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Capital Requirements Directive

The Basel Committee on Banking Supervision was formed by Central Bankers of the then G-10 nations in 1974 in a response to the liquidation of Herstatt Bank by German regulators. The bank was liquidated before a series of deutschmark / US$ trades had been completed, leaving an assortment of international banks waiting for their US $ payments, hence the widely used term, “Herstatt risk” to describe settlement risk.

The Basel Committee promulgated a set of minimum capital requirements for banks with a view to making bank insolvencies less likely and to establishing a common approach to risk supervision across their members. This became known as the 1988 Basel Accord, and was enforced by law in G-10 countries in 1992. Assets of banks were classified and grouped in five categories, depending on their risk weighting. Banks with an international presence are required to hold capital equal to 8% of their risk-weighted assets (RWA).

The Basel Committee supplemented and updated Basel I in a series of changes from 2004-2009. This became known as Basel II. Basel II introduced created more detailed methodology to measure a bank’s capital base, including the three pillars concept of minimum capital requirements (addressing risk), (2) supervisory review and (3) market discipline.

Basel II in turn was criticised following the Financial Crisis and in particular the collapse of Lehman Brothers and Bear Stearns. In response, the Basel Committee introduced a series of further reforms, known as Basel III. Basel III is intended to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage. Unlike Basel I and Basel II, which focus primarily on the level of bank loss reserves that banks are required to hold, Basel III focuses primarily on the risk of a Lehman style run on the bank by requiring differing levels of reserves for different forms of bank deposits and other borrowings.

Basel III does not, for the most part, supersede Basel I and Basel II; rather, it will work alongside them. Within the EU, the Basel accords have been implemented by the Capital Requirements Directive (s). The latest, Capital Requirements Directive 4 (CRD IV) is intended to implement the Basel III agreement and will include enhanced requirements for the quality and quantity of capital; measuring liquidity risk and leverage, rules for counterparty risk.

Additionally, CRD IV also makes changes to rules on corporate governance, including remuneration and in the UK has led to the introduction of the Remuneration Code.

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