Something I’ve been curious about – and I think deserves more attention – are the Basel accords.  

From what I know up front, there are two and provide guidelines for capital requirements for banks.  And that Basel is in Switzerland.

The second Basel agreement is more pertinent, yet still only recommendations.  It provides recommendations for capital adequacy…sound relevant?  

-side note – banks in Europe have more of a liberal accounting system, with the ability to write off non-performing assets to look like they’re profitable (e.g. Deutsche Bank in 4Q07 I believe, maybe 1Q08).  

Sparing myself from reading 350 pages, there are three pillars of the agreement: capital allocation is more risk sensitive, separating operational risk from credit risk, and align economic and regulatory capital to reduce the possibility of regulatory arbitrage.

Let’s look at the first pillar for now (as I don’t have the focus after work for all three at once!) – capital allocation being more risk sensitive – it outlines capital adequacy for credit, operational and market risk.  It also aligns itself with a minimum capital requirement.  When banks take deposits and turn it around for investments, they can choose investments or loans, and the Basel accord rates this on a scale from least to most risky, starting with government bonds at 0%, OECD countries at 20%, mortgages at 50%, commercial loans at 100% and now something new – subprime borrowers at 150%.  The minimum capital requirement that the Basel accord lays out is 8% with the risk weighted assets.  I believe this is to encourage banks to even out their risk – but I wonder why there isn’t a maximum.  Perhaps I’m not understanding this fully.  Lastly – the first pillar says that banks basically can evaluate credit risk by their own means: the “Standard Approach”, or the foundation/advance “Internal Ratings Based Approach.” 

So returning to that side note – the IRB approach? huh? so you have the power to rate your own credit risk, even right it down so much that you create the illusion to have a profit?  I hope this approach is moderated…or at least looked after.

next to come: pillar 2 of the 2nd Basel accord.