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Risk Management and Financial Institutions, + Web Site, 3rd Edition by John C. Hull

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CHAPTER 12

Basel I, Basel II, and Solvency II

An agreement in 1988, known as the Basel Accord, marked the start of international standards for bank regulation. Since 1988, bank regulation has been an evolutionary process. New regulations have modified previous regulations, but the approaches used in previous regulations have usually been preserved. In order to understand the current regulatory environment, it is therefore necessary to understand historical developments. This chapter explains the evolution of the regulatory environment prior to the 2007 credit crisis. Chapter 13 will cover developments since the crisis.

This chapter starts by reviewing the evolution of bank regulation between the 1980s and 2000. It explains the 1988 Basel Accord (now known as Basel I), netting provisions, and the 1996 Amendment. It then moves on to discuss Basel II, which is a major overhaul of the regulations and was implemented by many banks throughout the world in about 2007. Finally, it reviews Solvency II, a new regulatory framework for insurance companies, which is broadly similar to Basel II and is expected to be implemented by the European Union in 2013.

12.1 THE REASONS FOR REGULATING BANKS

The purpose of bank regulation is to ensure that a bank keeps enough capital for the risks it takes. It is not possible to eliminate altogether the possibility of a bank failing, but governments want to make the probability of default for any given bank very small. By doing this, they hope to create ...

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