This blog post examines why the Basel Committee’s BIS ratio regulation is widely followed by the global financial sector despite lacking legal binding force, exploring the reasons and background from the perspective of financial stability and trust.
In international law, treaties are generally norms created when states or international organizations explicitly agree on specific rights and obligations they must uphold among themselves. Such treaties play a crucial role in regulating relations between states and maintaining peace and stability. Particularly, because treaties are voluntarily agreed upon and drafted by the parties, they possess strong legal binding force, and their implementation significantly impacts trust between nations. For this reason, treaties serve as an important means to prevent and resolve disputes between states.
Customary international law consists of universal norms accepted and observed by the international community at large, irrespective of treaty formation. These customary norms have been recognized and maintained within the international community over an extended period, with states adhering to them even without specific documents or treaties. For instance, norms such as diplomatic immunity or freedom of navigation on the high seas are accepted as customary law by most states, and violating them can lead to international condemnation. Such customary law forms the foundation of international law and, alongside treaties, plays a crucial role in maintaining the legal order of the international community.
On the other hand, decisions made by international economic organizations generally have only advisory effect and lack legal binding force. As the importance of international cooperation on economic issues has grown, various international organizations have emerged to promote cooperation and regulation among states. However, decisions made by these organizations are primarily based on voluntary agreements among member states and thus lack legal binding force. Each nation can choose whether to apply them according to its own circumstances. Recently, however, such recommendations have increasingly taken on a normative character within the international community, meaning that even non-legally binding norms are exerting practical effects.
Yet, we often observe that regulations like the BIS capital ratios decided by the Basel Committee under the Bank for International Settlements are strictly adhered to even by non-member countries. This demonstrates that international financial regulations have evolved beyond mere recommendations to become crucial norms maintaining the stability of the global financial system. Considering the devastating impact financial crises can have on the global economy, such international regulations have established themselves as essential tools for promoting global economic stability through inter-state cooperation.
There is discussion on how to understand this reality, which exhibits a kind of normative character. This prompts reflection on the general tendency to focus on securing the effectiveness of international law through sanctions for violations. Specifically, it draws attention to the binding force that trust creates. Trust within the international financial system is an essential element for cross-border transactions and investments, directly linked to economic stability. This normative binding force based on trust demonstrates that even non-legally binding norms, such as treaties, can exert powerful effects in practice.
The BIS ratio was introduced by the Basel Committee to set the minimum capital adequacy ratio necessary for maintaining a bank’s financial soundness, ultimately protecting depositors and the financial system. This regulation serves as a crucial benchmark for assessing how well a bank can withstand economic shocks and is considered an essential safeguard for preventing financial crises. The Basel Committee has established a standard that the BIS ratio should be at least the regulatory minimum of 8%. The formula is as follows:
Here, capital is the sum of a bank’s Tier 1 capital, Tier 2 capital, and short-term subordinated debt. Risk-weighted assets are calculated as the sum of the values obtained by multiplying each held asset by its respective risk weight for credit risk. Risk weights reflect the credit risk associated with each asset type; for OECD countries, government bonds were uniformly assigned a 0% weight, while corporate bonds received a 100% weight. Subsequently, as demands grew to also reflect market risk arising from price fluctuations in financial assets, the Basel Committee redefined risk-weighted assets as the sum of components reflecting credit risk and market risk, mandating their use in calculating the BIS ratio. Unlike for credit risk, the method for measuring market risk was left to the bank’s choice, subject to supervisory approval, leading to the completion of the Basel I Accord in 1996.
However, as the limitations of Basel I became apparent, Basel II was introduced in 2004 to accommodate financial innovation. Under Basel II, the risk-weighted assets for the BIS ratio were modified to consider both the type of asset and its credit quality when applying risk weights for credit risk. Banks could choose to use either the Standardized Approach or the Internal Ratings-Based Approach for measuring credit risk. Under the standard model, OECD government bonds receive risk weights ranging from 0% to 150%, while corporate bonds receive weights from 20% to 150%, with higher credit quality resulting in lower weights. For example, if a bank holds KRW 10 billion in corporate bonds with a 20% credit risk weight, those bonds would be calculated as KRW 2 billion in risk-weighted assets. Internal models allow banks to use their chosen risk measurement methods under supervisory approval. Supervisors can also require domestic banks to maintain a minimum capital ratio exceeding the regulatory ratio for risk-weighted assets when necessary, thereby supplementing rigid capital standards.
Recently, with the introduction of Basel III, short-term subordinated debt was excluded from capital. Furthermore, the ratio of core capital to risk-weighted assets was supplemented to ensure a minimum of 6%, thereby strengthening the loss-absorbing capacity of capital. Thus, the newly announced Basel Accord effectively amends the relevant standards contained in the previous accord. These changes are part of efforts to respond to the rapid evolution of the international financial environment and the increasing complexity of the financial system.
The Basel Accord has been adopted and institutionalized by numerous countries, including Korea. Currently, financial authorities from 28 countries are members of the Basel Committee. Korea’s financial authorities joined in 2009. However, Korea had already introduced and implemented the BIS ratios long before joining, and this is reflected in its current legislation. By adhering to Basel standards, Korea needed to demonstrate to international financial markets that its banks were reliable. Banks whose financial soundness is questioned may struggle to establish a foothold in international financial markets or, in severe cases, may be barred from entering altogether.
The Basel Committee consults and establishes banking supervision standards. Its charter imposes an obligation on members to adopt the Basel standards domestically. However, it also explicitly states that the Basel Committee lacks supranational supervisory authority and that its decisions are not legally binding. The Basel standards are adopted and followed by over 100 countries. This means they are voluntarily accepted and implemented even in countries not formally bound by international organization decisions, a reality sometimes described as the nature of soft law. In contrast, treaties or customary international law are termed hard law. The Basel standards may themselves solidify into hard law in the future.
