International Standardization and Co-Operation in Banking Supervision

I. INTRODUCTION

The need for international standardization and co-operation in banking supervision was felt as early as in the 1930s with the negotiation of the Bretton Woods Agreement. In light of world wars, followed by financial deregulation and financial crisis, this need has only increased. Today the Bank of International Settlements (“BIS”), which is also the oldest international financial institution, issues the standards for international banking supervision.

II. BANK OF INTERNATIONAL SETTLEMENTS

BIS was established in 1930 and is owned by 60 central banks including the Reserve Bank of India (“RBI”).[1] It is the oldest international financial institution. From its inception to the present day, the BIS has played a number of key roles in the global economy, from settling reparation payments imposed on Germany following World War I to serving Central Banks pursuits of monetary and financial stability. BIS was created in the context of the Young Plan adopted on January 20, 1930 at the Hague Conference which aimed to settle once and for all the question of reparation of payments imposed on Germany (and to a lesser extent on the other central European countries) by the Treaty of Versailles following the World War I. The BIS was set up to take over the functions previously performed by the Agent General for Reparations: managing the collection, administration and distribution of annuities payable as reparation. Thus the name, Bank of International Settlements.[2]

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First unofficial meeting of BIS. For source, click here.

The Asian crisis of 1997 and the Russian crisis of 1998 prompted further rethinking of global financial architecture. In February 1999, the G7 Finance Ministers and Central Bank Governors created the Financial Stability Forum (“FSF”) – which became the Financial Stability Board (“FSB”) in 2009 to coordinate at the international level the work of national financial authorities and international standard setting bodies, and to develop and promote the implementation of effective regulatory, supervisory and other financial sector policies in the interest of financial stability.[3]

Global financial and banking crisis of 2007-08 accelerated the transformation of the governance structure of the international financial system. As a result, the G10, long the main organizational grouping in international financial policymaking including at the BIS, was superseded by the G20 grouping of major advanced and emerging market economies. At the same time, the work carried out by the BIS, the IMF and OECD and other organizations have become more integrated, not least thanks to the efforts of the FSB. Since the 1990s, the Committees that meet at the BIS, and the secretariats it hosts have all gone through this process of widening their membership and strengthening their cooperation with other international bodies and organizations, to remain globally representative. But, for international cooperation and coordination in banking supervision, the Bank of International Settlement, remains the primary authoritative body.

Through the BASEL Process, the BIS acts as a forum for discussions and a platform for cooperation among policymakers to foster monetary and financial stability. In its role, BIS contributes its practical experience in banking and knowledge in regulatory and supervisory issues, adding value to the discussions and cooperative efforts

BASEL COMMITTEE ON BANKING SUPERVISION (“BCBS”)

The BCBS is the primary global setter for the prudential regulation of banks and provides a forum for regular co-operation on banking supervisory matter. Its 45 members comprise central banks and bank supervisors from 28 jurisdictions.  The BCBS was established to create international norms for banking in light of major banks failing during the time and the risks of bankruptcy by Central bankers of the G10 Countries. The BCBS was formed in 1974 by central bankers from the G10 countries who were at the time, working towards building a new international financial structure to replace the recently collapsed Bretton Woods System. The committee is headquartered in the office of BIS.

The BASEL Committee on banking supervision develops global regulatory standards for banks and seeks to strengthen micro and macro-prudential supervision and the Central Bank Governance Group examines issues related to the design and operation of the central bank.

The BASEL framework includes a number of levers to allow jurisdictions to apply additional safeguards if needed. First, the framework consists of minimum standards, and jurisdictions are free to and encouraged to apply higher standards if warranted for respective banking systems.  BCBS has developed a series of highly influential policy recommendations known as Basel Accords which have formed the basis for capital requirements in member countries and even beyond.

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BASEL I the first of the three sets of BASEL Accord was finalized in 1988. BASEL I focused mainly on credit risk and creation of bank-asset classification. It developed methodologies for assessing banks credit risk based on risk-weighted assets. Banks operating internationally were thereunder required to maintain a minimum amount of 8% of the capital based on a per cent of risk-weighted assets. India adopted BASEL I norms in 1999.

The BASEL I Bank Asset Classification*
Risk Category Nature of Asset
0% Cash, Central Bank & Government Debt, Organization of Economic Co-operation and Development government debt.
20% Development bank debt, OECD bank debt, OECD securities firm debt, non-OECD bank debt (> 1-year maturity), non-OECD public sector debt and cash in collection
50% Residential mortgages
100% Private sector debt, non-OECD bank debt (> 1-year maturity), real estate, plant and equipment, capital instruments issued at other banks.

*The Bank must maintain Capital (Tier I & Tier II) equal to at least 8% of its risk-weighted assets.

BASEL II was effected in 2004. This second set of BASEL rules expanded the above rules for minimum capital requirements and provided for a regulatory review. It also set disclosure requirements for assessment of capital adequacy of banks. It aimed firstly, to make banks more capital risk sensitive; secondly, to promote enhanced risk management tactics for bigger banks and thirdly, to create common means for evaluation of bank

In order to evaluate the performance of banks, BASEL II laid down three pillars. Pillar I addressed risk and pertained to the capital adequacy requirements. It pertains to the ongoing maintenance of regulatory capital that is required to safeguard against the three major components of risk that a bank faces viz. credit risk, operational risk and market risk. Pillar II addressed the regulatory response to Pillar I vide providing regulators with better tools over those previously available. It further provides a framework for dealing with residual risk. Pillar III being Market Discipline aimed to encourage market discipline by developing a set of disclosure requirements, which allow market participants to assess key pieces of information on the scope of applications, capital risk exposures, risk assessment processes and hence capital adequacy of the institution. (See Image Flowchart)

BASEL II confirms the definition of regulatory capital and 8% minimum coefficient. For regulatory capital over risk-weighted assets.

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BASEL III is currently in use. It was put forth in response to the financial crisis of 2007-09 with an aim to strengthen the regulation, supervision and risk management of banks and to strengthen mainly micro-prudential regulation and supervision. It also adds a macroprudential overlay including capital buffers. BASEL III contained several changes for banks capital structures. Firstly, the minimum amount of equity, as a percentage of assets will increase from 2 to 4.5%. Additionally, it prescribed a buffer of 2.5%, thus bringing the total equity requirement to 7%. This buffer is permitted for use during times of financial stress, however, banks doing so, face constraints on their ability to pay dividends and otherwise deploy capital.

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The Reserve Bank of India imposed Prompt Corrective Action on many public sector banks. The Government infused these banks with cash injection in order to maintain the CRAR. All in all, BASEL III norms act as a floor to the minimum capital ratio to be maintained by banks. In India, as a precaution, the ratio is higher than as prescribed by BCBS.

III. OTHER ATTEMPTS AT INTERNATIONAL CO-OPERATION

In July 1944, a new international monetary system was developed by delegates from 44 countries at the United Nations Monetary Financial Conference in Bretton Woods, N.H. by negotiating an Agreement called Bretton Woods Agreement. This Agreements led to pegging of other currencies to the value of the U.S. Dollar and pegging of the U.S. Dollar to Gold. The system was primarily designed by John Maynard Keynes among others with an aim to establish a powerful global central bank which would be called Clearing union and would issue a new international reserve currency.

The principal goal of this agreement was to create an efficient foreign exchange system and preventing competitive devaluation of currencies as also to promote international economic growth. The Agreement created two important financial institutions, the International Monetary Fund (“IMF”) and the World Bank (“WB”) in December 1945. The purpose of the IMF was to monitor exchange rates and lend reserve currency to nations in need of support for their currencies and settle their debt. The WB (initially called the International Bank for Reconstruction and Development) was established to provide assistance to countries which were physically/ financially devastated by World War II.

The Bretton Woods Agreement collapsed in the early 1970s with the America n President Richard Nixon’s announcement that the U.S. would no longer exchange gold for its currency since gold supply was not adequate anymore to cover the number of dollars in circulation.

IV. OBSERVATIONS AND CONCLUSIONS

As discussed above, there is an indispensable need for international co-ordination and co-operation in banking supervision. This need has only intensified in light of globalization and technological advancements which have made financial systems around the world interdependent. The BCBS post-crisis reforms have undoubtedly enhanced the resilience of the banking system. There is no shortage of risks in the financial system today, with advancement in technology newer and more complex risks have surmounted.  To mitigate the impact and likelihood of a future crisis, it is imperative that BCBS strengthen its reforms and that these reforms are implemented by all members in a comprehensive, timely and consistent manner and that central banks take supervisory actions when and where needed. It is also pertinent to keep an open mind in order to ensure timely checks and balances, ultimately aiming to strengthen the reliance on financial systems.

It is almost certain that the reserve banking system relies on leverage and maturity mismatch and that there will most certainly be another financial crisis.[4] The aim, as a result, is not prevention of future financial crisis but to reduce their likelihood and the impact of it on the real economy.[5] There might be BASEL IV at some point in the future as there are no shortages of risks looming across the financial system with financial innovation taking place at a dizzying pace. The regulatory framework desperately needs to adapt to new risks and lessons learnt from the crisis, however, BASEL IV is not expected anytime soon.[6]

International co-operation would also be fundamental in determining a uniform and educated approach towards virtual assets such as cryptocurrencies and the utilization of blockchain technology in banking businesses.[7]

MANAL SHAH


[1] https://www.bis.org/about/index.htm?m=1%7C1 (last accessed 15.03.2019)

[2] https://www.bis.org/about/history_1foundation.htm (last accessed 15.03.2019)

[3] Ibid.

[4] https://www.bis.org/speeches/sp181128.htm (last accessed 16.03.2019).

[5] Ibid.

[6] Ibid.

[7] Ibid.

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