Contemporary Finance

19Regulation of Capital Funding, Liquidity, and Large Banks

19.1 Historical Background of the Capital Standards

During the international financial instability of the 1960s, foreign banks’ international activities were seen as a source of instability in domestic markets. The failure of German Bankhaus Herstatt had caused large losses at some US banks. Central banks and finance ministers grew more concerned about falling bank capital ratios and increased risk, taking. Concerns about competition from highly leveraged foreign banks with lower funding costs also played a role.

A year after its establishment in 1974, the Basel Committee issued a proposal for international regulatory cooperation, the Report on the Supervision of Banks’ Foreign Establishments, or “Concordat”. Since then, the Committee has led international coordination of regulatory standards limiting bank leverage and liquidity risk, beginning with the 1988 Basel Capital Accord (the “Accord”, or Basel I), an agreement on minimum capital ratios, meaning the share in banks’ funding mix of equity and equity-like claims. Statutory implementation is carried out by national authorities.

Initially, the standards focused on credit risk and set out a simple approach to calculating minimum capital ratios, assigning risk weights to different asset types, including off-balance-sheet exposures, and further entrenching agency credit ratings. The 1996 Market Risk Amendment to the Accord allowed the use of banks’ own internal models ...