Current Legal Issues Affecting Central Banks, Volume III.
Chapter

Chapter 18 Work of the Basle Committee

Author(s):
Robert Effros
Published Date:
August 1995
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Author(s)
WILLIAM A. RYBACK

History of the Basle Committee

The Basle Committee on Banking Supervision was set up in 1974 in direct response to a number of problem situations in international banking. For example, the failure of the Franklin National Bank in the United States marked, for the first time, a situation in which U.S. regulators had to coordinate the closing of a bank with an institution overseas, the Bank of England, since the Franklin National Bank had an overseas presence in London.1 Also, there was the situation of Bank Herstatt, a German bank that believed it could become more profitable by speculating in foreign exchange markets than by conducting the basic business of banking.2 The bank eventually got into so much difficulty that the German regulatory authorities had to close the institution. However, they did so in the middle of the business day, which ended up causing substantial losses for foreign banks on opposite ends of the foreign exchange contract. This occurred because in the United States, for example, banks had remitted their end of the contract in the morning and were waiting to receive instructions in the afternoon about where the counterparty funds were placed. In another U.S. case concerning the San Diego National Bank, the Federal Deposit Insurance Corporation elected not to pay some standby letters of credit that were, in essence, performance guarantees.3 Together these situations raised concerns, and the Group of Ten’s central bank governors thought that someone ought to look more carefully at the conduct of banking business in the international arena.

Two Agendas: Supervision of International Banks and Capital Adequacy

The Basle Committee comprises senior officials of the central banks and supervisory agencies of the Group of Ten (G-10) countries—which consist of Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, the United Kingdom, the United States and Switzerland—as well as Luxembourg. It originally had two specific agendas. The first was to set in place a mechanism to supervise the activities of international banks. The second was to address the unevenness of capital in the international banking systems: in short, to level the playing field.

Finding a way in which to supervise cross-border activities was not that difficult a task. Within six months of its inception in 1974, the Committee had prepared a set of principles that became known as the Concordat.4 At the time, this was not a public document. It was instead a framework describing how the various pieces of bank supervision ought to work in unison. In addition, it delegated certain tasks to the home supervisor and certain tasks to the host supervisor. The latest version of the Concordat incorporates revisions made in 1991.5 In addition, a supplemental paper was issued in 1992 on minimum standards for the supervision of international banking groups and their cross-border establishments.6

The second task, how to arrive at capital standards that were more international in context, took the Committee significantly longer.7 For years, many studies were conducted, all of which ended up with the same result. Each one of the G-10 countries would suggest its own particular approach as the solution. At the same time that the Basle Committee was struggling with this question, the U.S. Federal Reserve was also advocating that an international capital standard be put in place. Furthermore, the United States was planning to revise its leverage approach and move toward a risk-based capital formula. Originally, the United States used a risk-based system to assess capital adequacy in banks. Over time, however, as finer differentiations of risk were made, the examiners abandoned that approach in favor of a leverage approach, which gradually became the policy. It was therefore easy for the United States to return to a risk-based standard conceptually.

Nevertheless, as international banking continued to expand, and as the United States received an increasing number of applications for foreign banks to engage in business, the Board of Governors of the Federal Reserve System became uncomfortable with measuring capital adequacy according to a U.S. standard. As a result, there was a great push in the late 1980s to do two things: to move toward a risk-based capital standard and to resurrect the BIS Committee’s work on international capital standards.

It was difficult to arrive at an international standard despite agreement that the time was right. What made the work move forward was the concept of a two-tiered capital approach that would consist of (i) equity and other hard-core capital accounts in Tier 1 capital and (ii) all other kinds of capital instruments in Tier 2 capital.

Other Issues

Aside from working on the Concordat and the Report on Capital Adequacy, the Basle Committee looked at methods of harmonizing supervisory practices. Here again, no formal rules were established, but rather best practices were determined.

Since 1988–89, the Committee has been working on incorporating market-rate risk into the Basle capital standard because many countries believe it is a significant deficiency that the capital standard fails to incorporate market risk and because other countries believe that the significant growth in off-balance sheet items should be addressed.8

Two incidents showed the need to enhance supervisory cooperation globally. One was the BCCI scandal.9 Clearly, it was a bank that should not have been allowed to grow as large as it did and that should not have operated in as many countries as it did. It called into question the whole Concordat and how supervisors should organize themselves to deal with a bank like BCCI. The second situation occurred in the United States and involved a branch of an Italian bank, Banca Nazionale de Lavoro, which operated in Atlanta among other cities.10 In Atlanta, the branch was making significant unauthorized loans to Iraq using off-book funding (not recorded on the accounts of the bank), which ended up totaling about $2.5 billion.

Foreign banks have a large share of the U.S. market. It has been said that 45 percent of the commercial and industrial loans in the United States are granted by foreign banks.11 That is a very large segment of the market; consequently, legislation was enacted to enhance the supervision of foreign banks operating in the United States.

Authorization

How could the Basle Committee deal with cases like BCCI and Banca Nazionale de Lavoro? First consider authorization. When the Committee looked at the Concordat and drew a road map of who can operate in the international market, under what circumstances, and under whose supervision, it thought it was establishing a number of firm criteria that supervisors could use in assessing whether a bank was operating properly in the international banking market. Nevertheless, the authorization process often hindered communication among supervisors, making the criteria difficult to follow at times. In many countries, bank supervisors do not have the authority to prohibit the expansion of a bank into the international arena. Consequently, when U.S. supervisors write a letter to a country asking whether a bank has the permission of its supervisor to expand internationally, the response may be that the supervisor does not have the competent authority to respond to the letter or to authorize that bank to open an office in the United States.

The issue was starkly raised in the BCCI scandal. BCCI operated in a number of countries, many of which were very concerned because they did not know what supervisors at the Bank of England, in Luxembourg, and in the Cayman Islands were doing. These authorities were most involved in the supervision of BCCI. Other supervisors would have appreciated some forewarning of BCCI’s troubles in order to contain the damage to their own local markets. Furthermore, some foreign governments were doing business with BCCI and, in fact, had their own funds deposited in the local offices of BCCI. This information could not be kept confidential and became a potential problem in that governments might pull funds out of BCCI prematurely and cause a collapse before a solution could be orchestrated. Communication between supervisors is always difficult.

One of the results that derived from a consideration of the BCCI situation was a paper titled “Minimum Standards for the Supervision of International Banking Groups and Their Cross-Border Establishments.”12 Supervisors need to respond to one another more effectively when authorizing banks’ activities across borders. Therefore, as part of the preliminary work on this subject, a questionnaire was sent out to all the G-10 countries. Among other things, this compendium of questions asked host supervisors what information they would like to receive from parent bank supervisors in other countries. Of course, the survey respondents checked all the items offered, indicating that they wanted to know everything that a foreign supervisor could tell. The same question was also posed differently: what was the parent supervisor willing to provide to a host supervisor? Not many items were checked. This is not because supervisors are unwilling to pass along information on an informal basis but because laws protect information derived from the supervisory process.

In the end, the Basle Committee made four proposals for minimum standards for the supervision of international banking groups:

  • All international banking groups and international banks should be supervised by a home-country authority that capably performs consolidated supervision;

  • The creation of a cross-border banking establishment should receive the prior consent of both the host-country supervisory authority and the bank’s and, if different, banking group’s home-country supervisory authority;

  • Supervisory authorities should possess the right to gather information from the cross-border banking establishments of the banks or banking groups for which they are the home-country supervisor;

  • If a host-country authority determines that any one of the foregoing minimum standards is not met to its satisfaction, that authority could impose restrictive measures necessary to satisfy its prudential concerns consistent with these minimum standards, including the prohibition on the creation of banking establishments.13

Sharing of Exam Results

The staff at the Federal Reserve Board has looked carefully at the issue of what information U.S. bank supervisors should be allowed to convey to other supervisors.14 U.S. law now requires supervisors to assess consolidated supervision and prevents supervisors from authorizing a bank to come into U.S. markets, where the supervisor does not practice consolidated supervision.15

Issues have been raised as to whether and to what extent the United States should permit examiners from those jurisdictions that practice on-site supervision to join U.S. bank supervisors in conducting examinations of a branch or agency of a foreign bank operating in U.S. markets. This raises questions about whether they can share examination reports, which are confidential.

Secrecy Jurisdictions

Some supervisors at the BIS meetings continue to question why G-10 banks should be allowed to operate in secrecy jurisdictions. Some of the G-10 members, themselves, are secrecy jurisdictions, raising the fundamental issue of whether supervisors can get satisfactory information in those secrecy jurisdictions.

U.S. bank supervisors have taken the view that, if a bank supervisor cannot provide them with assurances that information can be provided relating to bank safety and soundness and compliance with U.S. law, then the U.S. supervisors would not normally grant the bank a license to do business in the United States. Nevertheless, many U.S. banks find dealing in secrecy jurisdictions to be tax advantageous. In addition, there is considerable legitimate business that is done in those jurisdictions. This question of secrecy and the ability of a bank to withhold information from a legitimate supervisor remain complex.

In the past, supervisors have relied essentially on the bank itself to ensure the legality and safety of activities in those branches. This is not possible any more. Supervisors need to find a way to conduct proper supervision over the whole of a bank’s activities.

Conclusion

The Basle Committee will continue to work at all deliberate speed. Yet, the issues before it raise the question of whether it should quicken its pace.

Each and every country has a renewed interest in bank supervision, because even though the cost of supervision is high, the cost of poor supervision is even higher. International supervisors must ensure that only those banks that have a lender of last resort and an adequate supervisory framework be allowed to do business internationally.

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