BIS Rule

The BIS Rule (BIS 자기자본비율규제) or the Basel Accords mean the banking supervision accords (recommendations on banking regulations) — Basel I, Basel II and Basel III — issued by the Basel Committee on Banking Supervision (BCBS) under the Bank for International Settlements (BIS, 국제결제은행).

The BIS requires the capital/asset ratio regulated by member central banks to be above a prescribed minimum international standard (i.e., eight percent for Basel I), for the protection of global banking system. The BIS's main role is in setting capital adequacy requirements, or prudential requirements, which became the powerful instrument of financial supervisory authorities.

Key words
BIS ratio, capital adequacy, prudential requirements, soft law

Legal effect
The Basel Committee does not have the authority to enforce recommendations, although most member countries as well as some other countries tend to implement the Committee's policies. This means that the BIS recommendations are enforced through national (or EU-wide) laws and regulations, rather than as a result of the committee's recommendations. So the BIS Rule is usually called as "soft law".

In Korea, the capital adequacy ratio is stipulated in Article 10 (Prompt Corrective Action)(1) of the Act on the Structural Improvement of the Financial Industry. In defining an "insolvent financial institution", the evaluation and assessment of liabilities and assets are subject to the standards predetermined by the Financial Services Commission (FSC), or the FSC notification in accordance with Paragraph 2 Article 2 (Definitions) of the same Act.

In this regard, the Constitutional Court ruled a constitutional appeal groundless that the prompt corrective action mandated by the FSC subject to the said FSC notification in compliance with the BIS Rule had been beyond the scope of the administrative legislation delegated by the Act, and accordingly illegal.

Basel I
In 1988, the Basel Committee (BCBS) published the Report on International Convergence of Capital Measurements and Capital Standards, known as the 1988 Basel Accord, which was enforced by law in the Group of Ten (G-10) countries in 1992. Basel I is now outmoded and superseded by Basel II and III, because financial conglomerates, financial innovation and risk management response to the financial crisis have developed.

Basel I primarily focused on credit risk. Assets of banks were classified and grouped in five categories according to credit risk, carrying risk weights of zero (e.g., home country sovereign debt), ten, twenty, fifty (e.g., residential house-mortgaged loan), and up to one hundred percent (e.g., corporate debt). Banks with international presence are required to hold capital equal to 8 percent of the risk-weighted assets.

Since 1988, this framework has been progressively introduced in G-10 member countries and other countries, currently numbering over 100, though the principles prescribed under Basel I and the efficiency with which they are enforced varies within the G-10 member countries.

Basel II
Basel II is the second of the Basel Accords, now extended and effectively superseded by Basel III. Basel II, initially published in June 2004, was intended to create an international standard for banking regulators to control how much capital banks need to put aside to guard against the types of financial and operational risks.

One focus was to maintain sufficient consistency of regulations so that this does not become a source of competitive inequality amongst internationally active banks. In theory, Basel II attempted to accomplish this by setting up risk and capital management requirements designed to ensure that a bank has adequate capital for the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability.

Basel II uses a "three pillars" concept – (1) minimum capital requirements (2) supervisory review and (3) market discipline. Compared with Basel I, the Basel I accord dealt with only parts of each of these pillars.

The first pillar
The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk, and market risk. Other risks are not considered fully quantifiable at this stage.

The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach, Foundation IRB and Advanced IRB. IRB stands for "Internal Rating-Based Approach". For operational risk, there are three different approaches - basic indicator approach (BIA), standardized approach (STA), and the internal measurement approach (an advanced form of which is the advanced measurement approach or AMA). For market risk the preferred approach is VaR (value at risk).

As the Basel 2 recommendations are phased in by the banking industry it will move from standardised requirements to more refined and specific requirements that have been developed for each risk category by each individual bank. The upside for banks that do develop their own bespoke risk measurement systems is that they will be rewarded with potentially lower risk capital requirements. In future there will be closer links between the concepts of economic profit and regulatory capital.

Credit Risk can be calculated by using one of three approaches: 1) Standardised Approach, 2) Foundation IRB, 3) Advanced IRB Approach.

The standardized approach sets out specific risk weights for certain types of credit risk. The standard risk weight categories used under Basel 1 were 0% for government bonds, 20% for exposures to OECD Banks, 50% for first line residential mortgages and 100% weighting on consumer loans and unsecured commercial loans. Basel II introduced a new 150% weighting for borrowers with lower credit ratings. The minimum capital required remained at 8% of risk weighted assets, with Tier 1 capital making up not less than half of this amount.

Banks that decide to adopt the standardised ratings approach must rely on the ratings generated by external agencies. Certain banks used the IRB approach as a result.

The second pillar
The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk and legal risk, which the accord combines under the title of residual risk. It gives banks a power to review their risk management system.

Internal Capital Adequacy Assessment Process (ICAAP) is the result of Pillar II of Basel II accords

The third pillar
This pillar aims to complement the minimum capital requirements and supervisory review process by developing a set of disclosure requirements which will allow the market participants to gauge the capital adequacy of an institution.

Market discipline supplements regulation as sharing of information facilitates assessment of the bank by others including investors, analysts, customers, other banks and rating agencies which leads to good corporate governance. The aim of pillar 3 is to allow market discipline to operate by requiring institutions to disclose details on the scope of application, capital, risk exposures, risk assessment processes and the capital adequacy of the institution. It must be consistent with how the senior management including the board assess and manage the risks of the institution.

When market participants have a sufficient understanding of a bank’s activities and the controls it has in place to manage its exposures, they are better able to distinguish between banking organisations so that they can reward those that manage their risks prudently and penalise those that do not.

These disclosures are required to be made at least twice a year, except qualitative disclosures providing a summary of the general risk management objectives and policies which can be made annually. Institutions are also required to create a formal policy on what will be disclosed, controls around them along with the validation and frequency of these disclosures. In general, the disclosures under Pillar 3 apply to the top consolidated level of the banking group to which the Basel II framework applies.