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I. Amendments to the 1988 Accord

The First Consultative Paper—The Three Pillar
Model

In June 1999, as a means of replacing the 1988 Basel
Accord, the first consultative paper (on a new capital ade-
quacy framework) was issued by the Basel Committee
on Banking Supendsion. The First Consultative Paper
introduced the “three pillar’’ model which comprises
of “the minimum capital requirements”—that attempt
to consolidate the rules established in the 1988 Accord,
“supervisory review” and “market discipline”—“as a
lever to strengthen disclosure and encourage safe and
sound banking practices”, 11 Whilst acknowledging that
the 1988 Accord had “helped to strengthen the sound-
ness and stability of the international banking system
and enhanced competitive equality among internation-
ally active banks”, it was added that the new framework
provided by the first consultative paper was “designed
to better align regulatory capital requirements to
underlying risks and to recognise the improvements to
risk measurement12 and control.”

One of the flaws inherent in the 1988 BaselAccord
was namely, the fact that it rewarded risky lending since
it required banks to set aside the same amount of capital
against loans to shaky borrowers as against those with
better credits.13Apart from the fact that capital require-
ments werejust reasonably related to bank’s risk taking,
the credit exposure requirement was the same regardless
of the credit rating of the borrower.14 Furthermore, the
capital requirement for credit exposure often depended
on the exposure’s legal form—for instance, an on-bal-
ance sheet loan was generally subject to a higher capital
requirement than an off-balance sheet to the same
borrower.15 In addition to such insensitivity to risk,
another problem which resulted from Basel 2 was the
unwillingness of banks to invest in better risk manage-
ment systems.

II.       Capitol Arbitrage

A general criticism of Basel I relates to the fact that it
promoted capital arbitrage. This is attributed to its wide
risk categories which provide banks with the liberty to
“arbitrage between their economic assessment of risk
and the regulatory capital requirements.”16 “Regulatory
capital arbitrage’’involves the practice by banks of“using
securitisation to alter the profile of their book and may
produce the effect of making the bank’s capital ratios
appear inflated.17 Such a practice justifies the extension
of regulation to the securities markets—rather than
being merely confined to the field of banking.

Four principal types of identified capital arbitrage
include: 18cherry picking, securitisation with partial
recourse, remote origination and indirect credit.

III. Basel Il

Some of the key factors which instigated the intro-
duction of Basel 2 include:19

“Changes in the structure of capital markets—resulting
in the need for the incorporation of increased competi-
tiveness of credit markets in capital requirements

The need for measures which would facilitate the
eradication of inefficiencies in lending markets

Explosive debt levels which were generated during
the economic upturn.”

Under Basel II, and in response to the fact that
the measurement of minimum capital was previously
based on a general assessment of risk dispersion which
did not correspond to specific circumstances of indi-
vidual institutions, credit institutions will be required
to retain more capital if required. Under Pillar 1, the
definition of capital and minimum capital coefficient
remain unchanged—however, credit institutions will be
required to retain more capital if their individual risk
situation so demands.20 Further advancements under
Basel II are illustrated in the areas of risk measurements.
The measurement methods for credit risk are more
sophisticated than was previously the case. For the first
time, a means of measuring operational risk has been
set out.21 Under Pillar One, credit and market risk are
supplemented by operational risk—which is to be cor-
roborated by capital.22

B. Basel Committee’s Proposals to Strengthen
Global Capital and Liquidity Regulations

I. Objectives of the Basel Committee’s Proposals
to Strengthen Global Capital and Liquidity
Regulations23

“As well as strengthening global capital and liquidity’
regulations (which would ultimately facilitate a more
resilient banking sector), the Basel Committee’s reforms
are aimed towards improving the banking sector’s

Volume 30 ∙ Number 9 ∙ September 2011

Banking & Financial Services Policy Report ∙ 27



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