Gunfight at the Basel II corral: as the dispute brews, will the Federal Reserve misjudge the mood on Capitol Hill?

• Author: Whalen, Christopher

In 1988, the bank supervisors from the G10 countries agreed on a new set of capital guidelines for commercial banks that became known generally as the Basel Accord, after the Swiss city where the Bank for International Settlements is located. The central focus of this relatively simple framework was credit risk and, as a further aspect of credit risk, country transfer risk-a legacy of the Latin American debt crisis. The new capital rules were hailed as an important tool to avoid bank collapses and the ultimate bogey man, "systemic risk."

By the end of the transition period in 1992, all banks were expected to maintain a minimum level of capital equal to 8 percent of total assets, of which core capital (Tier 1, equity and reserves) was at least 4 percent. The basic elements of the original Basel capital guidelines are shown in the chart. Since the early 1990s, the BIS has hosted a consultative effort among the G10 regulators to keep the capital standards and bank management practices up-to-date with the evolving marketplace, especially the growth in the use of derivatives and financial alchemy a la Enron. Andrew Crockett, then-general manager of the Bank for International Settlements, said in an October 22, 1998, speech in Sydney: "When properly used, [derivatives] can be a powerful means of controlling risk that allows firms to economize on scarce capital. However, it is possible for new instruments to be based on models which are poorly designed or understood, or for the instruments to give rise to a high degree of common behavior in traded markets. The result can be large losses to individual firms or increased market volatility."

As the financial markets have grown more complex, the ability of the regulators to understand much less supervise the activities of the major banks has diminished considerably. The largest banks have also grown increasingly dependent upon principal trading, especially trading in derivatives contracts, for a large portion of their profits.

Thus, the transition to the new "Basel II" capital proposal that was supposed to begin in December has as its central premise the idea that banks should use their own internal risk models to assess the appropriate level of capital required to support various types of business. In return for developing the internal capability to assess specific operational and credit risks, banks get to lower their effective capital cost.

The Federal Reserve Board and the thirty or so largest...