Although I have dealt with a number of enquiries regarding Basel II, it is one of those areas that I have never understood in great detail, so I was especially pleased when Katie McCaw agreed to run a seminar on the topic. About 30 people gathered at Baker & McKenzie to learn more.

Katie explained that the talk was designed to demystify Basel II, one of the most technical pieces of banking regulation, and explain the basics of capital adequacy regulation through asking a series of questions.

What is the Basel Accord?

Katie pointed out that it is important to note that Basel II is an agreement among international bank regulators that is designed to regulate the levels of capital to be held by banks (and other banking-type institutions such as building societies and EU investment firms) relative to their risks (in this case, credit, market and operational risks). These international bank regulators are made up of the central bank governors of the G10 countries, plus the EU and their agreements are reached under the auspices of the Basel Committee on Banking Supervision which is based in Basel in Switzerland.

The importance of the original Basel Accord of 1988 (now being known as Basel I), which is still in effect, is that it set a ratio of capital to risk-weighted assets of a minimum 8%. Risk-weighted assets must be expressed as a sum in £ and so a simple calculation is required to express that amount:

Amount of loan X Risk-weight X 8% = the capital required to be held against any given loan

Various examples were shown using some of the Basel I risk-weights of 100% and 50% and Katie explained that one of the most significant differences between Basel I and Basel II is the risk-weighting treatment of corporate loans, which was used as an example throughout the talk. This example was very clear, and using it throughout the talk made it easy to visualise the facts we were hearing being applied to a real situation.

Basel I has become a global standard since 1988 and so the next question was:

“Why Basel II?”

Basel I is now 17 years old and various market developments since 1988 in terms of product innovation, deal structuring, risk mitigation techniques and the use of increasingly sophisticated derivatives instruments led to a need for a more sophisticated way of allocating capital to risks.

Basel II will allow more sophisticated banks to set their own risk weights for each individual loan, while less sophisticated banks will use a Basel I-like measurement. While the 8% capital ratio remains under Basel II, this makes up just one “pillar” of Basel II, which is based on three mutually reinforcing “pillars”. Pillar 1 comprises the minimum capital requirements of Basel II. The other 2 pillars are equally as important and relate to supervisory disclosure and market discipline respectively. Katie explained, however, that the talk would focus on the minimum capital requirements of Pillar 1, as the most significant changes in capital calculations from Basel I are contained in Pillar 1 of Basel II.

How and when will Basel II be implemented?

While the “final” Basel II rules were released on 26th June 2004 (a Saturday!), further amendments are still being made to the framework. A staggered implementation in most jurisdictions is expected, with the first stage of implementation taking place on 1 January 2007 and the second stage on 1 January 2008. The vast majority of countries around the world are expected to implement Basel II into local regulatory rules and legislation (as they did Basel I) as it provides the most stable set of capital rules. Katie explained, however, that Basel II has no legal force. This led us to the next question of “Why do lawyers care?!”.

We care because Basel II will, like Basel I, have legal effect within Europe. The EU will adopt Basel II and transpose it into a Directive. In fact, there are two Directives, both of which will be re-cast: the Banking Consolidation Directive and the Capital Adequacy Directive. Each of the 25 member states will be required to transpose (at least part of) the Directives into national law by 1 January 2007.

How will Basel II apply in the UK?

The UK Financial Services Authority (FSA) will amend certain parts of the Handbook of Rules and Guidance to take account of the new Directives which will provide the legal basis for the new Handbook text. Three new Handbooks are expected to replace the existing “Interim” prudential sourcebooks for banks, building societies and insurance firms; these will be the General Prudential Sourcebook (GENPRU), the Banking Prudential Sourcebook (BIPRU) and the Insurance Prudential Sourcebook (INSPRU).

Katie brought along copies of the supporting materials to show us, and the complexity of the subject was brought home to us by the fact that she needed a large cardboard box in which to carry the hefty volumes.

The seminar rounded off with a review of the key points and a number of questions from the audience who were, by this time, in need of a large glass of wine!

Katie's presentation was extremely clear and thorough, and gave us a much deeper understanding of the Basel II agreement and the issues surrounding it.

Katie would like to thank Susanna Winter for the superb organisation of the seminar.