent BCBS meeting (the twenty-sixth on 27–29 October 1982, BS/82/73), This was so done under cover of a letter from the chairman (BS/83/13) in February 1983. 6 Dale (1984), especially pp. 58–9, sets out several of the key problems. 5

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Capital adequacy and the Basel Accord of 1988

the Chairman approached Mr Dahl (from the FRB in Washington) to form such a subgroup with members from Belgium, France, Germany and the UK, but not Japan, perhaps because the rapid turnover of Japanese participants in the BCBS would have been likely to make them a less effective contributor to the work in hand. The terms of reference (BS/82/69) were:

• to

work towards arriving at a common view among member countries of the main constituent elements of capital, paying particular attention to the treatment of subordinated loan stocks and the status of hidden reserves for prudential purposes. • to pursue the examination of different ratios7 which relate balance-sheet items to capital (e.g. risk asset ratios, gearing ratios and large loan exposure ratios) with a view to assessing their usefulness for different prudential objectives and to make recommendations for the application of any such ratios within the supervisory arrangements of member countries.

The Dahl Committee met for the first time in Brussels on 9 December, and reported back early in 1983 (BS/83/10). All agreed that six items should be included in the capital base, to wit: 1. paid-up share capital 2. preference shares 3. share premium account 4. accumulated past profits 5. current profits 6. general reserves. But there was less agreement on the inclusion and treatment of five other commonly found components: (a) asset revaluation reserves (b) undisclosed reserves (c) specific loss provisions (d) convertible debt securities (e) subordinated loans. As to solvency ratios, Dahl argued that both a risk-weighted ratio and a simpler gearing (leverage) ratio were ‘useful, and the employment of 7 The BCBS was not the only body engaging in this statistical exercise at this juncture. In its ‘Report on International Developments in Banking Supervision’ 1982 (BCBS, March 1983), the BCBS noted that similar work on solvency observation ratios was being undertaken by the Groupe de Contact of EEC Supervisory Authorities (who were also analysing the definition of own funds), and by the EEC Banking Advisory Committee. With Huib Muller being elected chairman of this latter committee, even the personnel were largely interchangeable. While Muller was not himself a member of the BCBS at this juncture, there were several common members of BAC and the BCBS.

The attempt by the BCBS to achieve consensus

153

both in some form might serve to allow one to act as a check on the other’.8 The more detailed account of the discussion revealed, however, how far apart the separate country practices were in many respects; in particular in Germany only own funds (items 1–6 above) were in principle accepted as capital. Dahl introduced this report at the twenty-seventh BCBS meeting (23–25 February 1983). He was then invited to return to the same exercise on the basis of a new mandate. This mandate invited his subgroup (BS/83/30): To consider further the constituent elements of capital with a view to offering a basic conceptual blueprint of the elements of the capital base which might have general application. Although recognising that some countries will include some elements of capital in the definitions in their own system which are excluded in others (and vice versa), it should nonetheless be possible, ignoring particular current national practices, to offer a common definition. To examine the nature and different degrees of risk present in the different categories of asset held by banks (and contingent liabilities)€– with particular reference to interbank claims€– and to suggest relevant risk weightings to be applied in relating these risks to capital resources.

Reading between the lines (since a fuller, but more informal, account of the February 1983 meeting was not available to me), it would seem that the BCBS wanted the Dahl subgroup to move on from itemÂ�ising differences in capital definitions to try to find a common position agreeable to all; similarly the Europeans had decided that they wanted a common risk-weighted ratio. Rather than further discussions on the relative benefits of gearing versus risk-weighted ratios, they wanted to move forward to choosing the (appropriate) weights. It was, alas, easier said than done. The Dahl subgroup took longer to come back to the BCBS and, when they did in October 1983, they only discussed the first part of the mandate, capital definition, and even then did not really advance beyond their previous note. Thus, on the components of capital, ‘undisclosed reserves’ were now advanced from (debatable) group 2 to (good) group 1, and asset revaluation reserves In the body of the discussion, Dahl: 8

recounted the US experience where the use of weighted risk asset ratios had been given up when the regulatory authorities found that they were being drawn into excessively detailed discussions with banks over the system of weightings. They had then moved to an unweighted capital to risk assets ratio (i.e. excluding interbank loans and Government securities), but without setting target ratios. More recently target ranges had been introduced, but, as part of a compromise agreement, a capital to total assets ratio had been adopted.

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Capital adequacy and the Basel Accord of 1988

and specific loss provisions were just dropped from the list, but otherwise nothing changed. The next Dahl subgroup report, on the second half of its mandate, that is the risk weightings to be adopted, was considerably more substantial, but had taken almost a full year, from revised mandate to submission, to produce. Recall that there was little urgency to complete the exercise by then; rather the aim was to shepherd the subgroup towards a consensus if possible. It did produce a proposed set of weights, reproduced here as Appendix D. There were two particular issues that Dahl flagged in his cover note:€ the first was on the weighting of interbank loans; the second on the treatment of loans to foreign governments. On the latter the proposed EC observation ratio would divide countries into two zones (industrialised, with a much lower weight; and the rest, a higher weight). Dahl’s subgroup preferred a simpler home/foreign split (line 1 in Appendix D). In the event the Europeans insisted on the OECD (Organisation for Economic Co-operation and Development)/ non-OECD split, since the Treaty of Rome did not permit any discrimination among EC members; this caused a lot of grief in the subsequent implementation of Basel I, as we shall see in Section D below. The BCBS discussed the two Dahl reports at its thirtieth meeting on 23–24 February. The short summary of that meeting (BS/84/28) is missing, but the meeting cannot have gone well, since Chairman Peter Cooke then prepared a plainly pessimistic letter to the new Chairman of the G10 governors, K. O. Pöhl, on the prospects of achieving consensus and convergence. In this letter (BS/84/27, dated 1 March 1984), Cooke wrote that: I should report a strong consensus among most members at our discussion that the current degree of convergence in the constituents of capital or in capital adequacy measurement in member countries is not such as to give any confidence that the application of one country’s rules to the banks in another country could be undertaken in any meaningful way for comparability purposes. I might also mention that the Committee is continuing to pursue its efforts to promote some greater degree of convergence in capital requirements for international banks than is currently evident from the enclosed paper. In doing so it is mindful of the work which is being done elsewhere on this subject, notably in the European community, and is anxious to maintain contact with such work in order to move forward as far as possible in a co-ordinated way. I have to say, however, that it does not seem to me this work will be either easily or quickly accomplished.

This may not have been welcome news for the Governors. The recession of 1981/82, and particularly the MAB (Mexico, Argentina, Brazil) crisis, starting in August 1982, had put bank potential losses, profitability

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and capital adequacy under enormous strain. So much so that the outline agreement of 1982 for no country to allow its banks’ capital ratios to erode any further was already under severe pressure. To explore how far the damage had gone, the BCBS issued a questionnaire, in July 1983 (BS/83/52), on recent trends in bank capital ratios, and ‘to indicate the number of institutions within the sample which show an improvement or deterioration in each period and the extent to which there is substantial dispersion around the average.’9 Nowhere had the MAB crisis fallen more severely than on the US (New York) city centre banks, several of whom were rumoured to be bankrupt should their loans to the distressed (MAB) borrowers be valued at current market prices. Congress was furious that such fragility had been allowed to occur, and wanted US major (international) bank capital ratios raised unilaterally. But the US banks lobbied successfully that to do so would cause them to lose competitiveness and business to foreign banks, notably the Japanese banks, who were rapidly expanding business and market share at that juncture on the back of apparently wafer-thin capital ratios (i.e. when measured without taking any credit for the unrealised capital gains on their equity crossholdings); see for example Kapstein (1994), Chapter 5, and (2007), p. 8, and Wood (2005a), p. 75. Anyhow, Congress was now putting pressure on Paul Volcker, the Chairman of the Fed, to obtain an international agreement on a higher, harmonised capital ratio, and Volcker was happy to transmit that same pressure on to the G10 Governors, and through them to the BCBS. So at the very same meeting of the Governors, on 12 March 1984, at which Cooke exposed the difficulties of reaching consensus and expressed his own doubts whether much easy or quick future progress would be possible, he was specifically given a mandate to achieve just that.10 Thus in his report of that meeting (BS/84/31), Cooke noted that: Chairman Volcker introduced his paper which went wider than the particular point about the US regulators assessing foreign banks’ capital adequacy in a takeover situation and discussed the need generally to harmonise capital adequacy measurement techniques and improve the general level of capital adequacy in major banks around the world. He indicated that the Federal Reserve and the US Treasury had been mandated by Congress to pursue these matters with supervisors worldwide and suggested the work already being undertaken on these matters by the supervisors in Basle should be given a new 9 The results (BS/83/61 and BS/84/12) were quite mixed. 10 Kapstein (1994), p. 104, appears to date the start of the BCBS’ work on CARs from this meeting. While it is clear that Volcker injected more urgency into the exercise, it had already been ongoing there for several years.

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impetus by the Governors. In particular he asked whether some measure of ‘functional equivalence’ could be devised on capital measurement to overcome national differences and allow a commonly agreed quantitative guideline for capital adequacy. In discussion the importance of trying to carry forward work in this area in Basle while being mindful of the EEC work was mentioned by more than one Governor and I reported that I had had a meeting with Mr Muller of the Nederlandsche Bank in his capacity as Chairman of the EEC Banking Advisory Committee in order to explore ways in which the development of two different approaches to the problem might, as far as possible, be avoided. The Governors eventually agreed on the following mandate, which I accepted: The G-10 Governors wish to give further impetus to the progress made to date in the Cooke Committee, and in that connection request the Chairman of the Committee, drawing on the views in that Committee, to undertake consultations with central banks and their Governors in order to develop recommendations for the September meeting of the G-10 Governors in regard to: 1. assessing comparability of different measures of capital adequacy, and 2. the most practical options for attaining over different periods of time comparable and adequate minimum international capital standards. I stressed the importance of not underestimating the difficulties of making substantial progress on this complex subject. I also reminded the Governors that the responsibility in these matters did not always rest directly with central-bank Governors in member countries, which was accepted and understood. I expressed the hope that undue expectations would not be raised by giving publicity to the mandate or to the timetable set. In this connection one or two Governors said that they recognised that a report in September might be only an interim one. It will be my hope that I can prepare for discussion at the June meeting of the Committee a paper which attempts to address the issues covered in the mandate just described. I hope I may call on all members’ support in attempting, in a spirit of compromise, to carry this work forward.

This mandate was, in my view, a ‘mission impossible’. Initially there was a great deal of uncertainty about the meaning to be attributed to ‘functional equivalence’; if the idea was that each country would continue to use its own preferred approach, for example gearing or riskweighted, but introduce adjustments to translate its approach also onto the other basis, then there would be problems, as the Chairman’s subsequent note of 18 June 1984, on ‘The measurement of capital adequacy’ (BS/84/41) indicated. Thus: An initial view would be that this approach gives rise to a number of difficulties. A complex series of adjustments needing bilateral agreement would seem to be required. Moreover, comparison on the basis of gearing might prove

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misleading for banks holding large portfolios of assets carrying little risk. Nor is it clear that the overall objective of convergence in both the methods of calculating capital adequacy and in capital standards would best be promoted by an approach of this kind. An alternative, and in my view a more promising, approach would be for the Committee to attempt to reach agreement on a common framework of measurement which, when applied to banks internationally, would present capital ratios on a roughly equivalent basis. No system of measurement can in itself be expected to capture and reconcile the different institutional, legal and accounting conventions obtaining in member states. Nevertheless, a common framework of reference would provide an important first step towards a qualitative interpretation of comparative levels and movements in capital adequacy after due allowance for considerations less capable of quantification.

But even more seriously such a common framework would force some countries to adopt requirements which would either conflict sharply with their strongly expressed positions (prejudices?), for example Germany on treating anything other than equity as capital, or would require a major increase in the relative capital ratios of their own banks and put their international competitive position at risk, for example Japan and, perhaps, France. Given such strongly entrenched views, what weapons did the Chairman, and Secretariat, have in this negotiating game, beyond a plea to ‘ask members of the Committee to approach the discussion in a spirit of compromise, not insisting on every element of their own national systems. Such flexibility will be essential in order to reach agreement on a uniform model’? Not surprisingly, national self-abnegation did not then suddenly become the order of the day. There were four main fields of debate. The first was the choice of risk ratios, since, as already noted, the Europeans11 were adamant that their preference was to have a risk-weighted ratio. So here the question was the choice of weights. At this juncture there were two proposals on the table, that of the Dahl working party and that of the EEC banking advisory group.12 These were summarised in the Chairman’s note of June 1984, as reproduced as Appendix E. The second, and more contentious, involved the proposed components of capital; again the position as of mid-1984 11 With the exception of the Luxembourg representative(s), who initially argued for the use of a gearing ratio. 12 As far as I can discern, none of those ratios was based on any empirical analysis of default probabilities, loss given default, etc., though perhaps that would have been asking a lot at that date. There was some additional consideration applied to the additional risk involved of concentration and larger exposures, but little, or no, attention given to the benefits of diversification, or to the importance of assessing co-variation, rather than just the variance, of out-turns among assets. In general, the risk weights combined the subjective, but practical, experience of their authors with added dollops of political economy considerations.

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was summarised in that same note, and reproduced as Appendix F. The third key question was the choice of number for the CAR. That may seem superficially to be even more difficult, but actually in the event was largely determined by the decisions on the first two issues. It had to be a round number(s), and, by the 1982 agreement on ‘no further erosion of ratios’, it had to be (just) above the capital ratio estimated by decisions on issues (1) and (2) above that ruling in the (important) country with the lowest ratio at the time. But the fourth, and most difficult of all, was how to persuade all (the important) countries to agree to move (i.e. to converge) to the adoption of a harmonised CAR, when it might appear contrary to their own specific national interest. There was a further generic difficulty in all this analysis. This was that simplicity, and brevity, is a virtue. Nevertheless, any simple approach (whether gearing or risk ratio for example) would tend to put into common groupings (or ‘buckets’) assets/liabilities that were in many respects dissimilar, thereby leading to anomalies, distortions and ‘gaming’. There is always a trade-off between simplicity and being appropriate or accurate. Next, in the run-up to any decision on the model to use, there is a need to compare alternatives, but this leads to a multiplication of case studies, with a consequential heavier workload and (what can be) a muddling collection of (often closely similar) sets of numbers. Be that as it may, much successful work was done on the subject of risk weights.13 One of the most difficult questions was the risk weights to apply to claims on foreign governments and banks. Here the Dahl proposal had been to distinguish between domestic and external claims. This approach was, however, blown out of the water by Huib Muller (Chairman of the EEC Banking Advisory Committee), who noted that loans to, say, a Brazilian bank made by a branch of a Spanish bank in Rio de Janeiro would then have a much lower weight than an exactly identical loan booked through its head offices in Madrid. This point was made at the Governors’ meeting on 10 September 1984, as reported in the Chairman’s note-for-the-record of 24 September (BS/84/55).14 Even 13 In his note-for-the-record on work done on the capital adequacy mandate put before the governors’ meeting in March 1986, the chairman wrote (BS/86/27) that: noted that some Governors had remarked in earlier discussions on the desirability of achieving a common approach to capital measurement in the work undertaken both under the auspices of the EC Commission in Brussels and in the work of the G-10 countries in Basle. A great deal of progress had been made to bring these two systems of measurement into line and I was hopeful that it would be possible to achieve a more fully consistent approach shortly. 14 ‘On a technical point relating to the construction of the risk asset categories, it was represented by Mr Muller of the Nederlandsche Bank, in his capacity as Chairman of the EEC Banking Advisory Committee, that the separation of claims on the public

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with the BCBS now accepting the EEC Brussels approach towards weights on lending to governments in non-industrialised countries (Zone B in Brussels terminology15), that still left some remaining differences on weights on claims on governments in industrialised countries (Zone A in Brussels) (i.e. Basel 5%, EEC 0%), and on claims on foreign-headquartered banks. The Secretariat (BS/85/70) advocated accepting the EEC approach on public sector loans largely because the 5% Basel weight was a partial, token attempt to capture market/interest rate risk, rather than credit risk, which was the primary focus of the current CAR exercise. Moreover, such assets ‘would still be given full weight within the gearing measure as part of the Basel exercise’.16 The Secretariat did not, however, advocate adjusting to the EEC observation ratios in all cases (for the sake of harmony), and after further examination stuck with their own preferred weightings on interbank lending, suggesting that in this respect the EEC Banking Advisory Committee sector between those in respect of domestic and host governments (weighted at 5 per cent) and those in respect of cross-border public-sector claims (weighted at 100 per cent) would present several difficulties, both practical and conceptual. For example, if a US bank held all its holdings of Brazilian public-sector debt in its Rio de Janeiro branch those assets would only be weighted 5 per cent, but if these assets were held in New York they would be weighted 100 per cent. It also ran into conflict with a basic principle of the EEC approach, i.e. not to differentiate between the credit standing of the various member states. Moreover, for some members of the Supervisors’ Committee, information on the location of particular holdings of claims on publicsector entities, sufficient to provide the cross-border/domestic breakdown would be difficult to obtain. This was recognised to be a difficult area to arrive at a solution which adequately reflected varying degrees of risk in holdings of public-sector assets. The Governors therefore agreed that the two separate items should be merged into a single category on the lines of the approach adopted in the draft paper of 20th July. This would encompass all claims on the public sector, domestic and overseas, and be weighted at 5 per cent. The cross-border element would be captured within the memorandum item giving a breakdown of cross-border risk between industrialised and non-industrialised countries.’ 15 The OECD/non-OECD distinction came later, but was virtually synonymous with the Zone A/Zone B distinction. The massive size of the difference in weightings (0% and 100%), often way out of line with true economic risk differentials, was bound to make trouble, but this was felt to be the only practicable method of getting agreement on the subject. 16 As the chairman’s note (BS/84/55) indicated, although the Governors all endorsed the risk-weighted approach at their September 1984 meeting, they still also wanted to see what a gearing model would produce. Thus: The substance of the proposals for a tiered framework for measuring capital and assessing capital adequacy was endorsed by the Governors. The Governors generally welcomed the paper as a positive step forward towards overcoming the basic problem of comparability. The risk assets approach was endorsed by all Governors including those whose own systems were based on a gearing measure. At the same time, to broaden the base of the exercise, it was agreed that for testing purposes at this stage the framework should be extended to include a gearing ratio approach alongside the risk assets approach.

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might gracefully withdraw. By and large, however, the problems of agreeing on risk weightings were soluble and generally resolved amicably enough. By 1984, however, it had become clear that a sizeable number of emerging countries faced grave difficulties in meeting their sovereign debt obligations. This caused two additional complications for the BCBS exercise. The first was that even higher risk weights than the 100 per cent weight on lending to non-industrialised countries might need to be applied to such fragile debtor countries, an additional country risk exposure element. The second was that, given the size of bank loans to such less-developed countries (LDCs), the measurement of current profits and capital would depend sensitively on how banks provisioned against such loans. If a group of banks provisioned more fully, they would appear to have lower profitability/capital adequacy, but that would be just appearance, not reality.17 Meanwhile the BCBS, as discussed further below, did not seem willing or able to reduce significantly the number of separate categories of capital that it identified. In Appendix F, no less than ten are mentioned, eight to be clearly included, plus two doubtfuls (subordinated debt and

17 In his note-for-the-record (BS/86/27) of the governors’ discussion of the BCBS report on the capital adequacy of international banks (BS/85/71), the chairman specifically commented on: The importance the Committee felt should be given to the link between capital and provisioning in making relative assessments of capital strength was emphasised in the report. Capital levels€– tout court€– were not necessarily a sufficient indication of capital adequacy. Hence the emphasis given to the risk assets approach. But even this might not be a sufficient test without some assessment of the current quality of those assets. It had become very clear in the Committee’s discussions that to obtain a more fully comparable assessment there was a need to include within capital adequacy tests some measure of the degree to which banks had provided against perceived problem assets or contingent liabilities which might lead to loss. Thus, the memorandum items concentrating on country transfer risk exposure (particularly important at the present time) were added to the tables. The notional provisioning figure of 20 per cent introduced into the paper was an attempt to bring capital and provisioning adequacy together. It was worth remarking, however, that the relative ranking of different countries changed rather little from the positions without such adjustment. The link between capital and provisions was the reason why the Committee had felt it would also be useful to highlight the fiscal treatment of provisions in the short note circulated earlier to Governors. The note had been prepared following a preliminary discussion in the Committee of provisioning levels expected for their banks in 1985 and also because it had come to the Committee’s notice that the EC Finance Ministers were likely to discuss this matter at their meeting in Brussels the same day. It was felt that Governors should also have an opportunity to consider the matter. The note sought to emphasise a point, already made briefly in the main paper, that differing fiscal regimes in G-10 countries appeared to be one not unimportant factor standing in the way of closer convergence of provisioning standards.

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Table 6.1. Elements of capital in a tiered framework Countries which do not include or do not allow these elements 1

Plus 2

Issued and fully paid ordinary shares Non-redeemable preference shares Share premium Retained profit and general reserves Legal reserves Undisclosed reserves

Plus 3

Asset revaluation reserves

Plus 4 Plus 5

General provisions Subordinated debt (up to a maximum proportion of 50 per cent of items 1 to 4)

Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Sweden, United States Canada, Germany, Sweden, Switzerland, United States Germany Germany, Italy, Japan

specific provisions). By the time that it was decided to go to member countries to attempt to quantify what each approach would imply for their own banks, this had been reduced to five, as outlined in BS/84/73, Table 6.1, and reproduced above: All this, however, meant that in the statistical questionnaire (BS/84/73) sent out by Christopher Thompson, the new Secretary of the BCBS, who replaced Michael Dealtry (see Chapter 3, Section C and Appendix B), to member representatives at the end of November 1984, there were no less than eighteen (average) risk ratios to be estimated and filled in for each country. Thus there were five possible definitions of capital, going progressively wider, applied to three bases (a generally agreed set of risk weights; that plus added country risk factors, and a gearing ratio). This led to fifteen cells, plus another three memorandum items. The basic table is reproduced as Table 6.2 (from BS/84/73, Annex 4). The attempt by the BCBS to reach a consensus on the appropriate categories of capital did not get any easier; indeed the problems got worse. Apart from the question of the appropriate degree of provisioning to be applied (against sovereign loans to LDCs), the banks were now innovating with new, ‘hybrid’ kinds of marketable instruments, which had some of the characteristics of equity and some also of more standard subordinated debt. Where did these fit into the various tiers of

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Table 6.2. Suggested tabular format for submitting responses to Secretariat Basic risk assets ratios (Annex 2) Capital base 1 method Ratio % Numerator … Denominator …

2

3

4

5

% … …

% … …

% … …

% … …

Risk assets ratio with country risk factor (Annex 2(a)) Capital base 1 2 3 4 method Ratio % % % % Numerator … … … … Denominator … … … … Gearing ratios (Annex 3(b)) Capital base 1 method Ratio % Numerator … Denominator … Memorandum items (Annex 2) Item No. 1(a) %

5 % … …

2

3

4

5

% … …

% … …

% … …

% … …

1(b) %

2 %

capital?18 Indeed, towards the end of 1986 the number of tiers, or definÂ� itions, of capital applied by the Committee had risen from five to six; see, for example, Thompson’s note of 9 September 1986 (BS/86/63). These were: 1. Shareholders’ equity and disclosed reserves 2. 1 plus undisclosed reserves 18 In his note-for-the-record of the Governors meeting of 10 March 1986 (BS/86/27), the chairman noted that: With all the innovative developments at present under way in the international capital markets, it was likely that the definition of the elements of capital would need to take continuing account of new capital instruments and the Committee would work to keep the analysis of the paper up to date in this regard. Significant improvements in capital levels seemed likely to have occurred in some countries in 1985, aided by these new instruments. One particular question which the Committee would be considering further was the extent to which certain forms of capital, notably in the form of subordinated, redeemable instruments, should be restricted in amount by the authorities within the overall capital base. In this regard, there was a measure of support for the proposition that was already accepted in a number of member countries that secondary capital in debt form should be limited to 50 per cent of the higher quality elements within the capital base.

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3. 2 plus perpetual and other hybrid debt capital instruments 4. 3 plus revaluation reserves 5. 4 plus general provisions 6. 5 plus subordinated term debt. Even to the extent that there was a generalised agreement that these were the reasonable candidates for consideration as the definitional base for a CAR, there was no agreement on which should be chosen. Strong differences of view remained. Moreover, the Chairman, and the BCBS, had no means of imposing either a decision with respect to the capital definition to be adopted, or, assuming that such a definition had been (somehow) agreed, of forcing an unwilling country to agree to converge to some higher level. In his note-for-the-record of the Governors meeting of 10 March 1986 (BS/86/27), at which the earlier BCBS note (BS/85/71) on its work on capital adequacy was taken, Chairman Peter Cooke stated that he told the Governors that: The process of definition and of analysis had taken the exercise a considerable way. It was always recognised, however, that it would be difficult to deliver convergence in the levels of capital in major countries, as for some countries it could involve significant upgrading from present levels. If Governors felt that such convergence was a desirable objective, it clearly could not be achieved by the efforts of the supervisors alone. It required considerable support and strong positive encouragement from the Governors. I said that the Committee would find it particularly useful if Governors could indicate whether they felt such encouragement and support could be given to help guide national policies or whether, in practice, they regarded this third stage of the mandate as unachievable.

Perhaps rather wistfully, he then concluded (paragraph 11, p. 5): I received no firm steer from Governors on the desirability of pressing forward to greater convergence of capital adequacy levels internationally.

Maybe Peter Cooke had not made the point forcefully enough, or had been misunderstood. But, according to his own account on paper of his participation in this meeting, he had warned the Governors, entirely correctly in my view, that the BCBS could not possibly be expected to achieve convergence on its own, and that he, and the BCBS, would need a great deal of help from the Governors should the latter really

This latter is the first reference that I have found of having a two-tier capital base, with restrictions on the scale to which the elements in the second, lower tier can be used. Peter Cooke confirms that it was around this time that the two-tier idea came to the fore.

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desire to achieve such convergence. Instead, the Governors left him, and the BCBS, to sink or swim.19 Not surprisingly, they could do no more than tread water. There were some further minor technical improvements and agreements during 1986, but essentially by the end of 1986 matters were not substantially advanced from what they had been at the end of 1985, or early 1986, and the constraints on the Committee remained unchanged. The BCBS’ latest report to the Governors (BS/86/73) still had the same six tiers of potential capital ratios, with no resolution or choice between them, and, lacking such agreement, there was no point in trying to choose a numerical norm, let alone to put pressure on unwilling countries to converge to that. Meanwhile, the Americans were becoming concerned and unhappy at this lack of progress in Basel. In particular the Federal Reserve Board decided to move unilaterally towards the introduction of a new, and prospectively higher, but by an undisclosed extent, risk assets-based CAR. This was announced in a press release of 24 January 1986. The BCBS, like other international institutions, was specifically asked to comment, and Chairman Peter Cooke wrote back to William Wiles about the US initiative on 16 May (BS/86/30), having taken soundings from other members of the Committee. In general the Chairman strongly endorsed the US adoption of a risk-weighted ratio (the Americans having been among the most reluctant to emphasise such a ratio, in place of a simpler gearing ratio, in the past), and he welcomed the FRB’s reference to the need for international convergence. His main concern, and that of the Bank of England (see below), was that the US proposal suggested a lower risk weighting on interbank claims on other US banks (30%) than on claims on banks in other industrialised countries (60%). This was criticised as being without micro-prudential foundation (e.g. lending to a ‘bad’ bank in the USA would have a lower weight than lending to a ‘good’ bank in, say, France or Canada), and likely to segment the interbank market. Besides that, the 19 It is my conjecture that, had Gordon Richardson of the Bank of England still been president of the G10 governors, he might have responded more forcefully to this cri de coeur from Peter Cooke, and even perhaps chivvied his gubernatorial colleagues into reaching interim decisions on the key points at issue. But Robin Leigh-Pemberton had taken over from him as Governor at the Bank of England in 1983. Robin was a ‘new boy’ among the G10 governors, and not in his early years as well versed in such regulatory issues as Richardson had become. Meanwhile, the new chairman, Karl Otto Pöhl, came from Germany, and the German position on these issues was that of an outlier. Also the Bundesbank was not the relevant German supervisory authority, which was Bafin, which may well have constrained Pöhl from giving a clear lead to his fellow governors. But this can, of course, never be more than conjecture.

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Chairman’s note warned against ‘too much elaboration’ of the weighting measures, against too much rigidity (so as to allow ‘some adaptation and modification in the light of developing experience internationally), and against trying to account for market risk as well as credit risk; thus a CAR based on a ‘snapshot test’ ‘is generally well adapted to measuring evolving credit risk but is less suited to measuring and controlling exposÂ� ures which may change continuously, even during the course of the day’. There were, of course, some other technical comments, for example on premium weightings for certain country risk exposures and how to handle off-balance-sheet positions. But the general conclusion was that the Chairman believed that ‘members of the Basle Supervisors’ Committee generally welcome the general thrust of the Board’s proposals which are seen to be in harmony with evolving views and practices elsewhere’. The Bank of England also responded in a generally favourable tone (May 1986, BS/86/52) to the FRB’s proposal, noting that its own suggested risk ratio, outlined in the Bank of England Quarterly Bulletin (BEQB) 1980 on ‘The measurement of capital’, ‘is similar to that now being proposed within the US’. Otherwise the Bank’s response largely reiterated the same technical queries that Peter Cooke had raised, and added a few new ones, for example on consolidation and joint ventures (the latter being a perennial British concern). The point of all this is twofold. First, there was nothing in the US proposal that was against the principle or spirit of evolving attitudes at the BCBS. Second, all the countries represented in the BCBS had a pretty good working knowledge of each other’s positions by 1986. After all, they had been going over the same ground continuously since 1982. Certainly the British and the Americans had a very good idea by then of the main similarities (post January 1986) and of the relatively few differences in their positions. The problem was the ‘level-playing-field’ issue.20 The US banks lobbied strongly against the unilateral adoption in the USA of a higher CAR. Thus Duncan Wood (2005a) states, at p. 75, that: 20 Kapstein (1991, pp. 13–14) writes as follows: In congressional hearings, the US banks warned that any new unilateral regulations could result in decreased international and domestic lending as well as a loss in relative competitiveness in relation both to foreign banks and to nonbank financial institutions. The banks argued that relatively high capital requirements in the United States had already placed them at a competitive disadvantage to the Japanese and French, and this line of reasoning was taken seriously in Washington, whatever its merits. Indeed, Representative Charles Schumer of New York, a regular target of bank lobbying, stated plainly during the IMF hearings that ‘we cannot put our banks at a competitive disadvantage to German, Japanese or other banks’ (US Congress, House, 1983, p. 183). The bankers’ pleas placed Congress in a quandary. The congressmen wanted tighter regulations, but they did not want American banks to suffer

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For their part, the US banking industry maintained a high level of interest in the international negotiations through the following years. US banks had objected strongly to the unilateral raising of bank capital levels by the ILSA [International Lending Supervision Act 1983] and complained to regulators now that the proposed risk-based capital measurements would further hinder their international competitiveness. Representatives of the banking industry argued that by operating with lower capital levels than US banks, foreign banks would be able to charge lower rates of interest on loans and still be able to meet the same profit margins as US banks. Clearly this would tip the competitive balance in the favour of foreign banks. Uppermost in US bankers’ minds was the competitive advantage that the new regulation gave Japanese banks. Kapstein (1989, p. 339) shows that the American Bankers Association (ABA) argued this point strongly in its comments paper to the Federal Reserve Board in May of 1986. In fact, a former advisor to Volcker stated that US banks were ‘a pain in the ass’ during the negotiations for the Accord, and that they kept a close eye on proceedings in the Committee (quoted in Wood, 1986).

But there were no signs that all the members of the BCBS would, as a group, agree to a move to a converged higher CAR, as Wood again notes (1986, p. 75): competitively as a result. A Solomonic decision was thus made by William Proxmire and John Heinz of the Senate Banking Committee.* The senators appeared to agree with the supervisors, for two reasons, that capital levels in international banks should be raised:€ (1) bank capital had the quality of a ‘public good’, in that its social benefits were greater than its private benefits; if each bank were to raise more capital, it would help to restore confidence in the international financial system as a whole; and (2) the imposition of tougher capital standards would demonstrate that the American taxpayer alone would not have to recapitalize the entire financial system through bilateral assistance to debtors and the US share of increased IMF funding; the burden would also be borne by bank shareholders. Tougher standards for US banks, however, might permit highly leveraged Japanese and French banks to gain market share at the expense of domestic institutions. In that case, the system as a whole would be no stronger and American jobs would be lost. Congressmen were concerned about the safety and soundness of the international financial system, but they were also paid to worry about competitiveness and jobs. The obvious solution to this dilemma was to promote international convergence in banking regulations, particularly in the area of capital adequacy. The IMF quota increase, regulatory concerns about capital levels, and the banks’ fears of unilateral regulations were synthesized in the subsequent IMF-related legislation known as the International Lending Supervision Act (ILSA) of 1983. In addition to legislating the recommendations put forth by the bank supervisors in early April, ILSA called upon the regulators to require increased levels of bank capital, and it encouraged ‘governments, central banks, and regulatory authorities of other major banking countries to work toward … strengthening the capital bases of banking institutions involved in international lending’. If the banks were going to be forced to raise capital, at least it would be done on a multilateral rather than a unilateral basis. * Both the congressional hearings and the interviews conducted for this essay suggest that international convergence of capital adequacy standards was put on the table by Congress rather than by the regulators. [I disagree with Kapstein’s judgement here.]

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The other members of the Basel Committee were far from receptive to the idea of a harmonized capital standard. Japanese regulators claimed that the Japanese banking system maintained ‘a high level of safety and soundness’ that negated the need for them to impose new standards on their banks. German regulators argued that their ‘universal banks’ and the tradition of ‘main banking’ were so different from other Basel member countries’ banking systems that a harmonized capital adequacy standard would be either too difficult to negotiate, or would fail to reflect the special situation of the German banking industry.

Caught between the level-playing-field objections of US banks, and the unwillingness of several members of the BCBS to agree to a new convergent CAR at levels and ratios acceptable to themselves, the US authorities had another option:€to do a side deal with a ‘coalition of the willing’. As in other circumstances, the most willing was the UK. C

The US/UK démarche and the negotiations of the 1988 Accord

The dinner in the governor of the Bank of England’s flat at New Change, on 2 September 1986, when Robin Leigh-Pemberton hosted Paul Volcker is, perhaps, the most celebrated occasion in the history of international financial regulation.21 Steven Solomon, in The Confidence Game (1995), makes it the keystone of his chapter (22) on ‘The world’s first capital standard’, pp. 413–17. Thus: On September 2, 1986, the fine cutlery was laid once again at the Bank of England governor’s official residence at New Change, site of some of the secret dinners that helped launch the LDC debt strategy four years earlier. The occasion was an impromptu visit from Paul Volcker, en route home from Europe. When the Fed chairman sat down with Governor Robin Leigh-Pemberton and three senior BOE officials, the topic he raised was bank capital. He discussed his political difficulty in upgrading its adequacy for US banks as well as perilous incompatibility of standards internationally … Volcker knew that the Bank of England was also trying to upgrade UK bank capital adequacy rules. Why not see if they could move in tandem in overlapping areas? Parallel upgrading of standards in the two main world financial 21 Kapstein (1991), however, dates the start of joint US/UK work slightly earlier in July 1986. Thus he writes (p. 19) that: In July 1986, Paul Volcker suggested to Bank of England governor Robin LeighPemberton a joint US–UK agreement on bank capital adequacy. According to Volcker, ‘they quickly agreed. The speed with which they jumped on it surprised me’ (Tobin, 1991). For the British, a joint approach with the United States would provide a powerful counter to the EC’s emerging standard, to which the Bank of England had objected. Now, the British and the Americans were in a powerful position to advance their preferences.

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centers might help break through the opposition each faced from their own bankers and give a badly needed shot in the arm to the development of compatible worldwide standards. Since both the Fed and BOE were struggling to incorporate ‘off balance sheet’ items, such as swaps, options, financial futures, and credit guarantees, into their separate risk-weighted bank capital models, Volcker recommended that their collaboration start there. Specifically Volcker endorsed the initiative of New York Fed President Jerry Corrigan. Corrigan had been discussing the supervisory implications of rapidly innovating global financial markets over the previous months with LeighPemberton and inside BOE power Deputy Governor George Blunden. Their expert staff were talking and were to make presentations to Corrigan and Leigh-Pemberton at the BOE a month hence, on October 6 and 7. ‘Certainly frustration was building up that there was something less than a great deal of enthusiasm for a risk-based capital system just for the United States. We, the Fed as an institution, had moved farther and faster on that issue than others might have liked’, says Corrigan. ‘This was the driving force of the London meetings.’ … At dinner that evening Leigh-Pemberton responded positively to Volcker’s overture. The Bank of England had some additional, British reasons for wishing to collaborate. For decades the Old Lady of Threadneedle Street had supervised banking and finance in the City through informal use of the governÂ� or’s winks, nods, and arched eyebrows among a club of ‘gentlemen’. But the volatility, dimensions, and sheer competitiveness of globalized finance, with its Euromarket heart in London, was effecting a transformation to a written, rule-based prudential system for ‘players’. At the time, the BOE was gearing up for the uncertainties of the all-at-once, systemic ‘big bang’ deregulation on October 27, 1986. The UK Treasury was then drafting its 1987 banking act, which included regulations for capital adequacy. This act was to rectify the flaws in the heavily BOE-influenced 1979 law. The BOE’s credentials and future role as bank supervisor were in the balance. At one point Exchequer Chancellor Nigel Lawson contemplated stripping the BOE of its supervisory authority entirely. But the BOE’s spring 1986 proposal to incorporate banks’ exploding off balance sheet activities into its risk-weighted model of bank capital adequacy was being impeded by UK bank opposition. ‘We couldn’t get it moving’, says Executive Director Brian Quinn. ‘Then Volcker and the governor came together.’ At dinner the governors’ hopes had been modest:€to find areas of sufficient convergence of goals and regulatory concepts to achieve separate but parallel upgrading moves. ‘We were not talking about the same standards’, stresses BOE Deputy Governor George Blunden. Yet the momentum it galvanized for the October sessions between the Corrigan-led Fed team and top BOE officials produced the unanticipated breakthrough of a fully articulated, common bank capital adequacy regime for the United States and United Kingdom. This in turn catalyzed one of the 1980s’ most remarkable diplomatic achievements€– the first worldwide protocol on the definitions, framework, and minimum standards for the capital adequacy of internationally active banks. It became one of those rare instances

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when years of tedious negotiation were suddenly rewarded by a fortuitous alignment of conditions that broke through all remaining opposition. ‘Even Volcker was extremely skeptical that we’d be able to get any international standard’, says Corrigan. Exploratory staff meetings held in Washington on September 24–26, 1986, revealed that the US’s and UK’s bank capital regulatory conceptions were not as distant relatives as first appeared. Instead of seeking limited regions of convergence, the four-man US team headed by Fed Board staff chief for supervision Bill Taylor and the three-man British team under his BOE counterpart, Brian Quinn, began to wonder excitedly:€ might it be possible to do the whole thing€– common definition, regulatory framework, and standards? ‘Sometimes it is more expensive to do renovation than to build a new building’, says Quinn. They literally wiped the blackboard clean, then explored designing a new risk-weighted capital adequacy regime for both countries. They resumed in London just ahead of Corrigan’s October 6–7 visit. At their Saturday morning presentations to Corrigan and Leigh-Pemberton, describes Corrigan, ‘It was as if all the lights suddenly went on! We just kind of looked at each other. We said, “We’re so close as it is, why not have our technical people put it under the microscope?” This they did over the next two weeks. At that point it became very apparent how close we really were.’ At that point ‘we set the objective to get convergence by the end of the year’, says Deputy Governor George Blunden, adding, ‘We didn’t actually believe we could get it by then.’ Over the next three months of ‘terrific, marvelous fun’, the supervisory experts worked on almost nothing else. By December they had an articulated, bilateral bank credit capital adequacy regime:€it included a common definition of capital and was based on a five-category framework of risk-weighted assets€ – 0 percent, 10 percent, 25 percent, 50 percent, and 100 percent€– for on and off balance sheet activities. It required banks to hold the full capital standard against the highest-risk loans, half the standard for the second riskiest category, a quarter for the middle category, and so on to zero capital for assets, such as government securities, without meaningful risk of credit default. The specific minimum standard was unspecified, but their common understanding was that it would be higher than the US’s existing 6€percent ratio.

Even if this account is slightly breathless, and recounted as a journalistic scoop, Solomon did seek to interview most of the participants (though not Peter Cooke) and managed to do so in many cases. So it is basically correct in all major details. A couple of nuances may be added. First, the idea that they ‘wiped the blackboard clean’, and the suggestion that there was a great deal of difference between their initial positions, are, in my view, considerably overstated. As indicated in the previous section, the officials in the Bank and the Fed (plus Solomon states€ – fn. 8, p. 417€ – two officials from the OCC) knew that they were starting from a very similar stance. Certainly there was a great deal of detailed work to do on the minutiae relating

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to off-balance-sheet items, swaps, options, and so on, but, in view of the commonality on underlying principles and the push given to the exercise by the leading figures in the Fed and the Bank, it is really not so surprising that they reached agreement. Though the speed with which they could achieve that, in less than four months, September to December 1986, is remarkable. What was so special about this exercise was not that the more junior officials were able to reach agreement on the technical details, but that the senior officials had decided to go for a (initially) bilateral agreement, rather than a multilateral one. As already noted, the Americans had given up hope of achieving a multilateral, consensus BCBS agreement, at least within the time frame that they considered desirable. The choice of the British as the key bilateral partner was not only that they were amenable to the main principles and approaches that the US authorities wanted to adopt, but also, indeed probably rather more so, that London was the main international financial centre besides New York. If the British and the Americans would, as they might, refuse to accept foreign banking establishments into London/New York unless they agreed to abide by the UK/US requirements, then all the international banks would have to do so, willy-nilly, whatever their own national regulations might require. In short, it was essentially a power play, to overcome resistance at the BCBS which was based on consensus. So, the UK/US agreement was, intentionally, a mechanism for both finessing and giving momentum to the procedures of the BCBS.22 But there was an awkwardness here. Chairman Peter Cooke of the BCBS was himself a senior official of the Bank of England! There was no easy solution; the practice that was followed was to keep Peter entirely out of the loop. He was not at the original dinner (Solomon records the other three Bank of England officials there as John Flemming, Rodney Galpin and David Walker), and a decision was subsequently taken to exclude him from all the consequential negotiations. By September 1985 he had left his former position as Head of Banking Supervision (a position which was then taken by Rodney Galpin), but continued in his role as an associate director. In this latter role he was free to focus more on his work as Chairman of the BCBS, and it was no longer necessary to pass on papers to him on domestic UK banking regulatory/ 22 It also enabled them to ‘grandfather’ some of their own special interests, such as the American desire for a large role for general loan loss reserves and the British enthusiasm for preference shares, subordinated debt and various hybrids. Several of these US/UK specialties failed to survive into the final (compromise) version of the Basel Accord.

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supervisory issues. In effect, he was excluded from these discussions, and kept ignorant of them, which later was beneficial to Peter, since it emphasised his independence (from the Bank of England) as Chairman of the BCBS. Going to such extremes, and there are several anecdotes about stratagems for keeping Peter in the dark, does help to reveal the self-conscious way in which the US/UK negotiators wanted to seal their bilateral deal before reverting to the BCBS. The next stage in the discussion was to try and bring the Japanese on board. The steps in that exercise are set out in some detail in Solomon (1995), pp. 421–44 (also see Wood 2005a, pp. 77–8), with Corrigan of the FRBNY taking the lead in the negotiations. The Japanese realised that, if the Fed/BoE, that is New York and London, were determined to go ahead and impose their own requirements, they would ultimately have to go along too, but their sticking point (how far the unrealised excess of market value over historic cost in their cross equity shareholding could be acceptable as base capital23) remained for consideration in the subsequent detailed discussions at the BCBS. Anyhow, the original agenda for the BCBS’ (fortieth) meeting on 10–11 December 1986 included a discussion of the latest further paper (BS/86/73) on alternative definitions (and the resulting implied ratios)€– without any breakthrough on agreement on which one to choose€– for onwards transmission to the Governors, to be followed by ‘consideration of how to take work forward on convergence in capital standards following the earlier Amsterdam Conference’. But this latter issue was hijacked by the shock announcement24 of the US/UK agreement on common minimum capital standards. Thus: Messrs Quinn and Taylor informed the Committee that the United Kingdom and the United States were close to agreement on a common basis for measuring capital adequacy and establishing an agreed primary capital ratio in both countries. They were asked to circulate to all members the details of the agreement as soon as it had been finalised25 and the Secretariat was asked to draw up a short paper comparing the US/UK system of measurement with the Basle capital framework (BS/86/90).

23 Japanese banks had much closer connections with many of their (industrial) clients than banks in the Anglo-Saxon tradition, and had large holdings of their equities, assets which would normally be saleable and thus added to their overall (capital) strength. 24 An announcement made without giving the Chairman, Peter Cooke, any prior notification. Peter regarded this as a gross, and unnecessary, discourtesy. 25 The terms of this agreement were then publicly announced in London and Washington on 8 January 1987.

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By some criteria the US/UK had acted in a most high-handed manner. While simultaneously being supposed to be negotiating on capital convergence multilaterally in the BCBS context, they had gone behind everyone else’s back to negotiate a private deal, and in a situation where there was at least an implicit threat that, if push came to shove, they could enforce it. The USA was seen as arrogant; the UK perfidious, especially in an EC context. There was considerable anger, some suppressed, some not. On the other hand: 1. The BCBS had not been making much progress towards convergence. Such an outside initiative may have been the only way to kickstart progress towards convergence; 2. The changes to the US/UK positions, in the course of their own negotiations, took them closer than formerly towards the Basel framework; 3. The differences with the Basel framework were relatively minor, and in some cases, for example on the definition of capital, rather simpler (fewer) tiers; 4. Because the US/UK initiative had made them seem high-handed and non-communautaire (especially the British, as they were EC members),26 they were under some pressure to accept some compromise; equally because the US/UK initiative could credibly be imposed, the other countries also were under pressure to compromise. The circumstances had finally been set for a negotiated agreement. It was no longer possible just to hold up in an intransigent position. Naturally the BCBS Secretariat, and Chairman Peter Cooke emphasised points 2 and 3. Thus the Secretariat’s note of 13 January 1987, comparing, as earlier requested, ‘The US/UK proposals for measuring capital adequacy’ with the Basel capital framework (BS/87/2), concluded that: Against this background, the attitude of other members of the Committee to the proposals will be coloured by the extent to which they view the proposals as 26 Kapstein (1991, p. 20) records that: European Commission president Jacques Delors had complained to the chairman of the Basle Committee, Peter Cooke, that the US–UK agreement was not ‘communitaire’. An interview provided this information concerning Delors’ complaint. Other interviews revealed that Cooke himself was disappointed that the Bank of England and the Federal Reserve System went the bilateral route, rather than continuing to work through the Basle Committee. Thus, he agreed with Delors’ pronouncement. Peter Cooke, in private correspondence, notes that it was, ‘The fact that the BoE and the FRS went the bilateral route IN SECRET was my objection.’

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being consistent with their own national system and approach and in line with the consensus developed in Basle. In this context it would seem reasonable to make the following comments: 1. The proposals would bring about significant changes in the existing systems for measuring capital adequacy employed in both the US and UK, the effect of which would be to move both systems more closely in line with the Basle system. In the case of the US this applies most importantly to the adoption of the risk asset weighting formula, without which basic decision meaningful convergence in the G-10 could not be achieved; in the case of the UK it applies to the downgrading of certain previously recognised components of capital. 2. While there are a number of aspects of the US/UK proposals where the approach differs from that followed in Basle, except as regards the treatment of country risk, these differences are largely matters of detail. The central elements of the proposed system would seem broadly consistent with the approach followed in Basle. 3. The US/UK proposals, if adopted, would achieve virtually complete alignment in the methods of measuring capital adequacy and also in standards of capital adequacy of two important national Â�banking systems. If it were the case that central elements of this bilateral agreement were seen as inconsistent with the approach followed in Basle or by other countries in their own national systems, then the fact that two members had chosen to go their own way would make the objective of multilateral agreement more difficult to secure. On the other hand, if members accept the assessment of this note, that the proposals reflect much of the thinking in Basle, then the bilateral agreement could provide additional impetus to the Committee’s own work.

The annex, comparing and contrasting the US/UK proposals with the Basel framework, is reproduced and recorded here as Appendix G. Frankly the differences between the two were not large. The greater issue was that, previously, several members of the BCBS had not subscribed to the Basel framework, let alone the US/UK proposals. Now they were under pressure to do so. Chairman Peter Cooke had been placed in an invidious position by this whole exercise. He wrote a Chairman’s note (BS/87/18), also emphasising points (2) and (3) above, trying in the best statesman’s way, to take the exercise forward. His letter is a carefully constructed masterpiece. I append the first four pages as Appendix H (the final page 5 reverts to more technical detail). This note was discussed at the BCBS’ forty-first meeting on 12–13 March 1987, together with comments on the US/UK proposals from Belgium, Netherlands, Sweden and Switzerland. While most of these notes cover points of technical detail, Musch (Netherlands) (BS/87/25)

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was quite scathing about the way that the US/UK had side-stepped the BCBS Committee, thus: Although it is clear that the US/UK-proposal provides an extra impetus to the Committee’s own work, we much regret that there are major differences with the results obtained in the international forums. The objective of multilateral agreement may consequently be more difficult to secure … Especially after the promising results on convergence achieved at the 4th ICBS it would very well have been possible, in our opinion, to use the international forums, which would be more in line with the progress made during the last few years with regard to co-operation between supervisory authorities.

Be that as it may, at the forty-first meeting it was agreed to hold a special meeting on 15–16 April to thrash out this subject, with the EC invited to attend as an observer, in order to lessen the likelihood of differences emerging between Basel and Brussels. In preparing for this, Chairman Peter Cooke once again emphasised, in a letter to the President of the G10 governors, Mr K. O. Pöhl (3 April) (BS/87/35), the urgency of getting support from the G10 governors themselves. Thus, he stated (BS/87/35) that, at the special April ad hoc meeting: I would wish to pursue the objective of a multilateral agreement on a relatively simple framework which could run either alongside or integral with national systems of capital measurement in G-10 countries. This framework would also need to include the main risks arising from banks’ off-balance-sheet business (on which further technical work is currently under way in sub-groups of the Committee). Agreement on levels of capital adequacy I would regard at this stage as a matter for later debate once the framework is in place. I am sure I do not need to stress that substantive progress in achieving these objectives will require not only the willingness of all members to approach the meeting with a readiness to accept modifications to their existing national approaches but also that there should be a commitment at the highest level in member countries to achieve a positive outcome to the discussions. As was the case with the US/UK bilateral accord, it is clear that it will be possible to resolve the many technical differences in the way of achieving a wider multilateral agreement only if the ultimate objective has the whole-hearted support of Governors and of the other relevant national authorities. If possible, it would be very helpful in planning the Committee’s meeting on 15th/16th April to have had some indication in the course of the April Governors’ meeting of G-10 Governors’ positions on the multilateral pursuit of capital convergence.

Furthermore, he also wrote a background note to introduce the special April meeting (BS/87/36) outlining eight propositions, as follows: 1. Our objective at the meeting should be to explore the possibility of moving towards agreement on common constituents of capital and a common framework of measurement. Agreement on a common minimum capital adequacy standard (or target), while an important objective, is a second stage objective to be pursued at a later meeting.

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2. The object will be to construct a framework to be applied normatively in member countries, either alongside or integral to the national regime. 3. The framework of measurement should be constructed on the basis of weighting the risks in the business. The measure should be simple and the risk relativities credible. 4. Some limited variation should be permissible in the national application of the measure to take account of particular local circumstances. Excessive variation, however, would negate the objective of convergence. 5. The measure should be directed both towards preserving and, where necessary, enhancing national prudential standards and towards removing competitive inequalities arising from different regulatory requirements, which can themselves lead to macro-prudential problems. 6. It is accepted that for international banks when addressing both overall prudential standards and influences on competitiveness, account must be taken of a wide range of considerations, not merely that of banks’ capital measurement and standards. These wider factors are, however, not for discussion at the meeting. The fact that they exist does not diminish the need to move ahead on capital adequacy convergence on its own. 7. The measure should be comprehensive, at least as far as credit risks are concerned. It should be applied on a consolidated basis and capture risks both on and off the balance sheet. 8. Practical problems of national implementation of the framework, particularly the likely need for some phasing in the timing of implementation, need not prevent us, as it has not for many other matters discussed in the Committee in the past, from reaching agreement on what we believe to be the best solution to be generally applied.

He further suggested that the meeting should ‘look first at the risk asset weighting formula where the outstanding points of difference seem to be less numerous and less difficult than in the constituents of capital itself.’ On this latter issue he distinguished between three approaches:€t he Basel six-tiered approach, the Brussels two-tiered approach, and the US/UK unitary measure of capital. The April ad hoc meeting was held at the Swiss National Bank’s Conference Centre at Gerzensee. Provisional agreement was reached on some of the technical issues; others were left unresolved. A tabular framework, contrasting the Basel, UK/US, Brussels and Gerzensee outline for capital, and the Basel, Brussels and Gerzensee suggestions for risk ratios are reproduced as Appendix I (taken from BS/87/41). One point to note on this latter issue:€ the Gerzensee outline did not follow the US/UK proposals slavishly; on capital it was, perhaps, closest to Brussels, on ratios to Basel. The BCBS may have been forced into proper negotiations by the bilateral initiative, but these were true negotiations with compromises all around. One of the main unresolved issues was how much to discount latent revaluation reserves, reflecting the difference between historic cost and

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the current market values of equities. This was, of course, crucial for the Japanese. National agreement on how to do this was reached. Thus paragraph 5 of BS/87/41 (a note by the Secretariat, summarising the earlier discussions at Gerzensee) recorded that such reserves should: be included in the capital base provided that: (a) such reserves are discounted by a factor to reflect the uncertainty of market prices; (b)╇a notional amount of tax prospectively payable (at the standard rate applicable) is deducted from the reserves, after discount; (c) after discount and tax deduction, the residual value of such reserves amounts to no more than X per cent of the total of items included in paragraph 2 to 4 above.

But what should X be? No attempt was made at this stage to establish what the ‘appropriate minimum (or target) level of capital adequacy should be’ (paragraph 18, BS/87/41) (NB How can a minimum also be a target?), but ‘it was suggested that members might find it helpful to work to a common figure and that a ratio of 9 per cent might be used for this purpose. This figure was derived from a figure of 6 per cent quoted in an earlier report to Governors as a possible target for tier 1, but also taking account of the suggested wider definition of the capital base.’ At the following Brussels meeting of the BCBS in June, it was agreed to send out another questionnaire to check how the various chosen formulae and ratios would affect the reported CARs of a sample of international banks. This was to be done quickly enough to inform the BCBS September meeting (BS/87/57). Meanwhile the Chairman reported to the Governors that there were three main problem areas remaining that would need to be decided at the September, or subsequent, meeting(s). These were: 1. cross-border risk; 2. constituents of capital; 3. levels of capital required. The key issues, as set out by the Chairman, are reproduced in Appendix€J (taken from BS/87/60). The EC caused the main problem with (1). The simplest way to approach (1) was to distinguish between lending to one’s own domestic public sector/government, and to all foreign governments. Then national supervisors could apply supplementary ‘add-ons’ to governments perceived as particularly risky. But the EC insisted, on communÂ� autaire/political grounds, that the risk weighting on lending to all EC

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governments by any EC bank had to have the same (zero) risk weight.27 But how could one possibly defend having a zero weight on lending, say, by a French bank to the Italian government, but a positive weight on holdings of US or Canadian bonds? So one had to draw the line at some wider point. At that juncture, as shown in Appendix J, it was suggested that the EEC and G10 could provide such a dividing line, but how could one justify having Australia or New Zealand outside the ‘club’ as it was already starting to be termed, and yet have Canada inside. On the second issue, the constituents of capital, it had become accepted by now that there should be two tiers, with equity and free reserves in Tier 1, and subordinated debt up to a limit included in Tier 2. The question was what to do with the other elements in the middle, for example hidden reserves, cleaned-up general provisions, revaluation reserves and other hybrid instruments. If these other elements were to be included in Tier 1, it would upset the Germans who insisted on a very restricted definition of capital; and also the Japanese, since the required Tier 1 number would then be higher, and given the separate restriction on their use of unrealised (latent) capital gains, it would give them a low starting point relative to the requirement (though for other countries/banks this latter issue was part of the purpose of the whole exercise!). On the other hand, if these middle elements were excluded from Tier 1, it would cause ‘particular problems to the United States, because of the recent provisioning exercise by the big banks’. On the level of capital, Cooke raised the question whether the number was to be ‘a minimum, or target or standard’. ‘If the former, it will have to be set at a very low level. If the latter, it can be higher but will require a transition period for some countries and/or some banks in some countries.’ Here I believe that the analysis can be faulted.28 First, there was little appreciation that I found in the papers that if the regulators set a ‘target’ of X per cent, that banks, the market and ratings agencies would come to treat it as a reputational minimum. Second, if it was 27 Note that this also prevented any attempt to use rating agencies’ risk ratings as an alternative measure, not that this was ever specifically mentioned or suggested in any of the papers that I have seen, but I have been told that there was some tangential discussion of the role of the ratings agencies in the system as a whole. Apparently the use of agencies’ ratings was discussed from time to time, but no one then wanted to make them a part of any supervisory arrangements. 28 Peter Cooke has responded to me, in private correspondence, that members of the Committee, in his recollection, were aware of both these points. On the first, it was realised that the target/standard would come to be regarded as a reputational minÂ� imum (although the degree to which this occurred was not anticipated). On the Â�second, members of the Committee recognised that the standard could be breached in particular circumstances, but it would be up to individual national supervisors to decide on the action which should then be taken.

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to be a target or standard, it implies that it is conceivable, indeed fully acceptable under some circumstances, that banks might fall below such a level. But there was no discussion at all of how national supervisors should react, and what sanctions they might apply, if the CAR standard was breached, but it would have been difficult or impossible for an international committee such as the BCBS to go into this latter subject. See the subsequent discussion in Chapter 14. Anyhow, the Chairman put these queries to the Governors. He reported back (BS/87/84) that, besides urging the BCBS to press on with the exercise, the Governors had agreed ‘that a “standard” level should be promulgated, with the accord on the framework set at a level judged appropriate on prudential grounds’. So, ‘a period of transition would therefore be required.’ There was no such agreement on the cross-border question, nor the capital constituent issue. Country positions were split down the middle, and it was simply referred back to the BCBS for their September meeting (16–17 September). By then the numbers from the earlier questionnaire had been received. In the detailed annotated agenda for this meeting (BS/87/70, dated 4 September, by the Secretariat), it was noted that: The results of the testing carried out by members (BS/87/71) show that, while there is some disparity in current levels of capital ratios, whether calculated according to the Brussels or Gerzensee formulae, the results for most countries seem to fit into a range of 7–10 per cent. To choose too low a figure would be undesirable since it would send the wrong signal to financial markets when supervisors are seeking to rebuild capital levels. Equally, however, an unduly demanding level might damage banks seen by the market as incapable of raising the necessary capital.

As noted earlier, the overall desired level (8 per cent) largely emerged naturally 29 once the chosen definition of capital was assessed against the pre-existing data. Rather surprisingly (to me), since a 50 per cent discount had been suggested earlier, this agenda proposed a ‘discount (or haircut) of 65€ per€ cent [on Latent Revaluation Reserves] … To reflect both the possibility of price volatility and forced sale risk and the fact that no tax will have been paid on the unrealised asset values included in the formula. There is a case for the total value of latent reserves being disclosed in published accounts.’ This was the key Japanese issue. Steven Solomon (1995, p. 433) suggests that Quinn from the UK and the 29 Peter Cooke has told me that he has a clear recollection that he took the decision, based on the balance of considerations that 8 per cent would be the most appropriate level and so proposed it to the Committee, which accepted it.

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German representatives had been pushing for a significantly higher discount, so maybe the 65 per cent number was a starting point for negotiations, which finally settled at 55 per cent. The next (forty-third) meeting of the BCBS, 16–18 September 1987, was crucial, and attended by a number of extra, and more senior, representatives from Japan, USA, EC and UK. Besides the Japanese discount issue, it was agreed, albeit without enthusiasm, to adopt the ‘club’ approach to sovereign debt. There was, however, disagreement whether the club should be narrow (EC/G10) or broad (all OECD members) and the choice was passed on to the Governors (BS/87/87, para. 4). The most difficult question of all remained that of the constituents of capital. The BCBS agreed to adopt the Brussels formula with a tightly defined Tier 1, comprising only equity and disclosed reserves, which should represent at least half of the total reserves. Moreover, subordinÂ� ated debt should, additionally, only be allowed up to half (50 per cent) of the level of Tier 1 capital. Limiting Tier 1 capital to the purest form of capital, and requiring that it must amount to 4 per cent of risk-weighted assets, was meant to mollify the Germans, as was a concession by the US team (Mr Taylor) on provisioning, ‘not only to accept the principle of “cleaning out” for country risk, but also to set an overall limit of 1.25 percentage points on the extent to which US banks’ loan loss reserves should be counted as capital within the supplementary elements’. The Germans, and to a slightly lesser extent (on my subjective reading) the French, were not assuaged, and reserved their position, in contrast with the Japanese who, once the latent revaluation issue was settled, went along with the majority. The Germans and French felt that they had been bulldozed too rapidly into reaching an agreement, and that, especially for the Germans, the allowance for lower quality Tier 2 capital was still too high. On Implementation (BS/87/87, para. 5) Ten member countries (the exceptions being France and Germany) were in favour of announcing now a minimum target standard ratio to be achieved by end-1992 of 8 per cent, 4 per cent of which should be core capital. Several countries spoke in favour of a short consultation process, but it was eventually agreed to recommend to Governors a consultation period of six months. So far as the transitional arrangements were concerned, it was agreed that there should be a phased build-up towards the final standard in 1992, with an interim standard to be achieved by end-1990.

What remained was to write up the detail of the Accord, present it to the Governors first and to the rest of the world thereafter, and to do so in a way that might reconcile the Germans, and also the French, to an agreement which had somewhat steam-rollered over their objections.

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The Chairman presented the draft Accord to the Governors at their meeting on 9 November 1987. In his speaking notes (BS/87/83) he pointed out the problems of the ‘club’ approach. Not only had it limitÂ�ed grounding in macro-prudential considerations, but also any Â�dividing line between the sheep and the goats would be hardly defensible and highly contentious. He also went on to discuss publicity and press notices. The timing of this meeting, however, was not conducive to a good discussion, coming as it did on the occasion of the first Governors’ meeting after the New York Stock Exchange (NYSE) collapse on 19€October 1987. Partly as a consequence, the discussion proved ‘inconclusive’; see Chairman’s note-for-the-record (BS/87/84). Meanwhile France and Germany both reserved their position, arguing that ‘the Committee’s present view of an appropriate standard at end-1992 of 8 per cent was inadequately researched and tested’. So they felt unable either to approve the report or to agree to a press release. So the BCBS was asked to resubmit a (slightly) revised version of the paper for the Governors’ meeting on 7 December. Meanwhile, the Chairman offered (threatened?) to call as many meetings of the BCBS between then (mid-November) and early December as required to satisfy the French and Germans that enough time/research had been given to the exercise. A revised version of the document was sent back to the governors under cover of a Chairman’s letter of 30 November for their meeting in early December. This had been redrafted in an attempt to make the text (somewhat) more palatable both to the French and the Germans.30 In this respect it was successful, though the Germans, in particular, continued to signal their doubts/reluctance about the whole exercise. The BCBS was given the go-ahead to circulate the Accord 30 In his cover note (BS/87/92) the chairman drew the Governors’ attention particularly to: The nature of the report. Paragraphs 1 and 2 have been rewritten to lay more stress on the consultative nature of the process set in train by the issuance of the Committee’s report. Indeed, unlike any previous Committee document, it is headed ‘consultative paper’. The promulgation of an initial view about a target standard. Section III (paragraphs 43 and 44) has been redrafted to reflect the position of France and Germany that they are not committed to the 8 per cent standard which the other ten member countries would wish to see announced at the time the proposals are issued as a basis for consultation. The treatment of provisions in the capital framework and particularly the French provisions. The report incorporates revised paragraphs 16–19 which discuss the delicate area of where the boundary should be drawn between provisions which should fall outside the definition of capital and provisions and reserves which can legitimately be included in that definition.

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under the title ‘Proposals for international convergence of capital measurement and capital standards’. It was dispatched to non-G10 supervisors under cover of a letter from Peter Cooke dated 8 December 1987. Basel I, as the Accord later came to be known, was earlier often described as the Basel 1988 Accord. In a sense that is a misnomer; it should have been entitled the Basel 1987 Accord, since almost all the main work on it was completed in 1987,31 and the consultative document sent to supervisors and banks, and revealed to the press, in December 1987. On the other hand, it was still, at least formally, just a consultative document. D

Implementation

So, the first need was to arrange such a consultative process. This was to be done within a maximum timescale of six months, up until the end of June. The Secretariat pencilled in (BS/88/3) meetings of the BCBS at the end of April, for a preliminary consideration of national comments, and in early July for final decisions on, and modifications to, the final framework, for transmission to the Governors’ meeting on 11 July, the last before the summer break. The central banks (and/or supervisory authorities) of the various countries each circulated their own banks with the consultative paper at the end of December/early January under a cover note, usually suggesting a meeting and/or the submission of responses by the end of March, or earlier. In view of the continuing doubts that the German authorities had, the most interesting such note came from the German Federal Supervisory Office (BS/88/12).32 Here the author [Kuntze] reiterated German objections to the proposals,33 but then went on to add that: Following the expected adoption of the proposed recommendations€ – with whatever modifications may arise from the consultations€ – at the end of the 31 Peter Cooke disputes this. He claims that: as with all international agreements the last 10% [of the points at issue] often involve the most debate as participants fight to get the maximum concessions for their national position. There were still a number of issues apart from the German and French problems and some of these went right up to the wire in the October ’88 meeting. 32 By now the French were responding much more positively to the consultative document. Indeed, the cover note from the Commission Bancaire (BS/88/12) states that ‘the principles adopted essentially reflect French thinking’. 33 ‘Concerning the definition of capital, the German delegation expressed the opinion that only so-called core capital, but not a whole range of supplementary capital elements, should constitute the capital base (consultative paper paragraph 11). One important consideration underlying the German view here was the fact that, in the case of

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consultation period, the competent national authorities in the Group of Ten countries will not be compelled to incorporate them in national regulations. On the other hand, it would undoubtedly have negative implications if one country were to dissociate itself from them completely because it held partially differing views. Moreover, in the Federal Republic of Germany only the relatively small group of banks actively involved in international business is affected. These banks would no doubt be concerned to meet internationally widely accepted capital requirements, be it solely for reasons of their standing.

Anyhow, the various national submissions were received (BS/88/30). It was concluded, at the 28–29 April (forty-sixth) meeting of the BCBS (BS/88/47), that the proposals had been generally ‘well received by the bankers and that, with the possible exception of the treatment of crossborder exposure, there was no disposition to consider any fundamental changes to the basic framework’, though there were plenty of minor technical points that needed to be addressed, many of which were clarified in an earlier note by the Secretariat (BS/88/32), and there was a further technical report, by the Danielsson subcommittee (BS/88/43), on the treatment of off-balance-sheet items. In many ways this was the part of the Accord where the BCBS was most innovative. The analysis of the way to handle futures, swaps, Note Issuance Facilities (NIFs) and Revolving Underwriting Facilities (RUFs) was the most technical input into Basel I. The suggested application of forward position exposures went beyond commercial banks’ thinking at the time, and had a significant impact on their own subsequent approach to derivative and off-balance-sheet risk. (I am grateful to Charles Freeland for these latter comments.) On the cross-border exposure issue: there was clear support from almost all countries for an OECD ‘club’. The Secretariat was asked to prepare a paper spelling out the implications of moving to a club approach. Since this matter was as much political as technical, it would be important for members to ensure in due course that any final conclusion reached in the Committee had been aired with and would be fully supported by the Governors and the heads of other institutions represented.

Other issues discussed included: 1. the definition of Tier 1:€no support for widening; 2. the treatment of mortgage collateral in risk ratios:€point taken but there was unwillingness to reopen the package as a whole; the German banks, national legislation allows only one kind of supplementary capital, viz. participating loan capital, to be counted towards liable funds to a very limited extent. Furthermore, the German delegation was against a premature stipulation of a minimum capital standard (consultative paper paragraph 43), bearing in mind the fact that the proposed capital ratio of 8 per cent would place the German banks at a considerable disadvantage internationally given the narrow national definition of capital.

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3. the treatment of non-central-government public sector debt:€to be considered in future work; 4. use of original vs. residual maturity:€ to be considered by the Secretariat (this was done in C. J. Thompson’s working party (BS/88/55)). A special meeting, chaired by C. J. Thompson, was arranged for 25–26 May, ‘to consider all outstanding technical issues’. This was done, and the outcome reported in BS/88/60. The most important decisions (in my view) related to reducing the weight on loans to individuals (but not to corporations) for owner occupation secured by mortgages from 100 per cent to 50 per cent. Clearly the ‘club’ approach remained the most sensitive and difficult issue (with the technical issues discussed in BS/88/57 and the ‘political’ issues in BS/88/59). A summary of the recommendations at this May meeting is given in Appendix K. This note from the Thompson working party, the two notes on the ‘club’ approach and a draft paper by the Secretariat (BS/88/62) setting out the final Accord were put on the agenda for the 28–29 June (fortyseventh) meeting of the BCBS. A number of decisions were made there (noted in BS/88/72 and 75); of these the most important, in my view, were: (a) to widen the club to include also countries concluding special lending arrangements under the IMF’s General Agreements to Borrow (GAB) (in effect making Saudi Arabia a club member); (b) extending the 50 per cent risk weight concession to rented, as well as owner occupied, dwellings, but not to commercial properties.34 The resulting drafting amendments were then rapidly incorporated in the Secretariat’s draft note on ‘International convergence of capital measurement and capital standards’ (BS/88/62), and despatched to the governors for their 11 July meeting, under cover of a letter by the Chairman dated 5 July (BS/88/73). In addition to reporting the main agreed changes noted above, the main issue related to the continuing German reservation.35 On this, paragraph 14 recorded that:

34 The Germans had been pressing for this latter issue. When this was not accepted, the German representative stated that ‘they had no alternative but to maintain their reservation on the definition of capital. However, he would explain to his superiors … that certain other concessions had been made to the German point of view’. 35 There was also a continuing, but less strong, concern expressed by the French delegation on the treatment of ‘latent’ revaluations of bank premises. But they did not want to go as far as to enter a formal reserve on the framework.

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In the interests of achieving a common stand on the issue of international capital convergence, the German delegation is willing to put aside its reservations provided that the following additions are incorporated in the final text of the paper: (a) Following paragraph 12 in the section on core capital: ‘One member country, however, considers that, in view of the Committee’s objective of enhancing the quality of banks’ capital, an international definition of liable capital should have been confined to core capital elements. This country is willing to put aside its reservations with regard to the present framework only in anticipation of further discussions with the objective of strengthening the share of core capital in the overall capital base, which should take place before the end of the four-and-a-half-year transitional period at the latest.’ (b) Following the third sentence of paragraph 41 in the section on mortgage loans: ‘The same applies to other loans secured by mortgages on domestic property provided that the amount of the loan does not exceed 60 per cent of the value of the property as calculated according to strict legal valuation criteria.’

Finally the Chairman outlined measures for publication, press releases, notes for editors, and so on. Nevertheless, the key final issue was how to deal with the German reservation. Negotiations, between Pöhl’s office and other German officials, and Peter Cooke and the BCBS Secretariat, went right down to the wire, according to a telex sent out by Cooke (BS/88/80) on the morning of 11 July.36 According to Peter Cooke (private correspondence): It was at the BCBS meeting in Tokyo in October 1988 that the Accord was finally put to bed. I did not retire as Chairman until early in November when the G10 Governors gave it their final endorsement. I recall very well at that October meeting that there were about five outstanding issues on which different countries had to be brought into line, I set them all out and said that in a spirit of compromise I hoped national positions could be relaxed to allow final agreement to be reached. In the event after extensive discussions in huddles in the corridors of the meeting everyone came into line. (I recall particularly the large Japanese delegation huddled together under the leadership of Tadeo Chino, the Vice-Minister of Finance for International Affairs who came 36 Peter Cooke records, in private correspondence, that he: flew over to Germany to see Tietmeyer, then State Secretary in the Finance Ministry, who had ultimate oversight over the Federal Supervisory Agency (later BAFIN), to seek to persuade him that the Germans should compromise for the greater good. It was a long meeting (two or three hours) and I recall the meeting vividly but I cannot find a specific reference to it in my diaries although they do record that I went to Germany for the day (purpose unstated) on 1st March. That must have been when I saw him. I remember returning feeling drained but on the whole pleased with the outcome. Any positive outcome it may have had, it must be admitted, was somewhat delayed! Incidentally, during this period, I also visited virtually every country represented on the Committee to discuss their problems with the outline agreement.

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to the meeting with the authority and seniority to settle.) We were thus able to announce the agreement, subject as always to the Governors’ approval, at the 5th ICBS which immediately followed the BCBS meeting. The Japanese Ministry of Finance with the Bank of Japan threw a big banquet at the end of the ICBS at which there was much mutual congratulation. That was the moment when the members of the Committee felt that the job was done. As I recall it, it was after the Governors’ November meeting that the final text was promulgated.

Shortly thereafter Peter Cooke stood down as Chairman 37 (to be replaced by Huib Muller; see Chapter 3); Quinn was replaced by Barnes as the Bank of England representative; and C. J. Thompson by Peter Hayward as Chief Secretary (both from the Bank of England also). All three had played a major role in achieving the Accord, particularly Cooke, without whose patient chairmanship the whole exercise might have collapsed in 1987 on the rocks of national disagreements. It is almost certainly the case that international convergence on a capital accord would not have been reached, at any rate within a few years, without the impetus of the US/UK bilateral agreement. Nevertheless, many of the extant commentaries on the Basel Accord treat it, to my mind, far too much as an extension of major state power politics, and dismiss the discussions in the Basel Committee as of second-order importance. I hope in the course of this chapter to have corrected this bias. Prior to the US/UK bilateral agreement, the BCBS had done much useful work clarifying the alternative definitions and alternative options. Without such groundwork, the US/UK teams would not have been able to reach agreement so fast, if at all. Then, once that initiative had, in effect, forced all the participants to negotiate seriously, the BCBS was the location for those negotiations. If it had not already existed, it would have had to be invented. The completion of the Accord38 on Friday, 15 July 1988, did not bring the BCBS discussions and further considerations on CARs to a close, a quietus, as Peter Hayward, in particular, was to discover, since it was part of his remit to handle the fall-out from its implementation. This essentially fell into four main categories: 1. Defending and considering possible modifications to the club approach; 37 He also shortly retired from the Bank of England. Given the Bank’s treatment of him, sidelining him in effect to an advisory position after the Johnson Matthey bank failure and keeping him excluded from all information on the US/UK bilateral negotiations, this was hardly surprising. 38 The Accord, however, could only be formally published after the Governors endorsed the final version in November and did so with a press communiqué.

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2. Handling technical details; 3. Exploring other regulatory avenues connected with the Basel Accord; and 4. Assessing the effect of its introduction on wider macro-economic developments. Let me take each of these in turn:

Defending and modifying the club approach

Almost from the very start of the Accord, the club approach dividing countries into ‘sheep’ (OECD + GAB, i.e. Saudi Arabia) came under sustained attack, from various ‘goats’. The first to protest was Kuwait, and its letter (BS/88/99) was followed up by a visit of representatives of the Gulf Cooperation Council (GCC) to the new Chairman, Huib Muller, in December 1988 (BS/88/122). They handed him a memorandum claiming (correctly) that the dividing line was not based on prudential criteria and was arbitrary and static (i.e. not dependent on time-varying risk records). The GCC argued instead for a criterion based on status at the IMF, for example having observed Article VIII, no restrictions on current payments, no borrowing. In response, Muller argued that the ‘club’39 approach was ‘the least unacceptable’ that the BCBS could find, and that GCC countries could adopt their own ‘privilege zone’, that is unilaterally lower the risk weighting on cross-country loans within the GCC. To this, ‘they answered that the GCC-authorities wanted their banks (also for reasons of international comparison) to adhere to standards identical to the ones observed by G-10 banks.’ So, right from the outset the BCBS found that recommendations and standards developed and intended only for large G10 international banks became regarded by all other countries, and their banks, as reputationally binding. 39 In advance of the arrival of the GCC delegation, the Secretariat issued an aide-memoire in defence of the ‘club’ approach (BS/88/113), including a vain plea for BCBS members not to use this term ‘club approach’ ‘in discussions with outsiders’. The issue was taken up again when the BCBS visited the GCC at Riyadh at the beginning of 1990 (BS/89/120 and BS/90/12), but by then ‘protests about the “Club” were relatively mild’. In the earlier briefing the Secretariat emphasised that: The point remains, however, that the Committee chose OECD membership because that group included all the major industrial countries and was a more or less permanent group. The Committee rejected objective criteria because they are variable and are likely to have arbitrary effects. The case for retaining the present definition and the line that members should take if the subject is raised, remains, therefore, that set out in BS/88/113.

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Hong Kong was the next to complain, in February 1989, with letters from HSBC (the Hong Kong and Shanghai Banking Corporation) and from Tony Nicolle, the Commissioner of Banking. Here the concern was not with respect to the differential risk weighting on loans to the public sector, since the HK public sector did not need to borrow (nor did the GCC), but on the differential in the longer-term interbank market, especially the swaps market. The response from the Chairman emphasised the need ‘to maintain the integrity of the agreement, at least during the transitional period’, but a willingness to review the ‘pricing effects’ of the Accord when the time came to review it. The issue rumbled on. It was specifically reconsidered in November 1990 (BS/90/101): At this juncture, the Committee may feel that enough experience has been gained in the operation of the club to take one of two alternative decisions:€one would be to stick with the present arrangement; the other would be to abandon the club altogether and give non-OECD obligors the same weight as OECD ones. If there is no consensus on either, a third option would be to undertake further work, including perhaps reconsidering the possibility of devising objective criteria for high or low quality.

However, the GCC had been the most vocal critics of the ‘club’, and the invasion of Kuwait weakened the case for lowering risk weights on lending in the Gulf. So no change was made. But the issue did not go away. Thus the Group of 24 developing countries specifically referred to it in advance of, and at, the IMF/World Bank meeting in 1991 in Bangkok, confirming that ‘the club distinction was still for them by far the most significant aspect of the Committee’s activities and clearly aggravates relationships between G-10 supervisors and authorities outside the club’ (BS/91/94). Further issues arose about the exact definition of OECD, for example Bermuda (BS/92/78). The Joint Ministerial Committee of the Boards of Governors of the World Bank and the IMF on the ‘Transfer of Real Resources to Developing Countries’ (Development Committee) wrote to the BCBS, dated 26€July 1993 (BS/93/34), to note that: – Two regulatory requirements were singled out by several members of the Committee as factors which might impair the resumption or expansion of commercial bank lending to developing countries; – although the economic performance and prospects of a number of these countries have substantially improved, the bank supervision authorities in some industrial countries have not eased what might appear as excessively stringent provisioning requirements against exposure to these countries;

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– second, the capital adequacy standards established under the auspices of the Committee on Banking Supervision might be seen as discriminating against creditworthy developing country borrowers; some members of the Development Committee felt that a more level playing field would require a refinement of the risk weight system to provide risk categories that would reflect more closely creditworthiness; the Bretton Woods Institutions might play a useful consultative role in establishing the criteria to be taken into account for a such a refinement.

Against that background (combined with the prospective entry of Mexico into the OECD in June 1994, despite its prior record as a problem debtor), it seemed necessary to take yet another look at the club distinction. The familiar list of (mostly unattractive) alternatives was set out in the Secretariat’s note of November 1993 (BS/93/47). This was discussed by the BCBS in some detail in early 1994 (BS/94/9 and 26), with the result that the Chairman, by then Tommaso PadoaSchioppa, put up a note to the Chairman of the G10 governors suggesting a minor revision to the Accord where ‘present and future members of the OECD qualify for the low-risk group unless a country has rescheduled its official external debt within the previous five years’ (BS/94/54); the relevant paragraphs are recorded in Appendix L. That, however, only gave rise to a heated discussion on how exactly one might define ‘reschedules’ or ‘external sovereign debt’, or the date of such rescheduling (BS/94/60, 75, 89, 92); truly in financial regulation, the devil is in the detail! But the BCBS managed to extricate itself from the swamp of detail in early 1995, and issued a press release that included the above revision among other minor changes to the Accord (BS/95/9). The next stage in this saga occurred in 1996/97 when the IMF undertook New Arrangements to Borrow (NAB) from a wider selection of (wealthy) countries including Hong Kong, Kuwait, Malaysia, Singapore and Thailand, which were neither OECD nor GAB Â�members. So the question was raised whether these extra five countries should be added to the preferential list, that is become ‘sheep’ (BS/96/39, 49, 88, 119). At this juncture the Governors themselves decided to reconsider the club approach, and requested a background note from the Secretariat about alternatives (BS/97/15 and 29), but try as they might, they too could not find any better approach than the existing one (with the addition of the new NAB members after ratification). But the Governors did ask for the issue to be, once again, referred back to them in two years’ time (i.e. in early 1999) (BS/97/131).

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Handling technical details:€the work of the Capital Liaison Group

There were, of course, a myriad of technical details on the interpretation of the Accord, especially in the years immediately following its promulgation, which were referred to the BCBS in general, and to Peter Hayward, its new Chief Secretary, in particular. These fell into four main categories (BS/88/104): 1. Points raised in the off-balance-sheet area; these were to be referred to the Danielsson subgroup, and generally resolved there. Important issues such as ‘netting’, however, were to come back to the full Committee in due course. 2. Purely factual queries which the Secretariat could handle. 3. Queries where there was no specific reference in the text, but an answer was suggested by ‘the logic and philosophy’ of the agreement (examples were given in an annex). 4. Queries without obvious solution, ‘or where separate elements are in conflict’. These would be brought before the Committee, after discussion in the liaison group on capital, which was established then to do this task. Examples of (4) were the new Capital Notes issued by Crédit Lyonnais (BS/89/7); the treatment of (a) non-domestic public sector entities (PSEs), (b) mortgages guaranteed by PSEs, for example Government National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA) in the USA, (c) claims collateralised by bank securities, (d) claims on central banks, (e) claims on non-OECD branches of OECD banks, (f) bonds guaranteed by an OECD bank, (g) claims on multilateral investment banks, for example International Bank for Reconstruction and Development (IBRD), Inter-American Development Bank (IADB), and so on (BS/89/9). Further issues raised in the liaison group on capital (BS/89/34) were the status of (a) hybrid debt instruments, (b) noncumulative preference shares, (c) mortgage loans to non-residents, (d) various forms of cross guarantees, (e) claims on insurance companies, (f) claims on clearing institutions, and so on, as well as a reprise on mortgage-backed securities. And so it went on (BS/89/73, and 101); these covered some older issues, for example treatment of latent and property revaluation reserves, mortgage-based securities, definition of PSEs, and some new ones. Thus (in BS/89/73, paragraph 12) the UK informed the Secretariat that it considered ‘The Channel Islands (Guernsey and Jersey) and the Isle of Man as a part of the United Kingdom and therefore of the OECD’ (NB no mention of Bermuda or Gibraltar); so there

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was a subsequent discussion (BS/89/101) of the equivalent treatment of Monaco, Puerto Rico, Liechtenstein, Vatican City, and so on. At the beginning of 1990 the BCBS issued a guidance note (BS/90/3) to supervisors around the world on its interpretation of ‘a number of technical issues that members have faced in the process of applying the agreement where, for example, the text was not sufficiently detailed or was ambiguous’, covering issues such as the definition of capital, risk weights for off-balance-sheet items. But the interpretative work of the Capital Liaison Group continued (e.g. BS/90/4). The Capital Liaison Group, to which such questions of interpretation were sent, not only continued its work throughout this period, but also adopted the practice of issuing occasional bulletins reporting its deliberations and decisions. The last of these available in this period is Bulletin 10 of its ‘Interpretation of the Capital Accord’, recording its agreements at its meeting in November 1996 (BS/96/51 and 112). The work of providing technical interpretations of the Basel Accord in response to specific questions from supervisors and banks was often finicky and sometimes tedious, but was an essential part of the successful implementation of Basel I. Given the nuances and difficulties involved, it is a tribute to Peter Hayward and his colleagues that there was so little debate and criticism (outside of the ‘club’ issue) about the BCBS’ interpretation and implementation of the Accord.

Exploring other regulatory avenues

Supervisors and banks outside the G10 countries, as well as inside, proved almost embarrassingly keen to adopt this new Basel standard, despite the fact that it was supposedly only designed for large international banks in developed economies. Apart from the ‘club’ issue, and the need for Bulletins of Interpretations for applying the Accord to particular, sometimes idiosyncratic national, detailed issues, there was little or no need for the BCBS to concern itself with implementation at the national level. That was undertaken, with enthusiasm by the supervisors and acquiescence by the banks, in virtually every country. The BCBS received, and filed, a massive set of documents recording national plans for implementation, (e.g. BS/88/88, and BS/90/83 on the application of national discretion), but it felt happy to leave implementation to national supervisory authorities (BS/89/55). There are no papers complaining about failures or gaps in such national implementation. The BCBS was concerned to see that country ratios did climb back to, and above, the desired levels along the transitional path, and designed statistical tables to check that this happened (e.g. BS/89/10). But there

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were very few, if any, complaints about failure to do so. Rather, as discussed later, the concern was about the possible macro-economic effects of doing so, possibly too enthusiastically. The BCBS was, however, keenly aware that it had only achieved the first, but perhaps the most urgent, part of a larger programme. It had: (a) stopped and reversed the downwards trends, evident in most countries, in aggregate capital ratios; (b) achieved an international agreement on convergence, and thereby helped to move towards a level playing field, especially in the definition and treatment of various elements of capital (NB no one subsequently felt the need, or had the stomach, to reopen this prickly issue until the financial crisis of 2007–9 led to a reconsideration); (c) applied, albeit in a very rough and ready manner, risk ratios relating to the respective credit risk of differing bank assets, including offbalance-sheet items. This is an impressive list of achievements. But the BCBS was equally aware that it had much left to do, both to achieve some degree of convergence in directly associated fields, such as provisioning policies, treatment of PSEs, netting and ownership structures, but also in dealing with other kinds of risk besides credit risk. There were several such risks, operational and reputational risks, liquidity and maturity mismatch risk, but especially the risk that the prices of (marketable) assets might change adversely for a bank’s position, whether fixed interest, equity, commodities or foreign exchange, that is market risk. Much of this was set out in the Secretariat’s note of September 1988 (BS/88/90) on ‘Future work on capital’. Thus ‘it was also agreed that if further work made it possible to develop a satisfactory method of measurement of interest rate risk for the business as a whole, consideration should be given to applying some appropriate control alongside the credit risk framework.’ There is a similar section on ‘Further work’ in BS/89/55. So we turn in the next chapter to review the work by the BCBS on the Market Risk Amendment.

Assessing the effects of the introduction of the Accord on wider macro-economic developments, or was Basel I responsible for the credit crunch of 1991/92?

There was no explicit discussion in the BCBS about the question whether there might be macro-economic consequentials of the introduction of the Accord; at least none that I have found, beyond the (implicit) assumption that bank holding of more capital (and especially

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so against riskier assets) would provide greater protection against both individual and systemic failure, and thereby stabilise and improve Â�macro-economic fundamentals. A reconsideration of this comfortable view was called for by the course of the recession of 1991/92, especially the recession in the United States. During this recession bank lending to the private sector declined unusually sharply. This occurred just at the end of the transition period, when all banks had to ensure that their capital rose to, and above, the Accord requirements. The weakness of financial markets in the recession of 1991/92 made it difficult and/or expensive for banks to strengthen their capital base by raising funds on financial markets, whether in equity or debt form. If they could not increase the capital (numerator), the only way to enhance their capital ratios would be to cut back on lending (the denominator). Thus some believed, and presented evidence, that there had been a Basel-induced ‘credit crunch’ in the USA in 1991/92, thereby deepening the recession. The problem was that the recession itself lowered the demand for borrowing, and it was extremely difficult to identify, and separate, demand effects from additional supply effects (if any). This led to various interpretations of the role of the Accord in a possible ‘credit crunch’. Thus Corrigan, the then Chairman of the BCBS as well as President of the FRBNY, at a public speech to bankers in New York in January 1992 (BS/92/9), was typically robust, admitting that there had indeed been a ‘credit crunch’ but allocating the blame for this to a prior explosion of bad lending and bad debt. A ‘credit crunch’ was a necessary part of a healing process, wherein ‘balance sheets had to be strengthened, capital positions had to be improved, and lending and underwriting standards had to be firmed.’ While the Accord may have been a (partial) catalyst for this process, and Corrigan had expected it to happen at an earlier date, it was a necessary exercise, even if painful at this time. Alan Greenspan also addressed the issue in the course of an address to the Tax Foundation in November 1992 (filed as BS/92/109; and the fact that these public presentations were filed attests to the sensitivities of the BCBS on this topic). He stated, pp. 8–9, that: The timing of the introduction of the Basle accord, coinciding as it did with the onset of an economic slowdown, makes it difficult to disentangle the effects of slack loan demand from those of the new risk weights on changes in the composition of banks’ interest-bearing assets. The implementation of riskweighted capital requirements probably has had some balance sheet implications. Indeed, it was intended to, since it was designed to strengthen banking systems around the world by lining up capital requirements with relative credit

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risk in a much more sensible way than the previous rule. The old standard, for example, assigned the same amount of capital to a commercial real estate loan as to a Treasury bill. To say the new risk weights have had some effect is one thing; it is quite another, however, to argue that they have caused the substantial increase in banks’ holdings of Treasuries and agencies relative to loans over the last couple of years of weak economic growth. Rather, as I previously indicated, the decisions of borrowers to restructure balance sheets by paying down short-term debt has played a major role. Some evidence in support of the importance of the demand side explanation can be found in the fact that it has been those banks that have the higher risk-based capital ratios that have been the largest purchasers of Treasuries. This finding is consistent with surveys of banks indicating that the major reason they have purchased Treasuries over this period has been their high relative profitability in an environment of weak loan demand and not their low risk-weights. It is also consistent with the behavior of credit unions, which also have been accumulating government securities even though they are not subject to the Basle capital standards. The shift toward securities has also given rise to concerns that it has materially increased banks’ exposure to interest rate risk (and it has also fueled demands for mark-to-market accounting procedures). It is probably true that greater interest rate risks have developed of late because securities tend to have longer maturities than bank loans. Nonetheless, one has to be careful not to exaggerate the degree of maturity mismatching. We see little shift toward longer maturities in banks’ securities portfolios, and we know that government and agency securities listed as over five years in maturity generally are mortgage-backed issues whose effective maturities are considerably shorter than their stated maturities. As regulators, we view both credit and interest rate risks as matters of concern.

Up till the early 1990s the BCBS had made little or no use of specialist, professional empirical studies to support their various exercises, relying instead almost entirely on questionnaires and on the experience and expertise of their own members, and the central banks’ (and other supervisory institutions’) wider experience and expertise. This was to change quite radically in the late 1990s, following Tommaso PadoaSchioppa’s appointment to the BCBS chair. The very first instance of a published working paper (No. 1€– April 1999) put out by the BCBS was a study of ‘Capital requirements and bank behaviour:€the impact of the Basle Accord’ by a working group of experts, including professional economists, led by Patricia Jackson, an official in the Bank of England. In the Introduction and Summary it was stated that: The overall message from the empirical literature and the data is that, at least initially, the introduction of minimum capital requirements across the G-10 appears to have induced relatively weakly capitalised institutions to maintain higher capital ratios. At the same time, however, there is some evidence that

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bank capital pressures during recent cyclical downturns in the US and Japan may have limited bank lending in those periods and contributed to economic weakness in some macroeconomic sectors. All of these effects may well have reflected both regulatory and market pressure on banks to maintain ratios at least as high as the minimum. In this context, a common structure of formal regulatory capital requirements across countries may have enabled financial markets to exert greater market discipline on undercapitalised banks than would otherwise have been the case. However, over time the banks have learnt how to exploit the broad brush nature of the requirements€– in particular the limited relationship between actual risk and the regulatory capital charge. For some banks, this has probably started to undermine the meaningfulness of the requirements.

And in their section 3, on ‘The effects of capital requirements on the macroeconomy’, the working group further concluded, section 3.3, p.€35, that: Theory suggests that changes in bank capital and their effects on bank lending may be important. There is some empirical evidence in the US, UK and Japan that banks have a special role and therefore that reductions in bank lending may not be fully offset by increases in lending from other financial intermediaries or markets. The key issue is whether there is empirical evidence that constraints on bank capital requirements have in some periods led to lower output. Some papers indicate that particular sectors in the US in the early 1990s may have been affected by pressure on the capital of some banks (although there was not, in general, pressure on all banks). Currently, the weakness of the Japanese banks may be contributing to the weakness of the economy but more evidence is needed to assess this effect. This section has not, however, addressed another aspect of the effect of capital requirements on macroeconomic activity which is that, by promoting financial stability, overall their effect on economic growth may be positive.

E

Assessment

The Basel Committee on Banking Supervision (BCBS) is best known for its regulations on capital adequacy requirements, CARs. The 1988 Accord, or Basel I, as it became more widely known, put the BCBS on the map for banks and policy-makers. It was perceived as a major success. Yet it also showed a weakness in the BCBS process. Since it was only a group of like-minded experts, it could only proceed by unanimity, and then could only recommend the adoption of its agreed �position to the G10 governors. When one or more major country dissented from the position of the majority, the BCBS could not move forward on its own. What broke this deadlock in the case of Basel I was the US/UK

Assessment

195

bilateral initiative; and its implied threat that, unless the dissenting countries, notably Germany, Japan and also France, were prepared to compromise and negotiate, then the US/UK could impose their own agreed CARs unilaterally. Nevertheless, the analytical framework for the US/UK initiative was greatly influenced by prior BCBS work, and the final Accord did not rubber-stamp the US/UK position, but owed much both to contemporary EC concerns (both the two tiers, and the infamous ‘club’) as well as to work and compromise within the BCBS itself.40 The task facing the BCBS was simple to understand, yet difficult to deliver. The need was to halt, and then reverse, the downwards trend in capital ratios in most countries, and do so in a way that would move, or at least appear to move, towards greater cross-border competitive equality, a level playing field. It succeeded brilliantly in both respects. Moreover, Basel I immediately became a standard to which all countries and major banks aspired, to an extent not previously expected by the Committee. In addition, the extremely detailed work on capital, its definitions and regulatory treatment was exhaustive then and has largely, though recently less so, stood the test of time. On the other hand the risk weights to be applied to the various groups of assets were ad hoc and broad-brush, based on subjective (and political) judgement, not on any empirical studies. Their application soon led to serious distortions in bank asset portfolios that undermined Basel I. There was little or no discussion at the time about the impact that the Accord might or should have on bank behaviour. The need was just to achieve the two desiderata:€higher capital ratios and a level playing field. There was no analysis, nor attempt made to assess what the optimal capital ratio should be. Instead, the actual numbers, 4 per cent Tier 1 and 8 per cent overall, largely fell out of the data, since the aim was to push up ratios somewhat everywhere, but not to do so by so much as to make it too difficult for large international banks to comply. As such it was the kind of pragmatic exercise with which the BCBS felt comfortable, and did well. There were no attempts to relate the measures to underlying theory, such as ‘Why do banks need capital?’, or ‘What is the market inefficiency (failure) which justifies regulatory 40 Kapstein (1994), especially Chapter 8, emphasises the special, almost hegemonic, role of the USA, with the British playing a subsidiary role in achieving international financial cooperation via the BCBS. While this was largely true in the case of the 1988 Accord, this was an a-typical occasion, a once-off from the normal affairs of the BCBS. In these earlier years the BCBS was pushed forward more by the Dutch and the British than by the Americans.

196

Capital adequacy and the Basel Accord of 1988

intervention?’41 Instead, the BCBS had been given its marching orders in 1984 by the G10 governors, that is to raise capital ratios in such a way as to enhance international equality among banks, and it marched successfully to that end. It is arguable that the failure to ask the wider theoretical questions reflects the inability of (theoretical) economists to explain, convincingly, to supervisory authorities that such questions were important, or even meaningful. Indeed, the supervisory, Â�financial stability, wings of central banks were generally the last part to be penetrated by professional economists (some would reckon that a ‘good thing’). One question that a professional economist would immediately ask is what is the incentive to achieve this (required) ratio. An answer to this is that there is a strong reputational effect, much reinforced by ratings agencies. But if such an effect is strong, as it proved to be in the case of Basel I, the CAR becomes a minimum. Recall Peter Cooke’s query whether the chosen ratio should be a ‘minimum’, a ‘target’ or ‘a standard’. This was never really properly followed up. The Basel I numbers quickly became minima. So all the flexibility in capital is limited to the buffer above that minimum. This can have extremely undesirable effects, for example in making economic cycles worse (procyclicality) and systemic crises more, not less, likely. Regulators have been traditionally slow to grasp this point. Economists tend to argue that establishing a ladder of incentives (to enhance capital) as capital ratios decline, as in the FDIC Improvement Act of 1991, is much more important than getting the definition or the precise numbers of the ratios exactly right. Yet here we come up against another inherent weakness (in some respects a strength!) of the BCBS. It was not a legislative, nor a legal body (see Chapter 14). It had no powers to suggest, certainly not to impose, legal sanctions. The latter is for the individual nation states. But that raises a conundrum. If the common imposition of sanctions should be a key ingredient of any international agreement on banking regulations, does it make sense to entrust the achievement of such international harmonisation to a body that has felt constrained from ever even discussing that issue?42 41 Peter Cooke, in private correspondence, notes that he does: not altogether agree that the BCBS did not address the economic issues you discuss. It is certainly true that the Supervisors were not economists and, in this phase of their life in particular, they were overwhelmingly preoccupied with developing a framework which helped make the international system sounder. But I would say that the Committee were not unaware of economists’ views which were relevant to their work but it is true that this awareness did not feature very highly as critical to the analysis the Committee was making. 42 That self-imposed constraint finally seems to have been lifted in the course of the BCBS’ work in 2009/10.

Appendix B

197

Appendix A 1. Methods of assuring the adequacy of a bank’s capital. (a) In Belgium, Germany, the Netherlands and Sweden the banks must maintain certain minimum relationships between their capital and their risk-bearing assets. In Germany there is one ratio which applies to the weighted sum of the banks’ risk-bearing assets; in Sweden different ratios apply to different types of assets; while in Belgium and the Netherlands minimum capital requirement is calculated by applying different ratios to different groups of assets and adding up the products. In Germany and Sweden foreign assets have a somewhat greater weight in determining capital requirements than domestic assets. In the Netherlands a distinction is made between assets guaranteed by Dutch banks and authorities and those guaranteed by foreign banks and authorities. In Belgium the formula takes into account forward exchange contracts. (b) In Japan, Luxembourg and Switzerland the banks must maintain a certain minimum relationship between their capital and their liabilities. In Japan and Luxembourg there is one ratio that applies to total liabilities; in Switzerland regulations distinguish between categories of liabilities according to the types of assets by which they are ‘covered’, the highest ratio applying to liabilities a large part of which are ‘covered’ by foreign assets. (c) In France banks have to maintain a certain minimum capital fixed in money terms, the amount of which depends on the type of bank. (d) In Canada, Italy, the United Kingdom and the United States there are no statutory capital ratios but the adequacy of the banks’ own funds is supervised by the authorities.

Appendix B Subordinated debt in bank capital structures in the United States The adequacy of bank capital has been the subject of considerable debate and public policy concern in the United States in recent years. Bank capital standards have never been legally defined in the United States nor has there been widespread agreement about appropriate levels of capital for the banking industry. The issue of bank capital adequacy has come to the forefront because of the marked decline in bank capital ratios throughout the 1960s and early 1970s. Banking activity grew at an exceptionally rapid pace during this period as banks played a larger

198

Capital adequacy and the Basel Accord of 1988

role in providing financing domestically and as the international financing operations of the major banks mushroomed. Questions about the level of bank capital and the composition of bank capital relate fundamentally to the purposes that capital is intended to serve in commercial banks. In the United States, there are a very large number of banks, all privately owned, that do not have an implicit guaranty by the government. The utility of bank capital is thus somewhat different than in other countries with different banking structures. In general, bank capital is thought of as serving (1) as a cushion to absorb losses, and hence protect depositors and creditors, in both a going concern and in liquidation; (2) as a curb to excessive leveraging and risk-taking by bank managements; and (3) as a protection to earnings for absorbing losses and meeting contractual obligations to depositors and creditors. Traditionally, the issuance of subordinated debt by banks was frowned upon and subordinated debt (no matter to whom issued) was not considered part of a bank’s capital structure. This view of subordinÂ� ated debt reflected the fact that the servicing of such debt represents a fixed charge on earnings, the debt needs to be repaid, and such debt is not available as a cushion to absorb losses. In 1962, however, the Comptroller of the Currency permitted national banks to include subordinated debt in their total capitalization up to a maximum of one-half of equity capital. Other bank supervisors disagreed with that decision and the matter has never been satisfactorily resolved. Recent efforts by bank supervisors to strengthen the capital structure of banks have been directed to slowing the rate of bank asset expansion through limiting regulatory approvals involving new activities or facilities. Those efforts have also included encouragement of earnings’ improvements as a means of contributing to capital. Efforts to induce new equity issues have met with limited success, in part because of market conditions. In these circumstances, there has been a reexamination of the question of the inclusion of subordinated debt in bank capital structures. Proposals have been devised that would allow the use of subordinated debt as capital subject to regulatory approval and to limits on amounts, maturities, redemption features, and also to conditions on the gradual replacement of debt with equity. A copy of the guidelines for the issuance of subordinated debt is attached. These proposals and guidelines have not yet been formally released.

Capital standards

In the period from 1914 to World War II, capital was related to total deposits, the generally accepted norm being a 10 per cent ratio. Relating

Appendix B

199

capital to deposits had its rationale in the notion that the function of capital was to protect depositors. With the expansion of deposits created by large bank acquisitions of US Government securities during World War II, this 10 per cent limitation soon became obsolete. Furthermore, it was recognized that if capital is to cover risks, it must relate to assets rather than deposits. Accordingly, in the early war years, capital adequacy was related to total assets. The standard used by the Federal Reserve Board was around 7 per cent. The first attempt to relate capital to degree of risk in the asset structure was made by the Comptroller of the Currency in 1948, with the introduction of a ratio of capital to risk assets€– total assets minus cash, due from banks, and Government securities. Further refinements came in 1952, when the New York Federal Reserve Bank developed a formula for deriving required capital from an analysis of a bank’s asset structure, with different percentage requirements assigned to each asset category. In 1956, the Federal Reserve Board staff expanded on this technique in its Form for Analyzing Bank Capital, which also took into account a bank’s liquidity. Since that time, approaches to capital evaluation have changed. In 1962, the Comptroller rejected use of any capital formula, and chose to rely on an evaluation of quality and efficiency of management, asset liquidity, past earnings and the retention thereof, and potential volatility of deposits. The Federal Reserve’s Form ABC has been revised to take account of more recent historic experiences. However, because of the complicated weighing system and the mechanistic result, its usage has declined as an analytic tool. A new over-all ratio has come into use at the Federal Reserve€– the ratio of equity plus reserves for loan losses to total liabilities minus cash and amounts due from banks.

Trends in bank capital ratios

During the 1950s, the ratio of equity capital to total commercial bank assets rose, and ratio of capital to risk assets declined quite slowly. During that period, banks were able to accommodate a marked increase in loan demand in large part by reducing their substantial holdings of US Government securities acquired during World War II. The rapid decline in bank capital ratios began in 1961, the year when negotiable CDs were introduced, and greatly expanded the scope for bank liability management. As Chart 1 shows, the decline proceeded without interruption through mid-1974 except in 1969, though it moderated in 1966. Both of these brief respites reflected disintermediation brought on by restrictive Regulation Q ceilings. Of

200

Capital adequacy and the Basel Accord of 1988 YEAR-END EQUITY CAPITAL RATIOS IN PER CENT FOR ALL COMMERCIAL BANKS 1961-1973 RATIO, PER CENT 18

16

14

12

RISK ASSETS RATIO

10

ADJUSTED LIABILITIES RATIO

8 TOTAL ASSETS RATIO 6 1961

1963

1965

1967 1969 YEAR-END

1971

1973

The Risk Assets Ratio equals Equity Capital plus Reserves divided by Total Assets less Cash and Due From Banks less U.S. Treasury and Government Agencies Securities. The Adjusted Liabilities Ratio equals Equity Capital plus Reserves divided by Total Liabilities and Capital Notes and Debentures less Cash and Due From Banks. The Total Assets Ratio equals Equity Capital plus Reserves divided by Total Assets

the three ratios shown in Chart 1, the ratio of capital to risk assets fell most steeply. Since mid-1974, bank equity ratios have increased, due primarily to a decrease in loan demand caused by recession, and probably also to increased conservatism on the part of bankers as a result of the problems of the US banking industry in recent years. While it appears at present as if many large US bank holding companies will issue new equity capital during the next few years, assuming conditions improve

Appendix B

201

in markets for bank stocks, it remains to be seen how long this changed attitude will last. The major force resulting in the attenuation of bank equity capital ratios has been increased domestic intermediation. This has reflected partly an increased ratio of growth in economic activity and total financing requirements, and partly a growth of banking relative to the economy. The importance of the latter factor should be stressed. During 1961–73, commercial bank equity capital and GNP both grew at a compound annual rate of 7.8 per cent. Risk assets held by domestic offices of commercial banks in this country grew much faster€– 11.9 per cent per year, on average:€total credit in the US economy (measured by the Federal Reserve’s Flow-of-Funds series ‘Total Credit Market Debt of Nonfinancial Sectors’) grew much less rapidly than bank credit€– about keeping pace with the growth of GNP. The decline in bank capital ratios has also been importantly influenced by overseas expansion of the large U. banks since the latter part of the 1960s. As recently as 1963, total foreign assets of US banks (net of claims on head offices) amounted to only about $85 million. Over the ensuing decade they increased more than twenty-fold, reaching $117 billion at the end of 1973. The average annual rate of growth of foreign assets other than cash during 1970–73 was nearly 40 per cent. Large banks generally have lower capital ratios than smaller banks, and the disparities have widened markedly in recent years. The major explanation has been a slower rate of growth of equity capital at larger banks, rather than more rapid growth of risk assets. The major source of additional capital for banks in all size classes is retained earnings, and at larger banks they have been at a lower level. During 1970–73, earnings retention rates rose, particularly for larger banks, and thus the major source of the differing behavior of equity capital ratios was ameliorating. In addition, larger banks issued sizable amounts of new equity capital, especially in 1972 and 1973, primarily through the sale of debt by parent bank holding companies and use of the proceeds to buy new equity in the bank. An important component of capital in US banks is the reserve for loan losses. Commercial banks have been permitted to accumulate substantial loan loss reserves out of pre-tax income, and these reserves provided an important supplement to equity. Through 1969, banks were permitted to accumulate such reserves equal to 2.4 per cent of eligible loans. In that year, such reserves for all insured commercial banks were equal to 2.2 per cent of eligible loans and nearly 15 per cent of total capital accounts.

202

Capital adequacy and the Basel Accord of 1988

The Tax Reform Act of 1969, however, provided for reductions over time of the allowable percentage, a change which will decrease considerably if not eliminate the sizable regular contribution of the loan loss reserves to the capital accounts. Then beginning in 1988, banks add to tax-free reserves only up to the average actual losses realized by the bank over the most recent six-year period. By the year 2000, bad debt reserves are estimated at only about 2 per cent of total capital accounts and about one-fourth of one per cent of eligible loans.

Subordinated debt

Subordinated debt played virtually no role in the US banking system until the Comptroller of the Currency ruled, at the end of 1962, that national banks could include it in their total capitalization up to a maximum of one-half of equity. By the end of 1973, total subordinated notes and debentures of commercial banks had grown to $4.2 billion. Such debt is now used by some banks in all size classes, but most banks still do not use it. The answer to the question of whether subordinated long-term debt may be regarded as an acceptable supplement to equity from the point of view of bank supervisors depends in large part on the effectiveness of such debt in performing the functions of capital. Such debt serves many of the traditional functions of bank capital, such as protecting the uninsured depositors of the bank in the event of insolvency due to its subordinated status. By providing a source of long-term funds to a bank, it presumably makes the institution less vulnerable to certain external shocks. However, subordinated bank debt is only a partial, not a complete, substitute for equity capital. It cannot be used to absorb losses while the bank is solvent, and hence is of no use in maintaining the bank as a going concern. Thus, it does not help to support public confidence in the bank’s ability to absorb unexpected losses without becoming insolvent. The advantages of subordinated debt may be listed as follows. Debt financing is likely to be a more accessible source of funds than equity, particularly at present when the US market for bank stocks is relatively depressed. Debt capital is generally available at appreciably lower cost than equity, due partially to the fact that in the United States interest expense is tax deductible and dividends on stock are not. Issuance of debt avoids the dilution of per-share earnings that would result from sale of equity, and can result in an increase of earnings per share if the bank earns more than it pays on the additional funds. Finally, bank earnings have traditionally shown stable growth in the United States,

Appendix B

203

which indicates that most banks are capable of bearing the additional business risk involved in the issuance of debt rather than equity. The use of subordinated long-term debt, while offering substantial advantages, also carries significant risks and disadvantages. First, issuance of debt puts the bank in a position of having to meet a fixed annual charge for interest and possibly also for sinking fund or redemption payments, regardless of earnings. Second, to the extent that debt is substituted for equity, the thinner is the equity margin out of which losses can be absorbed before capital is impaired. Third, long-term debt carries a requirement for repayment in entirety at a fixed maturity date; if not carefully planned, redemption could deplete capital and liquidity. Fourth, the issuance of long-term subordinated debt can impair operating flexibility in several ways:€restrictive covenants in the indenture may limit future alternatives open to the bank, such as payment of dividends, mergers, and transfers of assets; the issuance of debt could reduce the ability of the bank to acquire additional future debt in the event of a crisis, such a limitation being imposed either by a covenant or by the market itself; and acceleration clauses calling for immediate repayment of the debt generally would be triggered when an institution is most vulnerable to collapse. A further important trend in the banking industry which has a bearing on the capital question involves the growth and evolution of bank holding companies. Between 1956 and 1973, the proportion of total commercial bank deposits held by banks affiliated with holding companies rose from around 8 per cent to 65 per cent, and, of this, over half was at banks in multibank holding company systems. Bank holding companies often provide equity capital to their subsidiary banks, but in many cases derive these funds from long-term debt sold at the parent level. This practice, often referred to as ‘double-leveraging’, creates a need by the parent bank holding company for bank dividends to service that debt. Thus, bank equity capital resulting from double-Â�leveraging has many of the negative characteristics of subordinated debt sold directly by a bank. Still, double-leveraging is often preferred by bank supervisors, within prudent limits, to bank subordinated debt, because the resulting bank equity capital provides some protection of the bank against insolvency (but not the parent bank holding company).

The current approach to the problem of bank capital

The question of the ‘right’ level of capital for the banking system; or the ‘right levels for different classes of banks, has not been resolved in the United States. Work is proceeding on arriving at a more uniform

204

Capital adequacy and the Basel Accord of 1988

approach to that question among the bank supervisors. There is general agreement, however, that the present level of capital in a large segment of the banking system and in most of the large banks is too low. The recent upturn in bank capital ratios was due primarily to a decline in the growth of risk assets€– and actual declines in total assets at many banks€– rather than an increase in the amounts of new equity issues. This situation will not long continue with the resumption of more normal economic growth. In the short run, improved earnings appear unlikely to contribute sufficiently to capital, and in the absence of better earnings performance, the market for new equity issues by banks appears limited as well. In these circumstances, it has appeared desirable to consider other methods if present deficiencies in bank capital are to be corrected and if capital considerations are not to act as a drag on suitable growth in bank assets in the future. One method would be to encourage the practice of double-leveraging. However, such. a practice is likely to result in higher dividend payouts, thus reducing the amount of earnings retained and offsetting to some extent the benefits of the additional capital. Perhaps more importantly, this practice is only helpful within limits, and is not acceptable to many private market participants in the US€– one major debt rating agency, many investors, and some bankers. Another approach is to encourage banks to issue subordinated debt when such issuance would be beneficial to the banks, and to give banks some credit toward capital requirements for such debt. As described above, subordinated debt fulfills some functions of equity capital, but is definitely not a perfect substitute. The banking supervisory agencies have taken steps toward implementing this approach by issuing for public comment amendments to regulations and guidelines that would be used in evaluating prospective debt issues. The purpose of the published proposal was to provide greater flexibility in terms of subordinated debt issues, to establish uniform criteria between the Federal Reserve System and the Comptroller of the Currency for approving such issues, and to publish those criteria for the benefit of banks and others. Greater flexibility would be provided by replacing the present requirement of a seven-year minimum maturity for any subordinated note by a requirement that any issue on average have minimum maturity of seven years. This would allow for the issuance of amortized issues to institutional investors, sinking fund provisions in public issues beginning before seven years, and serial notes. The other amendment to provide greater flexibility would allow issuance of subordinated notes

Appendix C

205

in denominations of less than the current $500 minimum in special circumstances. Other proposed changes would have prohibited the issuance of subordinated debt of certain characteristics. First, such issues could not have acceleration clauses even for default, and could not be repaid prior to maturity without approval from the appropriate Federal banking agency. In addition, sale of subordinated debt by one bank to another (generally larger) bank would be prohibited except in compelling circumstances. Finally, all covenants in such debt would be carefully reviewed as at present to determine whether they are inconsistent with the public interest. The published proposal also set forth five quantitative tests that would have to be met before subordinated debt issues would be approved. First, the ratio of subordinated debt to equity could not exceed 50 per cent. Second, on average for the preceding five years, income before taxes would have had to exceed fixed debt service charges by a multiple of 3. Third, annual pro forma amortization on all subordinated debt could not exceed 50 per cent of a bank’s average retained earnings over the preceding five years. Fourth, the issuing bank would be expected to replace a debt issue with equity in equal annual instalments over the life of the issue. Fifth, no more than 15 per cent of a bank’s subordinated debt could be scheduled for repayment in any single year, unless the bank has the option to call it for redemption at least five years before maturity.

Appendix C I

Capital adequacy measurement

A wide-ranging examination of capital measurement in different countries immediately encounters several problems:€ in particular, the different approaches to the definition of capital and the elements of the balance sheet against which capital should be measured; and deciding what level of capital is generally acceptable as adequate. (a)╇Definitions of capital:€ Only irredeemable paid-up share capital is universally accepted as an immutable element of capital in the calculations of a bank’s ‘own funds’ for supervisory purposes. Reserve funds are subject to a variety of national treatments. Most countries include post-tax retained earnings under this heading:€in some countries some part of these must be held as a statutory legal reserve. General provisions for loan losses are usually not included

206

Capital adequacy and the Basel Accord of 1988

in the capital base. There is no general consensus on the treatment of reserves arising from asset revaluations. A number of countries furthermore permit the establishment of hidden reserves, which are known to the supervisor and included in his calculations, but do not permit the public to have a full picture of a bank’s own funds. The status of subordinated long-term debt may also vary. Subordinated loan stock is allowed to form part of the capital base in some countries, although the degree to which it is accepted, and the terms on which it is acceptable, vary considerably. Finally, on consolidation, the minority capital interests of outside shareholders may or may not be included in the calculation of the capital base. (b)╇Choice of ratio:€Several countries apply a capital measure against liabilities, though definitions of the latter may vary. At least two member countries use the concept of ‘free resources’, using a capital base modified by various deductions (e.g. goodwill, premises, etc.). Where the balance sheet is to be examined on a consolidated basis, participations above a certain level may also be deducted from the capital base. Some countries apply ratios to large loans, or require percentage capital coverage of fixed assets. Many Committee members measure capital adequacy against a weighted risk asset calculation, though there is no generally agreed system of applying the weightings or defining the assets. (c) Further work:€Would Committee members be prepared to describe briefly their national supervisory practices with regard to capital, its measurement, and adequate levels? Would a questionnaire drawn up by the Secretariat be of use in this regard? Would it be useful to try to secure general agreement on the constituent elements of capital and preferred forms of capital adequacy measurement? II

The significance of capital adequacy for the prudential conduct and relative competitiveness of international banks

The following questions, among others, may be worth discussing: (a) Is the progressive historic weakening of capital ratios being allowed to continue to an unacceptable degree? Should supervisory authorÂ� ities have a view on the point at which this process should be firmly resisted? (b) The erosion of margins, particularly in international business, directly affects banks’ ability to generate new capital by retention of earnings. Does the Committee feel that more liberal capital

Appendix D

207

requirements in some countries, allowing keener bidding by some banks and consequently lower margins generally, are having a significant impact in eroding profitability and thus the scale of retained earnings, to the detriment of capital levels of international banks in general? (c) Is there any evidence that some banks, which benefit from more favourable capital regimes and so can sustain higher levels of business at finer margins than their competitors, have consequently become overexposed internationally? (d) Is there any evidence that banks are increasing their engagement in off-balance-sheet activities to avoid capital restraints and increase their profitability? (e) In general is there any case for saying that the security and soundness of the international banking system would be served by some more consistent approach with regard to capital adequacy levels in the major countries? ANNEX

Appendix D SYSTEM OF WEIGHTS FOR CALCULATING CAPITAL RATIOS Category of asset

Weight Where the customer is situated in the same country as the bank

Where the transaction is cross-border

Government and government agencies’ loans, securities and governmentguaranteed loans

20%

24%

Loans to banks with one year or less to maturity

50%

60%

Contingent items other than those which substitute for credits

50%

60%

Commercial lending and creditsubstitute contingent items

100%

120%

Loans to banks with over one year to maturity

100%

120%

Fixed assets

100%

–

Securities, unless deducted from capital

100%

120%

Depending on method of measurement

–

Open positions in foreign currencies

208

Capital adequacy and the Basel Accord of 1988

Appendix E Annex 2 Comparative weights for calculating capital ratios

Category of asset

Government and government agencies’ loans, securities and governmentguaranteed loans

Weights suggested by Dahl Working Party*

20%

Weights used in EEC observation ratio exercise

0%

Loans to banks with one year or less to maturiy

50%

20% zone A 100% zone B

Contingent items other than those which subsitute for credits

50%

50%

Commercial lending and creditsubstitute contingent items

100%

100%

Loans to banks with over one year to maturity

100%

20% zone A 100% zone B

Fixed assets

100%

100%

Securities, unless deducted from capital

100%

100%

100% depending on method of measurement used.

100%

Open positions in foreign currencies

* There remains the question of whether an additional weighting should apply to cross-border transactions.

Appendix F

209

Appendix F Annex 1

Suggested Components of Capital 1. Issued and fully paid ordinary shares

Countries following different practices according to BS/84/20

2. Non-redeemable preference shares 3. Share premium account 4. Accumulated retained profit and general reserves 5. Legal reserves 6. Asset revaluation reserves

Canada, Germany, Sweden, Switzerland, U.S.

7. Undisclosed reserves

Belgium, France, Germany, Japan, Luxembourg

8. General provisions

Germany, Switzerland

Items not included 1. Subordinated debt

Belgium, Canada, France, Luxembourg, Netherlands, Sweden, Switzerland, U.K.

2. Specific provisions

Japan

Items to be deducted 1. Goodwill 2. Holdings of own shares 3. Participations in excess of 20%

Note:

Thresholds for deduction vary in a number of countries

Premises and equipment are not deducted from capital in this scheme.

210

Capital adequacy and the Basel Accord of 1988

Appendix G Annex Comparison between the US/UK proposals and the Basle framework of measurement I.

Components of capital US/UK proposals

(a) (b) (c) (d) (e)

Equity/common stock Retained earnings Minority interests General provisions Hidden reserves

(f) Preference shares (long life) (g) Perpetual debt (h) Mandatory convertible debt (i) Property revaluation reserves

Basle framework

Included without limit Included without limit in UK but to be phased out

tier 1 tier 1 tier 1 tier 4 tier 2

Included up to a limit of 50% of items (a) to (e) less deductions

tier 5 tier 5 tier 5

For UK only, existing reserves to be included

tier 3

Deducted in UK; existing intangibles not deducted in US

deducted

(b) Investments in subsids. and associated cos.

deducted

deducted

(c) Investments in capital instruments of other banks

Deducted in UK; case by case in US

not deducted

II.

Deductions from capital

(a) Intangible assets

Appendix G

III

211

Risk weights US/UK proposals

Basle framework

(a) Cash

0%

0%

(b) Balances at domestic central bank

0%

0%

(c) Govt. -guaranteed export credit

0% (UK only)

0%

(d) Short-term claims on US/UK Government

10%

0%

(e) Short-term claims on discount houses, etc.

10% ( UK only)

20%

(f) Cash in course of collection

25%

0% (ignored)

(g) Short-term claims on domestic and foreign banks

25%

(h) Claims on local authorities

20% (industrialised) 100% (non-industrlsd.)

25% (UK only)

0%

(i) Long-term claims on US/UK Government

25%*

0%

(j) Claims secured against US/UK Government debt or cash

25%

100%

25% (US only)

0%

(l) Claims guaranteed by US/UK Governments

25%

0%

(m) Claims on foreign governments funded by local currency deposits

25%

(k) Fed. Reserve stock

0% (industrialised) 100% (non-industrlsd.)

(n) Claims on domestic government sponsored agencies

50%

(o) Claims secured against domestic government agency debt

50% (US only)

100%

(p) Claims on US State and local government

50% (US only)

0%

(q) Claims on development agencies

50%

* The OCC and FDIC propose 10%

0%

100%

212

Capital adequacy and the Basel Accord of 1988 US/UK proposals

(r) Long-term claims on domestic and foreign banks (s) Claims on foreign government (t) Acceptances (u) Revenue bonds

100% 100% 100% 100% (US only) 100% 100% 100%

(v) Commerical lending (w) Fixed assets (x) Other assets (y) Open FX position

100% (UK only)

Basle framework 20% (industrialised) 100% (non-industrialised) 0% (industrialised) 100% (non-industrialised) 100% 100% 100% 100% 100% 0% (ignored)

Off-balance-sheet items* (a) Credit substitute items (b) Trading contingencies (c) Commitments - short-term - medium-term - long-term (d) Interest and exchange rate contracts

100% 50% 10% 25% 50% Still to be determined

100% 50% 50% Still to be determined

* In both the US/UK proposals and in the Basle framework off-balancesheet items are further weighted according to the category of counterparty.

Appendix H

BS/87/18

Chairman’s note

Capital adequacy

1. This note sets out to serve as an introduction to Item III of our agenda at the meeting on 12th–13th March, to address the main issues for the Committee and to suggest a framework for discussion. 2. The Committee, in recent years, has placed considerable emphasis on the importance of achieving a significant measure of convergence of capital adequacy standards and of the framework for the measurement of capital adequacy in order to iron out€– for those aspects at least€– competitive inequalities arising from a diversity of regulatory

Appendix H

213

systems in G-10 countries. All member countries have expressed themselves as supportive of the principle of convergence in this area. Strong support for pushing forward to realise this objective in practice was manifested by the delegates of 80 countries at the 4th International Conference of Banking Supervisors in Amsterdam last October. I am sure I may take it that members individually and the Committee as a whole continue to be convinced of the need to make progress in this area as a major part of our current work. 3. Since the Amsterdam Conference the supervisory authorities of the United States and the United Kingdom have announced an accord, which is currently out for discussion and comment, under which both countries propose the introduction of a common risk weighting system for the measurement of capital adequacy and a minimum capital standard for banks. The Secretariat has circulated a paper (BS/87/2) which makes a first attempt to assess the US/UK accord in the context of the present framework of capital adequacy measurement developed in Basle. It shows that there are some differences. There are also a number of areas where the framework proposed draws on and is consistent with the Basle framework. 4. I believe the Committee’s objective now should be to investigate whether and in what way this US/UK initiative can be used constructively to carry forward our work in Basle. 5. This objective is consistent with the hope expressed by the US and UK authorities that their invitation to other members of the Committee to comment will be picked up and that the accord may promote rather than impede a multilateral approach to this subject. Indeed, it seems to me that if progress toward a more multilateral accord cannot be made, the US/UK agreement will have only limitÂ�ed value to the authorities or to the banks in those countries and very little relevance to coming to grips with the problem of level playing fields internationally. 6. The US/UK accord has, I believe, made one particularly important contribution toward the possibility of greater G-10 convergence. If implemented, it places the US authorities where they were not before€– firmly in the camp of those countries who will be using the risk weighting approach to capital adequacy as a major supervisory tool. Acceptance of the risk ratio approach by the US authorities, along the lines followed in most other member countries, has always seemed to me one of the essential preconditions for further progress in this matter in the G-10 as a whole. It remains equally important, however, if real progress is to be made, that our colleagues in Japan, and in Canada and Luxembourg, are also persuaded of the merits of

214

Capital adequacy and the Basel Accord of 1988

the approach as an appropriate internationally applied supervisory technique€– although not necessarily to the exclusion of other techniques€– and are prepared to apply it to their own banking system. In Europe generally the risk weighted approach is already widely accepted and applied, but there may still be a need for all members of the Committee to take a fresh look at their own systems in the light of recent developments. 7. Ultimately, genuine convergence in the G-10 as a whole will only be achieved if there is the collective will€– political, as well as technical€– to reach agreement. The important question for the Committee is whether the substance of the US/UK framework can be seen as contributing toward achieving this objective or whether it impedes it. This will depend as much on the way member countries approach the proposals as on the substance of the proposals themselves. I hope, in our discussions, that any criticism of the way in which the proposals have been presented can be set to one side and that discussion can concentrate on their merits or demerits. 8. There is, of course, an important European Community dimension to this matter and I have arranged to have informal discussions with the Commission to review recent developments before our March meeting. As I have said on many occasions, it has to be recognised that the emphases of the work on capital convergence in Basle and in Brussels are different. Both in Basle and in Brussels, however, we have each been sensitive to the desirability of developing a framework which is, as far as possible, constructed on the basis of commonly agreed principles. I would hope that in Brussels, as well as in Basle, close attention may be given to the degree to which the US/ UK proposals can be a useful building block in promoting the work on capital convergence. It is, I think, fair to say that both in Basle and in Brussels the important objective is the achievement of convergence rather than holding out for one particular entrenched conceptual position or one specific existing system. Indeed, I hope that, in pursuit of an acceptable solution, each member country will feel able to react flexibly in relation to their own systems. In a number of respects, the US/UK accord, as I read it, includes for both countries significant modifications to their existing system. If further multilateral progress is to be made, a willingness to modify some detail of each of our systems may well be needed by all the parties involved€– as indeed has been the case already in bringing us to the point we have reached in Basle on this subject. 9. As background to our discussion, I would emphasise two points:

Appendix H

215

(i) our starting point should be the ‘Basle position’ reached at the end of the Committee’s last discussion of the subject and, more multinationally, at the end of the Amsterdam Conference; (ii) all parties, but particularly the United States and the United Kingdom, should acknowledge that if we are to achieve agreement multilaterally elements of the different systems must be regarded as negotiable. 10. In order to give some structure to the discussion, I would propose the following: (a)╇We should be able to agree that, as was envisaged in the original mandate (see Annex) to me, as Chairman of the Committee, from the Governors in 1984, there are three areas where convergence needs to be pursued: (i) the constituent elements of capital; (ii) the framework for measurement; (iii)╇ minimum levels of capital. (b) We need to determine at the outset what kind of convergence we are aiming for and in what order the elements of it can be achieved. Convergence in each of these areas can be pursued on a basis which either recommends certain elements, frameworks or standards (observation) or seeks to mandate them (normative). The US/UK accord appears to be suggesting mandating (i), (ii) and (iii) so far as the national systems in those two countries are concerned. Does the Committee agree we should aim toward a mandatory or normative outcome multilaterally? In one accord, or in stages? This would represent a significant move away from the observation approach hitherto pursued. (c) As a basis for discussion, I would suggest that the aim should be to arrive at one multilateral accord, but in stages€– (i) and (ii) first and (iii) later. The elements of capital and the framework, once agreed, should be binding on national authorities€– initially for purposes of measurement and comparison internationally, but in due course for application in each of our national systems. This would not preclude local variations to meet particular national circumstances where these are not critical to the framework. (iii) could consist of a recommended or ‘target’ level, or a minimum target, either on a ‘best endeavours’ basis, or in due course a mandatory level with a timetable to be implemented in national legislation or practice. How to proceed on (iii), I would suggest, is a second order question (except possibly at a fairly early stage to seek to agree on the promulgation of a ‘target minimum’) and is best left on one side in our initial discussions.

(b) Investments in subsidiaries and associated companies (c) Investments in capital instruments of other banks

(a) Intangible assets

Deductions from capital

deducted Deducted in UK; case by case in US

Deducted in UK; existing intangibles not deducted in US

Not included

(h) Term subordinated debt

II.

Not included

For UK only, existing reserves to be included

Included up to a limit of 50% of items (a) to (e) less deductions

(j) Latent revaluation reserves

(i) Property revaluation reserves

(h) Mandatory convertible debt

(f) Preference shares (long life) (g) Perpetual debt

deducted not deducted

deducted not deducted

deducted

External element

tier 6

deducted

Not included

tier 3

tier 3

tier 5

tier 5

Unresolved

deducted

deducted

to (e)

of 50% of items (a)

Included up to a limit

Included without limit

tier 5

Included without limit All recognised as internal elements of capital

tier 2

(e) Undisclosed reserves Included without limit in UK but to be phased out

Unresolved

tier 4

(d) General provisions

(c) Minority interests

tier 1

Included without limit

Included without limit

Gerzensee outline

tier 1

Brussels framework

(b) Retained earnings

Basle framework

Included without limit

US/UK proposals tier 1

Components of capital

(a) Equity/common stock

I.

Comparison between the US/UK proposals, capital measurement, the Basle and Brussels frameworks and the Gerzensee outline

Appendix I

III. Risk weights US/UK proposals

Basle and Brussels frameworks

Gerzensee outline**

(a) Cash

0%

0%

(0%)

(b) Balances at domestic central bank

0%

0%

(0%)

(c) Govt. -guaranteed export credit

0% (UK only)

0%

(0%)

(d) Short-term claims on domestic Government

10%

0%

(e) Cash in course of collection

25%

+

0% or 10% (Same for other EC)

0% (ignored)

(25%)

(f) Short-term claims on domestic and foreign banks

25%

(g) Claims on local authorities

25% (UK only)

0%

Unresolved

(h) Long-term claims on domestic Government

25%*

0%

0% or 25%+

(i)

Claims secured against domestic Government debt or cash

25%

100%

Unresolved

(j)

Claims guaranteed by domestic Governments

25%

0%

Unresolved

(k) Claims on foreign governments funded by local currency deposits

25%

(l)

50%

Claims on domestic government sponsored agencies

(m) Claims secured against domestic government agency debt

50% (US only)

(n) Claims on domestic State and local government

50% (US only)

(o) Claims on development agencies

50%

20% (industrialised) 100% (non-industrialised)

25%

0% (industrialised) 100% (non-industrialised)

Unresolved

0%

Unresolved

100%

Unresolved

0%

Unresolved

100%

Unresolved

* The OCC and FDIC propose 10%. + If market risk is included. ** Specific weighting categories which were not discussed but where logic would suggest a clear percentage weight are shown in brackets.

US/UK proposals (p) Long-term claims on domestic and foreign banks (q) Claims on foreign government

100%

(r) (s) (t) (u) (v)

100% 100% 100% 100% 100% (UK only)

Acceptances Commercial lending Fixed assets Other assets Open FX position

100%

Basle and Brussels frameworks

Gerzensee outline**

20% (industrialised) 25% (domestic and other EC) 100% (non-industrialised) 100% (foreign) 0% (industrialised) 25% (short-term) 100% (non-industrialised) 100% (long-term) 100% 100% 100% 100% (100%) 100% (100%) 100% Not discussed 0% (ignored)

off-balance-sheet items* (a) Credit substitute items (b) Trading contingencies (c) Commitments - short-term - medium-term - long-term (d) Interest and exchange rate contracts

100% 50% 10% 25% 50% Still to be determined

100% 50%

100% 50%

50%

50%

Still to be determined

Still to be determined

* In both the US/UK proposals and in the Basle framework off-balance-sheet items are further weighted according to the category of counterparty. ** Specific weighting categories which were not discussed but where logic would suggest a clear percentage weight are shown in brackets.

218

Capital adequacy and the Basel Accord of 1988

Appendix J I. The treatment of cross-border risk€– the framework of risk weightings has as one of its most crucial elements the treatment of cross-border exposure in respect of claims on banks and claims on sovereign governments. The majority view in the Committee at the last meeting in Brussels and following earlier discussions in Gerzensee, after much discussion, was that the least bad approach (for there is no ideal approach) would be to follow the original US/UK proposals of making a basic distinction between domestic risk on the one hand and all foreign risk on the other hand. (Although, for EC countries, it was acknowledged that on Community grounds it would be necessary for all EC governments’ debt to be categorised by EC countries as domestic rather than foreign.) From the chair, I leaned towards this solution as it was the basis broadly agreed in the first round of the Committee’s discussions at Gerzensee. The majority took this position largely on the grounds that all other solutions presented impossible political boundary problems. The alternative approach, favoured by some countries, including the United States and the United Kingdom who have moved from the position in their original proposals of a domestic/foreign split, was to treat the club of EC and G10 countries as low risk and all other countries as higher risk on grounds that such a division would reflect in a broad way not unreasonable credit judgments as between nations. Judgment on the alternative to be chosen thus depends critically on the view of the political problems which ‘the club’ approach would create. I would welcome Governors’ views on this issue. Should the split be domestic bank and government debt on the one hand and all foreign bank and government debt on the other (with the special treatment of EEC), or should there be a club approach on which all EC and G10 members have a special low weighting and all other countries a higher weighting? Are the political problems of trying to make credit judgments of sovereign governments in a capital adequacy framework such as to make the club approach untenable? The Committee would be happy to accept the Governors’ judgment on this matter. II.╇On the constituents of capital there are basically two propositions on the table€ – both drawing on the elements in the tiered approach to capital developed here in Basle over the past two years€ – the ‘Gerzensee’ and the ‘Brussels’ formulae. The first says that higher quality capital should consist of equity and free reserves, undisclosed reserves with the character of free

Appendix J

219

reserves and general provisions provided they are cleaned up of any specific provisions characteristics. To these elements of higher quality capital should be added revaluation reserves (suitably discounted where they have not been realised), other hybrid instruments (notably perpetual debt) and subordinated debt, but the total of these three elements should not exceed 50 per cent of the total of the higher quality capital items. The second says equity and free reserves are the highest quality capital. The Committee has always laid stress on this first tier of capital and this should be applied in the formula in such a way as to avoid the quality of capital being diminished over time. Tier 1, highest quality capital, should be included without limit and all other elements€ – hidden reserves, cleaned up general provisions, revaluation reserves, perpetuals and subordinated debt€ – should be included up to 100 per cent of the total of Tier 1, with a sublimit for subordinated debt as second-class capital of 50 per cent of Tier 1. The first approach gives particular problems to the Germans and the Japanese:€for the Germans, it broadens the capital base beyond their very restricted definition of capital; for the Japanese because, as so much of their existing capital is in the form of latent revaluation reserves, allowing only 50 per cent of equity to be included in this form may give them a too low level of capital. The second approach gives particular problems to the United States, because of the recent provisioning exercise by the big banks. If general provisions (US style) are not included in the unlimited part of the capital base, then their capital levels come out on the low side. The answer here could be one or other of these two approaches or some modification of them. But the answers are linked to the third point€– what level of capital is to be set? III╇ Level of capital 1. An important prior question to the level chosen is:€is it to be a minimum, or target or standard? If the former, it will have to be set very low to include everyone. If the latter, it can be higher, but will require a transition period for some countries and/or some banks in some countries. The latter will produce a more credible level to the market but will require transition for those below the waterline to come above it. For credibility, I believe this latter approach would be the better one. But it does raise the question how far the market would make it difficult for the laggards to obtain increased capital if they were known to be

220

Capital adequacy and the Basel Accord of 1988

below the international standard. With careful presentation, however, I doubt if this consideration should give rise to overriding difficulties. 2. There is also the question, discussed in April, of allowing adjustments in the framework so that in order to meet the capital level set, banks could take account of the scale of their international provisioning. This may be a less critical issue than it was since the recent substantial new provisions announced by some United States and United Kingdom banks means that there is now rather more convergence among G10 countries in their provisioning policies (with the exception of Japan).

Appendix K Summary of recommendations

General agreement

1. Non-cumulative irredeemable preference shares to be included in core capital (US prefers inclusion with limit). 2. Non-voting equity instruments which have all characteristics of core capital should be included therein (US prefers inclusion with limit). 3. National discretion to apply zero or 20 per cent weight to international development banks should be replaced by standard 20 per cent weight for all such banks. 4. Where gold bullion assets are backed by gold liabilities (i.e. no price exposure), members should have discretion to treat it as cash. 5. Loans partially capitalised with cash or government securities should attract a preferential weight on that part of the loan fully collateralised. 6. The 50 per cent weight should be extended to loans to private individuals secured by mortgage (i.e. owner-occupation condition should be removed). 7. Where, under a club approach, a country (e.g. US and UK) was proposing to apply a small weight to claims on its own government, it should not be obliged to apply a zero weight to other club governments. 8. The definition of non-club banks should be determined according to country of incorporation.

Majority recommendations

1. Cumulative perpetual preference shares should not be included in core capital (US and Canada favour inclusion, US with a limit).

Appendix K

221

2. References to maturity in relation to claims on foreign or non-club banks and commitments should be determined by original maturity (US, Canada and Luxembourg strongly support national discretion to apply residual maturity). 3. Loans partially collateralised by mortgage on residential property should not be recognised by preferential weight on that part of the loan fully collateralised (Netherlands dissents). 4. Collateral in the form of securities issued by banks and public sector bodies should not be recognised by preferential weights (France, Netherlands, Sweden dissent). 5. The 50 per cent residential mortgage weight should only apply to loans to private individuals and not to companies (Germany, Switzerland, Sweden strongly favour extension to companies where strict legal valuation rules ensure prudent margin of cover over loan). 6. The 50 per cent mortgage weight should not apply to commercial property (Germany, Netherlands, Sweden, Switzerland favour extension to commercial property subject to strict legal valuation as above). 7. Banks’ own premises should attract standard 100 per cent weight (France, Canada favour low weight in view of low risk). 8. Guarantees of non-club banks should be recognised to the extent that the underlying transaction is less than one year (Germany dissents). 9. In a club context, a consistent definition of non-central-government public-sector entities (PSEs) was needed. A restrictive definition, based on a power to tax is recommended (Japan strongly supports wider definition based additionally on provision of a public service function).

Unresolved points

1. In a club context, all members agreed that a standard weight for club PSEs was very desirable. There was disagreement on what that standard weight should be. However, two alternative propositions commanded a measure of support:€firstly, that the standard weight for all club PSEs should be 20 per cent but that federally constituted countries should have the option of applying the same weight to their provinces, cantons or lander as that applied to central government (i.e. zero); secondly, that the standard weight should be 10 per cent. 2. A proposal to apply a 0 per cent weight43 to all claims on central governments (club and non-club) denominated in local currency was 43 Or 10/20 per cent by those countries applying a proxy weight for interest rate risk.

222

Capital adequacy and the Basel Accord of 1988

discussed. In a club context, its purpose would be to reduce the discrimination against non-club countries; in a non-club context, its purpose was to encourage holdings of G-10 government securities against Euro-currency liabilities. It was concluded that the proposal might need further consideration, particularly if the Committee decided against a club.

Appendix L 1

The OECD/non-OECD distinction in the Capital Accord (BS/94/26)

As Governors are aware, the 1988 Capital Accord draws a distinction in the weighting between cross-border claims on OECD countries and Saudi Arabia (which receive a zero weight) and all other countries (which, generally speaking, receive a 100% weight). In the spring of this year Mexico joined the OECD and the Committee was faced with a decision as to whether or not Mexico should move into the privileged group (the present wording of the accord being ambiguous). This is the first time since the Accord was agreed that the OECD has been enlarged and further new members are imminent. This is, of course, a very sensitive issue politically, and the automatic inclusion of Mexico, in view of its debt performance record, would reinforce the grounds for protest by those countries excluded. The Committee has therefore decided that the matter needs to be resolved for the foreseeable future. Its conclusions, which offer two options for the Governors to consider, are recorded in the report attached. A first option would be to introduce only a minor change to the present arrangements in which present and future members of the OECD qualify for the low-risk group unless a country has rescheduled its official external debt within the previous five years. Indeed, the OECD membership criteria remain a fair proxy for countries with solid prospects of creditworthiness, and thus provide a legitimate basis for making the kinds of broad distinctions embodied in a risk-based framework. Several members continue to feel uneasy about maintaining a regime which excludes a number of highly creditworthy countries, and I am well aware that I will personally face some uncomfortable sessions with those who point out with some justification that the rule remains arbitrary and unfair. A second option, which would enable the privileged group to be enlarged with a number of non-OECD countries which meet certain objective criteria, has also therefore been explored and is

Appendix L

223

put forward for the Governors’ consideration. Unfortunately, despite much thought over the years, it has proved extremely difficult to define a set of such criteria which is both administratively workable and produces sensible results. The best formula the Committee has been able to work out so far is described in the report, but it has the drawback that a number of small countries would become eligible for the low-risk group. For the reasons above a sizeable majority of the Committee favours option one.

7

The Market Risk Amendment

A

Early work:€the Beverly subgroup

The BCBS was fully aware that the Basel Accord (1988) focussed almost entirely on credit risk, and indicated that it would undertake further work on interest rate risk and the investment risk on securities.1 Indeed, work on the assessment of such risks had begun several years earlier. Once again, the initial major paper on interest rate risk was put to the BCBS by a Dutch representative, Hugo Coljé, in mid-1985 (BS/85/36). At this point, it may be helpful to explain that there are several facets to interest rate risk. One facet relates to maturity transformation. Banks normally lend for longer periods than they borrow. If we assume that the relevant interest rates are fixed for the duration of such borrowing/ lending, then an (unforeseen) rise in interest rates will raise the cost of borrowed funds, in the interim before the loan matures, thereby reducing net interest income. Of course, both claims and liabilities may have rollover dates (at which the interest rate can be reset), or have variable rates, or be hedged, for example by interest rate swaps. So the maturity transformation related to interest rate risk measures the time elapse until the next readjustment of interest rates, which will be at most equal to, but often less than, the maturity adjustment ladder relevant for liquidity considerations, which were being simultaneously reviewed by the Musch committee on liquidity at the time (see Chapter€9). Such an interest-rate repricing maturity transformation ladder can either come Thus paragraph 7 of the Introduction to the Accord states that: 1

It should also be emphasised that capital, though important, is one of a number of factors to be weighed in assessing the strength of banks. The framework of measurement in this document is mainly directed towards assessing capital in relation to credit risk (the risk of counterparty failure) but other risks, notably interest rate risk and the investment risk on securities, need to be taken into account by supervisors in assessing capital adequacy. The Committee is examining possible approaches in relation to these risks.

224

Early work:€the Beverly subgroup

225

in a stock or a flow representation, though both should, if done correctly, come to exactly the same result. An illustrative example (Annex 2 of BS/87/34) is reproduced here as Appendix A to this chapter. Both the initial Coljé note and a supporting note drafted by one of his Belgian colleagues, Pierre Dubois of the Commission Bancaire (BS/86/3), focussed entirely on this facet of interest rate risk. But of course, such ongoing risks to net interest income were not the only risks arising from interest rate changes. An increase in interest rates reduces the current value of a marketable security. If a bank is subject to mark to market accounting, or is forced, for whatever reason, to sell the asset, its equity (capital) position is equivalently weakened. This was generally termed investment, or position, risk. Both net interest income and position (or investment) risk could be brought and assessed together. This could be done by applying a ‘Â�duration’ or an ‘economic’ perspective. Although technically much superior to a procedure of looking at maturity transformation ladders, or position (investment) risk on their own, such an ‘economic’ approach was dismissed on the grounds (mainly) that it was too complex and informationally demanding, especially for smaller banks (see for example BS/87/34 and BS/89/3).2 Moreover, as noted in paragraph 5 of the subgroup’s 1989 report (BS/89/3): The economic perspective is probably difficult to contemplate at present. However, approaches resting on accounting policies have their own difficulties.

Thus in their 1987 report, the Beverly subgroup (BS/87/34) commented (paras. 11–12): 2

An alternative and more sophisticated system of the measurement of income risk is sometimes referred to as the duration gap management system. This system was Â�originally developed for the analysis of portfolios of fixed rate securities. In this concept, duration indicates that for a given rise in interest rates the price of a short-term Â�financial instrument falls less relative to that of a long-term financial instrument. Hence, the interest sensitivity of net worth increases as the difference between asset and liability durations increases. In this way it makes it possible to calculate changes in the market value of fixed rate assets and liabilities, and thus changes in the net worth of a bank, as a result of an unexpected movement in market rates. The mechanism of a duration gap analysis is explained mathematically in Annex 3. For supervisory purposes, however, duration gap analysis is difficult to implement. It needs, in addition to dates of repricing, detailed information on interest rates, payment schedules and the current market value of fixed rate assets and liabilities. Moreover, it does not specifically identify mismatches which are concentrated within a specific accounting period and thus does not indicate the susceptibility of a bank’s profitability to movements in interest rates. Duration gap analysis does not appear to be as widely implemented by banks as the maturity ladder system and in principle a supervisory system for the measurement of interest rate risk should be capable of being

226

The Market Risk Amendment

It is relevant to note that accounting approaches do appear to vary amongst member countries. Even so, moving towards an economic perspective will give rise to significant issues for the accounting profession and for the supervisors’ relations with it.

From my own viewpoint (some twenty years later) this unwillingness to contemplate moving on to an ‘economic’ or a ‘duration’ perspective was most unfortunate, since such a perspective would naturally lead on to assessing the effects of shocks on banks’ portfolios as a whole, and would have brought regulators into much earlier contact with academic finance theory. Instead its rejection reinforced regulators’ predilection for maturity transformation ladders, and looking at individual ‘buckets’ of risk assets, rather than the portfolio as a whole. But we run ahead of the historical story. On the agenda for the (thirty-seventh) meeting of the BCBS on 27–28 February 1986, there was a slot (item VII) for a discussion on ‘interest rate risk’, to be related specifically to the Coljé/Dubois notes already mentioned. In the event, however, shortage of time prevented discussion, but ‘It was agreed that a small sub-group should be formed to examine this matter and to prepare a paper as a basis for an extended discussion at the Committee’s next meeting.’ This was to become the Beverly subgroup, John Beverly being a Bank of England official (perhaps yet another example of my earlier comment about the BCBS in its earlier years being an Anglo-Dutch cabal!).

related to banks’ own internal monitoring and accounting systems. It is for these practical and conceptual reasons that it is probably appropriate to seek to develop a supervisory framework of measurement on the basis of simple gapping analysis presented by way of a maturity ladder. And in their 1989 report, in Section III, (BS/89/3) the subgroup noted: III. The economic perspective 52. This approach focuses on the sensitivity of the value of an institution’s equity to future movements in interest rates. From an economic point of view, the value of shareholders’ equity is equal to the net total of the present values of cash flows arising from all assets, liabilities and off-balance-sheet contracts. An assessment of interest rate risk from the economic perspective corresponds to an assessment of the sensitivity to future interest rates of the net present value of all the future cash flows. 53. The approach for calculating interest rate risk under the economic perspective is in practice identical to the approach followed for the calculation of investment risk but taking into consideration all the financial instruments on and off balance sheet with the sole exclusion of capital. Thus, the calculation of interest rate risk using the economic perspective would yield the same results as the calculation of investment risk for an institution in which every item is marked to market.

Early work:€the Beverly subgroup

227

Anyhow, this newly established subgroup reported back with exemplary speed, by June (1986) (BS/86/37).3 Their terms of reference were (BS/86/37): To identify the issues for supervisors in developing a framework for the assessment of interest rate risk and to present the group’s conclusions to the Committee so as to provide a basis for discussion in the Committee on this subject.

They began their report by defining ‘interest rate risk’ thus`; At its simplest, interest rate risk has two elements. The first, referred to as income risk, is the risk of running losses in the stream of net interest income arising when movements in borrowing and lending rates are not perfectly synchronised. The second element, investment risk, is the risk of a fall in the market and book values of fixed rate investments when interest rates rise.

Having briefly reviewed the likely incidence of such risks and existing supervisory measurement and approaches to it (which were diverse between the different countries), the subgroup concluded with a series of questions for the main BCBS Committee: (i) Does the Committee agree that the incidence and significance of interest rate risks incurred by banks is such as to require a more systematic and thorough supervisory approach to its measurement and control than it has generally hitherto received? (ii) What do members feel about the effectiveness of their own approaches for monitoring interest rate risk? Do they agree that these are less than satisfactory? (iii)╇Does the Committee agree that a more systematic supervisory approach should include, as an important element, the introduction of reporting and measurement frameworks on the same lines as the Belgian and Dutch models? (iv) Does the Committee feel there would be value in the sub-group continuing its work with the aim of preparing an agreed supervisory framework for measuring interest rate exposures? (v) Would the Committee wish the sub-group to prepare a more general paper on interest rate risk for wider circulation to supervisors? (vi) Would the Committee see merit at some later stage in the sub-group examining the more sophisticated monitoring and control systems being developed by some major international banks, notably those which are increasing the volume of assets which are tradeable? These are sometimes referred to as ‘risk point’ systems.

Perhaps the speed of reporting back was enhanced by the more junior level of the officials involved in the subgroup. 3

228

The Market Risk Amendment

Note, in particular, query (vi), about approaching the major banks about their own control methods. From the outset the Beverly subgroup was much more open to communication and discussion with the major banks than had been the case in the run-up to the decisions on the credit risk weights in the Basel 1988 Accord. Not perhaps surprisingly, the BCBS accepted Beverly’s implied offer for his subgroup to do more work. Moreover, BCBS Chairman Peter Cooke amended Beverly’s list of queries into a more policy-relevant form, and asked members (BS/86/50) to reply to the following questions in July 1986: Do you think that a more systematic supervisory approach should include one or more of the following (please indicate your preference): (a) bilateral discussion between supervisors and banks about interest rate exposures; (b) examination by supervisors or auditors of the effectiveness of control systems to measure interest rate risk; (c) the introduction of standard reporting returns to measure interest rate exposures; (d) the introduction of limits and/or capital weighting on banks’ interest rate exposures. Do you feel that one objective of the sub-group’s work might be to seek to promote over time a degree of convergence in national systems for monitoring interest rate exposures? Would you favour as a product of the sub-group’s work one or more of the following alternatives: (a) an internal paper containing recommendations for an agreed framework for measuring interest rate risk for the Committee and perhaps ultimately for the Governors; (b) a more general educative paper on interest rate risk ultimately for wider circulation to non G-10 supervisors; (c) a paper on ‘best practices’ in measuring and controlling interest rate risk for banks (such a paper would be necessarily somewhat technical and would mean that the sub-group would need to examine the more sophisticated monitoring and control systems being developed by certain banks).

The next step of the Beverly subgroup was to prepare a position paper on interest risk for transmission to other supervisors, for example in non-G10 countries, and to major banks (BS/87/34), as foreshadowed in Beverly’s report to the BCBS at its (forty-first) meeting on 12–13 March 1987 (BS/87/28). The cover note to this discussion document is recorded as Appendix B. The document itself mostly concentrated on the net interest earnings risk and the maturity transformation risk, but did also discuss investment (position) risk, and also a means of integrating the two via

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‘a duration gap management system’, but then€– as already noted€– dismissed this latter as too complex and informationally burdensome. Not surprisingly, the banks that had been consulted were primarily interested in the ultimate purpose that any such measurement exercise might have4 (BS/87/81, November 1987). Thus (para. 7): Although the discussion document (cover note and paragraphs 42–44) made it clear that at this stage there was no suggestion of normative ratios, limits or capital requirements, this area represents a significant source of concern for the banks with which discussions were held. The precise use to which the information might be put, of course, influences the format of the measure. For example, if it is to remain a measure which is to serve as the basis for discussions between supervisors and the banks, the need to arrive at a single figure is less pressing. It might then be more appropriate to concentrate on mathematical modelling and sensitivity analysis which measures the impact of future interest rate changes rather than to devote attention to maturity gaps present in a bank’s books at the reporting date.

Indeed, the Beverly subgroup themselves felt that they could not sensibly proceed without some further direction about the end-purpose of the exercise. Thus they continued (para. 8): The ultimate use to which information on interest rate risk may be put is highlighted, not because the Sub-Committee has any definite views€– and indeed the issue has not been discussed in any depth€– but rather to illustrate the importance of this question in determining the direction of any further work which the Basle Supervisors’ Committee may commission. At the current stage of the work, members of the Sub-Committee take different views on the appropriate next steps. These views in part reflect the different stages which individual countries have reached in reviewing interest rate risk with their own banks.

They then suggested three possible alternatives: 1. to redraft the existing paper, in the light of the banks’ responses and then circulate it more widely as a public discussion document; 2. to do so, plus undertaking further work on systems of measurement; and 3. the ‘work might be extended from measurement to a consideration of the desirability of capital requirements as an extension of the existing work taking place on off-balance-sheet risks in the context of the convergence discussions’. Faced with this general request for guidance on the ultimate purpose of the exercise, the Chairman decided, after the Committee’s November 4 Though interestingly, ‘Some banks questioned whether greater emphasis might not be placed upon accounts which reflect the net worth of a bank by marking to market all assets and liabilities rather than just those for which there is an active trading market.’

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meeting, to revise the mandate of the Beverly subgroup (BS/87/90). In commenting on this new mandate, Peter Cooke noted that: The mandate of the Beverly sub-group invites it to continue to develop an approach to the analysis of interest rate risk (on and off the balance sheet) with particular reference to investment risk. If the sub-group is able to reach agreement on a system of measurement of interest rate risk, I would hope that, after suitable discussion in the Committee and with banks, it might form the basis for an approach to the monitoring and control of interest rate risk within or alongside the capital framework. The Committee’s objectives in this regard are, of course, already signalled in paragraphs 7 and 30 of the capital consultation document. The sub-group is, of course, presently only concerned with interest rate aspects of investment risk rather than the range of other considerations which affect the prices of securities, such as we have recently experienced in world markets. Assessing this wider position risk in investments seems to me increasingly important in the light of the trends towards the securitisation of bank assets and the growth in banks’ own securities trading. There are issues here that the Committee will need to address in due course.

In establishing the new mandate the Chairman signalled a shift away from the early focus on fluctuations in net interest income in traditional banking activities towards investment/position risk in newer trading activities. At this point, it should be noted that the field was getting more than a little overcrowded with overlapping BCBS subgroups. I have already noted the overlap between the maturity transformation ladder of net income risk and of liquidity risk (the Musch subgroup), but also there was the overlap with Peter Hayward’s off-balance-sheet exposure group, and with Danielsson’s foreign exchange risk group. After all, the investment, or position, risk on fx exposures was in principle amenable to exactly the same analysis as that on fixed interest rate securities. Moreover, the field was to become even more crowded. 19 October 1987 was the date of the crash on the New York Stock Exchange. With banks increasingly intermediating in capital markets, and taking up proprietary trading positions, they also stood at risk from their positions in equities. So yet another subgroup, under Michael Mackenzie of Canada, was established towards the end of 1988 to focus on investment/position risk in securities/equities. Indeed, the overall context was becoming even more complicated. In these first few years of dealing with interest rate risk, the exercise had been handled primarily within the BCBS. But particularly now that attention was to be given to banks’ trading position in securities/ equities, in addition to their positions in fixed interest instruments and foreign exchange, it was becoming impossible to ignore another

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level-playing-field issue, that was between investment houses, where the International Organisation of Securities Commissions (IOSCO) was the leading international forum for securities regulators, and the banks, where the BCBS had that role. The, somewhat difficult, relationship between IOSCO and BCBS forms one of the main themes of Chapter€13. We shall try to shift most discussion of this interrelationship to that chapter, but we cannot ignore it altogether here. Yet another cross-linkage was with the EC. It, too, was concerned about the treatment of interest rate and position risk for its proposed Investment Services Directive. The Secretariat wrote a nice note on this cat’s cradle of interrelating exercises (BS/88/105), which is reproduced as Appendix C. I cannot help wondering whether it was administratively sensible to maintain so many simultaneous subgroups, especially when the main issues of substance were as interlocking as those of the Beverly/ Danielsson/Mackenzie subgroups. To simplify and shorten this chapter a little, I shall continue to focus mostly on the interest rate risk subgroup. Armed with their new mandate, the Beverly subgroup, having met in January, March and July, produced ‘an analytical paper on banks’ exposure to interest rate risk’ (BS/88/91) in September 1988. This paper did ‘not make recommendations but rather [sought] to advance the analysis and discussion of a complex subject’. Beverly suggested that it might be circulated to member countries, which should be ‘free to issue the text in whatever way commends itself to them’. The text was, however, almost identical to that of its earlier work (BS/87/34) covering net interest income risk, via a maturity transformation ladder, and investment risk separately, with a brief, but dismissive, section on the concept of the duration (or economic) approach (paras. 12–13), plus a lengthy section on other relevant considerations, including foreign exchange risk (paras. 26–27), ‘structural aspects’ (paras. 28–31), ‘balance-sheet items with non-market rate characteristics’ (paras. 32–4), and so on. Perhaps more interesting were the subgroup’s thoughts on where the exercise might eventually lead. Here there was no general agreement. All favoured (BS/88/14, January 1988): (a) ‘an examination of banks’ own internal systems for monitoring and controlling exposure to interest rate risk’; and (b) ‘limits would be examined and perhaps, in time in some countries, set by [national] supervisors reflecting the differences in the characteristics of individual bank/categories of bank.’

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But only a minority wanted: (c) ‘capital requirements against interest risk positions. Some favoured this and others wanted to reflect shortcomings in the capital ratios expected of banks where this is legally possible.’ [NB:€ I do not understand the meaning of the second sentence.] The same divisions remained in September. So Beverly wrote (cover letter to BS/88/91) that ‘it will not be easy to resolve them [these divisions] in a technical sub-group. It is therefore for consideration whether it would be profitable to proceed further in the sub-group.’ At their next (forty-eighth) meeting on 11 October 1988, held in Tokyo, the BCBS agreed that the Beverly subgroup paper could be circulated ‘to selected banks or banking associations’, but also invited the subgroup ‘to prepare a short note for the Committee on the various options for developing a practical supervisory response to interest rate risk’. The Beverly subgroup responded with a paper (BS/89/3) on ‘Banks’ exposure to interest rate risk:€practical measurement methods’, covered by a letter from Beverly (22/02/89). This sets out three measurement alternatives: 1. the income risk approach, in maturity transformation mode; 2. the investment risk approach, on a present value basis; 3. an economic perspective, corresponding ‘to an assessment of the sensitivity to future interest rates of the net present value of all the future cash flows’ (p. 15, para. 52). A summary note of the main advantages and disadvantages of each approach was included as Annex 6, which is reproduced as Appendix D here. The subgroup noted that the measurements could be used for: 1. observation ratios; 2. limits; or 3. capital ratios. In his covering letter, Beverly commented that: The sub-group has not felt it right to offer a view now on which of these three approaches should be favoured and it may be that there could be some progression, ratios and/or limits being employed while further experimentation with the methodologies is carried out, with a longer-term aim of capital requirements when there is greater confidence in the methodologies. This particular issue is therefore not addressed extensively in the report. (I might observe, however, that if ‘convergence’ with securities supervisors is deemed desirable, then capital requirements must be envisaged at some stage.)

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This latter point is perhaps a good place for the Committee to start. Is it regarded as desirable to seek convergence with securities supervisors? If this is so, then capital requirements will probably be the inevitable goal. Moreover, this line of approach favours an economical perspective (as described in the report and the sub-group’s earlier work) or at the very least an investment risk approach. I should note at this stage that the sub-group’s thinking has continued to evolve and support for an economic perspective has tended to grow, even since the analytical paper was agreed. The economic perspective is probably difficult to contemplate at present. However, approaches resting on accounting policies have their own difficulties. It is relevant to note that accounting approaches do appear to vary amongst member countries. Even so, moving towards an economic perspective will give rise to significant issues for the accounting profession and for the supervisors’ relations with it.

This paper was, in fact, Beverly’s swan-song. At the next (fiftieth) meeting of the BCBS (9–10 March 1989) the Committee agreed that the report could be circulated, but only to the relatively ‘few banks involved in the testing’ (BS/89/20). Meanwhile, ‘it was agreed that work should continue along the lines proposed and that the sub-group should be invited to carry out some testing of the alternative measures set out on its paper.’ Possibly because of some initial confusion when Peter Cooke handed over to Huib Muller as Chairman at the end of 1988, it was initially not clear what, if any, was to be the remit of a continued (interest rate) subgroup. Thus, in January 1989 M Lieuze of the Commission Bancaire in France wrote to Stig Danielsson to state, inter alia, that: Opening the last meeting of the sub-group on interest rate risk (15–16 December 1988), John Beverly announced the dissolution of the sub-group and the pursuit of its work by the sub-group on position risk. According to the terms of reference of this new sub-group [subsequently recorded in BS/89/32], it is not obvious that it will consider the interest rate risk, specially as far as income risk is concerned. We take note that Mr Beverly is no more willing to chair the sub-group but, for the time being, the Committee has not decided to stop working on the important matter which is, for a bank, the interest rate risk.

The demise of the interest rate subgroup was prematurely recorded. When Muller became Chairman, the subgroups continued, but both the interest rate and the position risk subgroups chairmen changed, Beverly giving way to Giovanni Carosio, from the Banca d’Italia, and Mackenzie to Roger Barnes of the Bank of England. During his period in office Beverly had followed a relatively nonÂ�interventionist approach, trying to involve the commercial banks as far as possible in the design of measurement systems and their application in internal control mechanisms, and being sceptical of the utility of imposed (convergent) CARs in this context. This predilection was not to last.

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B

General and specific risk classifications for asset classes:€the work of the Carosio subgroup, 1989–1993€– difficult relationships with IOSCO

Initially the work of the interest subgroup continued along the lines already laid down. The September 1988 consultative paper (BS/88/91) was circulated to a set of banks and they were asked to send back data on their maturity transformation, divided by: 1. marked-to-market items: (a) in trading portfolio; (b) not in trading portfolio; and 2. all other items. In addition banks were asked to comment on: (a) data compilation problems; (b) their internal risk control methods; (c) how they separated their dealing and investment portfolios; (d) whether they calculated both net interest earning and investment risk; and (e) their treatment of options. The paper commented: (i) The collection of the information necessary for risk measurement appears feasible, but requires considerable investment on the part of banks in order to achieve sufficient accuracy and uniformity; in particular, full consolidation is at present beyond the reach of most banks. (ii) The reporting format devised by the sub-group will require some refinement in specific sections such as off-balance-sheet items and administered-rate retail activities; in the latter case the main problem is that contractual maturities do not reflect probable responses to market rate movements and may therefore give a distorted picture of risks arising from mismatches. (iii) There are very large differences at present among the banks’ own internal risk monitoring systems, though all banks use some form of the maturity ladder system. The general trend is, however, towards increasing sophistication and increased data availability. (iv) Banks clearly perceive the importance of having adequate systems to monitor interest rate risk. But what is more interesting is that banks appear to consider accuracy in measurement a necessary condition for the exercise, given its costs, to be worthwhile. They suggested refinements and additions in the reporting scheme more often than simplifications. (v) Should the Committee decide (after the form has been revised) to implement regular reporting, it would still need to allow the banks considerable time to adapt their system.

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Having reviewed the results of the questionnaire, the subgroup then notes its intention to abandon its prior methodologies, as already reported, in favour of an entirely new approach, set out in an influential Bank of England paper dated 28 July 1989 (BS/89/68). This presented: a prototype scheme for a capital adequacy test for banks that integrates the non-credit risks above (interest rate risk, position risk on equities, and foreign exchange risk) with the credit risk framework set out in the Agreement. This prototype scheme for an ‘integrated test’, which builds on the work of the three sub-groups and on the methods used by UK securities supervisors, is set out in this paper, and comments on it would be most welcome.

Since this approach then became dominant in the BCBS’ work over the next few years, it needs to be recorded in some detail: The scheme starts from the Basle Convergence Agreement of July 1988 and its credit-risk framework for banks’ capital … It then develops this to capture both credit and position risk, in a way that does not favour one accounting method above another and that achieves broad equivalence with UK securities supervisors. In summary, the scheme attributes a risk asset value to position risk, which is then allocated to the 100% risk-weight category in the Basle framework. This risk asset value is derived by the application of ‘Position Conversion Factors’ (PCFs) to the relevant positions. In return for these extra risk assets, some modifications to the credit-risk frame-work are suggested. The scheme captures interest rate risk by replacing the ‘national discretion’ proxy 10/20% weights for government securities by a more wide-ranging measure derived from a maturity ladder incorporating all interest rate dependent items, including those off-balance-sheet. This is accompanied by a partial modification of the Basle credit-risk frame-work, decreasing the credit-risk weight for high-quality traded debt securities. Equity position risk is captured by a complete replacement of the current approach to equities (i.e. a 100% weight applied to gross long positions). The scheme introduces a high basic PCF for equities (130% if liquid, 200% or 300% if illiquid), but allows a reduction in the 130% PCF for a diversified trading portfolio of liquid equities (to a possible minimum of 25% for a diversified portfolio of long positions offset by some short positions). Exchange rate risk is captured by allocating a measure of aggregate foreign currency exposure to the 100% risk-weight category. This would be additional to the current Basle frame-work (although such an approach is already a ‘national discretion’ item€– which the UK will be taking up). The measure of exposure could be the UK measure, or an alternative agreed by the Danielsson sub-group. At its simplest, the interest rate risk on a single item (loan/deposit/gilt/ etc.) would be derived by placing it in a maturity-ladder according to its next Â�interest-rate refixing date (as in the Beverly/Carosio group’s approach), and weighting it in a way that is representative of the weight UK securities

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supervisors apply to gilts. In effect the interest rate risk on an item is taken to be that on the equivalent gilt, and is supplementary to the credit risk on the item. A suggested set of maturity-bands and weights, termed ‘position conversion factors’ or PCFs (analogously to the ‘credit conversion factors’ or CCFs already used by Basle), is given below derived from the maturity-bands used by the Beverly/Carosio group in their current data-collection exercise and the ‘haircuts’ used by Wholesale Markets Supervision Division … Position conversion factors for interest rate risk Maturityband PCFs: WMSD haircut*

Sight

0–3m

3–6m

6–12m

1–2y

2–5y

5–10y

10–20y 20y+

0%

5% 0.5%

10% 1%

15% 1.5%

20% 2%

30% 3%

40% 4%

50% 5%

60% 6%

* for gilts excluding the 0–1 month band

Thus, for a single item, its value would be multiplied by the PCF appropriate to its maturity-band and the result allocated to the 100% risk asset weighting category. This interest rate risk asset would be additional to any risk assets resulting from the current Basle credit-risk framework (except for traded highquality debt securities). The PCFs have been chosen so that, for a bank with a 10% risk asset ratio requirement, a single gilt would attract the same capital requirement under either the banking or securities regimes (10% of the PCFs being exactly equal to the ‘haircuts’). To the extent that a bank has a required capital ratio above 10%, the banking capital requirement increases significantly€ – banks in the range 8–10% receive a slight benefit over the securities regime. As noted in the annex, this is a consequence of the fixed capital requirement of securities supervisors compared to the more judgmental approach of the banking supervisor. Hedging allowances The key question then to be addressed is the extent to which the hedging beneÂ� fits of assets against liabilities (and long against short positions) is recognised. For example, should a loan and deposit in the same maturity-band give rise to no interest rate risk (although, unless exactly matched, there is still some residual risk)? What if they were in adjacent maturity-bands, or very far-apart maturity bands? Should long/short positions in corporate debt securities be treated any differently? For a bank’s traditional lending and deposit-taking business, adding the interest rate risk weight to the credit risk weight would reduce a bank’s risk asset ratio. This is arguably severe, and may lead to pressure to reduce the Basle minimum ratio of 8%. This would be unwelcome, and a better alternative would be to allow fairly generous hedging in the interest rate risk measure. Severe mismatches would still show up, both in the capital requirement (even after hedging) and by examination of net interest income or selected yield data (as suggested in paragraph 4)€– and limits could be imposed on the

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mismatches that banks can run (e.g. on the weighted net positions in each maturity-band). For a bank’s securities-trading business, a less generous and more sophisticated approach to hedging is required€– something much closer to that used by securities supervisors. This is business that is not well-caught by the current Basle framework, although Basle’s credit-risk weight will be very severe for, say, a short-term corporate debt security compared to a securities regime. This is an inevitable consequence of the fact that Basle weights short-term exposures to prime corporate customers at the same 100% level as long-term loans to less credit worthy customers. It may be reasonable here to decrease the credit risk weight applied to the gross long position in high-quality debt securities. For banks that have both traditional and securities-trading business, different hedging rules would therefore be applied. As it is usual for banks to markto-Â�market assets and liabilities arising in securities-trading, marking-to-market could be a convenient way of distinguishing securities-trading activities (with some flexibility in particular cases e.g. where items not marked-to-market are of a securities-trading nature). This would link in well with the Beverly/Carosio group’s data-collection exercise, where marked-to-market items are clearly identified.

Having viewed the Bank of England’s paper, as well as the questionnaire responses, the Carosio subgroup went on to comment (BS/89/100) that: Having taken stock of these results, the group decided that to improve the reporting scheme it would be necessary first to have a clearer idea of how the data would be used. It therefore went on to discuss how to proceed in the next stage of its work, which is to select and recommend a measurement system suitable to yield an observation ratio or for use in the implementation of a prudential requirement on interest rate risk. As an introduction to this subject, the Bank of England’s method of measuring interest rate risk, presented in its paper on a proposed integrated capital adequacy test, was closely scrutinised. Different opinions were aired on some of its features. Nonetheless, most members found the scheme to be useful in that it set out the elements that have to be taken into consideration in order to derive a single figure, representing interest risk, from the various amounts slotted in the reporting form. On this basis, it was recognised that the general problem consists in devising rules on the extent to which positions in different time bands or in different groups of assets and liabilities should be offset and, further, that this should reflect the assumed correlation in interest rate movements between different currencies, segments of the yield curve, and groups of financial assets and liabilities. Consequently, a number of such rules were identified as representing possible assumptions and the Secretariat was asked to test them on the actual data provided by the banks. The testing will also incorporate some behavioural assumptions on the lagged responses of depositors and borrowers to market rate movements.

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The Bank of England prototype paper had many clear advantages: 1. it meshed extraordinarily well with the approach taken for credit risk in the 1988 Accord; 2. it unified the methodology for handling interest rate, position and foreign exchange risk; 3. it seemed, at the outset at least, more capable of being acceptable to, and consistent with, IOSCO’s methods for applying CARs to investment houses; and 4. it seemed not too difficult to introduce. That said, it also reinforced many of the weakest points of the Accord: 1. It was based on an asset by asset (building block) approach rather than with regard to the portfolio as a whole (to which, with the eye of faith, the economic approach of the Beverly subgroup might have led). 2. The position conversion factors (and allowable offsets) were based on seat-of-the-pants subjective judgement without any attempt at empirical justification. 3. So, while the prototype had advantages in practical convenience, it had no justification in academic (portfolio finance) theory, nor empirical support. Nevertheless, in a contest between patent practical convenience and (dimly understood) academic theory, the former is likely to succeed within bureaucracies. The various subgroups, for interest rate risk (Carosio), equity position risk (Mackenzie/Barnes) and exchange rate risk (Danielsson), took up, ran with and developed this Bank of England initiative enthusiastically. This was done early in 1990. Thus the Carosio subgroup (BS/90/7) suggested that the basic characteristics of a measurement scheme would be: (1) The banks would submit to the supervisory agency their interest rate positions on the maturity ladder report; (2) the total gaps reported at the bottom of the form, after netting the amounts in the individual time bands, would be multiplied by pre-defined weighting factors; (3) the weighting factors are based on the estimated duration and volatility of interest rates in the time bands; the longer the duration, the more sensitive, or risky, is the price of an item; (4) partial or full offsetting would be permitted between different time bands; (5) the resulting number could then be related to a bank’s capital or assets to give an index that permits comparability among different banks.

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By the same token, the Mackenzie/Barnes position risk subgroup explored alternative weightings for specific (individual, gross) equity holdings, as well as general net (after offset) positions (BS/90/8). No doubt the Danielsson committee did much the same, as indicated in the section on foreign exchange risk in the BCBS’ note on ‘The supervisory treatment of market risks:€an interim report’ (BS/90/26), Section II, pages 11–16 and also the note on ‘Foreign exchange risk-residual questions’ (BS/90/20). Basically, in all cases the same general approach was taken. First, an estimate was made of all (gross or specific) open positions (in fx; in fixed interest securities by maturity band; and in equities, whether long or short); then an estimate is to be made of allowable offsets, for example within and across maturity bands, to reach a figure for the net (or general) position in each case. Having got the data for gross (specific) and net (general) positions, the final stage would be to decide on the capital ratio to be applied to each gross (specific) and net (general) position. But this latter was to be the final step in the exercise. First, the BCBS wanted to consult more widely on whether their new methodology was acceptable. For this purpose a general paper on ‘The supervisory treatment of market risk:€an interim report’ by the BCBS (BS/90/26) and a supporting paper by the Carosio subgroup on ‘Banks’ exposure to interest rate risk:€ a proposed measurement scheme’ (BS/90/27) were prepared in July 1990. In the Introduction to the BCBS paper, the Committee noted: The conceptual and technical problems which arise in the measurement of market risk are often complex. In many areas of this paper, work is still in progress. The concepts are therefore not wholly fleshed out and the views expressed are thus less definitive than the Committee’s 1987 proposals in respect of credit risk. Nonetheless, the Committee believes that the time has come to report on the progress made to date and to invite comments from supervisors of banks in non-G-10 countries and from the regulators of major securities firms. This paper is designed to be discussed at the sixth International Conference of Bank Supervisors in Frankfurt in October 1990 and at the autumn meeting between representatives of the Basle Committee and G-10 securities regulators.

At the subsequent (fifty-fifth) meeting of the BCBS, at Ottawa on 31 May–1 June 1990 (BS/90/49), the Carosio subgroup was asked ‘to investigate the possibility of developing an instrument for weighting banks’ trading positions in debt securities to facilitate convergence with the rules of securities regulators’. The subgroup responded quickly with a paper on ‘Alternative treatments of debt securities in the trading book’, dated September 1990 (BS/90/52). In this, the subgroup favoured a ‘building block’ approach. Thus, the note reported (paras. 10–14):

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The Market Risk Amendment

An alternative to the comprehensive approach used by securities regulators is what could be called the ‘building block’ approach. Rather than setting composite capital requirements that cover a multitude of risks, one could design distinct requirements for each risk. Assuming credit risk and interest rate risk were to be the only risks covered, one could first apply a credit risk weight based on the credit quality. An interest rate risk weight could then be added on.5 For example, a government security maturing in 20 years might be judged to have zero credit risk, but carry a 5% requirement for interest rate risk. A high quality 20 year corporate might have a credit risk weight of 3% plus the same 5% for interest rate risk, or 8% total. Finally, a low quality corporate might have a credit risk weight of 10% plus the 5% requirement for interest rate risk, or 15% in total. It should be noted that the Bank of England, in its supervision of non-bank market makers in sterling and foreign exchange money markets, actually has implemented and now uses a system based on these principles. A system quite similar to that generally described above has been proposed by the Dutch member of the group, and is the basis for the scheme described in the second portion of this paper. One benefit of segregating risk components in this manner is that it simplifies the discussion of offsetting allowances. If one has long and short positions in different securities, the interest rate factor may be identified and segregated. Offsetting that component of risk then becomes a question of the degree of interest rate correlations. The credit risk factor, having only minor relation if any to the level or direction of interest rates, could not be offset. [A reader of this statement today might not agree with this comment!] Closely related, such a system might more readily permit the integration of trading and other activities of a bank, because the interest rate weights for both the trading and banking books could be measured on the same basis. These weights would not be dependent on having readily observed market prices, which usually are not available for assets and liabilities other than securities. The major difficulty with this type of system is actually deriving the appropriate risk weights. Whereas the comprehensive approach relies on price volatility, the building block approach may rely more on judgement and the critical assumptions that would be required in assessing which portion of risk should be assigned to credit risk and which to interest rate risk.

Moreover (para. 28): Under the building-block approach, separate capital requirements would be applied to cover specific risk and general market risk. The Committee will recall that a similar distinction has been made in the proposals of the sub-group on traded equities. In the context of the debt portfolio, specific risk is very similar to credit risk. However, it is broader than credit risk because a capital requirement would also apply to short positions (i.e., the risk that the creditworthiness 5 [Footnote in original text] Where the security is denominated in a foreign currency there is a third ‘building block’, namely foreign exchange risk, which is being treated in the subgroup on off-balance-sheet exposures.

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of the issuer will improve). General market risk refers to the risk that the market price of the security will change because of movements in interest rates, or what has been referred to in earlier papers of the group as general interest rate risk.

The BCBS wrote to the President of the G10 governors, then de Larosière, in June 1990 (BS/90/53), covering the note on market risk (BS/90/26) and recording two main concerns: 1. The need for consistency with: (a) the EC and its prospective directive on CARs for both banks and investment houses; and (b) IOSCO, especially so that there should be a level playing field with investment houses; and 2. that ‘applying capital weights for market risk in addition to the present weight for credit risk [should not] be an undue burden for some banks striving to meet the end€– 1992 deadline’. At their meeting on 20–21 September 1990 (BS/90/76): banking supervisors and securities regulators of the Group of Ten countries considered the possibility of devising a common system of measuring risk and a minimum set of capital adequacy requirements which could be applied to the securities business of bank and non-bank securities companies. Participants reached a general consensus as to the way forward and this is set out in this note … Participants concluded that a building-block approach was likely to be the most effective way of achieving convergence, given the need of the banking supervisors to be consistent with their existing capital requirements which are primarily based on credit risk and do not yet take account of market risk. Inasmuch as such a disaggregated approach has not yet been applied to the books of participants in securities markets, it would need to be tested before supervisors could apply appropriate quantities to the concepts involved. The building-block approach would involve separate requirements for general market risk, that is the risk to a regulated entity’s earnings and capital of an adverse movement in interest rates or the equity market, and specific risk, that is the risk of an adverse movement in the price of an individual security relative to rates or prices generally. Specific risk is essentially credit risk, but reflects changing market perceptions of the quality of the issuer, in either direction.

Meanwhile, the first stirrings began to be heard that the ‘building block’, ‘specific and general’, risk approach, with ad hoc judgemental weights, was falling behind the risk control methods adopted by the banks themselves. Thus, Stig Danielsson, Chairman of the off-balance-sheet subgroup, reported to the Chairman of the BCBS (BS/90/66) in a letter covering a paper on ‘The measurement of foreign exchange risk’ that: It has been difficult to present a balanced report on this topic because views in the sub-group are strongly divided on the practicality of applying

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The Market Risk Amendment

a ‘benchmark’ measure of foreign exchange risk. We are well aware that the major banks use advanced statistical techniques to measure and control their own risk profiles, but several members of the sub-group are convinced that this is not a suitable basis for devising a supervisory instrument. A minority, as you are aware, believe that failing to use a sophisticated measure will damage the level-Â�playing-field concept. A middle group is in favour of discussing the matter further to see whether a viable system can be devised in which banks (or supervisory authorities) would have the option of applying the simple measure or the benchmark (or perhaps some approximation of the benchmark).

In the main text the ‘specific/general’ with judgemental offsets and weights was contrasted with: The second idea, which is the focus of this report, is a fully developed statistical analysis using a ‘benchmark’ measure of risk derived from finance theory. The benchmark is a statistically-based measure that uses finance theory to gauge the level of risk inherent in a portfolio of currencies. The measure estimates, in terms of a domestic currency, how much the value of a given portfolio of long and short positions in foreign currencies is likely to change. The benchmark approach calculates the variance in the market value of a given foreign currency portfolio using standard statistical techniques. The square root of the variance is then calculated, which is called the standard deviation or benchmark. These changes in the value of a foreign currency portfolio are measured in percentage terms relative to the domestic currency investment in a foreign currency (para. 5).

As subsequently noted (paras. 15–19): The benchmark does, however, have conceptual and policy drawbacks, as well as involving considerable statistical work. On conceptual grounds, while clearly superior to the shorthand measure, the benchmark uses historical movements in exchange rates to represent future movements. Much depends on the technical specifications referred to in paragraph 9 and 10 above [on historical observation periods and time horizons], particularly the number of years observed. An underlying assumption is that exchange rate volatility will maintain a similar pattern as it has done over the observed period. However, some members believe that this fails to take account of the nature of markets, where sudden changes of fashion can and often do occur. Banks which have been encouraged by low capital weights to take large positions in closely-correlated currency pairs may then have a risk concentration problem if volatility increases significantly. Conversely, since the benchmark measure tends to discourage position-taking in volatile currency pairs, the market for these cross-rates might become thinner, tending to increase their volatility. The increased volatility, and the subsequent increase in capital requirements, might further discourage position-taking in these crosses, reinforcing the process. At the policy level, the application of the benchmark would represent a deliberate decision by the Committee to replace a neutral measure with a measure which, albeit for good reason, discriminates for or against certain currency patterns. In doing so, it will give banks an incentive to take positions in those

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currency pairs which have historically been well-correlated and encourage them to regard such positions as riskless. This would be a dangerous message. Moreover, it may prove difficult to reach agreement in the Committee on the statistical specifications, since they will have a significant effect on the capital levels required of different classes of banks. However well-specified, the statistical assumptions will be open to query. Several members of the sub-group feel that the process would give the Committee too high a profile in risk management (since it would be interpreted as instructing the banks on how to manage their risk on a micro level) and would introduce excessive complexity at odds with most other elements of the present capital framework.

Despite this shot across the bow, work continued on the building-block approach, as noted for example in the short summary of the (fiftyseventh) meeting of the BCBS, on 13–14 December, agenda item III. For example, for traded debt securities two papers taking forward the ‘building block’ approach were contributed in 1991 (i.e. BS/91/9, 22 February, and BS/91/65, 20 August). The main problem in 1991/92 was trying to agree a position with IOSCO on a consistent treatment for banks and non-banks (e.g. investment houses) on CARs for their trading books. There were many such meetings. Initially they did not go well (as discussed further in Chapter 13), but then the issue seemed to be resolved in a joint meeting of principals of the Technical Committee of IOSCO and the BCBS on 28–29 January 1992, which resulted in the issue of a press communiqué (29 January) by Gerald Corrigan, by then Chairman of the BCBS€– following Muller’s death in office, and Richard Breeden, Chairman of the Technical Committee of IOSCO, who was also then Chairman of the Securities and Exchange Commission (SEC) in the USA. This press communiqué is reproduced in full in Appendix E. Basically the meeting agreed to the ‘building block’ approach to traded debt securities (subject to a reservation by one country and allowance for use of a ‘duration’ methodology if this generated equivalent capital charges), and to the similar ‘general’ and ‘specific’ risk approach for equity securities. ‘Substantial progress’ was made on ‘mutually acceptable’ definitions of capital. Following this, it was hoped to issue ‘publicly consultative papers in the summer of 1992’. This was, however, not to be achieved. A draft consultative paper for banks, prepared by the Secretariat in April 1992 (BS/92/20) and subsequently revised in June (BS/92/65), was sent to the IOSCO, to form the basis for an agreed joint position. Although in some instances the BCBS had (reluctantly) acceded to IOSCO’s preferences, for example to use short-term subordinated debt (with an adequate lock-in clause) as additional capital backing for their trading book positions, up to a limit (a new Tier 3), viz. a note by the BCBS Secretariat on ‘Position

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risk€– the definition of capital’ (BS/92/13), the Technical Committee of IOSCO (and its principal member, the SEC) must have reconsidered that it had given away too much ground. The report back to the BCBS Secretariat (BS/92/75) was that the BCBS’ paper was not even discussed. There was no assurance that the Technical Committee would resolve the issues in the near future. No work was planned by them before the autumn of 1992. There were, the Secretariat suggested, in its 31 July paper, three options: (1) Wait until IOSCO does respond Mr Breeden’s term of office as Chairman of the Technical Committee expires at the IOSCO annual conference and it is possible that a new Chairman may be more interested in reaching agreement on convergence. However, continued opposition from the SEC could clearly prevent agreement from being reached in the Technical Committee. It now seems unlikely, therefore, that IOSCO would be in a position to respond before the end of 1992 at the earliest and the delay could well be much longer. Moreover, in the absence of pressure from the bank supervisors, the commitment of those securities regulators who are interested in convergence could wane.

Moreover, the EC were intending to push rapidly ahead with their own Capital Adequacy Directive (CAD), and, unless the BCBS moved fast, the EC could become committed to a different set of rules than the BCBS preferred (Corrigan had written to Sir Leon Brittan on 4 June (BS/92/64), asking him to prevent the EC moving precipitately to their own CAD). In addition, the earlier press communiqué (Appendix E) had publicly announced a prospective timetable. Finally, many in the BCBS were of the view: that there is little scope for further work in the Committee without the benefit of the views of the market and delay will simply deprive the Committee of those views for an indefinite period, thereby bringing the Committee’s own work to a halt. (2) Publish the consultative papers now The second alternative would be to proceed with publication of the consultative papers in September, subject to the G-10 Governors’ approval. Of course, the consultative exercise could no longer be described as a joint set of proÂ�posals. But the introductory paragraphs could make clear that they were designed to be implemented by both sets of regulators, that various securities regulators had participated in their preparation, that the development of the proposals was not complete but that the Committee had reached a point where the absence of the views of the market and of supervisors outside the G-10 meant that remaining differences were difficult to resolve. It might be necessary to make some further refinements to the language in order to give the documents even more of a consultative flavour, perhaps even at the cost of some of the precision Â� that is in the papers now.

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The advantage of this approach is that momentum will be maintained, market views and non G-10 supervisory views will be elicited, pressure on the Technical Committee will be maintained, the danger of the EC going it alone will be reduced, and the Basle Committee will retain the initiative. There are, however, disadvantages or at least awkwardnesses in producing proposals which it is hoped will be applied to institutions for which bank supervisors have no direct responsibility. There is also a danger that some securities regulators would find the approach unhelpful and discourteous. (3) Redesign the proposals to apply to banking groups alone The third option would be to abandon the attempt to achieve convergence with securities regulators on a global scale and return to the original objective of amending the 1988 accord to incorporate the treatment of market risks for banks alone. Some members have already indicated that they would wish any such proposals to be radically different from the present draft proposals, as many of the complexities have only been accepted as the price for convergence with securities regulators. There would also be less support for an amendment of the definition of capital to include short-term subordinated debt. But this option would make the resolution of the EC’s compromise much more difficult. The Capital Adequacy Directive would then appear more obviously to be a unilateral departure from the 1988 accord and, in the absence of the prospect of a similar amendment to the Accord by the whole Committee, less acceptable to non-EC members.

At its subsequent (sixty-fourth) meeting on 1 September: The Committee reviewed its position following the Quebec meeting of the Technical Committee of IOSCO. The Chairman said he had not yet received formal notification from Mr Breeden, but informal accounts suggested that the meeting had failed to generate a positive response. Following discussion of the options set out in BS/92/75, the Committee agreed that the Chairman should write to Mr Breeden indicating that the Committee was minded to issue on its own authority a consultative document based on the draft in BS/92/83 (but with the adoption of Tier 3 capital contingent on an agreement with IOSCO), unless the Technical Committee indicated before the paper was presented to the Governors on 9th November that it was prepared to resume discussions with the intention of proceeding to the issue of a joint consultative paper in the near future. It was further agreed that, if such discussions did not produce early results, the Committee would reserve the right to proceed with consultation on its own. A draft of the Chairman’s letter and a further version of the consultative paper (BS/92/83) redrafted to reflect the discussion would be circulated for members’ comments. If questions of substance remained, there would be an opportunity to reconcile them at the meeting of the Carosio group on 16th and 17th September.

By the date of the next (sixty-fifth) meeting of the BCBS, 2–3 December 1992, the Committee had received a letter from Mr Breeden. One of the concerns of the Technical Committee of IOSCO was that the different

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regimes envisaged for tradable debt securities, dependent on whether they were held in banks’ trading or banking books, might give banks an edge over investment houses in this field. So: it was agreed to conduct a survey of member countries’ rules and practices governing the allocation of government securities to banks’ trading and investment accounts.6 The Chairman said he would send a letter to Mr Saint Geours, the new Chairman of the Technical Committee, saying that the Committee was considering both the trading/investment account and the criteria for subordinated loans and would wait for proposals from the Technical Committee concerning equities (see BS/92/112). There was some reason to hope that the Technical Committee’s meeting in February would produce results, following which a joint meeting at the time of the Committee’s March meeting or shortly thereafter could be arranged to finalise the package.

In the event, the Technical Committee of IOSCO was not able to reach an agreement on the capital base for equity position risk at its February 1993 meeting (BS/93/8). Despite its own misgivings about its prior compromise with IOSCO on the use of short-dated subordinated debt (up to certain limits) as capital backing for banks’ trading books (Tier 3), the BCBS decided to stick with this in the consultative document (in the hope that this might make it easier for IOSCO to come alongside later). It was also needed as an input into the EC CAD, which would apply jointly both to banks and to investment houses within the EU. So the way was now open to the BCBS, after consultation with the Governors in mid-April, to issue by itself (and not jointly with IOSCO as had earlier been wished) a tripartite consultative document on ‘The prudential supervision of netting7, market risk and interest rate risk’. This was done on 30 April 1993 under cover of a press statement and an accompanying introductory overview. The key paragraphs in the overview on market risks and interest rate risk are reproduced as Appendix F. Whereas initially (in 1985/86) the focus of work had been on net interest income risk, this was now a rather secondary concern; the Basel Committee now only sought ‘to develop a [common] measurement system rather than an explicit capital charge for interest rate risk’. Instead the focus of concern had shifted to market (position/investment) risk in banks’ trading books. The consultation period with banks was to last until the end of 1993, so very little more was done on these subjects (i.e. netting, market risk and interest rate risk) during the remainder of this year. Even before the A questionnaire on this was sent to banks in December 1992 (BS/92/113). 7 The work of the BCBS on netting is discussed separately in Chapter 10. 6

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end of this consultative period, however, it was becoming apparent that many of the major international banks felt that they had much better (more ‘sophisticated’) models for assessing and controlling market risk, and indeed also interest rate risk, than that proposed in the consultative document, so that forcing all banks to converge to the latter would be a retrograde step. It is to this issue that we now turn. C

The use of internal models for regulatory purposes:€the Market Risk Amendment of 1996

Until this time (early 1994) the BCBS had been used to having its major proposals (e.g. Concordat and consolidation, the 1988 Accord) received with approbation, even applause, by the international banking community, as well as by the wider grouping of world supervisors (as represented by the ICBS). It must have been disconcerting for them to discover that the world’s major banks found the BCBS’ proposed methodologies old-fashioned.8 In some part the BCBS had been so boxed in by quasi-political constraints on determining supervisory regulations for market and interest rate risk (e.g. the need for consistency with the prior Accord; the need to achieve agreement not only within the BCBS itself, but also with the EC and IOSCO) that it had somehow failed to take notice, or sufficient account, of the considerable advances being achieved by the major international banks on modelling their own internal risk. The banks were now applying both up-to-date academic (portfolio) theory and empirical measures of risk, for example based on historical data on volatilities and correlations. The BCBS proposals had no backing in either theory or empirical evidence. The BCBS had been looking inward within the regulatory community, rather than outward to the innovations in risk modelling achieved by the major banks. Admittedly the adoption of these new risk measures, generally based on ‘value at risk’ (VaR) measures, had only occurred recently, and the pace of innovation had been swift, but quite how and why bank supervisors, or at least those represented at the BCBS, appeared to have become so out of touch with banking best practice, is not easy to understand.9 The BCBS were aware of the existence of models of this kind, but had assumed that they had been used to design trading models, not for capital adequacy and allocation. I am grateful to Charles Freeland for this information. 9 Charles Freeland has told me that there were representatives on the subgroups, if not on the main Committee, of the BCBS who were conversant with such modelling practices, people such as Dino Kos, Chris McCurdy and Carol Sergeant. He attributes the differences in approach more to the predilection of certain members of the BCBS, and of IOSCO and SEC, than to the BCBS’ maturity mismatch mechanism. 8

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To their credit, however, officials at the BCBS immediately recognised both the validity of the banks’ complaints about the consultative document, the superiority of the banks’ own techniques and the need for regulators to learn and master the new modelling techniques. It is always difficult for any set of authorities to eat ‘humble-pie’ and to accept external criticism, and it is praiseworthy that the BCBS did so, though admittedly more openly so in their internal papers than in their public response. Two examples are given; the first is taken from the summary paper of the Secretariat (BS/94/14) on ‘Market-risk€ – further steps’ intended to guide discussion at the March (1994) meeting of the BCBS. This is shown below. The second contains the main responses of the Carosio subgroup (BS/94/1) to the banks’ comments on ‘Market risk’. Since the second overlaps with the first, it is reproduced as Appendix G. So, from the Secretariat’s paper, it was stated that: A common response, at least from the major trading banks, has been that the frameworks developed by the Committee for measuring market risk are at the same time complex and inaccurate. The frameworks are further criticised for incorporating a methodology which banks no longer use and for being too inflexible to incorporate new instruments which may be developed in the future. Since the frameworks were developed several years ago, it is not necessarily surprising that they are regarded as rather outdated. In point of fact, the criticism only seems wholly justified in the case of debt securities:€the methodology proposed for equities is simple, albeit not necessarily very accurate, and the foreign exchange measure, with the exception of the treatment of options, is not subject to detailed criticism. The Carosio sub-group has reviewed the comments and concluded that the time has come to give serious consideration to the use of in-house models in the measurement of market risks, subject to close supervisory monitoring. The foreign exchange proposal already uses a modelling technique, the simulation test, as an alternative for sophisticated banks. The Committee needs to decide at its March meeting whether it wishes to examine how far this principle can be extended to the other risks. At the meeting in London of a number of Committee members to consider work on derivatives (see BS/94/4) it was concluded that the Committee needs to undertake a ‘crash course’ of education on banks’ in-house models. These are crucial in managing derivatives risk and without a sound knowledge of modelling techniques supervisors will find it extremely difficult to judge whether banks have adequate internal control systems. The paper prepared by that group proposes that the Committee consider the need for mutual assistance between its members in developing the necessary expertise. The need to develop a consensus on models is rather urgent in the context of the market risk exercise. Two months have already elapsed since the comment period ended and there is already media speculation as to when the Committee will issue revised or final proposals. It may therefore not be sufficient to allow

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time at the present juncture to develop members’ modelling expertise in the hope that in due course they will be in a better position to make judgements in relation to market risk. Rather, it seems necessary for a small team of experts already familiar with modelling techniques to be formed to advise the Committee on whether, and if so how models might be used in the market risk measurement process.

Faced with the overwhelming advice from the Secretariat and the working subgroups that the BCBS needed to get up to speed in its appreciation of banks’ internal modelling (VaR) methodologies, the BCBS, at its (sixty-ninth) meeting, 22–23 March 1994, set up a new Models Task Force. Its mandate (BS/94/24) is reproduced as Appendix H. Given the urgency of the exercise (in the past the BCBS had issued revised papers shortly after the end of consultation periods€– it was unthinkable to delay a response for several years) and the extent of ground to be made up quickly, this task force should assemble as soon as possible, and then work continuously together at the BIS (not as in the other subgroups meet for a day or two as necessary at discrete intervals), with the aim of producing a first paper by the end of May, in time for the BCBS’ June meeting. Meanwhile, the BCBS agreed (BS/94/22) ‘that the Carosio sub-group should take over all the work on market risk, including foreign exchange risk, freeing the Nouy group [which had been the Danielsson group] for work on derivatives’. The Models Task Force, chaired by Christine Cumming (FRBNY), began work immediately, and produced two reports (BS/94/30 and BS/94/32) in quick time. Like the Carosio subgroup, it found the work of the major international banks in assessing their own market risk to be impressive, and far in advance of the BCBS’ own ‘building blocks’ approach. Thus (BS/94/32): Following its incorporation, the individual members of the task force held bilateral talks with some of their banks to broaden their own knowledge and subsequently a number of major banks made presentations to the full task force. The task force has been impressed with the standards of presentations made to it and with the obvious sincerity and expertise with which the banks it has interviewed are addressing the issues. These intentions have reinforced the experience of its members that the speed of market developments is such that it is imperative to have a flexible and evolutionary measure of market risk which can adapt to new developments, at least for the major players. In the view of most members of the task force, there are compelling arguments in favour of allowing the use of models, including greater precision, avoidance of duplication and incentives to develop adequate systems. The task force is well aware that relying on banks’ internal systems as a basis for capital charges creates dangers of its own and is therefore proposing a set of carefully structured safeguards designed to minimise the risk of abuse.

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Whatever is put in place, however, will of necessity be to some extent evolutionary and may, as more experience is gained, require additional modifications or refinements.

Of course not all banks were yet equipped to run their own VaR modelling exercises, and for the less technically advanced the BCBS ‘building block’ or ‘standard’ procedure was still to be applied (BS/94/45) (with transition arrangements for moving from the standard to the internal models approach). But with the internal models approach clearly recognised as being superior/best practice, the clear assumption was that most large banks would soon have adopted this. So the focus was on the question of how to apply a model generated for banks’ own internal managerial control purposes to the somewhat different requirements and objectives of the supervisory authorities. There were, perhaps, three main considerations: 1. Qualitative standards; assessing each bank’s competence and track record in running models; 2. Quantitative standards; ensuring that all banks apply agreed common minimum standards, for example on percentile (99th), holding period (10 trading days), historical observation period, and so on. 3. Add-ons; to take account of ‘fat tails’ in return distributions (i.e. the fact that extreme movements in markets occur far more commonly than in a normal distribution) and other regulatory safeguards against the assumption of undue risk (for example that markets might become illiquid, and so banks might be unable to trade out of positions for much longer than 10 days). There was not much difficulty with the qualitative standards. The Models Task Force (BS/94/30) suggested that: The use of an internal model will be conditional upon the explicit approval of the bank’s supervisory authority. The supervisory authority will only give its approval if at a minimum: – it is satisfied that the bank’s risk management system is conceptually sound and is implemented with integrity; – the bank has in the supervisor’s view sufficient numbers of staff skilled in the use of sophisticated models not only in the trading area but also in the risk control, audit, and if necessary, back office areas; – the bank’s models have in the supervisor’s judgement a proven track record of reasonable accuracy in predicting losses; – the bank regularly conducts stress tests … Supervisors will have the right to insist on a period of initial monitoring and live testing of a bank’s internal model before it is used for supervisory capital purposes.

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Quantification issues were more contentious, especially how far the VaR modelling approach could be applied to the portfolio as a whole, or just applied sector by sector (e.g. interest rates, exchange rates, equity prices) and then aggregated on a simple sum basis (see indent (g) in Appendix I). The proposed quantitative standards (BS/94/30, Section B4) put forward, following work by both the Models Task Force and the Carosio subgroup in 1994/95, are reproduced in Appendix I. Before moving to a discussion of the most contentious issue, that is the add-ons for regulatory purposes, the next step for the BCBS was to try to obtain some quantified measure of how the two approaches might work in practice. Time was short; the Chairman, by then Tommaso Padoa-Schioppa, had ideally wanted a new consultation paper for circulation as early as September 1994 (with the aim of meeting a deadline of implementation of the new Market Risk Amendment by 1 January 1996) (BS/94/47). But at the (seventieth) meeting of the BCBS (28–29 June 1994) (BS/94/56): It was agreed that testing was required to ensure that the proposals as drafted would represent a reasonably balanced package. It was decided that one or more dummy portfolios would be tested by banks of at least the countries participating in the task force (a) on their own internal models; (b) against Â�reality10; and (c) against suitably defined stress situations. Capital charges on the dummy portfolio(s) would also be calculated by the models task force for the standard approach. The models task force was asked to consult with the banks with which it was in contact. This would not replace the more limited testing already in train which was designed to compare, for an individual bank portfolio, the capital charge that would be thrown out by its model with the capital charge calculated according to the standard methodology … Since this work would take some time, the Committee agreed to plan finalisation of this matter in a November meeting (brought forward from December) with a view to securing Governors’ approval in December and releasing a revised proposal at the end of the year. The Chairman said that he would in the meantime brief Governors orally at their July meeting on the progress of the work.

The questionnaire returns were received by November, and a paper by the Models Task Force (BS/94/87) prepared by 1 December. The results of the test portfolio exercise, a summary of which is reproduced in Appendix J, showed considerable dispersion amongst the VaR figures resulting from the application of individual bank models to identical ‘test’ portfolios; and some suggestions were made (more in the body 10 I presume that this means the use of subsequent ex post data of market prices. Why this might be expected to be useful, I do not know.

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of the report) about the benefits and costs of the extent of guidance and/or constraint on the detailed structure of each bank’s modelling techniques. The paper also discussed the application of a scaling, or multiplication, factor. Thus (BS/94/87): The task force has considered at length whether the results of the models-based capital charge under the alternatives presented above should be multiplied by some scaling factor. A scaling factor would provide a means of adjusting the value-at-risk numbers (assuming a two week holding period and a 99 percent confidence level) generated by banks’ internal models to produce an enhanced level of capital coverage against losses that banks might sustain in the event of severe or prolonged market movements. Assuming that supervisors decided to impose a scaling factor, a difficult issue relates to the appropriate size of the factor. The internal models proposal presented to the Committee last June had considered the possibility of a scaling factor of 5 (the square root of 25), which effectively converts the value-at-risk number based on a two week holding period into a value-at-risk estimate using a one year holding period. The test portfolio exercise revealed that a scaling factor of 5 would result in a models-based capital requirement significantly above that produced under the standard approach … Setting the scaling factor too high would eliminate the positive incentives for banks to develop more sophisticated risk measurement systems that the models alternative is intended to produce … Despite these potential difficulties, there is strong support in the task force for a scaling factor and general agreement that the factor should be no greater than five. However, in order to get a better sense of the capital ‘cushion’ that might be provided in practice, there is a need for additional work to assess the effectiveness of a scaling factor in providing sufficient capital levels to withstand losses arising from stressed market conditions.

That there should be an ‘add-on’ scaling, or multiplication, factor seemed to be common ground.11 But, apart from the desire to ensure 11 The reasons were spelt out in the draft consultation paper of 27 February 1995 (BS/95/2), as follows (pp. 15–16): The Committee has examined carefully how banks’ value-at-risk measures based on the parameters described above can be converted into a capital requirement that appropriately reflects the prudential concerns of supervisors. One of the problems of recognising banks’ value-at-risk measures as an appropriate capital charge is that the assessments are based on historical data and that, even under a 99% confidence interval, extreme market conditions are excluded. The Committee does not believe that a ten-day value-at-risk measure provides sufficient comfort for the measurement of capital for a number of reasons, which include: – the past is not always a good guide to the future; – the assumptions about statistical ‘normality’ built into some models may not be justified, i.e. there may be ‘fat tails’ in the distribution curve;

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that capital charges from the more sophisticated VaR method were no more onerous than those arising from the BCBS’ standard methodology, which was itself little more than a seat-of-the-pants exercise, there was no rigorous estimation or a rationale for the size of the scaling factor. Be that as it may, at the next (seventy-second) meeting of the BCBS (8–9th December) (BS/94/100)12 it was agreed to proceed to prepare a finalised draft market risk amendment to the Accord for the next BCBS meeting in November, for submission to the Governors in April, and consultation and completion by the end of 1995. On the scaling factor, the Committee decided that: The results of banks’ internal models will become subject to a scaling factor within a defined range. The size of the scaling factor within this range will depend on a supervisor’s assessment of how well the institution meets a series of qualitative criteria. These criteria will include a comparison of value-at-risk estimates with actual portfolio gains and losses, the results of stress tests, and the overall effectiveness of the risk management approach. The adjustable scaling factor may also serve as a substitute for a floor, which appears to be indefinable, and incorporate the spirit of the pre-commitment approach, since the ability of supervisors to adjust the scaling factor will provide incentives for banks to develop their internal models with an appropriate level of conservatism.

When the draft consultation paper was prepared (27 February 1995, BS/95/2), the rationale for having a scaling factor was spelt out in more – the correlations assumed in the model may prove to be incorrect; – market liquidity may become inadequate to close out positions. Many of the factors listed above are very difficult to quantify. Even if they were capable of quantification, a judgement would still have to be made as to how far it is necessary to guard against rare market occurrences. The conclusion of the Committee is that supervisors would not have sufficient comfort unless the value-at-risk measure as defined in Section II were to be multiplied by an appropriate factor. Such a multiplication factor would provide a means of adjusting the value-at-risk numbers (using the parameters set out earlier) generated by banks’ internal models to produce an enhanced level of capital coverage against losses that banks might sustain in the event of severe or prolonged market movements. The Committee, however, emphasises that the multiplication factor is not meant to substitute for regular stress testing (see Section V below) by market participants themselves. 12 At this same meeting: The Committee also examined a paper by the Federal Reserve Board describing a ‘pre-commitment’ approach to market risk capital. Although this idea generated a certain amount of interest, the prevailing view was that it could not be incorporated in a near-term proposal. However, it will be further discussed in the models task force and all agreed on the importance of including an incentive structure that would disadvantage those who were tempted to weaken the assumptions behind their internal models for the sole purpose of benefiting from lower capital requirements.

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detail (as recorded in footnote 11 above), but the proposed number was still left blank. With this draft to hand, Chairman T. Padoa-Schioppa circulated a detailed note on outstanding issues (8 March 1995; BS/95/12), which needed to be settled at the next meeting, in order to keep to the timetable. Among the issues were: (a) whether to conduct a second test exercise with banks; (b) the nature and length of the observation period; (c) the treatment of specific risk for equities in the standardised approach; (d) the use of Tier 3 capital. For the purpose of our own story here, the main interest relates to the ‘multiplication factor’, and the associated issues of ‘aggregation across risk factors’. Here Padoa-Schioppa summarised the issues as follows: Earlier drafts of the task force papers referred to a range between 2 and 3 for the multiplication factor. The task force has now deliberately excluded from the proposal such an indication for two reasons:€ one is that the aggregation method (see (4) below) is a crucial element in the size of the multiplication factor and it could be difficult to make the necessary adjustment if the aggregation method were subsequently relaxed; the other is that further insights would be gained from the next round of testing. Against this, however, there is the fact that the proposal should be as complete and informative as possible. Question:€Is the Committee content to give no indication at this stage of the size of the multiplication factor or would it prefer to indicate a range? The drafts offer two formulations for the Committee’s consideration. One is to set a minimum multiplication factor. The other is to set a norm, with discretion to apply a premium or discount to that norm (subject to an absolute minimum that would help supervisors to resist pressure to move to the lowest common denominator). In this context, the task force has also considered how to incorporate into the capital charge a ‘positive incentive’ to encourage banks to accurately measure market risk. This would mean, as we discussed in December, that the premium or discount also depend on a comparison of value-at-risk estimates with actual portfolio gains and losses. The task force considered this hypothesis and found it difficult to develop a precise rule. Instead, the discussion paper states rather generally that each supervisor has discretion to adjust the multiplication factor based on an assessment of the quality of an institution’s internal model (including the quality of its back testing program). Question:€Which of the two formulations does the Committee prefer? Do these alternative formulations, and the market risk package more generally, emphasise sufficiently the importance of creating strong incentives for an institution to accurately measure market risk? The task force has opted for simple-sum aggregation across risk factor categories, mainly in order to reduce dispersion, but also to make it easier to

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operate with ‘partial models’ and to improve comparability with rules elsewhere (for instance, credit risk and market risk charges will also be aggregated on a simple-sum basis). While the Committee should be aware that this will be strongly criticised by many in the industry, it should also consider whether more flexibility on correlations in the consultative paper not only would make it much more difficult to adopt simple sum aggregation in the end, but would also leave too much dispersion for the taste of some Committee members or for the Governors. Question:€Can the Committee accept to go for consultation on the basis of a simple-sum aggregation method?

At the subsequent (seventy-third) meeting of the BCBS (14–15 March 1995) (BS/95/16) it was accepted by all that simple sum aggregation should be adopted. On the ‘multiplication factor’: a ‘minimum-plus’ approach has been adopted, where the ‘plus’ is directly related to the ex-post performance of the model, thereby introducing a built-in ‘positive incentive’ to keep high the predictive quality of the model (e.g. the ‘plus’ could be derived from the outcome of ‘back-testing’). It would also be related to how well the other qualitative standards of the proposal are met. Further work will be done by the task force to arrive at a more precise definition of the ‘plus’. `The consultative paper would state that we were planning to set a minimum factor of 3, but that we would review that number before the end of the transitional period in the light of experience.

There are no indications that any theoretical or empirical work had been done to justify the choice of ‘3’ as the number. But a number had to be chosen. Such a number should result in capital charges below, but not too far below, the BCBS’ own (arbitrary) standard approach charges, and ‘3’ was a nice round number which did not cause any obvious ‘political’ pain to members, though one major country would have preferred 2, and another 4. Anyhow the new revised consultative paper, including the use of internal models, subject to the required quantitative conditions and subject to a scaling (multiplicative) factor of 3, was put before the G10 governors under cover of a letter from Padoa-Schioppa (BS/95/12, 4 April 1995) to be issued to supervisors and banks in mid-April, under cover of a BCBS press communiqué (BS/95/20). Comments were requested by July, with the intention of issuing the finalised Amendment by the end of 1995. One of the more innovative and interesting features of the discussion at this juncture concerned incentives for banks to make their own models more accurate. It was feared that the minimum 3x scaling factor by itself would induce banks to shade their models towards a reduction in capital charges. So the idea (not unlike the ‘precommitment approach’ in some

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The Market Risk Amendment

respects13) was to include a ‘plus’ factor as well, which could be based on either qualitative or quantitative measures of the predictive accuracy of each bank’s internal model. This nice idea was set out in a note by PadoaSchioppa (BS/95/34, 30 May 1995), which received the enthusiastic support of Professor R. C. Merton (letter dated 31 May 1995, BS/95/41). This is one of the relatively few examples of regulation becoming informed by economic theory; the note is reproduced in Appendix K. Comments from banks and national supervisors were sent in, and the Secretariat summarised these in a note at the end of August (BS/95/52). There were a number of general comments about the need for consistency with the Capital Adequacy Directive (CAD) of the EU and for convergence with IOSCO, and there were also numerous comments on the standardised (building block) approach and the use of Tier 3 capital, which will be skipped over here. On the internal models approach, the Secretariat reported that the main reactions were as follows: Scaling factor The scaling factor of three was the pre-eminent issue of concern among commenters. It was argued that the compounded effect of the scaling factor and the other model parameters (99% confidence level, ten-day holding period, simple sum aggregation across risk factors) would result in an excessive capital requirement, giving banks the perverse incentive to instead apply the standardised approach or to dispense with self-imposed prudential standards in the model. Many considered the scaling factor of 3 to be arbitrary and asked for clarification about how it was derived. A large proportion of respondents called for a scaling factor of 1, although some considered a factor in the range of 1 to 1.5 to be reasonable. Limits on aggregation methods Another key area of concern was the requirement that value-at-risk estimates be aggregated across broad risk factor categories on a simple sum basis. Several banks argued that there should be full recognition of empirical correlations both within and across risk factors. It was argued that the simple-sum approach in the models proposal would create disincentives for banks to diversify their portfolios. It was also argued that the use of empirical correlations was more precise and that it was integral to the models of many banks. Plus factor Those respondents addressing this issue generally supported the idea of a plus factor tied to the performance of a model. However, these respondents also 13 The Fed remained quite attached to the ‘precommitment approach’, partly on the grounds that estimating a quantitative basis for the ‘plus’ factor, and indeed the whole risk-based capital framework, was in danger of becoming dangerously unwieldy and impractical; letter from Spillenkothen to Padoa-Schioppa (1 September 1995, BS/95/70).

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257

asked for more clarification about the magnitude of the plus factor and the circumstances under which it would be applied. Respondents also noted that there are a number of difficult statistical issues related to the interpretation of backtesting results. Specific risk The models proposal (which focuses on general market risk) stated that banks using models should also be subject to a separate capital charge for the specific risk of traded debt securities and equities ‘to the extent that this risk is not incorporated in their models’. In addition, the proposal stated that ‘the total specific risk charge applied to debt securities and equities should in no case be less than half the specific risk charges calculated according to the standardised methodology’. Many respondents urged the Committee to eliminate the ‘floor’ for the specific risk charge applied to models, arguing that it was relatively arbitrary, that it did not sufficiently capture the effects of diversification, and that it could be too conservative in the case of institutions that explicitly incorporated specific risk into their model (e.g., in the case of equities, treating each stock as a separate risk factor). Some argued that the floor based on 50% of the specific risk charge of the standardised approach would require institutions to carry out two calculations, one using the standardised approach and one using the models approach, which was seen to be computationally burdensome. Respondents generally did not provide concrete proposals for determining the extent to which a model captures specific risk, as was requested in the consultative document.

The Models Task Force then turned to the task of reconsidering the package in the light of the comments received. There had been few adverse comments on the quantitative parameters, for example holding and observation periods, confidence interval or on the use of both qualitative and quantitative elements (the hybrid approach) for the plus factor, and these were summarily reconfirmed as remaining unchanged from the earlier consultative paper (BS/95/79, 17 November 1995). On specific risk: The task force discussed several proposed methodologies for incorporating specific risk into internal models. It is clear that this is a complex area and that market practices are still under development. It is also clear that at present there is no accepted industry consensus with respect to the modelling of the specific risk of debt securities. For equities, on the other hand, there are methods that largely capture the first element outlined above, for example models that treat each equity as an individual risk factor. These approaches are by no means universal, however, and many banks use what the task force regards as in-between methods that capture some but not all of this component. In addition, the task force generally regards the second aspect of specific risk as unusually difficult to model. The general concerns of the task force surrounding this issue can be summarised as follows. There is a willingness to give some recognition to banks whose

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The Market Risk Amendment

models capture specific risk and to create incentives to further improve upon these methodologies. On the other hand, there needs to be a prudential cushion to address the concern that practice is still developing and that a consensus does not yet appear to have emerged about how best to model the various elements of specific risk. Moreover, the task force believes that the industry needs to be prodded further to provide a sound framework in this area.

The Task Force then put forward three alternative methodologies, but the bottom line was that all of them involved having a floor for specific risk of at least 50 per cent of that obtained for specific risk under the standardised approach. On the crucial issues of scaling factor and correlations across major risk factor categories, the Task Force recognised that these needed to be reviewed together, and put forward: four possible alternatives for combining these two parameters: (1) (2) (3) (4)

scaling factor 3 with simple sum approach, scaling factor 3 with full correlations, scaling factor 2 with simple sum approach, and scaling factor 2 with full correlations.

The relevant issues in this decision, according to the Task Force (BS/95/79, pp. 2–3) were: (a) The capital impact overall on banks; (b) The effect of simple sum versus full correlations; (c) Comparability with the standardised approach. The latter (c) was probably the most important factor, and had the practical effect of eliminating options (1) and (4) above.14 At their subsequent (seventy-sixth) meeting (28–29 November) the BCBS chose option (2) above (subject to a caveat about adjustment should the models approach produce higher numbers than the standardised approach). The argumentation for preferring (2) to (3) is not 14 From (BS/95/79), p. 3: The four alternatives also have an effect on the amount of required capital produced under the models approach relative to that of the standardised approach (focusing in both cases on general market risk). The bank portfolio numbers in Table 4 of Section III show that for alternative #1 (scaling 3 with simple sum), the models capital charge exceeds that of the standardised approach for most of the portfolios considered. On the other end of the spectrum, alternative #4 (scaling 2 with full correlations) causes the models capital charge to fall below that of the standardised approach for a majority of the sample portfolios considered. The results also show that it is difficult to establish a stable relationship between the models and standardised approach over time; the relationship can change significantly with the composition of the portfolio and the market environment.

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259

reported; perhaps the BCBS felt that simple sum aggregation was less defensible than the 3x multiplier. With the main decisions now effectively taken, and with the approval of the G10 governors, the BCBS then issued a press communiqué announcing these on 11 December 1995. The relevant parts state: The capital charge for a bank that uses a proprietary model will (as proposed in April 1995) be the higher of: – the previous day’s value-at-risk; – three times the average of the daily value-at-risk of the preceding sixty Â�business days. Although a number of industry respondents questioned the size of the multiplication factor, the Committee considers it prudent to maintain the factor proposed in April 1995. The multiplication factor takes into account the fact that the actual capital charge is smoothed by its application to an average which may contain much higher daily exposures. The Committee believes that banks’ internal models provide a valuable starting point for measuring the riskiness of a bank’s trading portfolio. However, it considers that this daily value-at-risk estimate then needs to be translated into a capital charge that provides a sufficient cushion for cumulative losses arising from adverse market conditions over an extended period of time. Many banks themselves employ relatively conservative assumptions for the purpose of allocating capital internally, including methods such as scaling up their valueat-risk estimate. The multiplication factor is designed to account for potential weaknesses in the modelling process. Such weaknesses exist because: – market price movements often display patterns (such as ‘fat tails’) that differ from the statistical simplifications used in modelling (such as the assumption of a ‘normal distribution’); – the past is not always a good approximation of the future (for example volatilities and correlations can change abruptly); – value-at-risk estimates are typically based on end-of-day positions and generally do not take account of intra-day trading risk; – models cannot adequately capture event risk arising from exceptional market circumstances; – many models rely on simplifying assumptions to value the positions in the portfolio, particularly in the case of complex instruments such as options. Banks will be required to add to the multiplication factor of 3 a ‘plus’ directly related to the ex-post performance of the model, thereby introducing a builtin positive incentive to achieve and maintain a high predictive quality of the model. The plus will range from 0 to 1 based on the outcome of so-called ‘backtesting’. If the backtesting results are satisfactory and the bank meets all of the qualitative standards set out in the amended Accord, the plus factor will be zero. The approach adopted strikes a balance between recognition of the potential limitations of backtesting, and the need to put in place a clear and

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The Market Risk Amendment

consistent framework that contains incentives to ensure that banks model market risk with integrity. The framework for backtesting is described in greater detail in a document that is to be issued jointly with the amended Accord … Regarding specific risk, industry comments indicate that banks’ internal models may capture certain elements of specific risk, for example where each equity is modelled as an individual risk factor. However, it appears that other key elements of specific risk such as event or default risk are generally not captured by banks’ internal models. Banks provided little evidence in the comment process that their models were capturing specific risk in respect of debt securities. The Committee has accordingly decided to retain the treatment proposed in the April 1995 consultative document, whereby a modelled treatment of specific risk would be allowed subject to an overall floor on the specific risk charge equal to 50% of the specific risk charge applicable under the standardised approach. Banks whose models take little or no account of specific risk will be subject to the full specific risk charges applicable under the standardised approach. Should the industry come forward with a reasonable methodology for measuring specific risk in the context of the internal models approach, the Committee is prepared to reconsider its approach in this area.

So the BCBS had now established the basis of the capital charges to be applied to market risk, to come into effect at the end of 1997, subject to an expressed willingness to discuss further with the industry the treatment of specific risk. Various segments of the industry responded to that offer. Both the Institute for International Finance (IIF) (President Charles Dallara, situated in Washington) and a Joint ISDA (International Swaps and Derivatives Association€ – Chairman Gay Evans, situated in New York)/ LIBA (London Investment Banking Association€ – Director General Kit Farrow) Models Task Force prepared studies and simulations to examine the impact of back-testing on the 3x scaling factor (and plus factor) and of the specific risk requirement (e.g. BS/96/68). Having examined these submissions in November 1996, the Internal Models Task Force was not minded to revise the 3x scaling factor. The ISDA/LIBA empirical analysis covered only a short period (without a major crisis); and the results showed that, even with the 3x multiplier (and ‘plus’ factor), banks still preferred to use internal models (BS/96/100). But: Regarding the treatment of specific risk, the task force accepts industry claims that the standardised charge upon which the floor is based lacks precision as a method for measuring specific risk. However, the task force is not yet convinced that banks currently capture event/default components of specific risk in an empirically-proven manner. Thus, the task force thinks it would be premature to drop the floor until such time as the industry can demonstrate that standard modelling practices adequately address these risks. Task force members also

Net interest income risk

261

agree that industry practice is clearly evolving, and that it would be worthwhile to continue working with banks on a bilateral and group basis.

With one decision firmly taken (stick with the 3x scaling factor), but one remaining in play (specific risk), and the implementation date (end1997) rapidly approaching, there were some doubts about what to say, and when to say it, to the industry. These were resolved by the issue of the BCBS press communiqué of 9 December 1996 (BS/96/123), confirming the scaling factor (para. 2) but inviting further work on the modelling of ‘specific risk’ (para 3). The dialogue on specific risk continued, and the BCBS agreed, in September 1997, to adjust its position (BS/97/96). There were two key arguments for such adjustment. First, basing specific risk assessment on a floor of 50 per cent of the standardised approach would require banks using an internal models approach also to apply the, quite different, standardised approach in this respect, a wasteful and tiresome duplication of effort. Second, the models group accepted banks’ methodology for modelling ‘idiosyncratic risk’. But the models group still doubted whether the banks took sufficient account of ‘event’ and ‘default’ risk. So their proposed compromise was to accept banks’ internal estimates of ‘specific risk’ subject to a higher scaling 4x factor. This was announced in a BCBS press communiqué of 19 September 1997, supported by an ‘Explanatory Note’, the main part of which is recorded as Appendix L. With that, the Market Risk Amendment (to the 1988 Basel Accord) came into operation at the end of 1997. D

Net interest income risk

As related earlier in Section A of this chapter, the early work (1985–87) on the effects of interest rate changes on bank profitability focussed on the likely impact on net interest income. After 1987 the focus shifted towards the effects of market rate changes on trading book positions. By 1996, however, that exercise was almost complete; moreover, most of such work as did remain in this field came under the aegis of the Internal Models Task Force. This left the Interest Rate Risk Subgroup (where Smout of the Bank of England had taken over from Carosio of the Banca d’Italia as Chairman) in something of a vacuum. With encouragement from Padoa-Schioppa’s March note on ‘future work priorities and organisation’ (BS/96/16), the Smout group decided to revisit interest rate risk in the banking book (BS/96/13). There was general agreement on the need for a ‘sound practices’ paper on the

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The Market Risk Amendment

general subject of how a commercial bank should assess and manage interest rate risk internally. There was also much support for a descriptive annex to such a paper on how a bank might measure such risk (maturity gap measures, etc.). The group was, however, split on whether a common reporting framework should be proposed for onwards transmission to supervisors, who might use it to identify outliers, or for other purposes (yet another capital charge?) (BS/96/37). Meanwhile, the Federal Reserve Board unilaterally issued a press release (23 May 1996) in which they stated categorically that the American regulatory agencies: have elected not to pursue a standardized measure and explicit capital charge for interest rate risk at this time. This decision reflects concerns about the burden, accuracy, and complexity of a standardized measure and recognition that industry techniques for measuring interest rate risk are continuing to evolve. Rather than dampening incentives to improve risk measures by adopting a standardized measure at this time, the agencies hope to encourage these industry efforts. Nonetheless, the agencies will continue to place significant emphasis on the level of a bank’s interest rate risk exposure and the quality of its risk management process when evaluating a bank’s capital adequacy.

That pulled the rug out from those (European members) who had advocated a single reporting framework. So the next draft of a paper on this topic entitled ‘Principles for the management of interest rate risk’ (NB Principles and Standards were becoming à la mode and fashionable in 1996/1997 at the end our period) had an Annex A on ‘Interest rate risk measuring techniques’ and an Annex B on ‘Monitoring of interest rate risk by supervisory authorities’. But the latter made it clear that no common reporting framework was being proposed, no convergence was advocated, and no capital charge was in prospect. Thus, from paras. 2 and B1–5 of Annex B in the final published paper (September 1997, BS/97/96), it was stated that: While the precise information that is obtained will differ across supervisory authorities, one approach that some may adopt is a reporting framework that collects information on a bank’s position by remaining maturity or time to next repricing. Under such an approach, a bank would categorise its interestÂ�sensitive assets, liabilities and off-balance-sheet positions into a series of repricing time bands or maturity categories. The two sections that follow discuss the considerations that a supervisor should take into account in specifying the number of time bands and the grouping of positions in the reporting framework. The final section of this annex describes some general approaches that supervisory authorities may wish to consider in analysing the information that is obtained through such a reporting framework …

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263

A reporting framework designed along these lines may provide supervisors with a flexible tool for analysing interest rate risk. Supervisors can use this basic information to perform their own assessments of a bank’s exposure and risk profile. Such assessments may provide insights regarding an institution’s exposure to parallel shifts, a flattening or steepening of the yield curve or its inversion with rate changes of different magnitude either based on statistical probabilities or a worst case analysis. For banks with important exposures in foreign currencies, analysis investigating different assumptions on correlations between interest rates in different currencies can be useful. With respect to instruments with behavioural maturities, supervisors may wish to assess alternative assumptions than those used by the institution. The focus of supervisors’ quantitative analysis can either be the impact of interest rate changes on current earnings or on the economic value of the banks’ portfolio. In conducting their analysis information about average yields on assets and liabilities in each time band may be useful and supervisors may wish to collect such information in addition to pure position data. Depending on their overall approach, supervisors may conduct their analysis of interest rate risk either on a case by case basis or as part of a broader system designed to identify outliers with apparently excessive risk-taking. By conducting an assessment of interest rate risk using the proposed framework, supervisors may gain more insight into an institution’s risk profile than with a reporting system that reduces the complexity of interest rate risk to a single number. In doing so, supervisors can become more familiar with the sensitivity of risk measures to changes in the underlying assumptions, and the evaluation process may produce as many insights as the quantitative result itself.

Instead the focus of this continuing work on net interest rate risk was to be on general principles. At their (seventy-ninth) meeting (9–10 September 1996) the BCBS agreed (BS/96/78) that: the report of the interest rate risk sub-group (BS/96/57) should be upgraded to the status of a binding agreement (such as the Concordat or the Capital Accord) of a ‘qualitative’ nature. This would be done by solidifying the general recommendations contained in the present report into a set of basic principles to which every supervisor would be committed. The substance of the paper should not be altered significantly and the principles should not be quantitative in nature. The paper should contain a preface indicating that the Committee is aware of the potential severity of interest rate risk and of the difficulties encountered in its measurement, and that it will consequently continue to work on this subject.

This paper was ready shortly thereafter, but its actual publication was deferred until September 1997, presumably so that it could accompany the broader paper on ‘Core principles of banking supervision’, to which we turn next in the following chapter (Chapter 8), and the

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The Market Risk Amendment

decision on the treatment of ‘specific risk’, discussed in Section C above. Nevertheless, the decision to delay its issue so long implies that it was not regarded as being of prime importance. Certainly in comparison to the Market Risk Amendment or to the Core Principles, this paper on ‘Principles for the management of interest rate risk’ received relatively little attention at the time and has not stuck in the memory. The Principles themselves, like most such sets of Principles, are mostly banal statements of the obvious, though their more detailed exposition, on pp. 11–23, has several points of interest. Be that as it may, the publication of these Principles, together with the Core Principles and the completion of the Market Risk Amendment, helped to mark 1997 as a high-water mark for the BCBS, a year that saw the successful culmination of several strands of important work. E

Assessment

The work on the Market Risk Amendment followed a long and tortuous path, with several wrong turnings, notably the attempt by the interest rate subgroup to follow the ‘building block’ approach, initiated by the Bank of England 1987 paper, and some setbacks, in particular the failure to reach agreement with IOSCO, discussed at greater length in Chapter 13. Nevertheless the Market Risk Amendment was, in the end, seen as a considerable success for the BCBS. Even those points of greatest friction, especially the notorious (and arbitrary) scaling factor, seem to have become accepted over time. The great merit of the work of the subgroups, notably the Internal Model Task Force, and of Padoa-Schioppa, lay in their flexible appreciation of where the technical methodology of the commercial banks was much superior to that of the BCBS itself, and where the BCBS should remain stubborn. The exercise on the ‘plus factor’ was one (of the few) example(s) of high-grade economic analysis. Indeed, the whole exercise showed interaction between the regulated and the regulators in a positive light. Even so, this exercise also marked the point at which the BCBS began to become more influenced by the technical modelling expertise of the large international banks. The questions of the relationship of the BCBS with such banks, and whether the BCBS was ‘captured’ by the banks during these years, is discussed further in Chapters 12 and 15.

Appendix A

265

Appendix A Annex 2

Illustration of the ‘stock’ versus the ‘flow’ approach

The ‘stock’ approach presents the stocks of assets and liabilities which, at a number of dates after the reporting date, remain to be repriced at some future date. The difference between assets and liabilities in each time-band indicates the amounts to be repriced at the unknown prevailing market rates. The ‘flow’ approach presents the portion of assets and liabilities which, in a particular time-period after the reporting date, are to be repriced. The difference between those portions in each period indicates the net amounts to be repriced at the unknown prevailing market rates for that particular time-period. If in a particular time-period the liabilities which fall due for repricing exceed the assets falling due, then the risk that a more expensive refunding cannot be compensated by a higher pricing of assets will last until at some later stage the assets falling due for repricing exceed such liabilities. This aspect is incorporated in the ‘flow’ approach by adding up the ‘net outflow’ for each time-period by taking into account the sign of the ‘net outflow’. As can be seen from the format the ‘stock’ and ‘flow’ approach then come down to the same degree of risk (compare lines 3 and 7). “Stock” approach: stocks of assets and liabilities until repricing date On repor- 1 week ting date after

3 months 1 year after after

4 years after

7 years after

1. Assets .... 2. Liabilities

1000 1000

600 500

450 300

250 250

150 100

50 100

3. Net position (1-2)

0

100

150

0

50

–50

“Flow” approach: amounts of assets and liabilities to be repriced in each period 1 day– 1 week 4. Assets .... 5. Liabilities 6. Net outflows (4-5) 7. Net position (= cumulative net position)

1 week– 3 months– 1 year– 4 years– More than Total 3 months 1 year 4 years 7 years 7 years amounts

400 500

150 200

200 50

100 150

100 0

50 100

1000 1000

–100

–50

150

–50

100

–50

0

–100

–150

0

–50

+50

0

0

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The Market Risk Amendment

Appendix B

BS/87/34

The measurement of banks’ exposure to interest rate movements:€a supervisory approach

Discussion document



Committee on Banking Regulations and Supervisory Practices:€sub-committee on interest rate risk

Over the past decade interest rate volatility has increased considerably. This development has naturally increased the risks involved in the mismatching of the repricing of assets and liabilities, an activity which lies at the heart of banking. Banks now also have a greater ability to close or hedge interest rate exposures by resort, for example, to rollovers and floating rate notes and more recently by various off-balance-sheet instruments such as swaps, options and futures. In addition to hedging, however, these techniques and instruments also enable banks to increase their total exposure to interest rate risk. In addition to risks arising from gapping, another important aspect of banks’ exposure to interest rate movements stems from the impact of sharp variations in interest rates on the market value of fixed rate bonds. Particularly in countries where banks mark their holdings of such bond portfolios to market value, such movements in interest rates can have an immediate and substantial impact on their published net worth. The growth of tradeable instruments in recent years has given an added significance to this second aspect of banks’ exposure to interest rate movements. These developments in respect of banks’ exposure to interest rate movements have contributed to the importance of the management of this type of risk alongside other banking risks, such as credit risk, country transfer risk, foreign exchange risk and funding risk. As with these other types of risk, interest rate risk has the potential to inflict real damage on a bank if it is not well managed. Supervisors in G-10 countries therefore believe that an appraisal of the way in which banks manage their exposure to interest rate movements is important. They also believe that consideration should be given to ways in which exposure to this type of risk might be incorporated in the supervisory process. In some countries supervisors have already taken preliminary steps in this direction and during the course of 1986 have shared their experience with their colleagues from other G-10 countries. This work has resulted

Appendix C

267

in the development for the purposes of further discussion and consultation of a basic system of measurement of banks’ exposure to interest rate risk. It is a system which may be suitable for supervisory purposes, whilst not necessarily being of itself sufficiently detailed for banks’ own internal use. The Sub-Committee felt that discussions with banks in G-10 countries would be useful at an early stage of its study of any such supervisory system. The attached paper has been prepared as a basis for these discussions. It outlines the thinking so far and sets out, as a product of that analysis, the outline of a system of measurement of interest rate risk. The Sub-Committee would welcome comments on the analysis put forward and the framework presented in the attached paper. The Sub-Committee is well aware that a single framework cannot reflect all the specific institutional characteristics in different countries nor can it capture all the complexities of certain specialised institutions. The framework described should therefore be regarded as a basic one which may well need some adaptation for specific national circumstances. The framework may also serve different needs in different countries. Some supervisors might wish to develop such a framework within the context of their prudential statistical returns, whilst others might prefer just to use it as a basis for bilateral discussions with their banks. It has to be stressed that this document is to be considered strictly as a contribution to a better analysis of interest rate risk and should not in any respect be seen as normative or prescriptive. Basle, March 1987

Appendix C

BS/88/105

Committee on Banking Regulations and Supervisory Practices Note by the Secretariat

Position risk on trading securities

This note seeks (a) to place the risk involved in running positions in trading securities in the context of the overall risk structure of banks; (b) to relate these risks to the work being done in Basle and elsewhere and; (c) to suggest terms of reference for the small group which the Committee agreed to set up at its last meeting.

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Definitions

This note defines foreign exchange risk as the sensitivity of the bank’s net income to changes in foreign exchange rates. Interest income risk is defined as the sensitivity of a bank’s net income to changes in the level of interest rates and to changes in the shape of the yield curve. This is an overall measure comprising all on-balance-sheet and off-balancesheet elements (and includes interest payable as assets marked to market). Position risk (or investment risk) is used here in a narrow sense to describe the risk of capital loss arising from changes in the market price of assets held for trading or market-making purposes, normally funded at short term or at any rate at maturities not linked to the maturity of the assets, and normally marked to market. It includes forced sale risk but not, of course, credit risk. It excludes, on the other hand, marketable securities held for long-term investment purposes, even where such securities may be conventionally valued at market prices. To a large extent, this position risk forms part of a bank’s overall interest rate risk but it may also include, for example, the market risk in equity positions not necessarily related to the credit standing of the issuers nor to the level of interest rates. It can be argued that the two types of interest rate risk are so interrelated that to treat them separately involves a risk of double-counting. For example, a rise in interest rates may lead to a loss if there is a long position in a bank’s trading portfolio but this may be recovered over time if the bank has a short position in its deposit business. On the other hand, the distinction can be worth making if it is felt that the purpose for and management of a securities trading function is very different from the interest rate gapping conducted in a bank’s interbank deposit business. In many cases securities trading will be conducted in a separate affiliate€– this is often the case for equities. But in other areas, and particularly, in government bonds, trading activities can take place in the bank itself. In some countries supervisors have, therefore, felt the need to focus on position risk, in addition to the credit risk on the relevant securities, sometimes using techniques of risk analysis and measurement similar to those used by regulators of non-bank securities companies.

Present work

Foreign exchange risk is currently being analysed by the sub-group chaired by Mr Danielsson who hopes to be in a position to report on the first stage of this work at the March meeting. Interest rate risk

Appendix C

269

generally has been the subject of an analytical paper by the sub-group chaired by Mr€Beverly. This group is about to consider the means by which a measurement system could be devised for dealing with interest income risk. Work is beginning in the European Community on a capital adequacy test in connection with the proposed Investment Services Directive. It is intended that this will impact on banks as well as on non-bank securities trading businesses. Work is also being done in an IOSCO working party chaired by Mr Knight of the International Stock Exchange of London on the capital needs of non-bank securities companies. The Committee on Financial Markets has also commissioned work in the OECD. In addition, a considerable amount of work has been done by individual supervisory authorities responsible for banks with significant securities trading interests.

The way forward

At the October meeting of the Committee, it was agreed that work on the monitoring of position risk on traded securities should be activated given the rapidly increasing competition between banks and securities companies and the increased involvement by some banks in securities trading. It was therefore proposed that a small working group be set up comprising some members of the Committee but to include some securities regulators as well. Mr Mackenzie has agreed to chair this group and it is suggested that his brief be: 1. to survey present and prospective supervisory arrangements for banks and bank affiliates with significant securities trading activities and 2. to make recommendations as to what further action is necessary to improve international co-operation in this area. In view of the implications for banking supervisors of work being done in the EC, it is suggested that the European Commission be invited to attend as observers at future meetings of working groups where the respective chairmen consider that to be in the interests of banking supervisors. In the light of Mr Mackenzie’s findings, and taking account of the work also being done by the groups chaired by Mr Beverly and Mr Danielsson, the Committee will be invited to consider if further work needs to be done in Basle or whether the Committee’s interests would be adequately met by observing work being done elsewhere. 24 November 1988

Economic perspective

Current earnings -investment risk

Current earnings -income risk

Perspective

(sensitivity to future variations in interest rate levels)

Value of equity

(sensitivity to future variations in interest rate levels)

Value of marked to market items

(sensitivity to future variations in interest rate levels)

Income

Focus

All the items in one time band are assumed to be repriced at the same moment (the beginning or the end or the middle of the time band).

Main assumptions

Capable of identifying the concentration of risk falling in specific accounting periods

Capable of calculating reported income variations (in conjunction with the “investment risk” - see below)

At this stage still favoured by most banks

Easy to calculate

Requires a limited amount of data

Main advantages

In this process the model loses simplicity and calculation becomes more complex

The derivation of a single measure requires choices among many possible assumptions

The full set of maturity gaps in the maturity ladder is difficult to interpret

Main disadvantages

Net Present Value or Duration

Items with indefinite maturity and their associated cash flows must be attributed an arbitrary maturity.

Mismatched cash flows are assumed to be without risk if their duration (average value) matches.

The formula assumes that yield curves are flat and shifts in a parallel fashion.

For banks’ managements it facilitates the choice of hedging operations

Applied with a limited number of observations maintains a reasonable level of precision

Requires the command of some mathematical and analytical skills

In its complete form requires a very large volume of data

Capable of summarising in a “single Measures current risks but does not permit analysis of the structure number ” all available information of the risk and of its evolution over The “single number” has very time clear meaning

The methods of calculation of the economic perspective, their advantages, disadvantages and assumptions are relevant also for calculation of investment risk in the current earnings perspective.

Investment risk is not a complete method of calculation of interest rate risk, but only a complement to the current earning perspective-income risk, for the evaluation of “published” income sensitivity to future variations in interest rate levels.

Maturity ladder

Basic method of calculation

Annex 6

Appendix D

Appendix E

271

Appendix E

BS/92/8

Joint Statement by Richard C. Breeden, Chairman, Technical Committee, International Organization of Securities Commissions and E. Gerald Corrigan, Chairman, Basle Committee on Banking Supervision For release:€January 29, 1992 On January 28 and 29, 1992, the Technical Committee of the Inter� national Organisation of Securities Commissions and the Basle Committee on Banking Supervision for the first time held a joint meeting of principals to consider proposed minimum capital rules for �internationally active banks and securities firms. Important �preliminary understandings were achieved on a wide range of fundamental issues.15 These discussions reflected both ongoing internationalization of global capital markets and the similarity of market risks undertaken by both banks and securities firms.

Current situation

In addressing capital standards, the two Committees have sought to address certain issues with respect to existing capital standards. Among banks, the Basle risk-weighted capital standards have been in place since 1988 to address credit risks in bank assets. However, to date there have not been any international capital standards to take account of interest rate risk of tradeable securities and price risk in the equity positions held by banks. The proposed capital standards would for the first time close this important gap in existing international bank capital standards. Among securities firms, interest rate and credit risk have long been measured on a continuous daily basis in most major markets. However, there have been important differences in the level of required capital and in the measurement techniques utilised between different markets and types of firms. These differences create a risk of distortion of trading patterns and significantly varying levels of protection (both through capital levels or diversification of portfolios) for firms from different countries against both local and global market volatility. The proposed capital standards would seek to create agreed minimum levels of capital 15 Participants were aware of the ongoing discussions of this subject within the European Community, and recognised the desirability of consistency between the two sets of general discussions.

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that every securities supervisor would be obliged to follow or exceed as a buffer against market instability.

Debt Securities

In establishing a proposed standard for holdings of traded debt securities, the discussions led to development of a single methodology for computation of both general market and specific issuer risks. This methodology, called the ‘building block approach’, would be utilized by all supervisors. Minimum levels of capital and maximum permissible allowances for potentially off-setting positions were defined by the Committees, subject to reservation by one country. At the same time, the Committees also agreed to allow use of an alternative ‘duration’ methodology that would utilize a somewhat different technique where a supervisor can demonstrate the equivalence of resulting capital charges.

Equity Securities

In addressing the measurement of capital for equity positions, the Committees recognized that two alternative approaches would be utilized. For bank supervisors and for some securities supervisors, the ‘building block’ methodology for debt would also be adapted to equity positions. A general consensus was reached on the respective percentages to be used for the ‘x’ and ‘y’ factors (general and specific risks) applied to gross and net portfolio values, subject to certain reservations by a small number of supervisors. However, many securities supervisors that have long successfully applied a ‘comprehensive’ methodology would continue to do so. Any supervisor utilizing the comprehensive approach would undertake to demonstrate that its specific application of the comprehensive methodology would yield capital requirements that were consistently equal to or greater than the capital that would be required under the building block approach.

Definition of Capital

Substantial progress was also made in reaching mutually acceptable definitions of capital. The securities regulators have agreed that securities firms’ use of short term subordinated debt, with a ‘lock-in’ clause for capital purposes, should be limited to 250% of equity capital. A clear majority of the Basle Committee is prepared to entertain an approach to

Appendix F

273

a definition of capital for market risk purposes of a banks’ trading portfolio that would, in economic terms, closely approximate the approach followed by the securities regulators.

Implementation

Each supervisor has agreed to undertake its best efforts to develop and implement necessary requirements promptly following completion of a consultative process. Where supervisory standards already exceed the proposed minimums, such standards would not be the subject of any proposed change as a result of the agreements. All parties expressly agreed that the proposals represent minimum standards. Any supervisor would remain free to impose higher requirements.

Future Plans

On the basis of the preliminary understandings reached at the joint meeting, the Committees expect to be in a position to issue publicly consultative papers in the summer of 1992.

Appendix F II

Market risks

7. The work by the Basle Committee on market risks has been in progress for several years, having started when the Basle Capital Accord was finalised in July 1988. It was clear at that time that banks’ trading activities were expanding rapidly, particularly in the derivative markets, and that the Accord’s focus on credit risk would need to be widened, in due course, to encompass market risks. The Committee is now proposing that specific capital charges should be applied to open positions (including derivative positions) in debt and equity securities on banks’ trading books and in foreign exchange. Securities held in banks’ investment accounts would continue to be covered by the counterparty credit risk requirements of the present Accord and would also become subject to the measurement of interest rate risk described in the third paper in the package. 8. While the specific methodologies proposed for calculating the capital charges for each of the classes of instrument differ, the Committee has gone to great lengths to try to satisfy itself that the different

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The Market Risk Amendment

methodologies produce roughly equivalent economic results. The Committee is also seeking comment on a proposal to expand the definition of capital to include a new class of short-term subordinÂ� ated debt, which could be used for the sole purpose of meeting some of the capital charges for the market risk associated with debt securities and equities. ╇ 9. Parallel work in two other fora have interacted with and influenced the development of capital requirements for banks’ market risks. One has been the European Community’s attempts to establish a single market in banking and finance. Because of the need perceived in Europe to create a level playing-field between banks and nonbanks operating in the same securities markets, the Community has enacted a Capital Adequacy Directive which applies to both banks and securities firms. In general, the methodology and much of the detail in the Capital Adequacy Directive is similar to the approach favoured by the Basle Committee since the outset of its work. Where there are significant differences, notably in the treatment of foreign exchange risk and position risk in equities, the Committee favours a stricter prudential standard for banks. Banks are invited to comment on any problems that may arise from the need to comply with two regimes. The Committee is resolved to collaborate with its colleagues in Brussels with a view to achieving closer convergence. 10.╇ The second forum in which parallel work has been in progress is the Technical Committee of the International Organisation of Securities Commissions, which began to discuss the possibility of common minimum standards for securities firms at that Committee’s first meeting in July 1987. The Basle Committee was naturally interested in this project and joint work was undertaken with a view to developing common minimum charges for banks’ and securities firms’ positions in traded debt securities and equities and related derivative instruments. Unfortunately, these discussions have not led to a successful result because IOSCO has been unable to reach agreement within its own group. 11. While regretting the inability of IOSCO to associate itself with these specific proposals, the Basle Committee has decided to proceed with publication of the proposals because of the urgency of obtaining systematic input from banking institutions and practitioners. The banking industry is the focus of the consultation process. However, in anticipation of broader-based convergence, the overall approach has been designed with a view to its ultimate application to a wider spectrum of institutions.

Appendix G

III

275

Interest rate risk

12. The market risk proposals to apply capital requirements to debt securities on banks’ trading books do not address the overall interest rate risks run by banks, i.e. the risk that a change in interest rates might adversely affect a bank’s financial condition through its effect on all interest-related assets, liabilities and off-balance-sheet items, including the securities which are not held in the trading account. Interest rate risk for a bank is a much wider issue and raises many difficult measurement problems. At the same time, it is a significant risk which banks and their supervisors need to monitor carefully. Analytical work has been going on for a number of years to measure interest rate risk and the progress of this work is described in the third paper in the package. 13. This paper clearly indicates that it is the intention of the Basle Committee to develop a measurement system rather than an explicit capital charge for interest rate risk. Recognising that a certain degree of interest rate mismatching is a normal feature of the business of banking, the Committee holds the view that the existing capital requirements can be regarded as providing adequate protection against interest rate risk exposure in most situations. The measurement system is designed to identify institutions that may be incurring extraordinarily large amounts of interest rate risk. Within that context, it would be left to national authorities to determine what if anything might be done. The range of responses by national authorities might include an explicit capital charge on a case-by-case basis, but the situation could also be dealt with by a number of other supervisory remedies. 14. Following consultation on this paper, it is the intention of the Committee to seek to establish a common reporting framework for interest rate risk as a basis for developing, over time, a common approach to the measurement of the risk.

Appendix G Excerpts from the Carosio Subgroup paper (BS/94/1) on ‘Market risk-summary of comments received’. Page 2: The sub-group has noted the widespread criticism of the proposals as giving perverse incentives to banks in their management of market risk. It believes that there are three basic criticisms which need to be addressed:

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The Market Risk Amendment

• the proposals are not sufficiently compatible with banks’ own measurement systems;

• a desirable balance between simplicity and accuracy is not seen to have been achieved, especially in the treatment of debt instruments;

• the proposals do not encourage good control systems because the ‘equivalence test’ does not reward more accurate risk measurement.

The sub-group believes that it is necessary to pay close regard to these factors in reviewing the proposals since bad rules would arguably be worse than having no rules. Pages 3–4: Although a few members remain unconvinced, a sizeable majority of the sub-group believes that serious consideration should be given to the possible use of in-house models for measuring market risks as the basis for capital charges. The first step is to investigate in some depth the characteristics of different modelling techniques in order to improve the supervisors’ knowledge of how they operate. The key issue is to identify the types of models that could be permitted and to investigate the parameters that would need to be specified by the supervisors in order to ensure a level playing-field. A particular problem is to decide how far banks should be entitled to recognise correlations between price movements of different instruments and different markets, but there are many other technical and procedural issues to resolve. Some members believe that the validation of models will be a serious problem, especially those that at present have little or no modelling knowledge in-house. Clearly, one of the consequences of accepting capital charges which rely to any significant degree on banks’ own models is the need for verification by supervisors and/or by external auditors with specialist knowledge. However, others note that it is already impossible to pass judgement on banks’ risk management processes without some knowledge of models so there will shortly be a need for more specialist knowledge in any event. Another possible concern, which it will be necessary to guard against very carefully, is that using internal models as a basis for capital charges may create a bias in favour of more lenient assumptions in measurement parameters. Some members of the sub-group think that it would be very difficult to construct a model that consistently delivers a calculation favourable to the bank, However, it would clearly be dangerous if this approach were to result in banks under-estimating on a continuous basis the market risks they are running.

Appendix H

277

Pages 12–13: The main objection to the equities proposal is that the weights are too high and diversification is not sufficiently recognised. It is difficult to judge how far this is coloured by actual research or rather by the knowledge that the numbers in the CAD are half those in the Committee’s proposal. Some of the figures that have been produced by banks are based on far less rigorous assumptions than the Committee would wish (e.g. a one-day holding period). Some central banks (including US, AU) have conducted tests which indicate that 4% x 8% would not cover severe market moves such as some of the market crashes in the 1980s. The problem is that any numbers chosen will only approximate the risks because of the very different volatilities experienced in different equity markets. If it becomes possible to take account of in-house models, then the problem may lessen because those models, however they are specified, would presumably take account of historical price movements and correlations between different risks. It might then be perfectly justifiable to assume that the sophisticated market-makers would use such models and that those that do not are unlikely to hold exceptionally liquid and diversified equity portfolios. Some members of the sub-group are not very happy with the X + Y formula, which is a rough approximation of the nature of the risks and which does not take modern portfolio theory into account, but as a whole the sub-group thinks it is a method which can be useful as the simplified alternative. The subgroup (with one dissenter) believes that the Committee would then be justified in insisting on the 4 + 8 formula, with 8 + 8 for portfolios which are not liquid and diversified according to national rules. However, this is a major policy issue which the sub-group does not feel competent to resolve. Discussion in the sub-group on the possibility of agreeing on common tests for diversified and liquid portfolios revealed, as on previous occasions, that there are significant differences in national equity markets which make common guidelines impractical.

Appendix H

BS/94/24

Basle Committee on Banking Supervision Mandate for models task force 1. At the Committee’s meeting in Basle on 22nd–23rd March, it was agreed that a small task force should be established to work with the Secretariat in developing a proposal for the use of banks’ in-house models in the calculation of regulatory capital charges for market risks.

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The Market Risk Amendment

2. The members of the task force should be experts who are thoroughly familiar with the manner in which banks use modelling techniques to measure and control their market risks. They should be available to work intensively on this matter from shortly after Easter until a draft report has been finalised for the Committee’s June meeting. They would be expected to travel to Basle and work there on normal working group conditions for the time necessary during this period, and also be available to conduct research if required in the interim. The first meeting of the group will be scheduled in agreement with the Secretariat as soon as the names have been submitted. 3. The task of the group is to prepare a paper which sets out the conditions under which an institution would be entitled to use its inhouse model to measure market risk and defines how the results of the model should be translated into capital requirements. It should establish two separate sets of criteria, one of a quantitative character governing statistical tests such as holding periods, standard deviations, etc. and the other of a qualitative character governing the institution’s compliance with sound risk management procedures. The criteria should be presented in such a way as to be incorporated in a comprehensive document setting out the market risk regulations. 4. The task force, with the Secretariat’s full support, is expected to produce a draft report before the end of May. This would then be submitted for review to the Carosio subgroup before becoming part of a comprehensive proposal for the Committee’s June meeting. 11 April 1994

Appendix I Quantitative standards Banks will have flexibility in devising the precise nature of their models, but the following minimum standards will apply for the purpose of calculating their capital charge. Individual banks or their regulators will have discretion to apply stricter standards. (a) ‘Value-at-risk’ should be computed on a daily basis. (b) In calculating the value-at-risk, a 99th percentile, one-tailed confidence interval is to be used. (c) In calculating value-at-risk, the minimum holding period will be ten trading days. For positions that display linear price characteristics (but not options), banks may use value-at-risk numbers calculated

Appendix I

279

according to shorter holding periods scaled up to ten days by the square root of time. (d) The historical observation period (sample period) for calculating Â�value-at-risk will be [subject to a minimum length of one year, but the Committee is also considering the practicability of applying the higher of the value-at-risk measures calculated according to two historical observation periods.] (e) Banks should update their data sets no less frequently than once every three months and should also reassess them whenever market prices are subject to material changes. (f ) No particular type of model is prescribed. So long as each model used captures all the material risks run by the bank, as set out in B.3, banks will be free to use models based on Â�variance-covariance matrices, historical simulations, or Monte Carlo simulations. (g) Banks will have discretion to recognise empirical correlations within broad risk categories (e.g. interest rates, exchange rates, equity prices and commodity prices, including related options volatilities in each risk factor category). However, value-at-risk across these risk categories is to be aggregated on a simple sum basis. (h) Banks’ models must accurately capture the unique risks associated with options within each of the broad risk categories. The following criteria apply to the measurement of options risk: – banks’ models must capture the non-linear price characteristics of options positions; – banks must apply a minimum ten-day holding period to options positions or positions that display option-like characteristics. Since option risk is not linear, banks may not ‘scale-up’ the daily value-at-risk numbers by the square root of time; – each bank’s risk measurement system must have a set of risk factors that captures the volatilities of the rates and prices underlying option positions, i.e. vega risk. Banks with relatively large and/or complex options portfolios should have detailed specifications of the relevant volatilities. This means that banks should measure the volatilities of options positions broken down by different maturities. (i) The banks must meet, on a daily basis, a capital requirement expressed as the higher of (i) the previous day’s value-at-risk number measured according to the parameters specified in this section and (ii) an average of the daily value-at-risk measures on each of the preceding sixty business days, multiplied by a multiplication factor set by its supervisor. Based on their assessment of the quality of a

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The Market Risk Amendment

bank’s risk measurement system, supervisors have the discretion to apply a higher [or lower] multiplication factor than the specified [minimum/norm].16 (j)╇Banks using models will be subject to a separate capital charge to cover the specific risk of traded debt and equity securities to the extent that this risk is not incorporated into their models.

Appendix J Test portfolio exercise€– summary of results

• Fifteen banks provided useful responses to the test portfolio Â�exercise,

in which they were asked to evaluate the value-at-risk for four portÂ� folios of ‘plain vanilla’ instruments. The banks were asked to produce a total value-at-risk figure for each portfolio, as well as a Â�decomposition of this figure into interest rate risk, foreign exchange risk and equity price risk. • Depending on the particular portfolio and risk category being considered, roughly 7 to 10 of the 15 banks produced estimates of risk within a range of plus or minus 25 percent of the median estimate, with the remainder falling outside this range. • Although the overall amount of variation in the results is fairly consistent across risk categories and portfolios, it is not always the same set of banks that fall above or below the median estimate. Some of the largest deviations from median estimates are on the high side, which may reflect less sophisticated (but more conservative) approaches currently used by some banks to evaluate the risk on certain types of positions. • Analysis of the results and follow-up discussions with the participating banks suggest that a moderate amount of supervisory guidance as to acceptable risk measurement practices could substantially reduce the dispersion of the results. Examples of such guidance include the following: – Place a floor on the length of the historical sample period used to calculate volatilities and correlations. – Require that banks’ interest rate risk models account (implicitly or explicitly) for basis risk between different types of instruments (for instance, between government bonds and swaps); and that they model a sufficient number of distinct points on the yield curve. 16 [Footnote in original text] The level of [minimum] multiplication factor will be determined by the Committee after additional analysis and consultation with the industry.

Appendix K

281

– Standardize the approaches taken to aggregating risk amounts across broad categories such as interest rate risk, foreign exchange risk, and equity risk. – Require that banks’ models include a treatment of option positions that covers the risks of non-linear price movements over at least a ten-day holding period. • The results suggest that there is probably some amount of variability across banks that supervisors could never eliminate, because of many subtle model differences. For this reason, imposing even more stringent parameter and modelling restrictions is likely to result in little additional reduction in dispersion across banks, while imposing significant costs to both banks and supervisors. • The results do not suggest any major differences across different general types of risk measurement models (e.g., historical simulation versus variance-covariance) at the 99%, 10-day holding period level.

Appendix K

BS/95/34

Basle Committee on Banking Supervision Note to Committee members on the ‘plus factor’ The Chairman 1. I believe that it would be useful for the Committee to have a discussion on the so-called ‘plus factor’ at its June meeting under point IV of the agenda. From the initial progress reports of the models task force and from my contacts with a number of Committee members, I think that there are issues and concerns associated with this topic that the Committee needs to discuss in order to give guidance to the future work of the task force. This note is intended to present my assessment of the various issues that have arisen and how we may provide further guidance to the models task force in its work on the formulation of the plus factor. 2. After the release of the market risk proposals last April, the model task force was given the mandate to develop a method for incorporating a plus factor into the models-based capital charge. Recall that the plus was to be added to the multiplication factor and would be related directly to the performance of the model, in particular backtesting (it would be zero if the model performed well). I believe that such a plus factor is an essential component of the models approach,

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The Market Risk Amendment

because it would remove the otherwise ‘perverse’ incentive to adapt the model to minimize the capital charge and, to the contrary, introduce incentives for banks to measure their risks as accurately as possible. 3. At its meeting in early April, the models task force began to discuss the formulation of the plus factor. The task force found that there were a number of issues and difficulties associated with the development of a plus factor linked to the results of back-testing. For example, the task force found that the statistical properties of back-testing may be too poor to reliably distinguish between models of greater and lesser quality. Moreover, if the plus is seen as a penalty, it could create incentives for banks to develop very conservative models that may no longer be useful for managing risks on a day to day basis. Other more technical questions were raised as well. The task force agreed to conduct a fact-finding exercise to establish in greater detail how banks use results of back-testing internally to validate their models. The results of this exercise will be available in time for the next meeting of the task force on 22nd June and should assist in the formulation of the plus. 4. Against this background, I believe it is important that we develop a formulation of the plus factor that meets the dual objectives of (1) creating strong incentives to keep high the predictive quality of the model and (2) being relatively straightforward and meaningful in practice. 5. From discussions in the task force there seems to emerge two possible alternative approaches for the implementation of the plus factor. Under the first approach, the plus factor would be based on a case by case qualitative assessment of the performance of the model (which could, among others, include the results of back-testing). Under the second, quantitative, approach, the plus factor would be derived directly, via a formula to be defined, from the results of back-testing. 6. The main advantage of the qualitative approach is the flexibility it offers. There would be no hard-wired quantitative link between back-testing results and the plus, rather more general criteria could be specified. Moreover there would be the possibility of taking other elements into account when determining the plus. In mathematical language, the plus factor would be a ‘constant’ added to the ‘minimum three, and the size of this constant would be decided in a judgmental way by the supervisor. A case-by-case approach would give national supervisors more discretion in adjusting the capital requirements. However, such a procedure would lack the necessary

Appendix K

283

transparency and could lead to differences in supervisory treatment among banks and across countries. Moreover, in the absence of fixed and objective criteria, supervisors could find themselves ‘bargaining’ with banks over the value of the plus. 7. In the quantitative method, the plus would be a mathematical ‘function’ (albeit a very rudimentary one), e.g. one based on the number of times that trading results exceed the model’s estimated VAR. Since it is based on more objective criteria, it would result in a more equitable and uniform treatment of the different institutions and streamline the task of supervisors. Furthermore, it would explicitly provide banks with a permanent (i.e. not depending on the supervisor’s periodic check of the quality of the model) incentive to improve the accuracy of their internal models. On the other hand, the usefulness of this method depends on the robustness of the statistical hypotheses vis-a-vis real life events and the task force seems to encounter some technical problems identifying a fixed link between the back-testing results and the size of the multiplication factor. 8. To this presentation of the two approaches as mutually exclusive, in terms of an alternative some observations can be made. In the first place, the two possible approaches for the implementation of the ‘plus’ factor are not mutually exclusive. Our April document is clear on this point:€sections B.2 and B.4 of part B of the planned Supplement to the Capital Accord explicitly refer to the back-testing programme as part of the qualitative criteria and of the quantitative standards. Moreover, the two approaches share some key elements. Specifically, the Committee has agreed that in all cases supervisors should base their judgements on the outcome of the back-testing procedure. Thus, the difficulties inherent in the interpretation of the back-testing procedure, whose functioning and application in the banking system is being investigated by the task force, exist in both the quantitative and the qualitative approaches and cannot be avoided. The advantages and disadvantages of the two approaches have to be looked at in this context. 9. I think that a discussion within the Committee on the nature of the plus factor would smooth the way for the task force, which will have to work out the best or the ‘less bad’ technical formulation of a plus, leaving the final, more political, decision to the Committee. However, as the decision on checking on the feasibility of the plus is based on both political and technical considerations, it would be useful in this matter to stay in contact with your task force member.

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In any case no conclusions can be formulated before the industry express their comments on the package. 30.5.95 Tommaso Padoa-Schioppa

Appendix L Explanatory Note Modification of the Basle Capital Accord of July 1988, as amended in January 1996 The Committee has decided to remove the provision of the 1996 Market Risk Amendment which requires that the specific risk capital charge of the internal models approach be subject to an overall floor equal to 50% of the specific risk amount calculated under the standardised approach. Since the release of the Market Risk Amendment in early 1996, the Committee and national supervisors have had a dialogue with banks on their methodologies for assessing specific risk. As regards methods for modelling idiosyncratic variation, the Committee notes that it has seen sufficient improvement and innovation in these modelling techniques and enough similarity among methodologies used by banks to set general criteria for modelling idiosyncratic variation (i.e., the dayto-day variation not explained by the general market). However, the Committee as a whole has not yet agreed that currently existing methodologies used by banks adequately capture event and default risk. The Committee notes that approaches for measuring and validating this risk differ widely at present and that modelling in this area is in the process of rapid evolution, making it impractical at this juncture to set forth general guidance for capturing this risk. In the light of these findings, the Committee has established certain qualitative and quantitative requirements for idiosyncratic risk which will allow banks that meet them to base their specific risk capital charge on modelled estimates of specific risk without reference to the floor. Banks that do not meet these requirements (as set out in the attached text for amending the Market Risk package) must use the standardised approach to calculate the specific risk capital amount. The requirements are aimed at ensuring that banks accurately estimate and validate idiosyncratic variation as part of a portfolio’s overall price variation. Until a bank can demonstrate that the methodologies it uses capture event and default risk adequately, its modelling of specific risk will be treated on the same basis as if a model of general market risk proved deficient

Appendix L

285

during backtesting. As a result, it will be subject to a capital surcharge; that is, a multiplication factor of four on the treatment of specific risk. The minimum multiplication factor of three could only be applied to specific risk models for which it can be demonstrated that all relevant aspects of market risk are captured. The Committee expects that the banks’ continuing efforts to improve their models will soon lead to established market standards that adequately capture event and default risk for traded-debt and equity instruments and is prepared to work with the industry to this end. The Committee and national supervisors are ready to examine at any time the ability of individual methodologies to model both components of specific risk set forth in the regulatory definition. If such an overall ability can be shown to both bodies, any model that is based on the same methodology may immediately obtain the minimum multiplication factor of three; however, a higher multiplication factor of four would be possible if future backtesting results were to indicate a serious deficiency with the model. The Basle Committee and national supervisors will continue to cooperate to ensure that the implementation of such methodologies and practices are done in an appropriate and consistent manner. As soon as market standards have been established within the industry, the Committee will replace this interim approach by defining general guidance for capturing event and default risk for trading book instruments.

8

The Core Principles of Banking Supervision

A

The first set of BCBS Principles, on money laundering

The penchant for compiling principles, codes or standards of conduct for almost every, and any, variety of human behaviour imaginable was mainly a creature of the 1990s. It began, however, in the field of banking in the late 1980s in the guise of a code of conduct for the prevention of money laundering (or AML€– anti-money laundering, as it became known). Prior to 2001 this aimed at restricting the drug trade rather than terrorism. The Americans took the lead in the ‘wars’ against both drugs and terror; they were keen that foreign/international banks should not be used to launder drug money. So a note by the Federal Reserve Board proposing an AML Code of Conduct was submitted to the BCBS in June 1987 (BS/87/49). Comments were received from Switzerland (BS/87/51) (which was considering making money laundering a criminal offence), Canada, France and the Netherlands which were broadly in favour of such a code of conduct; from Luxembourg and Belgium, which, while supporting the aims of the exercise, thought that the BCBS was not the proper forum for it; from Germany, which was opposed to approaching banks so long as legal distinctions between criminal and civil laws remained to be resolved; and from both the Bank of England and the British Bankers Association (BBA), which were quite hostile1 (BS/87/74). The Banca d’Italia response (BS/88/9) was also lukewarm. Thus the BBA wrote: 1

The current fad is for codes of conduct in all sorts of areas, but they are not a proper solution to real problems. Let there be legislation where legislation is needed, or perhaps supervisory guidelines, but codes of conduct without effective sanctions€– as is the case with the RCC [Recommended Code of Conduct]€– are really no answer at all. And the Bank of England stated that: The UK has introduced some tough legal inhibitions to money laundering in the 1986 Drug Trafficking Offences Act. We doubt if Bank of England sponsorship of a code of conduct (which we have no powers to enforce) would have any real additional deterrent

286

The first set of BCBS Principles, on money laundering

287

Discussion of an AML code of conduct had been scheduled for the forty-fourth meeting of the BCBS, on 16–17 November 1987, but was deferred ‘to allow the US members to revise the draft code or present suggestions as to how this subject should be handled’ (BS/87/85). Despite the mixed reception of the earlier draft, at the next (forty-fifth) meeting of the BCBS (28–29 January 1988), it was reported (BS/88/21, Agenda item IV) that: The Committee expressed general support for the broad lines of the revised version of the code of conduct (BS/88/2) prepared by the US members. It was agreed that Mr Ryback in association with the Secretariat should redraft the text in the light of members’ comments. The revised document, together with some proposals regarding the procedure for its issue, would be considered at the next meeting.

And at the next (forty-sixth) meeting (28–29 April, BS/88/47): The Committee approved in principle the text of the draft Code of Conduct (BS/88/2, 2nd draft) subject to certain reservations about the last paragraph of the preamble and Sections II and III of the Code. The Secretariat was asked to circulate a revised text for members to use, if they wished, as a basis for discreet private consultation with bankers or with other national authorities which had responsibilities in this area. Members were asked to keep any discussions confidential; if pressed by the media they should reply that the topic was indeed one (among many others) to which the Committee had been giving consideration, but that no early results could be expected. In the meantime, the Chairman said that he would circulate a short note for Governors at their May meeting briefing them on the matter and indicating that the Committee might be in a position to submit a final version of the Code for consideration at their July meeting.

Meanwhile the German representative, Schneider of Bafin, the Federal Banking Supervisory Office, had reinforced his objection to the whole exercise on the grounds of locus of competence.2 Moreover, effect on money laundering through UK financial institutions. The success of a code in the UK will depend very much on how reasonable its terms appear to the banks. To that end we suggest that its coverage should be limited to discouraging banks from dealing with persons known or suspected to be disreputable. It should not require them to take steps beyond the needs of their commercial self-interest to seek to verify the credentials of their customers. Such requirements are too onerous and have too little evident benefit to be imposed by a code of conduct; if considered necessary they should be imposed by law. The possible need for changes in UK law relating to banking services generally is currently the subject of an independent review established by the Government and the Bank of England. ‘Leaving aside the above-mentioned reservations, the Federal Minister of Finance is of the opinion that the Code addresses issues and subjects that do not fall within the competence of either the central banks or banking supervisors. In the Federal Republic of Germany the competent authorities are the Federal Minister of Justice, the Federal Minister for Economic Affairs and the law enforcement authorities.’ 2

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two significant changes were made to the original document; first, the original heading ‘Code of Conduct’ was replaced by the somewhat softer term ‘Statement of Principle’ (on the prompting of France and the UK); second, the phrase ‘illegal activity’ was replaced by the term ‘criminal activity’ which narrowed the scope of the exercise, excluding tax evasion for example from its ambit (proposed by Luxembourg and the Netherlands). The full document, consisting of a preamble, followed by a Statement of Principle, was then sent to the governors in December 1988 (and is reproduced here in Appendix A to this chapter), under cover of an introductory cover letter by Chairman Huib Muller. In this (BS/88/102, paragraphs 5–7) Muller stated that: Paragraph 7 of the preamble sets out the degree of commitment which Committee members are able to give to the document in the context of their own national circumstances. The reason for the qualification as to competence in the second sentence of paragraph 7 is that in two member countries, Germany and Luxembourg, the banking supervisory authorities have no direct competence in this area. Nonetheless, the Committee judged it preferable to issue a statement to which all G-10 countries were able to subscribe rather than a slightly stronger statement by less than its full membership. It may be noted that, in order to avoid conveying the impression that the Statement has legal force, its title has been changed from ‘Code of Conduct’ to ‘Statement of Principles’. The Committee has given considerable thought to the way in which the document might be disseminated, bearing in mind the sensitivity of the topic and the absence of competence mentioned above. In order to allow a degree of national flexibility it is recommended that member countries should be free to disseminate the document in whatever way they think fit. So far as publicity is concerned, it is recommended that the media’s attention should not specifically be drawn to the Statement. If, as is likely, the press expresses an interest, Committee members would not deny its existence and would make the text available …

The Committee, and the Governors, were extremely averse to circulating a document which was not unanimous, on which one or more members, in this case Germany, maintained a ‘reserved’ position. In this instance, however, President Pöhl, ‘after consultation with the German Minister of Finance, was able to withdraw the reserve of the German authorities’ (BS/88/117, 12 December). So the statement was then sent out to non-G10 supervisors on 16 December (BS/88/119), and sent on to banks in G10 countries under cover of a letter from their own national supervisor in early January (BS/89/1). In the event the statement did not make much of a splash. A number of countries wrote back to the Secretariat (BS/89/64), mostly with messages of support and to report that they had passed the statement on to their own banks.

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Subsequently a completely separate body, the Financial Action Task Force on Money Laundering (FATF), was established in 1989, with its headquarters in Paris and a secretariat provided by the OECD, with the purpose of combating money laundering and terrorist financing. Initially members of the BCBS Secretariat participated as observers. But in 1991 Peter Hayward, the Chief Secretary, after discussion with the new Chairman, Jerry Corrigan, and with Rinaldo Pecchioli of the OECD, wrote to the Chairman of FATF, Alexis Lautenberg, that ‘any continuing collective activity by the Group of Ten bank supervisors [in FATF would be] unnecessary and perhaps confusing’ (BS/91/77), if only because of the direct involvement in FATF of the member national supervisory bodies. So ended the first involvement of the BCBS with Codes/Standards/Principles. B

BCCI and minimum standards

The BCBS intermittently struggled with the tension between trying to improve and uphold the best standards of regulatory practice, both in G10 and non-G10 countries, on the one hand and the aim to avoid becoming an executive and sanctioning body on the other. This has already been noted in Chapter 4 on the Concordat, where in 1983 (BS/83/73) the subgroup on the implementation of the Concordat, chaired by Hugo Coljé, noted that: The sub-group believes that it is appropriate for the Committee to discuss not only the principles of supervisory co-operation but its practical application too. Recognising that considerable duplication of effort would be involved if each authority strictly followed the guidelines laid down in the Concordat for bilateral approaches to other supervisors, the sub-group believes that a co-ordinated approach by the Group of Ten countries would be very helpful. Such an approach would imply that the Committee discuss details of the experiences members have had in their contacts with other supervisory authorities; in the past there may not have been sufficient opportunity for interchanges of this nature. At the same time, the sub-group feels that great care needs to be taken when reviewing supervisory standards in other countries. In its report to the Governors on the problems raised by the existence of offshore centres (BS/78/2), the Committee concluded that a co-operative and educational approach was preferable to any form of confrontation. Now that the benefits of this approach are beginning to bear fruit, the sub-group believes that the Committee should be careful not to compromise that principle. In particular, if it became known that the Committee as a body was formally seeking to judge, and perhaps condemn, particular supervisory regimes, the sub-group fears that the Committee would become subject to publicity and political pressure which would make it more difficult for it to operate effectively.

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The same issue resurfaced in 1992, when, in the aftermath of the Bank of Credit and Commerce International (BCCI) affair, the BCBS issued a further document, extending and amplifying the Concordat, on ‘Minimum standards for the supervision of international banking groups and their cross-border establishments’ (BS/92/15). Later at the sixty-fourth meeting of the BCBS (2–3 December), following a presentation by Mr Barnes on the Bingham Report into the BCCI Review: the Committee discussed the idea that some form of peer group review procedure should be adopted to assess the adequacy of supervisory standards in member countries or outside. In general, members were not in favour of the Committee playing any form of pivotal role. Mr Barnes said he would consider the views expressed and perhaps revert to the Committee with a concrete proposal at the March meeting.

In the meantime the Secretariat put forward a note (25 February 1993) on ‘Options for strengthening relations between Basle Committee and non-G10 supervisors’ (BS/93/5). In this paper it was stated, inter alia, that: During the recent ICBS conference in Cannes, the representatives of nonG-10 countries expressed a clear desire to establish closer contacts with the Basle Committee. While aware that many points of contact already existed, it was generally felt (particularly as a result of BCCI and the minimum standards) that such contacts needed to be intensified … The Committee has already decided to update the survey on home and host supervision which was first conducted in 1985 following the discussion of the 1983 revised Concordat at the Rome ICBS. A draft will be circulated for discussion at the Committee’s March meeting (see BS/93/4). There is a clear need for a new questionnaire in the aftermath of BCCI in order to assist in implementation of the minimum standards. To edit and circulate the answers to the questionnaire to all interested parties, as was done on the previous occasion, is a considerable administrative task for the Secretariat and the job is likely to be heavier now that the questionnaire is more detailed and the probable number of respondents greater … So far, discussion of home and host-country relationships has been done mostly in the corridors of Committee meetings. It has on occasion been suggested that this should be done more openly in the tour de table but members have evidently felt that the issues were too sensitive for open discussion. Given the minimum standards that have now been set, it seems desirable to have a discussion at the table. At the least, members need to be informed what action has been taken. The confidential nature could be preserved by having no informal record of such discussion. This could become a regular item of the agenda, either within or apart from the tour de table …

Such a questionnaire, a ‘Survey of banking supervisory practices’ was drawn up (BS/93/11) and discussed at the next (sixty-sixth) meeting

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of the BCBS (BS/93/19), under Agenda item VII on ‘Strengthening relations with non-G-10 supervisors’, at which it was suggested that a cover letter for the questionnaire be appended for onwards transmission to the Governors to record the ‘intensifying relationships between the Supervisors’ Committee and non-G-10 members’ (BS/93/27); this paper is reproduced as Appendix B. (NB The relationships between the BCBS and non-G10 supervisors are the main subject of Chapter 12, Section B.) At the next (sixty-seventh) meeting of the BCBS (10–11 June), the Committee reviewed members’ experience in the implementation of the ‘minimum standards’: The Chairman concluded that, off the record, members should feel free to say which countries, in their view, failed to meet the standards and, if appropriate, why. But the Committee should in no case seek to endorse the decisions which should remain individual ones. Mr Farrant noted that the Bank of England had arranged a meeting in London on 1st July with those interested to discuss the concept of the ‘peer group review’. Although it had circulated a paper on the topic, the Bank had no preconceptions about how it might work. It was willing, in the absence of other volunteers, to become the first institution subject to review.

In some respects such a ‘peer group review’ exercise could be regarded as a forerunner of the IMF’s current Financial System Assessment Programme (FSAP), but it was not taken further by the BCBS at the time. On the other hand, work on ‘minimum standards’ was followed up; resulting in a lengthy paper on ‘The supervision of cross-border banking’, the report of a joint working party comprising members of the BCBS and the Offshore Banking Supervisors Group, March 1996 (BS/96/9), which was subsequently made public under cover of a press communiqué of 8 October (BS/86/92), reproduced as Appendix C (see also Chapter 4). What this story underlines is the tension between the desire of BCBS members to cooperate with banking supervisors elsewhere in order to raise supervisory standards and the wish to avoid any executive responsibility for overseeing or judging such non-G10 supervisors. C

Strengthening Effective Banking Supervision

In May 1996 Chairman Tommaso Padoa-Schioppa, reviewed the course of future likely work for the BCBS and a restructuring of the proliferating subgroups. One of the key areas was the relationship of the BCBS with non-G10 supervisors. Here, the Chairman wrote that: Relations with non G-10 supervisors are a fourth broad area where the Committee will undoubtedly have to work according to a long time horizon …

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There are two broad issues involved. The non G-10 countries involved in the two issues may not be the same. First, there is the ‘political’ issue of consultation with (some key) non G-10 countries before our final decisions are made. In this respect President Tietmeyer called for ideas on how to involve emerging countries in some kind of consultation and approval process with reference to our G-10 rules (such as a wider meeting once a year). This implies that the Committee has to give further thought to cooperation with these countries, in addition to possible work following up the joint work with the Off-shore Group. Second, there is the ‘policy’ issue of supervisory standards in non G-10 countries. The scope of the Committee’s main interest in this area concerns the safety and soundness of cross-border banking and the effectiveness of the domestic supervisory framework and standards. But there is a new area which deserves the Committee’s attention:€ building on the coming debates in Stockholm and on the joint work done with the Off-shore Group, the Committee could consider whether its ‘exporting supervisory rules tailored for the G-10 to non-G-10 countries’ should not be complemented with work (to be done with non-G-10 countries) on standards tailored to their needs.

The Secretariat provided a supporting annex to this note, indicating: four separate aspects relating to the development of a more structured relationship between the Committee and the supervisory authorities in non-G-10 countries. (a) Closer consultation on the development of Committee policies Messages received by the Chairman and the Secretariat, and repeated by President Tietmeyer in the G-10 Governors’ meeting on 15th April, indicate that a number of countries directly affected by the Committee’s work (especially those that have implemented the Capital Accord or have committed themselves to implementing the Basle Committee standards) feel that they are not being sufficiently informed about the development of Committee projects or adequately consulted before decisions are taken. (b) Assistance in implementing Committee rules and standards The Committee has never seen itself as a forum for ‘technical assistance’ but over the last few years one member of the Secretariat has devoted much of his time to the organisation of training courses and assistance in structuring training facilities for the regional groups … (c) Improving the safety and soundness of cross-border banking Following the ICBS, it may be necessary to follow up the report on the supervision of cross-border banking prepared by the joint working group with offshore supervisors as a means of strengthening implementation of the minimum standards in more countries. In particular, this report provides guidance on what constitutes effective consolidated supervision. (d) Improving domestic supervisory standards A discussion on this matter will take place in Stockholm in the panel on the first afternoon and in working groups on the second day. The basis for the second-day discussion will be the survey currently being conducted on national supervisory arrangements and following the ICBS it will be possible to judge

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whether further guidance is desirable or possible on legal and administrative supervisory arrangements and their adequacy.

Following the summer Stockholm ICBS, Danièle Nouy of the French Commission Bancaire wrote (6 August 1996, BS/96/73) to Erik Musch, the Secretary General, to state, inter alia, that: There is a strong appetite for documentation on banking regulations and supervisory techniques. Emerging countries would certainly benefit from manuals on international standards for banking regulation, which could be maintained by the Basle Secretariat, and would serve both as reference documentation and as training material for non G-10 supervisory authorities.

But what transformed the ‘long-time horizon’ of the Chairman’s May 1996 note into urgent immediate action was the involvement in this field of leading politicians and the IMF. The G7 finance ministers’ report to the heads of state at Lyon (28 June 1996; BS/96/60) sought ‘Better prudential safeguards in international financial markets’; one key element of that should involve expanding effort to: Strengthen prudential standards in, and supervisory cooperation with, emerging markets. Effective prudential regulation and supervision must cover all important financial marketplaces, particularly those which are experiencing high growth rates and/or substantial capital flows. The Basle and IOSCO Committees are performing work in this area which reinforces bilateral and regional efforts underway. Because emerging markets are growing in significance, these Committees, and other appropriate fora should be encouraged to strengthen their outreach to and cooperation with emerging market supervisors in order to promote high prudential standards. The International Financial Institutions should give more attention to promoting effective regulatory and supervisory structures in emerging markets.

And the accompanying economic communiqué had as one of its objectives: encouraging the adoption of strong prudential standards in emerging economies and increasing cooperation with their supervisory authorities; international financial institutions and bodies should increase their efforts to promote effective supervisory structures in these economies. We ask our Finance Ministers in consultation with the relevant institutions to report back on this issue at our next meeting;

Note the relatively tight deadline of one year for getting a ‘progress report’. The need for speed was underlined in a letter from Jean Arthuis, French Minister of Finance and Chairman of the G7 finance ministers to H. Tietmeyer, President of the G10 governors, and copied to PadoaSchioppa, requesting a provisional response about ‘on-going work and places’ by the end of September (letter dated 29 August, BS/96/71).

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Effectively the IMF and the World Bank had been given a remit by the Lyons heads of state meeting to examine the financial supervisory capabilities of emerging markets. But by what yardstick could they make such a judgement? Some institution would have to establish a set of codes/practices/principles against which the IMF/WB could do so. This was, naturally, discussed at the next (seventy-ninth) meeting (9–10 September 1996), where it was stated (BS/96/78) that: Non-G-10. The Committee approved the plans for meetings/workshops scheduled in the months ahead. For the meeting planned with emerging market countries on 21st November, it was suggested that the starting point should be the survey conducted for the ICBS and the aim should be to develop a specific set of issues to be put on the table. The intention should be to listen to the views of the non G-10 supervisors and to be ready to react positively to any request for assistance. The Secretariat was requested to reflect on the views expressed by members and prepare a discussion paper for circulation to participants in middle October. IMF. As regards relations with the IMF, the Chairman reported on a discussion he had held with M Guitian in which he had been assured that the IMF had no wish to become involved in ‘rule making’ for supervisory policies but felt it could play a role in encouraging and monitoring implementation of Basle guidelines in less developed countries. The Chairman said he planned to discuss how such ‘complementarity’ would work in practice at a meeting with IMF staff around the IMF Annual Meetings.

From there plans for future work developed rapidly. In his letter to the President of the G10 governors (5 November 1996, BS/96/85), the Chairman wrote, on the subject of ‘world-wide prudential standards’: As you will recall, I reported to the Governors at their July and September meetings on the measures being adopted by the Basle Committee to strengthen co-operation and consultation with non-G-10 supervisors following remarks you made in earlier meetings and the successful international conference in Stockholm in June. I informed you that the Basle Committee had decided to hold regular annual meetings with various categories of non-G-10 supervisors and that the first such meeting, mainly with emerging market countries, would take place in November. Since the Governors discussed this matter again at their September meeting a great deal of activity has taken place. Later that same week, a one-day conference on ‘Strengthening the Financial System in Developing Countries’ took place in Basle under the auspices of the BIS, the IMF and the Basle Committee; you will receive a separate report on this conference. The IMF–World Bank annual meetings provided an opportunity for a number of further contacts with IMF and US Treasury staff. As you are aware, the G-10 Deputies of Ministers and Governors have set up a working group to undertake a study on financial stability in the emerging economies. In addition, a group of G-7

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Finance Ministers’ deputies is to undertake a similar study. I will report orally to the Governors on how these projects are likely to affect the work of the Basle Committee. Governors will also recall the discussion at their September meeting about the role of the IMF in strengthening supervision in emerging markets. In the various encounters I had in Washington, it was clear that the IMF, as well as the Finance Ministries and others, recognise the standard-setting role of the Basle Committee and agree that duplication of work should be avoided. However, they also expect action on the non-G-10 front in the coming months. What the Fund needs is a product that they can use in their country missions€ – a measure which they can use in performing their surveillance work. Taking account of this situation, the Basle Committee is now planning to make two partly complementary contributions, to this work: (a) A single-volume Compendium of the relevant policy documents produced by the Committee; (b) A relatively short set of Guidelines consisting of key principles for a sound supervisory system. Drawing up the Guidelines will be a challenging task. The intention is to prepare a normative document laying down key principles for sound supervision applicable to any country (G-10 as well as non-G-10). The document should be drafted in such a way that it could be used as a checklist. The coverage should be comprehensive, so that it would include principles that the Basle Committee has not addressed before, either because they were already in place in G-10 countries or because harmonisation was not perceived to be necessary. The Guidelines should carry real commitment, and therefore be more than a simple Committee paper. Support should stem from a co-operative process with supervisors outside the G-10. The nature of the Guidelines and their content will be the principal focus of the meeting between the Basle Committee and supervisors from sixteen non-G-10 countries that has been scheduled in Basle on 21st November. While there is a need for speed, the quality and status of the product will depend on the depth of the preparatory process. Moreover, after suitable Guidelines have been set, implementation is bound to take time. Since the IMF plans to use both the Compendium and the Guidelines in its surveillance work in non-G-10 countries, there will he informal exchanges of ideas and drafts with the Fund to ensure that it obtains an appropriate product.

Although it was then (early November 1996) envisaged that ‘drawing up the Guidelines will be a challenging task’, in the event it was done with quite remarkable speed. Indeed a first draft of the Guidelines was ready by the end of November, in time for the 21 November meeting of the BCBS with emerging countries. At that meeting the BCBS proposed (BS/96/112):

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the creation of a small working group of Basle Committee and non-G-10 countries to take forward the work.3 The Guidelines will be finalised in March, forwarded to the April Governors’ meeting and subsequently to Ministers. Working drafts will be circulated to all Committee members so that they can monitor progress. Written comments on the present text should be sent to the Secretariat within ten days. There would not be time to obtain worldwide endorsement by March, but that version would not be a final one. The process will be as transparent as possible and the Committee will consider, following the 21st November meeting, whether to use the regional groups as a channel. In a brief exchange of view between Committee members that attended the 21st November meeting it was concluded that a letter should be sent to regional chairpersons and supervisors of non-G-10 industrial countries to inform them of the ‘Guidelines project’ and to announce distribution of a draft by midDecember inviting their comments.

Not only was the speed of drafting remarkable, but there was relatively little contention or even debate about substance, at least as appears in the Archives. Personal discussion with Charles Freeland indicates that the more difficult areas to draft involved the questions of: 1. What were the necessary preconditions for successful supervision, for example the observance of the rule of law in a country. 2. How to deal with public sector banks. 3. What to propose for capital adequacy in countries which only adopted the Basel I CARs for their larger banks, or not at all. There were some drafting suggestions, for example about clarification, reordering and so on, from the Chairman (BS/96/117). In the course of drafting, the title of the document was changed from Guidelines to Core Principles. This was intended to be a slight hardening, more prescriptive than a ‘guideline’, but less so than a ‘standard’ (a lesson in the niceties of the English language). Following the December meeting a further revised version was ready by March 1997 (BS/97/9

In BS/96/124 it was reported that: 3

At our meeting it was proposed that a small joint group be formed to continue work on the guidelines. This group has now been formed and will be meeting in Basle the 17th and 18th of December. The group is comprised of representatives from several G-10 countries (France, Germany, Japan, the United Kingdom and the United States) as well as several non-G-10 countries which attended the 21st November meeting (Chile, China, Czech Republic, Hong Kong, Mexico, Russia and Thailand). I hope that you understand that the size of this joint committee had to be kept small so that real progress could be made in the drafting. There is never full satisfaction regarding the exact composition of such groups as rightly all want to contribute; however, I think this group represents a broad range of countries and regional areas.

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and€ 10).4 One reason for having a new draft available by mid-March was that the IMF’s Executive Board was to discuss this general subject at their meeting on 28 March, and the BCBS wanted their paper to be available for the Board, in addition to the Fund’s own internal paper, ‘Towards a framework for sound banking’. The BCBS were keen to forestall the publication of two, overlapping papers, as this could create confusion about who was doing what. Given the wide-ranging involvement of national supervisors in the preparation of the Core Principles (interaction between the authorities of at least forty countries) and the BCBS’ long-standing role in international financial regulation, the BCBS wished to achieve precedence for its own Core Principles paper (BS/97/2 and 34).5 The timetable outlined in footnote 4 was not only met; it was telescoped in time. The Core Principles were effectively published (though still as a consultative document) under cover of a press communiqué on Tuesday–Wednesday, 8–9 April 1997. The communiqué is reproduced as Appendix D, and the list of twenty-five Principles as Appendix E. One of the reasons for such speed was for the purpose of delineating relative responsibilities in this field with the IMF. This was effectively achieved as the report from the new Chairman, Tom de Swaan, indicates (12 May 1997, BS/97/60). He wrote: The proposed schedule then (BS/97/19, 5 March 1997) was: 4

On the basis of these comments and other developments, the Secretariat proposes the following minor changes to the schedule contained at the end of the Chairman’s note: • early March:€circulation of the present draft finalised by the joint group to the IMF for comments by the staff and circulation to Board members; • 18th–20th March 1997:€ approval of the Principles by the Committee and fifteen non-G-10 countries, with as much positive support as possible from the regional group chairmen; • 7th April 1997:€endorsement by the G-10 Governors and subsequent circulation to supervisors worldwide; • mid-April 1997:€transmission to Ministers; • early May 1997:€release of the Principles in the form of a consultative paper; • mid-August 1997:€deadline for comments; • 9th–11th September 1997:€review of comments at the Committee’s regular meeting, reconvening the drafting group if necessary; • 20th–25th September 1997:€presentation in Hong Kong; • 10th–12th November 1997:€ approval of final text by Committee for release after Governors’ December meeting; • spring–summer 1998:€questionnaire circulated to ICBS participants; • October 1998:€wider endorsement of Core Principles; • October (?) 2000:€review of progress at ICBS. 5 At one time a suggestion was mooted in the IMF that the BIS should propose guidelines for big international banks, and the IMF should do so separately for all other smaller banks. This, rightly, did not find any support at the BCBS.

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I would like to bring you up-to-date on a number of developments regarding the ‘Core Principles for Effective Banking Supervision’. The fact that the principles were sent out for consultation very timely ahead of the Spring meetings of the International Monetary Fund (IMF) and the World Bank Group (WBG) at the end of April proved to be successful. In a number of meetings on that occasion I clearly got the impression that a large number of parties involved received the principles very well. In the report of the G-10 Deputies on the Stability in Emerging Market Economies, a clear reference is made to the Core Principles which are annexed to the report. More important, the report clearly acknowledges again the fact that the different groupings of national authorities, such as the Basle Committee, should be responsible for the formulation of norms, principles and practices and that in its surveillance, the IMF should monitor the adoption of sound principles and principles developed by the international groupings. I had a meeting with Stanley Fischer and a follow-up conversation with Manuel Guitián on the cooperation between the IMF and the Basle Committee in which this division of responsibilities was again reiterated. During these conversations, we also discussed the possible further route to be followed concerning the Core Principles. As discussed in our March-meeting, in principle we agreed to organise a conference on the occasion of the meetings of the IMF and WBG in Hong Kong in September. The conference would be co-sponsored by the IMF and Basle Committee and would aim at attracting high level participation from Ministers of Finance and Central Bank Governors. As far as speakers are concerned, our preliminary thoughts centre around the possibility to invite a Central Bank Governor and a Minister of Finance from non G-10 countries, a G-10 Governor, the Managing Director of the IMF and myself. On short notice, further discussion will also take place on the papers to be presented to the participants of the conference. They will in any case include the Core Principles. As far as the IMF-paper ‘Toward a Framework for Sound Banking’ is concerned, I discussed with Stanley Fisher that it will be reviewed in consultation with the Secretariat. In this respect, we noted the possibility to either incorporate the Core Principles in the paper or to annex them to the paper. In the latter case, the paper itself would contain a clear reference to the Principles. I understand the IMF is at present repackaging the paper, so that there will be less overlaps.

Nor was there much comment, or criticism, from supervisors abroad. The Secretariat noted (BS/97/65) that: As of Friday, 13th June, 19 comment letters have been received on the ‘Core Principles for Effective Banking Supervision’. The majority of comments suggest minor wording changes to the document; however, there are also several requests for clarification, additions or deletions. Virtually all of the letters support the overall concepts included in the document and praise the Committee for its initiatives in this area.

The main objection came from New Zealand, where under Governor Don Brash, the Reserve Bank of New Zealand (RBNZ) had been

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pursuing a more market-based approach.6 With some minor drafting changes (and an attempt to take account of the RBNZ position), the Core Principles were revised, and then issued as a final document in September 1997, in time for the Hong Kong IMF/WB meeting. There remained a question about the implementation of the Core Principles, that is how to get all countries to endorse and then to comply with these Principles. This was addressed in the BCBS note of 23 December 1997 (BS/97/107), which is reproduced as Appendix F. Of even greater importance, perhaps, was the effect that this exercise may have had on the BCBS role and responsibilities more widely. On this the Secretariat commented (BS/97/82) (August 1997) that: It has become clear over the Summer that the Core Principles represent a radical change in the Committee’s relationships with the rest of the World. From being a body concentrating on industrialised country problems, we are now being expected to take a lead in the supervision of every type of banking system. It is no longer possible to pretend that their problems are not of relevance to us. This means some fundamental rethinking of the Secretariat’s role and resources. In all this, it should not be forgotten that the underlying objective is not so much the Core Principles themselves as the need to improve standards of supervision in the emerging markets. The Principles are only one tool to this end and the Committee should therefore continue to intensify its training programmes, to support the regional groups and to encourage bilateral assistance by its individual members.

The BCBS had now emerged upon the world stage as the institution responsible for establishing norms for the regulation of banking systems€ – as contrasted with monitoring adherence to such norms, which was the province of IMF/WB FSAPs and ROSC (Reports on Observation of Standards and Codes)€– right around the world. This was quite a distance from its starting point as a group of national supervisors making recommendations to their own Governors. One interesting feature of this latest Core Principles exercise was that it was so totally different in character from those discussed in Chapter 6 (the 1988 Basel Accord) and Chapter 7 (the Market Risk Amendment). ‘In particular, New Zealand states that the paper is too prescriptive and that there are viable alternatives to rule-based supervision. In addition, the objectives of banking supervision vary among countries and these objectives will mandate the nature of supervision. For example, depositor protection is not an objective of banking supervision in New Zealand and consequently, there are relatively few prudential rules. The Reserve Bank of New Zealand wants more emphasis on market discipline and notes that the paper could state more emphatically that supervision is a supplement to, not a substitute for, market discipline. They therefore urge that the Core Principles be issued as a statement of general intent rather than as minimum standards or best practices, and that there not be a requirement for line-by-line adoption of the document. 6

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Those had taken years to implement, and had been the subject of intense argumentation, and of shifts in position. Instead, in this case the basic paper had been written, primarily by Betsy Roberts (with considerable help from Charles Freeland on the trickier parts, e.g. preconditions), in weeks rather than months (admittedly under considerable outside pressure, e.g. arising from potential, ‘turf’, competition with the IMF) and, pace New Zealand, had aroused almost zero substantive debate. No doubt one reason was the Secretariat’s drafting skills, honed over many years at the BIS. Moreover, the question of the proper procedures for banking supervision lay behind almost all of the work done by the BCBS, so this was the culmination of its professional life’s work. There is considerable correspondence with Michael Dealtry’s early work on the Concordat. Everyone pretty much agreed on what needed to be done; it just needed to be set down lucidly and succinctly. It is, however, possible to take a more cynical view. Virtually anyone with experience of some relationship can write an adequate code of conduct about how best to support and maintain that relationship, for example a code of conduct about how to organise children’s mealtimes. I have often offered to prepare a code of conduct about how to write a code of conduct (about anything you care to suggest). This is not to suggest that the Core Principles were not valuable; they were! But it is at least arguable that the more important and more difficult issues relate to the incentives to abide by the Principles/Code, and the monitoring and sanctions available for transgressions. Here the BCBS were relatively fortunate. Peer pressure, to be seen to have a good reputation, would usually provide the incentive, while the IMF/WB with their FSAP programme would do most of the monitoring. Perhaps the BCBS did the easy part in their compilation of the Core Principles, but they did it well and remarkably quickly€– another success story, but of a very different kind from the tortuous struggle over the Basel 1988 Accord or the Market Risk Amendment.

Appendix A

BS/88/2e

Committee on Banking Regulations and Supervisory Practices Prevention of criminal use of the banking system for the purpose of money-laundering

Preamble

1. Banks and other financial institutions may be unwittingly used as intermediaries for the transfer or deposit of funds derived from

Appendix A

301

criminal activity. Criminals and their associates use the financial system to make payments and transfers of funds from one account to another; to hide the source and beneficial ownership of money; and to provide storage for bank-notes through a safe-deposit facility. These activities are commonly referred to as money-laundering. 2. Efforts undertaken hitherto with the objective of preventing the banking system from being used in this way have largely been undertaken by judicial and regulatory agencies at national level. However, the increasing international dimension of organised criminal activity, notably in relation to the narcotics trade, has prompted collaborative initiatives at the international level. One of the earliest such initiatives was undertaken by the Committee of Ministers of the Council of Europe in June 1980. In its report7 the Committee of Ministers concluded that ‘… the banking system can play a highly effective preventive role while the co-operation of the banks also assists in the repression of such criminal acts by the judicial authorities and the police’. In recent years the issue of how to prevent criminals laundering the proceeds of crime through the financial system has attracted increasing attention from legislative authorities, law enforcement agencies and banking supervisors in a number of countries. 3. The various national banking supervisory authorities represented on the Basle Committee on Banking Regulations and Supervisory Practices8 do not have the same roles and responsibilities in relation to the suppression of money-laundering. In some countries supervisors have a specific responsibility in this field; in others they may have no direct responsibility. This reflects the role of banking supervision, the primary function of which is to maintain the overall financial stability and soundness of banks rather than to ensure that individual transactions conducted by bank customers are legitimate. Nevertheless, despite the limits in some countries on their specific responsibility, all members of the Committee firmly believe that supervisors cannot be indifferent to the use made of banks by criminals. 4. Public confidence in banks, and hence their stability, can be undermined by adverse publicity as a result of inadvertent association by 7 Measures against the transfer and safeguarding of funds of criminal origin. Recommendation No. R(80)10 adopted by the Committee of Ministers of the Council of Europe on 27 June 1980. 8 The Committee comprises representatives of the central banks and supervisory authorities of the Group of Ten countries (Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, Switzerland, United Kingdom, United States) and Luxembourg.

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banks with criminals. In addition, banks may lay themselves open to direct losses from fraud, either through negligence in screening undesirable customers or where the integrity of their own officers has been undermined through association with criminals. For these reasons the members of the Basle Committee consider that banking supervisors have a general role to encourage ethical standards of professional conduct among banks and other financial institutions. 5. The Committee believes that one way to promote this objective, consistent with differences in national supervisory practice, is to obtain international agreement to a Statement of Principles to which financial institutions should be expected to adhere. 6. The attached Statement is a general statement of ethical principles which encourages banks’ management to put in place effective proÂ� cedures to ensure that all persons conducting business with their institutions are properly identified; that transactions that do not appear legitimate are discouraged; and that co-operation with law enforcement agencies is achieved. The Statement is not a legal document and its implementation will depend on national practice and law. In Â�particular, it should be noted that in some countries banks may be Â�subject to additional more stringent legal regulations in this field and the Statement is not intended to replace or diminish those requirements. Whatever the legal position in different countries, the Committee considers that the first and most important safeguard against moneylaundering is the integrity of banks’ own managements and their vigilant determination to prevent their institutions becoming associated with criminals or being used as a channel for money-laundering. The Statement is intended to reinforce those standards of conduct. 7. The supervisory authorities represented on the Committee support the principles set out in the Statement. To the extent that these matters fall within the competence of supervisory authorities in different member countries, the authorities will recommend and encourage all banks to adopt policies and practices consistent with the Statement. With a view to its acceptance worldwide, the Committee would also commend the Statement to supervisory authorities in other countries. Basle, December 1988

Statement of Principles

I

Purpose

Banks and other financial institutions may unwittingly be used as intermediaries for the transfer or deposit of money derived from criminal activity. The intention behind such transactions is often to hide the

Appendix A

303

beneficial ownership of funds. The use of the financial system in this way is of direct concern to police and other law enforcement agencies; it is also a matter of concern to banking supervisors and banks’ managements, since public confidence in banks may be undermined through their association with criminals. This Statement of Principles is intended to outline some basic policies and procedures that banks’ managements should ensure are in place within their institutions with a view to assisting in the suppression of money-laundering through the banking system, national and international. The Statement thus sets out to reinforce existing best practices among banks and, specifically, to encourage vigilance against criminal use of the payments system, implementation by banks of effective preventive safeguards, and co-operation with law enforcement agencies. II

Customer identification

With a view to ensuring that the financial system is not used as a channel for criminal funds, banks should make reasonable efforts to determine the true identity of all customers requesting the institution’s services. Particular care should be taken to identify the ownership of all accounts and those using safe-custody facilities. All banks should institute effective procedures for obtaining identification from new customers. It should be an explicit policy that significant business transactions will not be conducted with customers who fail to provide evidence of their identity. III

Compliance with laws

Banks’ management should ensure that business is conducted in conformity with high ethical standards and that laws and regulations pertaining to financial transactions are adhered to. As regards transactions executed on behalf of customers, it is accepted that banks may have no means of knowing whether the transaction stems from or forms part of criminal activity. Similarly, in an international context it may be difficult to ensure that cross-border transactions on behalf of customers are in compliance with the regulations of another country. Nevertheless, banks should not set out to offer services or provide active assistance in transactions which they have good reason to suppose are associated with money-laundering activities. IV

Co-operation with law enforcement authorities

Banks should co-operate fully with national law enforcement authorities to the extent permitted by specific local regulations relating to

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The Core Principles of Banking Supervision

customer confidentiality. Care should be taken to avoid providing support or assistance to customers seeking to deceive law enforcement agencies through the provision of altered, incomplete or misleading information. Where banks become aware of facts which lead to the reasonable presumption that money held on deposit derives from criminal activity or that transactions entered into are themselves criminal in purpose, appropriate measures, consistent with the law, should be taken, for example, to deny assistance, sever relations with the customer and close or freeze accounts. V

Adherence to the Statement

All banks should formally adopt policies consistent with the principles set out in this Statement and should ensure that all members of their staff concerned, wherever located, are informed of the bank’s policy in this regard. Attention should be given to staff training in matters covered by the Statement. To promote adherence to these principles, banks should implement specific procedures for customer identification and for retaining internal records of transactions. Arrangements for internal audit may need to be extended in order to establish an effective means of testing for general compliance with the Statement.

Appendix B

BS/93/27e

Basle Committee on Banking Supervision Report to Governors

Intensifying relationships between the Supervisors’ Committee and non-G-10 supervisors

In recent years there has been an increasing demand by non-G-10 supervisors for technical assistance from the Supervisors’ Committee and its Secretariat. At the Cannes international conference in October 1992 there were a number of pleas from a wide range of countries for closer contact with the work of the Committee. To a large extent this represents a request for guidance in setting supervisory policies but from some countries there is a desire for greater involvement in decision-taking on issues that affect national prudential arrangements. In recent years, the Committee’s Secretariat has significantly increased the service it provides for banking supervisors outside the G-10. It circulates working documents widely; receives frequent visitors and responds to telephone or written enquiries; organises an annual

Appendix B

305

supervisory training course and provides lecturers for training courses conducted regionally; encourages the formation of regional groups of non-G-10 supervisors and participates in many of their meetings; and organises biennial conferences of the world’s supervisors. These activities can be, and are progressively being, expanded according to demand. They do not involve a sudden increase in Secretariat resources but over time there is a gradual effect. The Committee has considered and rejected a number of ambitious options, for example the building-up of a data bank on national supervisory arrangements or the preparation of standard manuals, reporting systems or banking laws for widespread application. These would involve a major increase in Secretariat manpower and their use to non-G-10 countries is questionable, given that the information can be obtained from other sources and quickly becomes obsolete. It has also ruled out a significant training effort as being unsuited to the Committee’s major objectives. The conclusion of the Committee is that the most efficient way of proceeding would be to work more closely with the existing regional supervisory groupings and to aid the development of similar forums in areas where they do not already exist. At present, there are long-established groups in Latin America, the Arab countries, the Caribbean, the Offshore centres and the SEANZA countries, but the view of the Committee members who have attended such meetings is that the focus of the work needs to be sharpened. The Committee proposes to approach each of these groups and to offer to participate in a more structured manner in their work. They would be offered the following options: (a) the Chairman of each group would be invited to a joint meeting with the Committee in order to exchange information on the work their groups were engaged in and to discuss practical ways of more efficient collaboration; (b) the Committee would be represented at each of the annual regional meetings, reporting on and receiving feed-back on the work in train in Basle. The specific representation would be worked out on a case-by-case basis, depending on the availability of the Chairman, but it would in any event always include the Secretary or his designate and one or two Committee members; (c) on request, the Secretariat would supply background papers for one or more given topics; (d) the Secretariat would be prepared to structure and arrange presentations for one or more sessions. In resource terms, there would be a modest increase in demands on Committee members in options (a), (b) and (d), which would need to

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The Core Principles of Banking Supervision

be shared out among the membership. At present, however, many of the regional meetings are already attended by some Committee members, so the demands would not be very much greater than at present. Only option (d) would involve a significant extra burden on the Secretariat. In addition, the Committee’s Secretariat will continue to work more intensively, as it is already doing, with the recently-established group of eastern European supervisors and to foster the development of two sub-regional groups in Africa. 2 July 1993

Appendix C

BS/96/82

Basle Committee on Banking Supervision Bank for International Settlements, CH-4002 Basle Press statement The Basle Committee on Banking Supervision is today making public a report on the Supervision of Cross-border Banking that was endorsed by banking supervisors from 140 countries at the June 1996 International Conference of Banking Supervisors in Stockholm. The report, compiled by members of the Basle Committee on Banking Supervision and the Offshore Group of Banking Supervisors, contains twenty-nine recommendations designed to strengthen the effectiveness of the supervision by home and host-country authorities of banks which operate outside their national boundaries. It builds on an earlier Basle Committee report ‘Minimum Standards for the Supervision of International Banking Groups and their Cross-border Establishments’ issued in July 1992. The report consists of two principal sections. A first section examines the means by which home-country supervisors can obtain the information they need to exercise effective consolidated supervision of an international banking group. The starting point is that home supervisors must be able to make an assessment of all significant aspects of their banks’ operations, using whatever techniques are central to their supervisory process, including the conduct of on-site inspections. Many of the recommendations address the relatively few, but nonetheless significant, impediments to effective consolidated supervision that can arise and suggest ways in which these may be overcome. In particular, the paper contains recommended procedures for the conduct of crossborder on-site inspections by home-country supervisors. It also recommends a set of conditions designed to ensure that information obtained by bank supervisors from their supervisory colleagues in other countries remains confidential.

Appendix D

307

A second section of the paper addresses the need to ensure that all cross-border banking operations are subject to effective home and host country supervision. This section contains guidelines for determining the effectiveness of home-country supervision, for monitoring supervisory standards in host countries and for dealing with corporate structures which create potential supervisory gaps. It is recognised that some of the recommendations in the paper are in conflict with bank secrecy or similar legislation in certain countries. Where this is so, supervisors have agreed to use their best endeavours to have the conflicting legislation amended. In order to set some sort of target for legislative changes, it was agreed in Stockholm to review the evidence of individual countries’ compliance with the recommendations in time for the next ICBS in October 1998. The text of this report can be obtained from the BIS Web Site on the Internet at http://www.bis.org as from 8 October. 8 October 1996

Appendix D

BS/97/40

Basle Committee on Banking Supervision, Bank for International Settlements, CH-4002 Basle Press statement The Basle Committee on Banking Supervision, with the endorsement of the central bank Governors of the Group of Ten countries, is today releasing for consultation the Basle Core Principles for effective banking supervision. This document establishes a set of twenty-five basic Principles which the Basle Committee believes must be in place for a supervisory system to be effective. Comments are invited by 16th June 1997. The Basle Core Principles have been drawn up by the Basle Committee in close collaboration with the supervisory authorities in fifteen emerging market countries and have benefited from broad consultation with many other supervisory authorities throughout the world. The Principles represent the basic elements of an effective supervisory system. They are comprehensive in their coverage, addressing the preconditions for effective banking supervision, licensing and structure, prudential regulations and requirements, methods of ongoing banking supervision, information requirements, formal powers of supervisors and cross-border banking. The Basle Core Principles are intended to serve as a basic reference for supervisory and other public authorities worldwide to apply in

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The Core Principles of Banking Supervision

the supervision of all the banks within their jurisdictions. Following due consultation, supervisory authorities throughout the world will be invited to make a formal endorsement of the Core Principles, not later than October 1998. Endorsement will include an undertaking to review current supervisory arrangements against the Principles and to set a time-table for addressing any material deficiencies. The speed with which changes can be introduced will vary, depending on whether the supervisory authorities already possess the necessary statutory powers. Where legislative changes are required, national legis�lators will be requested to give urgent consideration to the changes necessary to ensure that the Principles can be applied in all material respects. In parallel with the Basle Core Principles, the Basle Committee will also shortly release for information a three-volume Compendium of its existing recommendations, guidelines and standards. This has been prepared in order to supplement the Principles, which contain crossreferences to the Compendium documents where appropriate. The text of the Principles can be obtained from the BIS Web Site on the Internet at http://www.bis.org with effect from 9th April, from national supervisory authorities or from the Basle Committee Secretariat at the Bank for International Settlements. The Compendium will be available later in April. 9 April 1997

Appendix E List of core principles for effective banking supervision

Preconditions for effective banking supervision

1. An effective system of banking supervision will have clear responsibilities and objectives for each agency involved in the supervision of banking organisations. Each such agency should possess operational independence and adequate resources. A suitable legal framework for banking supervision is also necessary, including provisions relating to authorisation of banking organisations and their ongoing supervision; powers to address compliance with laws as well as safety and soundness concerns; and legal protection for supervisors. Arrangements for sharing information between supervisors and protecting the confidentiality of such information should be in place.

Appendix E



309

Licensing and structure

2. The permissible activities of institutions that are licensed and subject to supervision as banks must be clearly defined, and the use of the word ‘bank’ in names should be controlled as far as possible. 3. The licensing authority must have the right to set criteria and reject applications for establishments that do not meet the standards set. The licensing process, at a minimum, should consist of an assessment of the banking organisation’s ownership structure, directors and senior management, its operating plan and internal controls, and its projected financial condition, including its capital base; where the proposed owner or parent organisation is a foreign bank, the prior consent of its home country supervisor should be obtained. 4. Banking supervisors must have the authority to review and reject any proposals to transfer significant ownership or controlling interests in existing banks to other parties. 5. Banking supervisors must have the authority to establish criteria for reviewing major acquisitions or investments by a bank and ensuring that corporate affiliations or structures do not expose the bank to undue risks or hinder effective supervision.

Prudential regulations and requirements

6. Banking supervisors must set prudent and appropriate minimum capital adequacy requirements for all banks. Such requirements should reflect the risks that the banks undertake, and must define the components of capital, bearing in mind their ability to absorb losses. At least for internationally active banks, these requirements must not be less than those established in the Basle Capital Accord and its amendments. 7. An essential part of any supervisory system is the evaluation of a bank’s policies, practices and procedures related to the granting of loans and making of investments and the ongoing management of the loan and investment portfolios. 8. Banking supervisors must be satisfied that banks establish and adhere to adequate policies, practices and procedures for evaluating the quality of assets and the adequacy of loan loss provisions and loan loss reserves. 9. Banking supervisors must be satisfied that banks have management information systems that enable management to identify

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The Core Principles of Banking Supervision



concentrations within the portfolio and supervisors must set prudential limits to restrict bank exposures to single borrowers or groups of related borrowers. 10. In order to prevent abuses arising from connected lending, banking supervisors must have in place requirements that banks lend to related companies and individuals on an arm’s-length basis, that such extensions of credit are effectively monitored, and that other appropriate steps are taken to control or mitigate the risks. 11. Banking supervisors must be satisfied that banks have adequate policies and procedures for identifying, monitoring and controlling country risk and transfer risk in their international lending and investment activities, and for maintaining appropriate reserves against such risks. 12. Banking supervisors must be satisfied that banks have in place systems that accurately measure, monitor and adequately control market risks; supervisors should have powers to impose specific limits and/or a specific capital charge on market risk exposures, if warranted. 13. Banking supervisors must be satisfied that banks have in place a comprehensive risk management process (including appropriate board and senior management oversight) to identify, measure, monitor and control all other material risks and, where appropriate, to hold capital against these risks. 14. Banking supervisors must determine that banks have in place internal controls that are adequate for the nature and scale of their business. These should include clear arrangements for delegating authority and responsibility; separation of the functions that involve committing the bank, paying away its funds, and accounting for its assets and liabilities; reconciliation of these processes; safeguarding its assets; and appropriate independent internal or external audit and compliance functions to test adherence to these controls as well as applicable laws and regulations. 15. Banking supervisors must determine that banks have adequate policies, practices and procedures in place, including strict ‘knowyour-customer’ rules, that promote high ethical and professional standards in the financial sector and prevent the bank being used, intentionally or unintentionally, by criminal elements.

Methods of ongoing banking supervision

16. An effective banking supervisory system should consist of some form of both on-site and off-site supervision.

Appendix E

311

17. Banking supervisors must have regular contact with bank management and thorough understanding of the institution’s operations. 18. Banking supervisors must have a means of collecting, reviewing and analysing prudential reports and statistical returns from banks on a solo and consolidated basis. 19. Banking supervisors must have a means of independent validation of supervisory information either through on-site examinations or use of external auditors. 20. An essential element of banking supervision is the ability of the supervisors to supervise the banking group on a consolidated basis.

Information requirements

21. Banking supervisors must be satisfied that each bank maintains adequate records drawn up in accordance with consistent accounting policies and practices that enable the supervisor to obtain a true and fair view of the financial condition of the bank and the profitability of its business, and that the bank publishes on a regular basis financial statements that fairly reflect its condition.

Formal powers of supervisors

22. Banking supervisors must have at their disposal adequate supervisory measures to bring about timely corrective action when banks fail to meet prudential requirements (such as minimum capital adequacy ratios), when there are regulatory violations, or where depositors are threatened in any other way. In extreme circumstances, this should include the ability to revoke the banking licence or recommend its revocation.

Cross-border banking

23. Banking supervisors must practise global consolidated supervision over their internationally-active banking organisations, adequately monitoring and applying appropriate prudential norms to all aspects of the business conducted by these banking organisations worldwide, primarily at their foreign branches, joint ventures and subsidiaries. 24. A key component of consolidated supervision is establishing contact and information exchange with the various other supervisors involved, primarily host country supervisory authorities.

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The Core Principles of Banking Supervision

25. Banking supervisors must require the local operations of foreign banks to be conducted to the same high standards as are required of domestic institutions and must have powers to share information needed by the home country supervisors of those banks for the purpose of carrying out consolidated supervision.

Appendix F

BS/97/107 Revised

Basle Committee on Banking Supervision Draft note for non-G-10 supervisors on the implementation of the Core Principles for Effective Banking Supervision In September 1997 the Basle Committee, with the endorsement of the G-10 central bank Governors, issued a revised version of the April consultative paper setting out Core Principles for Effective Banking Supervision. Both the April and September texts were developed in close consultation with the supervisory authorities in sixteen emerging market economies and with the chairmen of the regional supervisory groups. Since supervisors around the world have been given the opportunity to offer their comments in this exercise, as have also the international agencies such as the IMF and World Bank, the Basle Committee regards the Principles as a document which has the support of all the professionals working in this field. At the Fund/World Bank annual meetings in Hong Kong in the last week of September the Principles were introduced to an audience of Finance Ministers and central bank Governors and received their strong political backing. The Basle Committee believes that most countries, including some of its own members, are not at present fully compliant with the Core Principles document. It is therefore incumbent on all supervisory authorities to review their existing national arrangements and to initiate a programme designed to address any deficiencies as quickly as is practical within their legal authority. To support and to establish some structure to the process, the Basle Committee will be extending its technical assistance capabilities and will monitor progress towards implementation of the Principles. Precisely how best to do that will be the focal point of discussion at the next International Conference of Banking Supervisors (ICBS) in Sydney in October 1998. The process needs to be flexible and evolutionary. At this point in time, the Committee envisages the procedures as falling within the following four areas:€endorsement, coordination, implementation, and monitoring performance.

Appendix F

1

313

Endorsement

The document encourages supervisory authorities to endorse the Core Principles. Apart from the Basle Committee members and the sixteen other supervisory agencies that participated in their drafting, the Basle Committee Secretariat has received a number of written statements from supervisory authorities confirming their endorsement. A list of those will be maintained and will be made available on request to other supervisory authorities or official agencies, including the international agencies such as the IMF and World Bank, but at the present juncture the list will not be made public. The Committee plans to obtain endorsement for the Principles at the Sydney ICBS and to consider the merits of publishing country names. 2

Coordination

Since the ICBS only takes place every two years, the Committee believes it is necessary to create certain additional structures to support the Core Principles process. These will be in two ways:

• First, a Core Principles Liaison Group comprising a mixed group

of about fifteen G-10 and non-G-10 supervisors will be established to provide a forum for exchanging experiences in the implementation of the Principles and identifying where practical support is needed. This group will be comprised largely of the countries that participated in the drafting of the Core Principles. One of its first tasks will be to conduct a fact-finding survey (see below) the results of which will be discussed at the Sydney ICBS. The Group will meet for the first time in the early part of 1998. The IMF and World Bank will be invited to participate in these meetings in a consultative role; • second, a wider Consultation Group will be formed to provide an opportunity for the Principles to be discussed in a wider forum. The members of this group will include the chairmen of the regional supervisory groups, the members of the Basle Committee and of the Core Principles Liaison Group and representatives of some other non-G10 countries. Members of this group will receive documents of the Liaison Group and have the opportunity to react. This Consultation Group will probably only meet once a year, initially in the week of the Sydney ICBS; • two attachments to this report contain the intended composition of the Liaison and Consultation Groups.

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3

Implementation

The Basle Committee (in collaboration with the Liaison and Consultation Groups) plans to involve itself in a number of different ways in the process of supporting implementation of the Principles:

• It intends to collect factual information as a basis for identifying

obstacles to the implementation of the Principles and the areas in which technical assistance is needed. The initial step in this process will be the conduct by the Liaison Group of a fact-finding survey of the situation in different countries as a support mechanism for improvements in the supervisory framework. The intention of this survey will not be to ‘score’ countries’ compliance with the Principles, but rather to identify those areas to which attention needs to be devoted. At the ICBS, it will be necessary to discuss the possibility of adopting some form of time horizon against which to measure progress. The difficulty is that although some countries may already be close to full compliance, or have the ability to achieve it rapidly, others will require significant legislative and cultural changes. The Basle Committee will be inviting countries, when they compile information relating to their national arrangements for the ICBS, to identify each area where their systems are in non-compliance. It would be left to individual countries to determine their own time-horizons for possible changes. At the conference itself, we would need to consider the merits of individual countries determining and publishing a deadline or series of deadlines in order to put pressure on their own legislative and internal processes; • it will be ready to provide general guidance in interpreting the principles. Questions will inevitably arise as to the precise meaning of individual principles, either as a result of discussion of implementation within the Liaison Group or bilaterally in the form of questions to the Basle Committee Secretariat from national supervisors, advisers or the international agencies. Many of these questions will be capable of resolution within the Liaison Group, subject to any feedback from the wider Consultation Group. Ultimately, questions of interpretation will he referred back to the original process in which the Basle Committee has a final say. At this juncture, it is not possible to identify the areas where guidance will be most needed but it is inevitable that there will be several complex issues to discuss as implementation progresses; • it will be ready to provide technical assistance to countries that are seeking to implement the Principles. The Basle Committee Secretariat

Appendix F

315

will be adding to its resources so that it is in a position to continue to extend its training programmes at regional level. In addition, it will seek to coordinate its training more effectively with the international agencies and with other G-10 central banks and supervisory agencies. The Committee hopes that the widespread acceptance of the Principles will have the effect of achieving more consistency in the nature of the advice that is offered and will reduce some of the duplication of resources that may have been taking place. 4

Monitoring performance

The IMF and World Bank, in the context of their national surveillance and review programmes, have said that they intend to use the Core Principles as a yardstick to measure the adequacy of national supervisory arrangements (the World Bank has already undertaken a pilot project to assess compliance with the Core Principles in one of its recent missions in Africa). It will thus fall mainly to these two organisations to provide an independent assessment of whether individual countries are in compliance. This process will inevitably involve questions of interpretation and some countries as well as the IMF and World Bank may well turn to the Committee for guidance. It will be necessary to be pragmatic in responding to any such situations but the Committee would intend to use the expertise available in the Liaison Group to address them. The participation of the IMF and World Bank in this group in an informal capacity will, it is hoped, ensure that interpretation by the various bodies involved in implementation remains as consistent as possible. The Committee’s Secretariat will also maintain close relations with the IMF and World Bank on these issues. For example, preliminary discussions are already taking place concerning the content of the ICBS survey. In comparison with the two Washington agencies, it will be relatively difficult for the Committee’s Secretariat to be very active in performance monitoring because it does not have deep knowledge of the institutional arrangements in individual countries. Over time, the conduct of the ICBS surveys and other information-gathering will mean that a data-base of supervisory information will be available. However, the Secretariat’s role in monitoring the implementation of the Core Principles will have to be kept within bounds if it is to continue to function as an effective coordinator of policy development. The question also arises as to the role the regional groups can play in this process. The Core Principles states that ‘discussions are in progress to define the role the regional groups can play in securing

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The Core Principles of Banking Supervision

the endorsement of the Principles and in monitoring implementation by their members’. Some of the regional groups have already initiated procedures to support the implementation process and the Basle Committee strongly supports such efforts and is ready to assist where necessary. The role of the regional groups is a matter that will need to be considered by the Consultation Group with a view to presenting recommendations for the ICBS. 23 December 1997

9

Liquidity

George Blunden, the first Chairman of the BCBS, opened its initial meeting (6–7 February 1975) ‘by outlining what he saw as the mandate which the Governors had given the Committee’ (BS/75/1). In this respect, ‘the Committee’s main objective was to help ensure bank solvency and liquidity.’ So, from the outset, the BCBS appreciated that solvency and liquidity were interrelated; both were essential for the stability and survival of a banking system. An illiquid bank (system) would not remain solvent for long, nor would an insolvent bank (system) remain liquid.1 The BCBS’ first approach to both solvency and liquidity was in Muller’s paper outlining ‘Responsibility for supervision of banks’ overseas branches, subsidiaries and joint ventures’ (BS/75/5). This paper formed the basis for the Concordat, covering the question of which authorities (who) should be responsible for supervisory oversight, rather than what principles (or numerical ratios) should be applied. This ‘who’ issue has been already reviewed in Chapter 4 on the Concordat, and need not be rehearsed again here, except to remind that, as Muller himself stated (BS/75/5): a distinction should be made between solvency and liquidity control. The latter should probably be the responsibility of the host authorities, since only those who were familiar with local market conditions and discount facilities could adequately judge the liquidity position of banks operating on their territory (BS/75/5, p. 10).

That assessment was then, and has since remained, the accepted regulatory position. In more recent years, however, the ever-increasing globalisation of banking has led banks often to have outstanding positions in currencies other than those of their host countries. A host central bank can create domestic currency liquidity without limit (in principle), For a good contemporary account both of such interlinkages and of the difficulty of either measuring or controlling liquidity, see Dale (1984), especially pp. 60–1. 1

317

318

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but may be tightly constrained in its ability to provide foreign currency liquidity to banks sited in its domain. Similarly banks located in one country may have many of the assets that they could, again in principle, use as collateral for borrowing to enhance immediate liquidity situated abroad, a condition sometimes referred to as ‘trapped liquidity’. There are ways of getting around such problems, often involving the use of foreign currency swaps, either by the central banks or the commercial banks, but this is to run in advance of the historical account. One of the main constituent elements of bank liquidity is maturity transformation. The Governors and the BCBS were, from the outset, nervous about the cross-border exposures of international banks; so the maturity transformation of such banks in their foreign currency/ overseas operations was a continuous early concern, but this topic has already been addressed in Chapter 5. The first reference to a study on the overall liquidity of the international banks was made at the nineteenth meeting of the BCBS (26–27 June 1980), when Chairman Peter Cooke proposed that: the Committee might wish to discuss: –╇ members’ attitudes to capital adequacy; –╇ the liquidity of international banks.

Note how capital adequacy and liquidity issues are once again intertwined. In the event, however, discussion on capital adequacy received an enormous boost in the early 1980s, especially in the aftermath of the MAB crisis, and got taken forward under strong external pressures, as outlined in Chapter 6, whereas review and analysis of liquidity issues languished comparatively. Indeed it was not until 1984 that the BCBS revisited the subject of liquidity, under the impetus of a note from Chairman Peter Cooke (BS/84/7). Section 2 on ‘Elements of Liquidity’ is attached as Appendix A to this chapter. As usual with the BCBS, the Chairman ended by suggesting a need ‘to gather information on the way in which different member countries supervise liquidity’. The paper was on the agenda and discussed at the thirtieth meeting of the BCBS (23–24 February 1984); this led to the establishment of a new subgroup on liquidity (as had by then become the wont of the BCBS) under the chairmanship of Irwin Sandberg (from the FRBNY). As noted in BS/84/34: The sub-group is asked to prepare a paper for the Committee which seeks to establish the conceptual framework within which all the relevant aspects of liquidity management and control can be assessed and which offers views on those particular aspects in relation to which supervisors might agree guidelines or rules. The sub-group should consider in particular:

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(a) Conceptual questions:€What constitutes liquidity for an international bank and how can it be measured? What part does a requirement to hold some classes of assets play within an overall approach to liquidity in an international context? How does the degree of maturity transformation undertaken affect a bank’s liquidity? Is it important to distinguish between currencies when measuring liquidity? Can access to domestic currency liquidity be counted towards meeting liabilities in foreign currencies? (b) The interbank market and liquidity of foreign branches:€To what extent can lending in the interbank market constitute liquidity? Does the ability of banks to draw funds from the interbank market affect the extent to which they need liquid assets? How can the supervision of the liquidity of a bank’s foreign branches best be carried out?

This subgroup met for a couple of days in May 1984, and reported back to the BCBS with commendable speed in June. The subgroup’s Chairman noted that: the discussions were interesting and lively, but the wide-ranging scope of the subject made it difficult to focus on a clear approach to examining the liquidity concept. Nonetheless, the sub-group did reach some general agreement on the subject, [as represented by the Sections reproduced in Appendix B to this chapter], but seeks further guidance from the Committee regarding future work on liquidity.2 2 The questions (some might say the eternal questions) that they posed were the following: (1)╇Should supervisory authorities€ – given the elusive nature of liquidity€ – monitor actual levels (if so, how frequently and through which process) or should they put the emphasis on proper liquidity management systems (if so, what principles of sound liquidity management can be defined and recommended)? (2)╇W hat is the state of the art of liquidity management as practised by banks operating internationally? How do banks themselves view the relationship between management of liquidity risk and of interest rate risk? Which seem to be the most sophisticated techniques being employed by the banks? (3)╇W hat are the basic supervisory approaches to liquidity in the different countries represented on the Committee? What relationship do these approaches bear to the monetary policies applied by central banks? What is the relative weight attached, respectively, to the ‘stock’ and ‘flow’ approach in the assessment of liquidity? To what extent is harmonisation of liquidity requirements (assuming they exist in a given country) an important objective, bearing in mind that, other things being equal, a national banking system’s earning power is inversely related to the level of liquidity required? (4)╇W hat are the special problems posed by the need, for international banks, to maintain adequate levels of non-domestic currencies? Is it important to distinguish between currencies when measuring liquidity? Can access to domestic currency liquidity be counted towards meeting liabilities in foreign currencies? What degree of responsibility should the authorities assume for the effective functioning of the interbank euro-currency markets? (5)╇To what extent should supervisors try to limit the degree to which banks rely on liability management for liquidity? Is it possible and, if so, sensible to limit the extent to which a bank’s liabilities are dominated by purchased funds? Should the

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This report was discussed at the BCBS’ next, thirty-first, meeting (28–29 June) (BS/84/50), and it was agreed that the subgroup should be asked ‘to continue its work’.3 Moreover, in line with standard BCBS working practices, the Secretariat was asked to provide ‘a summary of information available from existing sources on the systems used by member countries to monitor and control banks’ liquidity’ (BS/84/58). The opportunity was also taken to issue a questionnaire on the ‘Prudential supervision of liquidity against euro-currency liabilities’ (BS/84/58, Appendix).4 This tour de table revealed a wide diversity of national approaches. Whereas all countries claimed to monitor the liquidity of their banks, the methods and formality of so doing varied from country to country. So the Sandberg subgroup went back to work and came up with a full report in the latter part of 1984 (BS/84/64), revised 15 February 1985. The Summary and Conclusions of this lengthy (nineteen-page), but well drawn-up, paper were as follows: 1. The sub-group takes the view that, though difficult to measure, there is a tendency for banks to become over-reliant on purchased money-market funds to generate liquidity. Although this technique provides a ready flow of liquidity in normal circumstances, in times of stress it cannot substitute for asset-based liquidity, whether in the form of marketable securities or short-term claims on banks and others of undoubted realisability. The group feels that as a matter of priority supervisors should review the adequacy of banks’ policies for maintaining such asset liquidity, particularly among those banks whose liabilities consist largely of purchased funds. 2. Since maintaining liquidity represents a cost to banks, the subgroup feels that it would materially assist individual national supervisors in raising standards of liquidity adequacy if the Committee were to take a co-ordinated initiative on this subject. The group therefore recommends that the Committee maintenance of liquidity, particularly in relation to foreign currency business, be viewed partly as an ability to ‘buy time’ in the event of funding difficulties? (6)╇W hat relationship does maturity transformation bear to the measurement of liquidity, i.e. is a bank which is heavily mismatched by definition less liquid than one which is not? How can the degree of mismatch best be measured? Should the sub-group review the purpose of the statistics on banks’ international maturity transformation being collected by the Committee with a view to recommending any changes which appear to be desirable? 3 The subgroup was also charged with the task of conducting ‘a case study of the liquidity and funding problems associated with Continental Illinois’ difficulties’. This was done (BS/84/75), but the document has been withheld from me. 4 The questionnaire on fc liquidity was discussed, revised and then sent out (BS/84/72) in November 1984. The results (BS/84/87) were circulated by the Secretariat in February 1985. They showed that though ‘all member countries supervise banks’ foreign currency liquidity’, the regulatory framework and the frequency of monitoring differed from country to country.

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give consideration to the possibility of taking a common position towards the need for a strengthening of liquidity adequacy, similar to that undertaken for capital adequacy. 3. The precise measurement of liquidity adequacy gives rise to a number of difficulties both in regard to quantification and qualitative assessment. No single formula is likely to capture all the elements and no single quantitative guideline will ensure adequate liquidity for a range of different banks. The sub-group notes some broad similarities in the systems of measurement currently employed in member countries but there are considerable differences in detailed construction. It believes that the maturity mismatch framework based on potential cash flows provides a useful starting-point for analysis and that for predominantly wholesale banks, a reasonable rough guideline for liquidity adequacy would be a capacity to draw on cash flow from potential sales of securities and maturing assets sufficient to withstand an inability to raise fresh deposits and to meet existing deposits as they mature at least for a limited period of time. 4. The group notes that to provide liquidity in foreign currency in the event of difficulties in raising fresh funds, most international banks tend to rely on maturing placements with other banks (including holdings of CDs) and standby lines. Beyond this, some nationalities of banks also hold a stock of securities denominated in local currency against their foreign currency deposits. The group considers that assets for which there is an assured market in the currency denomination of the deposits (e.g. US Treasury bills) would represent a more secure and direct form of liquidity and should constitute an element within banks’ liquid resources. Few banks hold such assets in significant quantities and the group considered that this practice should be encouraged. 5. A number of international banks, particularly smaller institutions, regard standby lines from major banks as an important part of their liquidity but the strength of the commitment to lend implied by these agreements varies greatly. The sub-group believes there is some uncertainty whether, in the event of a bank facing serious difficulty, they can be relied on as a source of liquidity and recommends that supervisors should not regard them as a substitute for holdings of marketable securities and short-term claims of undoubted quality. 6. Major international banks raise deposits through branches situated in funding centres around the world. The overall assessment of liquidity adequacy can only effectively be carried out by the parent supervisor but host supervisors, where funds are being raised for employment in some other part of a group, also have a responsibility to ensure that adequate liquidity is held against local liabilities. In some cases host supervisors may need to look to the liquidity of assets booked overseas. The group recommends that more regular bilateral collaboration between supervisors would be desirable to improve understanding and provide warning of unsound funding practices. 7. In the event of an incipient loss of confidence, banks may feel impelled to buy in their own CDs from the market and may face pressure for repayment of deposits before maturity. Acquiescence to those pressures presents obvious dangers for liquidity management but the choice of response is not clear-cut and, in particular, a refusal to support the price of a bank’s own CDs might serve to exacerbate nervousness.

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The sub-group considers that it would probably be impractical and might be counter-productive for supervisors to seek to restrict the not uncommon practice of banks supporting their own CDs. While it is difficult to assess whether the breaking of deposit maturities is, or might potentially be, a serious problem, the sub-group recommends that supervisors should consider establishing a code of practice designed to encourage greater discipline and make it easier to refuse requests for early repayment.

The Sandberg report on liquidity (and the paper on Continental Illinois) was discussed at the thirty-third meeting of the BCBS (27–28 February 1985), and the subgroup was asked to draw up a report for the Governors, to be discussed at the June meeting.5 This was done (BS/85/38). The main paper mostly recapitulates the earlier subgroup paper, but it was now covered by a new Overview, which introduced the concept of ‘survival time’€– ‘the length of time following the start of a run during which it could draw on its resources before collapse’. The paper tentatively proposed a minimum two-week survival time period. It noted that such a period might seem short, but argued that that also assumed ‘a total loss of deposits as they mature and an inability to attract new deposits, whereas in practice a loss of confidence generally tends to build up cumulatively’. This overview is reproduced in full as Appendix C. This was, perhaps, the high-water mark of the BCBS’ work on principles of liquidity risk management during these years. Chairman Peter Cooke introduced this paper to the Governors at their meeting in July. In his report back to the BCBS (BS/85/54) Cooke emphasised that: I summarised the main conclusions, referring in particular to the possible links between pressures on capital adequacy and the tendency to economise on liquidity standards (as both high capital and high liquidity implied costs to a bank) and to the concept of the ‘survival period’. I stressed it was very much an initial report and was in effect a basis for a future programme of work, and invited the Governors to give broad endorsement to the paper and its conclusions. The question of a possible statement from the Committee or the Governors about liquidity adequacy on the lines of the ‘no further erosion of capital’ statement in 1982 was referred to, but I said there was no disposition on the part of the Committee (or, it appeared, the Governors) to feel that the time was ripe for such a statement. I said that the Committee would keep this possibility under review … Governors were happy to endorse the paper generally and its conclusions. There appeared to be little disposition, however, on the part of the Governors

The issue of liquidity supervision and management was also broached at the wider meeting with supervisors of G10 countries, non-G10 countries and offshore centres in London (2–3 May 1985) (BS/85/32). 5

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to give special emphasis to certain conclusions or to direct the Committee’s further work along particular lines.

This was less than a ringing endorsement, nor a clarion call towards pushing through a general international agreement on principles of liquidity risk management. Indeed, the Secretariat put forward a subsequent note (BS/85/72), asking what role might be left for the Committee or its subgroup in a milieu in which it was apparently felt that the implementation of most of such liquidity issues should be ‘a matter for individual national authorities’. Nevertheless, the Secretariat reasserted that there was a need to encourage banks to strengthen asset liquidity, and that the concept of a ‘survival period’ had much merit.6 Despite the lack of enthusiasm for any international imposition of standards or principles for liquidity risk management, the BCBS was prepared to go (semi-)public with its work on the assessment of liquidity, and its fears that standards of liquidity management were being eroded and that too much weight was being placed on purchased funds from wholesale markets. This was done in Report 5 on ‘International Developments in Banking Supervision’ (Basel:€BIS, September 1986), Chapter 6, pp. 38–49 (also in BS/86/6). In this chapter on liquidity, the concept of ‘survival period’ was not expressly stated. The Secretariat, however, issued a paper (BS/86/17, February 1986) on possible BCBS further work on this subject. It was noted that ‘At present, however, the lack of consistent statistics in member countries probably rules out an approach of this kind’, but went on to suggest a list of assumptions (pages 3 and 4) that could be applied to major international banks on a comparable basis and suggested that the Sandberg subgroup might try to put this into practice.7 ‘One benefit is that it can be used as a yardstick for regimes based either on the stock approach or the maturity approach, or on a combination of the two. A number of members of the sub-group, however, believe that the concept needs further precision since methods of assessing cash flow can differ in detail and availability of statistics may also present problems. While it is clearly up to individual supervisors to decide whether and how the “survival” concept can best be incorporated within their own banking regimes, it might be useful for the sub-group to examine certain technical aspects of cash flow analysis to see whether it is desirable to suggest any guidelines for general application.’ 7 ‘This could be done by approaching informally one or two major banks in each member country (perhaps at Treasurer level) and seeking: 6

(a)╇t heir views on the concept [of Survival Period] itself as a measure of liquidity adequacy; and (b)╇ their estimate of the likely results of applying the test to their own bank. Alternatively, if sufficient data are already available to the supervisory authority, such testing might be done without the need to approach a commercial bank.’

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At the next (thirty-ninth) meeting of the BCBS (18–19 September 1986), the Chairman proposed (BS/86/68) that ‘a new liquidity subgroup should be formed to take work forward on two fronts’. First, it should examine the: survival period concept, including testing the model and its underlying assumptions in discussions with selected banks. Secondly, it should investigate the possibility of developing a new reporting framework for liquidity. This should concentrate on the short end (three months and under) of the maturity spectrum. It should ideally encompass the totality of banks’ operations in all currencies, including domestic and foreign branches, but with particular attention to foreign currency business as a sub-set. He would be in touch with members about the composition of the sub-group and would circulate a draft mandate to members in due course.8

At this stage the main focus of attention was on capital adequacy, particularly in the aftermath of the Anglo-American démarche on this in late 1986; see Chapter 6. So the new subgroup on ‘The liquidity of international banks’, to be chaired by Mr F. C. (Erik) Musch (Deputy Director of the Nederlandsche Bank) was not set up until late January 1987. Its terms of reference are shown as Appendix D. The Musch subgroup reported back in September 1987 (BS/87/64). The main gist of their report9 is as follows: As a first step to assessing the practical application of this measure, sub-group members consulted with several major commercial banks to learn about their own internal approaches to liquidity control and seek their views on the survival measure … None of the banks was found to use a survival test in the pure form described in the Committee’s note. Whereas the concept, in the mind of the Committee, was to measure the length of time before which cash resources from maturing and liquefiable assets were exhausted, the US and UK banks worked back from the opposite direction by first setting a ‘critical time horizon’ and then seeking to ensure as their objective of internal liquidity control that, using varying assumptions, the potential cash-flow position stayed positive or did not exceed a maximum permitted net outflow … The essential approach used by all four banks, though not the detailed method of calculation, was also found to be much like that employed by Federal Sandberg had then left, and Erik Musch took it over. Also the original subgroup had been small in size. With this subject now seen as more important, more countries wanted to be represented on the subgroup. 9 Another paper that clearly sets out current Central Bank thinking on prudential supervision of bank liquidity is Brian Quinn’s address to the SEANZA (South East Asia, New Zealand and Australia) forum of banking supervisors (Sydney, 23 March 1988). In this he presciently commented, p. 4, that the BCBS has ‘not yet addressed the much more taxing question of setting a common standard or requirement [for liquidity]. That lies some way off.’ (Reproduced in BS/88/44). 8

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Reserve examiners as part of their system of liquidity assessment. This consists of a series of cover ratios which measure the extent to which more volatile short-term liabilities are covered by readily realisable assets at short-term time horizons€– overnight, up to 30 days and up to 90 days. All these systems of liquidity measurement€– cover ratios, maturity mismatch profiles and the survival test€– use a maturity analysis of assets and liabilities as their starting-point. The terminology may seem confusing but, in fact, these measures are just different ways of expressing the same thing … The members of the sub-group expressed mixed views about the value of the survival period concept … Other members of the group expressed varying degrees of scepticism. It was accepted that for the purpose of an explicit regulatory control a single ratio, clean and simple, had advantages but it was generally felt that for the purpose of more comprehensive prudential analysis the emphasis on a single point in time was too simplistic … In view of the ominous overtones associated with the term ‘survival period’ (which itself induced unease on the part of some banks), the group felt the term ‘net asset period’ was to be preferred. The group concluded that the survival test was of limited value but, because of its essential similarity with other cash-flow based measures of liquidity …, it could readily be merged into a more general analysis … The members of the group had no illusions about the problems associated with making meaningful comparisons between the liquidity of different banking systems. Even comparisons between individual banks in the same country were fraught with difficulty and required a combination of objective statistical testing and subjective assessment. Moreover, difficulties in the availability of consistent data led the group to conclude that an ambitious project to construct a new and elaborate framework for measuring the liquidity of banks in G-10 countries, particularly one which required changes in national reporting systems, would probably be doomed to failure. This did not rule out a more cautious and modest exercise and all members of the group shared the view that it would be worth attempting to build a reasonably simple measure of liquidity and to test it on a trial basis among member countries. In support of such an attempt the group agreed that precisely the same arguments in favour of greater international co-ordination of capital measurement and standards could be advanced in favour of similar co-operation on liquidity. The tiered framework of capital measurement and comparison had yielded some important insights, helping national authorities to set standards and it was worth exploring whether something similar might be attempted for liquidity … Accordingly, the group recommends to the Committee that it approve the development by the sub-group of a framework for liquidity measurement to be used purely on a trial basis to test its value in making comparisons of liquidity firstly between banks in individual member countries and then, if successful, in making cross-country comparisons between banks. The presumption would be that such a framework would be compiled using existing resources of data as far as possible; it would be entirely consistent with and would build on the existing maturity profile approach in use within the European Community; and it would not involve significant statistical costs for supervisors or banks. At the end of a trial period the results would be evaluated.

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As with capital, measurement of liquidity requires a balance to be struck between elaborate refinement and practicality. No single ratio is likely to capture all the elements. The sub-group was attracted to the idea of developing a few reasonably simple tests in much the same way as the tiered framework of capital measurement had been developed. The group discussed the main constituents of a framework and recommends that it should have the following elements: (a) it should be based on a maturity analysis of future cash flows from assets and liabilities with fixed maturities, and should take account of the stock of liquid assets, of items without fixed maturities such as retail deposits, and of firm commitments to lend; (b) it should identify separately readily marketable securities. This would allow such assets to be folded into the maturity analysis either as liquefiable in the short term (with modest discounts against market value to reflect their susceptibility to forced-sale risk) or as generating cash at maturity; (c) it should distinguish between retail balances (savings and transaction balances) and more volatile wholesale purchased funds; (d) it should focus particular attention on the liquid position at short term (the critical time horizon)€– the group felt that the position at up to one month and up to three months were the principal points of interest:€the total maturity profile should not go beyond one year. These points were generally consistent with existing sources of data in most countries; (e) it should endeavour to incorporate the liquidity of the foreign branches of the banks to which it is applied or at least those branches situated in group funding centres€– London, New York, Tokyo, etc.; (f) it should not attempt to consolidate subsidiaries unless such data is readily available; (g) it should not attempt to distinguish between domestic and foreign currencies. Those members of the group who favoured such a split for policy reasons (notably in order to monitor the dollar position) agreed that, at least initially, a simple aggregated approach was more practicable. The attached annex provides an illustration of how several liquidity tests based on the above criteria might be constructed. The table shows a typical but hypothetical balance sheet and maturity profile of an international bank. [Set out here in Appendix E].

With so much else going on at the time (e.g. the run-up to the Basel I agreement and the fall-out from the NYSE collapse of 19 October 1987), at the forty-fourth meeting of the BCBS (16–17 November 1987) the Chairman proposed that discussion of the paper should be deferred until the next January meeting, but that the subgroup be invited to test their suggested framework. In the event, however, the 1987 paper on liquidity was not put on the agenda for the forty-fifth (January 1988) meeting of the BCBS, but was deferred until the April meeting. This was probably because in the meantime the consensus within the Musch

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subgroup had swung sharply against the idea of trying to reach common international principles and standards for liquidity risk management. There were a variety of reasons10 for this shift of position. The first reason was analytical. The concept of liquidity is, naturally, both slippery and fluid. At that juncture commercial banks’ own concept of liquidity was shifting from one based primarily on the holding of easily saleable assets, for example public sector bonds, to one based on reasonably assured access to borrowing additional funds on wholesale markets. The majority BCBS position would continue to put weight on asset-based liquidity. With the US banking system having moved furthest towards liability management of liquidity, the USA was reluctant to turn the clock back towards a mandated asset-based system. The second reason related to the wish to maintain national proÂ� cedures. The question of what asset might be defined as liquid depended in part on central bank decisions to accept them as collateral, for Â�example for repo lending, or not. An asset acceptable as collateral by a central bank was liquid; if not acceptable, then it was not liquid. Any international agreement on which assets should be defined as liquid would, in effect, constrain central banks to accept that set as collateral, but not a wider set. This meant that any international agreement threatened to require national central banks to revise their prior behaviour, some to have to accept a wider range of assets as acceptable collateral, and some a narrower set. None of the central banks saw any advantage to themselves in changing their own procedures, especially since there were no signs then of serious liquidity problems; moreover, the Basel risk-weighted capital Accord was expected to improve the incentive to hold more liquid assets, since their risk-weighting was lower. Thus, while the subgroup was close to a roughly acceptable compromise solution in a technical sense, practical issues for central banks made a workable framework unlikely. Although stress testing was not en vogue at the time, forward-looking exercises were part of the draft framework. Views on the percentage withdrawal of demand and savings deposits differed per country and per bank for times of crisis, especially in the context of lender of last resort action to be expected and the conditions for that, preferably to be known in advance. As at the time the majority of members were central bank representatives, such elements of the framework were met with hesitations, but there was a realisation that, without it, serious elements would be lacking.

10 I am most grateful to Erik Musch for a discussion on this subject. Any errors of fact or interpretation, however, remain entirely my own.

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In analogy with the Concordat€ – where liquidity was considered to be the responsibility of the host country€ – so liquidity was felt to be more a matter for national supervisors, and national central banks could remain in control of their own assessment of ‘constructive ambiguity’ in matters of last resort policies. This national assignment also fitted well with the liquidity assessment of banks’ foreign branches and subsidiaries. These matters were never discussed in the Committee in full detail, but the complexity of differing responsibilities of central bank and supervisory roles, the latter whether inside or outside a central bank, did not encourage it to come to a final agreement. Somewhat similarly, there remained a question whether banks’ business models might be so heterogeneous that ‘one size does not fit all’. This has been, over the years, a particularly British theme, and was so again on this occasion. The British had been moving away from their prior use of liquid assets ratios, and preferred a more discretionary system in which the Bank of England, while sensible of overall principles of liquidity management, would nevertheless tailor separate bank requirements to their individual, subjectively assessed, needs. The third main reason was operational exigencies. The G10 governors were pressing hard for the completion and implementation of an international Accord on capital adequacy, and were relatively unconcerned about liquidity issues. Given that any international agreement on liquidity would require unwelcome consequential changes in some member central bank procedures, there was unlikely to be any agreement among the G10 governors (recall the difficulty of getting agreement on the Accord, recorded in Chapter 6, where the momentum for change was so much greater). Moreover, the time and energy of BCBS members at this time was almost entirely exhausted by the effort of pushing through the Accord, a point emphasised by several erstwhile members of the BCBS. There were just not the resources, time and enthusiasm to fight on two major fronts simultaneously, especially when the prospects of success looked so bleak for this program. This withdrawal was not perceived by the members of the BCBS themselves as signalling any lessening of concern about the importance and need for adequate bank liquidity. Rather it represented a judgement that such concerns, and regulatory oversight, were best applied at the national level, for the reasons already described. In my own view, this view was, no doubt innocent, self-deception. Without an international agreement, any national central bank that

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sought unilaterally to tighten liquidity requirements would be hit by the standard level-playing-field argument:€‘You cannot do that to us as it will weaken our competitiveness, and shift business to foreign banks.’ In the event no central bank or bank regulator, to the best of my knowledge, was able to check the continuing erosion of commercial bank liquidity, culminating in the 2007 liquidity crisis.11 Nevertheless, at that time, in the late 1980s, the greater concern was felt to be excessive, rather than insufficient, liquidity. Even in 2007 liquidity had previously been regarded as in oversupply. What turned the corner in 2007 was mainly an increase in perceptions of risk, which closed several markets on which banks and investment houses had been relying for refunding. The key paper that advocated abandoning any attempt at such international harmonisation was the second report of the Musch subgroup on the ‘Measurement of liquidity adequacy’ (BS/88/38). This was drawn up, almost entirely, on grounds of practical statistical, data consistency problems, in view of national differences.12 Moreover, there 11 Some central banks had issued papers of various colours (green and white) on measures of liquidity. But with differing arrangements and practices in the various countries, the industry was able to fight off any proposals to tighten and control bank liquidity. 12 ‘Members of the Committee will know from their own national experience how difficult it is to develop a meaningful prudential measure of liquidity adequacy. These difficulties are, of course, multiplied at the international level … In testing the framework developed by the sub-group, it became clear that the data available in most countries were not fully consistent and in the view of several members the cumulative effect of these inconsistencies was to make it unrealistic to contemplate comparison of the underlying liquidity positions. The sub-group had hoped to overcome the problem of data by constructing a reasonably simple framework. The similarity of the sub-group’s framework to the framework used in Brussels eased the data problem for some of the EC members of the group. However, several other countries pointed out that in their case it was necessary to introduce specific adjustments or estimates in a rough attempt to reconcile reported data categories with those specified in the framework. The dilemma faced by the sub-group is that, if the measure is too simple, it does not capture significant aspects of liquidity; if too elaborate, it falls down for lack of data … Two members of the group reported that in their view there was little prospect in the near future that the two countries would contemplate the substantial changes in statistical reporting necessary to obtain regular data by residual maturity. Other members of the group whose data were not fully consistent with the framework agreed that significant modification to their data systems could probably be ruled out. An observation framework was not sufficient justification unless its value could clearly be perceived, carried high-level endorsement and, by analogy with capital, was likely to become the basis of common international regulations. In theory, it might have been possible to overcome some of the data problems by constructing a more simple framework of measurement. But the value of a simplified measure would be questionable and an approach to measurement that was significantly different from that pursued in Brussels would not attract support from some European members.’

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were also a number of conceptual problems.13 Anyhow, the report concluded that: In the light of the differences of view on both conceptual and technical issues described in this report, the sub-group considers that it would not be realistic to expect early progress towards the development of a measure or series of measures of liquidity that would command general acceptance … Apart from the technical and conceptual difficulties which hamper progress towards agreement on a system of measurement, some members of the group questioned whether there was the same general perception of a pressing need to seek convergence of liquidity regulation compared with capital. They suggested that the impact of the common system of capital adequacy measurement proposed by the Committee would itself tend to raise standards of liquidity by inducing banks to hold low-weighted assets. Capital regulation applied worldwide on a consistent basis may to some extent do the work of liquidity regulation.

Risk-weighted capital adequacy was thus seen by some as the ‘magic bullet’, resolving problems of both solvency and liquidity simultaneously. The failure of this optimistic viewpoint did not become patently apparent until 2007. The bugle had now sounded ‘retreat’. Shortly afterwards there was a changeover, with Huib Muller replacing Peter Cooke as Chairman, and Peter Hayward replacing Chris Thompson as Secretary to the Committee. Given the negative content of its second report, there was clearly a question of whether

13 ‘Following the process of testing, comments by individual members suggested considerable differences of view on the nature and value of the measurement system proposed. (i)╇A general concern was that reducing the analysis of liquidity to a series of mathematical calculations, which do not take account of subjective factors (e.g. market reputation, asset quality, diversification of funding sources, the effect of deposit insurance, etc.,), would not provide a sufficient basis for comparison … (ii)╇T he treatment of retail deposits and how to take account of their stability within the measure gave rise to differences of opinion … (iii)╇M any members of the group felt that supervisors needed to measure liquidity under the supposition that the institution was a “going-concern”. This had a bearing on the intrinsic assumptions of the framework, many of which were based on an “at worst” crisis situation of liquidation … (iv)╇T he trial framework aggregated foreign currency and domestic currency business. Some members felt that, in addition, a separate analysis of foreign and domestic currency would be useful. (v)╇Most members felt that supervisors should be most concerned that banks held adequate liquidity against the short-term position at up to one month. Three, however, maintained that the focus on one month, although important, should not ignore the position at longer bands up to one year … (vi)╇T here were also differences of view about the best means of constructing a summary ratio of liquidity based on the data included in the framework … ’

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there was a future for the Musch subgroup. At the forty-ninth meeting of the BCBS (1–2 December 1988) it was recorded (BS/88/114) that: Although some members questioned whether this [liquidity risk management] was an area where harmonisation of national practice was either desirable or possible, it was agreed that it was an important supervisory topic on which members had benefited from the sub-group’s work and needed to keep abreast of technical developments. The sub-group was therefore invited to continue in being, sharing information on new developments and on conceptual thinking and, where possible, testing the positions of a range of banks, with a view to preparing a progress report for the Committee in about one year’s time.

The subgroup took rather longer than one year to report back, doing so in the guise of a progress report in September 1990 (BS/90/80). This was a quite lengthy essay on the definition of liquidity, though, as usual, nicely written. Not only did it avoid suggesting any role for the BCBS in harmonising principles of liquidity risk management, but it indicated reasons why banks’ own desired liquidity ratios might continue to decline. Thus, it stated (pp. 9–10): Liquidity, unlike other banking risks, is a ‘blue-moon’ risk, that is a bank can expect to incur loss resulting from inadequate liquidity very rarely and in most cases not at all … Liquidity has a cost, and competitive pressures and the absence of any recent liquidity problems may lead banks, collectively, to a reluctance to pay the price.

The report noted some countervailing factors, for example peer pressure on outliers, the need to safeguard franchise value and to garner opportunities in the (unlikely) case of an erosion of liquidity, but the general sense was that liquidity margins had declined, and would continue to do so, without any resistance from the international regulatory community gathering under the auspices of the BCBS. Nevertheless the subgroup did not propose its own termination. There was still useful technical work to be done to achieve ‘A more systematic approach to the supervision of liquidity’ (p. 10). In particular, the subgroup wanted to learn more about: 1. ‘the techniques used by major international banks in the management of their global liquidity’; 2. the new technology ‘used to manage liquidity’; 3. how host supervisors ensure ‘that there are no supervisory gaps’; and 4. national differences in assumptions about the behaviour of assets and liabilities (particularly retail deposits) under stressed conditions (pp. 10–11).

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Liquidity

This report was discussed (briefly) at the fifty-sixth meeting of the BCBS (9 October 1990) (BS/90/74), and the subgroup was asked to continue with a view to ‘presenting a further report at the end of 1991’ (BS/90/88). Once again, this report was completed slightly later than requested, being presented and discussed at the sixty-third (3–4 June 1992) meeting of the BCBS (BS/92/45). The report comprised two separate papers. The first paper (BS/92/51) provided ‘A framework for measuring and managing liquidity’. The second covered the question of how assessment of the liquidity of foreign subsidiaries and branches might be undertaken by host and parent regulatory authorities respectively. The first, and much longer (sixteen pages, plus about thirty pages for four annexes), paper was intended for wider circulation, first to the seventh International Conference of Banking Supervisors (ICBS) in Cannes in October 1992, and from there to supervisory authorities worldwide and, via them, to their own commercial banks. A major channel for this was the republication of most of this paper as Chapter VI, pp. 37–58, in Report 8 on ‘International Developments in Banking Supervision’ (Basel:€BIS, September 1992). The paper’s purpose was to bring ‘together practice and technique currently employed by major international banks in a single analytical framework’ (p. 2). It suggested three main scenarios (p. 7), being: (a) a going-concern scenario, for identifying bunching problems; (b) a worst-case liquidity crisis from a reputational collapse at the individual bank; and (c) a general market crisis. The paper proposed estimating maturity transformation ladders ‘by cumulating the balance of expected cash inflows and cash outflows at several time points’ and discussed the assumptions that might be used in determining such cash flows (p. 10), including grading assets into various categories of marketability (p. 11). The four annexes (not included in the more widely published ‘Report on International Developments in Banking Supervision’) discussed how this approach might be applied to: (a) A US money-centre bank (Annex 1) (b) A European, predominantly retail bank (Annex 2) (c) A European, predominantly wholesale bank (Annex 3) (d) A Japanese city bank (Annex 4) While the report normatively advocated certain processes of reporting arrangements, of liquidity management and strategies, and so on, it consciously eschewed proposing any quantification of what liquidity

Liquidity

333

ratios banks should choose to hold. That was taken to be a matter for individual banks and their national supervisors. The second paper on the ‘Supervision of the liquidity of foreign establishments’ (BS/92/52) focussed on the relative roles of host and parent supervisors in a system in which foreign branches and subsidiaries might be operating in currencies other than those of the host (or parent) country, for example a European bank operating in dollar assets and liabilities in London. This paper suggested that there was ‘scope for further work’ on this topic. However, that was not to be. Although access to any record of the proceedings of the June 1992 BCBS meeting was unavailable to me, there is circumstantial evidence that the Musch subgroup was wound up at that meeting. Subsequently in a note on ‘Options for further work’ by the Secretariat in May 1995 (BS/95/30), when considering whether the BCBS should consider liquidity risk in relation to derivatives, the question was asked, ‘[W]ould it be useful to reconvene the liquidity subgroup, whose activities were suspended about three years ago?’ Moreover, after this date (1992), there appeared to be no further papers focussing on bank liquidity until the end of the period covered in this book (end-1997). As noted at the start of this chapter, ‘the Committee’s main objective was to help ensure bank solvency and liquidity.’ It succeeded pretty well on solvency, with the Basel I Accord on capital adequacy (see Chapter 6); but it failed on liquidity. The results were straightforward. If one takes the twenty years from 1967 until 1987, both capital and liquidity ratios were declining sharply in most countries. If one takes the next twenty years from 1987 until mid-2007, capital ratios recovered, but liquidity ratios continued to plummet. Owing to changes in the definition of liquidity, both over time and between countries, in definitions of the banking sector and in accounting techniques, it is quite hard to find consistent measures of liquidity that can document the continuing common downwards trend in liquidity. After some effort, my research assistant, Mr B. Tuger, and I settled on two measures. The first is the ratio of bank holdings of public sector assets to their holdings of claims on the private sector. A diagram, originally prepared by T. Congdon is shown in Figure 9.1. Public sector assets, when denominated in domestic currency, are (normally considered to be14) default free, and generally have a much more liquid secondary market than private sector assets. Thus, in general, a major

14 But Russia defaulted on parts of its rouble-denominated debt in 1998, in preference to paying it off by inflationary expansion of the money stock.

334

Liquidity

100% 90% 80%

Area above the line represents the banks’ claims on the private sector, as % of total assets

70% 60% 50% 40% 30% 20%

Area under the line represents the banks’ claims on public sector, as % of total assets

10% 19 5 19 1 1953 1955 5 19 7 1959 6 19 1 6 19 3 1965 6 19 7 6 19 9 7 19 1 7 19 3 1975 7 19 7 7 19 9 8 19 1 8 19 3 1985 8 19 7 8 19 9 1991 9 19 3 1995 9 19 7 2099 0 20 1 0 20 3 05

0%

Figure 9.1. The changing composition of the UK banking system’s assets

shift of banks out of public sector assets into claims on the private sector will represent a commensurate reduction in liquidity. The second chosen measure is the ratio of private sector domestic deposits to total liabilities, thereby excluding the bulk of wholesale deposits from other banks and overseas funding. This attempts to chart the changing ratio of retail to wholesale-type deposits. In general, retail-type deposits are much more stable than deposits from wholesale markets, so banks with a larger proportion of their funding from wholesale markets need a larger share of high-grade liquid assets to remain equally liquid. Data on these two measures is presented in Appendix F for the banks in the USA, UK, Canada and Sweden. We have not been able to elim� inate all the jump changes caused by various changes in statistical defin�itions, but the main trends are obvious, to wit the massive decline in proportionate holdings of public sector data and the rising reliance of banks on wholesale funding. The dangers that this could pose became obvious in 2007. It is hard to maintain that liquidity is a much more complex and intractable subject than capital adequacy, or that national differences in approach were more deep-seated; probably the reverse is the case. The key difference was that solvency and capital adequacy concerns had come to the fore in a major crisis in the early 1980s. There was

Appendix A

335

no such equivalent crisis then in bank liquidity. So there was political momentum to bring about higher capital ratios, and the Governors kept pressure on the BCBS to reach an accord. There was no such political momentum then on liquidity, and the Governors were, at least, lukewarm about supporting such an initiative when it was put to them in 1985. In 2007 the developed world’s financial system had to face a liquidity crisis, and this has had widespread contagious effects. Perhaps this will act as a spur for the BCBS to revisit this field, and possibly to reach a normative accord on quantitative principles of liquidity risk management.

Appendix A

BS/84/7

Liquidity of international banks Chairman’s note 2

Elements of liquidity

Management of liquidity is of fundamental importance to all banks and supervisors must be able to ensure that the banks for which they have supervisory responsibility have fully adequate liquidity policies. The concept of liquidity is however elusive and a number of issues fall to be considered, most of which have been touched on from time to time in the Committee’s earlier discussions. These inter-related issues are not easily separated, but they may be summarised in broad terms in the paragraphs which follow. Some discussion of these conceptual issues would seem desirable before the Committee becomes involved in any consideration of how liquidity should be monitored. (a) There are two basic approaches to the assessment of liquidity€– one the stock approach, the other the flow approach. In practice, the framework of liquidity control systems may frequently be an amalgam of both approaches. The stock approach involves a bank holding a certain level of liquid assets. The flow approach requires banks to achieve a certain degree of maturity matching. Both require some assessment of the quality of the assets and the nature of the liabilities. (b) The adoption of liability management techniques means that most banks in international markets now rely to a very considerable extent on their ability to take funds in the interbank market. The

336

Liquidity

role of the interbank market as a funding source and the extent of individual banks’ reliance on this market are important questions for supervisors. There are various means of ensuring reasonable access to interbank funds, but given banks’ need to maintain the confidence of other banks in the market and their potential vulnerability to loss of confidence, banks must always recognise that they can encounter funding difficulties. The risks can be reduced by increasing the proportion of longer-term funding in a bank’s liabilities and by increasing the proportion of short-term assets. (c) It may be desirable to make a distinction between local and foreign currency liquidity. In principle the foreign exchange market should enable banks to turn liquidity in one currency into funds in another, but in practice there is friction in the system€– there may be restrictions on banks’ ability to convert and domestic money markets may be quite small in relation to banks’ foreign currency needs. Therefore supervisors should take account of a bank’s liquidity position in individual currencies as well as in all currencies together. (d) The revised Concordat places primary responsibility for the supervision of liquidity of foreign branches and subsidiaries on the host supervisor, although it recognises that for many banks liquidity is controlled centrally. It is necessary therefore to consider how far it is appropriate to conduct supervision of liquidity on a consolidated basis. The judgement on this will vary from bank to bank, but at the very minimum the supervisors of the parent must ensure that there is an adequate system for monitoring liquidity throughout the bank even if individual foreign establishments have a considerable measure of autonomy. (e) The maintenance of particular liquidity profiles has a direct influence on the profitability of banks. Other things being equal, the more liquid a bank the less profitable it is likely to be. Therefore if supervisors require increased liquidity they must expect an impact on profits. Equally, in the light of relatively recent experience, banks need to recognise that adopting too adventurous an approach entails very considerable risks.

Appendix B 1

The purpose of liquidity

A fundamental responsibility of any bank’s management is to ensure that all financial commitments can be met€– at a reasonable cost and without impairing customer relationships€– when they fall due. Thus,

Appendix B

337

liquidity can be loosely described as ‘having the money when you need it’. Adequate liquidity provides basic reassurance to a bank’s management as well as to its creditors that all obligations can and will be repaid whenever they mature, and that all commitments to lend can and will be met. Market confidence in this ability is of crucial importance for the survival of any bank. A loss of confidence can easily trigger an irreversible chain of events culminating in partial or total loss of control over the bank’s fate. This may happen in the event of conditional liquidity assistance granted by one or several other banks and, particularly, in the event of government or central-bank intervention. At worst, a bank in severe liquidity difficulties may be forced to merge on dictated terms or even to close down. 2

The nature and various definitions of liquidity

Even a bank whose assets and liabilities are perfectly matched to maturity needs to maintain a cushion of liquidity because uncertainty and risk regarding timely repayment are natural attributes of all non-cash bank assets. At the same time, no bank can confine its assets to cash since its earning power would vanish. Beyond cash€– central-bank money€– itself, liquid assets are ordinarily defined to include all those that can be converted quickly and easily into cash without incurring a substantial loss of value. This definition clearly has elements of subjectivity, since assessments of marketability may differ substantially. Moreover, in contemporary banking, the concept of ‘liquidity’ in the minds of bank management applies mainly to the liabilities side of the balance sheet, and in particular to the ability to borrow cash quickly, easily and without a substantial premium over the market price. This ‘liability’ notion of liquidity has become, in practice, more important than the traditional ‘asset’ notion, which is more likely to become relevant in emergency conditions. However, from a supervisory viewpoint, a ‘liability’ concept of liquidity is a certain contradiction in terms:€after all, liquidity’s most basic purpose is to maintain the bank’s ability to meet its financial obligations€– thereby upholding market confidence€– precisely when access to normal funding sources, for whatever reasons, may become difficult. The sub-group discussed briefly the liquidity notions employed in various member countries. It is not easy to make such international comparisons. Both the ‘asset’ and the ‘liability’ notions of liquidity are inextricably intertwined with (1) the nature and the structure of national

338

Liquidity

banking and financial markets, (2) institutional constraints including those imposed by banking supervisory authorities (such as minimum levels of ‘primary’ and ‘secondary’ liquidity) and (3) different methods used by central banks to provide high-powered money to the banking system. Notwithstanding these differences, it was felt that the basic structure of a bank’s balance sheet provides a suitable framework for laying out, in a systematic manner, the issues to be examined more closely. In its most elementary form, a bank’s balance sheet is composed of:€ (1) liquid assets including cash, (2) interbank claims, (3) all other assets, consisting mainly of credits and loans to non-banks, (4) retail deposits, (5) interbank deposits (including other funding sources of a wholesale nature) and finally (6) the bank’s capital and reserves. Following the above scheme, illiquidity risk may be defined somewhat more precisely. A bank will experience a liquidity squeeze if, in sequence or at worst simultaneously, one or several of the following events occur:

• interbank, other wholesale and maybe even retail deposits do not get

renewed, i.e. there is a net drain of funds; • interbank claims are not paid on time; • cash and highly liquid assets become quickly exhausted, i.e. they allow insufficient time for the bank to be able to survive a temporary loss of confidence; • access to central-bank credit and/or to other standby lines of credit is insufficient or unavailable; • other assets cannot be converted rapidly into cash without incurring substantial losses or running the risk of losing market confidence. A bank’s management has various degrees of control over these events. The probability of occurrence will normally reflect the wisdom of earlier lending and borrowing decisions, since a perception that a bank’s assets are not of high quality can initiate liquidity problems. It should be clear, however, that liquid assets, access to central-bank credit and access to standby lines of credit from other banks represent the ‘core’ sources of cash in case of liquidity trouble. In line with this distinction, the remainder of this note enumerates briefly the factors affecting a bank’s liquidity in general, looks at the ‘core’ sources of cash and finally presents specific suggestions for future work. 3

Factors affecting a bank’s liquidity in general

A bank’s management, in monitoring its liquidity, will pay particular attention to the following factors:

Appendix B

339

(a) The volume, quality and maturity profile of interbank claims; (b) The volume, quality, maturity profile and saleability of other assets (including their potential use as security for emergency borrowing); (c) The volume and maturity profile of interbank deposits (including other deposits of a wholesale nature, such as those placed by large non-banks), together with the nature of the relationship with the depositor; (d) The stability and maturity profile of the retail deposit base. The continuing search€– under uncertainty€– for an optimal balancesheet structure will be guided by management’s preferred combination of (1) desired liquidity levels, (2) acceptable interest rate exposure and (3) anticipated profits. While it is perfectly possible to analyse these factors individually, a bank is in no position to determine them separately. This is what makes the study of liquidity issues such a complicated matter. To cut down the scope of its assignment, the sub-group recommends that it should not, at this stage at least, examine the question of interest rate exposure (including the use of futures markets), since it believes that it is a somewhat separate question from that of maturity transformation. Another difficulty is that international banks (with the exception of US banks) conduct a large part of their business in foreign currencies. This makes liquidity management even more complex because they have to take into account additional factors such as possible exchange controls and the absence of automatic lender-of-last-resort facilities in foreign currencies. These banks rely heavily on the interbank market for funding, making them particularly vulnerable to any impairment in the smooth functioning of the market. 4

Sources of ‘core’ liquidity

If, for whatever reasons, a bank must obtain funds quickly in order to meet immediate commitments, three main sources are available:

• Cash and liquid assets (however defined); • Access to central-bank credit (including that to foreign currency, if any); • Access to standby lines of credit from other sources, particularly in the interbank market.

Sound banking standards require bank management to be fully aware of the advantages and drawbacks of using each of these sources, and

340

Liquidity

to have at all times a clear picture of the maximum cash which can be raised in this fashion. Banks must also bear in mind that€– beyond formalised arrangements for very temporary loans such as Lombard lines€– central banks are normally unwilling to commit themselves formally to any lending of last resort. Moreover, when they do, the ultimate cost to the banks’ shareholders may be quite high, as in the case of forced mergers. In most countries, central banks are prepared, in principle, to buy ‘secondary liquidity’ (in the form of high-grade assets) and to provide high-powered money in exchange. However, central banks cannot be counted on to perform such operations under any circumstances, at any time, in any currency and in favour of any particular bank. In addition, as the interbank market study has confirmed, a bank believed to experience liquidity problems will not normally be able to attract funds by offering higher than market rates, since such a move is frequently regarded as a sign of weakness. In fact, it may very well accelerate the liquidity difficulties, in which case central-bank intervention normally remains the source of last resort. In the end, then, only cash, truly marketable assets of the highest quality and unconditional lines of credit (most lines are not unconditional) can be relied on to provide means of payment at the sole discretion of management. All other sources of liquidity involve decisions by other parties€– a risk management should never lose sight of.

Appendix C

BS/85/38

Committee on Banking Regulations and Supervisory Practices Report to Governors

The Liquidity of International Banks

(Overview and summary of the attached paper) Capital adequacy and liquidity adequacy are closely interrelated. Following its work on capital and efforts to strengthen international banks’ capital resources, the Committee has more recently been turning its attention to the liquidity of international banks. In troubled bank situations it is frequently unclear initially whether the problem is one of solvency or liquidity. Liquidity alone cannot indefinitely stop an unsound bank from failing. However, without a cushion of liquidity a bank and its supervisory and central-bank authorities may be overwhelmed by the first wave of pressure resulting from rumours of

Appendix C

341

problems, and may not have sufficient time to reassure the market, marshal defences or organise support. Resort to large-scale emergency assistance from the central bank may keep the bank alive, but knowledge of the need for such help may reduce the likelihood that the bank will be able to survive in its existing form. In the present environment of volatile markets and instant communication, inducing feelings of nervousness and a sense that the international financial structure may be more fragile, the need for adequate liquidity has become increasingly important. Against this background, the Committee has prepared the attached report on the liquidity of international banks which draws attention to a number of issues of supervisory concern. In particular, in the context of major banks’ reliance on purchased funds from wholesale money markets, it examines whether standards of liquidity adequacy have tended to decline as a consequence of the same kind of competitive pressure that had affected capital adequacy. In addition, the report addresses the question of the liquidity backing the Euro-dollar liabilities of non-US banks which many supervisors perceive to pose special problems. Other important but more technical subjects discussed include the different means of measuring liquidity, the relative qualities and advantages of different forms of liquidity, interbank exposures and the reliability of standby lines. It is noted that further work will be needed to assess the implications of the recent growth in off-balance-sheet activity for the management of banks’ liquidity. Several recommendations for supervisory policy aimed at strengthening standards of liquidity adequacy are summarised below. Some would have a significant impact on the way banks conduct their business. More detailed discussion in the Committee on particular issues will be necessary and this, the Committee’s first general report to the Governors on the subject, therefore represents a programme for further work. In view of the fundamental nature of the subject and the implications of supervisory initiatives in this area, the Committee has felt it appropriate to consult Governors at an early stage and to seek their broad approval for the courses of action the Committee is advocating. Raising liquidity, like raising capital, may be viewed as imposing a cost on banks. In highly competitive international banking markets one bank’s cost is another’s competitive advantage. The ability of national supervisors to implement policies for strengthening the liquidity of their domestic banks can be materially enhanced by collaboration among G-10 supervisors. In commending its report to Governors, the Committee believes it important to secure a wide measure of agreement and support for its proposals.

342

Liquidity



Summary of conclusions and recommendations

1. The Committee takes the view that, though difficult to measure, there has been a tendency for banks to become over-reliant on purchased money-market funds to generate liquidity and to neglect liquidity deriving from assets. Although wholesale funding techniques provide a ready flow of liquidity in normal circumstances, in times of stress they cannot substitute for asset-based liquidity, whether in the form of marketable securities or short-term claims of undoubted realisability. The Committee feels that as a matter of priority supervisors should review the adequacy of banks’ policies for maintaining such asset liquidity, particularly among those banks whose liabilities consist largely of purchased funds. 2. Competitive pressures, leading banks to curb their lower yielding assets, appear largely responsible for this erosion of liquid assets. However, there is some evidence to suggest that supervisory pressure to strengthen capital ratios is also having this unintended side-effect in some countries. The Committee feels this latter development is a matter of particular concern and highlights the need for a sensitive approach to measuring capital adequacy and in efforts to meet particular target ratios. An apparent improvement in capital adequacy should not be achieved at the expense of a real deterioration in liquidity. 3. The precise measurement of liquidity adequacy gives rise to a number of difficulties both in regard to quantification and qualitative assessment. The Committee notes some broad similarities in the systems of measurement currently employed in member countries but there are considerable differences in detailed construction. It believes that the maturity mismatch framework based on potential cash flows provides a useful starting-point for analysis. One advantage is that it provides a guide to the capacity of a bank to meet potential outflows of call and term deposits by drawing on cash from sales of securities and maturing assets. It also provides a guide to ‘survival time’€– the length of time following the start of a run during which it could draw on its resources before collapse. 4. The Committee considers this concept of survival time to be important since it represents the period during which remedial action or supervisory intervention may be administered. Such a concept may usefully be considered for incorporation within the liquidity regimes in force in different member countries. Committee members believe that it would be desirable for banks to organise their liquidity with the objective of being able to survive without help from the market or the authorities for a period of days (perhaps up to two weeks); and

Appendix C

343

that supervisors should encourage this objective. Such a two-week period may seem short; it assumes a total loss of deposits as they mature and an inability to attract new deposits, whereas in practice a loss of confidence generally tends to build up cumulatively. However, many banks would not at present meet this target. 5. The Committee notes that to provide liquidity in foreign currency in the event of difficulties in raising fresh funds, most international banks tend to rely on maturing placements with other banks (including holdings of CDs) and standby lines. Beyond this, a number of banks also hold a stock of securities denominated in local currency against their foreign currency deposits. Implicit in this latter policy there is a presumption that, faced with a loss of foreign currency deposits, in last resort banks would be able to raise foreign exchange by selling domestic securities and converting the proceeds into foreign currency, either through the market or at the central bank. The Committee considers that assets for which there is an assured market in the currency denomination of the deposits (e.g. US Treasury paper) would represent a more secure and direct form of liquidity and should constitute an element within banks’ liquid resources. With very few exceptions, banks do not hold such assets in significant quantities and the Committee considers that they should be encouraged to do so. In making this recommendation, the Committee is conscious of the wider implications it might carry for markets in public-sector debt. 6. A number of international banks, particularly smaller institutions, regard standby lines from major banks as an important part of their liquidity but the strength of the commitment to lend implied by these agreements varies greatly. The Committee believes there is considerable doubt whether, in the event of a bank facing serious difficulty, standbys can be relied on as a source of liquidity. Except in the case of legally-binding, irrevocable commitments, endorsed as such by the supervisory authority, they should not be regarded as a substitute for holdings of marketable securities and short-term claims of undoubted quality. 7. In the event of an incipient loss of confidence, banks may feel impelled to buy in their own CDs from the market and may face pressure for repayment of deposits before maturity. Acquiescence to those pressures presents obvious dangers for liquidity management but the choice of response is not clear-cut and, in particular, a refusal to support the price of a bank’s own CDs might serve to exacerbate nervousness. The Committee considers that it would probably be impractical and might be counter-productive for supervisors to seek to restrict the not uncommon practice of banks supporting their own CDs.

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Liquidity

8. The breaking of deposit maturities is seen as less likely to occur. However, the Committee recommends that it should be kept under review and that, if necessary, the Committee or individual supervisors should consider issuing a statement designed to encourage greater discipline and make it easier for banks to stand behind it to refuse requests for early repayment. 28 June 1985

Appendix D

BS/87/11

The liquidity of international banks Terms of reference for the Committee’s sub-group chaired by Mr F. C. Musch In the light of the Committee’s report to Governors on the liquidity of international banks (BS/85/38), the sub-group is requested to: 1. (a)╇Examine the concept of the ‘survival period’ as a test of the liquidity adequacy of banks. (b) Assess the validity of the particular framework for a measure of survival proposed in the Secretariat’s note (BS/86/7). (c) Test the practical application of the concept, where possible, by using existing supervisory data and by approaching banks in different countries with a view to establishing the usefulness of a supervisory measure of this kind. 2. Assess whether the Committee’s earlier exercise to collect data on banks’ maturity mismatching can be redirected to provide useful comparative information on standards of liquidity adequacy among international banks in member countries. For this purpose the subgroup is invited to consider the note to the Committee (BS/86/39) on the future of the earlier exercise. In making its assessment the sub-group is requested to have regard for: (a) the importance of monitoring banks’ ability to generate liquidity in the short term (under three months) by liquefying assets; (b) the need to monitor the liquidity of the total business and, as a subset, liquidity held against foreign currency liabilities; (c) the present observation framework for liquidity measurement employed in the European Community; (d) the practicality of a framework of measurement and, in particular, whether statistics of sufficient quality and consistency would be available in most member countries to achieve worthwhile results.

Appendix E

345

The sub-group is requested to present its recommendations to the Committee on both matters as soon as possible in 1987. 23 January 1987

Appendix E Illustrative example Balance sheet/maturity profile of an international bank (in millions of US dollars)

Balance-sheet items

Amount

Cash flow assumptions for items with no fixed maturity

Immediate available/ withdrawable

Maturity profile Up to 1 month

1 month to 3 months

3 month to 6 months

6 month to 1 year 1 year and more

Assets 1 Notes and coin 2 Items in collection 3 Claims on central bank securities 4 – Government < 1 year 5 – Government > = 1 year

1,560 3,621 4,372

immediate access quick access quick access

1,560 3,621 4,372

– – –

– – –

– – –

– – –

– – –

4,728

liquefiable (no discount)

4,728

–

–

–

–

–

864

–

–

–

–

–

17,421

–

–

–

–

–

– – – –

10,153 8,520 4,020 –

943 1,765 12,003 –

443 502 15,006 –

461 569 55,011 20,476

960

6 – Other marketable

21,776

7 Claims on banks 8 Other market loans

15,692

9 Term commercial loans 10 Demand loans 11 Fixed assets 12 Standby facilities

Total inflow

14,708 94,022 20,476 0 3,177 723

liquefiable (10% discount) liquefiable (20% discount)

no s/t cash flow no s/t cash flow immediate access

185,815

723

33,289

3,692 3,352 7,982 –

–

–

–

–

3,177

–

–

–

–

–

22,693

15,026

14,711

15,951

79,694

– –

– –

9,060 20,695

Liabilities 13 Equity + reserves 14 Long-term bonds

9,060 20,695

– –

15 CDs

11,269

–

3,920

2,764

4,321

264

16 Purchased funds

36,781

–

15,131

8,315

7,542

4,325

1,468

17 Other term deposits

52,348

17,563

12,464

11,154

7,324

3,843

16,341

Withdrawn 5% per month

–

18 Chequing accounts

–

817

1,552

2,096

3,563

8,313

19 Saving accounts 20 Commitments to lend

38,598 5,436

Withdrawn 10% per month

– –

3,860 3,840

6,948 1,596

8,337 –

11,672 –

7,781 –

Total outflow Mismatches 1) Cumulative mismatches

190,528

Net neg. mismatches in maturity profile 2) Mismatch ratios – Cumulative mismatches/ total liabilities of the same timebands. Coverage ratio – Total inflow/total outflow (cumulative) Overall ratio – Immediate inflow/immediate outflow plus net negative mismatches till concerning timeband.

– –

– –

–

45,131

33,639

33,450

27,148

51,160

33,289

(22.438)

(18,613)

(18,739)

(11,197)

28,534

33,289

10,851 (22.438)

(7,762) (18,613)

(26,501) (18,739)

(37,698) (11,197)

(9,164) 0

0.24

(0.10)

(0.24)

(0.27)

(0.05)

1.24

0.90

0.76

0.73

0.95

1.48

0.81

0.56

0.47

0.47

0

0

1) Assets minus liabilities. 2) Negative mismatches in maturity profile (not “immediate”) in so far not compensated by positive mismatches in earlier timebands.

346

Liquidity

Explanatory remarks concerning ratios 1. Mismatch ratios (MR) The cumulative mismatches (including immediate available/withdrawable) as a part of the cumulative liabilities in the same time bands. Examples of calculation: – column ‘up to 10.851 (= 33.289–22.438) 1 month’ : MR = = 0,24 45.131 – column ‘3 months to 6 months’ : MR = –26.501 (= 33.289 – 22.438 – 18.613 – 18.739) = –0,24 0 + 45.131 + 33.639 + 33.450 2. Coverage ratios (CR) That part of the (cumulative) liabilities (including immediate available/withdrawable) that is covered by (cumulative) assets in the same time bands. Examples of calculation: – column ‘up to 33.289 + 22.693 1 month’ : CR = = 1,24 0 + 45.131 – column ‘3 months to 6 months’ : CR = 33.289 + 22.693 + 15.026 + 14.711 = 0,76 0 + 45.131 + 33.639 + 33.450 3. Overall ratios (OR) That part of the outflow (immediate withdrawable plus net outflows in the time bands) that is covered by immediate available assets. Examples of calculations: – column ‘up to 1 month’ : OR = – column ‘3 months to 6 months’ : OR =

33.289 = 1,48 0 + 22.438 33.289 = 0,56 0 + 22.438 + 18.613 + 18.739

26.02% 93.10%

24.59% 92.84%

1966

1967

1983

1984

1985

1986

1987

2003

2004

2005

2006

22.80% 93.29%

21.34% 92.76%

22.41% 93.37% 15.73% 85.55%

14.82% 84.81%

463.657 485.751 537.529 2516.234 2873.982 497.013 523.664 575.667 2941.146 3346.456 15.64% 83.75%

14.62% 82.92%

12.80% 81.41%

5.89% 67.28%

Notes: US Banking Institutions: Comprises commercial banks, credit unions and savings institutions, and money market funds as defined in the FED Flow of Funds accounts. Commercial banks include U.S.- chartered commercial banks, foreign banking offices in the U.S., bank holding companies, and banks in U.S.-affiliated areas and exclude international banking facilities (IBFs). Savings institutions include savings and loan associations, mutual savings banks, and federal savings banks. The data are derived from the FED Flow of Funds quarterly publication. Claims on Central Government (line 22a) exclude claims on government-sponsored credit agencies and government enterprises, which are included in Claims on Nonbank Financial Institutions (line 22g). Demand Deposits (line 24) comprise checkable deposits as defined in the FED Flow of Funds accounts. + Beginning in December 2001, data are based on a new reporting system which provides improved classification and sectorization of the accounts

6.67% 69.81%

5.55% 67.46%

5.42% 66.30%

3070.96 3363.241 3492.314 7565.485 7989.899 8670.524 9493.215 3666.75 4055.822 4289.676 10836.73 11875.31 12853.26 14319.26

451.5 526.053 542.005 506.403 639.016 603.687 622.615 663.621 111.287 110.045 126.821 419.025 488.098 515.585 565.814 2663.63 3046.73 3363.098 3706.579 3954.89 9574.696 10244.29 11212.81 12233.83

1965

Copyright Statement: ‘Title and ownership of the data remain with IMF’ Citation for data: International Monetary Fund (IMF), IFS (website), ESDS international, (MIMAS) University of Manchester

Banks’ Claims on Public Sector/ Banks’ Total Domestic Claims Deposits/Total Liabilities

United States (February 2008). Annual IFS series. Time 1963 1964 Scale: billions Banks’ Claims on Public Sector 105.565 109.368 Banks’ Total Domestic Claims 405.665 444.759 Deposits (Demand Dep. & Time Dep.) 389.627 425.654 Total Liabilities (exc. other items) 418.49 458.462

Liquidity Ratio (LR) LR: US

Appendix F

9.152 9.574

40.11% 73.54%

76.37%

13.019

45.47%

11.984

72.68%

39.87%

14.168

10.298 17.965

12.025

70.08% 66.94%

40.25% 42.63%

15.272

10.703

1983

1984

1985 1986 1987

2003 2004

2005

2006

23.26%

32.87%

457.016

106.309

21.15%

30.21%

575.271

121.654

24.59%

23.50%

551.7

135.689

3.53%

25.39% 40.50%

4.28%

661.342 799.172

167.941 323.695

0.81% 40.57%

41.61%

3449.82

1399.55

0.37%

3055.09

1271.3

Banking Survey: A break in series occurs in July 1999 as a result of the change in the definition of the monetary authorities’ sector. A break in series occurs in January 1987 as a result of a change in the coverage of banking institutions. A break in series occurs in September 1992 as a result of new balance sheet report forms for the building society sector.

Notes: UK Banking Institutions: † A new system of bank returns was introduced in 1975. As a result of this change, (1) money at call and money placed overnight are now reported in line 24 rather that in line 25 – a shift of approximately 700 million pounds sterling – and (2) line 21 is estimated to have increased by about 1,300 million pounds sterling. † Beginning in 1981, they comprise the U.K. monetary sector as described in the December 1981 issue of the Bank of England’s Monetary and Financial Statistics, subject to the same exclusions as the banking sector. † Prior to 1987, building societies are treated as part of the private sector. Beginning in 1987, comprises U.K. banks authorized under the Banking Act of 1987 and, beginning in January 1987, building societies as defined by the Building Societies Act of 1986. † In September 1992, a new balance sheet report form was introduced for the building society sector in the U.K., resulting in a discontinuity for most of the building society data. † Prior to September 1997, the accounts of certain institutions in the Channel Islands and the Isle of Man were included as part of the U.K. banking institutions sector.

39.71%

0.72%

4016.38

1594.98

40.84%

–0.13%

4457.55

1820.51

6.033 58.6193 63.4357 51.41114 14.2283 13.82 5.957 14.742 14.521 –2.918 14.153 178.3633 209.9707 218.8041 332.6733 391.227 1630.597 1822.342 2009.391 2253.292

1967

Copyright Statement: ‘Title and ownership of the data remain with IMF’ Citation for data: International Monetary Fund (IMF), IFS (website), ESDS international, (MIMAS) University of Manchester

Banks’ Claims on Public Sector/ Banks’ Total Domestic Claims Deposits/Total Liabilities

Total Liabilities (exc. other items)

Deposits (Demand Dep. & Time Dep.)

United Kingdom (February 2008). Annual IFS series. Time 1963 1964 1966 1965 Scale: billions Banks’ Claims on Public Sector 4.986467 4.66881 4.97216 5.09306 10.96647 11.63881 12.47216 12.65306 Banks’ Total Domestic Claims

LR: UK

348 Liquidity

2004

2005

2006

7.70%

7.46% 94.89%

7.40% 94.96%

Canada Banking Institutions: Comprises chartered banks and Quebec savings banks. Beginning in March 1967, includes trust and mortgage loan companies, local credit unions, and caisses populaires. † Beginning in December 1981, all wholly- and majority-owned subsidiaries of the chartered banks (including mortgage loan subsidiaries and foreign banking subsidiaries) are consolidated in accordance with Canadian banking law. Unconsolidated data are not available on a monthly basis. In addition, data for lines 24 and 25, which were previously calculated from monthly averages of Wednesday figures in the absence of an adequate classification of month ends, are now calculated mostly from month-end figures. Adjustments have been made to exclude foreign currency transactions booked outside Canada from the IFS presentation. Beginning September 1987, excludes the Quebec savings banks. † Beginning in December 2001, includes life insurance company annuities, government owned savings institutions, money market mutual funds, and non-money market mutual funds and excludes caisses populaires. Data are based on a new reporting system which provides improved classification and sectorization of the accounts.

Copyright Statement: ‘Title and ownership of the data remain with IMF’ Citation for data: International Monetary Fund (IMF), IFS (website), ESDS international, (MIMAS) University of Manchester

8.05%

7.18%

94.66%

7.66%

6.30%

8.78% 72.21% 72.79% 71.23% 72.53% 74.71%

94.81%

7.45%

354.65 1764.32 1862.208 2046.085 2306.973

33.949 361.889 385.695 422.176 450.609 474.696 1863.809 1962.449 2154.692 2433.318

2003

29.966 261.312 280.729 300.726 326.827

1987

30.055

1986

26.033

1985

7.313 25.543 23.981 24.469 27.815 24.733 139.2309 138.4738 150.7608 174.6341 29.053 291.003 313.271 340.629 361.197 392.806 1729.191 1855.153 2036.592 2344.71

1984

3.745 22.196

1983

1967

1966

Banks’ Claims on Public Sector/ 18.75% 16.17% 15.56% 16.87% 25.17% Banks’ Total Domestic Claims 82.97% 83.59% 85.41% 86.62% 88.27% Deposits/Total Liabilities

Canada (February 2008). Annual IFS series. 1963 1964 1965 Time Scale: billions Banks’ Claims on Public Sector 2.106 2.016 2.36 11.231 12.466 15.171 Banks’ Total Domestic Claims Deposits (Demand Dep. 16.21 17.936 19.861 & Time Dep.) Total Liabilities (exc. other items) 19.537 21.458 23.255

LR: Canada Appendix F 349

1963

1964

1965

1966

1967

1983

2003

2004

2005

2006

612.375 652.801 732.044

1118.83

28.97%

32.18%

Notes: Sweden Sweden Banking Institutions: Beginning in December 2001, comprises all resident units classified as other monetary financial institutions (other MFIs) in accordance with 1995 ESA standards. Prior to December 2001, consolidates the commercial banks, large savings banks, cooperative banks, and deposit liabilities to the private sector of the postal giro system. Demand, Time, Savings, & Foreign Currency Deposits (line 251): From March 1990 to December 2000, data refer to the sum of liquid liabilities of commercial banks, large savings banks, cooperative banks, and the postal giro system. † Beginning in 1983, data reflect improved classification of accounts. † Beginning in January 1996, data on accounts of deposit money banks are not strictly comparable with earlier figures, owing to the adoption of the European Union accounting system. † Beginning in December 2001, data are compiled in accordance with the European Central Bank’s framework for monetary statistics using national residence approach. Prior to December 2001, deposit money banks’ positions with other banking institutions are classified in Other Items (net) (line 27r).

Copyright Statement: ‘Title and ownership of the data remain with IMF’ Citation for data: International Monetary Fund (IMF), IFS (website), ESDS international, (MIMAS) University of Manchester

6.57%

6.54%

28.70%

7.94%

819.65 3391.404 3862.198 4409.492

1091.47

28.49%

7.52%

5009

1427.2

1265.32

1987

385.474 398.353 454.489 481.588

1986

257.56 270.193 3244.45 3591.533

1985

110.634 96.43 96.731 116.918 177.7458 189.6733 434.149 437.049 495.445 570.806 2718.006 2886.013

1984

Banks’ Claims on Public Sector/ 11.25% 10.51% 8.30% 7.44% 7.78% 27.58% 25.48% 22.06% 19.52% 20.48% Banks’ Total Domestic Claims 71.29% 71.22% 70.90% 70.91% 73.23% 61.72% 62.95% 61.02% 62.08% 58.76% Deposits/Total Liabilities

Scale: billions Banks’ Claims on Public Sector 4.95 5.032 4.323 4.197 4.902 110.083 44.012 47.857 52.061 56.439 62.986 399.115 Banks’ Total Domestic Claims Deposits (Demand Dep. & 48.66 52.208 55.587 61.14 69.356 354.676 Time Dep.) Total Liabilities (exc. other items) 68.2585 73.3069 78.4065 86.2176 94.7125 574.648

Time

Sweden (February 2008). Annual IFS series.

LR: Sweden

350 Liquidity

10

Off-balance-sheet exposures and derivatives

A

Work on off-balance-sheet exposures

The attention of the BCBS was first drawn to off-balance-sheet exposures and activities in the course of the tour de table on ‘Recent developments in banking supervision’ at the thirty-second meeting of the BCBS (5–6 November 1984) (BS/84/70). Here it was noted that: in the context of the increasing ingenuity of banks in developing techniques for removing business from their balance sheets and the appearance of new forms of contingent liability, it was considered desirable to conduct a survey of the various off-balance-sheet activities being conducted by banks in different member countries. The Secretariat was asked to draft a short note requesting members to list and describe all the types of contingent commitment which they observed currently within their own banking systems. These should be sent in before the end of the year. The Secretariat would then be in a position to draft a paper summarising members’ contributions for discussion at the next meeting with a view to preparing a paper for the Governors.

A questionnaire was duly circulated, and the results for each country presented in early 1985 (BS/85/10)1, and then covered by a quite lengthy introductory note by the Secretariat (14 June) (BS/85/39). This paper began by listing the various forms of such exposures, and then continued with first a ‘Commentary’ on the supervisory implications of such innovations, and, second, ‘Supervisory responses to these developments’.2 The ‘Commentary’ gives a nice, clear account of regulators’ appreciation of these issues in the 1980s, and is, therefore, attached as Appendix A. As for the immediate policy implications, the Secretariat paper emphasised (emphasis in original) that: Banks from all member countries appear to be involved, to a greater or lesser extent, in the underwriting of NIFs [Note Issuance Facilities]. Some This file was not available to me. 2 This work was also mentioned in ‘Report on International Developments in Banking Supervision’ 1984 (BCBS, April 1985, p. 15). 1

351

352

Off-balance-sheet exposures and derivatives

co-ordination of supervisory initiatives would seem to be urgently required to preserve competitive equalities, to avoid undue distortions in international markets and to ensure that the risks associated with these instruments are effectively covered by capital and appropriately reflected in profit margins.

This led on to some queries which the Secretariat addressed to BCBS members: (a) Should irrevocable commitments under note issuance facilities be brought within the scope of capital adequacy measurement? (b) If so, is it a matter of urgency to do this and should an attempt be made to develop a consistent approach among supervisory authorities? (c) Should other irrevocable commitments to lend, for example interbank standby lines or undrawn commercial loan commitments and standby letters of credit, also be brought within the scope of member countries’ capital adequacy measures? (d) Should they attract the same requirement for capital as on-balancesheet credit risks or, where risk asset systems are applied, is it sufficient to accord them a lower weighting, for example 50 per cent? (e) In general, only high quality borrowers have access to the ‘securÂ� itised’ lending markets (NIFs and commercial paper). DisinterÂ� mediation confined to this high quality segment of the market would tend to reduce the average quality of the loan assets left on banks’ balance sheets. Does this provide an additional reason for raising standards of capital adequacy? (f) As regards the wider range of instruments and techniques listed in the annex, would it be practical for the Committee to attempt to reach a view on the relative degree of risk attaching to each (as a complement to the work of the Cross Committee) and as a basis for recommendations for the supervisory approach to these various contingent risks? At the subsequent thirty-fourth meeting (24–25 June 1985) of the BCBS: After a number of members had expressed concern at the implications for the integrity of supervisory systems arising from the rapid growth in off-balancesheet business, it was agreed that the Chairman should raise the matter with the Governors at their July meeting. He said that he would consult with the Committee in advance about the possibility of drawing up a short statement warning of the risks in off-balance-sheet activities and of the need for banks to have adequate control systems. It was also agreed that a sub-group should be formed to take forward the technical work in this area. The Secretariat was asked to circulate to the Committee draft terms of reference for the sub-group’s work.

Such a (brief, one-page) note for the Governors was drafted, and sent on to them, dated 8 July 1985 (BS/85/51). It is reproduced

Work on off-balance-sheet exposures

353

as Appendix€ B. As noted there, exactly the same topic, ‘Recent Innovations in International Banking’, was simultaneously being pursued by the Euro-currency Standing Committee. With the Governors’ blessing, this was then reviewed by a specially established study group under the chairmanship of Sam Cross (FRBNY), who reported, under the above title, in April 1986 (Basel:€BIS), though the lengthy (270page) book is more commonly known as the Cross Report. The main parts of this, Chapters 1–7, pp. 17–168, deal with factual questions of the nature and scale of these new innovations/instruments. The final chapters analyse ‘The impact of financial innovation on financial stability’ (Chapter 10), ‘Impact of innovation on financial statements and statistical reporting’ (Chapter 11), and ‘Issues for macro-prudential policy’ (Chapter 12). Although the Cross Report did comment on ‘Implications for the scope of prudential supervision’ (Chapter 12, pp. 239–41), this was primarily about the resultant enhanced competition between investment houses and commercial banks, especially in the USA (see further Chapter 12). It specifically did not comment on the micro-prudential implications, especially for risk-weighted capital adequacy requirements, since this latter was the specific province of the BCBS. While the work of the Cross Group was still in its early stages, the BCBS set up a subcommittee, under the chairmanship of John Beverly of the Bank of England, ‘to examine and report on the risks for banks associated with the various types of off-balance-sheet transaction and to make recommendations for supervisory policy on the means by which such risks might best be reflected within methods for measuring capital adequacy and, if appropriate, liquidity, foreign exchange and interest rate exposure’. Unlike the Cross Report, its deliberations and conclusions were not made public, but did of course inform the Basel CAR Accord (Basel I). Given the pressure to reach that Accord, the Beverly subgroup had to work fast. Its first report came in late autumn 1985 (BS/85/64), a lengthy twenty-four-page (plus six-page appendix) paper. Its Conclusions (pp. 22–23) were: 1. The Committee concluded that most of the risks associated with off-balancesheet business were no different in substance from those of on-balance-sheet exposures and could not be treated in isolation (paragraph 5). Accordingly, a number of its proposals affect both on and off-balance-sheet exposures (this applies particularly to interest rate and foreign exchange risk). 2. Existing prudential reporting systems should be urgently reviewed to ensure that they adequately capture the full range of off-balance-sheet activities (paragraph 8) and it is desirable that banks’ published accounts should disclose to a greater extent than they do at present exposures arising from offbalance-sheet activities (paragraph 24).

354

Off-balance-sheet exposures and derivatives

3. Supervisors should warn banks of the risks involved in options (particularly in writing options) and should seek to ensure that those banks which do so on a significant scale have staff who are competent in the techniques necessary to manage the risks. Banks which are unable to demonstrate both that they have a sound grasp of the risks involved in options trading and have installed appropriate monitoring systems should be strongly advised not to write options (paragraph 11). 4. Supervisors should continue to stress the need for banks to have adequate internal reporting and control systems which take account of both on and off-balance-sheet exposures. Where control systems are found to be inadequate, or where there is an inadequate complement of experienced staff, supervisors may wish to discourage banks from engaging in the activities which give rise to concern (paragraph 14). 5. Supervisors should seek to apply a methodical approach to the measurement and control of interest rate risk which includes positions arising specifically from off-balance-sheet activities (paragraph 18). 6. All countries should have some supervisory system for monitoring and controlling banks’ foreign exchange exposures. It is for consideration whether net open currency positions should attract capital weighting (paragraphs 20 and 21). 7. It is suggested that risk asset ratios and (where appropriate) gearing measures should be reviewed in the light of the credit risk arising from off-balance-sheet items (paragraph 22). The detailed proposals regarding capital weighting for credit risk are summarised in the table attached. 8. The Committee identified a number of off-balance-sheet risks which cannot easily be quantified. It recommends members to require banks to compile a check-list of such ancillary activities as a reminder of the nature and scale of their exposures (paragraph 43). 9. Supervisors should take a suitably cautious approach to back-to-back loan and deposit arrangements by requiring them to appear on the balance sheet of the intermediary bank and also to be treated by the depositor (if it is a bank) as a loan to the final borrower (paragraph 45). 10. Off-balance-sheet exposures should systematically be taken into account in the measurement and control of large exposures, taking a generally very cautious approach (paragraph 47). 11. Limits designed to capture and control settlement exposure should encompass the settlement risk arising from off-balance-sheet business (paragraph 48).

This report was discussed at the thirty-fifth BCBS meeting (24–25 October 1985) (BS/85/81). It was agreed that: it should be sent forward to the Governors, if possible in time for their December meeting. Mr Beverly was asked, with the help of the Secretariat, to seek to develop three particular aspects of the report (those relating to management and control systems, options and replacement cost) before submitting a revised draft to the Committee in November. In the meantime, the Chairman said that he would write to President Pohl informing him that the report would

Work on off-balance-sheet exposures

355

be ready for submission to the Governors shortly and saying that Committee members proposed to make use of the glossary of terms attached to the subgroup’s report in discussions with their commercial banks. It was also agreed that much of the analysis contained in the sub-group’s report would be of interest and value to commercial banks. Mr Beverly’s subgroup was therefore invited to prepare a revised version which, when agreed by the Committee and subject to Governors’ approval, could be ready for circulation early next year.

This latter remit was met by having a draft cover note (BS/85/83) to the existing note. The main proposals of this note are reproduced as Appendix C. This was further covered by a one-and-a-half-page cover letter from Chairman Peter Cooke to Mr Pohl, the President of the G10 governors. These advocated issuing the main paper, shorn of any recommendations about prospective risk ratios, to the main commercial banks. It was put to the Governors in time for their December 1985 meeting. This was agreed, and the revised main paper was circulated, to non-G10 supervisors and the main banks in March 1986, under the heading ‘The management of banks’ off-balance-sheet exposures:€a supervisory perspective’ (filed as BS/85/88); also see ‘Report on International Developments in Banking Supervision’, Report 5 (BCBS 1985), Chapter 5 on ‘Supervision of off-balance-sheet risks’, pp. 31–7. The member countries, following the general lines set out in the Beverly Report, then began to engage their own banks in discussion of how to bring off-balance-sheet business within the supervisory framework with the prospective application of risk ratios. The Bank of England’s consultative document was included in the archives, as file BS/86/12, and Aoki’s (Bank of Japan) article as BS/86/13. The Secretariat circularised all members (in April 1986, BS/86/33) asking for information on the scale of such business done by banks in their own countries; the answers received enabled the Secretariat to make: a very rough indication of the impact on capital ratios which would result from incorporating these off-balance-sheet transactions into the risk asset ratios of member countries’ banks.

In May 1986 the Governors requested a progress report on ‘national supervisory policies for off-balance-sheet exposures; this was made in August 1986 (BS/86/49): This paper is divided into three main sections. The first records the measures which a number of member countries are taking, or expect to take, to incorporate off-balance-sheet risks within systems of measuring capital adequacy. The second reviews progress made in extending supervisory reporting systems to capture information on banks’ engagements in new forms of off-balance-sheet activity. The third draws on data presently available (which is still limited and

356

Off-balance-sheet exposures and derivatives

in most cases somewhat provisional) to provide a tentative general assessment of the scale of major banks’ involvement in each of the main new types of offbalance-sheet activity.

And the conclusions were: The developments recorded in this note demonstrate that most member countries are taking steps to extend their supervision of off-balance-sheet exposures along the lines endorsed earlier by the Governors. The markets in which banks compete for business, on or off-balance-sheet, are international but the supervisory requirements which in some measure affect their ability to compete are set nationally. As competition intensifies, inconsistencies in these requirements are tending to attract attention and could become a source of friction. There appears to be some expectation that the Supervisors’ Committee can itself deliver a more level playing-field. As in other fields, with the approval of Governors, the Committee has developed a consensus on the appropriate approach to the supervision of offbalance-sheet business but the implementation of policy remains a matter for national authorities. In order to avoid the risk of significant disparities, Committee members have agreed to give early notice to the Secretariat if it appears that their countries are planning to adopt measures out of line with those proposed or in force elsewhere. In this respect the Committee has appreciated the invitation extended by the US supervisory authorities to comment on their draft proposals for a risk-based measure of capital adequacy.

At the thirty-eighth BCBS meeting (26–27 June, 1986) (BS/86/47) the Beverly subgroup were asked ‘to meet again in order to examine whether it was possible to give a little more precision to the weights suggested in its earlier report’. The subgroup met again in July and issued a further report in early September (BS/86/60). In their earlier work (BS/85/84) they had; identified three broad degrees of risk: (a) ‘full risk’ where the instrument is considered to be a direct credit substitute with a credit risk equivalent to that of an on-balance-sheet exposure to the same counterparty; (b) ‘medium risk’ where there is a significant credit risk but also mitigating circumstances which suggest a less than full credit risk; (c) ‘low risk’ where there is a small risk but not one which can be ignored. For each instrument, the aim of the analysis was to relate the credit risk involved to that arising from an on-balance-sheet exposure to the same counterparty. In its most recent work, the sub-group adopted the same approach. It did not set out to assign particular weightings to off-balance-sheet transactions, but rather to give some numerical value to the descriptive terms ‘full’, ‘medium’ and ‘low’. The following risk relativities were agreed:

Work on off-balance-sheet exposures

357

‘full’€– equal to the weighting given to an on-balance-sheet exposure to the same counterparty€– that is a risk relativity factor of 1.0 ‘medium’€– half the weighting accorded to an on-balance-sheet exposure to the same counterparty€– that is a risk relativity factor of 0.5 ‘low’€– a quarter of the weighting accorded to an on-balance-sheet exposure to the same counterparty€– that is a risk relativity factor of 0.25.

There were, however, still differences of view among the subgroup members about the classification of certain exposures into one or another credit risk grouping, for example documentary credits (paragraph 7) and NIFs and RUFs (Revolving Underwriting Facilities) (paragraph€9), and the subgroup also deferred estimation of the foreign exchange and interest rate risk of such exposures (paragraph 11). Nevertheless by the end of 1986 there was enough agreement to put before the wider group of the Gulf Cooperation Council (GCC) (see Chapter 12) supervisors a synopsis of recommendations, classifying off-balance-sheet exposures into each of the three headings (BS/86/82:€ Discussion paper by the Secretariat on off-balance-sheet items and their effects on the adequacy of banks’ capital).3 The recommended supervisory treatment is reproduced as Appendix D. Note, however, that options are not mentioned in this list, although the subgroup and the BCBS were aware of them. At this juncture the Beverly subgroup had effectively fulfilled its mandate by providing a basis for applying credit risk weightings to current off-balance-sheet exposures. This then enabled such exposures to be slotted into the wider work of agreeing the technical details of the Basel Accord during 1987, for publication in 1988 (see Chapter 6). That the BCBS had been able to go from its initial factual exploratory work, starting at end 1984 to an agreed, and defensible, approach to the application of credit risk weights by end 1986 represents something of a triumph. One important reason, fully recognised by Beverly and his group, why this work succeeded, whereas, for example, the work on profitability comparability had not done so, was that such off-balance-sheet exposures were new. There had been less time for differing, and idiosyncratic, national methodologies and techniques to congeal. Instead of protecting national positions, members were able to cooperate to reach harmonised international agreements. See also Chapter 14, Section B on this point. This was the end of a stage in the BCBS’ work on off-balance-sheet exposures. Private sector innovation in this field, of course, continued, Much of such innovative offshore business was at that time being booked through offshore centres, including in the Persian Gulf. So, it was not just by random chance that the first discussion of the subject with non-G10 supervisors was with the GCC. 3

358

Off-balance-sheet exposures and derivatives

in part stimulated by a reaction and response to the 1988 Basel Accord. Moreover the Beverly subgroup had put to one side the questions of the other risks, for example interest rate and foreign exchange risks, on such exposures. In his note on the future mandates for the Beverly and Danielsson subgroups (BS/87/88, December 1987), Chairman Peter Cooke switched the Beverly group ‘to the analysis of interest rate risk (on and off the balance sheet)’ (see Chapter 7), while asking the Danielsson subgroup to monitor ‘off-balance-sheet innovation and new instruments from the point of view of credit risk’, and also to explore their foreign exchange risk aspects. Over the next few years the Danielsson subgroup did produce several reports on the foreign exchange risk attendant on those exposures, for example BS/88/25, BS/89/6, BS/89/40, BS/89/77, BS/90/54, and so on, but having covered the BCBS’ work on external issues in Chapter 5, we shall not pursue that further here. On innovations and credit risk, the Danielsson subgroup reviewed ‘written put options with the character of guarantees’ in BS/89/6, and of commitments in BS/89/95. B

Netting

The next major issue that came up was the supervisory treatment of ‘netting’. This arose towards the very end of the 1980s following the publication of the ‘Report of the Committee on interbank netting schemes’ (Basel:€ BIS, November 1989), otherwise known as the Lamfalussy Report, named after the chairman of the group that produced it, though more generalised concern about the supervisory treatment of netting arrangements was arising independently (e.g. BS/89/42). Before the Lamfalussy Report was completed, the Chairman of the BCBS, Huib Muller, wrote to Lamfalussy (June 1989) to express cautious concern about the supervisory implications (BS/89/56), as the following two excerpts indicate: Supervisors recognise that legal contracts to net obligations may well have value in affording protection to banks in the event of counterparty failure. However, Committee members remain cautious about adopting supervisory regulations which directly or indirectly encourage banks to regard their counterparty risks on a net rather than a gross basis unless they are convinced that the netting arrangements will survive failure of a counterparty and any consequent insolvency proceedings. They are mindful of the danger that a liquidator or administrator may be able to indulge in ‘cherry-picking’, that is pursuing those contracts in which he has advantage and neglecting those where he has none, rather than claiming for the net amount. Moreover, they do not wish to give impetus to schemes which lead to a material increase in liquidity or systemic risks …

Netting

359

The Committee notes that actions to reduce risk on the part of those responsible for payment and clearing systems may have side-effects which create supervisory problems. In particular, the growing tendency to demand collateral from market participants has the effect of sterilising high quality liquid assets of the banking system. Members are concerned that this process, by hypothecating a bank’s best quality assets, can hamper the management by banks of their liquidity. Also it can effectively shift the risk to bank depositors whose protection is the supervisor’s major role. The Committee will therefore hope to keep close to the progress of the work on payments netting too.

This whole issue of the supervisory response to netting arrangements was then delegated to the off-balance-sheet subgroup. By now, in June 1991 (BS/91/59), its chairman had changed from Stig Danielsson of the Swedish Bank Inspection Board to Richard Farrant of the Bank of England. His subgroup reported back in November 1991 (BS/91/50), with the paper taking the form of a draft consultative paper, though the paper ‘represents the majority view of the sub-group, but members … should be aware that minority views on some issues are very strongly held’, especially for the German members who took a generally much more restrictive stance. Be that as it may, the paper was: divided into three sections. The first one describes the legal framework under which particular forms of netting would be recognised. The second and third ones deal respectively with the treatment of bilateral netting and multilateral netting for the purpose of capital measurement. Annex 2 summarises the proposed treatment.

Annex 2 is reproduced as Appendix E. The paper was taken at the sixty-first BCBS meeting (4–5 December 1991) (BS/91/105), where: it was decided that given the differences of view on a number of key points the Committee should not seek to issue a consultative paper at this juncture. The sub-group was asked to undertake some informal consultations with banks in member countries and then revise the paper with the benefit of these discussions. The Chairman also asked Mr Farrant to consider whether it might be possible to differentiate the approach to netting according to the class of instrument.

Farrant’s subgroup therefore revised the paper into the guise of a paper setting out ‘issues’ rather than recommendations (BS/92/24), for further discussion at the sixty-second BCBS March meeting (5–6 March, BS/92/32). At this meeting the BCBS ‘agreed to allow the subgroup to proceed to informal consultation subject to the addition of a cover note explaining the status of the paper to reflect the concerns of the German members’. This was carried out in April, and the responses reviewed and summarised in August (BS/92/107). The judgement was made that

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‘On the whole, even if the paper was viewed to be too conservative or cautious in many respects, comments have not seriously undercut any part of the proposals’. Remembering that the German members had wanted to be even more ‘cautious’, the way was now open to draft, and then issue a proper consultative paper setting out proposals to amend the 1988 Accord to take account of netting. A draft was prepared in November 1992 (BS/92/95), and together with a paper on ‘Add-ons’ (BS/92/108), was taken at the sixty-fifth meeting of the BCBS (2–3 December), where: the group was asked to add specific language for amending the capital accord and provide the Committee with some statistical material to guide a decision on conversion factors for the original exposure method. The Committee also agreed not to recognise netting for supervisory purposes in the case of contracts containing walkaway clauses. The group was asked to submit a final consultative paper for the March meeting.

This extra work was soon done (BS/93/2 and 3) and a revised consultative paper on ‘The supervisory recognition of netting for capital adequacy purposes’ was drafted, agreed and made ready for circulation by April (BS/93/1). The Introduction and Overview are reproduced as Appendix F. The consultative period lasted until the end of December 1993, by which time the chair of the off-balance-sheet exposure group had once again moved on, from Richard Farrant to Mme Danièle Nouy of the French Commission Bancaire. A paper summarising the ‘Comments on the netting paper’ was circulated in March 1994 (BS/94/7), covering bilateral netting, especially the calculation of ‘addons’ for potential future exposure and multilateral netting. The ‘add-on’ issue was further addressed in a new paper (BS/94/8), and revisions to the prior proposals recommended. By July the Nouy subgroup, and the BCBS as a committee, were in a position to issue a public paper on ‘The capital adequacy treatment of the credit risk associated with certain off-balance-sheet items’ (BS/94/36), which essentially covered the above netting issues; also see ‘Report on International Developments in Banking Supervision’, Report 9 (BCBS, September 1994), Chapter 111, pp. 11–17. Given the wide range of viewpoints that were held at the outset of this exercise among BCBS members, reaching this conclusion must also be counted as a successful outcome, even though the process took nearly five years from the date of the publication of the Lamfalussy Report. That was the conclusion, more or less, of the work on the credit risk treatment of netting (the Nouy subgroup came up with some further

Derivatives

361

proposals on ‘add-ons’ in November 1994) (BS/94/65).4 But the specific work on this topic became absorbed into a more general concern with monitoring and responding to market developments in derivative markets. In February 1994, Chairman Tommaso Padoa-Schioppa called a meeting of all subgroup chairmen to discuss future work. The following programme was suggested: – prepare a paper which sets out for supervisors’ guidance the main elements of sound risk management of derivative activities; – make a coherent effort to learn more about modelling techniques; – develop a recommendation for standardised disclosure by international banks of their derivative activities, and at the same time consider whether to develop a common basis for the collection of data; – prepare a report to Governors informing them of the Committee’s past, present and planned future work in this area. C

Derivatives

By November 1994 the BCBS had prepared and published a paper outlining its own prior and current work on derivatives (BS/94/76),5 entitled ‘Prudential supervision of banks’ derivative activities’. Nearly all the Committee’s publications released within the past decade have taken account of banks’ engagement in derivatives activities. However, in part because it subscribes to the view that derivatives themselves incur no risks to which banks are not already exposed, the Committee has not until this year released any publications directed solely to derivatives risks. The Governors of the central banks of the Group of Ten countries now believe it would be useful if the Committee were to publish the present report, primarily destined for other supervisors, describing the manner in which its own past and ongoing work takes account of derivatives risks in their various forms.

There have been several generic concerns that have affected the BCBS’ work on maintaining micro-prudential supervisory oversight and control of banks’ activities in derivative markets. The first is the extraordinarily rapid and continuing pace of innovation, which means that regulators/supervisors in general, and the BCBS in particular, have always been struggling to catch up with current market developments. The second is that the derivative market is shared between the major 4 Also see ‘Report on International Developments in Banking Supervision’, Report 10 (BCBS, June 1996), pp. 60–5. 5 Also see ‘Report on International Developments in Banking Supervision’, Report 9 (BCBS, September 1994), Chapter IV, pp. 18–29.

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banks, where the BCBS is the major international supervisory body, and the investment houses, where IOSCO, the International Organisation of Securities Commissions, is the major international supervisory body. Given the interaction and competition between banks and investment houses, it makes little sense for the BCBS and IOSCO to design supervisory initiatives for the derivatives markets independently. From 1995 onwards, much of the work in this field has been done jointly by these two supervisory bodies. So we take up the remainder of the story of work in this field in Chapter 13, in which an account of the interrelationship between the BCBS and IOSCO is given.

Appendix A Commentary on off-balance-sheet exposures It is apparent that far-reaching changes are taking place in the way banks conduct their business. In the space of a very few years a range of techniques has been developed which have the effect of removing conventional business from the face of the balance sheet. In many cases, however, while the asset may not be directly visible the risk is barely, if at all, diminished. Moreover, the scale of banks’ involvement in some of these novel techniques is already very substantial. Market estimates put the amount of outstanding NIFs at around $40 billion and interest and currency swaps at around $100 billion. That these are only market estimates rather than reliable statistics highlights the lack of information in this general area. As the results of the survey show, these innovations raise questions for individual supervisory authorities about the adequacy of existing reporting systems and controls. Furthermore, some of the new techniques carry risks, which in view of their novelty and the lack of experience upon which to base considered judgement, are not readily measurable by banks’ management, auditors or supervisors. The different off-balance-sheet instruments and techniques identified in the survey tend to fall into two broad categories. Some items have the effect of removing conventional loans and other assets from the balance sheet and in some cases may have been designed to escape capital adequacy controls. Many of the items involving direct or indirect guarantees are of this type. Others have been developed primarily to protect against, or on occasion to exploit, changes in interest and exchange rates. Banks’ participation as principals in this second group of transactions may have the effect of hedging against existing interest and currency mismatches elsewhere in the business or alternatively, depending on the strategy pursued, of opening exposures to interest rate or currency risk. To the extent that banks’ involvement in these transactions serves to

Appendix A

363

reduce risk, it would seem inappropriate to include the transactions (at least on a gross basis) within capital adequacy measures. In a number of supervisory systems procedures have been developed for monitoring and seeking to limit banks’ exposures to interest rate and currency risk and, where necessary, they will need to be adapted to incorporate these new techniques. Most importantly, supervisors will need to discuss with those of their banks participating in these transactions the nature and purpose of the involvement in order to establish that the banks possess sufficient operational expertise to engage in these transactions and that appropriate internal controls are in place. Rather different considerations appear to lie behind the emergence (and in some cases the rapid growth) of the first group of instruments and techniques, those that substitute an off-balance-sheet contingent risk for a conventional balance-sheet asset. The most significant devices within this group are perhaps NIFs, standby letters of credit and asset sales with recourse. These developments appear to be the consequence partly of concerted supervisory pressures on banks to strengthen capital ratios and partly of competition from non-bank financial institutions. These pressures have encouraged disintermediation, leading banks to arrange certain types of business in ways which either fall outside prescribed systems of measuring capital adequacy, or which, as contingent liabilities, attract lower risk asset weights. Supervisory pressures probably only play a limited part among the influences driving the development and growth of new techniques. A more important factor is that many of the instruments fulfil clear market needs, for example, providing access to fixed rate funds to those second-line corporations unable to tap bond markets (interest swaps) or reducing the cost of floating rate borrowing (NIFs and interest swaps) or by hedging currency exposures (options). While the assets associated with guarantee arrangements are held by other parties or take the form of as yet undrawn commitments, there is a danger that managements and supervisors will overlook or underestimate the credit risks carried outside the balance sheet. As a result, fees and commissions and the capital supporting the transaction may inadequately reflect the possibility of loss. In the case of some of these devices, for example note issuance facilities, the asset would be most likely to move onto banks’ balance sheets at a time when the risk of loss was beginning to crystallise, presenting an unwelcome combination of increased funding commitments and deteriorating asset quality. The scale of banks’ involvement in underwriting NIFs has led supervisors to address particular attention to the way in which these arrangements are treated within national supervisory systems. In their most simple form the facilities provide a guarantee that a borrower’s repeated

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issues of short-term promissory notes will be placed with investors or will be underwritten and taken up by banks. The lending commitment may extend over as much as ten years and may be arranged to support an intended programme of borrowing in other credit markets. As yet, drawings under these facilities are relatively low; of the $40 billion outstanding, no more than about $8 billion is believed so far to have been drawn. Although the instrument has been developed primarily with non-bank investors in mind and many such issues are priced to yield less than LIBOR, about 80 per cent of the notes evidencing the debt are believed to be held by banks. This may reflect the present lack of high quality conventional lending opportunities. Banks are in competition with stockbrokers and investment banks for the business of arranging these issues and placing the notes with investment clients. The underwriting function, however, is more generally undertaken by banks because they have the balance sheet and capital to take unsold notes onto their own books. In acting as underwriters, banks undertake a commitment to take up any outstanding amounts of the repeated short-term notes issued under the facility which cannot be placed in the market at below a prearranged interest margin. These commitments would be likely to be called on if the borrowers’ credit standing deteriorated, and perhaps in circumstances of general disturbance in the markets leading banks and investors to attempt to liquidate their holdings of short-term notes. Fees charged by underwriting banks are reported to have been as low as 1/16 per cent per annum. There appear to be many variations in the terms and conditions under which these facilities are arranged and it is not clear to what extent the underwriting commitment may be irrevocable in all cases. Some facilities contain clauses which at face value might relieve an underwriter of its obligation in the event of ‘material adverse change’ in the circumstances of the borrower; others would allow an underwriter to transfer the commitment to another party, if one could be found. These latter appear to have been introduced in anticipation of possible changes in supervisory practice. Such ‘escape’ clauses are untested and there is some doubt whether they could be invoked in practice.

Appendix C

365

Appendix B

BS/85/51

Committee on Banking Regulations and Supervisory Practices Off-balance-sheet business of international banks 1. The Basle Supervisors’ Committee at their June meeting discussed the development of off-balance-sheet business by international banks. The rapid growth in the volume of such transactions and the proliferation of new instruments and techniques was noted. Such activities can involve risks that are difficult to assess and to quantify because of their complexity and because there is little historic experience upon which to base a judgement. 2. The Committee believes that all supervisors should stress to their banks the importance of keeping a careful watch on the development of off-balance-sheet business and on the risks to which such activities expose them. It is important that the managements of banks undertaking such business should be sure that they possess the necessary skills and understanding to manage the often complex operations involved and to establish the appropriate internal reporting and control arrangements. Clear records should be kept not only for internal purposes but also to ensure that the necessary data on the various types of off-balance-sheet business can be accurately conveyed to the authorities. 3. The Committee is actively pursuing work on this subject (alongside and in co-operation with the Euro-currency Standing Committee)6 and supervisors in all member countries will be closely monitoring the development of this business in their own banking systems. The Committee believes that some co-ordination of supervisory responses to these developments would be useful; that supervisors should take steps to ensure that their banks are able to identify and assess the risks involved; and that such risks are appropriately reflected within national systems of capital adequacy measurement. 8 July 1985

Appendix C The fact that the existing supervisory regime does not cover many offbalance-sheet activities gives G-10 countries an opportunity to develop [Footnote in original text] To be excluded if the note is to be circulated to supervisors outside the G10. 6

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a supervisory response to this business in a more coordinated way than is possible with long-standing activities firmly enshrined in national practice. In view of the international character of much of this new business, the Committee feels it is highly desirable for national treatment to be seen to be broadly coordinated so as to limit the complaints of competitive disadvantage which can arise when individual supervisory authorities introduce measures in isolation. The Committee sees three stages in the development of supervisory approaches to off-balance-sheet risk.

• The first, and at present the most important, is for supervisory

authorities to keep abreast of the nature of the different activities and to ensure that banks’ managements themselves also understand this business and have adequate internal reporting and control systems. To this end, the glossary of terms which was circulated to Governors earlier this month sets out to define each of the instruments and techniques identified. It is already being used in bilateral discussions which some members are conducting with their banks. A key part of this process of understanding is to assess the type and relative degree of risk involved in the different activities. • The second stage is to review and extend prudential reporting systems to ensure that new and all major off-balance-sheet activities are adequately captured in the returns. This work will need to be handled in conjunction with requirements for data which authorities may wish to introduce for monetary and statistical purposes. • As a third stage, supervisory policies for the measurement and control of risk in individual banks will need to be revised to take account of these developments in off-balance-sheet business. These are all matters which national authorities will need to consider. Some authorities have already taken steps in respect of particular offbalance-sheet activities. Depending on their institutional circumstances, some countries may find it easier to implement new procedures more quickly than others. For example, there may be difficulties for countries which have not hitherto included any off-balance-sheet business in capital adequacy ratios or where a risk asset ratio approach to capital measurement, into which such new activities can most easily be integrated, is not currently applied. Difficulties may also arise in those countries where existing ratios are prescribed in a banking law which cannot easily or speedily be revised. The purpose of this report is not to lay down a precise prescription for national supervisory systems, still less to set a date for

Appendix C

367

implementation€– though the urgency of taking early action should be stressed. Instead, as with many of its initiatives, the Committee has set out to reach agreement on a broad framework of principles for tackling the problem, which its members can then build on in the context of their national supervisory systems. In this spirit, it may be possible for those countries which are unable to apply particular weighting at an early stage to take account of off-balance-sheet activities in judging the capital adequacy of their banks. Recognising that new instruments are appearing and will continue to evolve, the report also suggests broad guidelines for assessing the degree of capital weighting which is appropriate for certain types of instrument and categories of risk. In particular, any approach adopted should seek to minimise the scope for banks to devise new variants of the techniques discussed in the report with the object of frustrating supervisory arrangements. Committee members believe there would be value in giving an early signal to this effect. A major conclusion of the report is that the types of risk associated with off-balance-sheet business are, in principle, no different from business conducted on the balance sheet€– the one exception to this is that of option contracts to which the report pays special attention, in view of the potential scale of the risks involved and the difficulties of devising effective control systems. The report recommends that most off-balance-sheet activities should bear a weighting for capital adequacy purposes, with varied weightings according to the degree of perceived risk. In putting forward its preliminary conclusions on the appropriate capital weighting of different off-balance-sheet risks, the Committee is well aware that the volume of such business undertaken by banks in some member countries is very substantial and that full incorporation into capital measurement systems at the suggested weights could lead to a significant reduction in existing capital ratios. Most supervisory authorities currently do not have the necessary data to make a confident assessment of the impact of the Committee’s proposals in respect of their capital adequacy arrangements and it will be important in the further work envisaged to carry out tests of the likely impact on capital ratios of a more comprehensive method of measurement. These considerations, however, should not, in the Committee’s view, stand in the way of the further development of its proposals, since many banks are carrying risks which are clearly not reflected in the capital ratios as presently calculated. Implementation of changes in national supervisory arrangements will need to take account of the

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possible adverse effect on particular banks and transitional arrangements may need to be considered. While this is a matter for national supervisory judgement, it would seem to the Committee that the outcome should be one which does not lead to any significant deterioration in banks’ capital strength. Real capital adequacy, as opposed to measured capital adequacy, may, of course, already have declined to the extent that new ways of doing business are not being recorded in present measures. A concern of the banks is the extent to which they might lose business to other financial institutions if they have to set aside capital for certain off-balance-sheet activities. It is noticeable, for example, that in recent months there appears to have been a swing away from note issuance facilities underwritten by banks towards Euro-market issues resembling US commercial paper. These may be arranged by securities houses and placed directly with investors. They require no underwriting or standby commitments from banks. This trend is said to reflect in part expectations among banks of supervisory measures directed towards their note issuance obligations. Movement of business out of the banking sector will of course depend on the extent to which pricing of such services is affected by supervisory measures. The Committee believes that the present pricing by banks of some of their services may inadequately reflect the risks they are running and that they should not be engaging in certain activities on such terms, even if other financial institutions are willing to assume the risks at unrealistic rates of remuneration. The Cross Group is examining aspects of competition between banks and non-banks in this field.

Appendix D

369

Appendix D Supervisory treatment of credit risk (Synopsis of recommendations) Items

Capital weighting

Contigent liabilities Guarantees

Full

Acceptances

Full

Transactions with recourse Standby letters of credit with the character of guarantees

Full Full

Standby letters of credit with the character of warranties, indemnities and performance bonds

Medium

Documentary credits

Medium

Warranties, indemnities and performance bonds Endorsements

Medium Low

Commitments Asset sale and repurchase agreements Forward purchases Forward forward deposits (placing bank) Partly-paid shares and securities Partly-paid floating rate notes Unconditional standby facilities Standby bank lines NIFs and RUFs Revocable credit lines Overdrafts

Full Full Full Full Medium or low Medium Low Medium None None

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Appendix E Annex 2 Summary for calculations of the credit equivalent amounts under valid netting agreements BILATERAL NETTING (a)

Under the current exposure method Net replacement costs

PLUS

Add-ons for potential future exposure contained in the 1988 Accord

(b) Under the original exposure method Notional principal amounts

X

Conversion factors in the 1988 Accord Multiplied by [0.8]

MULTILATERAL NETTING 100% of exposure arising from default of any one other counterparty with clearing house PLUS 50% of the additional maximum exposure to loss resulting from the simultaneous default of other counterparties with the clearing house

Appendix F Proposal for a change in the supervisory recognition of netting under the 1988 Capital Accord I

Introduction and overview

One of the most significant advances of the 1988 Capital Accord was its comprehensive coverage of the credit risks arising from offÂ�balance-sheet items, including foreign exchange and interest rate related transactions. Careful consideration was given to the possibility of recognising various forms of netting, i.e., for risk weighting the net rather than the gross claims arising out of swaps and similar contracts with the same counterparties. However, only one particular and rather restrictive form€– bilateral netting by novation for the same currency and same value date€– was found to be sufficiently robust to be given supervisory recognition.

Appendix F

371

In November 1990 the BIS published the Lamfalussy Report on interbank netting schemes. It recognised that netting arrangements for both interbank payment orders and forward-value contractual commitments such as foreign exchange contracts have the potential to improve both the efficiency and the stability of interbank settlements, by not only reducing costs but also credit and liquidity risks, provided that certain conditions are met. It concluded that some form of bilateral netting was likely to be legally effective in each G-10 country. The report also concluded that multilateral netting of forward foreign exchange contracts was likely to be legally enforceable in those countries.7 The Basle Committee on Banking Supervision agrees with the analysis in the Lamfalussy Report. In this consultative report it proposes that the 1988 Capital Accord should be revised to recognise, in addition to netting by novation, other forms of bilateral netting of credit exposures to the extent that such arrangements are effective under relevant laws. Specific language to amend the Accord is proposed in Annex 1. The revisions would recognise bilateral netting where the appropriate national supervisors are satisfied that agreed minimum legal requirements are met. For banks using the current exposure method, the credit exposure on bilaterally netted forward transactions would be calculated as the sum of the net marked-to-market replacement cost, if positive, plus an add-on based on the notional underlying principal. For banks now using the original exposure method, a reduction in the credit conversion factors applied to bilaterally netted transactions would be permitted on a temporary basis until the market risk-related capital requirements are implemented. At that time the original exposure method will cease to be available for netted transactions. The Committee also has considered what might guide its future assessment of credit risk in multilateral netting arrangements. It is premature to make proposals for the treatment of multilateral netting schemes, which must await a further analysis when the operational workings particular to the various schemes under development become clearer. However, a discussion of the issues which might provide a basis for a possible approach at some future date appears in Annex 2. 7 [Footnote in original text] With the exception only of those contracts entered into on the date of a participant’s closure in those countries with a ‘zero-hour’ bankruptcy rule.

11

Other topics addressed by the BCBS

A

Criteria for selection

Especially in the early years of the BCBS, members were free to submit papers on any relevant topic that they felt might be germane to the BCBS’ discussions. Numerous papers were submitted and topics raised which were considered briefly, or not at all. So how can one classify the set of topics which did engage the attention of the BCBS, and separate these from those that did not? The main procedure here for making such a separation is to rely on the published reports of the BCBS on International Developments in Banking Supervision. These record what the BCBS saw as the main highlights of its own work since the previous report. There was a trial run in producing such a report, which was undertaken in 1981 (BS/81/42) and which covered the work of the BCBS in 1980; this was for internal (BCBS) consumption only; it was neither shown to the Governors, nor published. I have, however, used this as a reliable guide, in exactly the same way as later published reports. When one says ‘published’, that was during this period (up until the end of 1997) only to a limited circle of other supervisors, such commercial banks as such supervisors chose to pass the paper onto, and to a small, selected set of professional and interested commentators and journalists. These reports have, however, subsequently been made fully available. Reports 1 to 5, published in 1982–6 relating to the individual years 1980–85, were annual. As already noted in Chapter 6, 1987 was a year of great pressure for the BCBS. The opportunity was taken then to defer publishing a report until 1988 (Report 6) covering the two years 1986/87. Thereafter, at least until after the time period covered here, all the reports came out at two-year intervals, covering the activities of the BCBS during the previous two-year period. So the final report relevant to this exercise is Report 11, issued in 1998 covering BCBS activities in 1996/97. For the earlier years 1975–9 I have relied on my own assessment of what other matters attracted the interest of the BCBS, and which have 372

Bank secrecy as an impediment to supervision

373

not already been satisfactorily handled in preceding chapters. This has resulted in the following list of subjects, with the years in which they were assessed to be of particular relevance in brackets. Other topics: 1. Bank secrecy (1978, 79, 80, 81) 2. Other early concerns (a)╇ Deposit protection schemes (1977, 78, 79) (b)╇ Lender of last resort techniques (1975) 3. Bank profitability (1977, 78, 79, 82, 84) 4. Prevention of criminal use of the banking system (1986/87, 1988/89) 5. Large credit exposures (1988/89, 1990/91) 6. Risks in computer usage and in telecommunication (1988/89) 7. Supervision of conglomerates (1988/89, 90/91, 92/93, 94/95) 8. Bank insolvency regimes (1980/81/82, 92/93) I shall not deal at all with topic 6, since this comes rather in the province of other BIS committees, for example the Committee on Payments and Settlement Systems (CPSS), nor in this chapter with topic 7, the supervision of conglomerates, since this subject falls more easily into the subject matter of Chapter 13 on relationships with other non-bank regulatory bodies. Moreover, several of the other subjects caught the interest of the BCBS only in a passing fashion, being addressed to their satisfaction and then left on the shelf (e.g. topics 2(a) and (b), 4, 5 and 8) and will be treated quite briefly here. But we start with an issue that was of major and continuous concern to the BCBS, to wit bank secrecy. B

Bank secrecy as an impediment to supervision

The leitmotiv of the BCBS has been to engender cooperation and coordination between bank supervisors so that all parts of an international bank would be effectively supervised, and that it could become possible for the home/parent supervisor to oversee the whole bank in a consolidated fashion. The necessity of these developments was the central theme of the Concordat (see Chapter 4), which formed the main focus of work in the early years of the BCBS. But how could this be achieved if several key countries, notably Luxembourg and Switzerland, were subject to strict bank secrecy laws, apparently preventing the local supervisor from communicating with other supervisors? This concern was the subject of much early heart-searching in the Committee. Thus in the report to the Governors on the supervision of banks’ foreign establishments (BS/75/44), an early version of the Concordat, it was noted on p. 4 that:

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Other topics addressed by the BCBS

The Committee is aware that such transfers of information are often impossible because of bank secrecy laws in host countries; but many of its members consider that the operation of these laws should over time be modified so as to permit them … The Committee wishes to emphasize that the sole purpose of such transfers would be to facilitate prudential control of banks and that in no circumstances would they be directed to the affairs of individual customers.1

Similarly in the case of direct or indirect inspection by home supervisors, and by parent banks of their domestic banks’ foreign establishments, it was proposed that ‘Whenever possible steps should be taken to facilitate such arrangements, if necessary by amendment of legislation’. The issue of bank secrecy laws, and their potential impact on supervisory cooperation and coordination, was sufficiently cogent that, in the course of the thirteenth meeting of the BCBS (29–30 June 1978) (even though the subject had not been on the agenda, BS/78/14), the topic was raised under the heading of ‘Future Work’:€it was agreed that a paper on ‘Bank secrecy’ should be provided by each delegation ‘on their own country’s rules in this area. In addition Mr Bonnardin will consider the possibility of contributing an analysis of this question from the point of view of the supervisors’ (BS/78/20). Sweden (78/22), UK (78/23), Canada (78/24), Belgium (78/25), Switzerland (78/26), Japan (78/34), Italy (78/37), France (79/1) and the Netherlands (79/3) did so. There is no record of any such submission from Germany, Luxembourg or the USA. M Bonnardin of the French delegation also put in a general note on bank secrecy (78/27), which was complemented by a summary of the country notes by the Secretariat (79/9). The bulk of the country submissions consisted of somewhat dry restatements of the legal position, though the Swiss felt it necessary to conclude with an assertion that their own position was not that unusual.2 The more general papers by Bonnardin and the Secretariat are more interesting. They differ somewhat in tone. Bonnardin suggests that the obligations of professional secrecy on supervisors constitutes ‘a very grave obstacle to organised co-operation among the This latter declaration, however, became moot when the individual customer was itself a bank, as in the case of confirmation of interbank deposit placements, which turned out to be an important supervisory gap in the Israel-British Bank failure in 1975 (BS/75/47 and 56). 2 ‘We would point out in this connection that banking secrecy is not an institution peculiar to Switzerland. In western Europe in particular, a banker generally may not, at least under civil law, divulge information on a customer’s financial circumstances and relations without his consent, except under compulsion of law. The maintenance of secrecy is in effect a facet of integrity, and is one of the professional obligations of the banker, not only in Switzerland but also elsewhere. A number of countries have, moreover, taken legal measures regarding the preservation of secrecy. 1

Bank secrecy as an impediment to supervision

375

various supervisory authorities’, whereas the Secretariat (p. 4) claims that there was then a trend to allowing, even encouraging, cross-border exchanges of information between banking supervisors. Following limited discussion of this issue at the fifteenth meeting of the BCBS, those two papers were complemented by a further paper by the Secretariat on ‘Suggested points for discussion’ (BS/79/34). The key paragraphs from all three papers are reproduced in Appendix A to this chapter. That this was not regarded as a first-order problem is, perhaps, indicated by the fact that, though on the agenda, the subject was not fully discussed at the June and November (1979) meetings of the BCBS. It was not until the eighteenth meeting (28–29 February 1980) (BS/80/21) that: Following a tour-de-table on this subject, it was agreed that the Secretariat should draft a short report for the Governors drawing their attention to the fact that certain problems existed in this field, mostly in legal and political areas outside their influence, but which created impediments to the implementation of certain principles such as consolidation to which the Committee subscribed. That paper would not preclude the preparation of a later paper for possible discussion with offshore centre supervisors or for wider distribution to supervisory authorities.

This latter action was taken quite quickly. The Secretariat drafted a report for the Governors on ‘Banking secrecy provisions as a constraint on the co-ordination of international banking supervision’ in August 1980 (BS/80/29). Its main conclusions were: In order to make more effective the implementation both of the Concordat and of the consolidation principle, the Committee seeks the support of the Governors in encouraging member countries to remove obstacles deriving from banking secrecy laws, so that in all member countries the authorities are able to co-operate fully in the supervision of international banking activity. Every encouragement should also be given to authorities in countries which are not members of the Committee to pursue similar objectives. The aim would be to make possible for supervisory purposes: – the transmission to parent banks of all necessary information about the activities of their banks’ foreign branches and affiliates

We believe that we have amply demonstrated that banking secrecy is not absolute. We especially wish to stress that the numbered account gives no greater guarantee of secrecy vis-à-vis the authorities. The system of numbered accounts is no more than a technical device used by the banks to prevent any breach of banking secrecy, to the extent that only a few selected individuals (usually members of a bank’s management or of a special department) know the name of the account-holder. It therefore seems that there is no imperative reason to challenge the principle or basic terms of banking secrecy, for neither in Switzerland nor elsewhere does it stand in the way of proving that unlawful acts have been committed’ (BS/78/26, pp. 5–6).

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Other topics addressed by the BCBS

– the transmission of all necessary information from parent banks to parent supervisory authorities about parent banks’ foreign branches and affiliates – the transmission of all necessary information from host to parent supervisory authorities about the activities of foreign banks established in the host country – the verification by parent supervisory authorities of data relating to their banks’ foreign establishments through on-the-spot inspections either by the host authority, by external auditors appointed for the purpose or by the parent supervisory authority itself.

Following discussion of this report with the Governors3 it was agreed to circulate this report more widely to non-G10 and other bank supervisors under cover of a letter from Chairman Peter Cooke (BS/80/57) dated 30 December 1980, the main paragraphs of which read as follows: The subject of banking secrecy raises problems from time to time for all supervisors. It is of particular concern to the Committee since banking secrecy provisions can act as an impediment to the effective implementation of the international understandings between its members on supervisory responsibilities and on the principle of consolidation. The enclosed report concentrates particularly on the question of access by parent supervisors to information concerning the overseas activities of banks under their jurisdiction. It identifies three information channels through which free flows of information are regarded as desirable and it also considers the ways in which verification of data flows should be assured. In its conclusions, the report recommends that member countries should seek to remove obstacles to co-operation in the supervision of international banking activities deriving from banking secrecy laws and should encourage authorities in countries which are not members of the Committee to do the same. In circulating this report to you, I well realise that banking secrecy provisions in your own laws may give rise to problems in passing information through one or other of the channels mentioned in the Committee’s report. I hope, nevertheless, that you will share with the Committee the view that it is desirable for supervisory authorities to be able to cooperate fully so that international banking activities may be monitored with maximum effectiveness and that you will feel able to contribute to efforts to bring about a situation in which supervisory authorities worldwide are not precluded by law from exchanging information on a confidential and reciprocal basis. I shall, in any event, be very interested to receive any comments you or your staff may have on this report.

This generated numerous replies from supervisors elsewhere, ranging from Barbados to Tanzania (BS/81/13). A revised, shortened version (BS/81/16) was also prepared for the second International Conference of Banking Supervisors in September 1981, and subsequently went This topic was also a key point of discussion at the first meeting with the offshore centres in Basel (29–31 October 1980) (BS/80/31 and BS/80/38); see also Chapter 12. 3

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to supervisors worldwide (‘Report on International Developments in Banking Supervision in 1981’, BCBS, July 1982), asking for their support on the main points, which were: – it is desirable that parent banks be permitted to have access to all necessary information about the operations of their foreign branches and subsidiaries; – the law in the parent country should fully protect the confidentiality of such information as is passed to the parent authority and should limit its use to supervisory purposes; – host and parent authorities should ensure that, subject to reciprocity4 and appropriate confidentiality, exchanges of information should not be hampered by banking secrecy regulations; – information which parent authorities receive about their banks’ foreign establishments should be open to verification in some way.

Following a meeting of the Governors in November 1982, the Chairman was asked to provide follow-up notes on the state of play on the Concordat and provisioning policies (BS/82/72). The action programme was then extended to include a follow-up to the wider circulation of the note on banking secrecy to discover what obstacles, if any, member G10 countries were still encountering in respect of cross-border supervisory information flows (telex by Mr Dealtry, BCBS Secretary (BS/82/77). Replies were received and circulated early in the next year (BS/83/2). These replies suggested that ‘secrecy positions now present few practical difficulties for effective parental supervision’, as concluded in the progress report sent back to the Governors (BS/83/6). This broadly satisfactory position was summed up by Chairman Peter Cooke in a paper submitted for publication in the Swiss Institute for International Economics, Regional Science and Market Research. The relevant paragraphs are reproduced in Appendix B. Although banking secrecy was not then perceived as a major problem, there were still a number of sticking points and areas of difficulty. First, there was some concern among certain host countries (notably Singapore and Switzerland) about revealing information about large funders of branches/subsidiaries in their own countries; this was known as the problem of revealing ‘clustered’ or ‘concentrated’ deposits. Second, there were some worries that there may be demands that any information revealed to US supervisors also be made available to Congress and hence become public (though in practice this did not arise, since both sides realised that such demands would cut off all future information flows). Later on, the emphasis on reciprocity was toned down. 4

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The first problem was largely settled in the course of preparing and then agreeing the March 1996 paper on ‘The supervision of cross-border banking’ (BS/96/9) (see Chapter 4, Section C). In this four conditions for allowing home countries access to conduct on-site inspection in host country branches and subsidiaries were established. These were that: 1. the inspections should be for prudential reasons only; 2. all individual client names should remain protected; 3. there should be (partial) reciprocity between cross-border supervisors; and 4. the information should never be passed on beyond the home supervisor. C

Other early concerns



Deposit insurance

Given the importance attached in several of the G10 countries to deposit insurance as a means of maintaining confidence in banking systems, and thereby deterring systemic and contagious runs, what is perhaps remarkable is how little attention the BCBS paid to this instrument. The Committee may have felt that such insurance was inherently a matter for national choice and determination and hence outside the remit of a body charged with dealing with international and cross-border supervisory issues. Moreover, there were significant legal and institutional differences in approach between countries. Furthermore the BCBS felt that crisis prevention should be its main focus, since crisis management would inevitably require the involvement of additional (political) institutions. Nonetheless the Committee took steps to acquaint itself with deposit insurance arrangements in member countries. In 1975 both the German and the Japanese delegations submitted notes on deposit insurance arrangements in their own countries (BS/75/32 for Germany and BS/75/50 for Japan). Subsequently similar notes were tabled by the UK (BS/78/9) and the USA (BS/77/33). There was sufficient general interest in the topic for the Secretariat to prepare a general note on ‘Deposit protection schemes:€issues for discussion’ (BS/77/19) dealing with such questions as objectives, coverage, mode of operation, administration and financing. This was intended as background for a discussion of deposit protection schemes at the tenth (30 June–1 July 1977) meeting of the BCBS, at which there was also to be a ‘Presentation of their philosophies in this area by the United States, as well as by those countries which are now considering introducing deposit protection schemes’.

Other early concerns

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In the event, however, the tour de table on member state deposit insurance schemes dragged on beyond the June/July meeting and beyond the October meeting, to the twelfth meeting of the Committee in March 1978. This dilatory progress suggests that it was not perceived by the BCBS as a key issue. In the short summary of the discussion there (BS/78/10), it was stated that: Following the completion of the tour de table on this subject, originally started at the Committee’s ninth meeting,5 it was decided to ask the Secretariat to prepare a synoptic paper on the various deposit schemes in existence in, or being envisaged by, member countries. The paper should bring out the similarities and differences between countries’ schemes. The Chairman asked members of the Committee to provide the Secretariat with brief notes outlining their own present or prospective arrangements for deposit protection. In preparing these notes members of the Committee should follow the lines of the paper on this subject prepared by the Secretariat (BS/77/19). Thus members whose countries did not already have deposit protection schemes and were not considering introducing them should send the Secretariat a short note explaining the reasons for their attitude.

Such a purely factual paper was then duly prepared (BS/78/15). This was again put on the agenda for the thirteenth meeting of the BCBS on 28–29 June. Once again the subject was held over, and discussion not completed until the fourteenth (26–27 October) meeting, when it was finally agreed that ‘after suitable amendment the paper (BS/78/15) would be circulated to other supervisory authorities as a document of general interest’. And that was how it was left, apart from one request, from the then Secretary, C. J. Thompson, for an update in November 1985.6

Crisis management and lender of last resort techniques

Banks do occasionally fail. There had been several decades, from the late 1930s to the late 1960s during which there had been few bank failures, as noted in Bordo et al. (2001). Following the emergence of the Euromarkets and the increasing liberalisation of banking, bank failures This was a rare error on the Secretariat’s part. The subject was put on the agenda first at the tenth meeting. 6 ‘Reflecting growing interest in deposit protection among supervisory authorities and central banks outside the G-10, the Secretariat is often asked to supply details of the schemes operating in member countries. We have hitherto met these requests by sending copies of the attached survey prepared in 1978. However, in some aspects the information contained in it is out of date and may be misleading. 5

I should therefore be grateful if members would kindly review those passages which refer to arrangements in their own countries so that a revised version may be prepared. It would be helpful if suggestions for amendment could be sent to the Secretariat by the end of January 1986.’

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in the early 1970s were, however, beginning to become more common. The BCBS was itself in part established in consequence of the failure of Bankhaus Herstatt in 1974. The early years of the BCBS were spattered by reports and commentaries on bank failures, for example Franklin National and United States National Bank (BS/75/14, 15, 16, 17, 22), Israel-British Bank (BS/75/47, 56), the Chiasso affair in Switzerland (BS/77/40, 43, 48, 54, 56, 78/1), losses in Sweden at Gotabanken (BS/78/12), and so on. One might think that in this context the BCBS would have focussed on measures to handle and resolve a cross-border crisis caused by the failure of an international bank. After all, it could have happened at any time, and could have led, without prior planning, to a financial catastrophe. But in the event national procedures of crisis management were too different and idiosyncratic, and the subject matter too delicate to be taken by the Committee.7 Indeed the subject is still regarded as too hot for public consumption, and the key paper, the note by the Secretariat on ‘Techniques of support and rescue operations:€note on the Committee’s first round of discussions’ (BS/75/41), was removed from the files that I was allowed to see. The first paper to be put before the BCBS on this subject was a country paper from Belgium on ‘Techniques of support and rescue operÂ� ations’, which indicated that the key institution there was the Rediscount and Guarantee Institute. This was soon followed by a paper from the German delegation (BS/75/42) on the role of the Liko Bank. In the context of some general interest in the topic, the Secretariat then produced its (missing) paper on techniques among member countries more widely. This subject was discussed at the third meeting in June 1975 (BS/75/40) wherein some members expressed a wish that the extension of mutual assistance by central banks could be codified to some extent. This was thought by others to be a step too far. It was left that Messrs Willey and André would write a paper on this. There is no trace of any such paper from André (from Belgium), but Mr D. Willey of the FRBNY produced a short, and very general, paper on the topic (BS/75/48), reproduced as Appendix C. The paper had three general parts:€ first, a section on exchanges of information between countries, second, on problems when a bank getting into difficulties had affiliates abroad, and third, on cases in which problems about the availability of foreign exchange arose. This paper was discussed at the fourth meeting of the BCBS (September 1975). Several of the comments were of the nature that ‘although useful as a general 7 Apart from the joint work with the International Chamber of Commerce on ‘The supervision of foreign exchange contracts’ mentioned earlier in Chapter 5, Section B.

Bank profitability

381

conceptual framework, [it] did not make sufficient allowance for the legal constraints existing in individual countries.’ Nonetheless Chairman George Blunden asked Willey to revise the paper in the light of comments received, and, after further discussion at the fifth (December 1975) and sixth (March 1976) meetings, and redrafting by the Secretariat, the paper was sent forward for submission to the Governors ‘and circulation to those other supervisory authorities to which the earlier reports on supervision had been sent’. In truth, the paper was anodyne and the Governors were presumably not stimulated to ask for more work on this topic. So there was no follow-up on the subject of cross-border crisis management during the remaining years up until the end of 1997. There was, however, one more initiative in this general field. Huib Muller of the Nederlandsche Bank proposed circulating to all members a questionnaire on ‘last-resort’ lending. The questionnaire itself (BS/75/68) was short (two pages) and straightforward. But when it came to be discussed by the Committee at its sixth meeting (25–26 March, 1976) (BS/76/27), it raised a hornet’s nest of opposition. It was all too confidential to be set down on paper. One had to treat the matter in a case by case manner, and ex ante generalities could be misleading, and so on. Summing up, Chairman George Blunden: noted many countries’ difficulties in committing themselves in advance to decisions on last-resort lending. Those countries would therefore not be in a position to answer some of the questions put to them. He thanked Mr Muller for bringing the matter up, but concluded that they could not go ahead with the questionnaire. If those who had asked for a ‘think-piece’ would like to define more precisely what sort of thing they had in mind, the Committee could consider whether it should commission such a paper.

That was effectively the end of discussion on lender of last resort and cross-border crisis management. From an academic, historical viewpoint it looks odd that the BCBS should have eschewed further discussion, prior to the end of 1997, on what seems a central issue.8 But such a cross-border contagious crisis never occurred (BCCI being sui generis),9 and the issue was undoubtedly ‘delicate’. D

Bank profitability

Discussion of measures of bank profitability, and how such profitability affected bank solvency (and hence was of interest and concern to 8 It can be argued that some elements of ‘prompt corrective action’ are present in the Core Principles (see Chapter 8). 9 The Patrikis Report (see further Section G below) that ensued was more about crossborder insolvency issues than about crisis management techniques.

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Other topics addressed by the BCBS

bank supervisors), began with the submission to the BCBS of a note by Rodney Galpin of the Bank of England on ‘The usefulness of examining profit and loss accounts in banking supervision’ late in 1976 (BS/76/61). This initiative then elicited similar notes on the format, and usefulness (to the national supervisor) of Profit and Loss Accounts (P&L) in France (BS/77/10), Sweden (BS/77/20), Germany (BS/77/22), Switzerland (BS/77/23), Canada (BS/77/24), Japan (BS/77/26), USA (BS/77/28), UK-revised (BS/77/29), Belgium (BS/77/30) and Italy (BS/77/31). These were then collated and summarised in a synoptic paper by the Secretariat (BS/77/44), the main part of which is reproduced as Appendix D. Mr Coljé of the Nederlandsche Bank also provided a note (BS/77/53), not on methodology, but showing comparative figures for profits, and profit ratios, among the largest three banks in each of the G10 countries. This subject was then put on the agenda for discussion at subsequent BCBS meetings, but at low levels and was regularly passed over and deferred to the next meeting. With deeds speaking louder than words, it was apparent that this was not a field in which members felt that the BCBS could, or should, play a useful role. Eventually the subject did come forward for discussion at the fourteenth meeting of the BCBS on 26–27 October 1978. Here it was agreed that: the subject of profitability in general could not usefully be taken forward at the present stage. Nevertheless, profitability had specific implications for capital adequacy, an issue of direct interest to supervisors. The Chairman invited Mr€Coleby to prepare a paper for the Committee on the contribution of profits to the maintenance of capital adequacy.

The resulting paper, by Tony Coleby of the Bank of England, was even more dismissive of the use of P&L data for comparative assessment (BS/79/22). For example, he wrote: simple rate of return calculations based on aggregate profits are of only limited value … The high and variable rate of inflation in the United Kingdom in recent years has brought increasing questioning of the validity of the measurement of profits that results from applying the conventional approach of historical cost accounting.

With such a negative assessment, the subject was not brought forward into the agenda for discussion. Nevertheless, it did not go away. The subject was raised again10 at the twenty-fifth meeting of the BCBS (24–25 June) (BS/82/39), when following: 10 In the interim between 1979 and 1982 there was one other paper submitted to the BCBS, by the Central Bank of Ireland (BS/80/37), which presented formulae on the

Bank profitability

383

the course of the customary tour de table, the Chairman proposed that, since several members had expressed concern about the prospects for the profitability of their banks, the Secretariat should send out a questionnaire which sought information on the different factors which affected banks’ prospective profitability in member countries.

This was done (BS/82/43), and the results presented at the end of 1982 in a paper by the Secretariat (BS/82/85). This reported that: An aspect of particular importance emphasised in many responses is that while gross profits may in most cases have kept pace with inflation, retained profits have been more than offset by the erosion of own funds through inflation. This … is partly attributable to the need for increased provisions.11

Also see ‘Report on International Developments in Banking Supervision’ (BCBS, March 1983, p. 4). With the Secretariat’s paper to hand, the subject was put on the agenda for the BCBS’ twenty-seventh meeting (23–25 February 1983). Following a brief discussion … the Chairman suggested that it [the survey] should be repeated next year [1984] … It would in particular be useful to see how accurate the forecasts of future trends in profitability in individual countries would turn out to be (BS/83/22).

A further questionnaire was distributed in May 1984, (BS/84/35); the raw results were recorded (BS/84/42), and covered by two notes by the Secretariat (BS/84/46), a hurried note in advance of the June BCBS meeting and, after the subject was deferred from that meeting, a longer note (BS/84/57) in October. The earlier note remarked on the general upwards trend in bank profitability, from a low point in 1982, while the subsequent longer note stressed ‘the limited comparability of statistics on banking profits drawn from different countries’. This was discussed, briefly, at the thirty-second meeting of the BCBS (5–6 November) (BS/84/70), and: a number of questions concerning the comparability of the data supplied were raised. It was agreed that this was an important exercise and that the Secretariat, following bilateral discussion with members, should draw up a more precise set of definitions for the components of profits with a view to proposing a framework upon which future exercises might be based.12 The rate of profitability required to maintain a given capital adequacy ratio under various assumptions about inflation, real growth, etc. 11 The need for greater bank provisions at this time has already been discussed in Chapter 6. 12 The hope that it might be possible ‘to agree on a broad definitional framework within which data for banks’ 1984 accounts might be presented’ was also repeated in the ‘Report on International Developments in Banking Supervision’ 1984 (BCBS, April 1985, p. 14).

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Other topics addressed by the BCBS

Committee would consider this at its February meeting. The Chairman hoped that the Committee might then be in a position to repeat the 1983 exercise on the basis of end-1984 figures, and to report briefly to the Governors on the results.

The hope that it might be possible to set up an agreed common framework for recording and comparing profitability was soon dashed. In February 1985 the Secretariat, as requested, put forward a note (BS/85/16) recording how some member countries (notably Belgium, Canada, Germany and the UK) reacted to an attempt to provide a common framework. The response was not encouraging. The Secretariat reported (BS/85/16): In several cases data fully consistent with the framework are not available, particularly on the split between domestic and international profits. The Belgian response indicates that they would be obliged to ask the banks for some additional information … In some cases, however, the problem of comparability may be more fundamental, for example as reflected in the German comments on valuation rules. The Committee may wish to consider the following questions: 1. Would those members whose banks maintain undisclosed reserves be willing to submit data on profits before transfers to or from such reserves? 2. Do members consider that the suggested notes and definitions represent a reasonable basis for conducting a survey of profitability, to be followed on a ‘best endeavours’ basis with any material divergences in national approach separately identified? 3. Would members consider it more useful to follow a simplified approach, for example as suggested by Germany, omitting data on tax, dividends and retentions to reserve?

This was not promising; nor were concerns about bank profitability at the forefront of the BCBS’ list of priorities. So discussion of this issue was repeatedly deferred at the remaining BCBS meetings during 1985, until it was finally taken at the 12 December (thirty-sixth) meeting. At that meeting (BS/85/90): The Committee considered the draft note by the Secretariat (BS/84/85) proposing a basis for collecting comparable data on bank profitability in member countries. It was agreed that the Secretariat would pursue some of the outstanding technical difficulties on a bilateral basis with a view to drawing up a revised framework for consideration at a future meeting.

Given the much greater urgency and scale of other work priorities on the Secretariat, notably on the Basel I CAR Accord, and the extremely low likelihood of success in achieving a common framework, the above

Prevention of criminal use of the banking system

385

statement was, in effect, a death-knell for this work. There is no record that I could find of any such further bilateral explorations on technical issues, and the topic just expired. E

Prevention of criminal use of the banking system

At the thirty-eighth BCBS meeting, held in Washington DC on 26–27 June 1986 (BS/86/47), Mr Fred Dahl, of the Federal Reserve Board, ‘referred to the problem of money laundering by banks and suggested that the Committee might usefully consider its stance towards this politically contentious issue. Following discussion, it was agreed that the Committee should return to the subject at its next meeting.’ To facilitate such a discussion, the Secretariat prepared a paper on ‘The supervisors’ role in detecting or preventing criminal use of the banking system’, September 1986 (BS/86/58). The paper was of the ‘two-handed’ variety. Thus on the one hand most supervisors: are probably ill-equipped to detect criminal use of the banking system. The adoption of a new role in respect of the activities of banks’ customers risks raising expectations which may be incapable of fulfilment … Moreover, crossborder collaboration in respect of banks’ customers might well be substantially impeded by legal restrictions applying both to banks and supervisors on the passage of information. On the other hand, supervisors must be concerned that a bank’s reputation and standing will suffer if it becomes known that it is a channel for illicit transactions, which may have an adverse impact on confidence. Supervisors in several member countries co-operate with the police or revenue services to make such transactions more difficult.

The paper went on to ask questions about the class of offences to be covered, for example civil as well as criminal, which authorities would be involved, for example supervisory bodies or special purpose groups, and what kind of information might be exchanged, before outlining a list of possible future work projects: – conducting a survey of the extent to which supervisors in member countries are involved in restricting criminal use of the banking system and of the methods applied; – drawing up a ‘code of conduct’ for circulation to banks in member countries and beyond with the objective of making it more difficult for criminals to wash monies through banks; – considering what possibilities there are for bilateral collaboration on specific cases between banking supervisors in different countries, or between supervisors and other official agencies;

386

Other topics addressed by the BCBS

– setting up an independent ‘contact group’ of officials to work in liaison with each other as well as with police and judicial authorities.

This was discussed at the thirty-ninth BCBS meeting (18–19 September) (BS/86/68) and the Chairman asked members individually to reply to these questions, and to ‘report on existing specific supervisory measures in their countries to restrict criminal use of the banking system’. This was quickly followed up with (yet another) questionnaire by the Secretariat (BS/86/70), reproduced as Appendix E. By the end of October eight countries had replied (Canada, Italy, Switzerland13 and the UK did not meet the deadline). The responses were summarised in the Secretariat’s paper (BS/86/84) of end-November; they were very mixed. The USA was, then, the only country with reporting requirements for large cash transactions; four countries were opposed to, and four in favour of, a special code of conduct in this respect; four members were opposed to, and three in favour of, encouraging bilateral collaboration on specific cases; seven members were opposed to establishing a special contact group on this topic, with only the USA strongly supporting. Indeed, the USA was a clear ‘outlier’ on this subject, pressing for more action against the opposition, or lukewarm support, of other members. Nevertheless, at the fortieth BCBS meeting (10–11 December 1986) (BS/86/90) Chairman Peter Cooke asked: the US members to prepare a draft code of conduct and to give some precision to the nature and role of the ‘contact group’ for the Committee to consider at its next meeting. In preparing these documents, the US members were invited to consult with other members.

The work and attention of the BCBS were then diverted by the AngloAmerican initiative on capital adequacy and the need of the BCBS to respond to that. Even so, the Federal Reserve Board met the Chairman’s request by tabling a proposed ‘Code of Conduct’ under cover of a note at the end of June 1987 (BS/87/49). The draft code, which is reproduced as Appendix F, mostly focussed on the positive obligation on banks to identify beneficial account holders and the negative duty not to assist in illegal activities. It was too late to consider this at the BCBS June meeting, and members were asked to respond in writing. Such responses were gathered together by the Secretariat in September 1987 (BS/87/74). Some were 13 In January 1987 the Swiss Federal Justice Office tabled a paper (BS/87/51) proposing to make money laundering a criminal offence. See also BS/89/39.

Prevention of criminal use of the banking system

387

in favour of and some opposed to the principle of the BCBS being party to such a code of conduct. So far as the text is concerned, the obligation imposed on financial institutions to report all instances of illegal activities (Art. IV) is generally considered the most controversial and weak point of the code. It is noted that this not only destroys the traditional precepts of bank/customer confidentiality but, as presently worded, raises many practical and legal questions, among which are the definition of ‘suspected illegal activity’ and the legal framework of reference (e.g. are activities considered illegal under another country’s fiscal or foreign exchange laws to be taken into consideration?). Moreover, for many countries the obligation to report criminal activities (which are a police matter) is strictly limited to government officials and cannot be assigned to private individuals or entities.

The FRB revised its draft code, essentially replacing the word ‘illegal’ with the narrower word ‘criminal’, and resubmitted it at the start of 1988 (BS/88/2). This was now given broad support at the forty-fifth BCBS meeting (28–29 January 1988) (BS/88/21), with a view to proceeding to publish a revised version after the next (forty-sixth) meeting (28–29 April). This was done (BS/88/47); since certain revisions were still sought, members were asked to use the document confidentially until a final version could be put to Governors, and thence to publication in July. Even so, the publication of a Statement of Principles on money laundering was prefigured in the ‘Report on International Developments in Banking Supervision’, Report 6 (BCBS, September 1988, pp. 27–28). Further proposals for revision continued during 1988, for example BS/88/63, and somewhere along the line the ‘Code of Conduct’ became semantically switched to a ‘Statement of Principles’, no doubt a change of deep significance to some. Anyhow, the document on such a statement was sent to the Governors under cover of a note in December 1988 (BS/88/102, see also BS/88/111), which outlined some of the difficulties and sensitivities involved. The full document which the Committee is proposing to issue consists of a preamble, which takes the form of some preliminary remarks, and a Statement of Principles. There were two particular difficulties in the drafting of the principles: (a) in principle II, on customer identification, it is felt to be unacceptable to require banks to request identification from all casual customers, unless the sums involved are large. On the other hand, it is reasonable to expect banks to verify the identity of the owners of accounts and those with access to safe-deposits. The text does not directly address the problem of

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Other topics addressed by the BCBS

fiduciary account-holders, but countries are of course free to tackle this issue if it is a common feature of their banking systems; (b) a second difficulty arose in principle III, on compliance with laws. There are differences of view in the Committee as to whether the application of the Statement should be confined to transactions which launder the proceeds of crime, or whether it should also discourage transactions which are in contravention of non-criminal law (e.g. insider trading or tax and exchange control evasion). The Committee is of the view, in accordance with the principal concern of the US originators of the work, that the main focus should be on crime and drugs-related transactions in particular. The German authorities are unable to approve the document as, in their opinion, the problems concerned are not within the competence of banking supervisors. A statement which did not have the unanimous support of members could be damaging and the Committee would not wish to proceed with publication at this stage. However, one delegation reported that talks are in progress with the German authorities. Given the strong support of other members, the Committee feels it would be useful at this stage to bring the subject to the attention of Governors. Therefore, Governors’ approval is sought for the release of the document on condition that the German authorities have withdrawn their reservation.14

In view of such sensitivities, it was suggested that the publication of the statement, when feasible, should be ‘low-key’ in the extreme, with no press notice and handled by each national authority as it saw fit (BS/88/102 and BS/88/109). The German members must, shortly afterwards, have relented in their opposition, since Chairman Huib Muller then circulated the ‘Statement of Principles’ to non-G10 supervisors under cover of a letter of 16 December 1988, for potential wider release on or after 5 January 1989; see also ‘Report on International Developments in Banking Supervision’, Report 7 (BCBS, September 1990), Chapter IV, pp. 14–19. Most members then circulated this statement to their own banks on that date (BS/89/1). Numerous non-G10 supervisors also gave the statement strong support, and circulated it to their own banks (BS/89/64). That, for the time being, was that. Of course, concern with money laundering and transmission of funds for illegal purposes became much more prominent after 9/11 and the ‘War on Terror’, but that is another and later story.

14 As recorded in Chapter 6, the Germans had been, almost simultaneously, in a minority of one on the, much more important, Basel 1988 CAR Accord. They may well have been feeling aggrieved.

Large credit exposures

F

389

Large credit exposures

At the fortieth meeting of the BCBS, Dr Jürgen Becker of the Bundesbank asked whether it might be possible to conduct a ‘survey of member countries’ rules in relation to large loan limits’ (BS/86/90). Such a questionnaire was drawn up and sent out in April 1987, for reply by mid-May (BS/87/89). The answers were collated and circulated by the Secretariat on 1 June (BS/87/50). In the covering note, the Secretariat commented that: The results indicate that there is already some convergence in the approaches pursued in member countries: – – – –

all countries apply limits on large exposures; those limits are set as a proportion of capital; the definitions of exposure are similar; the numerical limits are roughly aligned.

Only in the field of underwriting are there significant differences in the approaches followed. In four countries (Canada, Italy, Japan and the United States) banks are not generally permitted to underwrite issues of equity by commercial companies. Of the remaining eight countries, in three (Germany, the Netherlands and Switzerland) underwriting exposures are included within the normal system of limits. Only in the United Kingdom are special limits applied to underwriting. The Dutch response to the survey draws attention to this area and requests that the Committee discuss the matter with a view to developing consistent policies.

This topic was then placed on the agenda for the forty-second meeting of the BCBS (23 June) (BS/87/44), but no action was then taken. The reported position was relatively satisfactory and the Committee was preoccupied with negotiations/preparations for the Capital Adequacy 1988 Accord. The subject was reopened early in 1989 with the submission of a (factual) note from the Bank of England (BS/89/2) on ‘Control of large underwriting exposures in the UK’. Following that, at the BCBS’ fiftieth meeting (9–10 March 1989) (BS/89/20), Chairman Huib Muller suggested that the earlier review of national approaches be revisited. This was done in a note by the Secretariat at the end of March 1989 (BS/89/23), just bringing members up to date with the prior 1987 survey results, and a further paper (BS/89/37) discussing the results of the (updated) survey. The results showed ‘some homogeneity in the general approach’, but considerable differences in: (a) numerical limits to the maximum exposure, ranging from 15% (Sweden, USA) to 100% (Italy);

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(b) application to quasi-public-sector bodies, etc.; (c) the treatment of underwriting; (d) the treatment of ‘connected’ lending; (e) the treatment of ‘concentrations’ of lending, for example to specific industries, sectors or foreign countries. Having raised such questions, the paper concluded that: Large loan limits or, more generally, limits on risk concentration have not yet been the object of particular consideration in the Committee. It is clear that they have an important role in ensuring the soundness and stability of the banking system. Subject to the Committee’s views, it may be timely to give some attention to this aspect of supervision. After an exchange of view on national approaches, the purpose of the exercise could be to see whether it might be appropriate to develop a commonly agreed position on some aspects of large exposure policies. One obvious example would be to see whether there is merit in adopting a common level for the basic limit as a percentage of capital.

This was discussed at the BCBS’ fifty-first meeting (25–26 May 1989) (BS/89/51), where ‘it was agreed to consider in more depth the conceptual questions … with a view to seeing whether some convergence in member countries’ practices was desirable and possible’. The Secretariat was asked to provide a further paper in advance of the October meeting. This was done in a note (6/9/89) (BS/89/65). It was suggested that a public discussion and paper on this topic would be particularly timely:€the reasons for this are shown in the page reproduced as Appendix G. But if the BCBS was to be able to put forward an agreed proposal, the Secretariat warned that it would be necessary to reach some common position on: (a) defining an exposure; (b) treatment of ‘related’ exposures; (c) consolidation; (d) the limit of the ratio; (e) treatment of economic and geographic concentration. At the fifty-second BCBS meeting (5–6 October 1989) (BS/89/92), ‘members supported the development of a paper presenting general supervisory principles, possibly including some numerical limits, with a view to tabling an agreed draft at the [ICBS] Frankfurt Conference’. The Secretariat was asked to draft such a paper in time for the next meeting, and did so by the end of November (BS/89/103), though this raised more questions than answers; it did, however, suggest that a public statement by the BCBS might contain:

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391

1. A definition of a credit exposure which would include off-balancesheet items and commitments, weighted according to the conversion factors used in the capital agreement. 2. A definition of a counterparty, including a comprehensive definition of a group of related counterparties. A basis for such a definition might be found in that used in the EC Recommendation. 3. A system of limits, perhaps including an upper limit and a lower reporting threshold, both expressed as a percentage of the capital base as defined in the capital agreement, applying to private sector non-bank exposures. 4. A requirement that such limits be observed on a fully consolidated basis. Not perhaps surprisingly, at the fifty-third (7–8 December) meeting of the BCBS, the Secretariat were told to go away, restructure their paper and resubmit it for the next meeting. This was done (BS/90/5), and approved at the fifty-fourth meeting of the BCBS (28 February–1 March 1990) (BS/90/22) subject to some amendments. Having first sent it to the Governors for information, Chairman Huib Muller stated that it would be tabled at the sixth ICBS Frankfurt Conference in October. The text (of BS/90/5), reproduced in the ‘Report on International Developments in Banking Supervision’, Report 7 (BCBS, September 1990), did suggest specific numbers:€‘An appropriate limit for a single exposure would fall within the range 10–40% of total capital, with 25% being a preferred central point.’ Its conclusion was that, in this respect, a sound system would include the following elements: – a definition of a credit exposure which encompasses not only the standard forms of lending, but all on and off-balance-sheet positions which may involve any element of loss if the counterparty defaults, valued at par with the exception of the replacement cost items referred to in paragraph 10; – a definition of a counterparty which is sufficiently broad to include entities related to the borrower in such a way that the failure of one is likely to involve failure of the others; – a maximum limit applicable to private sector non-bank exposures of approximately 25% of total capital on a fully consolidated basis, together with a lower reporting threshold of 10% of capital; – special attention being paid to ‘connected’ lending, with a limit well below the standard limit; – the need to monitor ‘clustered’ loan books; – banks’ attention being drawn to the need to monitor carefully its sectoral and geographic exposures.

Having been discussed at the Frankfurt ICBS Conference, and a few minor amendments made, the final version of text was circulated by

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Peter Hayward, the Secretary of the BCBS, for public dissemination on 25 January 1991 (BS/90/99) and, again, reproduced in the next ‘Report on International Developments in Banking Supervision’, Report 8 (BCBS, September 1992), Chapter 5, pp. 21–36. This was a well-done exercise, though there may be a couple of minor qualifications. First, it was in part a reaction to initiatives taken by other regulatory bodies in the EC, though the decision remained with the BCBS. Second, it was quite an easy exercise for the BCBS, given the general homogeneity of approach among member countries. The cynical may note that the feature where there were most differences in member country practice, that is the treatment of bank underwriting, is conspicuous by its absence from the published texts. G

Bank insolvency regimes

The question of how national bank insolvency rules might affect the resolution of a bankruptcy involving an international bank was first put on the agenda of the BCBS by the Swiss Federal Banking Commission in September 1980 (BS/80/46). The context in which they did so is not made clear in the document, though the Swiss Federal Supreme Court Judgement in the Israel-British bank case is specifically mentioned. Anyhow, the Swiss paper noted that: The internationalisation of banking is a feature of our time and banks conducting international business hold significant proportions of their assets and liabilities abroad. In the event of failure, this gives rise to numerous problems with repercussions beyond national frontiers, which cannot be satisfactorily solved either legislatively or administratively by the country of domicile alone. It seems desirable, therefore, to examine the current legal situation in the various countries and, where appropriate, to look into the possibilities of harmonisation.

The subject was put onto the agenda for BCBS meetings throughout 1981, but low down the list and continuously deferred. Meanwhile it triggered national responses on how each country would handle international bankruptcies, primarily factual legal accounts from the USA (BS/81/6), France (BS/81/25), Belgium (BS/81/43), Germany (BS/82/2) and Sweden (BS/82/30). Having been deferred for over a year, the subject finally came up for discussion at the twenty-fifth meeting of the BCBS (24–25 June 1982) (BS/82/39), where Chairman Peter Cooke firmly dropped the whole subject:

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393

The Chairman suggested that, since it would be difficult to generate a constructive debate on the basis of the seven papers which had now been received on this subject, the Committee should regard those papers as useful descriptive documents for the record and remove the item from its agenda. He added that if the remaining five member countries were able to submit similar papers on their national procedures relating to the insolvency of banks, these would usefully complement the papers already submitted.

One can, indeed, see why this subject was deemed out of bounds. The subject depended crucially on national legal practices, and the BCBS had no locus for intervening, or even for commenting, on such matters. Nevertheless, it remains the case that the globalisation of banking has made the failure of an international bank more likely, and that the international community of regulators/supervisors needed to be prepared to handle that. Not only did the Ambrosiano bank failure (1984) have international implications, but also the next failure that triggered reconsideration of bank insolvency regimes by the BCBS, the failure of BCCI (Bank of Credit and Commerce International) in 1991, involved numerous cross-border complications. In his note on this topic (BS/91/70) Chairman Jerry Corrigan (of the FRBNY; Huib Muller had died earlier that year) outlined three sets of questions. The first two concerned consolidated supervision (home/host issues) within the framework of the Basle Concordat, while: the last€– and in some ways most difficult€– set of issues relates to the failure and liquidation of a bank with important cross-border banking presence and operations. These questions would include the following: 1. Given the events on July 5 when BCCI was closed in many countries, are there workable steps that can be taken to better coordinate such events, including steps to minimize the so-called Herstatt problem? 2. Are ‘contagion’ effects such that it is unreasonable to assume that any crossborder affiliate of a failed institution€ – even if separately capitalized in a local currency€ – can be insulated from the problems of the parent or the relative and if not, what are the implications for supervisory policy? 3. The BCCI case has already demonstrated the enormous complexities that arise in the liquidation of a bank operating in multiple political and legal jurisdictions. Among other things, these complexities can cause major delays and uncertainties regarding the status of depositors and creditors in all countries and can cause unnecessary tensions in the liquidation process. While many, if not most, of these problems are well beyond the competence of the Committee, might there be some value to stimulating an effort to compile an inventory of problems and practices in the context of the BCCI affair with a view toward better understanding how these arrangements work and how they might be improved?

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Accordingly, at the next (sixtieth) meeting of the BCBS (2–3 September 1991) (BS/91/75) one of the practical issues for consideration involved ‘the liquidation of banks, bearing in mind that the relevant legal arrangements are usually governed by laws relating to companies generally’. The Secretariat was set to work to prepare papers on all the issues raised (BS/91/79€ – which was not available to me). At the sixty-first BCBS meeting (4–5 December 1991) (BS/91/105) two of the Â�longer-term issues, outlined in BS/91/79, were noted: VII 2╇Establish procedural guidelines for the closing of banking groups with foreign establishments. VII 3╇Compile an up-to-date inventory of bankruptcy and insolvency laws in member countries.

In the subsequent note by the Secretariat (BS/92/19) (27 February 1992), these issues were expanded: Establishing procedural guidelines for the closing of international banking groups (VII.2) This is not an area in which the Committee has done any work in the past.15 The note BS/91/79 suggested that the procedures might include determining: – – – – –

which national authorities should be consulted; what decisions and what information should be shared; when advance notice should be provided; how best to time the closure. Are these the right issues? How normative should the guidelines be?

Compiling an inventory of bankruptcy and insolvency laws This is potentially a lengthy task and needs to be carefully defined to ensure that the information is supplied in a manner which is useful to members. Would members favour a questionnaire format, which might be circulated in draft form for comment before responses are invited?

Then, at the sixty-second BCBS meeting (5–6 March 1992) (BS/92/32) in ‘Discussion of issues raised by the BCCI incident’, the Committee agreed that ‘a small group of legal experts should be invited to compile a case study of the BCCI closure with a view to clarifying the way in which national bankruptcy and insolvency laws were operating’. On 14 May the Secretariat noted that the FRBNY, Bank of England and Luxembourg Monetary Institute would make ‘experts available to compile a study and work is expected to start shortly’. This group was chaired by Mr Patrikis, then Chief Counsel of the FRBNY. He

15 Collective memory having presumably failed to recall the earlier 1980–82 set of papers.

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395

Â� presented his report to the sixty-fifth BCBS meeting (2–3 December 1992) (BS/92/114). It was agreed that the report was a valuable study which might usefully be made public in due course, perhaps revised to reflect the legal situation in the nine member countries which had not been represented in the working party. In any event, the contents needed to be reviewed and a carefully balanced introduction added. Mr Patrikis was asked to prepare a covering paper for the March meeting which would identify the supervisory policy issues raised. The Committee would then consider possible publication and/or the possibility of discussing the study in a symposium of legal experts.

This report, entitled ‘The insolvency liquidation of a multinational bank (December 1992), was subsequently published in the Compendium of Documents, produced by the Basel Committee on Banking Supervision (February 2000).16 At the time, the ‘Report on International Developments in Banking Supervision’, Report 8 (BCBS, September 1992), stated on p. 5 that ‘An investigation is being carried out into national bank liquidation laws to determine whether there are lessons to be learned for the future closure of international banks with worldwide networks. The main thrust of the Patrikis Report was that the differing legal arrangements in the three countries reviewed, that is Luxembourg, the United Kingdom and the United States, made the conduct of a crossborder insolvency fraught with difficulty. The difference between the American separate entity (that is, treating the US part of a foreign bank separately for insolvency purposes) and the single entity approach in Luxembourg and the UK (with all creditors treated pari passu wherever located) was a particularly serious hurdle. But there were numerous other differences, for example on practice in relation to set-off (whereby mutual claims may be extinguished). The implications for supervisors were manifold. Those reviewed in the report included: (a) The nature and timing of communications should be considered when closing a bank.

16 Despite the fact that this report was subsequently published, and consists primarily of a discussion of the differing legal arrangements in the USA, UK and Luxembourg for handling a bank liquidation, the files relating to the report, and the 1992 report itself, were not made available to me from the archives. Perhaps the original included some more confidential material that was subsequently bowdlerised in the published version.

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(b) Liquidation rules need to be considered when designing the form and nature of supervision of multinational banks, notably including the location of capital. (c) Liquidation rules can affect returns to creditors and the operations of deposit protection schemes. (d) The lack of harmonisation across countries of the treatment of insolvency set-off schemes is a problem. (e) Coordination and cooperation between liquidators can affect creditors and can be affected by the role of supervisors in a liquidation. (f) There were implications for payments and netting issues. The BCBS examined the Patrikis Report again at its sixty-sixth meeting (4–5 March 1993) (BS/93/19) but ‘felt that the cover note was not suitable for the Governors or for publication in its present form. Mr Patrikis was asked to redraft the cover note in more neutral terms as a briefing report for the Governors with options and their implications rather than recommendations. This would be considered at the June meeting.’ At that 10–11 June meeting (BS/93/30): Following a discussion of the draft report by the Patrikis working party (BS/92/101 revised), it was agreed that the report should be sent to the Governors for their September meeting. In the meantime, the working party was asked to redraft the final section of the covering paper, which listed the menu of options for possible action, and resubmit it for the Committee’s approval. The purpose would be not to hold out promise of early resolution of the problems identified in the report but to warn Governors of their implications and of the possibility of a deterioration in the present situation.

And that marked the end of discussions on national bank insolvency regimes.17 The ‘Report on International Developments in Banking Supervision’, Report 9 (BCBS, 1994) did, however, have a section on ‘Multinational bank insolvency liquidation regimes’, pp. 8–10, which distinguished between single and separate entity regimes, and expressed a preference for the former. The text of this section, which explains these concepts, is reproduced as Appendix H. This subject is delicate and sensitive since it intrudes into the territory of national legal sovereignty, a field into which the BCBS was constitutionally loathe to trespass. The Lehman Bros failure in September 2008 and the problems of resolving the Icelandic banks, Fortis and Dexia, have, of course, now reawakened attention to the question of 17 The Secretariat had also prepared a brief questionnaire on bank liquidation issues in December 1992 (BS/92/117). But there is no evidence on the context in which it was prepared, or whether it was ever sent out. If it was sent out, there are no records in the files of what answers were received.

Appendix A

397

how to handle cross-border insolvency. In the absence of much willingness by the major participants to agree to harmonise their own national laws, the problem remains intractable, despite the best efforts of the Financial Stability Board. Despite the sensitivity of the issue, a greater willingness, by the BCBS among many others, to engage in open debate on this subject would be healthy.

Appendix A (1) Excerpts from J. Bonnardin note on ‘Banking and professional secrecy’, 27 September 1978 III

The Supervisory Authorities’ Duty of Professional Secrecy

The object of the law in imposing an explicit duty on the supervisory authorities to maintain professional secrecy is to some extent to confirm the banking secrecy enjoyed by a bank’s customers but also to protect the banks themselves, whose reputation might suffer through the disclosure of information concerning them or their management. In this connection, Article 12, paragraph 1 of the first European banking Directive, establishing a general principle, requires each member country to introduce national professional secrecy regulations applying to ‘all persons now or in the past employed by the competent authorities’. This would seem to constitute a very grave obstacle to organised Â�co-operation among the various supervisory authorities, which, however, has been rendered necessary by the internationalisation of banking systems and operations. While the precedence of the public interest, national or international, may allow informal contacts between supervisory authorities in certain circumstances, it would doubtless be desirable, in view of the considerable interests at stake, to attempt to give a more solid legal basis to such exchanges of information and greater protection to the authorities involved. In conclusion, while fully appreciating the substantial progress that has been made in the area of co-operation on the basis of informal agreements and increasing contacts among supervisory authorities, any extension of such co-operation would seem to depend on the conclusion of full international agreements on a bilateral basis or, in most of the countries in question, a change in legislation. The development of international banking networks and the resulting erosion of the effectiveness of national supervisory systems should,

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at the very least, give the supervisory authorities sufficient grounds to draw the attention of the political authorities to the need for the legislative adjustments referred to above. (2) Excerpt from the Secretariat note on ‘Banking secrecy’ (BS/79/9) II

The obligation of the supervisory authorities

The fact that banking secrecy does not apply vis-à-vis the domestic supervisory authorities in no way invalidates the principle of banking secrecy, but simply means that the supervisory authorities have a duty to keep secret the information which they receive about the individual customers of banks. In fact the protection afforded to the confidentiality of information at the supervisory level is usually considerably greater than at the level of the individual banks. Thus violation of professional secrecy by supervisors can entail criminal proceedings even in countries where penal law does not extend to banking secrecy. In addition, the exceptions to the principle of banking secrecy are usually fewer than at the level of the individual banks. Thus the supervisory authorities will in general not be obliged to provide information to the tax authorities and will in most cases be able to resist civil court orders. The most important exception still applicable will usually be the obligation to testify before the courts in criminal proceedings. Moreover, the supervisory authorities will in general have an obligation to report when, in the exercise of their functions, they obtain knowledge of crime and violation of laws. One other area in which the supervisory authorities’ obligation of professional secrecy does not always apply is in their relations with the supervisory authorities of other countries, although the presumption here is that the supervisory authorities of these other countries too are bound by the duty to observe professional secrecy. The need for international exchanges of information between supervisory authorities has been greatly increased by the rapid internationalisation of banking. This is also recognised in the EEC’s first European banking directive which, with the aim of encouraging, in the interest of the soundness of the international banking system, prudent and limited cooperation among supervisory authorities, explicitly allows for communication of banking information between the competent authorities of the various member states where this is necessary for the proper exercise of their supervisory duties. In fact the Community initiative has not broken totally new ground but has lent support to a trend that was already present in a number of countries both inside and outside the EEC. Thus supervisory authorities in some countries are entitled not only to exchange information

Appendix B

399

with their foreign counterparts, but also to go beyond that and permit on-the-spot examinations of the local branches of foreign banks by parent authorities. The conditions usually attached by the host authorities to the granting of permission for such on-the-spot examinations are prior notice, sharing of the findings and reciprocity. (3)

Excerpt from the Secretariat note on ‘Banking secrecy:€suggested points for discussion’ (BS/79/34)

Supervision of the foreign branches and affiliates of domestic banks can occur on three levels: (a) collection of reports and information on branches and affiliates by parent authorities via the parent banks; (b) exchange of information between host and parent supervisory authorities; (c) on-the-spot examination of foreign branches and affiliates. Could the Committee members comment about the potential problems they see in these three areas? Points (a) and (b) will in general not give rise to difficulties as regards supervision of branches, but what about subsidiaries and participations? Can the subsidiaries themselves object to such a transmission of information? As regards (c), such inspections have already been admitted on an informal basis by the host authorities of several countries. What are the obstacles to making this a general practice? What has been the attitude of foreign branches and affiliates to such on-the-spot examinations by the host authorities? Should the Committee discuss the possibility of a recommendation that banking laws should include a provision stipulating that banking secrecy shall not be applicable vis-à-vis the authorities responsible for supervising a bank’s head office or parent? Could there be possible problems, arising from the fact that in the parent country the secrecy obligations of the supervisory authorities might be less strict than in the host country?

Appendix B Remarks by Chairman Peter Cooke on the question of banking secrecy, contained in his paper on ‘The Concordat’ (BS/84/22) A particular feature of national legislation which has an important bearing on the ability of individual countries to implement the principles of the Concordat is the degree to which banking secrecy laws may impede the free passage of information required for effective supervision. In

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nearly all cases, the information to which access is blocked is that which concerns the liabilities of banks to individual customers, information which is generally not required by parent supervisors. However, the Committee is very conscious of the need to minimise the constraints on co-operation which can arise as a result of such legislation and in some cases to have such legislation amended. In discussions during and following an international conference of banking supervisors held in Washington DC in September 1981 there was widespread agreement that obstacles should not be put in the way of flows of information within banking groups or between supervisors, subject to appropriate undertakings of confidentiality being given by the recipients. More recently, at a meeting between the Basle Committee and the Offshore Group of Banking Supervisors in October 1982, this question was further discussed and it was concluded that only in rare cases were there impediments on the flow of information between offshore establishments and their parent banks. It was agreed that in normal circumstances the proper channel for the flow of regular information of a prudential or accounting nature was from the foreign establishment to the parent bank, with appropriate verification of that information being carried out by internal or external auditors. Particularly among its own membership the Committee does not believe that national secrecy provisions significantly impair international supervisory co-operation. As a safeguard in cases where individual banks deliberately obstruct the passage of information and to enable relevant information to be passed freely in the event of difficulties arising in particular banks, the Committee is of the opinion that national laws should permit supervisors, under appropriate conditions of confidentiality and reciprocity, to pass to the authorities of other countries information of a supervisory nature which might otherwise be restricted by banking secrecy constraints. Several countries within the Committee or outside have recently introduced exceptions of this nature into their banking secrecy legislation. In this respect, EEC countries have an obligation to permit such exchanges under the terms of the 1983 consolidation Directive referred to earlier in this section.

Appendix C

BS/75/48

Possibilities for international official cooperation in specific bank cases A liquidity, solvency or foreign exchange problem for a bank in one country can have seriously adverse effects on the financial institutions

Appendix C

401

of other countries and on international markets. These effects can be of a general confidence nature or could be related to specific transactions, such as foreign exchange contracts or international deposits. In order to limit the spread of such specific effects, the following possibilities for official cooperation are suggested as examples. Other types of cooperation may also be possible. In considering possibilities for cooperation, each authority will take into account the individual circumstances of the specific bank case at hand as well as its own legal and regulatory responsibilities and limitations: (1) Authorities outside the country of the specific parent bank in difficulty may provide the parent bank authority with contacts or information related to banks, firms, individuals or markets in their countries that would be helpful to the parent bank authority in assessing the specific bank situation and may also assist the parent authority in selecting local legal counsel where this is needed. Conversely, the parent bank authority may provide a foreign authority with information about aspects of the bank’s difficulties of special interest to the foreign authority. (2) If the bank in difficulty has affiliates abroad: (a) Host authorities for the foreign affiliates may inform the parent authority about any difficulties being experienced by the affiliates and any actions the host authorities may be taking with respect to such affiliates. (b) Host authorities may assist the parent authority in obtaining information directly from the foreign affiliates. (c) Host authorities may provide safekeeping facilities for affiliate assets taken into custody by the parent authority. (d) Host countries may offer suggestions and assistance about the closing, merger, takeover or continuance of an affiliate. In the case of a joint venture, other affected authorities may also offer suggestions and assistance. (e) If financial assistance in foreign currency is extended to the affiliate indirectly by the parent authority (through the parent) or directly by the host authority, the currencies may be lent to the assisting authority by the central banks whose currency is needed. (3) If there is a foreign exchange problem associated with the bank’s difficulties: (a) The parent central bank may transact to sell or buy foreign currencies, spot or forward, with the bank in difficulty or with other banks in its market affected by the bank’s difficulties.

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Other central banks may assist this effort by foreign currency transactions with the parent central bank; such central bank foreign exchange transactions may be outright or through a swap. Similar cooperation may take place if the host central bank of a troubled affiliate undertakes foreign exchange transactions with the affiliate or with banks in its market. (b) If a central bank takes over the foreign exchange position of a bank in its market, central banks in those areas where counter-parties to the exchange contracts are located may assist the takeover process by helping assure that confirmation of the change in contracting party is prompt and complete. These central banks may also provide good offices for the reasonable settlement of any dispute that arises over the exchange contracts. HDW/dw 30 June 1975

Appendix D

BS/77/44 (revised)

The role of profit and loss account analysis in bank supervision

Introduction and Summary

Assessment of a bank’s profit situation is a central element in banking supervision since failure to achieve adequate profits may ultimately lead to erosion of a bank’s capital base as well as to a stretching of its gearing ratios, and thereby increase its vulnerability to internal or external shocks. Analysis of a bank’s profit and loss account and€– when available€– of the accompanying auditor’s report is therefore an essential part of banking supervision. This is particularly the case in countries where there are no regular on-the-spot examinations of banks and where the authorities have consequently to rely primarily on written reports and on discussions with the managements of banks. However, even in countries where on-the-spot examinations take place analysis of a bank’s profit and loss account will provide vital background information and may help to direct attention to actual or potential trouble spots. The efficacy of profit and loss account analysis for assessing a bank’s overall efficiency and performance will depend on a number of factors. These include:€the periodicity and timeliness of the reports; the

Appendix D

403

comparability of the data; the amount of detail given; and the extent to which its accounts provide a true picture of a bank’s situation. As regards periodicity and timeliness of the reporting, requirements differ greatly between countries. At one end of the spectrum are countries like the United States, where banks have to file detailed quarterly profit and loss statements within fourteen days of the end-quarter accounting date; on the other end is Switzerland, where the auditors are allowed one year in which to submit their reports on the banks’ annual accounts, and even then these reports are not always received on a yearly basis, but in the case of many banks at intervals of several years. Japan is a somewhat special case, in that the banks have to supply preliminary profit and loss statements immediately before the end of each semi-annual accounting period. Moreover frequent reports of various kinds enable the Japanese authorities to follow the evolution of the banks’ profit situations virtually continually. Similarly in Belgium the banks, in addition to their quarterly profit and loss statements, have to supply monthly information concerning, inter alia, provisions for prospective losses. As regards comparability of the data, both over time and as between banks, in nearly all countries this is guaranteed by laws, decrees or guidelines which set out in detail the form in which the accounts have to be presented and the content to be given to the individual items. In countries such as Belgium, Germany and Switzerland where the auditor’s reports are an essential supplement to the profit and loss statement, similar regulations apply to the content of those reports. In the United Kingdom however there are no laws or regulations relating to the form, or method of calculation, of the banks’ profit and loss accounts and each bank tends to use its own system. As regards the amount of detail to be reported, one general rule applied in all countries is that income and expenditure shall be reported gross. However, there appear to be some important exceptions to this rule; thus, in Germany valuation gains and losses on a bank’s credit and security portfolio may be offset against each other. Another principle which is more or less strictly applied in nearly all countries is the distinction between the various sources of income and expenditure. Thus banks in nearly all countries have to provide roughly the following breakdowns:€ interest and commissions received from normal types of banking business; profits from security and foreign exchange operations; income from participations; and other income. The same applies on the expenditure side. In addition, some countries distinguish between:€income from and expenditure on (a) interbank business and (b) operations with clients; income from and expenditure on deposittaking and lending in (a) foreign currency and (b) domestic currency;

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income from and expenditure on business (a) with residents and (b) non-residents. One field where major differences seem to exist between countries is in the degree to which the figures for a bank and its subsidiaries have to be consolidated; of special interest in that connection is the treatment of the banks’ foreign subsidiaries. The crucial question concerning the usefulness of the profit and loss account as an analytical tool concerns the degree of realism of the figures. The valuation of certain kinds of items, such as potential future loan losses, is to a large extent a matter of judgement; and so may be the allocation of various types of income and expenditure to particular accounting periods. Banks therefore unavoidably have considerable discretion in presenting their operating results. Two factors in particular may introduce a bias, especially in the presentation of published profit and loss accounts. Firstly banks seek, for a variety of reasons, to show as steady as possible a stream of net income. However these efforts may be quite dangerous. Where they conceal the fact that the deterioration in a bank’s profit situation is not just a temporary one the usefulness of the profit and loss account as an early warning signal would certainly be impaired. Secondly, the principle of what may be called ‘commercial prudence’ and, in several countries, statutory accounting rules tend to oblige banks to take potential or ‘unrealised’ losses into account, but not ‘unrealised’ gains. In other words, there will be a tendency to err on the side of caution. This asymmetry may at times understate a bank’s real profits, but at other times it may also lead to overstatement. The ability to identify the formation and/or drawing down of ‘hidden reserves’ is therefore an essential condition for meaningful profit and loss account analysis. In Germany and Switzerland, where the accounting rules are particularly liberal in this respect, the auditor’s report has to give detailed information about hidden reserves. Similarly, in Belgium auditors have to supply the authorities with detailed information concerning, inter alia, a bank’s valuation methods, its methods of allowing for depreciation, and the formation or reduction of provisions for losses. In Luxembourg, the banks, in addition to submitting profit and loss statements derived from their books, have to furnish a second version which must give as realistic a picture as possible of their actual situations. In Italy the supervisory authorities use standard rates of depreciation and provisions for losses to compute the ‘theoretical’ profits of a bank, which may of course diverge considerably from those actually shown. In Sweden banks, before submitting their annual statements to their Boards of Directors, must satisfy the Banking Inspectorate that adequate provisions have been made for bad loans. The adequacy of depreciation allowances and provisions, as well as the consistency of valuation methods, are

Appendix D

405

undoubtedly primary concerns of the supervisory authorities in all the other countries represented on the Committee. As to the focus of the analysis of the information contained in the profit and loss account a number of common features may be noted. Thus in most countries the supervisory authorities try to distinguish between what could be called ‘stable’ and ‘accidental’ income, i.e. essentially between the proportion of income derived from activities such as borrowing and lending operations, the proportion due to such relatively volatile factors as profits from dealing in foreign currencies, securities and commodities, and exceptional receipts such as those derived from the sale of real estate. Too large a share of ‘accidental’ revenue will tend to be interpreted by the authorities as a kind of danger signal warranting further examination. Within the category of ‘stable’ income attention may be paid to the relative shares of (a) interest income and (b) commission received, the latter being considered more variable than the former. On the expenditure side, emphasis is quite often put on the size of overheads in relation to total costs, with particular attention being paid to personnel and accommodation costs. One cost item which is quite often considered of particular significance for assessing the ‘quality’ of a bank’s profits is the amount of necessary provisions against losses in relation to the size of the loan portfolio. The various gross or net income and cost aggregates and components may then be related to one another or to certain balance sheet items in order to produce ratios of particular analytical significance. Some of the ratios most often used are those of net income in relation to own funds, of net income in relation to total funds employed, and the ratio between operating income and operating expenses. Other calculations which are often made are those of gross and/or net interest margins earned by banks on their lending operations. The degree of reliance on such indicators, as well as the use made of them, differs widely from country to country. In some countries, such as Germany, Luxembourg, Switzerland and the United Kingdom, no standard set of ratios is at present used. Although considerable importÂ� ance may be attached to certain key figures and ratios the profit and loss situation of each bank is studied individually. Here the emphasis will have to be above all on historical analysis, i.e. on observing the evolution of the bank’s net profits, and of the various income and expenditure components, over time. On the other hand, a group of countries which includes Belgium, France, Italy, Japan and the United States is working, or experiÂ� menting, with numerous ratios, and combinations of ratios, which may be used not only for tracing the development of an individual bank’s profits, but for obtaining averages for all banks or for groups of banks and for

406

Other topics addressed by the BCBS

making ‘peer group’ comparisons. Comparisons between banks clearly add a new dimension to profit and loss analysis. For example, even when a bank’s operating results show considerable improvement over time, its profit performance may still be less than satisfactory compared with other banks. On the other hand these comparisons depend in large measure for their validity on the existence of reasonably homogeneous groups of banks. The criteria most often used for the formation of ‘peer groups’ are the size of the banks and their business orientation. Where they are available, standardised sets of ratios and other key figures are of course used for data processing purposes. One basic aim is to obtain a kind of early warning system in which the computer points out those banks where the key ratios and indicators, or any combination of them, have reached a critical value or where there are some other unusual developments. While it is agreed that no automated system can substitute for flexible case-by-case examination of individual banks, some countries believe that such systems help to direct the attention of the authorities to those banks where it is most needed. This will be particularly important in countries where there are a large number of banks to be examined and where the manpower resources of the supervisory authorities are quite limited.

Appendix E

BA/86/70

Questionnaire on the supervisors’ role in detecting or preventing criminal use of the banking system It was agreed at the Committee’s meeting last week that member countries should be invited to respond to a number of questions raised in the Secretariat’s note BS/86/48 with a view to judging whether and how the Committee might wish to take forward work in this connection. The questions are as follows: 1. What, if any, measures have been introduced to restrict criminal use of the banking system in your country? Do these include, for example, gentlemen’s agreements obliging banks to maintain a general duty of care in verifying the status of new customers or reporting requirements for cash transactions? If so, please describe. 2. (i) Do you favour the Committee seeking to draw up a ‘code of conduct’ for circulation to banks in member countries and beyond with the objective of making it more difficult for crimÂ� inals to wash monies through banks? (In answering this question, you should be aware that in 1980 the Council of Europe recommended European governments to adopt measures which amount

Appendix F

407

Appendix F on this issue. See attached extract from the booklet circulated at the Committee’s meeting. It is not clear what practical results have followed from this initiative but you will wish to consider the scope for a parallel initiative by the Committee.) (ii) Are the supervisory authorities in your country competent to draw up and endorse such a code? (iii)╇ If so, have you views as to any particular elements that should form part of such a code? 3. Do you favour consideration being given by the Committee to the scope for bilateral collaboration on specific cases between banking supervisors in different countries, or between supervisors and judicial agencies? 4. Are you in favour of the Committee seeking to promote the establishment of an independent ‘contact group’ of officials to work in liaison with each other as well as with police and judicial authorities? If so, what form might it take? These questions may not be easy to answer but tentative or provisional replies would nevertheless be helpful. I would be grateful to receive your responses by the end of October so that the Secretariat may have time to prepare a paper for the Committee to discuss at its meeting on 10th–12th December. C. J. Thompson 25 September 1986 Appendix F Recommended code of conduct for financial institutions conducting currency transactions

Preamble

Financial institutions may be used, wittingly or unwittingly, as depositories for cash proceeds generated by illegal activity. This problem has been widely recognized by financial trade groups, government regulatory authorities and elected officials. This Code of Conduct is an attempt to outline efforts that financial institutions can implement that, if successful, should assist in eliminating money laundering in the international payments system. The code also points out the preventive role that financial institutions play. In essence, financial institutions must increase their awareness of possible criminal activity in the payments system, implement proper safeguards, and increase cooperative efforts with law enforcement authorities.

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Other topics addressed by the BCBS



Purposes

• To maintain the integrity of, and public confidence in, institutions responsible for the transfer of payments across national borders;

• To prevent the utilization of financial institutions to further illegal activity; and

• To establish consistent rules of conduct to be applied when conducting transactions which assist in the movement of currencies.



Article I:€Ensure that procedures are in place that will identify the individual conducting the transaction or requesting the bank’s service

A financial institution, prior to undertaking any transaction, should make all reasonable efforts to determine the identity of customers requesting the institution’s services. These services would include the creation of a deposit account or transfer of currency. Each institution should set a reasonable threshold amount; transactions above this amount would require careful scrutiny if initiated by individuals other than established customers. Each financial institution should institute policies regarding the type and nature of identification required for new customers. The financial institution should be guided by prudence and good judgment in formulating these policies but at a minimum should consider the following guidelines. (A)

Individuals

The financial institution should check the identity of the customer by means of an official document. In those relationships being initiated by correspondence, the financial institution should check the identity by obtaining confirmation by way of postal delivery or by some other equally valid method. The customer’s identity could be ascertained by obtaining a written recommendation from another established financial institution or a well known customer. (B)

Legal entities and companies

The financial institution should determine identity through means of independent verification or examination of corporate or legal documentation.

Appendix F

(C)

409

Beneficial owners

The financial institution should undertake all reasonable efforts to identify the beneficial owner of the assets being deposited at the institution. If unusual facts or doubts exist under the circumstances, the financial institution should not conclude that the individual requesting the transaction and beneficial owner are identical without inquiry or investigation. If an individual declares himself to be acting on behalf of a third party, the financial institution must obtain and verify the third party’s name, domicile and legal residence. If the individual acts for the account of a legal entity or company, the bank must obtain and verify the firm name, domicile and legal residence. Lawyers or solicitors opening accounts for beneficial owners should declare if the account is being opened and maintained for legal reasons related to the legitimate conduct of business and not as a money manager attempting to keep a client’s name secret from a financial institution. Obtaining the identification of the beneficial owner does not waive the institution’s responsibility to also identify the individual conducting the transaction. (D)

Instances of uncertainty

If doubts or uncertainties arise with respect to the identification of either the party requesting the transaction or the beneficial owner, additional inquiries should be made by the financial institution. If doubts persist, the financial institution should require a written declaration from the customer as to whether he is acting for his own account or the account of a third party. In instances where serious doubt or uncertainty remain with respect to the identification of the customer or beneficial owner or any other material facts, the financial institution should decline to participate in the transaction.

Article II:€Termination of financial relationship

The financial institution should act to terminate all financial relationships with an individual whenever a determination is made that all relevant information has not been provided, the information provided is substantially inaccurate, or inordinate delays are encountered in furnishing information.

410

Other topics addressed by the BCBS



Article III:€Prohibit any direct or indirect assistance to customers attempting to deceive law enforcement authorities

A financial institution should not provide support or assistance to customers attempting to deceive any governmental officials through the submission of incomplete, altered or in any other way, misleading information. Policies should be developed that give clear guidance to employees and officers that the financial institution discourages any role in a transaction that has, as its underlying intent, the deception of any individual, corporation or governmental entity. Government authorities would include tax authorities, law enforcement authorities, custom offices, monetary and bank supervisory authorities.

Article IV:€Financial institutions should report all instances of illegal activities

A financial institution should develop a policy on the reporting of known suspected illegal activities to appropriate law enforcement authorities. It is recognized that it is sometimes difficult to balance the need for effective law enforcement with a customer’s right to financial privacy. Nevertheless, each financial institution has an obligation to ensure that the international and national payment systems are not being used to deceive or defraud government agencies or that criminal elements are not using the system to perpetuate money laundering. It may be most effective for a financial institution to appoint an Officer to review any suspected illegal activity and weigh the merits of reporting the matter to law enforcement authorities.

Article V:€Financial institutions should review procedures; develop and retain necessary records; and properly instruct employees in an effort to ensure compliance with the Code

A financial institution should instruct and authorize its auditors to review compliance with the requirements of this Code. The financial institution’s auditors should periodically test the identification proÂ� cedures being conducted. The financial institution should ensure that all appropriate records regarding customer identification will be preserved in accord with normal recordkeeping procedures and that employees are properly trained regarding the procedures outlined in this Code.

Appendix G

411

Appendix G Limits on large exposures and risk concentrations At the May meeting it was suggested that the Committee should attempt to assess the concepts lying behind these differences and consider whether some kind of set of harmonised principles for the limitation of credit risk concentration was desirable. Any progress in this field would strengthen the soundness and stability of the international banking system in continuation of the process that began with the 1988 capital agreement. It would induce individual supervisory authorities to adjust their regulations in those respects which do not meet the highest standards observed internationally, and would be a valuable occasion for the updating and improvement of existing national regulations. Defining large loan limits is becoming increasingly complex with the introduction of new financing techniques and instruments. The difficulty in deciding how to treat arrangements for securities underwriting is an example of such a complexity. Any scheme recommended by the Committee would also represent an influential reference model for non G-10 regulators. Movement towards a harmonized framework would also contribute to the process of diminishing the existing sources of competitive inequality among banks, at a time when competition is growing rapidly and the internationalization and mobility of banking activity facilitates ‘regulatory arbitrage’. To consider this topic now would be particularly timely. A recommendation on the monitoring and controlling of large exposures of credit institutions was issued by the European Community at the end of 1986. The European countries have been adjusting to it rather gradually. As yet, their national rules are still quite different and a binding directive has not yet been adopted. This would leave, perhaps for a limited period of time, some room for manoeuvre for the European countries to take into account the attitudes of non-EC countries and to shape their approach in a way that can be recommended and supported at a worldwide level. As members will also be aware from BS/89/74, risk concentration is suggested as the general theme for the second day of the 6th ICBS in Frankfurt in October next year. This general heading would be an opportunity for discussion of the control of large exposures and of the various aspects of market risk.

412

Other topics addressed by the BCBS

Appendix H Multinational bank insolvency liquidation regimes The bankruptcy of BCCI brought into focus the fact that countries have different regimes for the liquidation and distribution of the assets of a domestic branch of a foreign bank. Since 1992, the Basle Committee has been studying insolvency regimes in G-10 countries with a view to determining the implications of the insolvency of an international bank for supervisors. This work has established that, at the extremes, there are two basic types€– the single-entity regime and the separate-entity regime. Some countries follow the single-entity approach, under which banks are wound up as one legal entity; all assets of the foreign bank are encompassed in the liquidation; and all creditors of the bank can prove their claims in that proceeding. Other countries follow the separate-entity approach, under which a branch is liquidated as if it were a separate bank. All assets of the branch, and sometimes all other assets of the bank in the host country, are encompassed in the liquidation proceeding, but only creditors of that branch can prove their claims in the host country proceeding. And, in some other countries, there is a blend of the single- and separate-entity liquidation regimes, or the country employs a variation of the single- and separate-entity regime. The blending or variation of regimes makes it difficult to generalise as to the differences in outcome between a liquidation under a separate or single-entity regime. Other notable distinctions between different regimes include the role of the supervisor in the insolvency and the scope of the right of set-off in insolvency. The Committee’s conclusion is that single-entity regimes, or regimes that allow for single-entity liquidations in certain circumstances, are more consistent with the philosophy represented by the Concordat and the Minimum Standards in that they place the major responsibility for supervision (and later, the results of the liquidation) on the home-country supervisor. Such circumstances include comparable supervision in relevant jurisdictions, sufficient exchange of supervisory information and appropriate reporting by credit institutions of their financial condition. The Committee recognises that it has limited ability to effect changes in insolvency law and that, in any event, changes to the single-entity regime are likely to involve lengthy processes that reflect national cultures and heritages. Nonetheless, the Committee continues to monitor efforts dealing with the liquidation of banks and will itself undertake further work, as it considers progress in this area to be important for the safety of international banking.

12

The relationship of the BCBS with banks and other banking regulators

A

Relationship with banks

It is impossible for regulators to do their job without close and continuous contact with the regulated entities, both to obtain basic information and to assess the effects of regulation, both current and prospective, on those being regulated. There is, no doubt, a fine line to be drawn between trying to regulate in an informational vacuum and the regulators ending up in the pockets of the regulated (capture). But the BCBS itself was, for the most part, freed from having to find this balance, since virtually all direct contact between banks and their supervisors/regulators came via the constituent national supervisors/ regulators. As repeatedly noted in earlier chapters, the main source of information and evidence for the BCBS came in the guise of questionnaires constructed by the Secretariat. These would normally be handed over to the BCBS members, who would be responsible for passing them on to an appropriate sample of their own commercial banks, coordinating these responses (so that individual bank confidentiality was maintained) and passing the results back to the BCBS Secretariat, who would then summarise the overall findings. This standard procedure for the BCBS was nicely summarised in a letter from the Chairman of the BCBS, then Tommaso PadoaSchioppa, to Charles Dallara, the Managing Director of the Institute of International Finance (IIF) (founded in 1983), in December 1994 (BS/94/98). In this Padoa-Schioppa wrote that: At present, the Committee maintains close contacts with the banking industry at many levels subject to certain ‘ground rules’. With the exception of an annual meeting between the Committee’s Chairman and the Chairmen of the G-10 national banking associations, contacts with the industry have typically been maintained by national supervisors with their respective banks. When we are formulating supervisory policy, each member is well aware of the views of his banks and the Committee is able to consider the best course of action. Given that national authorities have their legal responsibilities, this is a process 413

414

Relationship with banks and banking regulators

that seems to work well and the Committee has traditionally been reluctant to establish formal channels of communication with any particular group or organization of banks which could develop into a situation in which prudential rules are negotiated. That said, there is no reason why individual members of the Basle Committee should not, on a personal basis, participate in informal discussions with industry representatives, as they already do at various levels. However, in such circumstances, they obviously cannot speak on behalf of the Committee. In this spirit, each of us is always willing to listen to the views of leading banks.

The abovementioned annual meeting between the Chairman of the BCBS and the Chairmen of the G10 national banking associations had begun in 1988, no doubt facilitated by the fact that the then Chairman of the European Banking Federation, Jeremy Morse, and the outgoing Chairman of the BCBS, Peter Cooke, had been Bank of England officials together.1 Both sides emphasised that this meeting represented an ‘exchange of views’, and could in no sense be regarded as a ‘negotiation’. It was a good moment for such an exchange of views for several reasons. First, the 1988 Basel Accord on Capital Adequacy had just been published (see Chapter 6); second, the chairmanship of the BCBS was passing from Cooke to Huib Muller, and it was an opportune occasion for the incoming Chairman to become acquainted both personally and with the views of the Chairman of the G10 national banking associations. The meeting must have been viewed as useful and productive, since it continued to occur once each year, on the occasion of the annual IMF/IBRD meetings (for obvious practical reasons), at least until the end of our historical period (1997). What had prompted this description of the BCBS’ relationship with the banking industry was an initiative by Charles Dallara, the Managing Director of the IIF. The IIF, established in 1983 (see The First 25 Years, 1982–2007 (IIF 2007)), had recently set up a working group of many of the world’s largest derivatives dealers, which had then, in 1994, 1 In the short summary of the forty-fifth meeting of the B C B S on 28–29 January 1988 (BS/88/21), it was reported that: The Chairman reported that he had been approached by the President of the European Banking Federation, who suggested that the commercial banking associations in G-10 countries might establish some form of occasional contact with the Committee. After members had expressed reservations about the risk of short-circuiting national contacts between banks and supervisors, it was decided that the Chairman should not respond positively to the proposal in terms of the Committee ‘as an institution’ meeting with commercial bankers, but that this did not preclude him and/or some colleagues meeting from time to time with representatives of international banks or international bank groupings.

Relationship with banks

415

published a report entitled ‘A preliminary framework for public disclosure of derivatives activities and related credit exposures’. With this to hand, Dallara wrote to Padoa-Schioppa with two proposals, the first being to ask that the BCBS give public support to the IIF’s initiative and ‘join us in encouraging implementation of stronger disclosure policies along these lines’. The second was to suggest that, since the IIF had a sizeable membership of the largest international banks and investment houses, it could be useful to organise a dialogue between them and key supervisory and regulatory officials. Padoa-Schioppa, and the BCBS, was happy to acknowledge the financial industry’s encouragement of greater disclosure (on derivatives); in its report (6 December 1994), the BCBS stated publicly that it ‘encourages the industry to build on the initiatives announced by the Group of Thirty and the IIF, among others’. But, for the reasons just set out, Padoa-Schioppa was unwilling at that time to consider any relationship between the BCBS and the IIF as such, even if such a relationship was to be described as informal and off-the-record. Dallara was not, however, easily deterred from attempts to organise a continuing dialogue between IIF members and key regulators, notably at the BCBS. After having met Padoa-Schioppa at a social occasion, he wrote again, in March 1995 (BS/95/14), to propose an informal discussion between senior representatives of prominent financial institutions and bank supervisors (in their individual capacity) to consider a wide-ranging agenda of regulatory issues, under the aegis of the IIF (at Zurich in June 1995). Again Dallara got a cool reception. The BCBS discussed his proposal, and decided that any such meeting, if it was to be held, should be run by the BCBS, not by the IIF (BS/95/21). Thus: As to procedure, the Committee has taken the view that while informal meetings with the industry could be useful from time to time, it would be preferable that they should be organized by the Committee itself, which should define the occasion, the agenda and the people to be invited.2

The tone was, however, shortly to change, in the context of the recognition that the models used by the leading international banks to measure market risk were actually much superior to the, more ad hoc, Moreover, the B C B S argued that the timing was unfortunate since the B C B S was currently organising a workshop at Perugia (to celebrate the B C B S ’ twentieth anniversary) in September 1995, to cover an overlapping group of issues with an overlapping cast of participants. This was a slightly disingenuous argument since the Perugia workshop was largely academic (I was there), whereas the IIF proposal was for a strictly practitioner meeting. 2

416

Relationship with banks and banking regulators

techniques proposed by the bank regulators and the B C B S itself; see Chapter 7 on the Market Risk Amendment. So, when Dallara wrote again (10 November 1995) to suggest that the IIF Working Group on Quantitative Issues should work with representatives of the Basel Committee on certain aspects of the models-based approach to market risk capital requirements, he got a much more encouraging response. To be sure, Padoa-Schioppa delayed replying until the Market Risk Amendment was published on 10 January. But, with this now in the public arena, he wrote (BS/95/116) that ‘after careful consideration, the Committee welcomed the IIF’s proposal to work with the regulators on the efficient implementation of the models approach’. PadoaSchioppa’s letter went on to outline several technical areas where such cooperation might be particularly useful, and to suggest some ground rules for the joint work. This part of the letter is reproduced as Appendix A (i) to this chapter. Having thus agreed to work with IIF technical experts, three further related considerations were of concern to the B C B S , that is that the sample of banks analysed in such technical studies should not just be limited to IIF members; that the sample size be large enough; and that individual bank confidentiality be retained. This is set out in a further letter from Padoa-Schioppa to Dallara, 4 April 1996 (BS/96/14, Addendum), with the relevant Â�paragraphs reproduced as Appendix A (ii). Co-operation at the technical, modelling, level began almost immediately. The representatives of the BCBS models task force and of the IIF met on 15 March 1996, and ‘made significant progress’, as reported at much greater length in the note on ‘Status of work on model testing’ (BS/96/15, 20 March). Once it was recognised that the large international banks had a higher level of technical expertise on risk assessment and modelling than the regulators themselves, there was not much alternative for the BCBS than working more closely with them than previously, when almost all connection with individual commercial banks had been indirect and at arms length via the national bank supervisors (and with channels of communication being de haut en bas, questionnaires going down and answers coming back up). Of course one could argue that the regulators should ensure that they were always technically in the lead, but relative incentives and salary structures make that likely to be infeasible. In so far as the large international banks have stronger technical abilities in risk assessment and modelling, which the regulators have to take into account, does this also mean that such large banks may also be in a position to steer the regulatory process to their own advantage? This was, I would claim, not a problem during the period covered

Interactions with other banking regulators

417

here (1975–97), since such relative expertise only became recognised in the last year or so of the period. Whether individual national regulators/supervisors were ‘captured’ by their national banking industries in earlier years is a subject not considered here. But there is no evidence at all that the BCBS, as an international institution, was captured by the large international banks in these years (1975–97). Whether the same can be said of subsequent years will be for a later historian to determine. B

Interactions with other banking regulators



Supervisors/regulators in offshore centres

It may seem superficially surprising that the first, and therefore longest lasting, and closest relationship between the BCBS and other (nonG10) banking regulators and supervisors was with the group of offshore centre supervisors, mostly from small countries, often islands. But it should not really be surprising. Almost all large international banks operate primarily in G10 countries. They will only do international business (as contrasted with domestic business in host countries) in countries outside the G10 group that provide certain additional advantages. In the note on ‘Problems for bank supervisory authorities in the G-10 countries and Switzerland raised by the existence of offshore banking centres elsewhere in the world’ (BS/78/2), reproduced as Appendix B, four such advantages are enumerated: 1. Fiscal and other cost advantages; 2. Other legal advantages; 3. Freedom from macroeconomic controls, such as exchange controls; and 4. Advantages of location. Thus the main gaps in tracking and observing international financial transactions outside the G10 were likely to be found in such offshore centres, rather than in emerging countries in various stages of development. In particular much of the international loan business then was being booked through such offshore banking centres, of which the BCBS knew little. Nevertheless, the concern of the BCBS with such offshore centres did not arise from such general considerations, but was triggered by a particular event:€ the Chiasso Affair. In this affair, the Manager of the Credit Suisse branch in Chiasso diverted a lot of clients’ moneys (mostly from Italian sources) and some Credit Suisse assets that had

418

Relationship with banks and banking regulators

gone sour and that he wanted to hide, into a brass plate company in Liechtenstein, called Texon. The Manager, a Mr Kuhrmeier, told the clients that Texon was an affiliate of Credit Suisse, and even provided them, if requested, with purported guarantees for Texon by Credit Suisse, while keeping all trace of Texon (and such fake guarantees) hidden from Credit Suisse. As noted earlier in Chapter 3, the reason why the B C B S discussed such bank failures in detail was primarily to see what more general lessons for bank supervision might be distilled from such extreme events. So the Chiasso Affair stimulated a wider concern about offshore centres, starting with a paper by the Swiss Federal Banking Commission (BS/77/49) on ‘The supervision of banks based in Liechtenstein, the Bahamas, the Cayman Islands, etc.’, and then followed by papers by the UK (Rodney Galpin, BS/77/50) on ‘The control of relationships with off-shore centres’, by the Germans on ‘Activities of Liechtenstein-based companies in FRG’ (BS/77/51), by the Nederlandsche Bank (BS/77/54) on ‘Some lessons for the banking system to be learned from the Credit Suisse affair at Chiasso’, by Luxembourg (BS/77/56), the French Commission de Controle des Banques (BS/77/58), and so on. So, although the initial triggering event was a specific case of criminal fraud, the question of how the supervisory community should deal with offshore centres was much more general. On the basis of the member country submissions, the Secretariat and the Chairman then produced two major documents. The first, entitled ‘The Credit Suisse affair at Chiasso:€ lessons to be drawn’ (BS/78/1), dated March 1978, restated the essential elements of the fraud, and the immediate lessons for internal bank governance, for external auditors and for supervisors, but did not, intentionally, deal with the more general question of relationships with offshore centres. This latter, more important, issue was left for the paper already mentioned at the start of this subsection (BS/78/2) and reproduced as Appendix B. Having gone through the various problems that such offshore centres might entail for B C B S member supervisors, the authors came to a strong conclusion that the right way to proceed was not by confrontation, trying to suppress or prevent financial operations in such offshore centres, but by cooperation with them. Thus: The Committee is strongly convinced of the need to promote the integrity of banking supervision internationally, and to work towards a situation in which no bank remains unsupervised. As one step towards achieving this aim it believes that member countries should seek the co-operation of offshore

Interactions with other banking regulators

419

� centres in matters of banking supervision, in particular of those centres where banking supervision is at present nonexistent or minimal. The Committee is therefore of the opinion that for this purpose member countries should make a joint and simultaneous approach to the supervisory authorities, or to the authorities responsible for bank authorisation procedures, in all offshore centres.

While a cooperative, rather than a confrontational, approach may, with hindsight, appear obvious, since it paid such large dividends, it was not necessarily so clear at the time, and was a statesmanlike decision. Anyhow, this paper was sent to the Governors, under cover of a letter from Chairman Peter Cooke, in August 1978. The next stage was naturally to organise a meeting with the offshore supervisors. Despite the Governors presumably agreeing to such a step, no such meeting was set in motion until 1980, when, at the eighteenth BCBS meeting (28–29 February), the Chairman proposed to invite supervisors from some twelve such centres to a one-day meeting in conjunction with the BCBS regular October meeting, the agenda for which could be decided at their next June meeting (BS/80/21). Quite what caused the delay of over one year is not clear. Moreover, the BCBS seemed to have a somewhat hazy knowledge of what were the main offshore centres. In the ‘illustrative’ list accompanying the note BS/78/2, the following countries were listed:€Bahamas, Bahrain, Barbados, Bermuda, Cayman Islands, Hong Kong, Lebanon, Liberia, Netherlands Antilles, New Hebrides, Panama, Singapore. Not only were the UK Channel Islands absent from the list, but also, considering that the note was sparked by the Chiasso Affair, so was Liechtenstein! Perhaps the BCBS had been advised that Liechtenstein was unlikely to cooperate? By the time that invitations were sent out for the October meeting (in July 1980), the list had been revised to Bahamas, Bahrain, Cayman Islands, Guernsey, Hong Kong, Jersey, Netherland Antilles, Panama and Singapore. Lebanon was added later. Neither the Isle of Man, Gibraltar, nor Liechtenstein was included on either list. Barbados, Bermuda, Liberia and the New Hebrides were included in the first list, but not the second. Quite what the criteria might be for counting as an offshore financial centre was (and remains?) not at all clear. Be that as it may, the meeting was to be preceded by an exchange of papers. The BCBS provided a paper on ‘The principles of international co-operation between banking supervisory authorities’ (BS/80/38) (September 1980), an earlier, and shorter, note-form of which (BS/80/31) is reproduced as Appendix C. In return the centres invited were asked to prepare:

420

Relationship with banks and banking regulators

a paper describing the banking and market structure and the supervisory approach in their country with any particular emphasis on points which may be thought to be of special interest to them or to the international supervisory community. This paper could form the basis for a brief oral presentation by each centre at the initial session of the joint meeting.

Each of them (and Lebanon) did so (BS/80/41.1€– 41.10). The meeting was felt by the G-10 supervisors and the offshore supervisors to have been very worthwhile. Both groups of supervisors felt that they had benefited considerably from hearing of the concerns and the approach of their colleagues in other centres. The offshore supervisors themselves recognised there was a wide diversity between their centres€ – from major transaction centres (like Hong Kong and Singapore) to almost exclusively booking centres (like the Bahamas and the Cayman Islands). Nonetheless, a great deal of common ground was apparent among them and a general willingness to work together in a spirit of co-operation. Good personal relations were established among the participants and this should have a valuable longer-term benefit. The meeting started perhaps a little cautiously, but as it progressed the visitors were increasingly prepared to talk freely and frankly about their concerns and the G-10 Committee of Supervisors was impressed by the degree of professionalism and grasp of important issues shown by the offshore supervisors. All in all, the Committee felt the discussions had introduced a useful, fresh dimension to its perception of international banking business which could not easily be obtained through its regular discussions.3

In a sense those invited to, and agreeable to participate in, a dialogue with the BCBS represented a ‘coalition of the willing’. And as other centres became prepared to join the group, they were added to the list. Thus, by the next meeting (October 1982) Barbados, Cyprus, Gibraltar, the Isle of Man and Vanuatu had joined the group (but Panama was no longer represented) (BS/82/48). It was, no doubt, helpful that a large majority of the ‘willing’ offshore supervisors had had a close connection with the UK in general, and with the Bank of England in particular, for example over exchange control matters. Mr G. C. Powell, economic adviser to the States of Jersey, was a strong supporter of such cooperation between the BCBS and the It was noted that areas of continuing concern related to: 3

1. the licensing procedures for new banks in a few such centres; 2. the growth in foreign exchange business was outdistancing the capacities of the offshore supervisors to monitor it; 3. the lack of local liquidity to support the large volume of business, which raised an (unanswered) question about the willingness of parent banks’ central banks to provide lender of last resort assistance in a crisis. Also see ‘Report on International Developments in Banking Supervision’ 1981 (B C B S , July 1982), pp. 18–19.

Interactions with other banking regulators

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offshore centres, and became Chairman of the latter group (BS/82/16).4 Indeed, prior to the next meeting of the BCBS with the offshore supervisors in October 1982, it was Colin Powell, rather than the Secretariat or Chairman of the BCBS, who effectively wrote the agenda paper5 for the meeting (BS/82/29, 36 and 41). Powell continued to take an active role, not only in the narrower concerns of the offshore group, but also in the wider work of the BCBS. When the Concordat (see Chapter 4) was under revision in 1982, he was one of the very few outside the BCBS itself to comment on it (BS/83/5). He encouraged a proposal to establish a Memorandum of Understanding (MOU) between the BCBS and the offshore group.6 Once the revised Concordat was made available, the Coljé subgroup of the BCBS was asked to report on its implementation. In its report (BS/83/73) (October 1983) it noted that: it is appropriate for the Committee to discuss not only the principles of supervisory co-operation but its practical application too. Recognising that considerable duplication of effort would be involved if each authority strictly followed the guidelines laid down in the Concordat for bilateral approaches to other supervisors, the sub-group believes that a co-ordinated approach by the Group of Ten countries would be very helpful. Such an approach would imply that the Committee discuss details of the experiences members have had in their contacts with other supervisory authorities; in the past there may not have been sufficient opportunity for interchanges of this nature. At the same time, the sub-group feels that great care needs to be taken when reviewing supervisory standards in other countries. In its report to the Governors on the problems

The first meeting in Basel in 1980 was chaired by Abdullah Hassan Saif, Governor of the Bahrain Monetary Authority. 5 This paper concluded that: 4

It is to be recognised that there are considerable differences in supervisory approach from one country to another. The distinction between the approach of the US Supervisory Authorities, that of the Bank of England, and of other members of the Group of ten countries has been highlighted at the two international conferences of Banking Supervisors held in recent years. What parent supervisory authorities might accept, it is suggested, is that in applying the concept of consolidated supervision it may not be possible or practical to extend their own mode of supervision, without modification, to other jurisdictions. An inability to send inspection teams to the branch or subsidiary offices in an offshore centre need not necessarily be a cause for concern if through adopting a somewhat different approach (e.g. the use of external auditors to confirm procedures etc.) satisfaction can be obtained as to the degree to which the parent authorities requirements are being applied equally in other jurisdictions. This flexible, pragmatic, approach is in the view of the Offshore Group the more likely to develop into worthwhile results if closer links are established between the Supervisory Authorities concerned. On which, see Annex 3 of BS/82/82 (fourth revision) and BS/86/94. NB:€by this time Panama had rejoined the group. 6

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raised by the existence of offshore centres (BS/78/2), the Committee concluded that a co-operative and educational approach was preferable to any form of confrontation. Now that the benefits of this approach are beginning to bear fruit, the sub-group believes that the Committee should be careful not to compromise that principle. In particular, if it became known that the Committee as a body was formally seeking to judge, and perhaps condemn, particular supervisory regimes, the sub-group fears that the Committee would become subject to publicity and political pressure which would make it more difficult for it to operate effectively.7

Accordingly, at the next meeting between the BCBS and the offshore supervisors’ group (2–3 May 1985, in London) (BS/85/47), which mainly discussed practical problems in the implementation of the Concordat, the Chairman: suggested that a small joint working group be established under the chairmanship of Mr Powell, with two or three representatives from each group of supervisors present at the meeting … The findings of the work group would result in a framework capable of general application for collaboration between supervisors in implementing those aspects of the Concordat requiring crossborder transfers of information.

The terms of reference for this working group (BS/85/43) were jointly signed by Peter Cooke and Colin Powell. It was agreed that the Powell working group would meet in June. With typical drive and energy, the working group came out with a report on ‘Practical aspects of information flows’ by early October of the same year (BS/85/65, whose recommendations were further summarised in BS/85/89). This indicates how far the offshore group of supervisors, and in particular Colin Powell himself, were integrated into the wider work of the BCBS. If not unique, it was certainly very rare for someone outside the BCBS itself to chair one of their working groups.

Moreover, under the proposals for action at the end of this paper was included the following suggestion: 7

(b) that a questionnaire along the lines of the annex attached should be completed by Committee members; that the Chairman of the Offshore Supervisors’ Group should be approached to see whether any or all of his members would be ready to complete the same questionnaire, making it clear that it was a ‘trial run’ (paragraph 5); that the sub-group should meet again in the spring of 1984 to consider the answers to the questionnaire and to revise or expand it where necessary; that the revised questionnaire should be presented by the Committee to the participants at the international conference of banking supervisors in Rome in September 1984 with an explanation of its purpose; and that all participants who had not already done so should be invited to complete and return the questionnaire to the Committee Secretariat, on the understanding that all answers to it (including those of Committee members) would be made available to all respondents (paragraph 6).

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Meanwhile, Powell had written directly to Peter Cooke, 19 September 1984 (BS/84/61), suggesting an even closer relationship between the offshore group and the BCBS, as follows: Personally, I feel considerable progress has been achieved through the several opportunities that have arisen over the past four years in establishing a positive, open and friendly relationship between the members of the Offshore Group and of your Committee. For that we owe much to your good offices. My hope is that what has been achieved to-date can be further extended through an even closer working relationship in the future. Thoughts that I would leave with you in this context, in addition to those already referred to above, are: (i) the possibility of one or two members of the Basle Committee attending meetings of the Offshore Group – with the thought that Switzerland might have a permanent representative on the Group (I found of particular interest the similarities between much of what Mr Mueller had to say in his paper on the implementation of the Concordat in Switzerland and the views expressed by the Offshore Group); and (ii) the possibility of the Chairman of the Offshore Group and/or other members of the Group being invited from time to time to sit as observers at the meetings of the Basle Committee.

By that time, however, several other regional groupings of supervisors besides the offshore group had been established, on which more in the next subsection. Although the offshore group was not only the first, but in some ways closest to the BCBS, the BCBS could hardly play favourites among the groups. Moreover, the proliferation of regional groups raised the question of how to handle procedural relationships with them all. Finally, the idea of an (increasing) number of outside observers at BCBS meetings did not find support. All this was discussed at the next, thirty-second, meeting of the BCBS (5–6 November 1984) (BS/84/70): The Committee discussed its future relationship with other supervisory groupings, in particular with the Offshore Supervisors’ Group in the light of the letter the Chairman had received from Mr Powell (BS/84/61). Given the wish to preserve the existing homogeneity of the Committee’s membership and the limited time which could be spared for meetings with other groups of supervisors, it was decided to propose the setting-up of a steering committee, on which a small number of members of each supervisory grouping would be represented, to meet annually to coordinate the work being conducted in the various fora. If discussion by different groups of particular topics was considered desirable, they could be tackled by setting up joint working parties consisting of selected members of the groups concerned. The Chairman said that he would reply to Mr Powell’s letter proposing those two options, but without

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suggesting at this stage another joint meeting or regular participation by Mr Powell as an observer in the Committee’s meetings. It was also agreed that, if it could be arranged, it would be desirable to hold regular training courses in Basle to which non-G-10 supervisors might be invited.

Also relevant, and to the next subsection, is the note (BS/87/21), which questioned the value of BCBS meetings with other groups of supervisors, reproduced as Appendix D. Despite some such soul-searching on the benefits (to the BCBS) of bilateral meetings with other groupings of (regional) supervisors, occasional meetings with the offshore group continued. The next one was on 5 October 19898 (BS/89/109), considering implementation of both the Concordat (and its extension) (see BS/89/62) and the Basel I CAR Accord, money laundering and the relationship between supervisors and external auditors (BS/89/54). The paper on the implementation of the Concordat (BS/89/62) could, it was agreed, be reworked into a supplement to the Concordat. The other main purpose of the meeting was to obtain a widespread and positive response to the Committee’s prior Statement of Principles on money laundering (see also Chapter 11) (BS/89/64). No doubt the offshore group held meetings on its own, as well as meetings in conjunction with the BCBS. But if, and when, it did so, it did not feel obliged to send notes on its deliberations to the BCBS (or at least I failed to find any such in the archives) prior to 1991. In October (30–31) 1991, however, in the immediate aftermath of the BCCI affair, the offshore group of banking supervisors held a meeting at the Federal Reserve Board in Washington DC. The apparent main purpose of this meeting was to voice concern that offshore centres, as a group, were being blamed (for providing the context in which such an affair could occur), and to reiterate that members were as committed to the Concordat and to Basel I as any other countries. Furthermore, the offshore group ‘reviewed its conditions for membership’9 and agreed in principle that it: should depend on: (a) the necessary legislation being in place to provide for the principles of effective banking supervision to be implemented …â•›. (letter from Colin Powell to Gerald Corrigan, then Chairman of the BCBS, BS/91/97) 8 By now Aruba had joined the offshore group, and Bermuda and Malta sent representatives. 9 I noted that Panama was not among those attending the meeting; Nicaragua had never been a member.

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On the subject of the implementation of the Basel Concordat the following quote is taken from the ‘Report on International Developments in Banking Supervision’, Report 7 (BCBS 1990): In collaboration with the Offshore Group of Banking Supervisors, the Basel Committee has in recent years been exploring practical ways of implementing those aspects of the revised Concordat of 1983 which require flows of cross-border information between supervisory authorities. A joint report by the two Committees was discussed at the fourth international conference of banking supervisors in Amsterdam in October 1986, resulting in the circulation to supervisory authorities worldwide in August 1987 of a paper containing recommendations for practical international collaboration between banking supervisory authorities. The Committee believes the time has now come to recognise the permanent status of the 1987 paper by reviewing and re-issuing its proposals as a supplement to the 1983 Concordat.

In response to this, at the next BCBS (sixty-first) meeting (4–5 December 1991) it was suggested that: the time was opportune to renew contracts with the group and the Chairman replied that he was in the process of setting up a meeting. This has now been done for the 4th March, the day preceding the next Committee meeting. The Chairman suggests it would also be beneficial if Mr Powell were invited to participate in the Committee’s discussion on BCCI the following day. This would also give members an opportunity to respond to the points in Mr Powell’s letter. (BS/92/6)

There is no record (that I could find) of a meeting between the offshore group and the BCBS on 4 March. However, Powell did attend the BCBS discussion related to BCCI on 5 March. Here the main focus of attention was the (first draft of the) paper on ‘Minimum standards for the supervision of international banking groups and their crossborder establishments’ (BS/92/15) (also refer back to Chapter 4). Powell strongly welcomed this in a letter to Peter Hayward (10 March 1992) (BS/92/23), though he argued for stronger sanctions against lax regimes.10,11 10 ‘I appreciate why the Basle Committee is happier with the idea of simply giving a moral lead to supervisors world wide than with attempting to enforce minimum standards, but I feel there needs to be some “sanction” against those supervisory authorities who do not follow that lead. One sanction that some authorities have already employed, I believe, is for the parental supervisory authority to put pressure on the banks for which they are responsible to close branches or subsidiaries established in centres with a lax supervisory regime. Another sanction would be for host authorities to attach tighter conditions to the branches/subsidiaries of a bank that they believe is not subject to effective consolidated supervision by a parental authority.’ (BS/92/23) 11 The B C B S issued a questionnaire to all supervisory authorities on issues raised by the BCCI affair. The responses of the offshore group were collected together in a paper sent to the B C B S on 14 September 1992 (BS/92/96).

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Colin Powell then wrote to the BCBS (3 November 1993) with comments from the offshore group on the ‘Minimum standards’ paper: The Offshore Group endorses the Basle Committee’s minimum standards for the supervision of International Banking Groups and their cross border establishments. The Members are also committed to the application of the standards and to the objective of ensuring that the principles of the Concordat and the Supplement to the Concordat are applied in practice. The Basle Committee will be aware that the Offshore Group was directly involved in the drafting of the Supplement.

This preamble was followed by a whole series of specific points on the paper. The Secretariat professed that these were not easy to interpret: but reading between the lines it seems the points are essentially: 1. Quality of host country supervision (i) Home supervisors need to assess the quality of supervision in offshore centres on a case by case basis and not tar them all with the same brush. (ii) Where on-site inspections are not permitted, there are often satisfactory alternative arrangements for verification and the centres concerned would like to discuss the possibilities before home authorities take restrictive action. (iii) Home supervisory authorities have different views as to what is adequate host supervision€ – for example some accept a much wider use of external auditors in the supervisory process while others do not. There should be greater tolerance and trust. (iv) The Offshore Group is concerned that ‘the minimum standards could develop as legislative requirements as opposed to a best efforts approach on a case by case basis’. 2. Enhancing contacts and information exchanges (i) A contact list is needed to determine who is responsible for outward authorisation in each home supervisory authority. (Question:€ is this normally the same person as in the ‘red book’?)12 (ii) If a home supervisor decides that a bank is not ‘fit and proper’ to establish a foreign establishment he should nonetheless discuss the matter with the intended host in case a licence could be issued subject to special conditions. (iii)╇ Exchanges of information for effective consolidated supervision should not include information relating to individual depositors. (iv) Information passed to home supervisors should offer ‘the same degree of protection of confidentiality as the provider of the information’. Legislative changes may be needed. (BS/93/51)

12 At some date around 1992, at Chairman Corrigan’s initiative, the B C B S Secretariat compiled a contact list of approved banking supervisory authorities around the world. This was, I believe, the ‘red book’.

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Powell continued to push for himself and the offshore group to be involved in further work on this subject. Thus the Secretariat recorded, 25 May 1994 (BS/94/37) that: The Chairman has recently received a visit from the Offshore Group’s Chairman, Mr Powell, who suggested that a meeting between a small number of members from both the Offshore Group and the Committee might be held to examine the Offshore Group’s note and seek to clarify certain aspects of the minimum standards. Members may recall that about ten years ago similar joint work with the Offshore Group in connection with the revised Concordat of 1983 was useful in fleshing out important questions of implementation. The results of that study were discussed at the 1986 ICBS and formed the core of the Supplement to the Concordat issued in April 1990. Before agreeing to set any work in train, the Chairman indicated to Mr€Powell that he would need to seek the Committee’s approval. What is envisaged is a group consisting of four or five members from each Committee under the Â�co-chairmanship of Mr Powell and one of our members, with a mandate to report back to the two Committees within a year. The objective of the meeting could be to discuss and hopefully agree either on the need for and form of further discussions or on the content of an exchange of letters.

This led, at the end of 1994, to the establishment of a second joint working party between the BCB S and the offshore group, which was Â�co-chaired by Colin Powell and Erik Musch, who had by then succeeded Peter Hayward with the upgraded title of ‘Secretary General’. It held three meetings and then presented its interim report towards the end of 1995, revised in February 1996 (BS/95/73). The report was ‘prepared in the form of a discussion paper for consideration at the ninth ICBS in Stockholm next June 1996. For this reason, it was felt necessary to solicit the views of the two Committees at this juncture, even though some passages in the report have not yet been fully agreed by all members.’13 This 13 The outcome was the report on ‘The supervision of cross-border banking’ issued by the B C B S in October 1996, whose preface states that: This document reproduces a report prepared by a working group consisting of members of the Basel Committee on Banking Supervision and the Offshore Group of Banking Supervisors … The working group was established in order to consider a number of problems which had been experienced in the implementation of the Basel Committee’s report ‘Minimum Standards for the Supervision of International Banking Groups and their Cross-Border Establishments’ (July 1992) and to suggest practical solutions … The Basel Committee and the Offshore Group have endorsed the report and their members have undertaken to use their powers to work towards the implementation of its recommendations … In June 1996, the report was discussed at the Ninth International Conference of Banking Supervisors in Stockholm … Following detailed discussion of the contents of the report, Conference participants, in their capacity as bank supervisors, endorsed the principles set out in the report and undertook to work towards their implementation in national centres. This report was a significant document in establishing relationships between home and host supervisors.

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was then further supported by a descriptive paper on ‘â•›“Offshore” centres’ by Powell (BS/95/92). The conclusions of this, and his listing of such centres, is reproduced as Appendix E. This was the final record (found by me) of relationships with Colin Powell and the offshore group of supervisors until the end of my time period, the end of 1997. Given his phenomenal energy and enthusiasm, I have little doubt that he, and the offshore group, continued to interact with the BCBS in later years.

Other non-G10 banking supervisors, and the International Conferences of Banking Supervisors (ICBS)

Largely because of Colin Powell’s personal efforts, the offshore group of banking supervisors was not only the first to become organised by, and involved with, the BCBS, but also remained more closely connected with the BCBS than any other (regional) group. Most of such regional groups were focussed on concerns specific to their own areas, meeting together primarily in their own territories, and did not interact qua group directly with the BCBS. Most such groups took the opportunity to meet together around the occasions of the International Conferences of Banking Supervisors, held every second year, starting in London in July 1979, which was the main venue where participants in such groups came into contact with BCBS members and other supervisors worldwide. The one exception (that I have found) to this general description relates to the Gulf Co-operation Council (GCC), founded in 1981, consisting of Bahrain, Kuwait, Saudi Arabia, Oman, Qatar and the United Arab Emirates; see report on ‘International Developments in Banking Supervision’, Report 6 (BI S , September 1988). Having heard about the formation of the GCC, Peter Cooke, Chairman of the BC B S , wrote to Governor Al-Quraishi of the Saudi Arabian Monetary Authority (SAMA) to encourage cooperation, a dialogue and possible meetings between the BC B S and the GCC (BS/82/55) in a letter dated 16 September 1982, reproduced as Appendix F. In the event, the BC B S did hold a couple of joint meetings with the GCC. A note on ‘Relations with the Gulf Co-operation Council’, (BS/89/15, 21 February 1989) gives some background: The Gulf Co-operation Council was instituted in 1981 to foster co-operation between its six members (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates). A GCC Committee of bank supervisors, created by the GCC central-bank Governors, first met in 1983. Following bilateral contacts with Mr Cooke … the Committee was invited to send a representative to talk about the Concordat at a meeting in Riyadh in May 1984. Mr Danielsson kindly agreed to travel to Riyadh but the meeting was then cancelled.

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Early in 1986 Mr Cooke met Dr El-Kuwaiz, Secretary General of the GCC Committee, which resulted in a visit to Basle by fifteen GCC supervisors in December 1986, led by Governor Abdullah Saif of Bahrain. The GCC representatives held a meeting on their own in the BIS on 10th December and a joint meeting took place with the Basle Committee on 11th. Three discussion papers for the joint meeting were prepared by the BIS Secretariat (on asset quality and provisioning, external auditors and the incorporation of off-balance-sheet risks within capital measurement). A fourth paper on the freezing of assets, which the GCC side volunteered to prepare, was never circulated. Although the GCC representatives showed themselves to be well-informed about the supervisory issues involved, and some interesting information was supplied about the supervisory problems in the Gulf, none of the discussions led to any particular conclusions or future work (see informal record BS/87/5). Subsequently, the Committee was invited by the GCC supervisors to a joint meeting in Riyadh on 22nd February 1988. A delegation of eight Committee members was assembled … and preliminary work on an agenda undertaken by the Secretariat but, on 31st January, the meeting was called off owing to the illness of Governor Saif’s son. The Chairman has now received an invitation for the Committee to visit Riyadh in June 1989 (see BS/88/122). He will wish to canvass members’ views at the March meeting on what response to give. The invitation comes at an awkward moment. The major point at issue is the ‘club’ approach to country risk and this is not a subject on which the Committee would have anything new to say at this stage. On the other hand, the Committee has accepted an invitation to visit the Middle East in the past and it would therefore seem discourteous to reject the latest invitation. Nevertheless, June is a very hot month in the Gulf and it would be easy to plead that the Chairman’s state of health does not favour a trip at that time.

The awkwardness about the GCC invitation to a meeting in Riyadh (sent in January 1989) lay in the concerns of members of the GCC, other than Saudi Arabia, and especially Kuwait, of being excluded from the ‘club’ of countries whose public sector debt would carry a zero risk weight (see Chapter 6 for an extended discussion of the brouhaha over that). The BCBS were not keen to become embroiled in a battle over the club approach in the summer heat of Riyadh. With respect to the latter the BCBS deferred the date of the meeting until January 1990. Although the agenda was again quite general (BS/89/75), the BCBS remained nervous about being tackled on the subject of the definition of the ‘club’, and a defensive briefing was prepared (BS/89/120). In the event, however, their hosts were far too polite to make a public issue of the matter, though it was raised, en passant, by Mr Al-Wazan of the Bahrain Monetary Authority, and a couple of other GCC participants. In the main, however, the meeting discussed more general issues, such as information flows between supervisors, large exposures, EC banking directives, and so on (see BS/90/17, ‘Summary of highlights of discussion’).

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None of the other regional groupings of supervisors held face-to-face meetings with the BCBS (as far as I am aware), but they nevertheless had their own programmes of regional meetings, conferences, and so on. Such groups by end 1997 included:14

• The Arab Committee on Banking Supervision, founded in 1991. • The Caribbean Bank Supervisors Group, formalised in 1996. • The Group of Banking Supervisors from Central and Eastern Europe,

constituted in 1990. • The East and Southern Africa Banking Supervisors Group, started in 1993. • The Executives Meeting of East Asian and Pacific Central Banks (EMEAP) Study Group on Banking Supervision, founded in 1996. • The SEANZA forum of banking supervisors (South East Asia, New Zealand and Australia), established in 1984. • The Transcaucasia and Central Asia Supervisors Group, founded in 1995. • Plus several European groups of banking supervisors, relationships between whom and the BCB S will be discussed in the following subsection. (See ‘Report on International Developments in Banking Supervision’, Report 11 (BCB S, October 1998), Chapter VII, pp. 119–93.) This plethora of groups, which expanded hugely in the 1990s, neither expected, nor probably wanted, direct contact with the BCBS. Instead, the main forum for contact was the International Conference of Banking Supervisors and the main publication for disseminating the work being done was the ‘Report on International Developments in Banking Supervision’. The first ICBS was held in London in July 1979. This was first mooted in the fourteenth meeting of the BCBS in October 1978 (BS/78/41), when Chairman Peter Cooke: informed the Committee that, in view of the interest expressed by bank supervisors outside the G-10 and Switzerland in the Committee’s work, he was considering the merits of a special meeting in which a wider group of bank supervisors could participate. The Committee agreed that this should be explored further and the Chairman invited members to pass on to him any comments they might have on the organisation of such a meeting.

Shortly after the beginning of 1979 an outline programme and a list of invitees were prepared (BS/79/20). The outline programme is reproduced as Appendix G. The invitees were all professionally connected 14 Also see Walker (2001), Section 6.10.4, pp. 60–8.

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with bank supervision. As already noted in Appendix D, some 110 participants from non-G10 countries, representing 83 countries, attended the first London conference. Subsequent ICBS conferences during the period up until the end of 1997 were held in: Washington Rome Amsterdam Tokyo Frankfurt Cannes Vienna Stockholm

September 1981 September 1984 October 1986 October 1988 October 1990 October 1992 October 1994 June 1996

The meetings were large from the outset, and grew larger. By the time of the Stockholm Conference representatives from over 140 countries were expected, with up to three hundred participants.15 The participants€– the invitees€– were almost entirely limited to professional bank supervisors. The purpose of the exercise was, and remains, to showcase the work of the BCBS when it was ready to be unveiled, to involve nonG10 supervisors in discussions of how to improve current work on bank supervision, and to imbue all country bank supervisors with the notion that they belonged to a professional club with common principles and objectives. To that end the conference is quite tightly choreographed in advance with set speeches from the host central bank, the Chairman of BCBS, and other eminent banking supervisors (both G10 and nonG10), interspersed with smaller panel discussions on allocated issues, usually involving both BCBS members and other G10 and non-G10 supervisors. The subject matter, both for the set speeches and the panel discussions, generally relate to issues that had been of concern to the BCBS and to the banking supervisory community in the previous two calendar years. Thus, most of the issues successfully addressed by the BCBS (and noted in Chapters 4–11) would subsequently be rehearsed and discussed at ICBS meetings, with an average lag of a year or two. Combining the ICBS and the publication of the ‘Report on InterÂ� national Developments in Banking Supervision’,16 both occurring once every two years, the community of banking supervisors should have been able to gain a reasonably clear picture of what had been attracting 15 The Secretariat tried to keep numbers down, and there were never more than about 260 invited visitors, which, with the addition of hosts, came to a total of about 300. 16 This was designed to be a key brief for the ICBS, but was sometimes delayed and perhaps too lengthy for this purpose.

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the attention of the BCBS and the way that its thinking had been developing. But, as always, there were complaints that yet more could be done to improve communication flows, especially from the BCBS to nonG10 bank supervisors. Thus, in the follow-up note on ‘Issues resulting from the various working groups during the VIIth ICBS at Cannes’ (BS/92/100), the Secretariat recorded that: There was a strongly expressed need from the side of countries to have more contact with the Committee for a timely exchange of information, both for airing their views and hearing about the results of the Committee’s work. In the past the Committee has occasionally held a joint meeting with a regional group of supervisors (Offshore Group, GCC) but with long intervals of roughly four years. The groups’ own meetings have usually been attended by the Committee’s Secretariat and a few members of G-10 supervisory authorities, mainly from the United Kingdom and United States. It appears that these regional meetings lack preparation and detailed agendas, and are in some cases not much more than social gatherings. To obtain more structure and more involvement by the Committee the following points could be suggested for consideration by each regional group: – the Secretariat is prepared to assist in the preparation of regional meetings. This work could take the form of structuring the agenda and circulating discussion papers; – at regional meetings the Secretary could make a presentation on the Committee’s work and possibly co-chair some sessions, reporting back to the Committee on the views expressed; – each regional group would benefit from having its own permanent Secretariat. Some (e.g. CEMLA, GCC) have this already, others lack even a start. A gradual development in this direction might be suggested and supported, and there should be permanent close contacts between the Basle Secretariat and those of the regional groupings. There could possibly be a demonstration effect:€if the structure works well with one regional group, the others might follow suit; – occasional meetings at not less than four-yearly intervals between the Committee and some regional groups could still be useful but, if the abovementioned Â�procedure works well, there would be less of a direct need for them.

A much longer note on ‘Options for strengthening relations between Basle Committee and non-G-10 supervisors’ was subsequently prepared by the Secretariat (BS/93/5). This was divided into three sections: A. Working harder along existing lines (i) A larger, better address list;17 17 The ‘red book’ mentioned earlier in footnote 12.

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(ii) A new questionnaire on home/host relationships; (iii) Extending bilateral contacts with individual supervisors; (iv) Accepting more speaking engagements; (v) Having a tour de table, for example on minimum standards, at ICBS; (vi) Widening list of countries receiving BCBS documents.18

B. More substance and more frequent contacts

(i) Intensifying contacts with regional groups; (ii) Fostering secretariats for such groups; (iii) Holding joint meetings with the BCBS; (iv) BCBS participation in regional meetings; (v) Expand frequency and depth of information circulated; (vi) Analyse questionnaire on home/host supervision.

C. More ambitious efforts

(i) Training; (ii) Prepare a manual on good supervisory practice; (iii) Compile a database on national supervisory systems.

When this note was discussed at the next (sixty-sixth) BCBS meeting (4–5 March 1993) (BS/93/19): it was agreed that extending cooperation along existing lines as described in Section I was acceptable but that no action should be taken to pursue invitations involving significant new resources (Section III). The proposals in Section II to put the Committee’s relationships with the regional groups on a more structured basis were broadly supported. The Secretariat was asked to spell out for consideration at the June meeting exactly what was likely to be involved. Once agreed, these proposals could be discussed with the BIS management and perhaps also sent to Governors.

The main problem was shortage of resources, or in other words the pressures of work on the BIS Secretariat (see Chapter 3). But at least the BCBS was fully aware of the need to maintain as good communications with national supervisors outside of G10 countries as resources and the limited number of Secretariat staff allowed. There was no such concern about communication and presentation to a wider public of specialised journalists, academics, politicians, and so on. This was still before the era of central bank ‘glasnost’. The ICBS meetings and ‘Reports on International Developments’ were (almost entirely) restricted to professional bank supervisors. Whereas there was no great upset if some enquiring journalist or academic tried to delve deeper, and their questions would generally be answered, there was no attempt in these years to give a positive presentation to BCBS 18 Almost from the outset, the B C B S had been circulating agenda documents to a number of supervisory authorities in developed countries, e.g. other EU, Australia, New Zealand, Hong Kong and Singapore.

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activities, with the result, as will be discussed later, that its role was sometimes unrecognised, especially before 1988, or exaggerated, most frequently after 1988. From time to time, Peter Cooke approached the Governors with requests to broaden BCBS communications to a wider circle (BS/85/52), but the G10 Governors tended to believe that ‘least said, soonest mended’. Let me, finally in this subsection, return to the issue of training, already briefly noted in the final Section of BS/93/5. The idea of the BCBS (mainly via the Secretariat) holding training courses for (young) bank supervisors was first raised in a discussion between Peter Cooke and Colin Powell (following the latter’s September letter to Cooke (BS/84/61), which did not itself raise the question of training) in December 1984 (letter Cooke to Powell, BS/85/2). Cooke then raised the issue with Karl-Otto Pöhl, the Chairman of the G10 governors (BS/85/6). He received initially a cool response. In his note of the G10 governors March 1985 meeting, Cooke reported that: President Pöhl raised the question of training, suggesting that there was not much support for these proposals from Governors. Other Governors were more positive and it was agreed I would come back to the Governors with more considered proposals. I said I would hope to do this in time for their May meeting.

A letter containing such ‘more considered proposals’, plus an outline framework for such a course, was then prepared for the May meeting of the G10 governors, and revised again in July 1985. This revised letter and annex (BS/85/42) is reproduced as Appendix H. By the end of 1986, in the short summary record of the fortieth meeting of the BCBS (10–12 December) (BS/86/90): The Chairman reported that the Governors had now formally agreed that a limited programme of supervisory training courses could be conducted under the auspices of the Committee at one or two-yearly intervals. The courses would last for one week, and would be open to about 30 persons from nonG-10 as well as G-10 countries. He hoped that the first course would take place in the autumn of 198719 and asked the Secretariat to prepare an outline programme for members to comment on at the Committee’s next meeting.

Of course, the collapse of the communist empire then vastly increased the need for training, since there had been no real experience with true banking, nor much need for bank supervision, in those countries.20 19 It did, during the week of the 1987 NYSE crash. 20 A specialist and expert in this field, Harbrecht, was recruited from the Bundesbank to join the B C B S ’ secretariat to help with this work.

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Thus (BS/93/5) outlined the state of play on the provision of training in that year: At present [1993], the Secretariat organises a training course in the spring of each year. About 36 persons attend from a wide range of countries. Apart from the main fifteen or so countries, the Secretariat rings the changes in its invitations. The course is extremely popular and there is always a waiting list. The limitation specifies ‘relatively young staff who are likely to rise to high positions in their organisations’ but the average level of participants is high with some non-G-10 countries sending deputy heads of supervision or the equivalent. It would probably be counter-productive to expand the numbers beyond 35, and difficult administratively. To increase the frequency to twice a year would be a significant extra burden. One member of the Secretariat works full-time on the administration for about two months and all members, particularly the Secretary himself, are intensively involved just before and during the eight days of the course itself. An alternative would be for the Secretariat (and/or Committee members) to become more involved in the supervisory training courses which are organised in other forums. A summary of the training currently provided is attached at Annex 3 [reproduced as Appendix I(i)]. The Secretariat now participates in nearly all the courses conducted in English. However, in a few cases the participation may be relatively short (1–2 hours). Given the travel costs involved, the Secretariat now tries to insist that its speakers are allowed a half-day at least and preferably a full day. There still seems to be a substantial unfilled training need in many parts of the world and a more ambitious approach would be for the Secretariat to offer to organise targeted courses for individual regional groups or sub-groups. Such a programme would need careful preparation and, probably, the recruitment of a full-time training officer to the Secretariat with the necessary experience in administration and lecturing. It would also be necessary to draw on experts in member countries. A basic module (or modules) could be developed which could be repeated in different locations. An idea of what such a module could look like is attached at Annex 4 [reproduced as Appendix I(ii)].

The intensity of the BCBS’ work on training steadily increased, until the whole exercise was passed over to the Financial Stability Institute (FSI) in 1998.

Relationships with European banking supervisory groups

Of the twelve members of the BCBS, all but three (Canada, Japan and the USA) were European. So, even though the USA was its single most influential member, the BCBS was largely dominated by Europeans. Even so, Europe maintained its, supposedly separate, banking supervisory committees. As was described in Chapter 2, the background template for the BCBS was essentially the informal Groupe de Contact (on which Luxembourg had played a large role in 1972–4, which explains

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how it got a seat on the BCBS). Following the establishment of the BCBS, the Groupe de Contact did not dissolve, but instead widened to encompass all EEC supervisory authorities, and became formalised; see ‘Report on International Developments in Banking Supervision’ (BCBS 1981), Chapter III, pp. 10–13. Next there is the EEC Banking Advisory Committee. As noted in the above pamphlet, p. 14: The Banking Advisory Committee of the European Community was established in June 1979 under the terms of Article 11 of the First Banking Co-ordination Directive of 12th December 1977. Each Member State is represented by a maximum of three senior officials drawn from Ministries, central banks and banking commissions. The European Commission also has three representatives on the Committee, as well as providing its Secretariat. The main function of the Committee, which usually meets twice a year (in June/July and in December), is to advise the European Commission on moves to harmonise the regulatory framework of the EEC banking systems.

Finally, following the Maastricht Treaty when the European Monetary Institute (EMI) was founded, 1 January 1994, it too was gifted with a Banking Supervisory Sub-Committee, which, after the European System of Central Banks (ESCB) was established in 1998, became transformed into the ESCB Banking Supervision Committee. So, besides dominating the BCBS in terms of numbers, the Europeans had no less than three additional banking supervisory committees. But at the same time the number of senior bank supervisors at European supervisory authorities was limited. So it was commonplace for such senior officials to sit on, and attend, two, or even more, of these committees simultaneously. There was much overlapping of membership. In this respect there was widespread understanding, and sharing of knowledge of what other committees were doing. Also recall from Chapter 3 that from 1987 onwards EC representatives could, and often did, attend BCBS meetings. Because of the importance of level-playing-field (cross-border competitiveness) issues, an international (supervisory) agreement encompassing North America and Japan, as well as Europe, was much more to be prized than one just covering the EU. As a result the BCBS was generally accepted as the senior, more important committee by the purely European groupings, and they generally deferred to, and accepted, its overall decisions.21 Nevertheless, the EC, and to a lesser extent the 21 In his speech to the F.€T. Conference on ‘Re-regulating Europe’s Financial Sector’, London, 16–17 October 1989, Chairman H.€J.€Muller stated that: In concluding, let me share with you some thoughts as to what I believe we need to bear in mind for the success of Europe as a banking market. First, there is already a

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EMI/ESCB, had agendas, timetables, internal and external (political) dynamics and viewpoints that from time to time differed from those of the BCBS, and could cause friction. Thus we saw in Chapter 6 how there were no less than three sets of proposals on risk ratios:€the AngloAmerican, those of the BCBS and, finally, those emanating from Brussels. Even so, in my own notes on archival material I only found two other occasions where there was some need for diplomatic adjustments in relationships between BCBS and Brussels. The first was in 1992, when there was an exchange of letters between Gerald Corrigan and Sir Leon Brittan, then Commissioner of the EC. They had agreed to notify each other of issues that might interfere with each other’s work (BS/92/64). Brittan had raised some questions about the BCBS’ postBCCI work, and Corrigan later responded to suggest that the progress on the EC’s Capital Adequacy Directive might be slowed to allow the BCBS more time to advance its work on the Market Risk Amendment. The second occurred in the form of a letter, from Padoa-Schioppa to Mr E. Vinci, the Secretary General of the European Parliament in December 1995, again partly about the Market Risk Amendment to Basel I (BS/95/117).22 Overall, however, the general impression is that relationships between the BCBS and the European supervisory bodies were generally good, and that the BCBS did not have to use up scarce time in diplomatic discussions with them. single market in financial services but it is a global one, not a European one. We in Europe cannot expect to thrive in isolation from the rest of the world. It is important to remember, as we have seen before, that European Directives concerned with the operations of the banking system (such as the agreements on consolidation, the definition of own funds and the solvency ratio) tend to be based on agreements concluded on a global scale in Basle. 22 The letter included the following paragraph: The Basle Committee contains representatives of seven members of the European Union. It is very conscious that the rules which apply to banks and securities houses subject to the Capital Adequacy Directive are different in several important respects from the Amendment to the Basle Capital Accord which has recently been agreed, particularly in so far as internal models can play a part in the risk measurement process. Two years of transition are envisaged before this Amendment has to be implemented by the G10 countries. I am confident that our European members can work with the European Commission and other European countries to ensure that consistency between the Basle guidelines and the European regulations can be maintained, as has successfully been done in the past. The Basle Committee has asked me to express to you its sincere hope that the European Parliament will look favourably on any suggestions the Commission may make, in consultation with member countries, to adapt the Capital Adequacy Directive to the rules that have been negotiated on the wider world stage. If that is not done, it may be costly and inefficient for the major European banks subject to the Basle capital standards which will have to observe two different requirements.

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Relationships with the IMF

The same, broadly, was true for relationships with the IMF. Prior to the last few years of our period, the Fund was primarily a macro-economicoriented institution (the quip was that IMF stood for ‘It’s mainly fiscal’), paying little concern to more micro-financial stability issues. So there was little overlap, or cause for friction, between the work of the IMF and that of the BCBS. But that was to change in the 1990s, and increasingly so after the East Asian crisis of 1997/98, when the IMF came to appreciate that international currency and macro-economic crises could be greatly influenced, and indeed sparked, by fragile financial stability in member countries. There was one earlier meeting between the BCBS and the IMF in 1983 relating to new international lending by major banks in the aftermath of the 1982 MAB (Mexico, Argentina and Brazil) crisis (see Chapter 6). There was a discussion of ‘New international lending by banks€– the interests of the supervisors and of the IMF’, at the twentyeighth meeting of the BCBS, 29–30 June 1983. The record shows that David Finch of the IMF attended for that agenda item only, and the short summary recorded (BS/83/49) that: Following a discussion of this issue, the Chairman said that he and Mr Finch would be in touch in due course to consider whether it would be worth holding a similar discussion in the future. Members were asked to write to the Chairman with their views on this first contact with the IMF and on how the Committee’s relationship with the IMF might usefully be developed.

In practice there was no formal23 follow-up to this initiative, and there were no further occasions on which an IMF representative attended BCBS meetings during these years. That said, there would have been many other occasions, some formal, some informal, when individual members of the BCBS would have met with IMF staff, so connections between the bodies and understanding of each other’s views and agenda would have been maintained, albeit not in a formal fashion at Basel. Relationships with the IMF subsequently came back onto the agenda, just at the end of our period in 1996/97. The impetus for this came from the politicians, who at the heads of state and government annual meetings had been taking an increasingly interventionist approach towards financial supervisory issues through the 1990s (see Chapters 13 and 23 Finch was also asked to join the B C B S for dinner on the first Thursday evening of their thirty-first meeting in June 1984, ‘for a discussion on international financial issues, particularly debt, of interest and concern to the IMF and to supervisors’ (BS/84/47).

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14). Thus, during the 1996 Lyon Summit, the heads of state ‘agreed that better prudential regulation and supervision in the financial markets are essential elements in preserving the stability of the international monetary and financial system’. They emphasised four objectives (to be reviewed at the next April summit). One of these was ‘the adoption of strong prudential standards in emerging countries’. In order to monitor and reinforce this, what was needed was some form of ‘rule-book’, or set of standards, or codes, or principles, by which supervisors in emerging countries might be assessed. Initially the BCBS took the view that its existing work, for example in consultation with non-G10 supervisors at the ICBS, was sufficient to meet this remit. Thus, in the annex to the draft letter to be sent from President Tietmeyer of the G10 governors to the Chairman of the G10 ministers (Mr Kubo) (BS/96/75), it was stated that: also in Stockholm, there was a substantive discussion on supervisory methods, in preparation for which the Basle Committee had conducted a survey of the national supervisory practices in about one hundred countries. Guided by the results of this survey, the Committee has set in train a process of consultation with supervisors in the emerging markets to establish what assistance it may be able to provide in the establishment of comprehensive prudential arrangements which meet acceptable international standards. It is important, in its view, that the arrangements be sufficiently flexible to meet the needs of countries in differing stages of financial development and that a consensus be reached with these countries on the form and content of such arrangements.

This was not enough to satisfy the I M F. It was fairly clear that any exercise to monitor national adherence to supervisory good practice, and to press for improvement, would have to fall within the province of the international financial institutions (IFI) in Washington, the I M F / I B R D, rather than to the B I S / B C B S in Basel. Although Andrew Crockett, General Manager of the B I S (January 1994– March 2003), was subsequently to widen B I S membership considerably, by 1996 the B I S board of directors was still limited to a narrow G10 membership, whereas the IMF had worldwide coverage. Moreover, the B I S simply did not have the resources/staff to take this on, whereas with some rearrangement of staff, plus secondment of supervisory specialists, the I M F / I B R D could tack the F S A P s (Financial Sector Assessment Program) onto their other regular oversight exercises. So, the IMF was going to be the monitoring body. For that purpose they felt that they required a checklist (rule book, core principles, code of conduct) against which they could measure each country’s system. The current proposals for work in this direction by the BCBS were not

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urgent enough, nor did it look that they would provide what the Fund wanted. So a meeting was called between the BCBS and the Fund in September 1996. At this the Fund effectively threatened that, if the BCBS did not prepare an adequate checklist, the Fund might do so on its own. The report by Tommaso Padoa-Schioppa on this meeting (BS/96/80) is reproduced as Appendix J. As might be expected, this set off alarm bells. It immediately shocked the BCBS’ Secretariat into action to draft ‘The Core Principles of Banking Supervision’ in double quick time (though always remaining in contact with the principal non-G10 countries), as recorded at greater length in Chapter 8. It also led to further discussions between Stanley Fischer (IMF) and Tommaso Padoa-Schioppa (BCBS) on the ground rules for the division of labour between the two institutions. Although several of the key documents have been withdrawn, as being perhaps too sensitive, the outline of that agreement is pretty clear and, indeed, was obvious from the outset (also there was a related exchange of letters between the Chairman of the BCBS, Tommaso Padoa-Schioppa, and the Managing Director of the IMF, Michel Camdessus, in March 1997 (BS/97/28, 34) on this division of labour; finally see the IMF paper, ‘Towards a framework for financial stability’ (BS/97/92)). The BCBS, representing the most developed countries with the most developed financial institutions, remains the body where the ‘rules’, ‘principles’ and ‘standards’ are set; it is the world’s international financial regulatory body. The IMF/IBRD is the international institution that monitors whether those ‘rules’, ‘principles’, and so on, are maintained by each nation state, and presses for improvements (primarily under its FSAP programme); it is the world’s international financial supervisory body. Subject to undignified and unhappy squabbling between the Washington twins on who does what, here as in other respects [which is thankfully a separate story], this division of labour has stood the test of time.

Appendix A (i) Letter from Padoa-Schioppa to Dallara, dated 10 January 1996 There are several technical areas where cooperation with the industry appears likely to be useful:€the appropriate treatment for instruments that display nonlinear price characteristics; the extent to which models take account of specific risk for equities and/or debt securities; and the development of backtesting methodologies. The Committee recognises that techniques for addressing these topics are continuing to evolve

Appendix A

441

within the industry. The insights and expertise your member institutions could provide on how methodologies are evolving and how the Committee could best incorporate and encourage such developments would be welcomed. In addition, the Committee is aware of the industry’s concern that the internal models approach may result in a more conservative capital charge than would be required under the so-called standardised approach. In order to assess the exact magnitude of the capital charges produced by the two approaches on a ceteris paribus basis, the Committee will need more information from the industry on the amount of capital required under each measure, using banks’ actual portfolios. In order to obtain such information, it will be necessary to conduct further testing. In all this work, the Committee would be willing to have the assistance of the IIF and is therefore gratified to learn that the Institute’s member banks are prepared to devote significant resources in order to achieve high quality results. It goes without saying that this is not intended to be a negotiating or bargaining process. Moreover, the Committee will of course continue working with other financial institutions and organisations as it deems appropriate and individual Committee members will also continue to work closely with the banks in their jurisdictions, as well as with locally-based industry associations, both national and international. For this joint work to be an acceptable input to any future deliberations of the Basle Committee, and indeed for it to be feasible, some ground rules will have to be agreed. Two are particularly important; they concern confidentiality and the planning of work. So far as confidentiality is concerned, the Committee would require the IIF to agree€– unless the Committee itself decides otherwise at a later stage€ – that the work should remain as confidential as the past work undertaken with the industry through national channels in the preparation of our package. So far as planning the work is concerned, the Committee will wish to ensure that a balanced and sufficiently representative sample of institutions participate. It will also wish to specify the design of the empirical work to be done, although your expertise in setting this up will clearly be welcome. Notably, the tests to be conducted should be those the Committee feels are necessary to provide the evidence it needs. I am confident that the IIF will accept these as natural ground rules for our joint work to be both constructive and useful. I firmly believe that both supervisors and the industry share a common interest in ensuring that banks’ trading activities develop on sound and prudent lines. I therefore look forward to the cooperation of the IIF on these issues.

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(ii)

Letter from Padoa-Schioppa to Dallara, dated 4 April 2006

In this context, I would like to reiterate two points of critical importance to the Committee. The first relates to the appropriate balance between preserving the confidentiality of individual bank information and the need to provide the Committee with enough information to have confidence in the quality of the results. This balance is best achieved by making the detailed information about participating institutions available to the relevant national task force member; the final results could then be summarised in coded form according to a format acceptable to the models task force. The second point relates to the number of participants. The Committee is pleased that a relatively large sample of IIF institutions will participate. However, to ensure that an adequate sample of banks is included at the level of each of the major G-10 countries, the Committee also intends to carry out the same exercise with other institutions directly, as I informed you in my previous letter. Since the task force knows which institutions will be participating on the IIF side, there will of course be no question of overlap between the two exercises.

Appendix B

BS/78/2e (2nd revision)

Problems for bank supervisory authorities in the Group of Ten countries and Switzerland raised by the existence of offshore banking centres elsewhere in the world 1

Characteristics of offshore banking centres

This note is concerned with the problems that arise for supervisory authorities in the countries represented on the Committee (hereafter referred to as member countries) from the activities of banks in offshore centres located outside their metropolitan territories. For the purposes of this paper the three essential characteristics of such centres are, in general, considered to be the following: 1. a very large part of their banking business is carried out in currencies other than the domestic currencies of the centres in question, much of it by banks whose head offices are located in member countries; 2. the customers involved in these transactions are, for the most part, not residents of the centres in question, except in a fictitious legal sense;

Appendix B

443

3. the banks operating in these centres are subject to little, or no, prudential control by the authorities in the host country. The banks which do offshore business in these centres can be broadly divided into two categories: 1. ‘letter-box’ or ‘brass-plate’ companies, which act as legal and booking channels for business that is in fact conducted elsewhere, to a large extent in financial centres located in member countries; 2. genuine transactions offices, where business is conducted with at least some measure of independent decision-making. Most of the offshore banking centres with which this note is concerned are booking centres rather than transactions centres. There are however considerable differences between them, with some being almost entirely booking centres while others are also genuine transactions centres. A representative list of offshore banking centres, which makes no claim to being exhaustive, is given in the appendix to this note. 2

Reasons for the emergence of offshore banking centres

There are a number of reasons why certain places have emerged as offshore banking centres. One of them€– probably not the most important€– has already been mentioned in Section 1, namely the degree of freedom from local supervisory control enjoyed by the banks that are domiciled in them. Other reasons include: (i)

Fiscal and other cost advantages

By conducting business through branches in these centres, banks are usually able to limit or reduce their own tax burden and/or that of their customers, and may avoid the impact on their costs of reserve requirements. (ii)

Other legal advantages

As well as the regulatory and fiscal advantages mentioned above, banks engaged in offshore transactions in these centres usually enjoy the benefit of very liberal company legislation. (iii)

Freedom from macro-economic controls

This includes freedom from monetary policy regulations, from exchange controls and from other regulations motivated by balance-of-payments considerations.

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(iv)

Advantages of location

In the case of genuine transactions centres, some banks find it advantageous, by spacing their offices out around the world, to do business twenty-four hours a day. This may be of particular advantage for foreign exchange transactions. 3

Problems for the supervisory authorities

The problems that arise for supervisory authorities in member countries from the operation of these offshore banking centres may be grouped under four main headings: (i) those that relate to the activities of the establishments of member country banks located in offshore centres; (ii) those that relate to the activities in member countries of banks domiciled in offshore centres; (iii) those that relate to transactions between member country banks and offshore banks or non-banks; (iv) those that relate to the transactions of member country non-banks with banks domiciled in offshore centres. ad (i) The setting-up of establishments in offshore centres may permit banks with head offices or parents in member countries, by transacting or booking business through such establishments, to avoid adequate prudential supervision of that part of their activities, with possible unfavourable consequences for their overall solvency and liquidity. For example, a bank may, through its offshore transactions, exceed ceilings on individual credits or other limits on its risk exposure, it may engage in excessive maturity transformation or it may unduly stretch its gearing ratios. Where branches are involved the home supervisory authorities are usually able to obtain from a bank’s head office the accounting record of its offshore operations. But it may not always be easy to interpret this information and to evaluate its implications for a bank’s liquidity and solvency. In the case of subsidiaries and banking participations, information from offshore centres may be quite difficult to obtain and a bank may be able to keep certain types of business entirely concealed from both the parent bank and the parent supervisory authorities. ad (ii) Because of permissive banking regulations in offshore centres the setting up by offshore-centre banks of establishments in member countries may, if care is not taken, introduce doubtful elements, or at least unqualified operators, into their banking systems. This could result in losses for depositors in member countries, particularly those persons who are liable to be attracted by high-sounding banking names and promises of

Appendix B

445

unusually attractive terms and conditions. Moreover, even if any unsound or fraudulent business of such establishments were transacted mainly with non-residents of the host country, that too might have adverse repercussions on the general reputation of that country’s banking system. ad (iii) Permissive banking regulations in offshore centres may, if care is not taken, also create problems where banks located in member countries build up a clientele, whether bank or non-bank, in offshore centres, particularly where the customers with whom they deal are not, except in a fictitious legal sense, residents of those centres. Banks lending to such persons may not always be adequately informed about the status and soundness of their customers while deposits received from those sources may be potentially volatile, with possible risks for a bank’s liquidity position. Moreover, banks in member countries (or in offshore centres) may use non-affiliated offshore companies or nominee names to conceal from their own supervisory authorities (or managements) the ultimate borrower or the real uses to which funds are being put, for example speculative activities or illicit types of lending. Offshore addresses may likewise be used for the collection of improperly acquired funds. The Credit Suisse affair at Chiasso may be said to have exhibited some of the characteristics mentioned above. ad (iv) Banks or quasi-banking companies domiciled in offshore centres may accept deposits from and grant credits to residents of countries where they do not have banking offices. Where the absence of supervision in those countries means that the facilities offered could involve unsound€– or even€– fraudulent banking practices the exposure of residents of member countries to such offers cannot be a matter of indifference to the supervisory authorities concerned. 4

Possible courses of action

The Committee believes that the problems set out in Section 3 above can best be handled by action along two separate but complementary lines:€co-ordinated action taken in their own areas of jurisdiction by the supervisory authorities of member countries; and joint action by member countries to develop co-operation with offshore banking centres on matters of mutual interest in the area of banking supervision. A

Suggestions for possible measures to be taken by member countries

Suggestions for possible action by members in their own countries are set out below. The Committee wishes to emphasise two points in connection with these suggestions:€ that in their view the most important areas for action are those relating to the supervision of

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the offshore establishments of their domestic banks and to ‘branching-in’ by banks established in offshore centres; and that any action taken by members in their own countries should, as far as possible, be co-ordinated with policies pursued in other member countries, in the interests both of efficiency and of equality of competition among banks. Supervision of the offshore establishment of domestic banks i Two different methods, one or both of which are already in use in some member countries, have been suggested for improving parent authorities’ supervision of their domestic banks’ establishments in offshore banking centres. (a) Prior authorisation for the opening by domestic banks of foreign branches or subsidiaries; (b) The provision of consolidated information on banks’ operations world-wide. This requires the regular provision of adequate information on their overseas operations and/or the application of certain prudential requirements to banks’ consolidated balance sheets. ii Branching-in Authorisation procedures already exist in all member countries for the establishment in their territories of foreign bank offices. It is suggested that member countries should explore the possibilities for co-ordinating their procedures in this area, particularly with a view to discouraging, as far as possible, the entry of banks established in countries where supervisory arrangements are nonexistent, or where they exist but specific exemption has been granted from them. Great care will also be needed with banks from centres where supervisory arrangements are judged to be inadequate and it is suggested that host authorities should pay particular attention to such offices, possibly making them subject to special regulatory requirements. iii

Dealings of banks in member countries with their banking correspondents and non-bank customers in offshore centres The Committee considers that the risks run by their domestic banks in transactions with parties domiciled in offshore centres can best be monitored within the normal framework of domestic supervision. It is suggested however that the authorities may from time to time need to warn banks to exercise particular care in dealing with such parties.

Appendix B

447

iv

Transactions between banks domiciled in offshore centres and non-bank residents in member countries The supervisory authorities of member countries are in no position to regulate the activities of banks domiciled in offshore centres; moreover it would be administratively very cumbersome for countries in which such transactions are not already subject to exchange control to introduce restrictions on their residents’ dealings with banks in offshore centres. The Committee suggests, however, that member countries consider the practicability of confining the advertising of credit or deposit facilities to those banks authorised to operate in their territories and/or of making this kind of business subject to the provisions of domestic laws governing business practices, e.g. as regards the use of the word ‘bank’ in a company’s name. B

Co-operation with offshore banking centres

The Committee is strongly convinced of the need to promote the integrity of banking supervision internationally, and to work towards a situation in which no bank remains unsupervised. As one step towards achieving this aim it believes that member countries should seek the cooperation of offshore centres in matters of banking supervision, in particular of those centres where banking supervision is at present nonexistent or minimal. The Committee is therefore of the opinion that for this purpose member countries should make a joint and simultaneous approach to the supervisory authorities, or to the authorities responsible for bank authorisation procedures, in all offshore centres. Their attention should be drawn to the mutual benefits that could result from co-operation between member countries and offshore centres on banking supervisory matters and their active support invited in promoting such Â�co-operation. Areas in which co-operation could be suggested include the collection of information on the operations of banks’ foreign branches, subsidiaries and affiliates and, where appropriate, the facilitating of on-the-spot examinations of such offices by the parent banks’ supervisory authorities. It should be emphasised that the object of such co-operation would be strictly limited to matters affecting the liquidity and solvency of banks. The Committee believes that such co-operation would strengthen the hands of the authorities in many offshore centres in controlling the activities of banks established in their countries. It has already received indications from some offshore centres of their desire for closer Â�co-operation with member countries on banking supervisory matters.

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Relationship with banks and banking regulators

If Governors agree that an approach to the offshore centres along the lines indicated above is desirable, it would then be for consideration through which channels such an approach could best be made. Governors might wish themselves to contact directly the authorities in the offshore centres. Alternatively, since the central bank is not in all cases the supervisory authority, they might prefer the Committee to do so on their behalf.

Appendix C

BS/80/31

Discussion paper Principles of international co-operation between bank supervisory authorities 1

Introduction

1. Since 1974 G-10 supervisors have elaborated a number of principles which should underlie the supervision of banks’ international business, and have sought to encourage their widespread acceptance. 2. Feel these should include offshore centres:€problem of definition covers a very wide range of different kinds of centres. The Committee has invited those centres in which in its view significant international operations are conducted and in some of which there is a developed local market. 3. Would welcome the comments of offshore centre supervisors on these principles and invite their co-operation in the further elaboration and implementation of them. 2

Concordat

1. The cornerstone of this co-operation is the Concordat (BS/75/44 and review BS/80/24). 2. It is hoped that the offshore centre supervisors can subscribe to the principles of the Concordat: (a) in relation to G-10 countries’ banks (b) in relation to other countries’ banks. 3

Consolidation and maturity transformation

1. G-10 supervisors have taken major initiatives in this area as follow up to Concordat.

Appendix C

449

2. Would offshore centre supervisors be prepared to endorse and assist with implementation: (a) Consolidation (BS/77/52; BS/79/27; BS/79/30) envisages the consolidated supervision of banks’ capital adequacy and risk exposure (including country risks and large loans) (b) Maturity transformation calls for consolidated reporting of the international transactions of banks’ foreign establishments (BS/79/44). 3. Do, or should, offshore centre supervisors satisfy themselves that foreign banks operating in their jurisdiction consolidate/are required to consolidate? 4

Mutual co-operation, provision of information and bank secrecy considerations

1. Practical co-operation may require: (a) mutual exchanges of information at the time of establishment and on a regular basis thereafter (b) mutual assistance in individual cases (c) permission for inspections. 2. To what extent would such exchanges be hindered by: (a) unavailability of information (b) bank secrecy provisions. 3. Is there value in co-operation between offshore centre supervisory authorities as a group? 5

Licensing criteria

1. This is an important area. 2. Offshore supervisors no doubt accord to the maintenance of sound banking standards the same degree of importance as other countries. What are their views on: • minimum capital requirements • minimum standards for the probity of owners and the competence of management • comfort letters (distinctions between branches, subsidiaries, consortia€– bank and non-bank owners) • the appropriate level of local supervision and degree of reliance on consolidated supervision from parent.

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Relationship with banks and banking regulators

Appendix D

BS/87/21

Relations with other groups of supervisors Note by the Secretariat for consideration under item VIII Over the years the Committee has sought to maintain close relations with supervisory authorities outside the G-10 and particularly with the various regional groups. It has done this by circulating agreed papers and by holding a number of joint meetings to discuss various specific issues and papers. The attached annex provides a full list of such joint meetings. It is possible to take two views of the value to the Committee of maintaining such close ties. On the one hand, it may be felt that since G-10 countries and banks represent only part of the international banking system (though a very important part), member countries have a strong self-interest in doing as much as possible to help raise standards of supervision in countries outside the Committee and generally to promote closer supervisory collaboration. On this view, joint meetings with other supervisors would form an important part of the Committee’s work programme. On the other hand, some members may feel that such meetings are of relatively little benefit to the Committee and that the time spent on them could more usefully be devoted to the Committee’s own business. This is, of course, not a view that the Committee as a whole has taken hitherto. In structuring future meetings, the question is therefore of the appropriate balance and frequency of contact. The Chairman has recently been approached by the Chairman of the Offshore Group and by the GCC with a view to arranging future contacts with the Committee. Before responding substantively to these requests, he would like to canvass members’ views on the matter. 27 February 1987

Appendix E

451

Annex Committee’s main contacts with non-G-10 supervisors

Participants

Date

A. International conferences 83 countries July 1979 75 countries September 1981 79 countries September 1984 86 countries October 1986

Location

Number of nonG-10 supervisors present

London Washington Rome Amsterdam

110 100 115 115

B. Joint meetings between the Committee and other groups of supervisors Offshore Group October 1980 Basle 12 (10 countries) Offshore Group October 1982 Basle 21 (15 countries) Non-G-10 European November 1983 Basle 17 (11 countries) countries Offshore Group + May 1985 London 8 (7 countries) certain non-G-10 countries Offshore Group + December 1985 Basle 21 (16 countries) certain non-G-10 European countries GCC Supervisors December 1986 Basle 15 (6 countries) C. Joint working groups Joint working party with Offshore Group on information flows D. Steering group Chairmen or senior representatives of nine groups

June 1985

London

3 (3 countries)

September 1985

London

8

Appendix E Conclusion ‘Offshore’ Centres as a term embraces a wide range and scale of business activities, and of standards. There is evidence that success as an ‘Offshore’ Centre and high standards of regulation can go together. There is also evidence however that new centres must expect to develop slowly unless they offer something that is not available from the more established centres and there is a danger that many will be persuaded to seek business growth through a lowering of standards.

452

Relationship with banks and banking regulators

There is much that international organisations such as the IMF, and the regulatory authorities of the main industrial nations, can do to re-inforce the message that standards count. They could do more to distinguish (for example, in their response to requests for authorisation for the establishment of foreign branches/subsidiaries received from financial institutions for which they have overall responsibility) between Centres that offer ‘Offshore’ services and which are meeting international standards, including the FATF forty recommendations, and those that are not. A list of ‘Offshore’ Centres is attached as an appendix.

Appendix 1



Centres offering offshore banking and financial services



Countries offering ‘Offshore’ services within their jurisdiction

Ireland (Dublin) Morocco (Tangiers) Taiwan Thailand United Kingdom (City of London) United States of America (Colorado, Delaware, Miami, New York)

Island Centres

Americas

Asia/Pacific

Europe

Other

Anguilla Antigua Aruba Bahamas/ Barbados Bermuda Cayman Islands Montserrat Nevis Netherlands Antilles St. Kitts St. Lucia St. Vincent Turks and Caicos Virgin Islands

Hong Kong Labuan Macau Marianas Marshall Islands Nauru Niue Singapore Vanuatu West Samoa

Cyprus Guernsey Isle of Man Jersey Madeira Malta San Marino

Bahrain Mauritius Seychelles

Appendix F

453

Mainland Centres Andorra Belize Costa Rica Dubai Gibraltar Lebanon Liberia Liechtenstein Luxembourg Monaco Panama Switzerland

Appendix F Concerns about the international banking system in the current world economic environment lead me to write to you about the supervision of banks and banking activities, particularly from the perspective of the Basle Committee of Supervisors, as it affects countries in your part of the world. I know you have followed closely the work which we have been doing in Basle over recent years and we have had a number of valuable contacts and exchanges with individual supervisory authorities in the Arab world, not least from SAMA. I recall with particular pleasure participating in the Conference, convened on your initiative, of Arab countries’ supervisors in Riyadh in November 1979. In our work in Basle we are increasingly conscious that, in order to make the work of the Supervisors Committee as effective as possible, we need to reach a wider community than just the G.10 countries and Switzerland and we have been developing our contacts with other supervisors and encouraging the formation of other homogeneous groupings of supervisory authorities in different parts of the world with whom we can maintain a dialogue. Two groups of this nature are now well established, one a group of ‘offshore’ supervisors consisting of Hong Kong, Singapore, Bahrain, the Bahamas, Panama and a number of small centres, the other a grouping of Latin American and Caribbean authorities who held their second annual meeting in Peru last month. The offshore group, I think you may know, has already held one joint meeting with

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Relationship with banks and banking regulators

the Basle Committee in 1980 and another one is in the course of preparation for October this year. It has seemed to me that the Arab countries, and particularly the Kingdom and the Gulf States, constitute another such homogeneous group of countries, containing a number of major international banking businesses. In this connection, I have been pleased to hear that there have been meetings of Governors and others with supervisory responsibilities in the Gulf area, in order to promote co-operation and contact on banking questions. I have been wondering whether there would not be merit in encouraging a more formal grouping of these supervisory authorities, as a focal point for contacts outside the region, and particularly with Basle, as well as for purposes of mutual co-operation and understanding. I am writing to you because I feel rather ill-informed about the pres� ent extent of co-ordination in this field in the Arab world. I would very much appreciate your guidance on the concept of a formal grouping and contacts with Basle and, if it seems a sensible idea, how it might be brought to fruition. I hope that it may find some favour with you:€it seems to me, in what is in effect a single world banking market, that we need in the current environment to pursue to the utmost every possibility of co-operative endeavour and contingency planning in the interests of all. I would be very interested in your reactions and would welcome hearing your views or having the opportunity to discuss these ideas further with you. Even if some formal grouping of Arab supervisors were to present some difficulties it occurs to me that there would be great merit in encouraging a meeting between the members of the Supervisors Committee in Basle and the senior people in Arab countries with supervisory responsibilities and I would welcome your thoughts on this idea also.

Appendix G

BA/79/20

International Conference of Banking Supervisors London, 5 and 6 July 1979

Outline Programme

It is envisaged that the Conference will run for two full days from 9.30 to 5.30 on Thursday, 5th July, and 9.30 to 4.45/5.00 on Friday, 6th July.

Appendix G

455

The Conference would open with a speech from the Governor of the Bank of England on the theme of international co-operation in banking supervision. A series of specific subjects would then be considered with a broadly similar format of a principal speaker, a small panel to give brief but prepared comments and the opportunity for general discussion from delegates. The subjects to be covered have been provisionally identified as the following:1.

2.

3.

4.

The Supervision of International Bank Lending The Supervision of a Regional Financial Centre

Measuring Capital and Liquidity Adequacy for International Banking Business Links of Ownership and Control between Banks and Non-Banks

5.

Banking Supervision on a Consolidated Basis

6.

The Regulation of Foreign Exchange Markets and Banks’ Foreign Exchange Positions Country Risk in International Bank Lending

7.

A presentation by a major industrialised country of its approach towards supervising its banks’ international activities. A complementary view of international banking supervisory problems from the point of view of a regional centre with both indigenous banks and a substantial number of branches and affiliates of banks from abroad. Similarities and differences in assessing capital and liquidity adequacy for international banks as compared with those engaged solely in domestic banking activity. Considerations governing the ownership of banks by non-bank parent corporations and the appropriateness of banks maintaining subsidiaries, participations and investments engaging in non-banking activities. The case for measuring the exposure of banks operating internationally to take account of their overall international exposure through branches, subsidiaries and other participations and the aspects of the business to which such consolidation techniques can be applied. The particular problems which arise in respect of foreign currency dealing operations and the problems which they pose for supervisory authorities. Problems associated with the measurement of this particular manifestation of credit risk and the ways in which this exposure can be monitored and controlled by banks themselves and by supervisory authorities.

In view of the close links between the Basle Committee and the Conference it is hoped that some of the speakers and panellists will be drawn from members of the Committee. The meeting will be chaired

456

Relationship with banks and banking regulators

by the Chairman of the Committee, but it is anticipated that sessions may be chaired by the introductory speakers in some cases.

Appendix H

BS/85/42 Revised

Draft of a letter which the Chairman would propose to send to the Governors giving them additional information about the scope of the suggested supervisory training courses (for consideration under Item I(b) of the agenda for the Committee’s June meeting)

Draft



Training courses for banking supervisors

I wrote to you on 28th January 1985 about the possibility of the Supervisors’ Committee promoting periodical training courses for bank supervisors. At the Governors’ March meeting in Basle you kindly agreed to defer consideration of this subject to allow me time to consult further with my supervisory colleagues and to present more detailed proposals for the framework within which such courses might be conducted. As I reported to you, the Supervisors’ Committee has been considering for some time the possibility of arranging periodical training courses for bank supervisors, more particularly from countries and centres with limited resources to do this. At present, supervisory authorities within the G-10 countries run their own training programmes at which they receive visitors for training. They also send their own staff to non-G-10 countries on training visits. Such exercises in different centres are uncoordinated and to some extent overlap and duplicate each other. As mentioned in my January letter, there would seem to be many advantages in some centralisation of these training efforts under the aegis of the Basle Supervisors’ Committee. In particular, it seems to me that a training course for, say, some 30 high calibre younger staff would be a much more efficient use of available training resources and skills. In addition, contacts within such training seminars would help to develop personal contacts and an informed understanding among participants of different nations’ supervisory practices and would contribute towards a general enhancement of supervisory standards. Further discussions with my supervisory colleagues within the G-10 Committee and more widely indicate that there is a strong body of

Appendix H

457

support for the encouragement of some co-operative training efforts. One reflection of this demand for a pooling of training facilities is the recent establishment by the Commission of Latin-American and Caribbean Supervisory Agencies of a special committee to improve the opportunities and facilities for training among its members. A number of non-G-10 countries have expressed a strong interest in being able to participate in any co-operative training endeavour which might be undertaken. I also undertook to consider further the most appropriate mechanism through which these perceived training needs might be satisfied. In my view, the Secretariat of the Basle Supervisors’ Committee, recently strengthened, is well placed and well qualified to take on a major role in organising courses and preparing papers and, to some extent, in lecturing. Significant participation in such training seminars would of course also be required from senior banking supervisors, particularly in G-10 countries. Attached to this letter is a more detailed outline of the possible nature and scope of such training courses. The institutional involvement of the B I S (beyond the Committee’s Secretariat) in such courses would seem to me to be a separate question which may need to be considered substantively by its Management and the Board. I believe, however, that the B I S would be particularly well suited to undertake a central role. If this were not to find favour, however, an alternative procedure would be for certain of the G-10 central banks to agree to host such courses. The Federal Reserve Bank of New York has held such meetings in the past and President Languetin has said that, although the Swiss National Bank could not provide the detailed technical support for such courses, they would be pleased to allow their new conference facilities, not yet completed, to be used for this purpose. Several other Governors have also expressed strong support to me for the proposition advanced in this letter. I would be most grateful therefore if you would bring this matter back to the Governors for their consideration. If the Governors were to agree in principle to the proposals made in this letter, I would be happy to take the matter forward in discussion, as appropriate, with the BIS Management and/or individual central banks. If convenient, I would be pleased to attend on the Governors at one of their forthcoming meetings in Basle to introduce the subject. I am, dear Mr President, Yours sincerely, W. P. Cooke Chairman

458

Relationship with banks and banking regulators

Annex An outline framework for a training course in banking supervision under the aegis of the Basle Supervisors’ Committee 1. The course could be hosted either by the BIS in Basle, or in rotation by certain G-10 central banks. 2. The training course would be organised by the Secretariat of the Basle Supervisors’ Committee, who would invite lecturers from among senior officials of the banking supervisory community. Members of the Secretariat will also give some lectures and help run working seminars. 3. Participants will be invited from three major groups of countries. These three groups would be: • member countries of the Basle Supervisors’ Committee; • non-member but OECD countries; • important developing countries and offshore banking centres (e.g. Mexico, Brazil, Hong Kong and Singapore). Level of participants:€staff members with supervisory experience of two or three years. 4. Number of participants:€around 30. 5. Frequency:€probably annual intervals. 6. Budget:€ Course participants and lecturers would pay their own expenses. The BIS or central banks in other G-10 countries might be prepared to offer some limited hospitality. 7. The training course could be for one or two weeks. 8. Suggested programme (a) Introduction€– history and objectives of banking supervision. (b) Basic principles (i) Credit risk€– including sovereign risk and transfer risk; (ii) Funding risk; (iii) Foreign exchange risk; (iv) Off-balance-sheet risk; (v) Interest rate risk; (vi) Operational risk€ – including computer systems, payment mechanisms, clearing systems (c) Measurement and control of the risks • by banks • by supervisors • published accounts (d) Different approaches to supervision

Appendix I

459

• degree of formality • inspection:€routine/non-routine • the role of auditors

(e) Norms and regulations in different countries • compare and contrast (f) International cooperation • the Basle Concordat • the various international groupings • future work (g) Crisis management • domestic • international (h) Boundaries of banking supervision • deregulation€ – the removal of institutional and market barriers • prudential approach to financial conglomerates • role of other financial supervisors (e.g. insurance, securities) (i) Latest financial innovations and their supervisory implications Teaching methods

• lectures • working group discussions • case study • visits to financial institutions and markets (where appropriate)

• panel sessions 5 July 1985

Appendix I (i) Supervisory training Annex 3

One of the main feedbacks from the Cannes conference was a widespread need for more and better training facilities for bank supervisors. Many appeared to be looking to more experienced supervisors in other countries for assistance. The purpose of this annex is to review the present provision of supervisory training at the international level as a basis for action by the Committee as judged necessary. The information listed is confined to banking supervisory courses at an international level. It is not intended to cover courses arranged and delivered solely at national level or more general central-banking

460

Relationship with banks and banking regulators

courses where a session or two may be devoted to banking supervision. Detailed information on the programmes and participants is available on demand from the Secretariat. 1

The Committee’s own courses

Regular annual training courses now take place in Basle every spring. The course is an advanced one, designed for experienced but relatively young supervisors who are destined to rise to senior posts. The course deliberately has an international flavour and understandably focuses mainly on the work going on in the Committee. In June 1991 Mr Gehring organised a ten-day seminar for eastern European supervisors in Poland and this was followed in December 1991 by a shorter course for the National Bank of Bulgaria. In June 1992 he also ran a week-long course for the National Bank of Hungary. At the Cannes ICBS, the group of eastern European supervisors decided that two one-week training courses should be held during 1993, the first in Bucharest in the early summer. Mr Harbrecht will be closely involved in the planning and administration of these courses. 2

The World Bank/Federal Reserve Board seminars

These jointly planned seminars are currently held twice a year (ten courses to date). They are specifically targeted at senior bank supervisors from less developed countries. The main event is a three-week course each October in the Fed’s training centre in Washington with an average participation of 35. A second event now normally takes place outside the United States, e.g. in Ghana in 1990, in France in 1991 (conducted in French) and in Mexico in 1992 (conducted in Spanish). The next seminar will take place in Cairo in January 1993 in association with the Central Bank of Egypt. The participants will be exclusively from Arab countries. Another course is also being planned in conjunction with CEMLA for Latin-American countries in March 1993 in Mexico City. The Committee’s Secretariat is nearly always invited to address one session of the Washington seminars. In August 1992 a ‘retrospective seminar’ (one week only) was held for more senior staff (heads or deputy heads of department) which addressed major policy issues and benefited from a very high level of speakers (including Messrs Corrigan, LaWare, Spillenkothen and Taylor).

Appendix I

3

461

Arab Monetary Fund

A first course for banking supervisors in Arab countries took place in Abu Dhabi in the first two weeks of November 1992. The speakers were supplied by the Committee’s Secretariat, the World Bank, the IMF, the Bank of England, the Bank of France and the Deutsche Bundesbank. It is intended to conduct such courses on an annual basis in future. 4

SEANZA

SEANZA’s is annually organising a five-week training course of which one week is allocated to bank supervision. The course is limited to the central bankers from the SEANZA constituency, many of whom are not supervisors. The organisation has so far been handled by the Bank of Japan. This year’s speakers included Messrs Barnes, Ryback and Musch. 5

CEMLA

CEMLA (based in Mexico City) participated in the organisation of two courses for bank supervisors in 1991, in Jamaica and in the Bahamas (both in association with the Caribbean Supervisors’ Group) and also organised three courses in 1992 (in Argentina, Costa Rica and Guatemala). It also arranged national courses for the supervisors in Paraguay and Venezuela. 6

The Caribbean Supervisors’ Group

In addition to the two courses held in association with CEMLA referred to above, the Caribbean Group organised a ten-day course for junior supervisors in Curacao. 7

SEACEN

SEACEN (based in Kuala Lumpur and funded by ten central banks in South East Asia including Indonesia, Korea, Singapore and Thailand) has hosted twenty supervisory training courses at a rate of approximately two per year. The next courses will be in June 1993 and February 1994. (ii) A possible training module Annex 4



Background

The principal goal of the minimum standards is to encourage countries worldwide to apply sound supervisory standards in respect of banks

462

Relationship with banks and banking regulators

operating internationally. Judging by the informal comments of many of the G-10 participants in the Cannes conference, non-G-10 supervisors would welcome help from the Basle Committee in implementing the standards. One way the Basle Committee could respond would be to undertake an active technical assistance programme designed to focus on perhaps the most critical aspect of the minimum standards paper:€namely, the question of how an authority can ensure that it ‘capably performs consolidated supervision’. For each of a number of basic elements, the Basle Committee would provide individual training modules. For example, the basic elements could be: 1. authorisation procedures 2. prudential standards 3. reporting and monitoring of statistics 4. some kind of on-site inspection or examination 5. some kind of systematic sharing of information with a supervisory agency 6. problem-solving, up to liquidation and closure Design of the specific training modules would be apportioned among Basle Committee members. Representatives of the central bank or supervisory agency assigned to each module would need to work closely with the Basle Secretariat. Once the training package had been put together, the Basle Secretariat, working with the chairmen and/or secretariats of the regional groups, would discuss the nature of the proposed technical assistance programme and agree on a timetable for its application. If appropriate, the programme could take place to coincide with the regional group’s annual meetings. To present the programme, the Secretariat would need to co-ordinate teams of four or five individuals from Basle Committee members. The multinational character of the teams would give a broad scope to the training effort. Each team would also include a representative from the Basle Secretariat. For organisational purposes, a team leader would be designated in advance for each assistance programme so as to co-ordinate the training effort both before and during the actual programme. The precise length of each training programme could depend on the wishes of the regional group, with a suggested range of one to two weeks. It might also be possible to vary the level at which the programme was pitched, depending on the requirements of the pupils. Before going ahead with any such assistance programme, it would be sensible to establish how great a demand there is likely to be and

Appendix J

463

how the costs can be covered. It would also be important to ensure that the training does not interfere with efforts being undertaken by other international organisations, central banks and supervisory agencies, particularly with regard to scheduling (see Annex 3).

Appendix J

BS/96/80

Basle Committee on Banking Supervision Note by the Chairman

12th September Conference

I feel I should report to members on the outcome of the tripartite conference (Basle Committee, BIS, IMF) which took place at the BIS last week. Although the title of the conference was very broad-Â�ranging across the causes of financial instability and possible solutions, the focus of many speakers and all the policy conclusions related to supervision; essentially, the IMF said that they needed a clear and concise compendium of the Basle Committee’s ‘rule book’ so that they could point to specific concepts and numbers in advising emerging markets on improvements in their supervisors’ practices. This request is one which I think we should seek to fulfil€– indeed I referred to such a document in the Committee’s own meeting earlier in the week. I have therefore asked the Secretariat to think about the contents of such a document and put a proposal to the Committee. Stanley Fischer did at one point indicate his preference for a ten–fifteen page paper rather than a ‘telephone book’ but it is not at all clear how easy it would be to do this or how useful. A second request was that the Basle Committee seek to develop some basic supervisory principles for areas that it has not hitherto addressed. Near the close of the meeting, Stanley Fischer circulated the attached outline of the issues on which the IMF felt guidelines were needed. As I pointed out in the meeting, it touches on many issues, particularly in points 1 and 4, that are outside the control of supervisors. It would clearly be an enormous task to develop agreed practices/rules in each of these areas, even at a fairly superficial level. The problem is that, if the Basle Committee does not do so, the IMF says it might. We need to think carefully about this at our next meeting. It is not clear yet what output there will be from this conference or what will be the follow-up, but I will keep the Committee fully informed.

464

Relationship with banks and banking regulators

In the meantime, we should continue with our plans to consult our non-G-10 colleagues. Tommaso Padoa-Schioppa September 1996 Basle, 12 September 1996

Topics for consideration

I

Financial disclosure and accounting, loan valuation

Minimum standards for financial accounting rules for banks, particularly those related to asset valuation, loan classification, interest suspension, and provisioning. Reporting requirements pertaining to group-wide on- and off-balance-sheet financial exposure. Disclosure of financial and other data to the public. II

Supervision of cross-border banking

Supervision of cross-border banking, including home and host country supervisory responsibilities, as well as consolidated supervision of onand off-shore entities, licensing, transparency of corporate structures and issues pertaining to information-sharing among supervisors. III

Prudential rules

Prudential standards, rules and ratios including:€ capital standards; liquidity ratios; limits relating to loan concentration and connected lending; and foreign currency, interest rate and equity exposure. IV

Authority of national supervisors

Authority to regulate banks, require provision of data, inspect banks, issue corrective orders, decline licence applications, and close and force exit of banks. Practices to enhance supervisory authority, reduce political interference, and monitor and evaluate the exercise of this authority.

13

Relationships with other non-bank oversight and supervisory bodies

A

Relationships with other BIS standing committees

The BCBS was not, and is not, an autonomous committee. As has been amply documented in previous chapters, it was established by, got its mandate from and answers to the G10 central bank Governors. While it has always had a certain latitude to initiate work unilaterally, its work programme is reported to the Governors and they can set its priorities. It cannot communicate conclusions, nor make proposals, to bodies outside the BIS without the general agreement and support of the Governors. The G10 Governors (and the subcommittees that the Governors establish) are serviced and provided with a Secretariat by the BIS. The relationship between the G10 governors and the BIS, under the General Manager, is somewhat intricate, and has been nicely described by Toniolo and Clement in their book Central Bank Cooperation at the Bank for International Settlements, 1930–1973 (2005). The BIS does not control the BCBS in any sense. The BCBS takes its own decisions, subject to the wishes of the G10 governors and subject to the constraints on resources for the Secretariat made available to them by the BIS (normally agreed by consensus, but subject to negotiation between the Committee’s Chairman and the BIS if resolution is needed). The BCBS was neither the first, nor the only standing subcommittee set up by the G10 governors. Perhaps the most important such committee has been the Euro-Currency Standing Committee, set up by the G10 governors in 1971, whose main purpose, as its name suggests, was to monitor macro-international financial developments. Subsequently, in February 1999, it changed its name to the Committee on the Global Financial System. The ECSC/CGFS has been the premier macroÂ�economic forum for the discussion of international tensions/imbalances; the BIS economic adviser (Chief Economist) represents the BIS on this committee, and plays a major role and provides much of the input to its discussions. In contrast, no senior member of the BIS (apart 465

466

Relationships with non-bank supervisory bodies

from the allocated Secretariat), nor Governor1 ever during this period participated in BCBS discussions; the Chairman of the BCBS, in conjunction with the head of the Secretariat, arranges the Committee’s own agenda, subject only rarely to direction from the G10 governors. These were not the only economic and financial standing subcommittees established during these years. For example, the Committee on Payments and Settlement Systems (CPSS) was set up in 1990 as a follow-up to the work of the Committee on interbank netting schemes, and to take over and extend the work of the Group of Experts on Payment Systems that had been in existence since 1980 (see www.bis.org/cpss/ cpssinfo.htm). The Gold and Foreign Exchange Committee grew out of the experts’ group set up in 1961 to monitor the gold market and became a de facto G10 committee in 1964. It changed its name to the Markets Committee in 2002 (see Toniolo and Clement 2005, p. 365). This subsection is, therefore, primarily about the relationships between the BCBS and the other standing subcommittees. On the whole my impression is that such relationships were good and smooth. While there were many areas of overlap, notably between the ECSC and the BCBS on international financial problems in the immediate aftermath of the 1982 MAB crisis, and between the CPSS and the BCBS on subjects such as e-money, each committee was aware of its locus of responsibility, and that of the other committee(s). There were relatively few attempts at trespass or fights over turf. The first record that I could find in the archives of cross-committee interaction was when Alexandre Lamfalussy, the Chairman of the ECSC, asked the Chairman of the BCBS in early 1981 to issue a questionnaire to members on banks’ accounting treatment for rescheduled international loans (BS/81/15); this questionnaire was sent out and replies discussed at the twenty-second BCBS meeting in June 1981 (BS/81/14). The next occasion was in relation to the exercise on netting schemes, also chaired by Alexandre Lamfalussy in 1989, which was naturally of some concern and interest to the BCBS. The third concerned the reporting of derivatives’ activities and public disclosure of such activities, in relation to the Brockmeijer Report in 1994. Padoa-Schioppa’s note for the record to the members of the BCBS nicely describes the relationships between the ECSC and BCBS. Thus (BS/94/43), in May 1994 he wrote:

Corrigan, who was both chairman of the BCBS and president of the Federal Reserve Bank of New York, was an exception during these years, as McDonough was to be later. 1

Relationships with other BIS standing committees

467

Following our discussion in March, I attended the meeting of the Eurocurrency Standing Committee (ECSC) on 8th May and expressed the concerns of our Committee. I made the point that in areas where so-called macro and micro-prudential issues may overlap proposals should not be brought to the Governors unless agreed with the Basle Committee. This general point was accepted. More specifically, the ECSC agreed that in the two following areas its report should be agreed with banks’ supervisors:€(a) regular reporting of derivatives activities by major players in the market; (b) recommendations to enhance public disclosure in order to improve the functioning of financial markets and reduce the risk of financial disruption.

Finally there was a joint meeting of the BCBS and the CPSS in April 1996 (BS/96/22 and 96/32) to discuss: 1. Settlement risk in foreign exchange; 2. Loss-sharing and liquidity-sharing arrangements in payments and settlement systems; 3. Interpretation of the Capital Accord for the multilateral netting of forward value transactions; 4. Issues related to electronic money; 5. Other issues of relevance to both Committees. Electronic money, in particular, continued as a matter of joint concern to both BCBS and CPSS. Overall, as noted earlier, the impression is of how few areas of friction there were between the various standing subcommittees, and how well delineated were each of their areas of responsibility. One, perhaps minor, qualification to that is that the same note (BS/96/32) reporting on the meeting between the CPSS and BCBS also reported a frank exchange of views between the BIS (Crockett and W. White, Head of Monetary and Economic Department) and representatives of the BCBS. This is documented further in an exchange of letters between Crockett and Padoa-Schioppa (BS/96/81). The BIS wanted to carry out research on systemic stability issues, but the BCBS was concerned that this might conflict with their own work, as evidenced by the letter from Padoa-Schioppa to Crockett dated 10 May 1996 (BS/96/31): The meeting was very productive. It gave you an opportunity to hear directly the concerns of several Basle Committee members. Since the Basle Committee is worldwide perceived as the body responsible for international banking supervision and its work is so closely linked to Basle and the BIS, any papers or ideas promulgated by the BIS which deal with prudential issues would inevitably and understandably be regarded as reflecting the views of the Committee and thus of the authorities that are responsible for banking supervision in the G-10. Also, the Committee is concerned that its agenda and priorities could

468

Relationships with non-bank supervisory bodies

be unduly influenced by work, albeit of a research rather than policy character, done outside its deliberations. Finally, Committee members feel that they and the Committee Secretariat do not have enough resources to devote to the revision and discussion of research papers.

The broader issue of the BCBS’ involvement with professional economists is addressed in Chapter 16 on ‘The BCBS and the social sciences’. B

Relationships with the accountancy profession

The first, and longest-lasting of the relationships between the BCBS and outside professional bodies, besides the offshore group of banking supervisors, was with the accountancy profession. There were two main such groups; the first was the International Accounting Standards Committee (IASC), which came to focus on accounting issues; the second was the International Federation of Accountants (IFAC), which mainly concentrated on auditing issues. The BCBS’ relationship with both was distinctly time-varying, as will be demonstrated below. Its relationship was willing, but increasingly hesitant and cautious, from 1975 until 1988, almost non-existent from then until 1996, and finally was restored in the last year of this period 1997, under the chairmanship of Tommaso Padoa-Schioppa and Tom de Swaan. What caused such variations, I do not know; no doubt personalities played a role, as well as the differing professional vocabularies of accountants and supervisors. Be that as it may, following concerns that ineffective bank auditing had been one of the factors in the failure of the Israel-British bank (BS/75/47), one of the first set of BCBS country papers related to the state of bank auditing in member countries, for example Germany (BS/75/60), Japan (BS/75/62), Canada (BS/75/63), and so on.2 The UK delegation produced a paper (BS/75/66) bemoaning the lack of a body able to establish international auditing standards, but it hoped that the newly formed International Accounting Standard Committee (IASC) would widen its field of reference to fulfil this role. This document, of some historical interest, is reproduced as Appendix A to this chapter. This then led to a letter being sent from George Blunden to Mr Joseph Cummings, the Chairman of the IASC. The letter (BS/76/44) of September 1976 reads: The Secretariat summarised and collated the respective country contributions in their note on ‘Existing arrangements for the appointment of bank auditors’ (BS/76/6), and ‘Matrix on paper on the appointment of bank auditors’ (BS/76/32 and 43). 2

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469

Following conversations and exchanges of letters between my colleague Mr Galpin and your predecessor, I am writing on behalf of the Committee on Banking Regulations and Supervisory Practices to your organisation, as the international body which my Committee feels is probably best qualified to deal with such questions, to put certain views to you about international accounting standards and auditing practices. In the paper that he handed to Sir Henry Benson last February Mr Galpin mentioned studies that we have undertaken of difficulties which have occurred in the international banking system. These studies suggested to us that differences between countries’ accounting standards and auditing practices had been a significant factor in some cases where international banks got into difficulties or failed. We were thus led to the view that greater international harmonisation of accounting standards and auditing practices would be desirable in order to help reduce the risks of a repetition of such incidents. My first purpose, therefore, in writing you this letter is to draw this view to the attention of the IASC, as a body formed to prepare and issue accounting standards for the widest possible international use. We then went on to consider what we could usefully do to promote greater harmonization of accounting standards and auditing practices. The Committee itself is neither authorised by its mandate nor qualified by its membership to undertake detailed work of this kind. Instead it has asked me to put before you certain problem areas which it has identified in the course of its work and where it feels that the IASC might be able to do useful work. As regards accounting standards we have identified three specific areas in which it would seem that greater international harmonisation could be beneficial. The first of these concerns the content of banks’ published financial statements. We are of the opinion that an attempt should be made to draw up agreed minimum standards of disclosure for such statements. In that connection, we have noted with interest the IASC’s exposure draft no. 5, ‘Information to be disclosed in financial statements’, which however relates primarily to the statements of non-financial institutions. Such minimum standards could take particular account of those areas, e.g. foreign exchange and security business, in which banks have got into difficulties in recent years. The second aspect concerns the terms used both in banks’ financial statements and more generally in bank accounts. Our work has led us to the conclusion that bona fide misinterpretation of bank accounting terms was an aggravating factor in some of the cases we have studied. Thirdly, we feel that a more harmonised presentation of the financial statements of banks in different countries could help to avoid misunderstandings, as well as facilitating inter-country comparisons. Such harmonisation might usefully relate to: (a) banks’ accounting policies, that is the way in which individual items are treated in their accounts; (b) the order in which items are presented in banks’ financial statements. As regards auditing practices, we are aware that such questions have so far been excluded from the scope of the IASC’s work. We noted however that in your predecessor’s view the IASC might be a suitable body for preparing

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documentation on auditing subjects. In this field, we believe that there is scope for improvement and harmonisation of auditing procedures.

There was no immediate response to this (or at least not one filed in the archives). Instead, there is a letter from Cummings to Peter Cooke, who had by then taken over from Blunden as BCBS Chairman, dated September 1977 (BS/77/55). In this Cummings states that, should the IASC agree that the subject of bank confirmations (only one of several key issues that the BCBS wanted tackled) was within its purview, the committee ‘would be willing to undertake such a project upon completion of its present work’. Moreover, Cummings complains about the costs of IASC meetings, and intimates none too delicately that the IASC would want ‘the possibility of financial support to IASC that might be forthcoming from the Group of Ten’; the unstated implication was that the IASC would have to be paid to do this exercise. In his reply to Cummings, Peter Cooke dodged the issue of funding the IASC, noted that the IASC’s current exercise was due to continue until early 1979, but sought to stay in touch. Not the most auspicious start, though not the fault of the BCBS. The IASC did then prepare an exposure draft on ‘Disclosures in financial statements of banks’, dated June 1978 (BS/78/16). One of the members of the BCBS (not the Chairman, but no record of who exactly, except that he was Francophone) was invited to attend the meeting in Perth, Western Australia, to discuss the draft in April 1978. He was not unduly impressed (BS/78/17): The IASC takes the view that the banks’ accounts as submitted to the supervisory authorities and their published accounts are directed towards different objectives and consequently adopt different methods. Nor is the Statement prepared designed to harmonise the rules for the presentation of banks’ published accounts. In addition, it does not set out all the standards applicable to the rendering of bank accounts. It is necessary to refer to each of the general norms (international auditing standards) to see which are waived for banks, and what is the scope of the waiver. It is understood that the banks, on the other hand, will disclose their methods of valuation and of arriving at the result. The Statement is therefore a rather short and simple document. It may be summarised as follows: I. Group assets and liabilities by their nature; classify these groups by order of liquidity; do not use item headings of the type ‘current’ as opposed to ‘permanent’ or ‘banks and money market’ as opposed to ‘customers’ … The members of the Steering Committee did not ask me to set out the point of view of the Group of Ten Committee with regard to their work. They did not give me any message or ask me for any statement which might have had any implication for the Group of Ten Committee. They did not ask me for my

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opinion or even for a personal impression of how the Group of Ten Committee might view the Statement which had been prepared. They answered my requests for clarification and adopted some amendments based on my personal thoughts … This said, my presence remained that of a passive observer. The future Statement will settle various differences of opinion between members of the profession. In this respect it seems to be a compromise. The members of each of the associations grouped in the IASC will therefore have to modify their attitude to particular points they feel to be important … It seems likely that this compromise should lead to a certain degree of international harmonisation of the accounts published by banks. In this respect, it represents definite progress. It will still be possible for differences in practice to exist but, as far as the main ones are concerned, the reader of the published accounts should be informed of them. Numerous questions are left open. A comparison of the future Statement of the IASC with the proposal for a directive prepared by the EEC Accountants’ Study Group would provide an initial list of these. But that is not the important thing. If the Statement enables the association and federations of accountants to feel that the gap as regards accounting standards applicable to banks has thus been adequately filled, we must be thankful that a major obstacle to the formulation of auditing standards has in this way been removed. The promulgation and effective application of this new international accounting standard may not be within the competence of the Group of Ten Committee, but the prospect of an improvement in the quality of external audits is of the greatest interest to it. It may therefore be thought that the Group of Ten Committee would do well to take formal note, in these terms, of the work accomplished.

Despite the somewhat distant reception of the BCBS representative at the IASC meeting, Cummings wrote to Peter Cooke on 16 June 1978 (BS/78/19) asking the BCBS to give its formal endorsement to the IASC exposure draft. This was raised at the immediately following (thirteenth) meeting of the BCBS (29–30 June) (BS/78/20): The Committee considered the stance it should take with regard to the IASC Exposure Draft on Disclosures in Financial Statements of Banks (BS/78/16) and to the letter (BS/78/19) from its chairman Mr Cummings inviting the Committee’s endorsement of that paper. After the views had been expressed that the analysis was too superficial and that the Committee could in no way endorse some of the Draft’s recommendations, in particular that relating to the treatment of banks’ hidden reserves, it was agreed that the Chairman should reply to Mr Cummings in a friendly but neutral manner, welcoming the paper as a contribution to the debate on these complex and sometimes controversial issues (for example, hidden reserves) but saying that the IASC should understand that the variations in the practices of different member countries prevented the Committee taking up a formal position on the document.

Nevertheless, Cummings returned to his proposal to get the BCBS to give public support to the IASC’s proposed exposure draft on ‘Disclosures in financial statements in banks’ in June 1979 (BS/79/35).

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Once again this was discussed (sixteenth meeting, 28–29 June 1979) and rejected.3 Meanwhile, the BCBS had also been in contact with a separate international body of accountants, the International Federation of Accountants (IFAC). Like Mr Cummings of the IASC, Mr Sempier of the IFAC was short of money.4 But, unlike the IASC, the IFAC was much more willing to work alongside the BCBS. Given the technicalities of accountancy, the BCBS had delegated responsibility for pursuing its concerns about interbank confirmation requests to a subgroup in March 1976 (its first ever subgroup, see Chapter 3) chaired by the indefatigable Jurgen Fitzenreiter of Germany (BS/77/6). The IFAC were prepared to incorporate Fitzenreiter and David Mallett, of the Bank of England, onto a special IFAC subgroup to discuss audit confirmation.5 This reported in mid-1979 (BS/79/40); the document was then to be 3 ‘The Committee considered the IASC’s discussion paper (BS/79/35). Following requests by several members, the Chairman said that he would propose to IASC that all reference to the Committee should be removed from the two front pages and that the phrase underlined near the foot of the third page should be replaced by a new text, agreed by the meeting, which was as follows: This discussion paper is put forward by the International Accounting Standards Committee for discussion and comment. The issue of the paper as a contribution to the general debate is welcomed by the Committee on Banking Regulations and Supervisory Practices of the Group of Ten major industrialised countries and Switzerland in recognition of the benefits that they believe are to be derived from work directed towards the harmonisation of the financial reporting practices of banks throughout the world. The contents of the paper have not however been endorsed by the Basle Committee of Banking Supervisors nor do they necessarily represent the views of the governing bodies of the members of IASC or the countries represented on the Basle Committee.’ 4 The author of the earlier cited note (BS/78/17) continued: I met Mr Sempier, the permanent representative of the IFAC, outside the [IASC] meeting, and gathered from the minimalist description he gave me of his facilities that budgetary problems are his prime worry. Encouraging the direction of his activities towards the auditing standards applicable to financial intermediaries will undoubtedly involve financial aspects, but I myself wonder whether one could not envisage assistance in terms of material co-operation:€help with the secretariat for, and cost of meetings of, a working party (travelling expenses of experts chosen after consultation with the Group of Ten Committee), entrusted with the preparation of draft standards relating to well-defined points, established by agreement with the Committee. No mention was however made of such an idea. 5 Thus in BS/78/20 it was reported that: As far as work by the IFAC on audit confirmation procedures was concerned, the timetable which had been proposed, i.e. to produce an exposure draft within twelve months, appeared satisfactory to the Committee. The presence of Messrs Fitzenreiter and Mallett on the IFAC working group dealing with the subject would ensure that the Committee’s interests were taken into account. The Committee approved the Chairman’s suggestion to write to IFAC’s executive director, Mr Sempier, confirming

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circulated to banking associations and auditing bodies for comment, to be then passed on to Fitzenreiter (BS/79/59). The speed, and extent of response, by national bodies was slow and limited, so Fitzenreiter and his subgroup decided to draw up ‘a questionnaire for circulation to banks and auditors in member countries in order to stimulate a response from them’ (BS/80/47). This was done in May/June 1981 (BS/81/17). This work finally began to bear fruit in early 1983 with the drafting of a note on ‘Inter-Bank Confirmation Procedures’, to be issued jointly by the IFAC and the BCBS (BS/83/12). Even then, Peter Cooke noted separately (BS/83/11) that: Some concern was expressed, however, about the pro forma confirmation request letter appended to the document as it gave the impression that IFAC and other accounting bodies were trying to impose a standard form of confirmation request worldwide. This was not the intention, but in recognition of the concern that was expressed the pro forma confirmation request letter is not incorporated in the International Auditing Guideline (BS/83/12) which it is now proposed to issue.

This note was finally circulated publicly in February 1984 (BS/84/16 and 17), over five years after the joint work started and nearly eight years since the establishment of the Fitzenreiter subgroup. That marked the end of the Fitzenreiter subgroup; there were no more meetings or discussions with accountancy bodies from 1983 until late 1986, as the energies of the BCBS became focussed and absorbed on the Basel I CAR Accord. Even so, there was a useful note for the record provided by the Secretariat, on the basis of work done elsewhere, on ‘The relationship between external auditors and supervisors’ (BS/85/11). This is, in my view, a useful historical document and, therefore, is reproduced here as Appendix B. Late in 1986 the BCBS agreed to restart joint work with the IFAC in a joint task force, the International Auditing Practices Committee (IAPC) to:

• prepare a general paper examining relationships between bank supervisors and the external auditors of banks; • draw up a guide for the auditors of international commercial banks.

The former, an extension of BS/85/11, was primarily drawn up by the BCBS’ Secretariat (BS/87/47), and a draft of the latter, prepared by the its participation in the work on audit confirmation, repeating its request for speedy results, requesting an interim report as soon as possible and offering sympathetic consideration to any request for a modest (but unspecified) financial contribution to the costs of the work.

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IAPC, was made ready early in 1988 (BS/88/24). Despite the fact that much of this work was done jointly with BCBS participation: at the last two meetings some Committee members have sought to distance themselves from the results of that work. The objections appear to range between two opposite points of view. On the one hand, there are one or two member countries where regular on-site inspection is the rule and where little or no relationship with auditors exists or is sought; and, on the other hand, there are one or two countries where long and close relationships with auditors exist and the auditors have to some degree become an extension of the supervisory arm. In essence, the first wing sees no need for the Committee to become involved in this exercise and the second believes that the definition of the auditor’s tasks in the two draft papers prepared by the task force does not go far enough because it does not prescribe the particular practice followed in those individual countries. Very few countries outside the Committee have supervisory systems which fall within either of these two categories referred to above. Indeed, comments from non-G-10 countries on the general paper concerning the relationship between bank supervisors and external auditors have been positive and have not reflected the attitudes referred to above. The Committee now needs to address the way in which its name should be associated with the issue of these two documents. The Chairman will wish to address this question at the October meeting. It would seem very difficult for the Committee totally to disown this work, in which representatives of three member institutions (Deutsche Bundesbank, Swiss Banking Commission and Bank of England) as well as its own Secretariat have taken part. Equally, it is clear that full endorsement by the Committee is not appropriate. Accordingly, it is suggested that both papers might carry a form of words which, while indicating that the Committee has been associated with the preparation of the document, states clearly that the arrangements described are not intended to be prescriptive for the supervisory systems in individual member countries. For the approval of members, a draft form of words is attached. These paragraphs would appear prominently at the start of both papers. (BS/88/86).

This formula found acceptance,6 and both documents were released in June 1989 (BS/89/16). Thus the covering material to IFAC’s proposed statement on ‘The audit of international commercial banks’ (BS/89/36) contained the following disclaimer: 6

The supervisory authorities of the countries represented on the Basle Supervisors’ Committee … attach considerable importance to thorough and reliable standards of external audit. However, there are considerable differences in the way in which individual supervisory authorities use the work of auditors in their supervisory arrangements. Some authorities have specific regulations relating to the scope of the audit and the suggestions made in this proposed Statement are not intended to limit or alter those arrangements but it is hoped that they will be helpful guidance where auditors and supervisors are involved together in the supervisory process.

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Meanwhile, following a meeting with Peter Cooke at the end of 1987, the new Chairman of the IASC, G. B. de Ruyter, wrote to Cooke (January 1988, BS/88/15) to suggest a joint ‘task force’, comprising members of the BCBS, IASC and national banking associations, be set up ‘to recommend ways in which the requirements relating to the financial statements of banks could be further improved and harmonised’. The BCBS was not keen to take up this offer. At its next (forty-fifth, 28–29 January 1988) meeting, the Committee decided (BS/88/21) that: It was not appropriate for the Committee to be formally represented on a joint task force, since this was primarily a matter for accountants and bankers. However, the Committee would not object if representatives of national supervisory authorities wished to serve on a task force in an expert capacity.7

So, by the end of 1988 the BCBS had become increasingly cautious about links with the various international accountancy bodies. Nevertheless, there were a few occasions when assistance was sought from them. Thus, in 1991 Chairman Huib Muller wrote to senior accountants in both the IAPC (the International Auditing Practices Committee of the IFAC) and the IASC about the treatment of general loan-loss reserves and whether they could be included in Tier 2 capital (enclosing a draft consultative paper (BS/91/4)) (BS/91/20). The IAPC wrote back (BS/91/67) asking to change the phrase ‘future losses’ to ‘losses resulting from future events’ to placate the UK accountants, whose practices ‘prohibit the setting up of provisions for unidentified losses that relate to unknown conditions which could arise in the future’ (BS/91/67). By and large, however, there was an almost complete hiatus in relationships between the BCBS and the international accounting bodies between 1988 and 1997.8 By then this separation had become perceived by the BCBS as undesirable, and a new Accounting Task Force9 was established, under the chairmanship of Nick LePan of Canada, ‘to contribute to the work of the Basle Committee … in promoting sound international standards for banks in such areas as capital adequacy, risk management and disclosure, and to contribute directly to international 7 The IASC went ahead, without BCBS participation, to produce in 1989 a new proposed statement on ‘Disclosures in the financial statements of banks’, and requested comments (BS/89/80). The BCBS decided to take no action (BS/89/92). 8 There were a couple of letters from American representatives at the BCBS to the chairman, from Chet Feldberg in 1995 and from Spillenkothen in 1996, relating to accounting issues, which have been withdrawn from the files. 9 This task force still exists.

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accounting harmonisation and standard setting’ (BS/97/22, February 1997). The Task Force discussed relations with the IASC and its accelerated work program. The Chair reported on his discussions with the IASC Secretary General and the chair of the financial instruments project. It was agreed that there was a need for the Task Force and the Basle Committee to establish its involvement quickly. Accordingly, though a number of current IASC projects were identified as being relevant for banks, it was decided to focus on the financial instrument project, because of its importance and sensitivity. There was considerable discussion of the draft IASC discussion paper for this project, which has at its core the idea of marking to market all financial instruments widely defined (including assets and liabilities well beyond the ‘trading’ book). This paper will be released for comment in the next few months and the Task Force is preparing a substantive response. It will be shared with the Committee in draft form for comment, through appropriate procedure, depending on timing.

At the subsequent March meeting of the BCBS (eighty-first meeting, 18–20 March 1997) (BS/97/36): Mr LePan raised the following points concerning the Task Force’s work programme for the Committee’s reaction. • The need to more closely follow and react to the Financial Instruments project currently pursued by the International Accounting Standards Committee (IASC), in a way that preserves the Committee’s independence. • The need to discuss the comments to be forwarded to the IASC on their discussion paper for financial instruments accounting. • The intention of the Task Force to devote time and effort to conducting a survey on loan valuation and another on general accounting issues in the G-10. Committee members expressed their satisfaction with the work programme and the increased focus that will be provided to accounting issues through the Task Force. The interrelation between accounting standards and capital standards was highlighted as an area of particular interest in the future. The Task Force was asked to prepare a written comment on the Financial Instruments discussion paper for the Committee’s June meeting.

This was a volte-face, albeit a welcome one, from the cautious distance from accountancy bodies that the BCBS had maintained over most of the previous decade. An occasion to renew relationships was provided when the new Chairman of the IASC, Sir Bryan Carsberg, sent the new Chairman of the BCBS, Tom de Swaan, the former’s discussion paper (IAS 32)

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on ‘Accounting for financial assets and financial liabilities’. As was foreshadowed by the just-mentioned change of policy at the BCBS, de Swaan sent Carsberg a lengthy, forthcoming, detailed and encouraging response that was clearly intended to reopen discussions with the IASC (BS/97/46). Besides seeking to re-establish, and to intensify, good working relationships between the BCBS and IASC, this note (BS/97/46) is valuable since it records the BCBS’ position on fair value accounting as of that date, 1997. On the assumption that readers will appreciate that views will have subsequently evolved, this long section of the note is reproduced as Appendix C, as a historical document (BS/97/123 is also relevant). More or less at the same time as the BCBS Task Force on Accounting was re-establishing contacts with the IASC, so the risk management subgroup co-chairs, Roger Cole and Christine Cumming, were seeking to re-establish links with the IAPC of IFAC (BS/97/24 and 97/84).10 So, by the end of 1997 connections and relationships with the international accounting bodies which had disintegrated at the end of the 1980s were being put back on the rails again.

10 Thus, it was reported in BS/97/84 that: Consequently, the Subgroup is seeking guidance from the Committee as to whether additional resources should be applied in order to: • Open a dialogue with the International Auditing Practices Committee (IAPC) to encourage the development of improvements to international auditing standards. This involvement could include having one or two representatives of the Subgroup attend certain meetings of the IAPC in an advisory capacity. In this regard, the IAPC will host on 8th December a meeting of international organisations interested in enhancing international audit standards. The IAPC has recently asked for representatives of the Risk Management Subgroup to attend, together with representatives from IOSCO, the World Bank, the IIA, the European Union and other organisations. The Subgroup believes that, while it is too early to begin to influence the process, it is not too early to start observing the process and getting to know ‘the players’. Once this is done, the Subgroup would be in a better position to identify for the Committee ways in which the Committee could influence the process in order to maintain its key position as a standard-setting body for matters related to banking and banking supervision. • Provide comments on proposed international auditing standards and bring matters to the attention of the international standard-setting bodies that are of concern to bank supervisors. For example, when the IAPC requests comments (most likely, not until 1999) on possible updates to standards for audits of international banks, the Subgroup could develop a comment letter for consideration by the Committee.

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C

Relationships with securities regulators, notably IOSCO

While the relationships between the BCBS and the international accounting bodies (IASC and IFAC) were variable and rather distant, the relationship with the main international securities regulator, IOSCO, the International Organisation of Securities Commissions, began much later (around 1988) but then, after an encouraging start, came to border on the dysfunctional (as far as the key issue of capital standards was concerned; relationships on other issues, for example information-sharing, remained much more cordial) for much of the rest of our period, until the end of 1997, so much so that it led politicians to intervene for the purpose of banging heads together. Some historical background may be helpful. One of the causes of the US Stock Exchange bubble prior to the crash of 1929 was viewed at the time as residing in conflicts of interest between the underwriting and investment departments of banks and the more traditional loan and deposit banking department. Thus it was alleged that the underwriting/investment wing would not only foster and support new issues (IPOs) of dodgy equities, but would also pressurise their own banking departments to make margins loans on easy terms to clients wanting to buy such equity (which would be further puffed by the bank analysts). Thus equity prices, stock market margin loans and monetary expansion would all rise together. Although such analysis has been challenged by subsequent research (see Benston (2010), Calomiris and Mason (2000) and Calomiris (2007)), it was widely accepted at the time, and led directly to the Glass-Steagall Act, which forcibly separated investment banking activity, such as underwriting, from traditional banking. The traditional banks were to be regulated and supervised by a variety of federal and state bodies depending on their legal circumstances, including the Federal Reserve System, Office of Comptroller of the Currency (OCC) and Federal Deposit Insurance Corporation (FDIC). In contrast the Investment Houses (broker/dealers) were not allowed to take traditional deposits, but instead were to finance themselves by equity, longer-term debt and shorter-term borrowing in wholesale markets. Since they had no traditional retail deposits, and their liabilities were not protected by deposit insurance, it was thought that they had no need of central bank support in the guise of access to the discount window or lender of last resort back-up, a hypothesis which was shown to be flawed in the 2007/8 financial crisis.11 11 As a result, the Paulson Committee Report (2008) advocated that macro-prudential oversight of all systemically important financial intermediaries should be transferred

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This somewhat encouraged the view that the investment houses could operate on the basis of generally much lighter, less intrusive regulatory oversight, and that this should be done by the Securities and Exchange Commission (SEC), a body which was much more focussed on conduct of business issues than on macro-prudential control.12 Meanwhile, the Fed and the other US banking regulators had no locus whatsoever for oversight, monitoring or influencing the broker/dealers and investment houses. In contrast, the dominant business model in Continental Europe was that of the universal bank, which could combine investment banking with traditional retail banking. The Japanese banking structure was more akin to that in the USA, not surprisingly since their banking laws had been restructured along American designs after World War II. The UK banking system was a mixture of both. Prior to Big Bang in 1986, much investment banking in London was done by the specialised merchant banks and accepting houses. Thereafter these were progressively taken over by US investment houses such as Merrill Lynch, by US banks such as Citibank, by European universal banks such as Deutsche Bank, and by the main London clearing banks such as Barclays. So, all the various business models were represented in London. Not surprisingly, as technical progress allowed for greater competition on a global scale, the business models of traditional and universal banks led them into ever closer competition with the investment houses. to the Federal Reserve Board, with the SEC reduced to providing conduct of business (customer protection) supervision. This issue was effectively overtaken in autumn 2008, when the demise of the large US investment houses occurred. The DoddFrank Act (The Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111–20–3, H.R. 4173, (Washington DC)), 21 July 2010, has taken this matter on further. 12 Herring and Litan (1994), p. 125, claim that there was no case for imposing Baseltype CARs on securities houses, or for any international harmonisation for such houses, let alone jointly with banks: The case for adopting Basel-like standards for the securities industry also has yet to be supported, even if obtaining agreement on such standards were possible (an outcome that has thus far proved elusive). Proponents of this course point to the dangers exhibited by the collapse of Drexel Burnham Lambert and how, but for active intervention by US regulatory authorities in particular, the international payments system could have been jeopardized. We challenge this view in Chapter 3, demonstrating that the dangers from Drexel’s collapse were overstated and that, in any event, the regulatory system as it existed was fully capable of responding to the crisis. More fundamentally, the case for harmonizing capital standards for securities firms across countries fails to recognize a fundamental fact:€to the extent that failures of securities firms pose risks to the international financial system, they do so principally because of their linkages with banks. But many other types of firms also expose banks to risk; banks lend to nonsecurities firms also. We see no compelling case why international capital standards should be set for nonsecurities firms, and so we believe the same logic applies to securities firms.

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In particular, in the course of the 1980s many of the larger traditional and universal banks came to reorganise their business into two parts:€the banking book and the trading book. Activities in banks’ trading books were closely akin to, and competitive with, those in investment houses. Especially when they came to consider market risk (see Chapter 7), but even with credit risk (Chapter 6), the BCBS had to be concerned with the riskiness of banks as a whole, including the trading book. But that immediately brought it face to face with ‘level-playing-field’ issues with the investment houses. In turn these latter were ‘regulated’ by the SEC domestically in the USA, and internationally came under the oversight of IOSCO. It took some time for the BCBS to realise that it needed to negotiate common regulatory arrangements for trading book issues with IOSCO.13 Indeed the initial approach, from the BCBS to IOSCO, did not arise from concern with level-playing-field supervisory issues, but in the aftermath of the stock market collapse in October 1987. Thus C. J. Thompson reported to BCBS members (23 December 1987) (BS/87/90) that: At the Committee’s November meeting you will recall that, in his concluding remarks following the tour de table on the impact of the stock market collapse, the Chairman said that he would like to establish a small working party to explore issues for bank supervisors in seeking to develop a relationship with supervisors of institutions specialising in securities business.14

13 As noted in Davies and Green, Global Financial Regulation:€ The Essential Guide (2008), p. 60: IOSCO itself grew out of an association of the stock exchange commissions of the Americas set up in 1974. At a conference in Quito in 1983 it was agreed that other countries could join the organization, and that it would become a global body. In the following year the United Kingdom, France, Indonesia and South Korea were the first group of new countries to join. Since then, effectively all securities regulators have become members, with also an associate category of membership for offshore centres, for second regulators in the same country as a full member (e.g. the CFTC) and for other affiliates including exchanges themselves. 14 The note continued: The Chairman has asked me to say that he is, of course, aware of the delicacy of this matter for some countries, particularly as regards questions of jurisdiction and responsibility for securities supervision. He would also like to make clear that there is no question of the Committee itself seeking to establish a responsibility for the supervision of securities markets. He feels sure, however, that members of the Committee generally share the view that, even before recent events, the convergence of banking and securities business made it important for the Committee to seek to establish a dialogue on matters of mutual concern with a representative grouping of securities regulators.

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The first stage was to set up a small working party of the BCBS, to be chaired by Chairman Peter Cooke, ‘to explore the issues that bank supervisors would wish to address in any discussions with securities supervisors; in other words to set an agenda and an order of priorities for the subsequent dialogue’. This was arranged to occur in London in mid-January 1988. At this meeting, the working party identified three types of issues that could, and should, be discussed with securities regulators and, as was their wont, sent out a questionnaire to elicit the characteristics and functions of securities regulators in member countries (BS/88/11, 20 and 30). These main issues were (BS/88/4):

• systemic or macro-prudential issues arising from the process of securitisa-

tion, such as questions relating to the lender of last resort, the risk to banks of contagion arising from affiliated companies operating in securities and the risk to payments systems arising from the possibility of counterparty failure in the settlement process; • Concordat-type issues, namely the sharing of supervisory responsibility and the problem of confidentiality; • specific technical subjects, such as the measurement of position risk on securities and its incorporation into capital adequacy frameworks. • It was agreed that the systemic issues, while of great importance to the central-bank members of the Committee in particular, are not specifically supervisory in nature and that they should not be the particular focus of any initial discussions with securities regulators. In its own work, of course, the Committee will need to continue to bear them in mind, particularly the question of settlement risk. It is suggested that there are a number of Concordat-type issues on which discussion with securities regulators would be useful. These would include: – the question of parental supervision of securities companies which operate as banks in other countries; – the need for cooperation between securities regulators and bank regulators in the supervision of international financial conglomerates (including the regulatory standards applied by securities regulators to foreign banks operating in the securities markets); – procedures for the exchange of supervisory information between bank reguÂ� lators and securities regulators, and the possibility of using existing bank supervisory channels as a conduit. The Chairman would wish to stress the informal and exploratory nature of these contacts with securities regulators. What is needed is the possibility of some early dialogue on the issues. In each G-10 country there may be a number of different agencies concerned with various aspects of securities regulation. By pursuing informal contacts, the working party would deliberately avoid ascribing any special status or representative capacity to particular agencies on the securities side. Note the initial uncertainty about who the counterparty, or counterparties, on the securities side might be.

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The working party has identified three technical issues which could merit joint work with securities regulators: – the measurement of position risk and its application within supervisory regimes. This would not be limited to interest rate risk but would also cover foreign exchange risk and the risk of adverse changes in the price of marketable securities; – the consolidated supervision of banking groups which include independent securities businesses; – the desirability of removing competitive inequalities, particularly in relation to capital adequacy requirements.

Opening up discussions with securities regulators was, rightly, perceived as being potentially a major initiative, with open-ended implications for the resources and functions of the BCBS. So, the proper next stage was for the Chairman to appraise the governors of what was intended. This was then done (BS/88/13) (1 February 1988). This note provides a nicely drafted account of the BCBS’ position at the outset of relationships with securities regulators, and is therefore reproduced as Appendix D. There was no specific reference to IOSCO; indeed it was stated: that there are several existing organisations which have some expectations that they should act as an international co-ordinating body … but it is unclear whether any of the existing groupings are wholly appropriate to fulfil this role … Instead, … the Chairman … should invite certain designated national regulatory bodies to send ‘experts’.

Initially some of the Governors were hesitant, concerned (BS/88/28) that such a meeting: could encourage comment either that the central banks were moving to extend their responsibilities to cover securities supervision, or that, as a consequence of these contacts, lender-of-last-resort facilities were being assumed to extend to securities business (although the paper, of course, made it clear that the subject was specifically excluded from the issues to be addressed by the Committee).

Consequently much of the rest of 1988 was taken up with further clarification, within the BCBS and between the BCBS and the Governors, on the nature and substance of the prospective dialogue with securities regulators (BS/88/31, 35, 42 and 46). In national comments on ‘Issues for discussion between banking and securities regulators’ (BS/88/42) France argued that ‘the International Technical Committee of the IOSCO … would appear to be the most appropriate organisation for the Cooke Committee to approach’. Nevertheless, the more general view among BCBS members then was that ‘talks should be held directly with the supervisory authorities of these [big] markets’, rather than with international bodies (of whom not only IOSCO, but also

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Wilton Park and CMF (Conseil des Marches Financiers) were mentioned). This latter was done, agreement having been obtained from the Governors; and such a meeting was held at the BIS in September (BIS/88/63, 82 and 85). Five main topics were discussed (BS/88/85, 100 and 101): Constraints on exchanges of supervisory information between different reguÂ� lators; authorisation procedures involving cross-border establishments; the allocation of supervisory responsibilities as regards financial conglomerates; convergence in national regulations in the banking and securities field; and consolidation. The agenda therefore addressed a wide range of issues and the tone of the discussion at this inaugural meeting was exploratory and educative. The most encouraging discussion was on exchanges of information between banking and securities supervisors. There are obviously legal impediments in most countries to a full and free flow of information but several speakers made the point that, provided the parties had trust in one another and confidentiality was maintained, ways could often be found to communicate necessary information. Personal contacts with other supervisors would do much to further the degree of trust. Several participants, however, noted that they would find it difficult to pass sensitive information to self-regulatory organisations under any circumstances. Reciprocity also appears to be an issue in some countries. It was agreed that the Secretariat would draw up a paper on the issues raised in the discussion with a view to identifying the crucial constraints on effective information sharing. On cross-border authorisation, experience appeared to suggest that there was already a good deal of consultation between host and parent supervisors in the banking field and, separately, in the securities field. It was less clear, however, whether securities and banking supervisors normally consult each other when a bank sets up a securities business or vice versa. The discussion on the allocation of supervisory responsibilities€– on the lines of a Concordat for securities regulation€– was much more complex and inconclusive. Wide differences became evident in the nature and degree to which securities operations were regulated and in the philosophy regarding the regulation of financial services groups. As regards the more discrete topics of supervisory policy, the treatment of position risk in capital adequacy rules was the main topic. Some participants questioned whether it was right to measure position risk in the same manner for banks and securities houses, since the nature of their activities and their supervision was so very different. Others felt that it was logical to have the same capital requirement for the same risk, in whatever institution it arose. It is clearly desirable for banking and securities regulators to keep abreast of the work being developed in this area and arrangements have been made for those working on position risk to keep in close contact. The final topic of discussion was consolidation. Some felt that it was difficult to consolidate fully separate banking and securities companies within a group, given the very different types of risk being run. But there was nevertheless general appreciation of the need for some form of consolidated overview of the group as a whole, in addition to separate supervision of the constituent parts.

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The meeting was assessed by the BCBS as ‘useful and constructive’. There were two consequentials. First, it was ‘agreed that a further meeting along similar lines should take place in the summer of 1989’. Second, it was ‘agreed that the Beverly subgroup of the BCBS, in which the Committee’s work on this topic [i.e. the treatment of position risk in capital adequacy rules] was progressing should keep in close contact with the IOSCO technical working party chaired by Jeffrey Knight,15 with the possibility of sending observers to each other’s meetings where this was felt to be useful.16 So far, so good. Meanwhile, the various BCBS subgroups, under Beverly and Mackenzie, charged with studying the application of capital adequacy requirements to position, interest rate and market risks (from bank holdings of tradable assets), were pressing ahead with their exercises (see Chapter 7). So in May 1989 the Secretariat proposed an agenda for the September meeting (BS/89/41),17 covering the following topics: – tour de table on national developments since the last meeting on relevant developments in banking and securities regulation; 15 As noted in the report of the discussion (BS/88/100): In 1987, the countries with the most active securities markets (Australia, Canada, France, Germany, Hong Kong, Italy, Japan, the Netherlands, Switzerland, the United Kingdom and the United States) had formed a Technical Committee within IOSCO designed to address more intensively matters concerning the interaction between their markets. This Committee had in turn created six working parties, which were addressing accounting and auditing standards, the capital markets (notably legal impediments to securities offerings on a transnational basis), off-market trading, settlement, exchanges of information and capital adequacy. The work of the technical group on capital adequacy had begun with a survey of national arrangements for measuring capital and setting minimum standards. It was clearly necessary first to study and compare the different systems and then to seek to identify a common approach. This was now being done with a view to constructing a theoretical model which would define the functions of capital and specify the types of risk to which it should be related. Consideration was also being given to monitoring compliance with capital standards and the arrangements for segregating clients’ funds as a means of investor protection. The working party planned to present progress reports to the Technical Committee in October and to the annual meeting of IOSCO in Melbourne in November, with a view to concluding the present stage of its work by mid-1989. 16 IOSCO had a complicated committee structure. There were a number of senior committees. The key committee with which BCBS dealt was the Technical Committee. This, in turn, had several working groups, of which the Group on Regulatory Standards was most important. During these years this group was chaired by a UK official from the Securities and Investments Board (SIB) (while an official from the SEC would regularly chair the working group on accountancy issues). It sometimes appears as if the working group, under its British chairman, was willing to be more forthcoming in negotiations with the BCBS, than the senior authorities of IOSCO, led mostly by the SEC, were subsequently prepared to ratify. 17 Subsequently agreed (BS/89/49) and sent out to the same invited participants as had attended the September 1988 meeting (BS/89/57).

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– a paper being prepared by the Secretariat on information flows between banking and securities supervisors [BS/89/50]; – a possible paper by the Mackenzie sub-group, perhaps a modified version of BS/89/31 or, if time permits, a new paper, addressing problems relating to the consolidated supervision by bank supervisors of banking groups significantly engaged in securities activities; – some material from the Knight working group set up by IOSCO’s Technical Committee to examine capital requirements of securities houses; – consideration of the progress of work on the EC’s Investment Services Directive; – exchange of views on the implications of the Group of Thirty report on clearance and settlement systems in the world’s securities markets and on the work being undertaken in the BIS on interbank netting schemes.

This meeting was held at the BIS, in September 1989 (BS/89/85). The first main topic after the tour de table was on information flows; naturally regulators and supervisors favour, in principle, greater information flows between themselves. Chairman Huib Muller (and the BCBS) wanted to develop the paper on information flows before them: into some kind of joint statement by participants in the meeting about the desirability of relaxing legal constraints on information flows between the banking and securities supervisors, subject to the four conditions mentioned in the paper. The result, he suggested, might be suitable as a basis for developing information exchanges, not only between those represented at the meeting but also between supervisors in non-G-10 countries … The Chairman concluded that participants agreed that this was a delicate matter but that it was worth making an effort to express the group’s views in a not too formal document recording the discussion it had had. Subject to the approval of the G-10 Governors, the result could then be made available to the regulators in other financial centres. However, it would not be issued as a press communiqué or given a high profile.

This was then done (BS/89/95) and issued in early 1990 (BS/90/24). The discussion then turned first to the Mackenzie subgroup paper on ‘Issues relating to the supervision of securities business undertaken by banks and bank affiliates’ (BS/89/31), and then to the ‘Report of the Technical Committee of IOSCO on capital adequacy standards for securities firms’ (to be discussed at the subsequent IOSCO meeting in Venice). Here the differences in viewpoints were much more marked, mirroring the perceived disparities in structure and operation between investment houses and banks. While the objectives of capital adequacy regulation were the same in both instances, securities regulators emphasised that the general holdings of highly marketable securities by investment houses made them much more liquid than banks. Moreover, the securities regulators argued that, since the investment houses were so

486

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liquid, they could rely on shorter-term debt to protect them against default, and needed less overall capitalisation than banks. The Chairman nevertheless attempted to claim that the two groups of regulators could still reach ‘broad equivalence’ in this field. An edited version of some of this part of the discussion is presented as Appendix E. The BCBS was now in a difficult position. On the one hand it wanted ‘equal rules for business of the same type’, and that meant similar rules for trading books in marketable securities, whether such books were in banks, banking affiliates or investment houses18 (see BS/89/112 and BS/90/14). On the other hand it had no control, or power, over securities regulators who reckoned that the characteristics of investment houses enabled the latter to operate with generally less capital, and a higher proportion in comparatively short-dated subordinated debt, than the BCBS could easily swallow. Chairman Muller expressed these issues nicely and tactfully in a public speech on ‘International regulation of securities markets’ at a meeting of the Fédération Internationale des Bourses de Valeurs Workshop at Amsterdam on 24 April 1990 (BS/90/29). In this he said (pp. 5–6) that: Intuitively, it would appear sensible and appealing to apply similar, and some would say identical, rules for both sets of institutions where the risks undertaken are identical. Unfortunately, as we are all aware, matters are never quite that simple. Banks and securities firms, and their respective supervisors, have fundamentally different perspectives. Securities firms trade a wider portion of their balance sheet and are always expected to be liquid. Their assets are 18 The Germans were particularly vehement on this point; see BS/90/14, letter from Karl Otto Pöhl to Chairman Muller, and Muller’s reply (also BS/90/43). In particular, Pöhl wrote: In reply to a letter from my colleague Mr Gaddum [BS/89/112] on this matter you stated, inter alia, that the Committee, in the end, could only draw up regulations for banks. Although this is technically correct, it must not impede vigorous and persistent efforts being made to develop a plan in cooperation with the supervisory authorities responsible for securities transactions, even if this were to entail a delay in completing the work. Without such a plan it will hardly be possible to apply the principle of consolidation, on which the Governors agreed a long time ago, to financial groups consisting of both banks and securities houses. I would therefore like to state quite firmly, and I am sure that representatives of some other states represented in Basle will agree with me, that supplementing the Capital Agreement by regulations on securities risks would not be acceptable to me for competitive reasons if these regulations were limited to banks. Since Pöhl was then the chairman of the G10 governors, his views carried much weight. The thrust of this series of letters was that the Germans would refuse to accept a proposal for capital adequacy requirements to be applied to banks alone, but would insist on a level-playing-field basis for CARs on market (position) risk between banks and investment houses.

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capable of ready and objective valuation minute by minute. Hence, securities regulators tend to apply a liquidity test intended to assure that all customer obligations could be met if the firm had to be wound down. Banks hold less liquid assets for a longer period and often are viewed by their regulators on a going-concern basis with less scope to apply the strict liquidity requirements used by their securities counterparts. A broader portion of banks’ assets does not have a ready market and the valuation of those assets is more subjective. In short, bridging the two regimes, though not impossible, is far from a simple task. Although the debate is louder in Europe at present, similar€– if not identical issues€– are being, or will soon be, confronted in other centres. Clearly, this is a problem that will not go away, and at some point will have to be addressed on a global basis. Indeed, the main issue for regulators will be how to accomplish the necessary convergence of rules without detracting from the traditional effectiveness of either group of supervisors. Some might say there is a conflict between the two objectives. I would argue that all efforts should be made to reconcile these objectives, and indeed the market will demand that they be reconciled! [Emphasis in original.]

At this point, however, there was little that the BCBS could do, except to wait until the IOSCO Technical Working Group, under Jeffrey Knight, came to a preliminary decision about CARs for investment houses against position risk, in the hope that the initial proposals of the Knight group (IOSCO) and the Mackenzie subgroup19 (BCBS) could then be reconciled in subsequent discussion/negotiation. In that view, Chairman Huib Muller wrote to Jeffrey Knight (20 March 1990) (BS/90/25) as follows: The second group, currently chaired by Michael Mackenzie, Superintendent of Financial Institutions in Canada, has been looking at the position risk in equities. It has been pursuing two possible treatments. The first would be based on the treatment of credit risk in the Basle framework, extending it to short positions and adding a requirement for the risk that the market as a whole may move against the bank concerned. However, some members feel this approach may give rise to competitive inequalities vis-à-vis non-bank securities firms. Therefore, the group is also studying an alternative approach which would involve separating trading positions in equities from the rest of the bank’s business and applying a capital adequacy test to that part of the business similar to that applied by securities regulators. Not all members feel that any such arrangements should be identical to the securities regulators’ approach. Many feel that the test for banks should be simpler, particularly because, for many banks, the trading of equities is a very small part of the total business of a banking group. Moreover, the regime must also adequately meet the prudential needs of the bank’s supervisors. But perhaps crucially, it would be necessary 19 At this juncture Michael Mackenzie had to resign as subgroup chairman and his role was taken over by Roger Barnes of the Bank of England.

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for securities regulators to reach a greater degree of convergence on their own capital rules. The Committee therefore does have a very direct interest in the work of your working party. You will understand that it would be very helpful if, to the extent possible, you were able to steer your group’s work in a direction compatible with that of the Mackenzie group. May I therefore ask you to concentrate in the first place on the convergence of rules in respect of equities. Given the connection between the work of the two groups, and also the European dimension, it would obviously be helpful if progress could be as rapid as possible.

The Knight subcommittee then drafted a series of papers in the summer of 1990, comprising studies on: 1. ‘Capital requirements of banks and securities houses’, draft 28 September 1990 (BS/90/67). 2. ‘Definition of capital’, 31 July 1990 (BS/90/68). 3. ‘The base requirement and the minimum requirement for capital’, 8 June 1990 (BS/90/69). 4. ‘Comparison of position risk requirements for debt securities’ (10€August 1990) (BS/90/70). 5. ‘Comparison of equity position risk requirements and scope for harmonization’ (10 August 1990) (BS/90/71). The omens (from the BCBS’ point of view) were, however, mixed. In the first place the (Technical Working Group of) IOSCO was already struggling to agree a common position on CARs among its own members, and going further to reach equivalence with banking supervisors was likely to be a step too far for its members. In part following the Stock Market crash of 1987, France had introduced new requirements on equity position risk in January 1989; the Japanese had introduced new requirements on an experimental basis in the summer of 1989 (to be fully implemented from 1 April 1990); the UK (SIB/TSA) requirements were introduced in April 1988 (BS/90/71). Thus, with their own new requirements hardly bedded down, it would be hard enough for securities regulators to agree a common position among themselves, let alone make significant changes to their own approaches in order to make common cause with banking supervisors. There were significant differences in the operational characteristics between the two sets of businesses, which drove differences in regulatory philosophy. Investment houses held primarily marketable securities, and could revalue these on a mark-to-market basis daily; banks did not. Securities regulators discriminated much more closely (than bank regulators) between high (and lower) quality assets in trading books. Because investment houses could, and did, adjust their books (leverage)

Relationships with securities regulators, notably IOSCO

489

much more rapidly than banks, securities regulators were happy to allow the investment houses to hold shorter-dated subordinated debt, and even guarantees, against position risk. Investment houses could, at least in principle, be wound down much more quickly and easily than banks, and hence their regulators could take a much shorter-term perspective. At this juncture, the Technical Working Party of IOSCO held out an olive branch, suggesting that: One way of bringing the requirements [of BCBS and IOSCO] close together would therefore be to add an extra tier to the capital of the banks and have the same requirements for banks and non-banks. Tier [3] Short-term subordinated loans allowed to back the securities activity€ – must have a clause preventing repayment, even at maturity, if it would bring the capital below a set threshold (such loans could be subject to a limit) (BS/90/67).

Moreover, because investment houses’ main assets were marketable securities, any attempt to apply the BCBS’ 8 per cent capital requirements against counterparty (credit) risk would risk destroying the business model of investment houses (instead investment houses tended to have a base requirement, though that varied from one country to another) (BS/90/67). With IOSCO’s Technical Working Party having now put forward position papers, the next step was to convene another joint meeting, at the BIS in September 1990 (BS/90/72). Despite the extent of differences in operational characteristics and regulatory philosophy, this meeting apparently went well, 20 enabling a common position paper to be produced (BS/90/76), with the hope that this could be taken forward at a further joint meeting at a more senior level in April 1991. This paper is reproduced as Appendix F. At this juncture there was considerable optimism (see the note by Chairman Muller, BS/90/79) that not only could enough convergence be obtained to reach sufficient equivalence, but that the working groups of the BCBS and IOSCO could coalesce into one, rather than work on time-consuming parallel lines. This optimism was further reflected in an address by the Chairman to the fifteenth Annual Conference of IOSCO in Santiago in November 1990. In this (BS/90/102) he said: Two major issues have thus confronted banking supervisors in this environment. The first is a need to ensure that all intermediaries are subject to requirements, particularly with regard to capital adequacy, that do not encourage regulatory arbitrage. We have found that in the battle to raise capital 20 The complete minutes of this meeting (BS/90/77) were not made available to me.

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standards, it is very much easier to do so if all supervisors can act together. The agreement the Committee reached in July 1988 under the chairmanship of my predecessor, Peter Cooke, was primarily designed to raise capital standards. But the second objective was to create a level playing-field. That agreement dealt principally with credit risk. We are now working on the treatment of market risks, which include the risks on positions held by banks in debt and equity securities. If we are to reach agreement on a set of minimum standards for this work, it is clear to the Basle Committee that such an agreement will need to involve some form of understanding with the regulators of competing non-bank firms. But that process has been hindered by the absence of a uniform set of standards among IOSCO members. We are therefore very much encouraged by the work being done in your Technical Committee and in particular in the working group on capital adequacy chaired by Mr Jeffrey Knight, to work towards such common standards. Only in the context of this work will we be able to establish minimum standards that can be applied to all significant players, both bank and non-bank securities houses, in the international capital market. A second subject that is of mutual importance is the supervision of financial conglomerates. Increasingly, financial intermediaries of different cultures are creating alliances or, alternatively, setting up operations in new fields. As banking supervisors we have, as I have said, a long tradition of supervising banks on a consolidated basis and assessing the totality of risks in a group of companies. This is of course more difficult to do when the parent company is not a bank and is not directly subject to our authority. And we are presently exploring the possibility of guidelines that might help provide a common approach to this work. Securities regulators have not always felt so great a need for consolidation, and indeed have seen virtue in being able to compartmentalise risk. But as securities firms grow more bank-like and indeed, may now often own banks, it seems to me that such an attitude is becoming less defensible. I believe the Drexel affair has demonstrated that the confidence factor is now almost as important for you as it is for us, and I am glad to see, for example, that the SEC now has greater right of access to information on the unregulated affiliates of the entities it regulates. With these sorts of problems in mind, it is perhaps hardly surprising that banking supervisors have felt a need to develop a dialogue with the members of IOSCO. Only two years ago we started, rather tentatively, with a joint meeting in Basle between the members of my Committee and securities regulators from Group of Ten countries. We have now had two further meetings and the first fruit of that dialogue was a paper on the exchange of prudential information between our two professions. This was circulated in IOSCO in April this year and will, I hope, lead all supervisors to examine their own regulatory framework to see whether they cannot remove any remaining impediments to such exchanges. But we have gone on from there, and at our last meeting in September of this year both sets of regulators agreed to consider the possibility of devising a common system of measuring risk and a minimum set of capital adequacy requirements which could be applied to all players in the international securities markets. Any such standards would of course be minimum standards and should not compromise the rights, or indeed the obligations, of individual

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authorities to impose tougher requirements where they believe they are prudentially necessary. Participants in the meeting also agreed on a possible approach to such a framework and already a number of working parties are at work on the details. In all cases these include regulators of both sides, banks and nonbanks, of the securities industry. We have set an ambitious timetable requiring at least an outline of such an approach to be presented to your Technical Committee and to my Committee early next year and to another Group of Ten joint meeting next spring. Of course there are a number of difficult conceptual and practical problems which are as yet unsolved but to me the significance of last September’s meeting was that we all agreed to try and solve them together. The onus is now on us as individual participants in that process to do what we can to produce that solution as soon as possible. As was the case with our own convergence agreement in 1988 the outcome will inevitably be a compromise. To achieve it will involve concessions on hallowed traditions and practices which we will all be reluctant to make. But agreement is necessary. We have to work together if we are ever to maintain supervision over an industry that is less and less contained by national boundaries. So you can see that my presence here today is symbolic of a very considerable amount of practical co-operation which is already taking place.

Work then continued towards the proposed meeting in April 1991 of more senior officials in the BCBS and IOSCO, at which it was hoped that common positions on market risks on trading books, and associated CARs, could be agreed (BS/91/2). Originally it had been intended that the respective subgroups would start work on a composite paper for the April meeting of senior officials from the BCBS and IOSCO, but now it was suggested that the subgroups would prepare individual papers for intermediate preliminary (and separate) March meetings of the BCBS and the IOSCO Technical Committee, albeit papers that, it was hoped, would be mutually consistent.21 Only after these meetings 21 Thus Chairman Huib Muller wrote to Roy Croft, who had taken over from Jeffrey Knight, as chairman of the Technical Working Party on Capital Adequacy (7 January 1991) (BS/91/3): Roger Barnes reported that following bilateral discussions with you it was felt that the procedure agreed to at the September joint meeting should be slightly modified. In particular, rather than having a composite paper go forward to the Basle Committee and Technical Committee for their respective March meetings, the three working groups would prepare individual papers for those meetings. After review at that level, a composite paper would need to be prepared for the April joint meeting. The Committee had no objection, though it noted the obvious need for the papers prepared by the working groups to be consistent in their content. Three key areas must ultimately be agreed upon:€ capital requirements for traded equities, capital requirements for debt instruments, and the definition of capital. Work is proceeding in the two Basle working groups (with enlarged representation from securities regulators) on debt and equity securities. Comments on these aspects from your group would be welcome but, given the overlap in membership between the groups, it may not be necessary for you to address them in great detail.

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would the subgroups get together again to produce a composite joint paper for the April meeting. It was at that point that the wheels began to fall off. Richard Breeden, who had been made Chairman of IOSCO for two years at its Santiago Conference in November 1990, 22 telephoned BCBS Chairman Huib Muller, following the IOSCO Technical Committee meeting in Hong Kong in March, to ask for a postponement of the April meeting (BS/91/34). Apparently (since the details of that meeting are not available to me), the Technical Committee of IOSCO had had second thoughts about the extent of convergence expected of them, in order to reach an agreed joint position with BCBS. Muller responded diplomatically (BS/91/34), emphasising the need for convergence, 23 and hoping It would be most helpful, though, if your group could give a lead in relation to the definition of capital. Most banking supervisors, as you will recall from the September joint meeting, have considerable reservations about recognising short-term debt as capital for banks. They are also likely to recognise that the reasons for permitting such capital for securities firms€– as set out in your annex€– are valid ones. However, in the context of the convergence exercise, competitive equality is an important ingredient that must be considered. Banking supervisors are only likely to agree to an arrangement that permits securities firms to use such debt if the competitive effect is not deemed to be material. Your note provides a useful starting point to achieve some common understanding on this topic. A clear exposition of the criteria and conditions for the recognition of short-term debt as capital will also be necessary. Two items are particularly relevant. First, the so-called ‘lock-in’ provision that prevents repayment of debt under certain conditions needs to be standardised. Second, an upper limit on the aggregate amount of such debt (relative to equity) would also be an essential ingredient. The annex to your letter mentions the SIB’s current cap of 400% of equity less intangibles. I have to say that a number of that order appears rather high to banking supervisors. For example, in the Basle agreement, the sum of all tier 2 elements (including subordinÂ� ated debt) cannot exceed 100% of equity. Subordinated debt itself (which must have an original maturity of at least five years) cannot exceed 50% of equity. 22 Previously the chairman had been the local host, and rotated from meeting to meeting (see BS/90/106, note for record by BIS Secretariat on the prior IOSCO meeting). 23 ‘I would like to put on record how highly my Committee values the great contribution of our securities regulators colleagues in developing the proposals of the Barnes and Carosio sub-groups. For this reason we still hope we can arrive at a common message to the world markets on agreed minimum standards for the securities trading business, be it by banks or non-bank securities firms. And my Committee sees a need to press ahead with all due speed, as indeed do our central-bank Governors. The banks we supervise are becoming increasingly important players in the world’s securities markets, both directly in the universal bank tradition and indirectly through the establishment and acquisition of securities firms. It is our impression that financial groups dominated by securities firms are also increasingly active in markets beyond their own domestic market. For those reasons it is of vital importance for regulators that they establish common minimum standards applicable to bank and non-bank traders, at least in the major securities markets. Indeed we are concerned that this principle, which we accepted last September, apparently found only limited expression in Hong Kong. It is also clear to us that there are considerable market

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that ‘a joint meeting at senior level can be convened after the July meeting of the Technical Committee’ (also see BS/91/56). Such a meeting became delayed. The member of the Barnes working group who attended the IOSCO Working Party 3 meeting in Tokyo in May reported (BS/91/47): no strong opposition to the building block approach per se, although a number of technical concerns were voiced with the Basle proposals. However, the discussion did reveal varying degrees of scepticism from several delegations on the benefits of convergence with banking supervisors; some felt that the exercise had distracted IOSCO from its primary goal of achieving convergence among securities regulators.

Subsequently, following IOSCO’s annual September (1991) meeting in Washington, Richard Breeden sent Gerald Corrigan, who had become Chairman of the BCBS following the death of Huib Muller: a memorandum summarizing the views of the members of the Technical Committee on certain capital adequacy issues that are being considered by various working groups of the Basle Committee on Banking Supervision and IOSCO regarding minimum uniform standards for internationally active securities firms and banks.

Whereas the memorandum (BS/91/81) was couched in positive terms about agreements ‘in principle’, and about the degree to which the Technical Committee had reached ‘either consensus or a majority view’, what strikes the reader is the continuing extent of strong reservations and differences of opinion between the main member state representatives of the Technical Committee, the insistence on certain aspects of keeping short-term subordinated loans (Tier 3) as part of capital, and generalised doubts on other aspects of the BCBS’ positions, that made it unlikely that the members of IOSCO could sign up to a significant joint agreement with the BCBS on market risk. The memorandum was quite clear on this: Because the outcome of ‘partial convergence’ is far from clear, some members remain sceptical about the value of harmonising market risk requirements only and not other elements of the respective capital adequacy tests. Given this, the Technical Committee believes, and hopes that the Basle Committee would agree, that the value and extent of the agreement now contemplated should not be exaggerated and that it should be seen as a first step toward convergence. The Technical Committee appreciates, however, that expectations of such action and that, in its absence, participants will increasingly seek to take advantage of inequalities between the regulatory systems. In the European Community, for example, there is an urgent need to develop common standards if inconsistencies are not to be exploited.’

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there will be substantial difficulties to be overcome if fuller convergence is to be achieved and it remains to be established whether further progress is feasible in the near future.

Yet pressures were building up, perhaps especially on the BCBS. It had been warned by Pöhl and the Germans that the Governors would not accept an outcome for an accord on capital adequacy on market risk unless it provided competitive equality between banks and investment houses. The BCBS, and its subgroups, had been working for several years on this subject (see Chapter 7), and now wanted to go semi-public by consulting the banks. So it needed some kind of statement of agreement, at least in principle from IOSCO. Despite the doubts and internal disagreements among the IOSCO membership, Chairman Gerald Corrigan managed to persuade Richard Breeden to issue a joint public statement, following a combined meeting of the BCBS and the Technical Committee of IOSCO in January 199224 (BS/92/8). This is reproduced as Appendix G. As noted in the final paragraph, this was intended to pave the way for the start of a wider public consultation later that summer. Peter Hayward, the Secretary of the BCBS, gave a public speech at the Institute of International Bankers in March, at which he said (BS/92/30): This growing overlap [between banks and investment houses] had led to pressure on the supervisors to converge their approaches. Of course some see more point in this exercise than others. At one extreme there is the view attributed to some German bankers:€‘one business, one risk, one rule’ and, at the other, the view that the businesses are still so fundamentally different in nature that it would be imprudent to adopt a common approach. The compromise to which we are now working will not entirely satisfy either side€– compromises rarely do€– but it will be designed to produce a common minimum standard that will ensure that the regulatory framework does not have too great an influence on the corporate structure of those businesses active in securities markets. As many of you will have read, at a meeting in Geneva at the end of January, the Basle Committee and the Technical Committee of IOSCO made a considerable amount of progress towards such a common framework. We are not completely there yet and the last bit will be the hardest. But at least it is possible to see the shape of the structure that we hope will emerge in a set of consultative papers this summer. It is, I should stress, a minimum framework which will allow individual supervisory authorities to use, or continue to use, different techniques provided they can be demonstrated to achieve as great a coverage of the risks as the agreed minimum. 24 G.€ Carosio (BCBS) and R.€ Croft (IOSCO) had prepared a ‘Preparatory note for the joint meeting between the Basle Committee and the Technical Committee’ (BS/92/2), summarising the areas of general agreement and of continuing debate and discussion.

Relationships with securities regulators, notably IOSCO

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Meanwhile, work went on towards the preparation of drafts that could be used as part of the joint consultative paper(s) to be issued later in the summer, including those aspects, such as the acceptance of Tier 3 capital (shorter-term subordinated debt), which the BCBS had unwillingly accepted as a necessary price to pay for getting agreement with IOSCO, for example BS/92/13 on ‘Position risk€– the definition of capital’ (February 1992). A draft consultative paper (BS/92/19) was prepared within the BCBS and transmitted to IOSCO for approval at its forthcoming July meeting in Quebec. So it must have been a major shock for the BCBS when it learnt that the Technical Committee of IOSCO was not, in the event, prepared to go ahead with a jointly agreed position paper after all! On this occasion, the Technical Committee meeting in Quebec, the BCBS had not been asked to send observers, but the Secretariat learnt ‘indirectly’ that the draft consultative paper (BS/92/69), which had been intended by the BCBS to form a basis for an agreed joint paper, had not even been discussed, although a number of the issues contained in it had been (report by the Secretariat (BS/92/75)). Moreover, the Technical Committee had clearly withdrawn from the exercise of working towards a joint position, which could form the platform for a consultative paper to go out to banks and investment houses that summer. Thus: No work is planned before the Committee’s next meeting at IOSCO’s annual conference at the end of October; the Croft Group to which the treatment of equities was apparently referred back, plans to meet next in November.

It was not clear to the BCBS Secretariat at that time what the causes for this breakdown, and what appeared to be a volte-face by IOSCO, may have been. The Secretariat (BS/92/75) at the time25 seemed to attribute this to a lack of enthusiasm by Breeden in person, and by the SEC more generally, to regulatory convergence with the banking supervisors. Based purely on the documents available to me, my own view is that it was unwise and premature for Breeden to have signed the prior joint public statement with Corrigan (BS/92/8). Given the 25 Subsequently by the end of August (BS/92/85) the Secretariat had discovered that, rather than discussing the draft consultative paper (BS/92/69), Breeden had submitted a note outlining several of the outstanding features of the proposals ‘which posed problems to the SEC’. Roy Croft then distilled the serious differences into three main points (in a letter to IOSCO Working Party 3): (i) The parameter for accepting short-term subordinated debt as capital. (ii) The weights to be applied to equities (largely a dispute between the SEC and UK’s SIB rather than with the BCBS). (iii)╇T he limitation of the proposed framework to marketable securities in banks’ trading books, i.e. excluding those held in their banking books.

496

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differences of viewpoint among his own members, and their continuing doubts about convergence, he had got too far ahead of his own troops in appearing to signal a move to joint action. Be that as it may, the question then to hand was what options the BCBS had, following the apparent withdrawal of IOSCO from the joint programme. Given the Secretariat’s attribution of much responsibility for the breakdown to Breeden, one option was to wait until a successor as Chairman of IOSCO might be named. But that would be time-consuming and of uncertain delay (Breeden could be reappointed after his first two-year period in office ran out at the end of 1992). Meanwhile, the EC was pushing now to get ahead with its own capital directives on market risk (‘the further the EC progresses in implementing this understanding, the more constrained the negotiating position of EC members is likely to become, and the more difficult it will be to negotiate a global accord acceptable to both EC and non-EC members’). Moreover, the summer timetable for sending out a consultation paper was now widely known, at least among the regulatory and international banking communities. A lengthy delay would be, at best, embarrassing, and at worst might ‘diminish the Committee’s authority’. The other proposals were, first, to publish the joint consultative papers as applicable to both banks and investment houses, but going over the heads of IOSCO, that is without their agreement, or, second, redesigning the proposals to apply to banking groups alone. While this second alternative had several advantages (e.g. it could allow the BCBS to drop those proposals, such as Tier 3 capital, which it had only accepted as a compromise to achieve a joint front), it had the disadvantages of failing to achieve a level playing field and of widening potential differences between EC and non-EC capital adequacy requirements. Probably inevitably, the BCBS chose the third alternative, that was to press ahead alone. Thus, at the next (sixty-fourth) meeting of the BCBS in September 1992 (BS/92/89): Following discussion of the options set out in BS/92/75, the Committee agreed that the Chairman should write to Mr Breeden indicating that the Committee was minded to issue on its own authority a consultative document based on the draft in BS/92/83 (but with the adoption of Tier 3 capital contingent on an agreement with IOSCO), unless the Technical Committee indicated before the paper was presented to the Governors on 9th November that it was prepared to resume discussions with the intention of proceeding to the issue of a joint consultative paper in the near future.26 It was further agreed that, if such 26 Meanwhile, drafts of the consultative paper on ‘The supervisory treatment of market risk’ (BS/92/83) continued to be sent to Breeden and IOSCO, under cover of a cool, formal letter from the Secretariat (Peter Hayward).

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discussions did not produce early results, the Committee would reserve the right to proceed with consultation on its own.

Meanwhile, the froideur that was now settling on relationships between the BCBS and IOSCO not only affected the work on capital requirements against market risk (and competitive level-playing-field issues between investment houses and banks), but also problems of consolidation and supervisory oversight of what was now becoming known as LCFIs (large and complex financial intermediaries), especially those containing both banks and broker/dealers (investment houses). This also had been planned as a joint exercise, but now Roy Croft had to rewrite his paper on ‘Principles for the supervision of financial conglomerates’ as emanating solely from IOSCO (BS/92/87, August 1992) and to contain the defensive paragraph (21), as follows: International efforts are currently in train, both in the joint Basle/IOSCO forum and in the European Community, to develop a single, comprehensive capital adequacy methodology for banks and securities firms. However, as the joint Basle/IOSCO meeting in Geneva recognised, what is in prospect at present is partial convergence of capital adequacy standards; and any moves toward convergence with insurance regulators still remain some way off. Thus, it is likely that for some time yet, regulators will need to find some way to adapting the techniques they employ in undertaking prudential consolidation to take account of the technical difficulties which arise because securities firms, banks and, in particular, insurance companies are still for the time being subject to capital adequacy requirements which differ to some extent.

At this same time, a new European working group, the Tripartite Group, was organised by the EC, 27 in conjunction with the BCBS, under the chairmanship of Tom de Swaan from the Netherlands Central Bank, a tripartite group of securities, insurance and bank regulators, with a BCBS Secretariat (BS/92/116, also see BS/92/98) to review ‘The supervision of financial conglomerates’. Being an EC-organised group, there was no representative from IOSCO, nor from the SEC nor Japan on this, though there were securities regulators from several European countries, and a representative from the EC (Geoffrey Fitchew). In some part this may have been seen as a means of bypassing the breakdown in relationships between the BCBS and IOSCO. Recall that there were three major sources of disagreement between IOSCO and the BCBS, as outlined earlier in footnote 25, to wit:

27 As previewed in BS/92/106, which presented the report of a working group on ‘Financial conglomerates’ set up by the Conference of Insurance Supervisors of the EEC.

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1. the different treatment of marketable assets, especially government debt, in banks’ trading and banking books; 2. the weights to be placed on equities; and 3. the eligibility of short-term subordinated debt as capital. The BCBS believed that (3) was negotiable; at their sixty-fifth meeting (December 1992) (BS/92/114), they decided to conduct a survey to assess the practical importance of (1), but issue (2) was an internal matter for IOSCO to decide.28 The BCBS hoped that IOSCO could agree (ii), and then progress in putting forward a joint consultative paper could be quickly resumed. These hopes were soon dashed. Jean Saint-Geours (the successor to Breeden as Chairman of IOSCO’s Technical Committee) wrote to Gerald Corrigan (12 February 1993) to report that ‘the Technical Committee [of IOSCO] has not been able to bridge its remaining differences’ (BS/93/21). Accordingly the BCBS would now go ahead on its own to issue its proposals for ‘public’ consideration, even though the BCBS was still ‘hopeful, further down the road, that broader-based convergence may become possible’. The overview to the press statement (30 April) that accompanied the market risk consultative paper (BS/98/22) was quite explicit on the problems of interacting both with the EC (para. 9 of the overview, see also Chapter 12) and IOSCO (para. 10): The second forum in which parallel work has been in progress is the Technical Committee of the International Organisation of Securities Commissions, which began to discuss the possibility of common minimum standards for securities firms at that Committee’s first meeting in July 1987. The Basel Committee was naturally interested in this project and joint work was undertaken with a view to developing common minimum charges for banks’ and securities firms’ positions in traded debt securities and equities and related derivative instruments. Unfortunately, these discussions have not led to a successful result because IOSCO has been unable to reach agreement within its own group.

28 ‘The Committee reviewed the letter from Mr Breeden (BS/92/102) conveying the Technical Committee’s concern on outstanding issues. It was agreed to conduct a survey of member countries’ rules and practices governing the allocation of government securities to banks’ trading and investment accounts. The Chairman said he would send a letter to Mr Saint Geours, the new Chairman of the Technical Committee, saying that the Committee was considering both the trading/investment account and the criteria for subordinated loans and would wait for proposals from the Technical Committee concerning equities (see BS/92/112). There was some reason to hope that the Technical Committee’s meeting in February would produce results, following which a joint meeting at the time of the Committee’s March meeting or shortly thereafter could be arranged to finalise the package.’

Relationships with securities regulators, notably IOSCO

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This breakdown in relationships between the BCBS and IOSCO was serious,29 leading to some fragmentation among international regulatory authorities just as international financial markets were becoming more unified. Subsequent relationships may have been assisted by a change in personnel, with Tommaso Padoa-Schioppa taking over as Chairman from Gerald Corrigan, and Jean Saint-Geours from Richard Breeden. The two Europeans were on friendlier terms than the two Americans had been. In particular, IOSCO and the BCBS could still work together in areas, other than capital adequacy requirements for market risk.30 Thus Saint-Geours wrote to Padoa-Schioppa in March 1994 (BS/94/19) to propose joint work ‘on matters of mutual interest concerning the regulation of OTC derivatives’ and Padoa-Schioppa wrote back favourably, to suggest that the chairs of their relevant subgroups in this field, Martin Vile for IOSCO and Daniele Nouy for the BCBS, should get together to decide how to take this collaborative exercise forward. However, the Secretariat subsequently noted (BS/94/51, June) that: risk management [of derivatives] might be a suitable candidate for collaboration between the two Committees but that the preparation of a joint paper in co-operation with IOSCO was likely to be a slow process. We therefore decided to proceed to draw up a paper unilaterally and this message was conveyed by the Chairman to Mr Saint-Geours (see BS/94/19), together with an undertaking to pass the results to IOSCO before the paper was finalised at our June meeting. A draft of our report (BS/94/29) has therefore been sent to Mr SaintGeours. In the interim, IOSCO’s Working Party 3 chaired by Mr Vile has been undertaking work of its own in this area. Members will note that [this draft] has a distinctly different character to our own text and only addresses OTC derivatives, whereas ours covers all derivative activities.

These two papers on derivatives (BS/94/29 and the WP3 Vile paper) were finished in July (the IOSCO paper becoming ready sooner than expected (BS/94/58)) and were then published together under a joint covering press statement (BS/94/62). Following this, Padoa-Schioppa wrote to Saint-Geours in October (BS/94/79) to suggest further collaborative work in the same field on derivatives, in this instance on the collection and disclosure of information, to which Saint-Geours responded 29 The large (European) commercial banks regretted this, since they felt that the forthcoming market-risk amendment would leave them at a competitive disadvantage to the (American) investment houses, but they understood why this had happened (BS/93/53). 30 Even here the BCBS kept IOSCO broadly informed of the passage of events, such as the move towards internal bank models of risk (BS/94/25 and 95/24).

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favourably (BS/94/46 and 84). Tim Shepheard-Walwyn, who had by then taken over from Martin Vile as Chairman of Working Party 3 of the Technical Committee of IOSCO, wrote to Padoa-Schioppa in March 1995 to ask for help in assessing value-at-risk models (BS/94/22) since securities regulators were becoming increasingly interested in this, in relation to investment houses.31 Meanwhile, when Tom de Swaan sent the three international regulatory bodies, the BCBS, IOSCO and IAIS (the International Association of Insurance Supervisors) an intermediate progress report 32 from his (informal) tripartite committee on ‘The supervision of financial conglomerates’, Saint-Geours welcomed it warmly (BS/94/83, 84), despite the fact that it had been set up originally without IOSCO involvement, in order to maintain momentum in this area. Indeed the way was now open to transform this informal committee into a more formal joint regulatory committee, bringing together regulators from all three sectors; see the letter from Padoa-Schioppa to Edward Waitzer (who had taken over from Jean Saint-Geours as Chairman of the Technical Committee of IOSCO) proposing just that step (BS/95/47) (June 1995). Despite these evident signs that the rupture between the BCBS and IOSCO was beginning to mend,33 the breakdown of those relationships in 1992/93 had become rather obvious to a wide audience, including ministries of finance and politicians. No doubt partly as a result, the Summit communiqué of the G7 heads of state, issued after the Halifax 31 Edward Waitzer, who had by then become chairman of the Technical Committee of IOSCO, in succession to Saint-Geours, wrote a letter to Padoa-Schioppa, dated 13 July 1995 (BS/95/65) (but almost certainly drafted before the Halifax communiqué was received) on the subject of internal, value at risk, models. It ended as follows: To conclude, the Technical Committee welcomes the work of the Basle Committee on value at risk models and believes that there would be great value in undertaking a joint programme of work between our relevant Working Groups in this area. Once the issues raised above have been addressed to our satisfaction, the Technical Committee should be in a better position to consider the use of models for capital purposes. Pending the outcome of such work, the Technical Committee believes that it would be premature to commit to a specific timetable or to the objective of achieving uniformity of capital standards for banks and securities firms. 32 The report on ‘The supervision of financial conglomerates’ was subsequently issued in April 1995 (BS/95/32), though de Swaan (BS/95/38) states that it was completed a year earlier in April 1994. Perhaps the 1995 paper was an extended version of the earlier internal 1994 paper, also now including some of the work of the Spencer subgroup. 33 Saint-Geours had asked Padoa-Schioppa to address the final IOSCO meeting that he, Saint-Geours, would attend as chairman. Padoa-Schioppa chose as his topic ‘Globalization of risk:€cooperation between banking and market regulators’, and had, I believe, drafted the text (BS/95/49) before the Halifax communiqué was issued. It was timely. The final conclusions are reproduced as Appendix H.

Relationships with securities regulators, notably IOSCO

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meeting in June 1995 expressed their interest and concern to establish34 (para. 22) that: Closer international cooperation in the regulation and supervision of financial institutions and markets is essential to safeguard the financial system and prevent an erosion of prudential standards. We urge:

• a

deepening of cooperation among regulators and supervisory agencies to ensure an effective and integrated approach, on a global basis, to developing and enhancing the safeguards, standards, transparency and systems necessary to monitor and contain risks; …

• Finance

ministers to commission studies and analysis from the international organizations responsible for banking and securities regulations and to report on the adequacy of current arrangements, together with proposals for improvement where necessary, at the next Summit.

This was clearly a shot across the bows of both the BCBS and IOSCO. The Minister of Finance (from Canada) Paul Martin then wrote to Hans Tietmeyer, Chairman of the G10 governors, in July (BS/95/13) to note that the G7 lenders had specifically asked IOSCO and the BCBS to ‘prepare reports addressing this topic’. An interim statement was 34 Excerpt from background document Strengthening Financial Market Supervision and Regulation The growth of financial markets, the development of new instruments, and a desire for diversification of investment have spurred global integration of national markets and increased liquidity. These developments have led to a more efficient allocation of capital and thus greater growth of economic activity. At the same time, with today’s highly integrated financial markets, there is a greater potential for the rapid transmission of financial disturbances. Close international cooperation in the regulation and supervision of financial institutions and markets is essential to the continued safeguarding of the financial system and to prevent erosion of necessary prudential standards. Continued strengthening of these efforts has the full support of G-7 Finance Ministers and Central Bank Governors. We look forward to the development and further enhancement of concrete international understandings, where necessary and appropriate, on the safeguards, standards, transparency, and systems necessary to reduce potential risks. In this context, we recognize the important initiatives being undertaken separately and jointly by various committees under the aegis of the BIS and the International Organization of Securities Commissions as well as by national authorities. •â•‡T he G-10 should be encouraged to intensify their review of work in this area and there should be a call for the Basle Committee on Banking Supervision and the International Organization of Securities Commissions to work closely together in addressing the major issues in this area and the desirable steps to address identified problems and to report back. These reports should help Ministers to reach conclusions regarding the extent of systemic risks and their implications for the world economy, and the need for any measures deemed essential to an integrated approach to potential systemic risks.

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sought by October, for the next meeting of the G7 finance ministers, and ‘A final report should be provided by the end of January in order that G-7 Finance Ministers may report back to the Summit heads prior to the 1996 Summit’. This was the first occasion in the history of the BCBS of overt and direct political intervention in its work (there had been political concerns in the background on the occasion of the BCBS’ establishment in 1974 (see Chapter 2) and again to press for the Capital Accord in the 1980s (see Chapter 6) but they had never been quite so blunt as this). It was a bolt from the blue, though one could argue that the regulators’ failure to work smoothly together had brought it on their own heads. Padoa-Schioppa responded (BS/95/61 and 62) by preparing a letter (1 September 1995, BS/93/62) in which he briefly outlined the history of previous collaboration with IOSCO, and then went on to set out the then current programme for ongoing and future collaboration, as follows: Previous collaboration between bank and securities regulators In 1988, with the Governors’ formal approval, the Committee held the first of a series of meetings which certain G-10 securities supervisors were invited to attend in a personal capacity. Three of these meetings took place at annual intervals. The topics discussed included the need to improve arrangements for the exchange of information between bank and securities regulators, capital requirements for position risk and the supervision of the securities operÂ� ations of banks. In 1991, the circumstances changed with the establishment of the IOSCO Technical Committee (which contains fourteen members, ten of which are also G-10 members, Belgium being the exception). Since that time, only one full meeting has taken place between the Basle Committee and the Technical Committee, in January 1992. However, the contacts have continued between the Chairmen and at the working group level, first on common capital requirements for market risk and more recently on financial conglomerates, risk management guidelines and on derivatives reporting standards. The Basle Committee has prepared and issued several papers jointly with securities regulators. These include: – exchange of information between banking and securities supervisors (April 1990); – two separate papers on risk management guidelines for derivatives which were developed simultaneously and released under a joint cover note (July 1994); – a joint paper on a derivatives reporting framework, consisting of a ‘catalogue’ and a minimum reporting framework representing a subset of the catalogue (May 1995); a paper on the supervision of financial conglomerates prepared by an informal Tripartite Group of bank, securities and insurance regulators (July 1995). This Group was established at the initiative of the Basle Committee although, because of objections from the US

Relationships with securities regulators, notably IOSCO

503

Securities and Exchange Commission, IOSCO’s Technical Committee did not endorse its formation. The significant failure in the formal contacts between the bank and securities regulators to date has been, as Governors are well aware, the inability in 1992 of the Technical Committee to accept the Basle Committee’s proposals regarding capital standards. The critical stumbling block was the treatment of equity risk, though there were also several minor problems that were left open because the two parties could not come to a general agreement. On-going and future collaboration between bank and securities regulators. There are several important projects in progress which are designed to strengthen prudential standards and encourage sound industry practices. However, these are highly complex issues and rapid results cannot be expected. These include: – on capital adequacy, IOSCO’s Technical Committee is currently doing some work on the use of internal models for measuring market risks and we are hoping that we will shortly be able to re-open the question of similar capital standards for banks and securities houses; – on derivatives, more work is in train at the technical level in order to expand the reporting framework (see 5 above) in two respects. The first would be to cover market risks in more detail, and the second to develop guidelines for banks’ disclosure of their trading and derivatives activities, drawing on the reporting framework paper and possibly going into disclosure more generally at a later date. A related project is to discuss the possibility of establishing a central register for derivatives contracts, a suggestion put forward by the German delegation in Halifax; – on financial conglomerates, IOSCO’s Technical Committee has now agreed (as had, earlier, the Basle Committee and the equivalent insurance regulators’ forum) to reconstitute the Tripartite Group as a forum which formally represents the three parent Committees under the Chairmanship of Mr de Swaan of de Nederlandsche Bank. As I informed you in my letter of 27th June, the group now has a formal mandate which includes the review of practical means to facilitate the exchange of information between the competent supervisors, examination of the possibility of establishing criteria to identify a lead supervisor and development of a set of principles to govern the future supervision of financial conglomerates. One objective of this work is to strengthen communication between supervisors in dealing with subsidiaries of regulated entities. More generally, I have been in close personal contact with the Chairman and senior members of IOSCO’s Technical Committee in order to develop the mechanics of more formal co-operation between supervisors and regulators of financial institutions and markets on each of the topics mentioned. I am hopeful that this will lead to a clear course being set for the ongoing work, particularly that on market risk and disclosure.

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Relationships with non-bank supervisory bodies

The suggestion made in the final paragraph above was then rapidly taken further, so that a more positive response could be sent forward to the G7 finance ministers in October. Thus, in BS/95/66 it was stated that: Since the Halifax summit, the Basle Committee has taken two initiatives in this area: – first, it has attempted to intensify existing contacts … with members of the Technical Committee of the International Organisation of Securities Commissions (IOSCO) both at Chairman and at working group levels. A coordination group consisting of the Chairmen and Secretaries-General of each Committee, assisted by one or two senior members, is being set up for this purpose and will shortly hold its first meeting; – second, it is preparing a draft response to the Halifax Communiqué for despatch early in 1996 (see paragraph 9). The coordination group will seek to ensure overall consistency between the Committee’s response and that being prepared separately by IOSCO.

Such a coordinating group did then meet, at the offices of the SEC on 11 October 1995 (BS/95/87). They agreed that each (BCBS/IOSCO) could submit a separate report, but that these reports should be covered by a joint statement: – The document should contain an assessment of the present situation in terms of general risk and its containment, as seen jointly by the two Committees, and an explanation of what is being done to address the problems that arise in this context, describe the mechanisms and procedures already in place to deal with the situations that gave rise to the Ministers’ concerns, and those that, in the view of both Committees, should be strengthened. – The need to emphasise the degree of coordination and understanding among the two Committees in their approach to the concerns expressed by the Ministers. – Not to raise unfounded expectations on issues where the approaches and concerns are still different, as it will take time to reach agreement, or agreement may not emerge at all, for perfectly justifiable reasons. The General Secretaries were also requested to give further thought to the notion of developing some formalized rules for cooperation in standard and serious situations, which could be expressed in a ‘concordat’ form, and to advise their respective Committees as to the scope of the exercise (i.e. a project on its own or just in the context of the response to the Ministers).

On the continuing vexed question of the Market Risk Amendment and internal models, the IOSCO team reported that these standards, according to their assessments, would lead to capital figures much lower than those currently ruling. They were concerned that this could lead to regulatory arbitrage and eventually to securities business being constituted legally as banks, but with unduly low capital figures. Thus

Relationships with securities regulators, notably IOSCO

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the old source of dissension remained raw. All that could be agreed was that: An effort will be made to explain why, due to the different nature of the securities and banking business, securities regulators could not endorse the recommendations at this time, while at the same time these differences did not necessarily preclude the future possibility of convergence.

Other areas of common work were more propitious, notably that on the public disclosure of trading and derivatives activities of banks and securities firms (BS/95/82). The other main initiative was the transformation of the informal tripartite committee on ‘The supervision of financial conglomerates’ into a formal committee, recognised and supported by the BCBS, IAIS and IOSCO (see BS/95/97). This was now renamed ‘The Joint Forum’. Its mandate was included as Annex 1 to the ‘Progress report by the Joint Forum’ (BS/97/13), sent to the G8 Denver Summit (BS/97/13), and is attached as Appendix I.35 Anyhow, the BCBS and IOSCO collaborated to put forward a joint statement to be sent to the G7 finance ministers and thence to the G7 heads of state for their next Lyons meeting in 1996 (BS/96/1). The final version of this is reproduced as Appendix J. The main addition in this is the proposal ‘to develop satisfactory arrangements for oversight of diversified financial groups’ (emphasis in original), though this would have seemed to me to trespass on the existing remit of the Joint Forum. Meetings between the key members of the BCBS and of Working Party 3 of the Technical Committee of IOSCO continued, both within the newly formed Coordination Group and outside it. The BCBS kept on pressing IOSCO to return to the question of quantitative standards for the application of capital to market risk. Thus Padoa-Schioppa emphasised, in a letter to the incoming Chairman of IOSCO’s Technical Committee, Anthony Neoh (BS/96/110), that it had become even more urgent to resolve the differences between the two bodies. This is all the more necessary as outside pressures have increased. The market risk package is to be implemented for banks in G-10 countries at the end of 1997 and the market risk capital standards applied equally to banks and securities firms in the European Union (through the Capital Adequacy Directive). The EU is now in the process of allowing both banks and securities firms to apply internal models for capital purposes in the so-called CAD II. In the United States we observe a progressive erosion of the barriers set by the GlassSteagall Act. Furthermore, the attention of the Ministers in the G-7 summits 35 This had been lost from the archives. I am grateful to Mr Edward Atkinson for then finding it, but he notes that its provenance cannot be guaranteed.

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is increasingly oriented towards fostering greater cooperation between our two Committees. Finally, there is the interest of the industry itself:€in the case of banks and securities firms, basing the capital requirement on in-house models is the best way supervisory capital requirements can evolve with the market.

Although a February 1997 meeting of the coordinating committee gave hints of progress in some respects, for example ‘some readiness on the part of the SEC to relax its opposition to the use of models for securities’ firms capital requirements’, there was no general breakthrough; indeed the BCBS turned down ‘IOSCO’s suggestion of a joint Models Task Force’ (BS/97/85). Perhaps as a result, the Chairman (by that time Tom de Swaan at his first BCBS meeting in June 1997) reported that ‘he had agreed with Mr Neoh that a meeting of the Basle Committee/IOSCO Coordination Group was not needed in the near future’ (BS/97/67). So our period ends without a convergence in the CARs required against market risk for investment houses and commercial banks. However, the situation differed between the USA and the EU. Within the EU most securities business was done in-house by universal banks, and subsidiaries of US investment houses were required to register in the EU as banks. So within the EU the CARs, as laid down by the relevant Directives, imposed conformity between securities houses and banks, while within the USA the regulatory approach relating to CARs continued to be different for investment houses and banks.36 Given the likelihood of a continuing divergence between the CARs and the general regulatory mechanisms applied to securities’ firms and banks in at least one very important market, that is the USA,37 this then 36 Following the collapse of Lehman Brothers in September 2008, the remaining US investment houses all became banks, so this distinction disappeared. 37 From BS/97/16, on ‘Risk weighting for securities firms’: Since the promulgation of the 1988 Accord, there has been a great deal of convergence within some countries with respect to the supervision and regulation of banks and securities firms. In particular, EU-member countries are required to apply the same capital requirements, large exposures rules, and consolidated supervision framework to banks and securities firms. In contrast to the European model, there has not been a similar degree of convergence in the regulation and supervision between banks and securities firms in the United States. Towards this end, US securities firms are subject to different capital requirements than US banks, and they are not necessarily regulated on a consolidated basis. In this regard, the Securities Exchange Commission’s (‘SEC’) regulatory jurisdiction pertains only to activities related to securities. Therefore, the SEC does not regulate affiliates of broker-dealers whose activities involve products that are not securities and who are not registered as broker-dealers. US broker-dealers tend to conduct a substantial portion of their OTC derivative dealing in one or more affiliates outside the entity regulated by the SEC. While not subject to consolidated Â�supervision

Relationships with securities regulators, notably IOSCO

507

led on to the need to review and to reconsider the relative risk-weighting (for credit risk) to be applied by banks on their claims on such securities’ houses, for example in wholesale interbank markets. The problem was (BS/97/16) that there was now: a discrepancy in the credit-risk weight applied to claims on investment firms, clearing houses and exchanges between the 1988 Basle Accord and the European Union’s (‘EU’) regulations. The 1988 Basle Accord applies a 100 percent risk weighting to counterparty credit risk resulting from claims on investment firms, clearing houses and exchanges, while the EU’s Capital Adequacy Directive, together with its reference to the Solvency Directive, allows a 20 percent risk weight to be applied to these claims.

There were differing views on which, the Accord or the EU CAD, should have priority, but the underlying question was the comparative inherent strengths, or riskiness, of claims on banks versus those on securities firms. This was reviewed by the capital subgroup, now chaired by Claes Norgren (BS/97/16): The sub-group also analysed whether claims on securities firms were inherently riskier than those on banks. Overall, the sub-group agreed that there has been a fair amount of convergence in the activities conducted by internationally-active banks and securities firms, particularly with respect to their mutual focus on trading activities in money, capital and foreign exchange markets. The increase in trading activities, as well as expansion into traditional investment-banking activities, has served to diversify banks’ income streams and raise the percentage of secured liabilities relative to instantly liquid deposits, as well as the percentage of liquid assets compared to the more traditional non-liquid assets. As to whether securities firms or banks are riskier counterparties, there were mixed views. Some members argued that, as a result of special access to a lender of last resort and the comfort of deposit insurance, banks had more options than securities firms if they were to confront a constrained liquidity scenario. In response to this line of reasoning, some members noted that:€(i) not every central bank has a clearly-stated policy of bailing out a bank when it runs into difficulties; and (ii) safety nets were not necessarily designed to prevent bank failures but mainly for the purpose of protecting small depositors. Other members argued that, unlike banks, securities firms do not function with a mismatch between highly liquid liabilities and less liquid, non-marketable assets. Rather, their balance sheet is the reverse of banks (i.e., secured liabilities and highly liquid assets) which means they are less likely to suffer in a constrained liquidity scenario and better positioned to protect themselves from loss by rapidly contracting the size of their balance sheets.

and regulation, these entities are subject to market discipline, with several of them organised to secure ratings that substantially exceed those of their parents.

508

Relationships with non-bank supervisory bodies

There were several interchanges on this question during the course of 1997, including letters to the outgoing Chairman, Tommaso PadoaSchioppa, from the Swiss Federal Banking Commission and the Federal Reserve Board in March 1997 (BS/97/25). The issue was finally wrapped up in the report of the capital subgroup (BS/97/114, December), ‘Progress report on the risk weighting of claims on investment firms’, where the subgroup proposed: a possible alternative to amending the Accord which potentially may achieve more universal acceptance given the differences across regulatory regimes. Under this alternative, the Accord might be amended to allow a 20% risk weight to be applied to: Claims and guarantees on OECD securities firms that are subject to supervisory and regulatory regimes comparable to those applied to OECD banks, including in particular capital requirements based on the risk profile of the firm [emphasis in original].

Meanwhile, one of the mechanisms that had been put in place in 1992, partly to paper over the disagreements between the BCBS and IOSCO, was the Tripartite Group, as noted earlier. By 1996, with improved relationships between IOSCO and the BCBS, and outside political pressures for more cooperation, this had metamorphosed into the Joint Forum of the BCBS, IOSCO and IAIS.38 38 In a progress report by the Joint Forum, for onwards transmission to the G8 Denver Summit in June 1997, it was stated (BS/97/13) that: The Joint Forum was established in early 1996 by the Basle Committee on Banking Supervision, IOSCO and the IAIS to take forward the work of the Tripartite Group. This predecessor group was comprised of some twenty-five individuals from the banking, securities and insurance supervisory-sectors who acted in a personal capacity in examining supervisory issues relating to financial conglomerates. Its report was released in July 1995. The Joint Forum is comprised of an equal number of senior bank, insurance and securities supervisors representing each supervisory constituency. Thirteen countries are represented in the Joint Forum:€ Australia, Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Spain, Sweden, Switzerland, United Kingdom and United States. The EU Commission is attending in an observer capacity to liaise with similar work undertaken in the EU. The Joint Forum’s mandate, which was agreed by the three constituting CommitÂ� tees; the Basle Committee on Banking Supervision, IOSCO and the IAIS, is attached (Annex 1). In accordance with its mandate, the Joint Forum is pursuing practical means at domestic and international levels to facilitate the exchange of information between supervisors within their own sectors and between supervisors in different sectors and investigating any legal or other barriers which could impede the exchange of information between supervisors within their own sectors and between supervisors in different sectors. Also, based on its mandate, the Joint Forum is examining ways to enhance supervisory coordination, including the benefits and drawbacks to establishing criteria to identify and define the responsibilities of a coordinator, and is working on developing principles toward the more effective supervision of regulated firms within financial conglomerates.

Relationships with securities regulators, notably IOSCO

509

One of the main initiatives of the Joint Forum was to establish a task force, chaired by Christine Cumming of the FRBNY, ‘for the purpose of enhancing the understanding of the operations of internationally active financial conglomerates and the impact of their rapidly changing and global nature on supervisory approaches’ (BS/97/13). To this end the task force developed questionnaires, to be answered both by the LCFIs involved and by their supervisors, and also undertook ‘a study of thirteen conglomerates with diverse business activities’ (see also BS/97/87 on the ‘Proposal for the Joint Forum on financial conglomerates’, Annex on ‘Brief summary of the work of the Joint Forum’, pp. 4–5). The original mandate of the Joint Forum was quite narrow, and in its proposal for a revised mandate (BS/97/87) it was stated that it had ‘made significant progress towards the achievement of its mandate’.39 That paper continued: Given the international attention that cooperation among supervisors crosssection is receiving, particularly as a result of the annual Summits of Heads of State and Governments, it is considered essential that cooperative efforts between the three supervisory sectors continue and that cooperation mechanisms be strengthened to this end. It is considered an opportune time to move from the stage during which guidance relating to the supervision of financial conglomerates was developed to a phase during which such guidance would be implemented. A restructuring of the existing Joint Forum should be undertaken to strengthen cooperation and facilitate implementation efforts, e.g. to implement the basic framework that has been developed for sharing information on a bilateral and multilateral, and intra and cross sectoral basis. It is therefore proposed that a new Joint Forum be established under the auspices of 39 Though the earlier communiqué of the G8 Denver Summit was, in my view, more than a little sanguine when it was reported (BS/97/66) that: At the request of the Heads of State and Government in Lyon, the G-7 Ministers of Finance are pleased to report on the extensive progress that has been achieved in promoting the stability of the global financial markets in the four areas delineated in the Lyon Summit communique: International Regulatory Cooperation •â•‡Supervisors [see below] have developed a set of proposals for enhancing cooperation in the supervision of globally-active financial institutions on an on-going basis and in emergency situations. •â•‡Supervisors have made substantial progress toward agreement on a framework of supervisory principles for globally-active financial institutions, including techniques to assess capital adequacy. [The term ‘Supervisors’ is meant to refer broadly to national supervisory and regulatory authorities, and, where applicable, to organizations of supervisors, including the Joint Forum on Financial Conglomerates, or its sponsoring bodies, the Basle Committee on Banking Supervision, the International Organization of Securities Commissions (‘IOSCO’) and the International Association of Insurance Supervisors (‘IAIS’).]

510

Relationships with non-bank supervisory bodies

the three parent organisations, with a broadened mandate, a new membership structure and a mechanism for rotating the Chairmanship of the group.

As proposed in this paper, the new Joint Forum would remain ‘in a subsidiary capacity’ to its three parent committees, which would be chaired by (the chairman of each of) its parent committees in rotation. The key problem was what to do if the participating committees disagreed, and to resolve such problems what was needed was a superior, umbrella committee, not a subsidiary committee. But the further history of progress in establishing coordinating committees in this field, notably the Financial Stability Forum (FSF) and subsequently the Financial Stability Board, would take us beyond the terminal date of this history. D

Relationships with insurance regulators, notably IAIS (The International Association of Insurance Supervisors)

Whereas the BCBS’ relationships with IOSCO were at times fraught and difficult, those with IAIS were generally smooth and untroubled. The main reason for this is that much of the (trading book) business of banks and investment houses was virtually indistinguishable, whereas insurance business, whether done in a bancassurance universal bank or by a stand-alone insurance company, was markedly different from standard banking business. Thus BCBS (or IOSCO) requirements, for example for CARs, could greatly upset the competitive status quo (the level playing field) for one or other set of commercial institutions. In contrast, BCBS proposals for banks had little or no effect on the competitive position of the insurance business done within banks or their holding companies, as compared with that done outside banks; similarly the requirements of IAIS for insurance business, whether done within or outside banks (or their holding companies), had little effect on the competitiveness of purely banking business. In short, frictions arose between the BCBS and IOSCO because banks’ and investment houses’ (trading book) business was so similar; it did not arise between the BCBS and IAIS because insurance and banking was so dissimilar. Whereas the first tentative meetings between the BCBS and IOSCO occurred in 1988, the first meeting with IAIS did not take place until seven years later in 1995.40 The reason why it took place then was 40 Note that the Tripartite Group, set up in 1992, which included insurance supervisors, was begun as an EC initiative, and the relevant body for that was the Conference of Insurance Supervisors of the EEC, not the IAIS. But when the Tripartite Group was reformulated in 1985/86 into the Joint Forum, the EEC Conference of Insurance Supervisors gave way to the IAIS.

Relationships with insurance regulators, notably IAIS

511

that European insurance supervisors had been included in the EC Tripartite Group, established in 1992; with relationships between IOSCO and the BCBS improving, it was the intention then to reformulate that Group into the Joint Forum in which the BCBS and IOSCO would be directly represented. The equivalent international body of insurance supervisors was the IAIS, though this had only just been established.41 But the level of awareness of each other’s activities was so limited that much of the first meeting, held in Basel on 27 November 1995 (agenda set out in BS/95/85), was taken up with simple, broad-brush descriptions of what each of these bodies did; thus one of the papers prepared for that meeting (BS/95/102), for the benefit of BCBS participants, was a ‘Summary view of IAIS:€what it is, who it represents and what it does’. Similarly at the meeting (BS/95/114): Mr Padoa-Schioppa set out the historical background for the establishment of the Basle Committee, explaining that the G-10 framework, the support of the Governors of the G-10 central banks and the relationship with the Bank of International Settlements were all sources of strength to the Basle Committee which other similar organisations lacked. A particular advantage was the Secretariat provided by the BIS. He briefly recalled the cornerstones of the Committee’s work, namely the ‘Concordat’ principles which were intended to ensure that no bank operating internationally escaped supervision, and the ‘Basle Capital Accord’ of 1988.

At that meeting, following discussions on matters of joint concern, it was agreed that ‘the focus of future joint work in the near term between the Basle Committee and the IAIS should be in the following areas: 1. Derivatives. The Basle Committee subgroup chaired by Mrs Nouy has done considerable work in the areas of internal controls, and derivatives 41 Thus at this inaugural meeting in November 1995 (BS/95/114): Mr Badenhorst briefly described the composition and objectives of the IAIS, indicating that the IAIS as an association had been in existence for only two years and that 77 countries were members. He proceeded to outline the progression in the integration of banking, securities and insurance businesses explaining the economic forces behind these developments, the advantages and disadvantages of such integration and the regulatory response that such developments entail. His conclusion was that these developments pointed to the need for international convergence of regulatory objectives, structures, principles and practice and suggested that the two Committees investigate areas of possible cooperation. In the paper which he presented to the IIF in April 1997 (BS/97/37), Tom de Swaan attributed this late start: to the fact that, within the insurance industry, the guiding principle is solo supervision, that is, supervision on a stand-alone basis for each individual insurance company. In such a framework of solo supervision, little attention is paid to group-wide risks.

512

Relationships with non-bank supervisory bodies

reporting and disclosure. The pertinent documents will be transmitted to the IAIS. The Basle Committee offered to arrange a presentation for insurance regulators and the IAIS will identify a representative with whom the Secretariat can communicate with respect to IAIS participation at such a meeting. 2. Exchanges of information. The Joint Forum on financial conglomerates will be asked to develop practical means of exchanging information between bank, insurance and securities regulators.

Even with IAIS participation in the Joint Forum established, it was clear that the BCBS regarded the key issues as those involving relationships with IOSCO, for example as indicated by the letter from the Joint Forum’s Chairman, Tom de Swaan, to members of the Joint Forum (BS/96/41) dated 31 May 1996. Meanwhile, following their Paris meeting in October 1996, at which there was an address by Padoa-Schioppa on ‘Inter-agency co-operation in financial supervision’ (BS/96/94), the IAIS took up the offer by the BIS to locate its own offices at the BIS headquarters in Basel, as recorded in the letter from George Pooley, Chair of the IAIS Executive Committee to Padoa-Schioppa, dated 23 October 1996 (BS/96/84).42 So from the outset of the work of the Joint Forum in early 1996 the IAIS was a full participant, alongside the BCBS and IOSCO; indeed one of the Forum’s main working groups, that on capital adequacy (for LCFIs), was chaired by a member of IAIS, Jonathan Spencer of the UK Department of Trade and Industry€– Insurance Directorate (BS/97/87). Nevertheless, there is a perception that, although relationships were cordial, the IAIS was seen (by the BCBS) as a less important player (than IOSCO) in the overall regulatory exercise. There was, for example, no great pressure within the BCBS for closer bilateral relationships with the IAIS. Thus in a note by the BCBS Secretariat on ‘Future joint meetings’ (21 August 1997) (BS/97/89), it was reported that: We had also pencilled in as a possibility a joint meeting with insurance regulators in November 1997, following a request by the IAIS in the spring. However, we do not have a commitment to meet the insurance regulators, given the attendance by the Chairman and a few other members at the IAIS’s May meeting. Given that the IAIS Secretariat is not yet in place and that there are no

42 ‘The Bank of International Settlements’ generous offer of assistance and financial support from the Government of Switzerland, plus the synergies of the IAIS Secretariat being located in one place with the Secretariat of the Basle Committee, influenced the IAIS to accept this offer from Switzerland ahead of other generous offers.’ Although IOSCO was offered a similar package to relocate to the BIS, it refused, preferring to maintain its separate location in Canada.

Appendix A

513

immediate topics to discuss, the Secretariat suggests that no further action be taken at present with the IAIS.

This takes us up to the end of our period.

Appendix A

BS/75/66

Harmonisation of accounting principles

Development of international auditing standards

There appears to be no formal body for the development of international auditing standards. In general the responsibilities of auditors are determined by national legislation and the national institutes give a lead to the profession in setting standards. The Institute of Chartered Accountants issues statements on auditing from time to time (there are fifteen currently included in the members handbook) but it is not unfair to say that in recent years it has given more emphasis to the Statements of Standard Accounting Practice, many of which have implications for auditors although not of course in the manner in which they conduct their audits. However, professional firms in the United Kingdom are engaged in a continuous review of auditing methods and proÂ�cedures both with the aim of improving methods and efficiency and as a response to, for example, developments in computer accounting and the ever increasing complexity of international business. For major firms this will involve standing committees on auditing standards and consultation and cooperation on a world wide basis. The accountancy profession is nevertheless conscious of its international responsibilities, Philip Defleise€– Chairman of Council of the American Institute of Certified Public Accounts€– said in a recent address to Chartered Accountants in London that:€‘users of financial statements must also have confidence in the reliability of the figures … unless there is universal understanding of the meaning of an audited statement our capital markets will not be justified in ascribing to these statements the credibility they deserve’. He referred to multinational accountancy firms establishing uniform approaches to auditing and said ‘substantial differences in auditing standards do exist among many countries, all these can be resolved more quickly by the establishment of an International Auditing Standards Committee’. This body has yet to be formed. It has been suggested that the International Accounting Standards Committee (IASC), which is discussed below, should widen the scope of its activities to include consideration of auditing standards. It is not

514

Relationships with non-bank supervisory bodies

clear, however, whether or not the terms of reference of the IASC would permit it to fulfil this role. With specific reference to problems experienced over audit confirm� ations, proper procedures for obtaining bank confirmations are well established and usually carefully set out in the procedures manuals of professional firms.

Development of international accounting standards

The Councils of the principal accountancy bodies in the United KingÂ� dom (see Appendix) have approved the objectives of the InterÂ�national Accounting Standards Committee. Through this Committee, set up in 1973, the United Kingdom accountancy profession seeks to promote world wide acceptance and observance of basic standards in the presentation of audited accounts and financial statements. The undertakings given by the United Kingdom Councils to further the objects of the Committee are set out in Section 2 of the Appendix attached to this note. However, the International Standards do not override the requirements of the United Kingdom Companies Acts or Institute’s own Accounting Standards. The Committee responsible for the International Standards takes account of local standards in producing their recommendations; one obvious intention is to harmonise the diverse accounting standards, the policies reflected in those local standards. For this reason the emphasis of the IASC is on basic standards which can be effectively applied on a world wide basis and which if necessary can be enforced by national professional bodies. Standards on the ‘Disclosure of Accounting Policies’ and exposure drafts of proposed standards on stock valuation and presentation, depreciation accounting and information to be disclosed in financial statements have been produced.

The Accountants International Study Group

The three Institutes of Chartered Accountants in Great Britain and Ireland have organised a study group with the following terms of reference: To institute comparative studies as to accounting thought and practice in participating countries, to make reports from time to time, which, subject to the prior approval of the sponsoring Institutes, would be issued to members of those Institutes.

It is hoped that its studies help enhance international cooperation within the accounting profession. They are, however, not ‘official’ documents

Appendix B

515

but express the views of the members of the Study Group which are not necessarily those of the participating bodies. The studies published are listed in the Appendix.

Conclusion

There would appear to be no absence of goodwill in the United Kingdom towards establishing international accounting standards and these directly or indirectly determine good standards of disclosure in bank accounts. However, Schedule 8 of the 1948 Companies Act can be a significant factor in determining the degree of disclosure in bank accounts and the application of the recommendations, international or national, of the accountancy profession may be restricted by its constraints. Bank of England 19 November 1975

Appendix B

BS/85/11 Revised

The relationship between external auditors and supervisors A summary of points drawn from a Contact Group survey (GC/83/26) and a paper by the Office of the Inspector General of Banks in Canada (BS/83/66) There are considerable differences among member countries in the degree of contact and collaboration between supervisors and external auditors. In some countries supervisors rely heavily on the work of external auditors as a source of information about the condition of banks and place specific obligations on them in the conduct of their duties while in others, there appears to be little contact between the two parties. These differences are in large part the product of historical, legal and institutional factors in individual countries; in particular, they appear to reflect the relative quality and comprehensiveness of the external audit function vis-a-vis the supervisory inspection process and the incidence of legal and ethical barriers to the passage of information between the parties. In view of these disparities, no common code of practice or framework for collaboration between supervisors and auditors seems likely to be applicable or to serve the needs of supervisors generally. However, recent events in several countries have prompted supervisors to review the nature of the existing relationship with auditors with a view to

516

Relationships with non-bank supervisory bodies

strengthening contacts and, where possible, providing early warning of specific problems. The role of auditors in the supervisory process and the responsibilities placed on auditors may fall under the following headings. These are listed in ascending order according to the extent of collaboration and the degree of responsibility placed on auditors in the process of supervising individual banks. 1. Regular supervisory dialogue with the auditing profession to direct attention towards specific areas of difficulty which may be encountered among banks generally. 2. Supervisory approval required for the appointment of particular auditors and supervisory right to revoke a particular appointment if found unsatisfactory. 3. The scope of the audit of the bank and management control systems and the content of the audit report determined by specific supervisory guidelines or regulations. 4. Audit report to management (the ‘management letter’) required to be submitted to supervisors. 5. Supervisors have right to ask auditors for additional information. 6. Auditors required to confirm accuracy of certain supervisory data. 7. Regular supervisory dialogue with auditors about problems relating to individual banks. 8. Auditors under a specific duty to report immediately to supervisors if they become aware of material problems which threaten the stability of the bank. The attached table summarises the legal position in different member countries as regards the compulsory external audit of banks, qualifications of auditors, supervisory appointment of auditors and the submission of auditing information to supervisors. This table is an expanded and updated version of that contained in Annex II of the Contact Group paper GC/83/27. An important question that the table does not, however, cover is that of the role of auditors in providing supervisors with early warnings of specific problems. In most member countries there appears to be no procedure for auditors to report to the supervisor as soon as they become aware of material cause for concern about the future stability of a bank. This largely reflects legal and ethical duties of confidentiality which preclude an auditor from discussing the affairs of his client with an outside party. In principle, it may be possible to overcome this barrier, for example, by obtaining the client’s consent, or by a gentleman’s agreement with the audit profession or by imposing an additional legal

Appendix B

517

duty on the auditor towards the supervisor. Despite this, the auditor may still face a conflict of interest tending to erode the quality or timeliness of information passed on to the supervisor. Four member countries (Belgium, Germany, the Netherlands, Switzerland) have experience of, or have recently introduced, procedures requiring auditors to report serious problems promptly to the supervisor. In Belgium and Switzerland the potential conflict of interest is avoided by the auditors having a direct responsibility to the supervisor, by whom they are appointed. These ‘supervisory’ auditors may be the same as those reporting to shareholders but they need not necessarily be so. Where different firms are employed, the role of the ‘supervisory’ auditor is analogous to that of an inspection system. In Germany and the Netherlands the same external auditor appointed by the shareholders is also under a specific obligation to report to the supervisor. Here, the conflict of interest is diminished by the parties seeking to establish a close relationship and a consistent view of their responsibilities. 24 May 1985

1

(a) for the appointment of auditors (i) is the selection of auditors controlled by no8 yes the supervisory authorities? ................................ (ii) must the supervisory authority be informed of no8 yes the auditor(s) selected? ..................................... (iii) does the supervisory authority have the right to revoke the appointment of the auditor(s) no8 Yes selected?

2. Responsibilities of supervisory authorities

(b) auditors’ professional qualifications and associations* yes yes (i) must auditors pass a special examination to qualify for the profession? ................................... (ii) is there a professional association of auditors? yes yes yes yes (iii) does this association issue guide-lines concerning auditing standards? ..............................

yes yes

no

no yes

yes

yes

yes yes

yes yes

yes yes

no no

no

yes4 yes4

yes4

no

yes

no

yes

no

yes2 yes3

yes

no

no

yes yes

yes

yes yes

yes yes

Belgium Canada France Germany Italy

A B (a) general arrangements (i) is such auditing compulsory? .............................. yes yes no no (ii) is it carried out on a regular basis by: – general auditors or auditing firms? ................. yes yes – approved specialist bank auditors or auditing firms? ................................................

1. External auditing of banks

Item

TABLE I

no

no

no

yes

yes

no

no

no

yes yes

Yes no yes yes

no

yes

no

yes yes

Yes

no

yes optional

yes

yes

In certain cases

yes

yes yes

yes

Yes

yes no

no

yes

yes yes

no

no

yes yes

no

no10

no9

no

no

no

yes yes yes

yes yes7

no Recom– mended no

United States

yes

no

yes yes

Luxem– Nether– Switzer– United Sweden bourg lands land Kingdom

yes

no

yes yes

Japan

External auditing of banks: existing arrangements and responsibilities of supervisory authorities

yes

(iii) has the supervisory authority the right to ask auditors for additional information? ................... no yes

no

no

yes

yes

yes

yes

yes

yes yes6

yes5

no

no in certain cases

no

yes

yes

yes

no

no

yes

* These items cover auditors in general and not simply bank auditors. 1 Column A refers to the “commissaire-réviseur” appointed by the shareholders; column B to the “réviseur agréé” appointed by the Banking Commission. 2 As from 1975, but only for banks whose shares are quoted on the stock exchange. 3 Approved by CONSOB (National Stock Exchange Supervisory Commission). 4 In principle. 5 The guide-lines issued by the profession and referred to in 1. (b) (iii) above are official in the sense of being legally binding. 6 In practice. 7 Auditors are drawn from a number of professional associations, none of which restricts its membership to auditors. 8 Except when the “réviseur agréé” is also the “commissaire-réviseur”. 9 But authorities would make their views known if a particular appointment was felt to be inappropriate. 10 But in practice the authorities would expect to be informed of any new appointment.

yes

yes

yes

yes yes

yes

no

yes

(b) for the work of bank auditors (i) are there any official guide-lines concerning the content of the auditors’ reports? ................... yes yes (ii) must audits be submitted to the supervisory authority? ........................................................... no yes

yes

no

in certain cases

520

Relationships with non-bank supervisory bodies

Appendix C BCBS’ views on fair value accounting (1997) III

Fair value accounting

The Steering Committee has put forward a comprehensive proposal and has made a conceptual case for fair value accounting for financial assets and liabilities. It has also pointed out, correctly, that problems exist in the current mixed measurement model. The Basle Committee believes that while fair-value accounting for all financial instruments potentially has benefits, it also has a number of pitfalls. As benefits, fair-value accounting has the potential to result in financial statements that better reflect the results of risk taking and risk management and thereby enhance market discipline. Fair-value accounting also could better reflect the economics of certain transactions and reduce the scope for transactions being entered into primarily to achieve accounting results. Moreover, fair-value accounting could be a complement and encouragement to improvements in the risk management practices of banks and other organisations. On the other hand, without prudent and balanced standards for the estimation of fair values (particularly when active markets do not exist), fair-value accounting for all financial instruments could reduce the reliability of financial statement values, increase the apparent volatility of earnings and equity measurements and lead to amounts being counted as capital that do not have an adequate degree of permanence, thus potentially requiring offsetting regulatory adjustments. For example, there is a risk that, in practice, discounted cash flow methodologies may give a wide range of estimates of the fair value of illiquid instruments because there may be significant differences between equally valid estimates of the discount rate to apply. The credit risk of unlisted organisations with no ratings may not be fully reflected in fair values. If fair-value accounting were adopted, disclosures that go far beyond those of IAS 32 would be needed to disclose the methodologies being used and to assess the risk profiles and earnings impact of financial assets and liabilities. The Basle Committee firmly supports comprehensive disclosures allowing assessment of a bank’s risk profile and its methods and performance in managing risk.43 The Discussion Paper 43 [Footnote in original text] For example, jointly with IOSCO the Basle Committee has issued disclosure recommendations in the report on ‘Public Disclosure of the Trading and Derivatives Activities of Banks and Securities Firms’ (November 1995) and reiterated in the report ‘Survey of Disclosures about Trading and Derivatives Activities of Banks and Securities Firms’ (November 1996).

Appendix C

521

does not adequately address this matter. As a result, the quality of the information available to market participants and supervisors could diminish substantially. Fair value accounting is appropriate when such an approach is workable, e.g., for financial instruments held for trading purposes, when a liquid and efficient market exists. It may also be appropriate where a realistic and reliable estimate of fair value can be made that is suited to the economic rationale of the activity. However, the Basle Committee believes that the Discussion Paper’s approach€ – which would require a rapid adoption of full fair-value accounting in the primary financial statements for all financial instruments€ – raises a number of difficult issues and that to adopt this approach too hastily would not improve financial reporting. While many of the goals of the fair value approach are desirable, we have serious reservations about IASC going ahead with the proposals as currently constituted on comprehensive fair valuation in the balance sheet and income statement at the present time. IV

Concerns

Our major concerns about the present proposals may be categorised as follows:

• They are based on the presumption that most assets of a bank directly

flow through active, liquid markets, or indirectly through derivatives. While there continues to be a move in that direction, from a worldwide perspective an important part of many banks’ balance sheets does not fall in this category. • Despite the developments in trading risk and interest rate risk management techniques noted above, many banks do not (or are not yet in a position to) manage the totality of their risk exposures based on the accounting model lying behind the fair value proposal, although bank trading accounts are often marked to market. A number of banks do regard banking book activities as different from trading book activities€– not just because the accounting is different but for fundamental business reasons, including a view that changes in the fair value are not clearly real changes in income or capital available to the enterprise. Also, from a world wide perspective, loans, for example, represent financial assets that in many cases are not designed to be traded in the market because they arise from ‘bilateral’ relationships between debtors and creditors based on the exchange of confidential information. As a consequence, it might not be appropriate to evaluate them in the primary financial statements primarily from a trading stand point on the basis of the present value of their future cash flows. Nevertheless

522

Relationships with non-bank supervisory bodies

a present value approach for loans could, theoretically, provide useful information€– through internal systems and disclosures€– for analysis of the economic value of the enterprise. • More rigorous guidance for the estimation of fair values is needed. The proposal for estimating fair values risks substituting a significant new degree of management discretion for the existing discretion, which while undesirable to some from a theoretical perspective, at least has the benefit of being widely understood. Additional guidance is necessary, for example, for the measurement of non-traded and illiquid instruments (including OTC derivatives), for the credit risk component of fair values, and for discounting methods. The Committee is prepared to provide assistance in developing this guidance and in consulting with financial institutions on its appropriateness. • Any standard on the measurement of fair values for financial assets and financial liabilities should ideally apply both to internationally active and to smaller banks, including banks in emerging markets. This would ensure comparability and fair competition. Increasingly, bank supervisors and other international financial bodies, as well as G-7 ministers, are interested in sound world-wide principles. However, the degree of development of capital markets providing reliable indications for determining fair values varies enormously within industrialised countries and even more so between those countries and emerging markets. Typically, smaller institutions are not active in capital markets or international activities. We believe that, for smaller and non-public entities, the costs of fair value accounting are likely to outweigh the benefits. Moreover, as a practical matter, we are worried that if all enterprises were required to apply these proposals, it is likely that compliance would not be widely practised. • The requirement to adjust liabilities to reflect the credit worthiness of the institution is of fundamental concern to regulators and is likely to complicate a meaningful regulatory assessment and the necessary action for banks in financial difficulty. The result of this part of the proposals is€ – as the paper itself acknowledges€ – ‘counter-intuitive’ and may considerably obscure the financial statements for many users since as an institution’s credit worthiness deteriorates, it appears to receive a gain in its income and capital. • The proposal does not comprehensively address a fundamental issue in the valuation of certain assets. The fair-value of certain loans, for which there is no market, may not necessarily be altered for changes in credit risk under certain conditions. Yet issues of when and how to recognise these losses, or to set up allowances for losses, are absolutely key to a bank’s financial position and performance. And increasingly, international banks are exploring methodologies that attempt

Appendix C

523

to provide for these changes in credit risk more accurately. Having guidance in this area is essential to true and fair financial reporting. Reasonably specific accounting guidance on this issue could be of great use in many countries for bank accounting and supervisory purposes. The Task Force on Accounting Issues of the Basle Committee stands ready to assist in this regard. V

Way forward

The Basle Committee suggests that the IASC follow an alternative approach for accounting for financial assets and liabilities. This approach may, over time, help to resolve the problems associated with fair-value accounting and provide more fair-value-based information in published annual accounts. Such an alternative approach could have two elements: 1. First, IAS disclosure requirements could be expanded to include supplemental consolidated financial statements reported on a fair value basis along with additional quantitative and qualitative disclosures.44 These disclosure requirements should initially be limited to larger market participants (as the Basle approach focuses on international banks) and would be coupled with enhanced accounting guidance on the estimation of fair values. The exact form and scope of these additional consolidated financial statements, and the description that surrounds them, would need to be considered, to reduce the risk of misunderstandings about which are the institution’s main accounts. The possibility of starting with fair value balance sheets before requiring fair value income statement disclosure could be considered. 2. Second, we recognise that current IASC standards contain little on recognition and measurement of financial instruments. If the IASC believes that this should be altered in the short term, it could issue simplified guidance based on a modified historical cost framework for the primary financial statements. For example, this would recognise that trading portfolios should be reported at their fair values, and would maintain a simple hedge accounting approach for derivatives used to hedge the banking book. While certain aspects of this suggested approach were previously proposed in E 48, which was rejected, it would be possible to deal with some of the criticisms of that proposal. [Footnote in original text] The Basle Committee’s recommendations in the report on ‘Public Disclosure of the Trading and Derivatives Activities of Banks and Securities Firms’ provide some guidance for possible disclosure requirements regarding banks’ trading and derivatives activities. The recommendations put forward in a discussion paper issued by the G-10 Euro-currency Standing Committee on ‘Public Disclosure of Market and Credit Risks by Financial Intermediaries’ (September 1994) may also be considered. 44

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Relationships with non-bank supervisory bodies

3. The advantages of this two-part approach include the following: • It could provide a laboratory for experimentation to improve fairvalue information for illiquid instruments before determining whether or not fair value financial statements should become the primary basis of accounting. Such an approach could also lead to the necessary degree of acceptance and understanding by preparers and users of financial statements and development of examples that we believe is necessary. • Supplemental fair-value financial statements could provide additional information beyond historical cost-based statements. Over time fair-value financial statements could eventually become the primary basis of accounting if financial statement users determine this is the more useful basis of accounting. • A modified historical cost framework (e.g., with fair valuation of trading instruments and a simple derivatives hedge accounting approach) and supplemental fair-value statements would be more transparent and understandable to users. Many of the disclosures that now exist would be retained, for example on credit risk. • Modified historical cost financial statements with supplemental fair-value statements in the notes would limit the extent to which accounting standards constrain prudent risk management hedging programs. • The fair-value statements could encourage institutions to manage risks that may not be fully reflected in a historical cost regime and to manage them comprehensively and not on a piecemeal basis. Along with mandating expanded fair-value disclosure requirements, we believe that the IASC should further consider certain implementation issues and, in particular, provide expanded guidance on fair value in key areas. In addition to areas noted above, additional consideration and/or expanded guidance would be appropriate in such areas as:

• Core deposits. On the one hand, these have attributes of financial

instruments; on the other, they have some aspects of intangibles, that may raise valuation issues. • Illiquid assets, such as many commercial loans. Guidance would be helpful in valuation and in dealing with situations of asymmetric information between buyers and sellers. • Disclosure of fair value sensitivities and the management of risk exposÂ� ures, in order to place the fair value information in perspective and provide disclosures about important aspects of the risk profile of organisations. We believe that, initially, supplemental fair-value financial statements should be limited to the consolidated accounts of larger organisations

Appendix D

525

which are more actively involved in capital markets. Over time, these disclosure requirements could be extended to smaller institutions as experience with the relevance and reliability of fair value statements is gained and the cost of compliance is determined. It would be particularly important to resolve these and other issues associated with fair value accounting before it is expected of smaller companies or businesses in emerging market economies.

Appendix D

BS/88/13

Committee on Banking and Supervisory Practices

Report to Governors Relationships between banking supervisors and securities supervisors

The convergence of the banking and securities markets has been the subject of widespread comment and analysis in recent years. With it has come about an increasing interaction of the major players in those markets€ – banks, securities houses, investment banks and other brokers/dealers in financial instruments. Banks underwrite, deal in and hold large portfolios of securities. Through the clearing and settlement systems, banks face daily exposures to non-bank dealers in securities and vice versa. In a number of countries the close association in the nature of banking and securities business has led to a range of different ownership or affiliate relationships. For banking supervisors these developments present several formidable problems. Firstly there is a need to extend existing risk measurement techniques to capture the risks for banks associated with their role as traders of securities. Secondly, where banks are connected through ownership with securities dealers, safeguards are needed against the risk of contagion. Thirdly, given that securities houses and investment banks are increasingly in direct competition internationally with banks, there is a need to consider ways in which some equivalence of regulation can be secured for these businesses in order to avoid the risk that the efforts by banking supervisors to strengthen the capital position of banks could be undermined. Finally, a matter of concern for banking supervisors, even though going beyond their direct responsibilities, there are systemic issues for central banks, highlighted by recent events in the world’s stock markets, involving questions of intervention and support for particular securities companies, or particular markets, which may be under threat. For all these reasons the Committee

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believes it is an important part of its function that it should develop a fruitful dialogue and build informal relationships with securities regulators in the major markets. The limited scope of the Committee’s intentions in this field should be stressed at the outset. In most countries banking supervisors and central banks do not have any direct responsibility for regulating the securities markets. The Committee has no wish to assume for itself any role or responsibility for the supervision of securities markets or nonbank securities dealers. Neither does the Committee consider that it is competent to take a lead in discussions on systemic issues affecting, for example, assistance to securities markets and market-makers. The Committee also recognises that there are a number of interested organisations and groups of organisations which also see the need to pursue the debate on the issues described and that there will be, and should be, a number of different forums where these matters are discussed. Within the limited scope envisaged, however, the Committee believes there are a range of important issues which should form an agenda for discussion. The subjects fall under two broad headings. Firstly, there are Concordat-type questions to do with identifying where prudential responsibility lies for the international securities operations of banks and securities houses and the handling of those supervisory relationships; at present there is scope for duplication and confusion or, even worse, no supervision of certain operations. Secondly, there are technical questions relating to the interrelationship of securities and banking regulators’ capital adequacy rules, in particular the measurement of position risk, which bear on issues of competitiveness between the two industries. The Committee has given careful thought to the way in which any approach to securities regulators should be made. There are several existing organisations which have some expectations that they should act as an international co-ordinating body for securities regulatory bodies but it is unclear whether any of the existing groupings are wholly appropriate to fulfil this role or are generally acceptable to securities regulators worldwide. It is considered inappropriate, therefore, to make a formal approach to any existing organisation. Instead, it is proposed that the Chairman, on the advice of Committee members, should invite certain designated national regulatory bodies to send ‘experts’ rather than ‘country representatives’ to discuss specific subjects with a working party of the Committee. In this way it should be possible to avoid creating frictions between different securities regulatory groupings with competing claims to representation. Governors are invited to give their approval for work to proceed along these lines. The Committee would also appreciate any guidance they have to offer.

Appendix E

527

1 February 1988

Appendix E A French participant [BCBS] wondered whether the differences between the perspectives of banking and securities regulators were as clear-cut as the text implied. Bank supervisors were also interested in short-term aspects, such as liquidity, since liquidity and solvency problems were often inter-related. He thought that placing too much emphasis on the time horizon could lead to the wrong conclusions. Banks and securities houses ran similar risks and the same risks should be analysed in the same manner. If one measured the risks differently, one would not achieve competitive equality. The Chairman agreed that the differences in the approaches of banking supervisors should not be exaggerated, but the Knight working group had drawn a similar distinction in Annex B of its report. Securities regulators had reason to recognise guarantees and short-term credit lines or subordinated debt as capital since they took a shorter time horizon than bank regulators. An American participant [Securities Regulator] disputed the implication in the text that securities houses were under-capitalised in relation to banks. The top fifteen US securities houses were very well capitalised. The SEC was content for any securities house to withdraw from the market if it wished to, and its main concern was to see that the assets covered liabilities. Any US securities house could be liquidated in two months. That was not possible with a bank since they did not have sufficient liquidity. A British participant [BCBS] thought that the key difference in approach was due to the nature of the assets. An institution whose assets were liquid and easily valued could be much more flexible in reacting to changes and some short-term capital was acceptable. For a bank, however, valuation was much more difficult and it could take years for a loan to be repaid. This created difficulties in consolidating banking and securities business. In his view, it could be legitimate for bank supervisors to take into account some of the liquid capital regarded by securities supervisors as eligible capital in respect of trading assets. A French participant [SR] agreed with those who thought that the paragraph over-exaggerated the differences between the approach of the banking and securities regulators. The Knight working party had concluded that the general objectives were identical, though it had not been possible to recommend a standard capital test. In France, the definition of capital used by the securities supervisors was very similar to that of the banking supervisors, even if subordinated debt and

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guarantees were acceptable for historical reasons. However, these were recognised only on a temporary basis to allow time for more permanent capital to be raised. The Chairman said that he would be comforted to learn that securities regulators recognised liquid capital on a transitional basis only, since this would narrow the differences in approach. However, he feared some securities regulators gave it more permanent recognition. The same US participant explained that the SEC’s rules did not generally allow subordinated liabilities unless they had a maturity of at least one year. Moreover, they could not be repaid, even on maturity, unless the firm was above the early warning levels of the net capital rule. Thus the amount was locked in until a firm was able to reconstitute its capital. There were two main exceptions. First, a temporary subordinated loan could count as capital for the purpose of underwriting, but even that would be locked in for the period of the underwriting and could not be repaid if the capital fell below the early warning level. Second, there were revolving subordinated loans which were in principle locked in for at least one year, although the New York Stock Exchange was able to authorise prepayment if the capital level was above a given level of comfort and if the transaction was seen as a genuine one. The purpose of these rules was to give securities houses the flexibility to observe the capital requirements on a continuous basis. A British participant [SR] added that, as in the United States, the UK treatment of subordinated liabilities was designed to respond to very rapid movements in asset values and in particular to the problem of underwriting, where the risk could be very large but short-lived. Subordinated loans were very effective in providing funds rapidly when capital threatened to fall below required levels. The conditions Mr Macchiaroli had described ensured that subordinated liabilities could if necessary be turned into permanent capital. The question for the regulators was to determine the appropriate parameters. The Chairman observed that the basic concept of capital as net worth plus a limited volume of subordinated liabilities subject to a minimum maturity came very close to that agreed in the Basle capital framework. He further noted that some banks conducted securities business inhouse. It was questionable whether a differentiation should be made between the same activities according to whether it were done through a separate subsidiary or not. He then asked for comments on the final two paragraphs of the paper, which raised the key question of the ‘level playing field’ between banks and securities houses. Should the same risk have equivalent supervisory treatment, or were banks and securities houses so different that

Appendix F

529

different rules should apply? He was encouraged by the discussion so far to believe that the differences were partly linguistic and not so fundamental as they appeared at first sight. He was therefore not too pessimistic about the possibility of achieving broadly equivalent supervisory approaches, while not identical in every detail. A British participant [BCBS] thought that the ‘level playing field’ was something of an illusion. Securities trading and traditional banking were very different. He feared that when one got down to the details of supervisory rules, it would not be possible to do more than generalise. The Chairman said that he was only asking for broad equivalence. The problem for the banking regulators was that the securities portfolio was only a part of a complex business. It had a bearing on the bank’s foreign exchange risk, its interest rate risk and its liquidity. An Italian participant [BCBS] believed that the main risk to guard against was systemic risk. If it were concluded that the systemic effect of the failure of a securities house was less serious than the failure of a bank, there was no presumption that the prudential instruments should be the same. That was not to say that banking supervisors could not learn from techniques already developed by securities supervisors. The Chairman, summing up the discussion, realised that some participants had reservations about the conclusion he had expressed. Nonetheless, he believed that banking supervisors should at least attempt to see whether their treatment of position risk could achieve a broad measure of equivalence with the securities supervisors’ rules. Otherwise there would be competitive distortions and regulatory arbitrage. So far as the discussion paper BS/89/31 was concerned, he did not see any reason to redraft it to reflect the discussion, but the views expressed would be recorded in the subsequent record of the meeting.

Appendix F Supervisory treatment of traded securities At their meeting on 20th and 21st September 1990, banking supervisors and securities regulators of the Group of Ten countries considered the possibility of devising a common system of measuring risk and a minimum set of capital adequacy requirements which could be applied to the securities business of bank and non-bank securities companies. Participants reached a general consensus as to the way forward and this is set out in this note. Such standards would not compromise the capability of individual supervisory authorities to impose more conservative requirements provided that these could be established as being at least as onerous as the agreed minima. The standards would also need

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to be consistent with supervisors’ responsibilities to ensure that their requirements are prudentially adequate. Participants concluded that a building-block approach was likely to be the most effective way of achieving convergence, given the need of the banking supervisors to be consistent with their existing capital requirements which are primarily based on credit risk and do not yet take account of market risk. Inasmuch as such a disaggregated approach has not yet been applied to the books of participants in securities markets, it would need to be tested before supervisors could apply appropriate quantities to the concepts involved. The building-block approach would involve separate requirements for general market risk, that is the risk to a regulated entity’s earnings and capital of an adverse movement in interest rates or the equity market, and specific risk, that is the risk of an adverse movement in the price of an individual security relative to rates or prices generally. Specific risk is essentially credit risk, but reflects changing market perceptions of the quality of the issuer, in either direction.

Equities

Participants concluded that they should base their approach on the presumption that institutions have well diversified portfolios. Less diversified portfolios would require more onerous treatment. The requirements to be applied in respect of specific and general market risk should take account of research into the historic volatility of share prices, but should not solely be based on such evidence. As far as specific risk is concerned, there was a readiness by some to give preferential treatment to a qualifying group of equities. The test for such a group could derive from turnover figures, participation in market indices, or quotation on organised markets. Any such tests should be simple and objective. It was agreed that equities held by banks for long term investment reasons could, with the specific approval of the supervisor, be excluded in which case the standard credit risk requirements would apply.

Debt securities

It was agreed not to attempt initially to integrate banks’ position risk on debt securities in the trading portfolio with the interest rate risk on the remainder of their business. However, the continuing work on interest rate risk generally would need to be borne in mind in order to avoid any subsequent problems when an integrated approach became feasible. A cautious approach to netting across time bands (horizontal offsetting)

Appendix F

531

would be needed to guard against short-term movements in interest rate differentials, which it was recognised was of more concern to securities regulators than to banking supervisors. Depending on the width of the time bands full offsetting between different categories of instrument within the same time band (vertical offsetting) might be appropriate for market risk. For specific risk purposes, three basic categories of instrument were envisaged:€ central government, other qualifying and other. The test for private sector ‘other qualifying’ securities could be based on market factors, as expressed, for example, by credit ratings, or by the meeting of quotation requirements. Specific risk requirements for ‘other qualifying’ could also take account of up to a maximum of three zones of remaining maturity.

Base requirement and illiquid assets deduction

Participants concluded that the differing approaches of banking supervisors and securities regulators, the former taking a ‘going concern’ approach, and the latter a ‘gone concern’ approach were equally valid. In particular, base capital requirements of various types and the deduction of illiquid assets by certain securities regulators were felt appropriate for securities companies but not for banks. The only practical approaches to convergence, therefore, were for securities regulators to impose these special features, in addition to common position risk requirements, an approach described as ‘super equivalence’, or by a mix of requirements which would produce the same minimum result. This alternative would effectively involve the application of a dual test.

Capital definition

Participants noted that acceptable components of capital differed, again due in part to the differing approaches of banking supervisors and securities regulators. In particular, treatment of subordinated debt differs. It was noted that convergence would be promoted if such debt was held within a group supervised on a consolidated basis. Participants agreed that provided that there were suitable cap and lock-in arrangements rendering subordinated debt more akin to equity, the apparent differences in definition would be substantially reduced. Participants also welcomed pending US legislation which seems to be reducing regulatory gaps. With the exception of the German and Luxembourg delegations, participants agreed that remaining differences in capital definitions were not on their own felt likely to prove a significant barrier to effective convergence at this stage.

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Procedure

It was agreed that this note would be submitted by the banking supervisors present to the Basle Committee on Banking Supervision and by the securities regulators present to the Technical Committee of IOSCO and to their respective working groups. Participants expressed the hope that both bodies would instruct their working groups to proceed, with such consultative arrangements as would be necessary, to elaborate an agreed measurement system and set of minimum standards capable of adoption by all relevant supervisory authorities. The Chairmen of the working groups were therefore invited to liaise in the presentation of an agreed submission to the Technical Committee at its meeting in January 1991 and to the Basle Committee at its meeting in March 1991. Participants agreed to meet again at senior level in April 1991 to give their approval to the work. 21 September 1990

Appendix G BS/92/8 Joint statement by Richard C. Breeden, Chairman, Technical Committee, International Organization of Securities Commissions and E. Gerald Corrigan, Chairman, Basle Committee on Banking Supervision For release:€29 January 1992 On January 28 and 29, 1992, the Technical Committee of the International Organisation of Securities Commissions and the Basle Committee on Banking Supervision for the first time held a joint meeting of principals to consider proposed minimum capital rules for internationally active banks and securities firms. Important preliminary understandings were achieved on a wide range of fundamental issues.45 These discussions reflected both ongoing internationalization of global capital markets and the similarity of market risks undertaken by both banks and securities firms.

Current situation

In addressing capital standards, the two Committees have sought to address certain issues with respect to existing capital standards. Among 45 [Footnote in original text] Participants were aware of the ongoing discussions of this subject within the European Community, and recognised the desirability of consistency between the two sets of general discussions.

Appendix G

533

banks, the Basle risk-weighted capital standards have been in place since 1988 to address credit risks in bank assets. However, to date there have not been any international capital standards to take account of interest rate risk of tradeable securities and price risk in the equity positions held by banks. The proposed capital standards would for the first time close this important gap in existing international bank capital standards. Among securities firms, interest rate and credit risk have long been measured on a continuous daily basis in most major markets. However, there have been important differences in the level of required capital and in the measurement techniques utilized between different markets and types of firms. These differences create a risk of distortion of trading patterns and significantly varying levels of protection (both through capital levels or diversification of portfolios) for firms from different countries, against both local and global market volatility. The proposed capital standards would seek to create agreed minimum levels of capital that every securities supervisor would be obliged to follow or exceed as a buffer against market instability.

Debt securities

In establishing a proposed standard for holdings of traded debt securities, the discussions led to development of a single methodology for computation of both general market and specific issuer risks. This methodology, called the ‘building block approach’, would be utilised by all supervisors. Minimum levels of capital and maximum permissible allowances for potentially off-setting positions were defined by the Committees, subject to reservation by one country. At the same time, the Committees also agreed to allow use of an alternative ‘duration’ methodology that would utilize a somewhat different technique where a supervisor can demonstrate the equivalence of resulting capital charges.

Equity securities

In addressing the measurement of capital for equity positions, the Committees recognized that two alternative approaches would be utilized. For bank supervisors and for some securities supervisors, the ‘building block’ methodology for debt would also be adapted to equity positions. A general consensus was reached on the respective percentages to be used for the ‘x’ and ‘y’ factors (general and specific risks) applied to gross and net portfolio values, subject to certain reservations by a small number of supervisors.

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Relationships with non-bank supervisory bodies

However, many securities supervisors that have long successfully applied a ‘comprehensive’ methodology would continue to do so. Any supervisor utilizing the comprehensive approach would undertake to demonstrate that its specific application of the comprehensive methodology would yield capital requirements that were consistently equal to or greater than the capital that would be required under the building block approach.

Definition of capital

Substantial progress was also made in reaching mutually acceptable definitions of capital. The securities regulators have agreed that securities firms’ use of short term subordinated debt, with a ‘lock-in’ clause for capital purposes, should be limited to 250% of equity capital. A clear majority of the Basle Committee is prepared to entertain an approach to a definition of capital for market risk purposes of a banks’ trading portfolio that would, in economic terms, closely approximate the approach followed by the securities regulators.

Implementation

Each supervisor has agreed to undertake its best efforts to develop and implement necessary requirements promptly following completion of a consultative process. Where supervisory standards already exceed the proposed minimums, such standards would not be the subject of any proposed change as a result of the agreements. All parties expressly agreed that the proposals represent minimum standards. Any supervisor would remain free to impose higher requirements.

Future plans

On the basis of the preliminary understandings reached at the joint meeting, the Committees expect to be in a position to issue publicly consultative papers in the summer of 1992.

Appendix H Dr T. Padoa-Schioppa on ‘Globalisation of risks:€cooperation between banking and market regulators’, 12 July 1995 V

Conclusions

Let me summarise and conclude. Banking and securities regulators have made considerable progress in certain aspects of our work in the

Appendix I

535

last year, but much remains to be done. In my remarks, I have identified four areas of particular importance:€conglomerates, disclosure, consolidated supervision and capital requirements. Firstly, in the area of financial conglomerates, further cooperation through the Tripartite Group can serve as an important vehicle to promote improvements in the exchange of information between banking, securities and insurance regulators. Recent developments clearly suggest that more work needs to be done in this area. Secondly, banking and securities supervisors can jointly contribute to greater financial market stability by promoting standards for improved disclosure about trading activities. The joint IOSCO/Basle Committee reporting paper released last May has made an important contribution to ensuring that supervisors have meaningful information about the trading and derivatives activities of banks and securities firms. Looking ahead, the measurement concepts developed in the reporting paper can serve as the basis for improved disclosure practices by both banks and securities firms. Thirdly, in the area of consolidated supervision, which has long been a basic principle of banking supervision, I hope there will be increasing convergence of practices among banking and securities supervisors. Finally, and most importantly, we need to work to develop consistent market risk capital requirements across banks and securities firms. The internal model approach developed by the Basle Committee is sufficiently flexible to be applied to the activities of both banks and securities houses and there are signs that the thinking of bank and securities supervisors is consistent in this area. These four points arc suggestions for what could become an agenda for our future cooperation. The Basle Committee will be happy to hear your suggestions in their respect and is grateful to you for giving me the opportunity to be here today.

Appendix I

Annex

Mandate for the financial conglomerates group

To draw up proposals for improving cooperation and the exchange of information between bank, securities and insurance supervisors and to work towards developing principles for the future supervision of financial conglomerates. The group would:

• seek practical means at domestic and international levels to facilitate the

exchange of information by supervisors within their own sectors, e.g.

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Relationships with non-bank supervisory bodies

bank supervisor to bank supervisor and by supervisors in different sectors, e.g. insurance supervisors to securities supervisors or vice versa; • investigate any barriers, legal or otherwise, that would impede the exchange of information between supervisors within their own sectors and between supervisors in different sectors; • examine the possibility of establishing criteria to identify a ‘lead regulator’ or ‘convenor’ and consider the role and responsibilities of such ‘lead regulator’ or ‘convenor’; • work towards developing principles for the future supervision of financial conglomerates. It is anticipated that these principles for future supervision would parallel the issues identified in the present report: 1. Supervision of financial conglomerates on a group-wide perspective. 2. Techniques for assessing the adequacy of capital of financial conglomerates. 3. Supervisors’ ability to check on fit and proper standards of managers and their ability to ensure that shareholders meet adequate standards. 4. Supervisory approach to participations of less than 100% in entities within financial conglomerates. 5. Supervisory approach to large exposures and to intra-group exposures within financial conglomerates. 6. Supervisors’ ability to intervene in structures that impair effective supervision. Topics may not necessarily be taken up or finished in the same time frame.

Appendix J

BS/96/1 11.04.96

BASLE/IOSCO Joint Statement

Introduction

The Halifax Summit Review of International Financial Institutions (the Communiqué) identifies issues of critical concern for supervisors and market participants in the financial services sector. Globalisation of capital markets, integration of financial services and the exponential rate of technological and financial innovation, including notably the increased

Appendix J

537

use of derivative products, permit significant enhancements to risk management procedures. They also pose the challenge of potentially greater risk. The ability of markets and their supervisors to respond flexibly to firms’ failures and other disruptions is encouraging. Nevertheless, regulators cannot afford to be complacent. Close international cooperation is crucial to continued success in meeting the challenge of the future.

Responding to the challenge

The Basle Committee on Banking Supervision (the Basle Committee) and the International Organisation of Securities Commissions (IOSCO) recognise that the process of globalisation and innovation leads to more efficient allocation of capital and contributes to economic growth. Both organisations share the common goal of improving the quality of supervision worldwide and responding to financial market developments in a timely, effective and efficient manner. However, they remain aware that efficient global markets may accelerate the transmission of financial disturbances. The occasional failure of individual market participants is an unavoidable feature of an efficient market system. The ultimate objective of supervision cannot be to avoid all such failures. In pursuit of their common goal, the Basle Committee and IOSCO have identified the following eight major principles which will guide their efforts and which their members agree to promote:

• cooperation and information flows among supervisory authorities

should be as free as possible from impediments both nationally and internationally; • all banks and securities firms should be subject to effective supervision, including the supervision of capital; • geographically and/or functionally diversified financial groups require special supervisory arrangements; • all banks and securities firms should have adequate capital; • proper risk management by the firm is a prerequisite for financial stability; • the transparency and integrity of markets and supervision rely on adequate reporting and disclosure of operations; • the resilience of markets to the failure of individual firms must be maintained; • the supervisory process needs to be constantly maintained and improved. The Basle Committee and IOSCO are fully resolved to work actively together, as they have been doing, to promote these principles. They

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will anticipate and respond to concerns such as those noted in the Communiqué, albeit determining their priorities in addressing these concerns according to their respective perspectives and responsibilities as banking and securities regulators. Since 1995 a Coordinating Committee of representatives of the Basle Committee and IOSCO has been meeting regularly to review what joint work is in train as well as to exchange information on the respective agendas and projects. A Joint Forum of bank, securities and insurance supervisors is also continuing the work previously done informally by a Tripartite Group to enhance international cooperation and coordination in the supervision of financial conglomerates. More detailed accounts of the activities and work programmes of the Basle Committee and IOSCO are set out in the two documents accompanying this statement.

Completed and ongoing initiatives

In line with the above principles, the work programme of the Basle Committee and IOSCO in the recent past has aimed to establish concrete international understandings on safeguards, standards and transparency. The results have included initiatives in the following areas, many of which have been developed jointly: (a) Internal management control systems. In order to encourage strong internal management control systems within the firms, in July 1994, IOSCO and the Basle Committee issued guidance papers concerning risk management of derivatives activities and have since kept this issue under review, in close collaboration with industry groups. Both IOSCO and the Basle Committee are committed to further efforts to encourage financial institutions to implement effective internal control and audit systems. (b) Capital adequacy. An Amendment to the Basle Capital Accord issued by the Basle Committee this January will allow banks to use the results of proprietary ‘value-at-risk’ models (subject to strict qualitative and quantitative standards) as a basis for measuring the market risk element of their regulatory capital requirements. IOSCO has also published papers on capital standards for securities firms and on the implications of increased use of valueat-risk models by securities firms and is working with the Basle Committee (and a number of major financial institutions) to test such models against a wide range of securities portfolios. (c) Reporting, disclosure and accounting. With the objective of promoting market transparency, in November 1995 the Basle Committee and IOSCO jointly issued a report on the public disclosure of

Appendix J

539

trading and derivatives activities of banks and securities firms. Compliance with a common minimum reporting framework identified in a joint report issued in May 1995 (as well as with other quantitative and qualitative disclosure requirements) is being actively monitored and it is expected that standards will continue to evolve rapidly. These efforts complement work being undertaken in other fora, as well as national efforts, to promote market transparency by improving the quality of global market data. â•… IOSCO is working closely with the International Accounting Standards Committee and the International Auditing Practices Committee to promote the development and implementation of global accounting and auditing standards for international securities issuers as alternatives to the use of national standards. (d) Financial conglomerates. Significant work continues on developing procedures for the effective supervision of international financial conglomerates. A discussion paper was published in July 1995, the conclusions of which are now being addressed by the Joint Forum of representatives from IOSCO, the Basle Committee and the International Association of Insurance Supervisors. (e) Operational and settlement systems. Cooperation among authorities charged with prudential supervision and payment systems oversight can strengthen the operational and settlement systems upon which financial markets are based. Effective management of credit and liquidity risks and strong internal controls within banks and securities firms are essential, as are appropriate risk management procedures for netting arrangements, clearing houses, and other settlement systems. Substantial work is being done in these areas as evidenced by reports of the Basle Committee and the BIS Committee on Payment and Settlement Systems (CPSS) and by the May 1995 Windsor Declaration which is being implemented by IOSCO. Future work by IOSCO on selected projects will be undertaken in consultation with the CPSS, and work on bank supervision/payment system issues will continue to benefit from cooperation between the CPSS and the Basle Committee. (f) Worldwide supervision. The Basle Committee and IOSCO seek to influence supervisory and regulatory policies and procedures throughout the world. Both have structures and mechanisms to ensure that their initiatives are communicated to and discussed with financial institution regulators worldwide. Both also have established procedures to embrace input from market authorities and participants.

540

Relationships with non-bank supervisory bodies

(g) Market emergencies. The global market enhances banking and financial markets’ sensitivity to crises wherever originated, calling for prompt exchange of information and immediate, coordinated action among relevant authorities. Banking and securities supervisors continue to develop contact and communication procedures to strengthen their ability to react effectively at times of market emergencies. Strengthening cooperation between the regulators of diversified financial groups The collaborative efforts described above address key elements in supervision and regulation and represent positive developments in the overall regulatory and operational framework. In light of the evolving market place and the risks associated with new trends in global trading, the Basle Committee and IOSCO continually review supervisory practices and procedures in order to ensure that these remain effective and that supervisors are in a position to deal with market disruptions should they occur. A particular concern is to develop satisfactory arrangements for oversight of diversified financial groups which offer a wide range of financial services on a global basis. The two organisations are resolved to foster arrangements that promote:

• an improved understanding of the roles, powers and responsibilities of the different regulators of such groups;

• access by each regulator of such a group directly or through a coordin-

ating authority to the information needed to fulfil its responsibilities, including making meaningful assessments of the risks to the relevant entities within the group and to those entities taken together; and • communication lines that will maintain and enhance regulators’ abilities to react to market developments in a timely and effective manner. The Basle Committee and IOSCO have therefore agreed to pursue a joint initiative to promote additional cooperative and collaborative arrangements, including effective lines of communication, in the supervision of diversified financial groups. It will build on the ongoing efforts of banking and securities regulators on a national, bilateral and multilateral basis, as described above. The principal focus of this initiative will be:

• the types of groups or institutions for which such arrangements would be useful and appropriate;

• the types of information that may need to be exchanged;

Appendix J

541

• ways to facilitate the resolution of possible legal, confidentiality, policy or practical issues that may arise; and

• any additional arrangements that may be appropriate to coordinate the activities of the relevant supervisors.

A particular aspect of this initiative will be to consider the need for and feasibility of additional coordinating arrangements in order, for example, to facilitate the exchange of information between the relevant regulators of the group, both in normal and emergency situations. This exercise will support the work of the Joint Forum of banking, securities and insurance supervisors and the practical arrangements will be consistent with the Joint Forum’s mandate. In addition, the exercise may need to consider the extent to which existing provisions of national law (for example, existing secrecy legislation which in some jurisdictions restricts the ability of regulators to share information) interfere with the achievement of desirable supervisory objectives; the members of IOSCO and the Basle Committee are prepared to assist Ministers in addressing such legal concerns. The joint Basle/IOSCO initiative is aimed at promoting more effective cooperation between banking and securities regulators, and will enhance the ability of regulators to fulfil their responsibilities more effectively. It should be emphasised, however, that any arrangements to improve coordination and cooperation at the international level will not in any way reduce the powers and responsibilities of any authority that is responsible for regulation of the different parts of a group as defined in national law.

Conclusion

The Basle Committee and IOSCO appreciate the opportunity to provide the G-7 Finance Ministers with this review of their current work programmes and arrangements to strengthen cooperation. Although the work has been demanding, progress has been substantial. Indeed, these initiatives are required to keep pace with the evolution of capital markets and the international financial services sector. Looking forward, both organisations are committed to increasing the effectiveness of banking and securities supervision without stifling innovation and efficiency.

14

The legal position of the BCBS

A

The status of the BCBS

The legal status of the BCBS is simple to discuss; it had none.1 Norton quotes Peter Cooke2 in two related papers:3 The committee does not undertake a formal supernational supervisory role; its conclusions do not have, and were never intended to have, legal force. Rather it formulates and recommends broad supervisory principles and guidelines of best practices in the hope and expectation that individual authorities will take steps to implement them through detailed arrangements€– statutory or otherwise€– which are best suited to their own national systems. In this way the committee encourages some gradual convergence towards a common approach and common standards without attempting far reaching harmonization of member countries supervisory techniques. 1 Kern Alexander and Rosa Lastra, in private correspondence, would qualify this flat statement, respectively as follows: It had no formal legal personality when it was set up. Yet, it was a committee set up under the auspices of the BIS (with a defined albeit complex legal personality), which has acted as an umbrella institution for the BCBS and other international standard setters/committees. The growth in soft law has two dimensions: the rules or standards themselves and the standard setters. Soft law is law; the process of law-making in a broad sense encompasses both hard law and soft law. The legal status of traditional law making institutions (Parliaments, formal international organizations, etc.) is well defined. The legal status of informal/soft law making bodies (groups of experts, groups of practitioners, etc.) is not clearly defined, but that does not mean that it is inexistent. What the BCBS clearly does not have is legal personality. Though the Committee acts as an informal forum (a ‘club’ of central banks and other supervisory agencies), and its decisions do not have direct legal binding force upon the member countries of the expanded Group of Ten (G-10), it has become a de facto international regulatory body. A wide array of countries have adopted many of the Committee’s resolutions and recommendations, incorporating them into national legislation and regulations. In this respect, the powers and influence of the Committee extend well beyond its founding mandate. See Lastra (1996), p. 169. 2 See discussion of the role of the Committee by W.€P.€Cooke, the chair of the Committee, in Basle Supervisors Committee (21 June 1984) (Committee document for external distribution). 3 J.€J.€Norton (1989b and 1991).

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The status of the BCBS

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Indeed, according to the BCBS’ own website:4 The Committee does not possess any formal supranational supervisory authority, and its conclusions do not, and were never intended to, have legal force. Rather, it formulates broad supervisory standards and guidelines and recommends statements of best practice in the expectation that individual authorities will take steps to implement them through detailed arrangements€– statutory or otherwise€ – which are best suited to their own national systems. In this way, the Committee encourages convergence towards common approaches and common standards without attempting detailed harmonisation of member countries’ supervisory techniques.

(As quoted in Lastra (2006); see also Alexander (1996).) In this latter respect, it is not unusual. As Giovanoli (2000, p.11) notes: From the institutional point of view, the new international financial system involves a great number and variety of institutions, entities and bodies which are directly or indirectly concerned with setting international financial standards. In other words, the new system is decentralized, although some institutions, in particular the IMF, have a prominent position as a result of their strong institutional basis and broad membership. The legal status of the multitude of entities involved varies significantly. The IFIs are fully-fledged international organizations, while the ‘Gs’ (G-7, G-10 or G-20) are de facto groupings created at the initiative of the governments of a number of states and meeting at different levels. There also are sectorspecific international groupings of supervisors and regulators, central bank experts’ committees and other groupings such as the FSF.5 However, what all these bodies have in common is the fact that, as a whole, they have no competence with regard to law-making or rule-making at either the national or international level.

The BCBS was a prominent member of such ‘sector-specific international groupings of supervisors and regulators’.6 Although it was not uncommon in this respect, the degree of informality whereby it was founded was unusual. As noted in Chapter 2, the central bank 4 www.bis.org/bcbs/aboutbcbs.htm 5 The Financial Stability Forum, established by the G7 in 1999, partly to coordinate the work of the multifarious bodies already established, including the BCBS, seeking to promote international financial stability (see Lastra 2006, especially pp. 459–60). The FSF was transmuted into the Financial Stability Board in 2009. 6 Norton (1991, p. 3) points out that ‘the Basel Committee has in fact had a legally significant impact upon international bank supervision in a variety of ways’. He further clarifies that the term legally significant connotes not only formally enacted or derived rules, but also acts that may nevertheless have no capacity to generate legal rules, to effect formal or administrative changes, to affect public or private transactions, or to influence the decision-making process of judicial or regulatory authorities. I am grateful to Kern Alexander and to Rosa Lastra for drawing my attention to this.

544

The legal position of the BCBS

Governors of the G10 agreed to its establishment at their meeting in December 1974 (announced in their later communiqué of February 1975), but it was ‘without any extensive formal mandate or any constitution or bylaws’.7 It was just an informal committee, set up by and answering to the G10 governors, though it was unusual and particular among such G10 committees in that it drew membership from bodies, that is nationally established regulatory/supervisory authorities in G10 countries, which were not themselves central banks. Despite this, the BCBS reported solely to its superior body, the G10 central bank Governors. The BCBS has never seen itself as an executive committee, that is one that makes rules or even sets down standards. Instead it has perceived itself, certainly within these years 1975–97, as a body that, after deliberation, makes recommendations to its parent body, the G10 central bank Governors. Should the G10 Governors accept and endorse such recommendations, it is then the responsibility of the latter to ensure that such proposals would be adopted in their own country (and not the responsibility of the BCBS). While that may have been the formal position, the reality was slightly different.8 Having established a standing committee of specialists in this field, the G10 governors would find it difficult to reject a proposal from them, especially on a technical matter. The relationship between the G10 governors and the BCBS emerges from the analysis of what the BCBS actually did (Chapters 4–11) and was quite complex. The G10 governors set priorities for work, and frequently required papers to be revised and reconsidered. But at the same time they often gave 7 J.€J.€Norton (1989b, p. 249). 8 Rosa Lastra has also pointed out to me, in private correspondence, the following:

Soft law-making has different stages: issuing rules is the first (and in this stage the language of the BCBS has become more assertive over time); the implementation stage refers to the ‘observance’ or ‘adherence’ to the rules (in hard law ‘terminology’ compliance and enforcement are key) and then, related to the observance, ‘incentives’ act as a substitute for formal enforcement mechanisms. Soft law rules themselves can be gradated according to their forceful (instead of binding) nature: from gentlemen’s agreements to uniform rules or standards, in which various actions (substitute for sanctions) apply in the case of non-observance (substitute for non-compliance). Negative incentives€ – from institutionalized peer review to name and shame practices€– can often have the same deterrent effect as formal sanctions. As pointed out in Chapter 3, the modus operandi of the BCBS (technical expertise of those involved, commonality of knowledge and interests fostering a club atmosphere, and the relative small size of the group) is conducive to pragmatism, mutual trust and consensus. This is actually a benefit of soft law. A further point regarding the modus operandi is the fact that technical decisions by technocratic institutions can be more easily reached than politically sensitive decisions by democratic institutions (where rightful concerns about legitimacy and accountability are likely to hinder or delay the ability to reach agreement on certain issues).

The status of the BCBS

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the BCBS considerable freedom to decide its own agenda, and frequently rubber-stamped the papers emerging from it; basically, the Governors did not have the time or the desire for textual criticism. They had a general oversight role; the detail was to be hammered out in the BCBS. This background has had a major influence on the form and wording in which BCBS documents have been prepared. Thus, Peter Hayward (1991, pp. 67–8) noted that: The 1988 Agreement (actually a Report of the Basle Committee) is a modest, unpretentious document and, perhaps to the lawyer, rather unprepossessing.9 The language is deliberately lay and avoids the precision of a legal text. It is not even called an agreement but rather a ‘framework’, a ‘statement’, a ‘report’, and a set of ‘recommendations’. And there is not a single ‘whereas’ clause. It is not even signed; there is merely a footnote describing in general terms the sorts of institutions represented in the Committee. The document claims to have been ‘endorsed’ by the Group of Ten central bank governors, but the inquiring investigator will find no statement uttered by the governors to verify this claim, just a simple press release. Indeed, on the face of it, the document is nothing more than a statement of intent, a consensus that the authorities represented in the Committee ‘intend to implement in their respective countries at the earliest opportunity’. Moreover, the document continues, ‘each country will decide the way in which the supervisory authorities will introduce and apply these recommendations in the light of their different legal structures and existing supervisory arrangements’. The paper goes on to note that there are indeed great differences in these arrangements and the relative speed with which they can be changed. There are a number of reasons for this informal approach. For a start, Â�neither the members of the Committee nor the institutions they represent have the power to bind themselves formally in a treaty or any other form of legally binding agreement, let alone to legislate for the supervisory authorities in the many other countries which, as we shall see, have also applied the terms of the agreement to banks within their jurisdiction. In fact, however, the terms of the agreement are a good deal more specific than the language suggests. And the agreement secures commitments considerably more precise than any of the Committee’s previous papers.10

9 [Footnote in original text] See generally, Cooke, ‘International Convergence of Capital Adequacy Measurement and Standards’, in Festschrift für Jack Revell (Institute for European Finance, 1990). 10 [Footnote in original text] Editor’s Note: Although Mr Hayward is not writing as a lawyer, he raises, in this chapter, significant issues of legal significance concerning the nature of this evolving ‘rule-making’ in the international bank supervision. For example, are these ‘rules’ becoming ‘soft law’ and will a more formal regulatory structure be required? Cf. Gold, ‘Strengthening the Soft Law of Exchange Arrangements’ (1983) 77 Am.J.Int.Law., 444.

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The legal position of the BCBS

B

International agreements in a world of sovereign states

The greatest constraint on the promulgations of the BCBS was not, however, that they had to answer to a superior body, the G10 central bank Governors, but that its members were each members of separate sovereign states.11 The proposals of the BCBS, having been endorsed by the G10 governors, could not become effective until separately implemented, whether by hard, or soft,12 law in each separate state. At Rosa Lastra’s kind suggestion, I have added some pages on the subject of soft law, from Lastra (2006, Chapter 14) as Appendix A to this chapter. There is no international legal machinery in this field. Whether such international machinery is either desirable13 or feasible is beyond the scope of the chapter;14 it neither existed, nor was expected to exist, during these years. The way that the BCBS, under its various Chairmen, interpreted this constraint was that all proposals for forward transmission to the G10 governors, and thence to the wider community of regulators/supervisors around the world, had to be accepted consensually by all country members of the Committee.15 Each had a veto. This was, in practice, 11 As Rosa Lastra writes (private correspondence): The relative recent history of international monetary cooperation and the even more recent history of cooperation in the area of financial regulation and supervision needs to be considered in the light of the reluctance of nation states to cede sovereign powers. Though central bank cooperation on a bilateral and multilateral basis already existed in the nineteenth century as documented in Toniolo’s book, an institutional system of intergovernmental economic relations sanctioned by law was not established until Bretton Woods. Joseph Gold wrote in 1981: ‘International Monetary Law in a sufficiently comprehensive and systematic form to justify recognition of it as a separate province of public international law came into existence on December 27, 1945’. [That was the day the IMF Articles of Agreement came into force]. 12 See, for example, Alexander (2000) and the references therein. 13 See Eatwell and Taylor (2000). 14 Consult Giovanoli (2000) and Walker (2001) for example. 15 Walker (2001) writes (Preface, p. xxiii) that: International standards have become of particular importance in recent years due to the need to develop some common or, at least, minimum level of rules and regulations in various core areas of modern financial and economic practice. In light of the difficulties that naturally arise in attempting to agree any formal treaty, convention or similar formal prescriptive solution at the international level, a more informal consensus based approach has to be attempted, at least, during the early stages until some basic common agreement (and supporting sense of self-interest and commitment) may be achieved. This will certainly be the case in many such sensitive and complex areas as international bank and financial market control. A standards based approach also has the obvious advantage of flexibility and informality although this necessarily means that it suffers from the associated operational limitations of weak adoption and compliance. The key issues that then arise with international standards

International agreements in a world of sovereign states

547

somewhat less of a constraint than it might seem at first sight. The smaller countries, for example Benelux, Canada, Italy, Sweden and Switzerland, were averse to making waves, and would rarely take a minority position, except on a matter of extreme national importance, an example of this being banking secrecy for Switzerland. Despite its economic and financial scale, the Japanese representatives on the BCBS usually remained quiet and withdrawn, again partly due to the rapid turnover of personnel, so they had little opportunity to build up expertise. As noted earlier (Chapter 3), the BCBS was in some respects an Anglo-Dutch cabal in these early years, with Bank of England and Nederlandsche Bank officials or ex-officials filling the roles of Chairman and Secretary for most of this period. The two most awkward countries, because they were both large in size and had idiosyncratic regulatory and supervisory systems, which they were (naturally) unwilling to adjust in any way at foreign, international behest, were Germany and the USA. So, in practice much of the hard work of the Chairman would lie in reconciling the positions of the US and German representatives with that of the BCBS as a whole. Nevertheless the BCBS adopted, more or less from the outset, the unwritten rule (I found nothing set down on paper) that all BCBS proposals and papers, to be forwarded to the G10 governors, and thence to a wider audience, would have to come from a consensus of the Committee as a whole. There were a handful of occasions, mostly relating to the 1988 Accord (see Chapter 6), when papers were sent from the BCBS to the G10 governors with one or more country positions explicitly ‘reserved’, but those were the exception.16 There were virtually no cases where a vote was taken. Instead the Committee discussed and deliberated until a common position could be obtained. If, in the event, this could not be found, as in the case of the discussions on liquidity (see Chapter 9), then the subject was just abandoned. Reaching a consensus was often a time-consuming exercise. Peter Cooke saw his role, and indeed that of the BCBS, as guiding the country representatives along the pathway of the four Cs:

• Consultation • Cooperation • Coordination • Convergence are not with regard to legal classification and formal enforcement but with national adoption and implementation and implementation review. 16 Much could be achieved by subtle drafting, for example replacing the word ‘must’ by ‘should’ and ‘recommendations’ rather than ‘requirements’.

548

The legal position of the BCBS

Movement along this path was generally a lot easier when country representatives did not already have established national positions to protect. When the BCBS found itself dealing with some new technical innovation, whether it be derivatives, off-balance-sheet positions or VaR modelling, individual Committee members, and indeed the BCBS as a whole, could be far more flexible and capable of compromise than when dealing with old ‘chestnuts’ such as capital, or liquidity requirements, or the structural shape of banking. In these latter cases each of the (main) countries already had their own methods and procedures, which, almost by definition, they thought to be best for themselves. In such cases it was not easy to get a sovereign country to shift; indeed, the 1988 Accord was one of the few cases when such adjustment did occur, under special circumstances (see Chapter 6). The inability of the BCBS to impose its will on a recalcitrant member was not the only reason for seeking consensus and unanimity. The objective of achieving a level playing field with competitive equality was another. If one of the countries involved, especially one with a major financial centre, refused to adhere to the common view of the other members of the BCBS, then it could lead to regulatory arbitrage. The BCBS, initially at least, saw itself as having a restricted mandate (recall Blunden’s apocryphal jest about only needing a few meetings to do its business). It was there to recommend the best ways of jointly dealing with internationally active banks, not to introduce regulation, or ‘soft law’, for (all) banks in most countries of the world. How it migrated from the first to the second position is part of the story of this work.17

17 Herring and Litan (1994) were opposed to this change of approach. Thus they wrote (pp. 134–6): More fundamentally, however, we question the wisdom of further efforts to refine the initial Basel standards. Regulators are always trying to catch up with rapidly changing market practices. Internationally negotiated regulation will inevitably be even slower. International regulatory agreements are cumbersome to negotiate, implement, and revise. While it is easy to be enthusiastic about harmonizing the right rules, in a rapidly changing financial system there is a very real danger that the wrong rules will be harmonized, or that rules that may be right for the moment will become wrong after they are implemented. The complexity of international negotiations means that international agreements are very difficult to fine-tune after they are made because all parties are likely to find it costly to reopen negotiations. This does not mean that national regulators should ignore market risks. Rather it means that efforts to develop internationally harmonized regulations may not be the best approach. The first maxim of regulators should be: ‘Do no harm’. But this dictum is often very difficult to live by. International harmonization of capital requirements for market risk may be premature because we simply do not know enough about how to quantify such risks and how market participants are likely to respond to alternative regulations. This may be a case where there is value in regulatory diversity …

International agreements in a world of sovereign states

549

This restricted mandate meant that the Committee tended to avoid trying to tackle topics that were particularly subject to sovereign control. Thus it was reluctant to get involved in issues relating to crisis management (see Chapter 11, Section C), and it did not pursue the questions relating to cross-border insolvency raised in the Patrikis Report (1992) (see Chapter 11, Section G), perceiving such crisis and insolvency management as being primarily subject to national discretion, and having to involve treasuries and politicians. It stuck instead to dealing with crisis prevention. Such reluctance to opine on crisis management has persisted; even now there remains no general blueprint on how to handle a cross-border crisis. This is, of course, quite a limitation. As Kapstein (1994, pp. 180–1), put it: Yet the evolution of regulatory cooperation among nation-states should not make us overconfident with respect to the global economy’s ability to withstand future shocks. International agreements, such as the Basle Accord and the Concordat, may contribute to the stability of the marketplace during ‘normal’ periods of economic activity, but they have proved a weak reed during periods of crises, or even in meeting scandals of the BCCI variety. In the absence of leadership by one or more states that are willing and able to play the role of crisis manager, we must therefore recognize that an international financial shock could cause the global economy to collapse. To put this point in its starkest terms, we might ask what would have happened had public officials allowed the market alone to develop a response to the debt crisis. Would we have achieved stability or chaos?

A second field that the BCBS preferred to avoid was that of sanctions. Initially this was relatively easy for the BCBS since its recommendations were primarily for its members as regulators/supervisors; with the governors having accepted the recommendations, for example on the Because of uncertainty about the correct risk weights and how market participants may respond to new risk weights, we question the usefulness of further extension of the rule-making function of the Basel Committee. Instead we believe the Committee should continue to place primary emphasis on its role as a forum in which supervisory authorities can exchange views about how best to measure and to control various sorts of risks … Now that at least some minimum capital standards are in place, we would recommend that individual countries be given considerable discretion about how to set additional standards, if any, for other types of risk not yet covered by the Accord. We recognize, of course, that such a policy will not level the playing field across countries. But this was an illusory goal to begin with. Banks and other types of institutions are affected by too many other regulatory, tax, and cultural factors that differ between countries. Attempts to defy this reality are likely to be self-defeating. Thus, even if bank capital standards could be truly harmonized, given the differences in supervisory attitudes toward asset valuation, countries can and almost certainly would continue to generate offsetting differences along other lines.

550

The legal position of the BCBS

Concordat, they could be expected to implement them, though even in this respect, some commentators may doubt whether regulators in other countries are really pulling their weight.18 The problem of how to ensure the implementation of proposed standards, or codes of conduct, without any specification of incentives and sanctions for abiding by them of course became much more severe when these were to be applied to others, for example to banks, rather than to oneself. This wider problem is taken up below in the next section. But even when the recommendations were self-imposed on the G10 regulators themselves, the question of sanctions could not be totally avoided. Thus one of the issues relating to international banking activity was what were the (minimum) regulatory and supervisory conditions within a non-G10 country that would make it a suitable home/ host for a bank wanting to establish itself vis-à-vis a G10 host/home (see Chapter€4). But that route could easily develop into a procedure for public assessment of the (minimum) quality of the regulatory standards of foreign countries, a division into sheep and goats, or naming and shaming. As already noted in Chapter 4, Brian Quinn warned that the application of any such sanctions could significantly alter the nature and status of the Committee.19 In the event this tricky corner 18 See Kane (2006, p. 3): BCBS negotiations are founded on the premise that group expressions of regulatory intentions are something more than cheap talk. How much more is unclear. The Accord fails to include clauses that could make regulators in individual countries directly accountable to one another for enforcing the standards the BCBS promulgates. And at p. 9: At Basel, agents failed to bond the Pillar II activities of foreign regulators to the goal of financial stability or to negotiate the kinds of inter-regulator and public disclosures that would reliably buttress market discipline by allowing independent experts to assess the quality of Pillar II activity. 19 ‘As I recall the discussion on this subject in November, there was a broad consensus that the committee should not itself take on the role of passing judgement on other supervisory systems. I shared that view. I am not entirely convinced, however, that it will be possible for the Committee to avoid giving the impression, at least to some, that it is in fact moving in the direction of a collective judgement once it starts to gather and disseminate the information upon which judgements about supervisory standards will be reached. The particular method chosen to start the exercise, the questionnaire on supervisory practices, might well convey the impression to respondents, especially those anxious to gain the approval of the Committee, that they are participating in some qualifying process. At the very least, we should take care to avoid any such impression. If, efforts to the contrary notwithstanding, or because it was felt that the object of meeting the Governors’ request to extend the ambit of the Concordat was otherwise unattainable, the Committee did move in the direction of making collective judgements, it would have important implications for the role of the Committee,

International agreements in a world of sovereign states

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was finessed (see Chapter 4 and Chapter 12, Section B); there was no public list of sheep and goats, no naming and shaming; it was left to national supervisors to have quiet words with individual applicants20 about the propriety of their plans for international diversification. Some such plans would be considered acceptable, and some not, but without any public song and dance. Once Basel I had been promulgated, a growing gap developed between the BCBS’ self-image, as a committee offering recommendations about the regulatory affairs of its own members21 (to the G10 governors who could then implement such recommendations in their own countries), and the view of most outside commentators that the BCBS had become in effect a world regulator, establishing soft law for all countries. It was this difference in perception that led to the initial reluctance of the BCBS to accept the invitation to draft the ‘Core Principles of Banking Supervision’. This was consciously aimed at non-G10 Â�countries, and BCBS members reckoned that it was not part of their purpose to tell others how to act. It was not until the BCBS realised that, should the Core Principles be written by another body (probably the IMF), it could threaten the BCBS’ own basic role and status, that it changed its tune. But as Quinn had noted, this would raise the question of ‘democratic legitimacy’. Once the BCBS consciously ventured into the territory of prescribing standards, codes of conduct, and so on, for others, how could it justify its narrow membership?22 Although prior to this juncture the question of democratic legitimacy had not been perceived as a its standing and the nature of its work. It has occasionally been suggested that, in the longer run, the Committee might develop into more of an executive body coordinating supervisory standards around the world. To fulfil such a role effectively the Committee would require some form of sanctions in order to enforce its decisions; otherwise the Committee could find itself in the awkward position of having responsibility without power. Such a development would almost certainly require it to broaden its membership, if it was to enjoy widespread support for its actions.’ 20 A few of the comments committed members to sharing adverse opinions so that a consistent stance could be taken, but this was done during these years orally in corridor discussions on a bilateral and/or limited basis. 21 Of course, the BCBS hoped that other countries would also voluntarily adopt the capital requirements of the Basel Accord, but that was entirely a matter for each country to decide individually. 22 Kern Alexander, in private correspondence, wrote that: Legitimacy has two aspects: a formal, normative one which refers to legality of the political system and a societal or empirical one, which is determined by the acceptance of, or loyalty to, the system. See Amaryllis Verhoeven, The European Union in Search of a Democratic and Constitutional Theory (2002), pp. 10–11. No rule can survive in the long run without societal legitimacy. With regard to those countries that are not represented in the BCBS, in particular emerging economies, a further issue

552

The legal position of the BCBS

major issue for it,23 the BCBS nevertheless had a missionary enthusiasm for establishing a club-like, worldwide, cohesive community of financial regulators and supervisors (see Chapter 12), connected via the biannual International Conferences on Banking Supervision (ICBS) and the ‘Reports on International Developments in Banking Supervision’, whose target audience was this community of worldwide regulators. By such means the BCBS usually gave regulators/supervisors an insight into its thinking, and an opportunity to comment, before BCBS proposals took their final form. Moreover, towards the end of this period (1997), more formal means of consultation with non-G10 regulators became increasingly employed.24 After the Core Principles were issued in 1997, a standing committee (the Core Principles Liaison Committee) was created to oversee their implementation and maintenance. C

Implementation

In the course of its work during these years (1975–97) the BCBS progressed from establishing standards that regulators/supervisors should observe, in both G10 and non-G10 countries (notably the Concordat in its various editions€– see Chapter 4, and the Core Principles€– see Chapter 8, to writing quite detailed prescriptions for banks’ risk management techniques (on capital adequacy€– see Chapter 6, and market risk€– see Chapter 7).25 Yet it steadfastly refused to address the Â�question of legitimacy and fair representation is the adequacy of complex standards designed for sophisticated financial systems in such emerging economies (a point in particular with regard to Basel II). 23 This issue was of greater salience for the BIS itself, and was subsequently addressed by Andrew Crockett, its General Manager, January 1994–March 2003. 24 Thus Giovanoli (2000), p. 30 notes, in his section 1.38 on ‘The problem of legitimacy and fair representation’, that: In this connection, mention should be made of the wide-ranging consultation process that has become customary in connection with the essential documents being developed by the Basel Committee on Banking Supervision (for instance those relating to the revision of the Basel Capital Accord), which are circulated in all parts of the world. 25 Walker (2001, p. 73) has written: The evolution in the work of the Committee accordingly demonstrates a move from more general principles of best practice to more specific minimum standards. In more specific policy terms, the Committee has moved from general allocation of supervisory responsibility between authorities and the development of more detailed rules to facilitate the exchange of information and supervisory co-operation, to the introduction of more specific control provisions in particular areas of activity such as capital adequacy, market risk and financial derivatives. This policy shift on the part of the Committee then reflects a clear shift from co-operation in relation to more limited

Implementation

553

of sanctions for failing to meet such standards or requirements, regarding these as a national prerogative. In this sense BCBS pronouncements were extremely ‘soft law’.26 But how then were they implemented? Not all such soft law is successfully implemented. Besides the Ten Commandments, the IOSCO Code of Conduct for Credit Rating Agencies comes to mind; European Commissioner McCreevy famously described the latter as ‘toothless’ in his speech on ‘Regulating in a global market’ (16 June 2008). What teeth did the ‘soft law’ pronouncements of the BCBS have?27 To answer this question, let us divide the recipients of BCBS pronouncements into four groups: 1. Regulators/supervisors in G10 countries; 2. Regulators/supervisors in non-G10 countries; 3. Banks (and their regulators) in G10 countries; 4. Banks (and their regulators) in non-G10 countries; and consider each in turn. supervisory activities to the introduction of more specific regulatory requirements in particular areas of bank activity. This change of policy is reflected again in the programme of measures adopted by the Committee in the supervisory and regulatory areas although this has unfortunately been more selective and partial rather than coherent and complete at times. 26 For a discussion of the definition and advantages and disadvantages of ‘soft law’ see Lastra 2006, Chapter 14, Section C. Also see Lee (1998) and the references in footnote 10 of this latter paper, and Walker (2001, especially Chapter 1, footnote 4 on p. 2). 27 Walker (2001, pp. 78–9) writes: Despite the creation of a growing body of substantial supervisory and regulatory provision, the Basel process remains fundamentally incomplete in the absence of any formal review and enforcement mechanism. In the event of partial or complete failure to implement, the voluntary adoption based nature of the system means that no formal corrective action can be taken. This is a basic common problem inherent in many aspects of international relations. Commitments can only be enforced against particular territories where they have already consented to become subject to the jurisdiction of a particular court or tribunal. In light of the important and highly sensitive nature of the banking and financial services sectors within any economy it has to be accepted that it is very difficult, if not impossible, to agree any detailed series of comprehensive supervisory and regulatory rules which could be set out in an international treaty and to which all countries could then adhere. There is then a basic treaty or source of law vacuum in this area. In the absence of an international treaty, various interim positions or partial mechanisms are possible although for various reasons associated with each of these alternative devices, the most effective way to proceed, at least in the interim period, may be through a Basel Committee type process. If this is to be followed, however, some form of more complete review and implementation mechanism must be constructed. Attempts have been made to introduce a more formal peer group review procedure, although early attempts failed. This is a difficult area in which work continues by the Basel Committee and the FSF.

554

The legal position of the BCBS

For regulators/supervisors in G10 countries, BCBS pronouncements are self-imposed. Their Governor has signed up to them. Partly because they are soft law, there was generally no requirement for politicians and the legislature to get involved, and as a rule they did not do so. A partial exception, occurring after the end of our period, took the form of US Congressional hearings on Basel II. It is, perhaps, remarkable that there were no cases during these years (1975–97) when a proposal, consensually agreed by the BCBS and then endorsed by the G10 governors, ran into subsequent political trouble in any of these countries. Once a G10 governor had endorsed such a recommendation, s/he (and his/her successors) were honour-bound to implement it. Of course there can be differences of interpretation, and several aspects of the recommendations incorporated considerable room for discretion. I have no doubt that there were privately expressed grumbles about the differential rigour with which some countries would have been introducing and implementing BCBS recommendations, but none, I believe, found their way into the public record. Among the G10 countries, BCBS recommendations, once endorsed by the G10 governors, were regarded as effectively self-enforcing. This was not true for non-G10 countries. Since they were not represented at the BCBS, the BCBS could not presume to legislate for them, and did not try to do so. Each such other country had sovereign freedom to choose to adopt, or not, BCBS proposals. Overwhelmingly they have done so, though in some cases such adoption was, at least initially, somewhat superficial. There were three incentives for non-G10 regulators to sign up. The first is peer pressure, to be seen as in the vanguard, the top league, of the profession. The second was the concern that, unless they met the standards required, the key members of the G10 would refuse to allow their own banks access to the world’s major financial markets. The third has been that the IMF has been carrying out, since 1999, Financial Sector Assessment Programmes (FSAPs), including Reports on the Observance of Standards and Codes (ROSC) (Lastra 2006, pp. 469–71). Although introduced after our period ends, such FSAPs have represented a major step forward for implementing BCBS recommendations. Given such enhanced implementation, it is now valid to regard the BCBS as effectively the international regulator and the IMF as its counterpart supervisor.28 28 See Lee (1998), especially Sections VII and VIII. Also Lastra (2006, p. 500) wrote that: The IMF is uniquely placed to monitor the compliance with standards through its function of surveillance, through its assessment of the health of the financial sector

Implementation

555

But such regulations are now addressed to (international) banks, and not only to other regulators/supervisors. What incentives did banks have to abide by such regulations? Once again, the BCBS refused to address this question, treating sanctions on banks for any such failures, for example to attain the required capital adequacy ratios, as a matter best left to their appropriate national authorities. The nearest that the BCBS came to any discussion of this was when Peter Cooke raised the question of whether the CAR in Basel I should be a ‘minimum’ or a ‘target’ or a ‘standard’ (see Chapter 6). But that question was not adequately discussed and followed up. Even given the understandable reluctance of the BCBS to trespass on the question of sanctions, the failure to do so strikes me as a serious shortcoming of the BCBS approach. It can, and should be, contrasted with that taken in the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 where the conjunction of an increasing ladder of penalties/sanctions, as capital erodes, lies at its heart, up to the point when a bank is so ‘severely’ undercapitalised (a leverage ratio of less than 2 per cent) that it must either be swiftly recapitalised, taken over or shut down. With no similar ladder of increasing penalties, there is just a single point metric, though Basel I incorporates two such metrics, 4 per cent of risk-weighted assets for Tier 1 capital and 8 per cent for overall capital. More or less inevitably, given the single metric, this is taken by most outside commentators, including the Credit Rating Agencies, as representing a minimum acceptable level (though supervisors themselves might on occasions wish to be more flexible and lenient). As a result market confidence could rapidly drain away from any bank whose published figures showed it to be below this minimum, and its continued existence could be then imperilled.29 In matters of regulation required minima may protect the taxpayer, who ultimately supports the deposit insurance fund, but does little to benefit the bank against (unexpected) loss, because that minimum cannot be (via the FSAP and ROSCs) and to provide countries with the incentive to comply through the design of conditionality policies. 29 Kapstein viewed such incentives favourably. Thus he wrote (1994, p. 184): One example of market-based enforcement is provided by the Basle Accord, in which rating agencies and investment banks will play an important role in informing the public about which banks have achieved the required capital adequacy levels, and in providing the incentives for meeting these levels; as a consequence, there is no need for a large international bureaucracy to monitor the agreement. My own view is that the existence of stark regulatory minima with no ladder of increasing penalties, prior to closure (or recapitalisation), is a mixed blessing.

556

The legal position of the BCBS

encroached upon. There is the story of the train traveller reaching his destination late at night, who is overjoyed to see a single taxicab waiting, only to be told that the taxi-driver cannot take him since local byelaws require one taxi always to be waiting at the station. Thus from the viewpoint of the bank (though less so from that of other bank creditors) the general treatment of the CARs as required minima meant that they provided not much of a buffer against (unexpected) loss. Instead the buffer was provided by the margin that the banks voluntarily carried in excess of those minima, as pointed out in several papers by Milne and co-authors.30 With such required minima already putting a dent into banks’ objectives for achieving desired returns on equity (ROE), there would be an incentive for banks to economise on their buffering margins above such minima. As a result the Basel Accords did not fully achieve what was widely taken to be their purpose: to provide banks with an appropriate buffer against unexpected loss. Instead what we have is a sizeable minimum requirement, but one that cannot be used by banks, enhanced by an, often skimpy, surplus buffer which can be. Although there is as of 2008 more (minimum) capital to protect taxpayers/creditors, it does not provide an appropriate buffering function for banks themselves. As a consequence of this self-imposed refusal even to consider the appropriate pattern of incentives and sanctions, the Basel Accords have been less successful in diminishing the fragility of the banking system than their authors presumably hoped. Nevertheless, the Basel 1988 Accord was very widely adopted. Although it was directly aimed only at internationally active banks in G10 countries, it became adopted by a much wider range of banks, regional as well as international, and in non-G10 as well as G10 countries, though the BCBS put no pressure on non-G10 countries to do so. There were many reasons for this. The Basel Accord had many innate attractions. It addressed an obvious problem, that is the declining trend in bank capital ratios; it was short, simple and straightforward. Peer pressure, among regulators, credit ratings agencies and banks themselves, was strong, probably stronger than the BCBS had anticipated. Basel I was adopted by the major commercial banks (thus excluding the Communist countries) in most countries. Within the European Union (EU) its prime requirements were incorporated into the Capital Adequacy Directive (CAD) that all banks had to meet. Thus adoption

30 For example Jokipii and Milne (2008), Milne (2004), and Milne and Whalley (2001).

Appendix A

557

was not only widespread, but general. Once adopted, supervisors and credit rating agencies (CRAs) ensured that it was implemented. The key question, therefore, was not implementation, but whether, once implemented, the Accord would deliver the desired objectives of the exercise. In one respect it did; the trend decline in capital ratios was halted. But whether this accompanied a significant increase in the resilience and strength of the banking and financial system is a deeper and more complex question.

Appendix A The essential feature of ‘soft law’ is that it cannot be enforced by formal legal means because it is not legally binding.31 While ‘hard’ law is characterised by formality, ‘soft’ law is characterised by informality. Soft law is observed in a voluntary, self-imposed way. Hard law is binding in a coercive, externally-imposed way. Enforcement is the key element to distinguish between hard and soft law. With regard to the contents of the rules, a distinction can be made between ‘substantive rules’ and rules that allocate regulatory jurisdiction. Most international financial ‘soft law’ instruments intend to regulate the substantive aspect of a given matter, e.g. the Basel Capital Accord. Other international standards however are concerned with the allocation of regulatory responsibility€– division of labour€– among national authorities in cross-border financial transactions or activities, e.g. the Basel Concordat of 1975. As Giovanoli points out, it is important to differentiate between implementation and enforcement.32 ‘While enforcement is a legal concept, implementation is a ‘factual’ concept. The competent state authorities€– such as administrative authorities or courts of justice€– enforce the rules, i.e. take the necessary measures to apply legally binding rules. It is the binding force of the rules that triggers the ‘availability of measures of compulsory execution’. Implementation, on the other hand, is a factual concept, meaning that a certain result has been achieved, through appropriate legislation or otherwise’.33 Soft law rules are not ‘legally enforceable’ and yet they have often proven to be effective in finding their way into national law or into 31 [Footnote in original text] Giovanoli points out (2000, p. 83) that ‘from the legal point of view, no remedies are available if the rules are not followed. This does not, of course, preclude the existence of factual “sanctions”, either from the market or from other bodies, which can be very effective’. 32 [Footnote in original text] Ibid., p. 46. 33 [Footnote in original text] Ibid.

558

The legal position of the BCBS

EC law, as the success of the Basel process (i.e. the work of the Basel Committee on Banking Supervision) clearly indicates. Voluntary observance is often driven by regulatory competition which induces national jurisdictions to adopt and implement the latest ‘must have’ set of rules, lest they be frowned upon by the international community and international business. The international bodies which issue international financial standards tend to provide assistance for implementation. For instance, with regard to the Basel Core Principles of Banking Supervision (1997), the Core Principles Methodology (of October 1999) sets out detailed guidelines for the assessment of compliance with the core principles. For each principle, there is a set of criteria (essential and additional) against which compliance can be assessed.34 In the absence of formal enforcement mechanisms, ‘incentives’ compel those to whom they are addressed to observe the rules. [Though the word ‘compliance’ is a term typically used in the case of hard law and ‘observance’ (or adherence to) in the case of soft law, sometimes the word compliance is also used in references to soft law]. These incentives function as a substitute for formal enforcement mechanisms. The official sector has developed a number of policies and measures to promote observance of soft law rules. For example, the ‘name and shame’ practice associated with the list prepared by the Financial Action Task Force on Money Laundering (FATF) regarding non-Â�cooperating jurisdictions or the OECD list of offshore financial centers responsible for harmful tax competition35 act as deterrents against ‘non observance’. Institutionalised peer review is another official incentive to promote observance, often as a complement to financial sector surveillance. The use of IMF conditionality can act as a very powerful official incentive, when the country’s adherence to a particular set of standards is made a ‘condition’ for the disbursement of IMF funds under a stand-by or extended arrangement. In addition to official incentives, there are various voluntary instruments of market discipline that act as incentives to adhere to soft law rules. International investors often require that developing countries adopt the best available standards of best practice. This adoption enhances their credit standing and improves the attractiveness and reputation of their financial systems in the international marketplace.

34 [Footnote in original text] See Basel Committee on Banking Supervision (1999). 35 [Footnote in original text] See Organisation for Economic Co-operation and Development (2010).

Appendix A

559

My own view on the relationship between ‘soft law’ and ‘hard law’ can be summarized as follows. Law has progressed throughout time, both with regard to its substance and with regard to the way it is created (the process or procedures). It is in this context that soft law€– as an instrument of change and reform€– ought to be understood. Soft law is indeed law (rules of an informal nature, but yet rules). International financial soft law is often well suited to the changing needs and rapidly evolving structures that characterise the workings of financial markets. It would be wrong to dismiss it because of its ‘softness’. It is ‘soft’ from the perspective of traditional mechanisms of enforcement (international standards are not international obligations), but in many instances it is or it can become as compelling as ‘hard law’.36 Indeed, one can argue that there is hard ‘soft law’ (e.g. the international standards on money laundering, i.e. the Forty Recommendations on Money Laundering and the Eight Special Recommendations on Terrorist Financing by the Financial Action Task Force, where specific measures to be taken at the criminal justice and regulatory measures have been detailed) and soft ‘hard law’ (e.g. treaties dealing with economic integration in West Africa, such as the 1975 and 1993 ECOWAS Treaties37, notorious for their lack of enforcement). Furthermore, soft law can turn into hard law and/or complement hard law, as exemplified by the case of the IMF. 36 [Footnote in original text] See Tommaso Padoa-Schioppa (2004). 37 [Footnote in original text] ECOWAS stands for Economic Community of West African States.

15

The international relations of the BCBS

A

The salient events

I have chosen five key occasions as those that changed the relationships between the BCBS and the rest of the world. These are in chronological order: 1. The abandonment of the mandate to introduce an international early warning system (EWS) (see Chapters 2 and 5) and its replacement by a self-generated programme of harmonising cross-border supervision of international banking (Chapter 4). 2. The political pressure to introduce common capital adequacy requirements on international banks, to approach a ‘level playing field’ (see Chapter 6). 3. The realisation, when preparing the Market Risk Amendment, that the large international banks had become technically more sophisticated with respect to risk management than the BCBS (see Chapter€7). 4. The growing perception of a need for some political oversight of the international regulatory process, initially because of breakdowns in the negotiation of common positions between IOSCO and the BCBS (see Chapter 13). 5. The political request to the BCBS to set ‘Core Principles of Banking Supervision’ (see Chapter 8), which changed the BCBS’ self-perception from its narrow role (as recommending proposals to G10 governors) towards a wider role as standard-setter for banks worldwide. Let us take each of these, in turn, starting with the BCBS’ reinterpretation of its mandate. As described in Chapters 2 and 5, the Governors had originally established the BCBS, in the aftermath of the Herstatt failure and at a time of raised concern about the effects of the Euromarkets, to construct an early warning system for future international crises. Each member country of the G10 (except Luxembourg) 560

The salient events

561

was to have two members, and initially the second participant was to be an expert in foreign currency and exchange rate matters from the central bank. But the BCBS, under the chairmanship of George Blunden, quite rapidly came to the conclusion that the Committee could add little, or nothing, to the analyses and predictions of international crises done at national level. The Governors put up no fight against this rejection of their initial pet scheme, and allowed the BCBS a wide measure of freedom to set its own agenda. As described in Chapter 2, the real precursor to the BCBS had been the Groupe de Contact. This has been formed by an initiative of those at senior working level dealing with supervisory issues in their own countries. While it was supported by the Governors of their central banks, it was in practice a bottom-up exercise, carried out by the central bank equivalent of army majors and colonels. That continued once the Groupe de Contact became transmuted into the BCBS. While the BCBS reported to the G10 central bank Governors, and all recommendations had to be endorsed by them before wider circulation, the agendas were largely set by the Chairman and Secretary, in conjunction with the Committee as a whole. Within the overall field in which they had a locus, i.e. issues relating to the micro-prudential oversight of international banking, the BCBS largely chose its own programme of work in the years prior to 1983/84. With hindsight, what is remarkable is how little top-down direction of BCBS activities there was in these early years (1975–83). There was virtually no interference from politicians, and relatively little from the G10 governors, after the rejection of the EWS idea. The main feature of the work of these early years, the Concordat (see Chapter 4), was devised, formulated, named and refashioned (by events) at the initiative of the BCBS itself. It was an archetypal self-standing committee. Recall (Chapter 14) that the BCBS agreed to operate by consensus, and that all the recommendations were treated as strictly applicable only to members’ own (G10) countries. So the BCBS was only proposing convergence onto a code of best practice for its own member bodies, not for imposition on anyone else. In these circumstances it would have been quite difficult for the G10 governors, let alone politicians, to object. Indeed, once the scare about international financial conditions subsided after 1974/75, it is doubtful whether politicians gave the BCBS, and its doings, as much as a thought. This happy state of affairs (from the point of view of the BCBS) came to an end in 1983/84. The trigger that led to greater outside direction of the work of the BCBS was the 1982 Mexico, Argentina, Brazil (MAB)

562

The international relations of the BCBS

crisis.1 In particular, the US Congress was horrified by the revelation of the fragility of the core US banking system, notably the city centre banks, and by the degree of support that the Fed had had to provide, and to which US taxpayers (if affairs had gone worse than they did) might have found themselves liable. It sought to pass an Act to constrain US banks both to hold more capital and to limit the concentration of their lending. But this led to determined and vociferous lobbying by US banks to the effect that such constraints, while absent from other countries’ banks, would lead to a major competitive disadvantage for US banks. To provide a ‘level playing field’, any such constraints had to be applied internationally. So when Congress passed the International Lending Supervision Act of 1983, ‘it called for greater regulation of international banks and for international coordination of regulatory activities’.2 As Norton (1989b) put it: Within the United States, during these same two decades, the bank regulators were becoming more aware of the general deterioration of capital levels of US banking institutions. In particular, as the magnitude of the Third World Debt Crisis and its implications for these US institutions became apparent in 1982, capital adequacy3 went beyond the examination level and was transformed into a core regulatory banking objective to bolster the prudential supervision of banking institutions and the safety and soundness of the banking system itself.4 Further, the International Lending Supervision Act of 1983 (ILSA) gave statutory credence to capital adequacy as a regulatory objective,5 not only with respect to the international debt problem but also with respect to the US domestic banking system as a whole.6 With the ILSA and the intervention of the United States Congress, the capital adequacy issue was legitimized through legislation, and, as such, it also became politicized (that is, of concern to the federal political decision-makers).7 As a result of the new public visibility Prior to the 2007/8 crisis, this was, perhaps, the moment of greatest danger to the international financial system since the 1930s. It was, however, largely nipped in the bud by some outstanding statesmanship, e.g. among the leading central bank governÂ� ors of the time, and hence had few repercussions on the ‘real’ economies of the main developed countries. Partly perhaps as a result, it has not yet had a full and proper historical treatment, but see Lamfalussy (2000). 2 Kapstein (1989, p. 333, 1992 and 2008). 3 [Footnote in original text] For discussion of the policy, practical and legal significance of the capital adequacy issue, see Norton (1989a). 4 [Footnote in original text] For detailed discussion of and references on the historical role of bank capital adequacy in US regulatory practice from the 1930s through 1988, see Capital Adequacy Standards, supra note 6, section III. 5 [Footnote in original text] See Pub. L. No. 98–181, title IX, 975 Stat. 1278 (1983). 6 [Footnote in original text] For the legislative history of the Act, see US Code & Admin. News 1768, at 1913 et seq. (1983). 7 [Footnote in original text] For further discussion of ILSA, see, e.g., Bench & Sables, International Lending Supervision, 11 N.C.J. Int’l & Com. Reg. 427 (1986); Lichtenstein, 1

The salient events

563

and concern for the issue, the need for uniformity of and transparency in developing capital adequacy standards, on the domestic and international levels, became heightened. Also, as the public significance of bank capital adequacy unfolded, so also did the multitude of complexities involved in defining capital and its composition, in selecting a proper measurement test, and in determining institutional coverage. These concerns lent to a greater need for regulatory uniformity and transparency, and in attaining this goal, to a greater degree of formal legalism in the regulators’ approaches.8

It was not as if Cooke and the BCBS were unaware of the worrying downwards trend in capital ratios and of the need to reverse that. Indeed, as noted in Chapter 6, the BCBS had begun work on this before the 1982 crisis, and the subsequent politicisation of the issue. Rather, the problem was that different (major) countries had already adopted sepÂ� arate approaches to capital adequacy requirements. Since each thought their own position correct, no consensus was immediately possible or practicable. It was ironic that, at the very same meeting of the governÂ� ors (March 1984) at which Peter Cooke revealed the inability of the BCBS to reach a consensus, Volcker passed on to his confrères among the G10 governors the political pressures emanating from Congress to reach some agreement on ‘functional equivalence’ of international CARs. The immovable object (the need for BCBS consensus) met the irresistible political force. In the event this dilemma was resolved outside the BCBS by the Anglo-US separate agreement. While this was clearly a ‘power-play’, its progenitors maintained the threat to go it alone, without the BCBS, as latent. The agreement was reported to the BCBS and used as a lever to force realistic negotiations among all the (BCBS) participants, including the USA and UK, within the context of the BCBS. The power-play successfully broke the log-jam. The main players in this drama were the politicians, especially in the USA, the central bank Governors and the members of the BCBS. Commercial bankers played an indirect role, by lobbying for a level playing field. But while each representative at the BCBS was cognisant of, and sensitive to, the interests of their own national banks, the Â�discussions and decisions relating to the Basel I Accord were essentially top-down. The regulators/supervisors at Basel, drawing on their own and their institutions’ accumulated experience and wisdom, decided among themselves on the outlines and structure of the proposed CAR. The U.S. Response to the International Debt Crises: The International Lending Supervision Act of 1983, 25 Va. J. of Int’l L. 401 (1985). 8 [Footnote in original text] See Capital Adequacy Standards, supra note 6, sections V and VI.

564

The international relations of the BCBS

A consultative document was sent out, but by then the decisions had been largely taken. Prior to the 1990s the BCBS worked largely independently of their own commercial bank clientele. This was soon to change. Having already worked on details of the Market Risk Amendment (see Chapter 7) for several years, it came as a shock to BCBS members to discover, when they issued their consultative paper in 1993, that the commercial banks rejected their approach as technically inferior to that which the main international banks were already using, based primarily on Value at Risk (VaR) measurement. The BCBS approach was felt by the banks to be both ‘complex and inaccurate’. In that judgement the commercial banks were correct, and it is to the credit of the BCBS that it recognised this. The final Market Risk Amendment (1997) was much better as a result of being based on banks’ internal risk measurement methodologies, than it would have been if the BCBS’ initial proposals had been rammed through on (unwilling) banks. But the BCBS then, on this view, made the mistake of generalising from this particular case. There was a subsequent tendency to believe that the right approach for the BCBS was to base regulatory norms on the ‘best’ models constructed by the banks for their own management purposes. Thus one of the proudest claims of the authors of Basel II has been that it aligned the regulatory model much more closely with the economic models of capital requirements already in use by the commercial banks themselves. But such an alignment is not necessarily desirable. Regulators should have different objectives from bankers; the purpose of regulation€– to deal with externalities and market failures€– is quite different from the purpose of banks€ – the maximisation of the current value of future discounted income flows; and therefore the models used by regulators should, as a generality, be quite different from those used by banks. On this, see Jon Danielsson (2008, 2009a and 2009b). Thus, from the mid-1990s there was an interesting variant of the ‘capture’ hypothesis, wherein regulators come to adopt the self-interested positions of the regulated. In this variant the regulators are intellectually captured by the belief that the best versions of models designed by the banks for their own purposes should also be applied by the regulators. Perhaps the fundamental reason for this has been a failure of most regulators, both at the BCBS and elsewhere, to go back to basics and ask themselves what was the underlying rationale of regulation; instead there has been an implicit tendency to view an important objective of bank regulation as being to improve the risk management of the individual

The salient events

565

bank, to bring the behaviour and performance of each individual bank up to the standards of the best. One of the great dividing lines between countries in the financial sphere in recent decades has been their treatment of investment banking. This marks out those countries that believe that investment banking should be strictly separated from ordinary commercial banking, for example because of conflicts of interest, as codified in the GlassSteagall Act in the USA, from those countries which were happy to allow universal banking. The USA, and Japan were in the first group; most of Continental Europe in the second. The UK was in the first group until its Big Bang, that is its capital market liberalisation in 1986 (with the merchant banks (also known as accepting houses) playing a different role from the London clearing banks), but thereafter moved decisively into the second group. When investment banking was separated from commercial banking, the structure of both its liabilities and its assets became quite different from that of commercial banks. On the liability side the investment houses borrowed in wholesale markets, rather than holding (sight/ demand or time) deposits. On the asset side such houses held marketable assets that could be rapidly sold, rather than illiquid (held to maturity) loans. Not surprisingly, the form and nature of the regulations applied to them, notably by the SEC in the USA, differed markedly from that of those applied to commercial banks, notably by the Fed and the OCC (Office of the Comptroller of the Currency) in the USA. At the margin, however, investment houses and commercial banks, especially universal banks, were bound to compete. With the development of commercial bank trading desks, the establishment of bank trading books, securitisation, and so on, the margin at which investment houses and large banks competed became bigger and bigger. One of the main structural effects of Glass Steagall had been to separate J.€P. Morgan, the commercial bank, from Morgan Stanley, the investment house; now most people can hardly tell the structural difference between J. P. Morgan Chase, which has just swallowed Bear Stearns, and Morgan Stanley, which became a bank in 2008. As earlier noted (Chapter 14), it was difficult, sometimes almost impossible, to reach consensus within the BCBS when different countries already had established their own separate prior conventions and practices (see Chapters 6 and 9). It was even more difficult to do so when the discussions and negotiations were between separate professional bodies, that is between IOSCO and the BCBS. Seen in this light, what is perhaps remarkable is just how close the two bodies came towards an agreement on capital requirements for trading books in early 1992.

566

The international relations of the BCBS

The subsequent rupture of relationships made a good story, somewhat embellished by personalities, but the underlying circumstances made any such agreement unlikely. Nevertheless, such a disagreement, particularly one relating to such a wide and important area of financial intermediation, threatened serious problems both for crisis prevention and competitive equality. Since democratic politics are a means for settling such disputes, the issue came to the attention of politicians. It was taken up at a series of meetings of G7 heads of state, beginning at Halifax in June 1995. The political pressure took two main forms: first, direct pressure on the main agents, the BCBS and IOSCO, to cooperate, for example by writing a joint report on their positions for the next Summit, and, second, by considering oversight mechanisms which could provide an umbrella institution for all the various international bodies concerned with international financial matters. Following a study by Tietmeyer, this latter took the form of the Financial Stability Forum (FSF), established in 1999, and beyond the scope of this study. The particular salience of this was to underline the necessary interaction of the BCBS with other professional bodies involved in international financial regulation. Prior to this the BCBS had operated rather on its own, ploughing its own furrow. From the late 1990s onwards, it became clear that it was one of a wider group (under the overall coordination of the FSF and subsequently the Financial Stability Board (FSB)). The IMF was another player on this team, increasingly so after the 1997/98 Asian crisis, whose severity was exacerbated by shortcomings in financial regulation/supervision in several of the countries involved. The Fund went from a focus on macro-economics and fiscal policy to a more balanced concern with finance and financial regulation taking a more prominent role. As concern with the need to improve financial regulation/supervision in all countries grew, beyond the advanced developed countries, so also there were requests from the less-developed countries for some external guidance on best practice in this field. Initially the BCBS was hesitant about taking on the role of standard-setter for non-G10 countries (see Chapter 8, Section B, and Chapter€14). But when it became clear that the political authorities (in the guise of the G7 finance ministers report to the heads of state at the Lyons Summit in June 1996) would demand that some such set of codes of conduct be drafted, the question then boiled down to the simple issue of who would do the drafting, the BCBS or A. N. Other, in this instance almost certainly the IMF. Given this choice, the decision was straightforward; the BCBS would do it, and quickly.

Power and knowledge

567

What this episode did was to bring the BCBS’ self-image more into line with outsiders’ views of its role. Ever since Basel I (prior to which the BCBS had not generated much public attention, apart from a small professional audience) outside commentators had perceived the BCBS9 as rule-maker for all major banks all over the world. In contrast BCBS members clung to the narrower view that they were only recommending to their own (G10) Governors on best practices among their own countries, that, if accepted, were for the Governors to implement. Following the request for, and publication of, the Core Principles, it could no longer seriously be denied that the BCBS was in the business of establishing soft-law codes and standards for bank regulators and major international banks all around the globe.10 B

Power and knowledge

In his 1989 paper, Kapstein focuses on ‘the role of market forces, consensual knowledge and state power in bringing the banking accord [of 1988] to fruition’. I shall follow Kapstein by focussing on the role of state power and consensual knowledge in this section. There is less to say about the role of market forces, not because these were unimportant€ – rather the contrary€ – but because their role has become well understood and there is little that needs adding or further emphasis. Thus Kapstein wrote in 1989: Recent years have witnessed the ‘globalization’ of financial markets. This has created profitable opportunities for banks but has also exposed them to severe losses. The volatility of bank earnings and the number of major bank failures point to the costs of a global financial system. Banks have not found it easy to manage the risks inherent in cross-border activities. For public officials, globalization has raised the classic interdependence problem of how to benefit from increased economic intercourse while pursuing legitimate national objectives, such as bank safety and soundness.11 The growth of international banking has created new investment in the financial sector, especially in centers such as London, Hong Kong, and Singapore, 9 Despite the fact that the BCBS had not been able in this case to reach a consensus initially, and had to have the impasse broken by the external US/UK separate agreement. 10 Thus Walker (2001, p. 135) writes: The importance of the Core Principles cannot be underestimated. Apart from its other more specific achievements in connection with addressing particular technical areas within the G10 markets, with this single document the Basel Committee has transformed itself from being a limited and selected co-operative forum to a global leader in the development of complete regulatory programmes for bank supervision. 11 [Footnote in original text] Cooper (1968).

568

The international relations of the BCBS

which have relatively lax regulatory regimes. In an interdependent financial community in which every state wants to enhance or maintain the competitiveness of its banking sector, deregulation by one state must be countered by that of others. This competitive spiral forces regulation toward its lowest common denominator. With the globalization of capital markets, public officials have been forced to make tradeoffs between domestic regulation on the one hand and international competitiveness on the other. One response to the regulator’s dilemma has been to pursue international policy coordination. During the 1970s, central bankers tried to develop a crisis management system that would contain any major banking problems and halt their transmission across borders. In the 1980s, and especially since the debt crisis of 1982, the regulatory focus has been on crisis prevention and the establishment of guidelines to ensure the safety and soundness of international banks. I argue that the successful negotiation of a common standard for adequacy of capital by the G-10 countries was due to the development of consensual knowledge regarding systemic risks, combined with decisive leadership on the part of the United States and Great Britain. To put the formulation more concisely, international coordination reflected the interplay of knowledge and power.

I shall follow Kapstein’s footsteps in focussing on power and knowledge, taking power first. The Basel 1988 Accord was the occasion when the application of state power was most prominent. But, as emphasised here, not only was this strictly atypical of the normal workings of the BCBS, indeed virtually unique, but also once the log-jam had been broken and proper negotiations established, the USA and UK were, for a variety of reasons, under almost as much pressure to make compromises within the setting of the BCBS as the French, Germans and Japanese. Indeed, what is more remarkable has been the absence of state power from the ordinary day-to-day working of the BCBS; remarkable but not perhaps surprising. After all the BIS was itself set up to be a haven for central bankers from national political pressures (Toniolo and Clement 2005). Although the locus of the BCBS was micro-prudential bank regulation, a field in which ministries of finance and treasuries play a major role at the national level and one that depends on the support of national legislation, the G10 governors were able to found the BCBS as a subcommittee obliged to report only to them. It may have been the narrow mandate that the BCBS perceived itself as having (i.e. as only making recommendations, by consensus, to the G10 governors, and for the latter to implement them, if necessary by legislation in their own countries) that allowed the BCBS such independence from political direction. As noted earlier, there were really only three major occasions of political pressures being applied, and in each case to achieve an end (an international level playing field in CARs in 1985/86; cooperative agreement on CARs between squabbling international regulatory bodies in

Power and knowledge

569

1995/96; on the need for international standards for bank supervision to be promulgated in 1996/97), rather than to prescribe details of how this might be done. So, even in these cases, although the BCBS was presented with an overriding political objective, the means and mechÂ� anisms for achieving it were left to the BCBS. But for the most part the BCBS enjoyed almost complete freedom from political control, and a large modicum of freedom from direction by its superior body, the G10 central bank Governors. It was primarily a self-starter. Largely because the world is divided into sovereign states (and formal treaties between such states are hard to establish and maintain), so that almost all ‘hard’ law is national, there is a vacuum wherein technical committees of experts can play a major role in achieving agreements about the conduct of international behaviour€– soft law; and do so outside of formal political control for the most part. The BCBS has been a prime example of such an apolitical international professional group. The sceptic will protest at this juncture that the absence of political control, of power politics, was just disguised. After all, those experts who attended the BCBS would be national representatives, aware of and attuned to their own country’s positions and objectives. Surely the representatives of the bigger countries, for example the USA, Germany and Japan, would have had more clout on the BCBS than those from smaller countries? Up to a rather limited point, that was probably so. But as noted several times previously, the real drivers of this exercise in our period (1974–97) were the British and the Dutch, neither any longer world powers, while the representatives from Japan took little part in most exercises. Moreover, national positions played a more prominent role when these were historically entrenched, for example with capital or liquidity ratios. When the BCBS addressed the regulatory response to the many financial innovations in their decades, such as derivatives, netting, off-balancesheet activities, and so on, the Committee was able to discuss and debate with less constraint from pre-set national standpoints. In these latter cases the exercise involved a real, unfettered exchange of ideas. Even where such an exchange of ideas was hindered by prior national standpoints, as in the case of the 1988 Basel Accord, the discussions in the specialist subcommittees and in the BCBS itself did lead to intellectual revision and development€– though as will be seen in the following chapter largely independent of the advances in financial economics in these years. A major benefit was learning from each other, in particular learning to avoid the mistakes of others. That is one reason why post-mortems were taken seriously. Nevertheless, the meetings of the BCBS, and of its various subcommittees or working groups, only took up a relatively few days each year, generally less than ten per year, so that the development of ideas among

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The international relations of the BCBS

those involved would have depended rather more on the various influences that affect such processes in their respective home countries. Even so, regulators have tended to place a lot of weight on the experience and views of their colleagues in other countries. Kapstein describes this process of assimilating ideas as one of ‘consensual knowledge’. Thus he writes (1989, pp. 331–2): During the 1980s, the regulatory emphasis has shifted to crisis prevention. In this section, I argue that the formation of consensual knowledge regarding systemic risks has played a crucial role in recent efforts to establish international banking regulations. While consensual knowledge€– which Ernst Haas defines as ‘a body of beliefs … that is widely accepted by the relevant actors, irrespective of the absolute or final “truth” of these beliefs’€– has been cited as an important variable in international regime formation, it has failed to attract much sustained analysis.12 To be sure, Haas has been a tireless champion of the role of cognitive factors in international politics, but relatively little empirical work has been built on this analytical foundation.13 International banking regulation provides a good test for consensual knowledge. Obviously, banking is a highly technical area, and an understanding of capital markets requires specialized training and professional experience. Banking regulation is the subject of substantial research efforts in public agencies, universities, and international organizations. While there is little controversy about the need for some regulation, there is vigorous debate among scholars regarding the costs and benefits of various regulations. Public officials rely on this professional theorizing in determining appropriate policies for the banking sector.14 Consensual knowledge may be particularly important in this case because government regulation of banking generally fails to mobilize participants outside the banking sector; regulation is thus removed from the ‘pulling and hauling’ of domestic politics, at least relative to such economic issue-areas as trade. The spread of consensual knowledge can be traced because the important regulatory actors in each country are readily identifiable, whether they be located in finance ministries or central banks. The systemic structure of banking also suggests that consensual knowledge plays a critical role in international policy coordination. On the basis of his research on multilateral commodity negotiations, Robert Rothstein concluded that consensual knowledge is likely to be important in situations characterized 12 [Footnote in original text] See Stephen D. Krasner, ‘Structural Causes and Regime Consequences’, in Stephen D. Krasner, ed., International Regimes (Ithaca, N.Y.: Cornell University Press, 1983). Haas’s definition is cited in Robert L. Rothstein, ‘Consensual Knowledge and International Collaboration’, International Oganization 38 (autumn 1984), p. 736. 13 [Footnote in original text] Ernst Haas, ‘Why Collaborate?’ World Politics 32 (April 1980), pp. 357–405. 14 [Footnote in original text] For a recent overview of research on international banking regulation, see Richard Portes and Alexander Swoboda, eds., Threats to International Financial Stability (Cambridge: Cambridge University Press, 1987).

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by ‘dispersed power, complex decisions that require complex negotiations, [and] structural uncertainty.’15 Capital markets possess many of these characteristics. Power is dispersed among states and private-sector economic agents, and the problems are complex because of the number of actors and issues involved.

The main feature of this ‘consensual knowledge’ in these years was the heightened awareness of the importance of capital adequacy, and by the same token diminished concern with liquidity. Prior to the 1960s banks had failed because they had run out of ready money; the main emphasis of prudential supervision had been on preventing this, via the application of various required cash and liquidity ratios. A sufficiency of capital was also important, but in earlier years a less pressing matter since such ratios were still quite high (and supported in the nineteenth century by the ability to call on shareholders for additional funding, e.g. with unlimited or double liability). In the second half of the twentieth century all that seemed to change. The growth of wholesale markets raised the prospect that a bank could always obtain additional cash, if needed, by borrowing on wholesale markets, so that liquidity in the shape of cash, or cash-type (public sector) assets became of less moment, as did concern about maturity mismatch. What mattered instead was counterparty confidence that a prospective borrower in such wholesale markets would repay its debt, and that was believed to depend on its solvency, not its liquidity.16 Meanwhile, under the pressure of international competition, capital ratios were quite rapidly declining, just when their importance for the safety and soundness of banks and for the financial system was coming more to the forefront at attention. So ‘consensual knowledge’ led to an increasing focus on trying to establish appropriate standards for bank capital holdings. The experience of 2007/8, however, suggests that the ‘consensual knowledge’ of earlier decades had certain limitations, not least the view that wholesale (unsecured) markets would always stay open for fund-raising. Among other reconsiderations, this will lead to a revived interest among international regulators on the need for better liquidity management. 15 [Footnote in original text] Rothstein, ‘Consensual Knowledge’, pp. 733–62. 16 And if the market should become (incorrectly) suspicious of a solvent bank, the central bank should lend it to directly, but only, so the theory went, if it had convinced itself at the time that the bank in question was solvent, but not otherwise.

16

The BCBS and the social sciences

A

The BCBS and professional advice

The BCBS made hardly any use of outside professional advice from social scientists of any discipline during these years. The only examples of interactions between the BCBS and outside professionals1 that I found in the archives was when Chairman Tommaso Padoa-Schioppa, himself an economist, corresponded with Professor Robert Merton on the design of the plus factor for the Market Risk Amendment (see Chapter 7), and when Chairman Gerald Corrigan asked lawyer Ernest Patrikis, then the General Counsel of the Federal Reserve Bank of New York, to write a special report on cross-border bankruptcy issues following the BCCI collapse in July 1991 (see Chapter 11). The BCBS dealt with international accountancy bodies, but sought no specialised accountancy advice, other than through its contacts with such bodies as IASC and IFAC. It dealt with statistical questionnaires (its preferred form of gathering empirical information), and sought to collect data, for example on maturity transformation and country risk exposures (see Chapter 5), but employed no statistician outside the ranks of the BIS. It pronounced on matters of soft law, but did not normally seek legal advice. Its regulatory proposals impinged on financial markets and on the real economy, but it hardly ever asked for advice or comment from (financial) economists, or those dealing with the economics of regulation. The only major case when outside expert help was perceived to be needed arose in the run-up to the Market Risk Amendment, when a special modelling subgroup2 was established to catch up with the technical work carried out by the commercial banks on (VaR-type) risk models. Indeed when economists inside the BIS wanted to undertake research on systemic stability issues, the BCBS expressed reservations about such an exercise; see Chapter 13, Section A. 2 The members of the group were primarily specialists already employed in the central banks involved, but the group did also consult outsiders, for example from such institutions as J.€P.€Morgan and Oliver Wyman. 1

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The BCBS and professional advice

573

But did they need much, if any, outside advice? It would be a categorical mistake to view the BCBS as starting to introduce (soft-law) regulation from a clean slate, a tabula rasa. Instead, their task was to provide coordination, with the intent of reaching consensual convergence, from the starting-point of pre-existing national member positions. And each BCBS member, whether from a central bank or specialised financial supervisory body, spent the bulk of their time in their home institution and only spent a few days a year at Basel. On this view it was primarily for the home member institutions to utilise professional advice as they thought fit, themselves individually, in order to develop their own initial positions. The role of the BCBS was the more narrow one of trying, via compromise and discussion, to reach agreement among national positions. In this sense the BCBS saw itself as taking practical and incremental minor steps to achieve international consensus in a world where the fundamental views on financial regulation had already been reached at national level. In a world of sovereign states the BCBS could not, in any case, force any national representative to change their position except under extremely unusual conditions. Thus the role of the BCBS was primarily one of adjusting pre-existing national positions into international harmony, if possible. The force of ideas would have their main effect at the national level. Given this narrow view of the BCBS’ remit, it is certainly arguable that the Committee had little or no need for outside professional (academic) support, except in rare cases. That may well have been the case, at least until the end of the 1980s, but increasingly through the course of the 1990s the role and function of the BCBS altered and broadened. Starting with the Basel Accord, and continuing further with the Market Risk Amendment, the BCBS entered the field of assessing and seeking to limit banks’ risk. This is, or at least has become, a highly technical field, full of abstruse mathematical models (of varying relevance and quality). Relatively few officials in regulatory/supervisory institutions have the ability to comprehend, and fewer yet to criticise, such models. A large fraction of those that did have this ability, and worked in the relevant department, will have been chosen to represent their institution in the BCBS, in one of its subcommittees, in Basel. Just as commercial bank CEOs often do not know what to make of their quants’ models, so central bank Governors are often stymied by the background formulae for risk assessment that lie behind the proposed regulations. In this context one can argue that there has been a, somewhat subtle, change, mostly during the course of the 1990s, from the BCBS being an institution which tries to bring harmony within the international sphere, given well-established

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The BCBS and the social sciences

Â� pre-existing national positions, towards an institution which devises and sets international regulations ab initio, which are then transposed back into the national regulatory framework. But in so far as this is the case, then the rationale for not needing expert professional advice for the BCBS in Basel, that is that professional input should and could take place at the prior national level, becomes less cogent. Of course, there is a further question whether the advice of professional economists, specialised in this field, would have been worth much. Economists had been hired by central banks dating back at least from the years between the two World Wars, and they played an increasing role in advising on macro-economic issues and providing forecasts, but they had much less of a role, usually none, in the financial stability or supervisory functions of central banks (and specialised supervisory agencies), although some of the officials therein will have had some prior economics training at their university. At the Bank of England there was no specialised financial economic advisor in the relevant division(s) before 1990 (and probably not until quite a long time afterwards). Indeed, bank officials in those sectors used to take a certain pleasure in being free of direct input from academic economists. It was, perhaps, felt to be a field where a combination of common sense and the accumulated wisdom and experience of central bank official practitioners over the decades was far more valuable. Given that the main concern of regulators was, increasingly, with required capital ratios, and, decreasingly, with required liquidity ratios, it could be said that they had a point. The best-known work on capital structure in this period (Miller and Modigliani 1958) stated that the capital structure of a firm would have no effect on its overall market valuation were it not for tax effects and bankruptcy costs. Whereas the value of the tax shield could be reasonably well estimated and quantified, the costs of banking failure, both to the individual bank and, more importantly, to the wider financial system and the economy, could not be so easily estimated. The externalities involved in closing and liquidating a bank remain uncertain. Estimates of such externalities still range all the way from assessments that these are no worse than in the case of a normal non-financial firm (Kaufman, 1999) to the apocalyptic, that the whole system could be sufficiently fragile, at least in certain cases and absent official support to the remainder of the system, to ‘implode’ (whatever that may mean). In such cases professional advice is limited to nostrums about remembering incentives and checking moral hazard, for example to penalise managers, shareholders and subordinated debt-holders, even if

Insufficient appreciation of (financial) economics

575

depositors are protected and the (good parts of the) bank maintained in operation. Quite how far banks should (or could) be restrained from following individual profit maximisation in good times in order, hopefully, to reduce failures, defaults and credit crunches in bad times remains a matter of judgement; such a judgement itself swings wildly among all those involved depending on recent experience. In general bank regulation is tightened in the aftermath of crises, only to be avoided or evaded by gaming and innovation by banks in the next boom, usually with the acquiescence, if not applause, of bank clients, politicians, the media and even, sometimes, of the regulators themselves (e.g. credit risk transfers). The state of play is no better on liquidity. Economists find it no easier to define or to measure liquidity than practitioners. The belief that (wholesale) markets could always be relied upon to function (almost perfectly) to transfer liquidity to a less liquid (but solvent) bank from a more liquid bank was even more ingrained in (most) economists than in practitioners. So economists were, perhaps, even more taken aback by the widespread collapse of (unsecured) wholesale markets in 2007/08 than were practitioners. The kind of steps and measures that banks could take, and regulators might require, against the prospect that banks might find their access to markets cut off, such as maturity mismatch ladders and differential ‘hair-cuts’ on assets of varying classes, were devised and developed by practitioners with little help from economists. Certainly, as an economist one must be prepared to admit that academic economic analysis has, as yet, far less to offer officials in their role of maintaining financial stability than it has had in the design of measures to maintain price stability. Indeed, as a direct consequence, economists usually now play a large role both in the advice for, and being members of, monetary policy committees, but play a much more muted role, if any, on financial stability committees (FSCs). But that does not mean that financial economics has nothing to offer to such FSCs, or to the BCBS. Indeed, in the next section I shall specifically turn to some academic advances in financial economics that were not sufficiently taken into account by regulators, either at the national level or internationally at the BCBS, during these years. B

Insufficient appreciation of (financial) economics

There are two strands of economic analysis on which this section will focus. Both relate to the tendency of practical regulators, both nationally and at the BCBS, to fail to see the systemic wood from the

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The BCBS and the social sciences

individually risky trees. The first relates to the analytical argument (see, for example, Markowitz 1952, Sharpe 1964) that the riskiness of an asset within a portfolio depends on its covariance with other assets already in the portfolio, not with its individual variance. That had become the basis, by the mid-1980s at least, on which all portfolio analysis was taught, alongside estimates of assets’ betas, capital asset pricing model (CAPM) measures, and so on. Yet the credit risk measures of the 1988 Basel Accord, and the early BCBS steps towards the Market Risk Amendment largely ignored such analysis. Instead, assets were somewhat arbitrarily divided into buckets of greater or less granularity, and risk weights, plucked again subjectively from general experience (or by lobbying by politicians or banks) with virtually no empirical support, were applied to such buckets (with hedges and offsets, often reluctantly, being sometimes accepted). The gap between this procedure and best academic practice, even at the time, was large. Given that this was, analytically, the wrong way of addressing the problem of portfolio risk, how could it be established and continue? The first reason was that almost everyone accepted the need to halt and to reverse the downwards trend in capital, and the outcome for actual capital derived from Basel I was, as the regulation had intended, broadly acceptable to all concerned– regulators, banks, politicians, and so on. Even if the means were flawed, the end outcome was welcomed. Second, innovation, notably in the form of securitisation of assets offbalance-sheet, allowed banks to adjust their balance sheets to avoid regulatory constraints where these bit hardest, for example on relatively high-required CARs on claims on high-quality private sector assets. Third, Basel I was simple to understand and to apply. Moreover, where this flawed approach would have an adverse effect, in particular in the application of CARs to the market risk in trading books, the banks did protest, and brought forward models that were based on modern portfolio theory, that is VaR models. Unfortunately, the regulators, having been persuaded of the better analytical foundations of the banks’ VaR models, did not fully appreciate their limitations from the viewpoint of regulatory objectives. Co-variances and correlations that determine portfolio risk and VaRs are not stable over time. In particular, during a crisis co-variances and correlations that were, under all normal conditions, low would suddenly rise dramatically towards unity. If one based risk estimates on behaviour during such normal times, for example relating to the last 250 days, and a crisis strikes (as at the end of September 1998 or August 2008), then one can, and does, easily find events occurring all too often that appear, on the

Insufficient appreciation of (financial) economics

577

basis of normal times, to be totally impossible, for example a 25 standard deviation effect. What this means is that standard VaR models, though of great use as a management tool during normal times, give regulators little feeling for what may be flung at them if a crisis should occur, or in jargon terms past experience provides little indication of future tail risk. What one can see is what actually happened during the occasional sporadic crises that have punctuated past history. The regulators did have some appreciation that standard VaR-type models were only a fair-weather guide, whereas they were supposed to protect the system against bad weather. They responded in two generic ways. First, they would introduce multiplication factors, so whatever the VaR figure turned out to be, the commercial bank would have to hold capital multiplied by X, but generally the choice of X could only be done by guesswork. The commercial banks would protest if X was so large as to be commercially damaging for them. Second, if VaR-type models were only fair-weather guides, why not use the occasional examples of crises and whatever other crisis scenario regulators might think up to examine how banks might fare in such circumstances, in other words to use stress tests as a means of supplementing CARs based on other approaches. One problem is that crises are not easily foreseeable; if they were, they would not happen. Virtually no one foresaw the likelihood or the path of the crisis that began in August 2007. Had regulators asked banks, prior to that time, to assume a scenario in which most term wholesale financial markets closed, this would have been dismissed as too improbable to be worthy of consideration. But there is another more general problem with stress tests. This is that they generally do not, perhaps cannot for practical reasons, incorporate second and subsequent round effects. The procedure is to ask each bank how its own circumstances would change if, say, a scenario occurred in which house prices went down 15%, interest rates rose 3% and the exchange rate rose, or fell, by 10%. The almost universal answer would be that the bank concerned would do fine. At a 15% decline in housing prices, defaults and foreclosures would rise, but the loss given default would be manageable. The basic problem with this is that the extra forced sales on the foreclosures would drive housing prices further down, possibly much further down. If, aware of this possibility, banks held onto foreclosed property (at a severe operational loss), they would face a net cash outflow. If they tried to staunch this by raising money elsewhere, that would just turn prices and interest rates against them in these other markets. Again, if their capital ratios were found

578

The BCBS and the social sciences

to be impaired in the scenario of the stress test, each bank individually would believe that it could raise additional capital easily enough in capital markets; after all, in normal times most banks have a good name and reputation. But if most banks are simultaneously driven to seek to raise capital, the market will become ‘crowded’ and turn strongly against them (as in 2008). The cycles of financial booms and busts are driven not only, perhaps not even primarily, by (auto-correlated?) fundamental shocks, but by the dynamic effects of amplifying forces within the financial system. Several of these vicious (in a downturn) and exhilarating (in a boom) spirals have been identified by economists; recent examples include Kiyotaki and Moore (1997), Abreu and Brunnermeier (2003), Brunnermeier and Pedersen (2009), Shin (2008), Adrian and Shin (2008a, 2008b, 2009, 2010). The problem is that such amplifying spirals are, in general, not captured by stress tests. Indeed, the way stress tests have been normally designed, they focus solely on first round effects. If amplifying behavioural spirals are, as many of us believe, a major element of financial booms and busts, then by definition stress tests cannot catch such reinforcing factors. So stress tests, as normally designed, are likely to give a systematic under-estimate of financial system fragility. Moreover, the regulatory process itself is likely to exacerbate such internal self-reinforcing dynamics. It does so through a number of routes. First, by introducing a single set of international standards, it tends towards making more banks behave in the same way at the same time (Alexander, Eatwell, Persaud and Reoch 2007). Thus it adds to the likelihood of crowded trades forcing major and sudden price reÂ�adjustments. Second, the riskiness of bank assets rise (and credit ratings migrate downwards) during bad times, and vice versa during good times. So a risk-weighted system of CARs must by construction be more procyclical (than e.g. either Basel I or a simple leverage ratio). A procyclical CAR will, again by construction, have no restraining effect on bank expansion during upturns and will serve to reinforce the credit crunch and pressure on banks’ capital during crises. Currently, of course, the widening application of mark-to-market accounting practices, at the same time as the introduction of a procyclical, risk-weighted CAR, has given a yet further twist to such self-reinforcing amplifying forces. How was all this allowed to happen? Here is where the second failure to see the wood from the trees comes into effect. This is that national bank regulators, and the BCBS, have commonly seen themselves as having the duty of improving the risk management practices of individual banks. On this view this is not their proper responsibility. Their duty is to strengthen the stability of the financial system as a whole. If

Insufficient appreciation of (financial) economics

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it were not for the externalities that attend bank failures, bank regulators/supervisors would have no grounds for concerning themselves with individual bank management of their own risk-taking at all. But is not this rather like asking Mrs Lincoln whether ‘otherwise she liked the play’? It is because of the contagious effects on other banks, and on financial markets, and on taxpayers (with respect to deposit insurance and public sector financial bank recapitalisation), that reguÂ� lators/supervisors do have a locus and duty to constrain risk-taking among individual banks. Just as Mrs Thatcher is supposed to have said ‘There is no such thing as society’, so there is no such thing as a financial system separate from its component parts. And yet if one does take as the proper starting point the view that the concern of the regulator/supervisor should be to the system as a whole, and for the externalities that may arise when an individual entity fails (and not the behaviour of the individual bank), then a number of consequences follow, and policies which would have been quite different from those actually adopted by national regulators and the BCBS during these years. Let me take three examples, though many more could probably be found. First, the systemic effects and externalities are, I would assert, generally a function of the size and inter-connectedness of the individual institution. There is no good reason why required CARs, for example, should be the same for all institutions. Bear Stearns, for example, should have had a much tougher CAR than a unit national bank in the USA, not the other way around. This differentiation is implicitly recognised by supervisors by their allocation of much greater resources to monitoring large and complex financial institutions (LCFIs). But it could be usefully applied by imposing differential requirements in the first place. The fact that this does not happen is in part due to the lobbying powers of the big banks and investment houses. Second, from the point of view of the system as a whole, risk is assumed during booms and crystallises in panic downturns; the subprime fiasco is a perfect example. The systemic need is to be much more restrictive in booms and, generally, more relaxed during crises, when enhanced risk aversion among bankers themselves will do the supervisors’ work for them in any case. This is the opposite of the present effect. Such a counter-cyclical mechanism could be achieved by applying a simple leverage ratio in addition to, or instead of, a risk-weighted ratio, or by making the risk-weighted ratio counter-cyclically time-varying. The attraction of a risk-weighted ratio was precisely that it appeared to make the individual bank more risk aware and risk conscious. But once it should be accepted that the focus of regulation should be the system as a whole, and not the individual bank, that argument loses force.

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The BCBS and the social sciences

Third, capital is supposed to be a buffer against unexpected loss.3 It makes no sense for the system as a whole if the required minimum remains the same, or even rises, for example because of credit risk migration, after such an unexpected loss actually transpires. A required minimum cannot itself play a role as a buffer.4 We have already noted (in Chapter 14) the unwillingness of the BCBS to discuss, or to propose, sanctions. This concern, about the use of capital as a buffer, is just another aspect of that. It is true, the more so when deposit insurance is in place and the taxpayer at risk, that a bank ought to be closed, or recapitalised, before its capital reaches zero, but there ought to be a carefully designed ladder of increasingly harsh penalties on the way down, before that ultimate step is taken, as in FDICIA (1991), but patently absent from almost all of the BCBS’ recommendations.5 In so far as capital is required against unexpected loss, since expected loss should be handled by appropriate interest rate margins, the use of credit ratings as a guide to risk weights for CARs is wrong and inconsistent, since these give a measure of expected credit loss. What is needed instead is a measure of the uncertainty of such losses, the second moment rather than the first. Credit rating agencies (CRAs) have become aware, in the aftermath of the 2007/08 crisis, of the need to provide some guidance of the potential volatility, and extent of possible migration, of such ratings and hence of ‘unexpected losses’ from such holdings. If capital risk weights had been based, as they should logically have been, on the uncertainty attending future losses, rather than their expected modal performance, the financial system might have avoided much of the worst disasters of the 2007/08 financial crisis. 4 It remains surprisingly difficult to persuade regulators of this simple point. It does, however, get recognised from time to time. One such occasion, reported to me in conversation, was that during the Scandinavian banking crisis (1991/2), Corrigan (not the source of the report) would have been willing to see the Swedish banks’ capital ratios fall below their supposed minimum levels. 5 Charles Freeland states that such a ladder of responses was covered in the ‘Core Principles’ and in a subsequent document ‘dealing with weak banks’. 3

17

Epilogue

This book was set in motion in 2004, and most of the background research, and even the writing, was done in 2006 and 2007. The reason that it has taken so long to reach publication is that the process was then drastically interrupted by the financial crisis starting in August 2007. This crisis has been severe and prolonged. It has, of course, centred on the working of the monetary, banking and financial systems. So economists (even older, retired ones) who had focussed on money and banking issues, especially those relating to financial regulation, suddenly found themselves in current demand, to explain events, to predict developments and to propose remedies. In the face of such immediacy, history had to wait. Among the many questions that the crisis raised, a key question was why the apparatus of financial regulation then failed to prevent a systemic failure. In order to understand how that occurred, it is, I believe, desirable, perhaps necessary, to have a sufficient understanding of how such financial regulation developed over time, its ethos and purpose, its strengths and weaknesses. So at the same time as the financial crisis significantly delayed the appearance of this book, it has also underlined its importance in the wider scheme of things. The workings of the BCBS, an international institution, certainly had both strengths and weaknesses, as the previous chapters have sought to document. In the immediate aftermath of the financial crisis, and with the inestimable benefit of 20/20 hindsight, perhaps the failings are somewhat overstated here. I would, however, argue that most of the failings on which I have dwelt, such as: 1. the lack of any theoretical basis; 2. the focus on the individual institution, rather than the system; 3. the failure to reach an accord on liquidity; 4. the lack of empirical analysis; 5. the unwillingness to discuss either sanctions or crisis resolution, and so on, had been noted in much of my work elsewhere before the crisis hit. 581

582

Epilogue

Nevertheless from an ex ante, forwards-looking viewpoint, the BCBS achieved an enormous amount of good work in these years; the Concordat, the Basel I Accord and the Core Principles stand out as great achievements and successes. In comparison with the lack of common principles, or any order to the international regulation and supervision of cross-border banks, at the outset of the period in the early 1970s, a proper framework had been established by the close of the period, 1997. In part this end date was chosen, since it also marks the start of the work on Basel II, and that issue remains too recent and too difficult and contentious for me to want to tackle. It is a widely held view, and one that I share, that the attempt by Basel II to make capital ratios more sensitive to risk also made such ratios more procyclical; measured risk declines in booms and rises in downturns. So Basel II exacerbated the leverage cycle. This, and several other shortcomings of both Basel I and II, are now better appreciated by the regulatory community. As a result I have high hopes that Basel III will represent a significant improvement on what went before. But time will tell and some other future historian will, no doubt, document this.

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Index

accountancy profession and the BCBS, 468–77, 513–17, 520–5 accounting standards, 539 Accounting Task Force, 475–6 aggregation methods across risk factors, 254, 255, 256, 258–60 Alexander, Kern, 542n.1, 543, 551–2n.26 Aoki, S., 68–9, 355 Arab Monetary Fund (AMF), 461 Arab/Israeli (Yom Kippur, fourth) war, 31 Argentina, 5, 134, 140–1, 154–5, 561–2 attendance record of BCBS meetings, 88–94 auditing profession and the BCBS, 468–77, 513–17, 520–5 auditing standards, 468, 513–15, 539 Australia, 461 Baeyens, Herman, 12, 13, 16 Banca d’Italia, 104, 106 Banco Ambrosiano, 77, 82–4, 104–7, 114 Bank for International Settlements (BIS) and the BCBS, 1, 60–4, 65, 70, 74, 88–94, 465–8 euro-dollar market concerns, 43–4, 47–50 and the G10 governors, 465 General Managers, 8–9 and the Groupe de Contact, 21–2 scope of, 439 standing committees, 465–8 training, provision of, 457 see€also€Secretariat of the BCBS Bank of Credit and Commerce International (BCCI) BCBS analysis, 84, 393, 394–5 Concordat implications, 107–9, 114, 290–1 Offshore Group of Banking Supervisors (OGBS), 424, 425

Bank of England ‘building block’ approach, 240 consortium banking, 98 economists, role of, 574 G10 governors role, 42–4 off-balance-sheet risks, 355 peer group review, 291 prototype capital adequacy test, 235–9 supervisory powers, 168 UK/US joint agreement on CARs, 56, 167–74 Bank of Japan, 355 bank provisioning, 81–4 Banking Advisory Committee (BAC) and the BCBS, 2, 55, 57, 152n.7, 436 capital adequacy requirements (CARs), 157, 158–60 and the Groupe de Contact, 45 Banking and Money Market Services (BAMMS), 43, 53 banking associations and the BCBS, 413–17 bankruptcy of banks, 392–7 banks crises, 76–7, 82–4, 104–10, 392–7, 412 and the euro-dollar market, 33, 35 implementation of BCBS standards, 555–7 Institute of International Finance (IIF), 440–2 internal models, and the plus factor, 281–4 internal models, recognition by BCBS, 264, 277–8, 284–5, 415–17 internal models, test exercise, 280–1 internal models, use in the Market Risk Amendment, 247–61, 564–5 internal models, weaknesses of, 576–7 investment (position) risk, 246–7 and investment houses, 478–80, 488–9, 565–6 portfolio risk, 575–8

589

590

Index

banks (cont.) quantitative standards for market risk models, 278–80 relations with BCBS, 1, 413–17, 440–2, 564–5 secrecy, 373–8, 397–400, 449 stress tests, 577–8 Barings Bank, 82–4 Barnes, Roger, 65, 185, 233, 239, 290 Baschnagel, Herbert, 40–1n.21 Basel Committee on Banking Supervision (BCBS) and the accountancy profession, 468–77, 513–17, 520–5 aims of, 45–7, 50 and the Banking Advisory Committee (BAC), 2, 55, 57, 152n.7, 436 and banks, 1, 413–17, 440–2, 564–5 and the BIS, 1, 64, 65, 70, 74, 88–94, 465–8 Chairmen, 8–9, 51–60, 78, 88–94 communication with supervisors, 431–4 consensus decision-making, 546–8 creation of, 50 crisis management, 379–81, 400–2, 540, 549, 575–80 early warning system (EWS) discussions, 127–30, 141, 406, 560–1 economists, role of, 574–5 and the European Community (EC), 44–5, 58, 65, 70–3, 88–94, 435–7 failings of, 581–2 financial system responsibility, 578–80 and the G10 governors, 1, 465, 543–5, 568 and the Groupe de Contact, 2, 21, 23, 24–5, 44–5, 74–5, 141, 435–6, 561 growth to prominence, 1–7, 10–11 and the Gulf Cooperation Council (GCC), 428–9, 453–4 and the ICBS, 53, 54, 59, 88–94, 430–2, 454–6 and the IMF, 438–40, 463–4 implementation of standards, 552–7 and insurance regulators, 510–13 international relations, key developments in, 560–7 and IOSCO, Joint Forum, 505, 508–10, 535–6, 538, 539, 541 and IOSCO, joint position paper, 489, 495–6, 529–32 and IOSCO, joint public statement, 271–3, 494, 532–4 and IOSCO, joint statement to G7, 536–41

and IOSCO, relations between, 287, 82–4, 230–1, 243–6, 478, 480–506, 508–10, 534–5, 536–41, 565–6 knowledge, role of, 569–71 market forces, role of, 567–8 meetings, structure of, 73–4 micro vs. macro regulation, 138–9 and national supervisors, 289–91, 413–17, 440–2, 546–52 and non-G10 banking supervisors, 290, 304–6, 423–4, 428–30, 450–1, 453–4, 551–2 and offshore regulators, 417–28, 442–9, 450–3 opening address, 45–7 overlap with other groups, 230–1 participants, 9, 65–73, 141 political interest in, 85–6 previous names, 7 professional advice, use of, 572–5 public profile, 1 role of, 110–13, 560–7, 573–4 sanctions, 549–51, 555–6 securities regulation position, 525–9 state power, role of, 567–9 status of, 542–5 successes of, 582 topics discussed, 74–86, 372–3 training, provision of, 292, 314–15, 434–5, 456–63 visitors, 70, 77 see€also€Secretariat of the BCBS; subgroups of BCBS Basel I (Basel Accord, 1988) adoption by national authorities, 190–1 attempts to achieve consensus, 154–67 BCBS Chairman’s role, 56 ‘club’ modifications following implementation, 186–8, 222–3 and the Core Principles, 309 Dahl sub-group, 151–4 further work following implementation, 191 implementation of, 181–6, 555–7 initial agreement on general framework, 146–51 international need for, 5, 561–4 macroeconomic effects of, 191–4 Market Risk Amendment (1996), 247–61, 264 negotiation of, 174–81, 216, 220–2 off-balance-sheet risks, 182, 353 and portfolio risk, 575–8 successes of, 194–5, 582 technical details, resolution of, 189–90, 220–2

Index US/UK bilateral agreement, 167–74, 194–5, 210, 212–15, 563 weaknesses of, 194–6 Basel II (Basel Accord, 2004), 582 Basle Committee on Banking Regulations and Supervisory Practices see€Basel Committee on Banking Supervision (BCBS) Becker, Jürgen, 65, 389 Belgium attendance record, 88–94 capital adequacy requirements (CARs), 161, 197 crisis management, 380 decision-making in BCBS, 547 Groupe de Contact, 12–13 money laundering principles, 286 participation in BCBS, 65 profitability of banks, 403, 404, 405–6 supervision of banking, 4, 9 see€also€G10 (Group of Ten) central bank governors Benston, G., 478 Beverly, John interest rate risk sub-group, 226–33, 268–9, 358, 484–5 off-balance-sheet risks sub-group, 353–5, 356–8, 365–8 Blunden, George attendance record, 88–94 auditing standards, 468–70 as Chairman of BCBS, 8–9, 43, 45–6n.27, 46n.28, 50, 52–4, 141 consortium banks, letter to, 114 correspondence about BCBS guidelines, 119–20 crisis management, 381 early warning system (EWS), 129 meetings of the BCBS, 74–5, 85 opening address to BCBS, 45–7 US/UK bilateral agreement, 168, 169 withdrawal from BCBS, 86–7, 88 Blunden Committee (1975–77) see€Basel Committee on Banking Supervision (BCBS) Bonnardin, J., 65, 88, 132–3, 374–5, 397–9 Brazil, 5, 134, 140–1, 154–5, 561–2 Breeden, Richard BCBS/IOSCO relations, 492–4, 495n.25, 495–6, 499, 532–4 securities, treatment of, 243, 244, 245–6, 271–3 Brimmer, A.F., 26 Brittan, Leon, 437 Byatt, Derrick, 65, 130

591 Calomiris, C.W., 478 Calvi, Roberto, 104 Canada attendance record, 88–94 Basel I negotiations, 220–2 capital adequacy requirements (CARs), 149n.3, 161, 197 credit exposures, 389 decision-making in BCBS, 547 liquidity, trends in, 347 money laundering principles, 286 participation in BCBS, 65 risk weightings, 213–14 supervision of banking, 4, 9 see€also€G10 (Group of Ten) central bank governors capital as buffer, 580 definition of, 150, 272–3, 531, 534 capital, constituent elements of attempts to achieve consensus, 157–8, 160–4, 162–3n.18, 209 Basel I negotiations, 177, 179, 218–19 definitions, 150 national practice, 161 sub-group, 151–4, 157, 158, 507, 508 Capital Adequacy Directive, EC, 244, 245, 246, 274, 496, 506–8 capital adequacy requirements (CARs) adoption of Basel I by national authorities, 190–1 attempts to achieve consensus, 154–67 capital, level of, 177–8, 196, 219–20 Chairman’s note (1981), 205–7 Chairman’s role, 56 ‘club’ modifications following implementation, 186–8, 222–3 and consensual knowledge, 571 consolidation of balance sheets, 100–3 in the Core Principles, 309 differential requirements, 578–80 implementation of Basel I, 181–6, 555–7 initial agreement on a general framework, 146–51 international need for, 5, 561–4 IOSCO/BCBS joint work, 483, 485–99, 503, 527–34, 535, 538 IOSCO’s work, 238, 269, 484n.15 and liquidity, 318, 330, 342 macroeconomic effects of, 191–4 national practice, 197, 205–7 negotiation of Basel I, 174–81, 216 offshore banking, 448–9 and portfolio risk, 575–8

592

Index

capital adequacy requirements (CARs) (cont.) and profitability of banks, 381–5, 402–6 records of discussions, 81–4 subordinated debt, 146–7, 197–205 successes of Basel I, 194–5 technical details, resolution of, 189–90, 220–2 US/UK bilateral agreement, 167–74, 194–5, 210, 212–15, 563 weaknesses of Basel I, 194–6 work following Basel I, 191 Capital Liaison Group, 189–90 Caribbean Supervisors’ Group, 457, 461 Carosio, Giovanni attendance record, 65 foreign exchange (fx) sub-group, 249 interest rate risk sub-group, 233, 234–41, 248, 261–4, 275–7 Carsberg, Bryan, 476–7 CEMLA (Center for Latin American Monetary Studies), 461 central banks demand for BCBS guidance, 86 euro-dollar deposits, 30–1, 35–6, 48–9 international supervision, 38–44 lender of the last resort, 35, 37, 49, 379–81, 400–2 role in BCBS, 1 Chairmen of the BCBS, 8–9, 51–60, 78, 88–94 Chiasso Affair, 82–4, 417–18, 445 ‘club’ approach to cross-border risk adoption of, 154, 176–7, 179, 182, 218 GCC criticism, 186, 187, 429 membership, 183 modifications to, 186–8, 222–3 problems of, 180 Cole, Roger, 477 Coleby, Tony, 382 Coljé, H. attendance record, 65, 88–94 country risk exposures, 139 implementation of the Concordat, 110, 421–2 interest rate risk, 224, 225 profitability of banks, 382 role in BCBS, 52, 85, 88, 141 commercial banking, vs. investment houses, 565–6 Committee of European Central Bank Governors, 62 Committee on Payment and Settlement Systems (CPSS), 466, 467

Committee on the Global Financial System (CGFS), 3, 465–6 communication, 431–4 Concordat consolidation of balance sheets, 100–3, 113, 120–3 functions of, 80–1, 100–3, 113 home/host supervisors’ responsibilities, 96–100, 113, 114, 128 implementation of, 110–13, 119–20, 289, 421–2 offshore banking supervisors, 421–2, 424, 425, 427, 448 recommendations to G10 Governors, 115–19 reviews of, 104–10, 114, 123–6 supervisory standards in other countries, 289 consensual knowledge, 569–71 consolidation of balance sheets, 107–9, 113, 120–3, 141–4 consolidation of banking and securities operations, 483 consortium banking, 97–8, 114 Continental Illinois, 320n.3 Cooke, Peter attendance record, 65, 88–94 auditing standards, 470, 473 on bank crises, 106–7 Basel I negotiations, 174–5, 177, 178n.29, 181n.31, 184–5, 196n.41, 563 on capital adequacy requirements (CARs), 147–8, 154, 156–7, 162–3n.18, 163–5, 196, 205–7 as Chairman of BCBS, 8–9, 51–2, 53–6, 63, 69, 141, 547 consolidation of balance sheets, 101–2, 103 country risk exposures, 137–8 insolvency of banks, 392–3 interest rate risk, 228, 230 interpreters, 61n.4 liquidity, 318, 322–3 meetings of the BCBS, 45–6n.27, 75, 85 money laundering, 386 off-balance-sheet risks, 355 recommendation for Chairman of BCBS, 87–8 relations with non-G10 banking supervisors, 428, 453–4 relations with other regulators, 414 secrecy in banking, 376, 399–400 securities regulation working party, 481

Index status of BCBS, 542 structure of meetings, 73 sub-groups of BCBS, 63n.7 on supervision of banking, 105n.7 training, provision of, 434 US participation, 70n.9 US/UK bilateral agreement, 170–1, 172, 172n.26, 173, 212–15 Cooke Committee (1978–88) see€Basel Committee on Banking Supervision (BCBS) cooperation between supervisory authorities, 99, 118–19, 127–30, 448–9 Core Principles of Effective Banking Supervision BCBS role, 80–1, 566–7 compliance assessment, 558 initiation of, 291–300 list of, 308–12 non-G10 supervisors, 291–300, 307–16 press statement, 307–8 Corrigan, E. Gerald attendance record, 88–94 Basel I, macroeconomic effects of, 192 BCBS/IOSCO relations, 494, 499, 532–4 as Chairman of BCBS, 8–9, 52, 57–8 correspondence about BCBS guidelines, 123–5 and the European banking supervisors, 437 professional advice, use of, 572 response to BCCI banking crisis, 107–8, 109 securities, treatment of, 243, 271–3 US/UK bilateral agreement, 168–9, 171 country risk exposures, 132, 133–4, 137–44 Coussement, André, 40–1n.21 credit exposures, 389–92, 411 credit risk ‘building block’ approach, 239–43, 272 in the CARs, 224 prototype integrated test, 235–9 securities regulation, 530 and specific risk, 240–1 Credit Suisse, 417–18, 445 criminal use of banking system, 286–9, 300–4, 385–8, 406–10 crisis management, 379–81, 400–2, 540, 549, 575–80 Crockett, A.D., 8–9, 439 Croft, Roy, 495n.25, 497 Cross Report, 353

593 cross-border banking ‘club’ approach, modifications to, 186–8, 222–3 ‘club’ approach to cross-border risk, 154, 176–7, 179, 180, 182, 183, 218 Concordat, implementation of, 110–13, 119–20 Concordat, reviews of, 104–10, 114, 123–6 consolidation of balance sheets, 100–3, 113, 120–3 crisis management, 379–81, 400–2, 549 G10 Governors, recommendations to, 115–19 globalization, 567–8 home/host supervisors’ responsibilities, 96–100, 113, 114, 128 IMF concerns, 464 insolvency of banks, 392–7, 412 offshore banking, 417–28, 442–9, 451–3 and securities regulation, 483 supervision of, 306–7, 311–12 Cumming, Christine, 88–94, 249, 477, 509 Cummings, Joseph, 468–70, 471–2 currency see€foreign exchange (fx) Dahl, F.R. attendance record, 65 capital sub-group, 151–4 money laundering, 385 subordinated debt paper, 197–205 US banks, 23, 26, 132 work with the BCBS, 85 Dale, R., 27, 29 Dallara, Charles, 413–16, 440–2 Danielsson, Jon, 564 Danielsson, Stig attendance record, 65, 88–94 foreign exchange (fx) sub-group, 230, 239, 241–3, 249, 268 off-balance-sheet risks sub-group, 241–3, 358, 359 Davies, H., 480n.13 Dealtry, Michael appointment of Chairmen of the BCBS, 88 attendance record, 65, 88–94 maturity transformations sub-group, 134, 135, 136 meetings of the BCBS, 74–5 role of, 94–5, 141 Secretary General, 43–4, 60, 61, 62, 64 sub-groups of the BCBS, 85

594

Index

debt securities, 530–1, 533 Defleise, Philip, 513 Delors, Jacques, 172n.26 Denmark, 18–19, 42, 146 deposit protection schemes, 378–9 derivatives BCBS/IOSCO joint work, 499–500, 502–3 discussion at the BCBS, 81–4 insurance regulation, 511–12 Nouy sub-group, 249, 499, 511–12 supervision of, 361–2 Dodd-Frank Act, 478–9n.11 domestic supervision vs. international supervision, 1–7, 48 Dondelinger, Albert attendance record, 88–94 Groupe de Contact, 12, 16, 18, 19n.7, 20, 21, 22, 24, 41 Herstatt Bank failure, 35 double gearing of capital, 81–4 Drexel Burnham Lambert, 479n.12 Dubois, P., 65, 225 duration gap risk, 225–6, 233 early warning system (EWS), 127–30, 141, 406, 560–1 economic analysis, use in banking regulation, 575–80 economists, banking regulation role, 574–5 equity position risk, 235, 503, 530, 533–4 see€also€position (investment) risk Euro-currency Standing Committee and the BCBS, 44, 50, 466–7 country risk exposures, 137–9 off-balance-sheet exposures, 353 role of, 2–4, 10–11, 465–6 euro-dollar market BCBS Secretariat, 60, 61 BIS governors’ activities, 43–4, 47–50 exchange rate system, effect on, 30–1 Groupe de Contact, 17, 20, 27–9 growth of, 25–9 and international financial stability, 31–44, 47–50 monetary policy concerns, 29–30 official deposits, 30–1, 35–6, 48–9 petro-dollar recycling, 31, 32–5, 37, 49 supervision of banking, 2–4, 10–11 European Banking Federation, 414 European Community (EC) (European Union from 1993) Basel I negotiations, 174, 175, 176–7 and the BCBS, 44–5, 58, 65, 70–3, 88–94, 435–7

Capital Adequacy Directive, 244, 245, 246, 274, 496, 506–8 capital adequacy requirements (CARs), 506 cross-border banking, 154, 176–7, 218 domestic vs. international banking supervision, 2 and the Groupe de Contact, 13, 14–15, 17, 19, 23–4 information exchanges, 398–9 interest rate risk, 231, 269 large credit exposures, 411 market risk assessment, 241 securities regulation, 506–7n.37 Tripartite Group, 497, 500, 503, 505, 535 European Monetary Institute (EMI), 436 European System of Central Banks (ESCB), 436 exchange rate risk, 235 see€also€foreign exchange (fx) risk factor applied to model-based capital requirement, 252–6, 258–60, 281–5 fair value accounting, 520–5 Fanet, Pierre, 12 Farrant, Richard, 65, 359–60, 370–1 Federal Deposit Insurance Corporation (FDIC), 69, 555 Federal Home Loan Board (FHLB), 69 Federal Reserve Bank of New York (FRBNY), 69, 132, 457 Federal Reserve Board (FRB), 69, 132, 167–74, 262, 386–7, 460 Federal Reserve System (FRS), 69 Financial Action Task Force on Money Laundering (FATF), 289, 558 financial conglomerates IOSCO’s work, 497, 500, 503, 505 Joint Forum, 505, 508–10, 512, 535–6, 538, 539, 541 supervision of, 490 Tripartite Group, 497, 500, 503, 505, 535 financial crisis economic analysis, contribution of, 575–80 regulation, role of, 581 standards, role of, 123–5 financial oversight organisations, 82–4 Financial Sector Assessment Programme (FSAP), 6, 291, 300, 554 financial stability, 3–4, 11, 31–44, 40–1n.21, 47–50 Financial Stability Forum (FSF), 543, 566

Index Financial Stability Institute (FSI), 435 Finch, David, 438 Fischer, Stanley, 440, 463 Fitzenreiter, J., 85, 88–94, 131, 472–3 foreign establishments see€overseas banks foreign exchange (fx) risk benchmark approach, 241–3 Carosio sub-group, 249 contracts, supervision of, 131–2 Danielsson sub-group, 230, 239, 241–3, 249, 268 experts on the BCBS, 141 G10 central bank governors, 41–2 Herstatt Bank failure, 3–4, 31–2 and liquidity, 317–18, 339, 343 modelling techniques, 248 nature of, 268 positions, 118, 132 prototype integrated test, 235–9 supervision of markets, 130–2 foreign government debt see€‘club’ approach to cross-border risk forward foreign exchange contracts, 131–2 Fourcade, J.-P., 37–8 France attendance record, 88–94 Basel I negotiations, 179, 180, 220–2 capital adequacy requirements (CARs), 149n.3, 157, 161, 197 Groupe de Contact, 12–13 money laundering principles, 286 participation in BCBS, 65 profitability of banks, 405–6 securities regulation, 488, 527–8 supervision of banking, 4, 9 training, provision of, 460 see€also€G10 (Group of Ten) central bank governors Franklin National Bank, 32, 84 Freeland, Charles attendance record, 65, 88–94 banks’ internal models, 247n.8, 247n.9 maturity transformations, 132 principles of banking supervision, 296, 300 role of, 94 Secretariat role, 62, 64 Friedman, M., 29 futures, 182 see€also€derivatives G6 (Group of Six), 36–8 G7 (Group of Seven), 293–4, 500–5, 536–41, 566

595 G10 (Group of Ten) central bank governors Basel I, 174, 180–1 and the BCBS, 1, 465, 543–5, 568 and the BIS, 465 capital adequacy requirements (CARs), 147, 154, 155–6, 163–4, 174 ‘club’ approach to cross-border risk, 188 consolidation of balance sheets, 101–2, 120–3 early warning system (EWS) request, 127–9 euro-dollar market concerns, 38–44, 47–50 and the Groupe de Contact, 21–2, 41–2 implementation of BCBS standards, 554 liquidity, 322–3 membership, 2 presentation of papers by BCBS, 78 Presidents, 8–9 securities risk assessment, 241 status of, 543 supervision of banking report (1975), 115–19 Galpin, Rodney attendance record, 88–94 BAMMS, 43, 53 BCBS, 53 Groupe de Contact, 18, 19, 24n.13 profitability of banks, 382 Gehring, W., 88–94, 460 Gemmill, Robert, 132 General Arrangements to Borrow (GAB), 10–11n.1 General Managers of the BIS, 8–9 general market risk, 240–3, 530–1 Germany attendance record, 88–94 Basel I negotiations, 178–9, 180, 181–2, 183n.34, 183–4, 219, 220–2 capital adequacy requirements (CARs), 146, 149n.3, 153, 157, 161, 167, 177, 197, 486n.18 credit exposures, 389 crisis management, 380 decision-making in BCBS, 547 euro-dollar market, 27, 39 Groupe de Contact, 12–13 money laundering, 286, 287, 288, 388 participation in BCBS, 65, 69n.8 profitability of banks, 403, 404, 405 supervision of banking, 4, 9

596

Index

Germany (cont.) see€also€G10 (Group of Ten) central bank governors Giovanoli, M., 543, 552n.28, 557, 557n.35 Glass-Steagall Act, 478, 565 globalization, 567–8 Gold and Foreign Exchange Committee, BIS, 3n.1, 466 Grand Cayman, 107 Green, D., 480n.13 Greenspan, Alan, 192–3 Groupe de Contact background, 10–11 and the BCBS, 2, 21, 23, 24–5, 44–5, 74–5, 141, 435–6, 561 euro-dollar market, 17, 20, 27–9 and the G10 central bank governors, 21–2, 41–2 solvency ratios, 152n.7 structure of meetings, 73–4 work of, 12–25 Gulf Cooperation Council (GCC) and the BCBS, 428–9, 453–4 ‘club’ approach, objections to, 186, 187, 429 off-balance-sheet risks, 357 Haas, Ernst, 570 Harbrecht, E., 434n.20, 460 Hayward, Peter attendance record, 88–94 banking/securities regulation, 494 implementation of Basel I, 185, 190 money laundering principles, 289 off-balance-sheet sub-group, 230 Secretariat role, 64, 185 status of the BCBS, 545 hedging, 236–7 Herring, R.J., 76, 479n.12, 548–9n.21 Herstatt Bank, 3–4, 11, 31–5 Herstatt risk, 3–4, 32 holding companies, 104–10 Hollom, Jasper, 53 Hong Kong, 187, 188 Huth, Meir, 77, 88–94 Hutton, Robin, 12–13n.2, 14–15n.4, 15n.5, 24 information exchanges between banking and securities supervisors, 483, 485, 499–500, 502, 535 exchanges with insurance regulators, 512

financial conglomerates Joint Forum, 505 joint BCBS/IOSCO statement to G7, 536–41 infrastructure of banking, 83–4 insolvency of banks, 117, 152n.7, 317, 392–7, 412 Institute of International Finance (IIF), 260–1, 413–16, 440–2 insurance, 378–9 insurance regulators, 510–13 inter-bank confirmation requests, 472–3 interest rate risk banks, consultation with, 246–7 banks’ internal models, 247–61, 264, 277–85 BCBS/IOSCO joint work, 271–3 Beverly sub-group, 226–33, 266–7, 268–9, 358, 484–5 ‘building block’ approach, 239–43, 272 Carosio sub-group, 233, 234–41, 248, 261–4, 275–7 consultative document, 275 general market risk, 240–3, 530–1 IOSCO/BCBS joint work, 243–6 Market Risk Amendment (1996), 81–4 maturity transformations, 224–5, 264, 266–7 measurement methods, 270 nature of, 224–6, 227 net interest income risk, 261–4, 266–7, 268–9 and position (investment) risk, 225–6, 227, 267–9 Principles for the Management of Interest Rate Risk, 261–4 prototype integrated test, 235–9 and securities regulation, 484–5, 530–1 test portfolio exercise, 280–1 International Accounting Standards Committee (IASC), 82–4, 468–72, 475, 476–7, 513–14, 520–5 International Association of Insurance Supervisors (IAIS), 82–4, 508–13 International Auditing Practices Committee (IAPC), 473–4, 475, 477 International Chamber of Commerce (ICC), 131–2 International Conference of Banking Supervisors (ICBS), 428, 430–2, 454–6 International Federation of Accountants (IFAC), 468, 472–4

Index international financial stability see€financial stability International Lending Supervision Act (ILSA), 5, 166 International Monetary Fund (IMF) and the BCBS, 53, 54, 59, 88–94, 438–40, 463–4 conditionality, 558 early warning system (EWS), 129 Financial Sector Assessment Programmes (FSAPs), 6, 291, 300, 554 New Arrangements to Borrow (NAB), 188 principles of banking supervision, 294–5, 297–8, 300, 312, 315 role of, 566 International Organization of Securities Commissions (IOSCO) and BCBS, Joint Forum, 505, 508–10, 535–6, 538, 539, 541 and BCBS, joint position paper, 489, 495–6, 529–32 and BCBS, joint public statement, 271–3, 494, 532–4 and BCBS, joint statement to G7, 536–41 and BCBS, relations between, 82–4, 230–1, 243–6, 478, 480–506, 508– 10, 534–5, 536–41, 565–6 capital adequacy requirements (CARs), 238, 484n.15 Code of Conduct for Credit Rating Agencies, 553 derivatives, supervision of, 361–2 financial conglomerates, 497, 500, 503, 505 market risk assessment, 241 origins of, 480n.13 Technical Committee, 484, 484n.15, 485–6, 487–96, 498, 500, 502–4 international supervision central banks’ role, 38–44 vs. domestic supervision, 1–7, 48 lender of the last resort, 35, 37, 49, 379–81, 400–2 see€also€supervision of banking International Swaps and Derivatives Association (ISDA), 260–1 investment (position) risk banks’ internal models, use of, 247–61, 264, 277–85 BCBS/IOSCO joint work, 243–6 Beverly sub-group, 226–33

597 consultation with banks, 246–7 Mackenzie/Barnes sub-group, 230, 239, 269, 484–6, 487–8 nature of, 225–6, 227 prototype integrated test, 235–9 quantitative standards for models, 278–80 and securities regulation, 483, 484–6, 487–8 test portfolio exercise, 280–1 investment houses and banks, 478–80, 488–9, 565–6 BCBS/IOSCO joint work, 243–6 BCBS/IOSCO relations, 230–1 capital adequacy requirements (CARs), 238, 506 Ireland, 18–19, 42, 452–3 Israel-British Bank, 77, 82–4, 130–1, 141, 468 Istituto per le Opere di Religione (IOR), 104, 106 Italy attendance record, 88–94 Banca d’Italia, 104, 106 capital adequacy requirements (CARs), 161, 197 credit exposures, 389 decision-making in BCBS, 547 euro-dollar market, 27 Groupe de Contact, 12–13 money laundering principles, 286 participation in BCBS, 65 profitability of banks, 404, 405–6 supervision of banking, 9 see€also€G10 (Group of Ten) central bank governors Japan attendance record, 88–94, 152 Bank of Japan, 355 banking structure, 479 banking supervision, 2 Basel I, macroeconomic effects of, 194 Basel I negotiations, 175–6, 177, 178–9, 184–5, 219, 220–2 capital adequacy requirements (CARs), 155, 157, 161, 166, 167, 197 competition from, 5 credit exposures, 389 decision-making in BCBS, 547 participation in BCBS, 68–9, 569 profitability of banks, 403, 405–6 risk weightings, 213–14 securities regulation, 488 supervision of banking, 4, 9

598

Index

Japan (cont.) translation services, 61 US/UK bilateral agreement, 171 see€also€G10 (Group of Ten) central bank governors Johnson Matthey Bankers (JMB), 55 Johnston, Barry, 25–7, 30–1 Joint Forum, 505, 508–10, 512, 535–6, 538, 539, 541 joint ventures, 97–8, 114 Kane, E., 550n.22 Kapstein, E.B., 36n.17, 46n.28, 70n.10, 99n.3, 113–14n.10, 155, 165–6n.20, 166, 195n.40, 549, 555n.33, 567–8, 570–1 Knight, Jeffrey, 484, 487–8 knowledge, role of, 569–71 Kuwait, 186, 187, 188 Lamfalussy, A., 8–9, 137–8, 358–9, 466 Lamfalussy Report, 358–9 languages, 61 large credit exposures, 389–92, 411 Larosière, J. de, 8–9, 37 Larre, R., 8–9, 130 Lastra, Rosa, 7n.3, 542n.1, 543, 546, 546n.15, 554–5n.32 Latin America, 457, 460, 461 Lawson, Nigel, 168 LCFIs (large and complex financial intermediaries) IOSCO’s work, 497 Joint Forum, 505, 508–10, 512, 535–6, 538, 539, 541 supervision of, 490 Tripartite Group, 497, 500, 503, 505, 535 legal status of the BCBS, 542–5 Leigh-Pemberton, Robin, 164n.19, 167–8 lender of the last resort, 35, 37, 49, 379–81, 400–2 LePan, Nick, 475–6 Liechtenstein, 417–18, 419, 452–3 liquidity and capital adequacy requirements (CARs), 318, 330, 342 conceptual issues, 317–18, 335–6 and consensual knowledge, 571 declining trend in, 329, 331, 333–5, 342, 347 factors affecting, 338–9, 340–4 international harmonisation, attempted, 320–7 international harmonisation, retreat from, 327–30

Musch sub-group, 230, 324–7, 329–33, 344–5 nature of, 337–8 purpose of, 336–7, 340–1 Sandberg sub-group, 318–23, 336–44 and solvency, 317 sources of, 339–40 supervision of, 81–4, 116–17, 336 tests of, 345 Litan, R.E., 76, 479n.12, 548–9n.21 loans, 389–92, 411 see€also€sovereign debt London Investment Banking Association (LIBA), 260–1 Luxembourg attendance record, 88–94 Banco Ambrosiano, 104 Basel I negotiations, 220–2 BCCI (Bank of Credit and Commerce International), 107 capital adequacy requirements (CARs), 146, 149n.3, 161, 197 decision-making in BCBS, 547 G10 governors membership, 2, 42 Groupe de Contact, 12–13 insolvency of banks, 395 money laundering principles, 286, 288 offshore banking, 452–3 participation in BCBS, 65, 69n.8 profitability of banks, 404, 405 risk weightings, 213–14 secrecy in banking, 373 supervision of banking, 9 see€also€G10 (Group of Ten) central bank governors MAB (Mexico, Argentina and Brazil potential default) crisis, 134, 140–1, 154–5, 561–2 Mackenzie, Michael, 88–94, 230, 233, 239, 269, 484–6, 487–8 Malaysia, 188 management control systems, 538 market forces, 567–8 market risk banks, consultation with, 246–7, 275–7 banks’ internal models, 247–61, 264, 277–85, 415–17, 440–2, 564–5 BCBS/IOSCO joint work, 243–6, 504–5, 538 ‘building block’ approach, 239–43, 530 consultative document, 273–4 prototype integrated test, 235–9 quantitative standards for models, 278–80 test portfolio exercise, 280–1

Index Market Risk Amendment (1996), 81–4, 247–61, 264, 564–5 Markets Committee, 466 Mason, J.R., 478 Matsuda, Takamasa, 40–1n.21 maturity transformations interest rate risk, 224–5, 264, 266–7 and liquidity, 318 offshore banking, 448–9 wholesale international markets, 132–3, 134–7, 141–4 Mayer, Helmut, 60, 61, 62–3, 65, 88–95, 136 McMahon, Kit, 34, 37, 41 membership of the BCBS, 65–73 Merton, R.C., 256, 572 Mexico, 5, 134, 140–1, 154–5, 222–3, 460, 561–2 Mitchell, George, 22–3, 37 Models Task Force, 249–61, 264, 277–8, 415–17, 440–2 money laundering, 286–9, 300–4, 385–8, 406–10, 558 money supply, 29–30 Monterastelli, Giuliano, 12 Morse, Jeremy, 414 Muller, Huib attendance record, 65, 88–94 and the BAC, 152n.7 capital adequacy requirements (CARs), 158, 186 as Chairman of BCBS, 8–9, 43, 52, 56–7 consolidation of balance sheets, 100 crisis management, 381 European regulators, role of, 436–7n.21 Groupe de Contact, 12, 13–14, 16–17, 19, 19n.7, 22 home/host supervisors’ responsibilities, 97, 128 liquidity, 317 money laundering principles, 288 netting, 358–9 role of, 141 securities and banking regulation, 485, 486–8, 491–2n.21, 492–3 work with the BCBS, 85 Musch, Fredrick (Erik) attendance record, 65, 88–94 liquidity risk, 230 liquidity sub-group, 324–7, 329–33, 344–5 offshore banking, 427 Secretariat role, 64 US/UK bilateral agreement, 173–4

599 national supervisors adoption of Basel I, 190–1 authority of, 464 financial system responsibility, 578–80 relations with BCBS, 289–91, 413–17, 440–2, 546–52 net interest income risk, 261–4, 266–7, 268–9 Netherlands attendance record, 88–94 Basel I negotiations, 220–2 capital adequacy requirements (CARs), 197 credit exposures, 389 decision-making in BCBS, 547 Groupe de Contact, 12–13 money laundering principles, 286 participation in BCBS, 65, 569 supervision of banking, 9 see€also€G10 (Group of Ten) central bank governors netting, 358–61, 370–1 New Arrangements to Borrow (NAB), 188 New Zealand, 298–9, 461 non-bank holding companies, 104–10 non-G10 supervisors Basel I, 181 and the BCBS, 290, 304–6, 423–4, 428–30, 450–1, 453–4, 551–2 communication with, 431–4 Concordat, implementation of, 110–13 Core Principles of Effective Banking Supervision, 291–300, 307–16 correspondence about BCBS guidelines, 119–20, 123–5 country risk exposures, 140 International Conference of Banking Supervisors (ICBS), 430–2, 454–6 off-balance-sheet risks, 355 secrecy in banking, 376–7 standards, implementation of, 554, 556–7 supervision of banking, 109, 125–6 Norton, J.J., 542, 543n.9, 562–3 Norway, 18–19 note issuance facilities (NIFs), 182, 362, 363–4 Nouy, Danièle, 64, 249, 293, 360–1, 499, 511–12 off-balance-sheet risks Basel I, 182, 353 Beverly sub-group, 353–5, 356–8, 365–8 classification of, 368

600

Index

off-balance-sheet risks (cont.) Danielsson sub-group, 241–3, 358, 359 discussion at the BCBS, 81–4 Farrant sub-group, 359–60, 370–1 Hayward sub-group, 230 management of exposures, 351–8, 362 netting, 358–61, 370–1 Nouy sub-group, 360–1 supervision of, 356 weightings, 356–7 Office of the Comptroller of the Currency (OCC), 69 offshore banking, 417–28, 442–9, 450–3 Offshore Group of Banking Supervisors (OGBS), 109–10, 125–6, 419–28 oil, 11, 31 options, 363 see€also€derivatives overseas banks Concordat, implementation of, 110–13, 119–20 Concordat, reviews of, 104–10, 114, 123–6 consolidation of balance sheets, 100–3, 113, 120–3 home/host supervisors’ responsibilities, 96–100, 113, 114, 128 recommendations to G10 Governors, 115–19 Padoa-Schioppa, Tommaso attendance record, 88–94 BCBS/IOSCO relations, 499–500, 502–3, 534–5 capital adequacy requirements (CARs), 188 as Chairman of BCBS, 8–9, 52, 58–9 derivatives, 361 empirical studies, 193 and the European banking supervisors, 437 Market Risk Amendment (1996), 251, 254–5, 256, 264, 281–4 non-BCBS members, 291–2 professional advice, use of, 572 relations with non-bank supervisory bodies, 466–7 relations with other regulators, 413–14, 415, 416, 440–2 relations with the IMF, 440, 463–4 structure of meetings, 74 Patrikis, Ernest, 88–94, 394–6, 572 Paulson Committee, 478–9n.11 peer group review, 291 petro-dollar recycling, 31, 32–5, 37, 49

‘plus’ factor reflecting performance of bank models, 255–6, 259–60, 264, 281–4 Pöhl, Karl-Otto, 8–9, 154, 164n.19, 288, 434, 486n.18 portfolio risk, 575–8 position (investment) risk banks’ internal models, use of, 247–61, 264, 277–85 BCBS/IOSCO joint work, 243–6 Beverly sub-group, 226–33 consultation with banks, 246–7 Mackenzie/Barnes sub-group, 230, 239, 269, 484–6, 487–8 nature of, 225–6, 227 prototype integrated test, 235–9 quantitative standards for models, 278–80 and securities regulation, 483, 484–6, 487–8 test portfolio exercise, 280–1 Position Conversion Factors (PCFs), 235, 236 Powell, G. Colin, 110, 420–8, 434 pre-commitment approach, 253, 253n.12, 256n.13 Presidents of the G10 governors committee, 8–9 principles see€core principles profitability of banks, 81–4, 381–5, 402–6 Quinn, Brian attendance record, 65, 88–94 Basel I negotiations, 178–9, 185 Concordat, 112, 113 democratic legitimacy, 551 sanctions, 550 US/UK bilateral agreement, 168, 169, 171 regulation of banking see€supervision of banking regulators see€supervisors Report on International Developments in Banking Supervision, 430, 431–2 rescheduled loans, 81–4 reserve ratios, 29–30 retail banking see€traditional banking revaluation reserves, 175–6, 178–9 revolving underwriting facilities (RUFs), 182 Richardson, Gordon and the BCBS, 43, 56, 62 euro-dollar market, 34, 36 lender of the last resort, 35

Index letter from, 86–8 President of the G10 governors committee, 8–9 risk weightings attempts to achieve consensus, 157, 158–60, 161, 208 claims on securities firms, 506–8 counter-cyclical mechanism, 579 Dahl sub-group, 152, 154, 207, 208 and portfolio risk, 575–8 United States (US), 164–5, 213 weaknesses of, 195 Roberts, Betsy, 300 Rothstein, Robert, 570–1 ‘rules’ for banking supervision, 439–40, 463–4 Saint-Geours, Jean, 498, 499–500 sanctions, 549–51, 555–6 Sandberg, Irwin, 65, 137, 318–23, 336–44 scaling factor applied to model-based capital requirement, 252–6, 258–60, 281–5 Schmidt, Helmut, 36 Schneider, Manfred, 12, 65, 139 Schwartz, A.J., 29 SEACEN (South East Asian Central Banks), 461 SEANZA (South East Asia, New Zealand, Australia) Forum of Banking Supervisors, 461 secrecy, 373–8, 397–400, 449 Secretariat of the BCBS appointment of Chris Thompson, 94–5 attendance record, 65, 70 role of, 315 training, provision of, 292, 314–15, 434–5, 456–63 work of, 60–4 Securities and Exchange Commission (SEC), 479, 480, 506–7n.37, 527, 528 securities regulation BCBS position on, 525–9 BCBS/IOSCO joint position paper, 489, 495–6, 529–32 BCBS/IOSCO joint public statement, 271–3, 494, 532–4 BCBS/IOSCO joint statement to G7, 536–41 BCBS/IOSCO relations, 287, 82–4, 230–1, 243–6, 478, 480–506, 508–10, 534–5, 536–41, 565–6 ‘building block’ approach, 239–43, 272

601 and supervision of banking, 478–80, 506, 525–32, 533, 535, 565–6 securitisation of banking assets, 81–4, 576 Seipp, Walter, 40–1n.21 Sempier, Robert, 472 settlement systems, 539 Shepheard-Walwyn, Tim, 500 Singapore, 188, 377 Smout, Clifford, 88–94, 261–2 soft law, 546, 557–9, 569 Solomon, Steven, 167–9, 171, 178–9 solvency, 117, 152n.7, 317, 392–7, 412 sovereign debt ‘club’ approach, 154, 176–7, 179, 180, 182, 183, 218 ‘club’ approach, modifications to, 186–8, 222–3 sovereign states, and the status of the BCBS, 546–52, 567–9 Soviet Union, 29 specific risk banks’ internal models, use of, 257–8, 260–1, 284–5 capital requirements, 240–3 and credit risk, 240–1 securities regulation, 530–1 Spencer, Jonathan, 512 stress tests, 577–8 sub-groups of BCBS capital, 151–4, 157, 158, 507, 508 Concordat implementation, 110–12, 289, 421–2 country risk exposures, 139 cross-border banking, 427–8 derivatives, 249, 499, 511–12 foreign exchange (fx) contracts, 131–2 foreign exchange (fx) risk, 230, 239, 241–3, 249, 268 growth of, 85 insolvency of banks, 394–6 inter-bank confirmation requests, 472–3 interest rate risk, 226–33, 234–41, 248, 261–4, 266–7, 268–9, 275–7, 358, 484–5 investment (position) risk, 226–33, 239, 269, 484–6, 487–8 liquidity, Musch group, 230, 324–7, 329–33, 344–5 liquidity, Sandberg group, 318–23, 336–44 maturity transformations, 134–7 nature of, 63–4 off-balance-sheet risks, 182, 230, 353–5, 356–8, 359–61, 365–8, 370–1

602

Index

sub-groups of BCBS (cont.) overlap, 230–1 risk management, 477 securities regulation, 481–2 subordinated debt, 146–7, 162–3n.18, 197–205, 272, 274, 527–8 supervision of banking adoption of Basel I by national authorities, 190–1 central banks, role of, 38–44 Concordat, implementation of, 110–13, 119–20 Concordat, reviews of, 104–10, 114, 125–6 consolidation of balance sheets, 100–3, 113, 120–3 Core Principles of Effective Banking Supervision, 80–1, 291–300, 307–16, 558, 566–7 cross-border banking, 306–7, 311–12 discussion at BCBS, 75–6 economic analysis, contribution of, 575–80 economists, role of, 574–5 euro-dollar market, 2–4, 10–11 financial conglomerates, 490 and financial crisis, 123–5, 581 financial system responsibility, 578–80 foreign exchange (fx) risk, 130–2 G10 Governors, recommendations to, 115–19 home/host supervisors’ responsibilities, 96–100, 113, 114, 128, 306–7, 311–12 implementation of BCBS standards, 552–7 institutions, 4, 9 IOSCO and the BCBS, 478, 480–506 liquidity, 81–4, 116–17, 336 market forces, role of, 567–8 minimum standards, 289–91 off-balance-sheet risks, 356 portfolio risk, 575–8 qualitative assessment of banks’ internal models, 250, 564–5 relations between supervisors, 423–4, 450–1 and secrecy, 373–8, 397–400 and securities regulation, 478–80, 506, 525–32, 533, 535, 565–6 state power, role of, 567–9 supervisors communication between, 431–4 European banking supervisors, 435–7 and external auditors, 473–4, 515–17

G10 supervisors and the BCBS, 413–17, 440–2 ICBS, 430–2, 454–6 IMF, 438–40, 463–4 offshore banking supervisors, 417–28, 442–9, 451–3 survival time (of bank liquidity), 322, 323, 324–5, 342–3, 344 Swaan, Tom de accounting standards, 476–7 attendance record, 88–94 as Chairman of BCBS, 8–9, 51, 59–60 principles of banking supervision, 297–8 Tripartite Group, 497, 500 swaps, 182, 362, 363 Sweden attendance record, 88–94 Basel I negotiations, 220–2 capital adequacy requirements (CARs), 161, 197 decision-making in BCBS, 547 liquidity, trends in, 347 participation in BCBS, 65 profitability of banks, 404 supervision of banking, 4, 9 see€also€G10 (Group of Ten) central bank governors Swiss Federal Banking Commission, 392 Switzerland attendance record, 88–94 Basel I negotiations, 220–2 capital adequacy requirements (CARs), 149n.3, 161, 197 credit exposures, 389 decision-making in BCBS, 547 euro-dollar market, 39 G10 governors membership, 2 money laundering, 286 offshore banking, 423, 452–3 participation in BCBS, 65 profitability of banks, 403, 404, 405 secrecy in banking, 373, 374, 377 supervision of banking, 4, 9 training, provision of, 457 see€also€G10 (Group of Ten) central bank governors Taylor, Bill, 169, 171 Technical Committee of IOSCO, 484, 484n.15, 485–6, 487–96, 498, 500, 502–4 Terrell, Henry, 132 Thailand, 188, 452–3 The Economist, 31, 31–2n.15, 32–3

Index Thompson, Chris attendance record, 88–94 capital adequacy negotiations, 161 relations with IOSCO, 480 Secretariat role, 63, 64, 94–5, 185 Tietmeyer, H., 8–9, 566 Timm, Bernhard, 60, 61, 62 Timmerman, P., 131 Toniolo, G., 465 traditional banking, 478–80, 506, 565–6 training, provision of, 292, 314–15, 434–5, 456–63 translation of BCBS documents and proceedings, 61 Tripartite Group, 497, 500, 503, 505, 535 two-tier capital base, 162–3n.18, 177–9, 218–19 United Kingdom (UK) attendance record, 88–94 auditing standards, 468, 513–15 banking structure, 479, 565 Basel I, macroeconomic effects of, 194 Basel I negotiations, 220–2 BCCI (Bank of Credit and Commerce International), 107 capital adequacy requirements (CARs), 146n.2, 165, 197 ‘club’ approach to cross-border risk, 189, 218 credit exposures, 389 decision-making in BCBS, 547 euro-dollar market, 27, 29, 39 G10 governors role, 42–4 and the Groupe de Contact, 18–19 insolvency of banks, 395 liquidity management, 328, 347 money laundering, 286 offshore banking, 452–3 participation in BCBS, 65, 569 profitability of banks, 403, 405 securities regulation, 488, 528 supervision of banking, 9 UK/US joint agreement on CARs, 167–74, 194–5, 210, 212–15, 563 see€also€Bank of England; G10 (Group of Ten) central bank governors United States (US) attendance record, 88–94 Basel I, macroeconomic effects of, 192, 194 Basel I negotiations, 220–2

603 capital, constituent elements of, 177 capital adequacy requirements (CARs), 56, 155–6, 161, 164–74, 197, 219, 506, 561–4 ‘club’ approach to cross-border risk, 218 credit exposures, 389 decision-making in BCBS, 547 euro-dollar market, 26–7 foreign exchange (fx) positions, 132 and the Groupe de Contact, 22–3 insolvency of banks, 395 investment houses, 478–9, 565 liquidity management, 327, 347 money laundering, 286, 287, 386 offshore banking, 452–3 participation in BCBS, 65, 69, 77 profitability of banks, 403, 405–6 risk weightings, 164–5, 213 secrecy in banking, 377 securities regulation, 506–7n.37, 527, 528 subordinated debt, 197–205 supervision of banking, 2, 4, 9 US/UK joint agreement on CARs, 167–74, 194–5, 210, 212–15, 563 see€also€Federal Reserve Board (FRB); G10 (Group of Ten) central bank governors universal banks, 479–80, 506, 565 Vachon, S., 65, 130 value-at-risk models, 500, 504–5, 538, 564–5, 576–7 Vatican Bank (Istituto per le Opere di Religione), 104, 106 Vile, Martin, 499 Volcker, Paul, 5, 151, 155–6, 167–9, 563 Voluntary Foreign Credit Restraint Program (VFCR), 26 Waitzer, Edward, 500n.31 Walker, G.A., 546–7n.19, 552–3n.29, 553n.31, 567n.10 Weissmüller, Alberto, 40–1n.21 Willey, D., 65, 85, 132, 139, 380–1 Wood, D., 155, 165–7 working groups of BCBS see€sub-groups of BCBS World Bank, 6, 300, 312, 315, 460 Zijlstra, J., 8–9, 35, 43, 47, 56, 102, 122–3