Bank regulation up to 1988

Before 1988, bank regulation focused on setting minimum levels for the ratio of capital to total assets. Since capital requirement levels as well as regulatory enforcement varied between countries, banks could gain a competitive edge by operating from countries with a laxer regulatory environment.

The emergence of over-the-counter derivatives markets made further complicated things for regulators. Instruments such as interest rate swaps, currency swaps, and foreign exchange options increased the credit risk of banks without increasing the level of capital required.

A way of determining total risk in a bank, including these off-balance sheet items, was needed.

In 1988 the BIS accord made the first attempt to address these issues by setting an international risk-based standard for capital requirements. The accord was signed by all 12 members of the Basel Committee and paved the way for the Basel accords.

The BIS accord included two requirements: the ratio of bank's assets to its capital had to be less than 20, and the Cooke ratio. The Cook ratio takes both on-balance sheet and off-balance sheet items into account to form a measure of a bank's total risk exposure, also called the risk-weighed assets.

The risk weights under the BIS accord

OECD governments, gold, cash 0%

OECD banks 20%

Uninsured mortgage loans 50%

Corporate bonds 100%

An important part of the risk weighed assets is how off-balance sheet items are given a risk-weight. The credit equivalent amount for non-derivatives is calculated as the loan principal that is considered to have the same credit risk.

For OTC-derivatives, the credit equivalent amount is calculated as max(V, 0) + aL. V is the current value to the bank, a is an add-on factor, and L is the principal. The add-on factor accounts for the fact that the exposure might increase in the future.

The BIS accord requires that banks keep a capital buffert equal to 8% of the risk-weighted assets. The capital consists of tier 1 capital, equity and noncumulative perpetual preferred stock (net of goodwill), and tier 2 capital, cumulative perpetual preferred stock, certain types of long debenture issues and subordinate debt. A minimum of 50% tier 1 capital is required.