How have the Basel Accords evolved to respond to crises?

Alright, no problem. Imagine you and I are sitting in a coffee shop, and I'm going to walk you through what the "Basel Accords" are all about, and how they've evolved step by step, overcoming challenges along the way.

The Evolution of the Basel Accords: A History of "Patching" in Response to Crises

You can imagine the global banking system as a vast, interconnected ecosystem. And the Basel Accords are essentially a set of "health guidelines" formulated by a group of the world's top "financial doctors" (central banks and regulatory authorities) for the main players in this system – banks.

The goal is simple: don't let banks get out of control, collapse themselves, and ultimately drag all of us down with them.

These guidelines aren't static; they've undergone three major upgrades, with almost every upgrade prompted by a painful financial crisis.

1. Basel I: Where the Dream Began (1988)

• Context: In the 1980s, many large international banks lent too much money to Latin American countries. When these countries couldn't repay, banks accumulated a huge amount of bad debt, almost triggering a global crisis. Everyone was scared and felt that banks needed some rules.

• Core Idea: Simple and crude, but effective. The Accord stipulated a core metric: the Capital Adequacy Ratio (CAR). You can understand it this way: for every 100 units of money a bank lends out, it must hold at least 8 units of its "own money" (i.e., capital). These 8 units act as the bank's "safety cushion." If the lent money can't be recovered, these 8 units are used first, making depositors' money relatively safer.

• The Problem? This rule was too "one-size-fits-all." It didn't matter if the 100 units were lent to a nearly zero-risk entity like a government or to a startup with an uncertain future. In the eyes of the rules, the risk was the same. This was clearly unreasonable, and banks felt constrained.

2. Basel II: From "One-Size-Fits-All" to "Refined Management" (2004)

• Context: The financial world became increasingly complex, with various dazzling financial derivatives being invented. Bankers felt Basel I was too outdated and couldn't keep up. They hoped to use more scientific models to measure risk.

• Core Idea: Introducing the concept of "risk" and establishing "three pillars".

  1. Minimum Capital Requirements (Refined): This was an upgraded version of Basel I. It was no longer one-size-fits-all; instead, it stated: "To whom you lend money, and how much risk is involved, determines how much 'safety cushion' you need to prepare." Higher risk meant a thicker 'safety cushion.' It even allowed large banks to use their own internal "advanced models" to calculate risk, which sounded very scientific, didn't it?
  2. Supervisory Review: This was like putting a "tightening spell" on regulators. Regulators could periodically examine banks, and if they felt a bank's risk models were too optimistic or its management was inadequate, they could compel the bank to increase its "safety cushion."
  3. Market Discipline: Required banks to "disclose information." How much risk you had, and how thick your "safety cushion" was, had to be publicly disclosed to the market. This allowed investors, depositors, and other banks to supervise you, putting pressure on you to prevent reckless behavior.

• The Problem? The 2008 Global Financial Crisis delivered a resounding slap to Basel II. It proved that:

  • Banks' own "advanced models" were completely unreliable; they severely underestimated the risk of products like US subprime mortgages.
  • The Accord only focused on whether individual banks would fail, but it didn't consider "systemic risk" – if one large bank collapsed, it could trigger a domino effect, bringing down many others.
  • It overlooked a fatal issue: liquidity. A bank might appear wealthy on paper (assets greater than liabilities), but if all that money was tied up in long-term loans, and it didn't have enough cash on hand to meet daily depositor withdrawals, it could still collapse instantly. Lehman Brothers died this way.

3. Basel III: "Mending the Fold After the Sheep Are Lost" Post-Crisis (2010-Present)

• Context: The painful lessons of the 2008 financial tsunami. The global economy nearly collapsed, and everyone realized that banks needed a "major overhaul."

• Core Idea: A thicker, higher-quality "safety cushion," and the introduction of "liquidity" as a lifeline.

  1. Dual Enhancement of Capital Requirements: Quality and Quantity: Not only was a thicker "safety cushion" required (higher capital adequacy ratio), but also a better quality "safety cushion." It had to be solid "hardcore capital" like common equity, not flashy instruments that become useless in a crisis.
  2. Introduction of Two Key "Liquidity" Metrics (Crucial!): These were entirely new and the most important patches.
     • Liquidity Coverage Ratio (LCR): Mandates banks to hold enough high-quality liquid assets (e.g., government bonds) that can be readily converted into cash, ensuring they can survive for 30 days even under extreme stress (e.g., a massive bank run). This is like a household being forced to save a month's worth of emergency living expenses.
     • Net Stable Funding Ratio (NSFR): Requires banks' "long-term assets" (e.g., five-year loans) to be supported by "stable long-term funding" (e.g., depositors' time deposits). You cannot use short-term funds that are due tomorrow to make long-term loans. This is like not being able to buy a house with a credit card loan; the risk is too high.
  3. Introduction of the Leverage Ratio: This is a simple, blunt metric to prevent banks from "inflating" their balance sheets. Regardless of how safe your risk models calculate things to be, your total asset size cannot exceed a certain multiple of your core capital. This adds a "fuse" to the complex risk models of Basel II.
  4. Focus on "Too Big to Fail" Banks: Higher additional capital requirements were imposed on Globally Systemically Important Banks (G-SIBs) (e.g., JPMorgan Chase, China's major banks). The message is: "You're big, your collapse would have a huge impact, so your 'safety cushion' must be thicker than others!"

In Summary

The evolution of the Basel Accords is like a history of software upgrades, constantly being patched:

• Basel I was version 1.0, simple in function, only concerned with sufficient capital.
• Basel II was version 2.0, introducing risk weights, becoming smarter but with serious vulnerabilities.
• The 2008 Global Financial Crisis was an epic "hacker attack" that caused the 2.0 system to completely crash.
• Basel III is version 3.0; it fixed the vulnerabilities of 2.0, not only strengthening the original capital requirements but also adding new "liquidity" firewalls and "leverage ratio" antivirus software, specifically designed to combat "too big to fail" systemic viruses.

The entire process is a "cat and mouse game" between regulation and risk. Each crisis exposed the shortcomings of old rules, leading to the creation of stricter, more comprehensive new rules, all aimed at making the financial world operate more steadily.