Eastern Market: The Interaction Between the Basel Committee on International Banking Regulation and the Opening of the Chinese Banking Market

Author:David A. Curtiss
Position:J.D. Candidate, 2009, American University Washington College of Law

I. Introduction. II. Background. A. Capitalization of Assets and Deposit Insurance in International Banking. B. The Basel Committee. 1. Banking Post-World War II: The Rise and Fall of the Bretton-Woods System and the Creation of the Basel Committee. 2. Basel II: The Post-Modern International System and the Complex Modern Financial Risk Assessments which Better Serve Large Multinational Banks. C.... (see full summary)


    David A. Curtiss. J.D. Candidate, 2009, American University Washington College of Law; B.A., Political Science, Gettysburg College. David Curtiss serves as Editor-in-Chief of the American University International Law Review, Volume 24. The author would like to thank Professor Ken Anderson, Professor Jerry Comizio, Andrew Haynes, Vidhi Shah and the entire Volume 23 Note and Comment Editors Board for their invaluable comments on the piece, Geoffrey and Linda Curtiss and Erin for their encouragement and support.

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I Introduction

Since the global currency crisis of the 1970s, the directors of the world’s largest central banks have met in Basel, Switzerland to promulgate international standards governing the global banking system.1 Though the Basel Committee on Banking Supervision (“Basel Committee”) does not have formal legislative power,2 over one hundred nations adopted the first comprehensive Basel Capital Accord (“Basel I”), effectively meaning that the Basel Committee’s regulations govern the global banking sector.3

Now the banking world is moving East, and China’s accession to the World Trade Organization (“WTO”) will lead to the opening of a vast, rich market for banking.4 However, with the emergence of great opportunities in China come the challenges of integrating a growing, newly free-market economy into the international banking market—an essential market which has fueled the economic progress of the West and Japan since the end World War II.5 As the banking world continues to globalize, the Basel Committee must consider the effects of international banking on the Chinese market.6 The Basel Committee’s promulgations are binding international law because the Committee occupies and controls a broad expanse of power and regulation over the international banking sector.7 As the primary international bank regulation, the most recent Basel Committee framework (“Basel II”) fails to sufficiently require capital adequacy requirements and robust deposit insurance as the Chinese banking market opens to the West.8 An institution developed and traditionally staffed by Western banking regulators, the Basel Committee must now grapple with issues presented to banks originating in less developed economies as the next step in the globalization of the banking marketplace.9

Part II of this Comment will describe the need for international banking regulation,10 the historical impetus and development of the Basel International Banking Regulations,11 and the current banking sector in China.12 Part III of this Comment will argue that Basel is binding customary international law,13 analyze the effect that the implementation of soft capitalization requirements will have on the Chinese banking sector,14 and consider China’s competitive disadvantage due to the existence of non-performing loans..15 Part IV of this Comment will recommend that the Basel Committee update its regulations in order to confront the unique problems Chinese banks will pose to the global banking sector.16 Finally, Part V will conclude that the Basel Committee should act with conclusive legal force to strengthen capitalization requirements and ensure strong deposit insurance requirements worldwide.17

II Background

The international banking system has developed into an integrated global system since World War II.18 Since the creation of this global market, banks have evolved from simple institutions for consumer and corporate deposits and lending to large investment institutions with complex asset and liability portfolios.19 The unique characteristics of the Chinese market pose new challenges to multinational banks as they enter the market.20

A Capitalization of Assets and Deposit Insurance in International Banking

In their most basic form, banks are institutions that take deposits and issue loans.21 A depositor gives the bank its money with the understanding that he will be able to retrieve that money; the bank then invests that money in assets, usually loans.22 A bank makes a profit by assessing the repayment risk of loans, but it must retain some capital to ensure solvency and the ability to return deposits to customers on demand.23

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In a theoretical free market, the percentage of capital necessary can be determined by the market, because investors would only deposit funds if a bank’s capitalization ratio was not overly risky.24 However, banks have become an essential part of the global financial infrastructure and of the daily life of most citizens of the industrialized world.25 A complex regulatory framework governs banks to protect them from failure and to protect citizens’ deposits in case of failure.26 Effectively, the risk of bank failure rests squarely on the government because government sponsored insurance programs (the Federal Deposit Insurance Program (FDIC) in the United States) protect virtually all deposits.27 The insurance of bank deposits has become a necessary part of an increasingly complex financial system.28 However, with the insurance of deposits, governments also regulate the capitalization of bank assets.29

Critics suggest that the issuance of deposit insurance by governments removes the market constraint which prevented banks from investing in overly risky enterprises.30 If a bank now loses depositors’ money in the process, the government insurance will pay the depositors.31 As a result, experts argue that with insurance there is no longer a market incentive for depositors to choose their banks based on risk.32

Governments solve this problem by mandating that banks retain a certain proportion of their assets with no risk of loss (capitalize) and by regulating the investment risks banks take with their assets.33 As the banking business globalizes, the central banking institutions responsible for regulating banks in specific nations recognize the potential for abuse if these regulatory requirements do not also globalize.34 For example, critics suggest that changing national regulations could leave domestic banks vulnerable to threat from countries with perceived or actual favorable regulations; and, nations with those advantages would be remiss to change their regulations absent a destabilizing crisis in the banking sector.35

B The Basel Committee

The central bankers from the largest ten banking nations recognized the need for international unity in bank regulation, establishing the Basel Committee to promulgate international regulations and to close gaps created by differing standards across national borders.36 The Basel Committee creates regulations by consensus and implements them through the authority of its members.37 Its stated purpose is “to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide.”38

The modern banking system has its roots in the aftermath of the market-dominated West winning global wars against totalitarianism, rebuilding a battered continent, and encouraging the reemergence of European economic power.39 Critics suggest that the current banking system will be challenged with the rising incorporation of developing nations to the global system, such as a decreasingly controlled Chinese market.40

1. Banking Post-World War II: The Rise and Fall of the Bretton-Woods System and the Creation of the Basel Committee

Initially following World War II, the Bretton-Woods system tied U.S. dollars to gold and most world currencies to the dollar, creating a stable environment for the United States to lead the rebuilding of Western Europe.41 However, as European nations regained economic power and U.S. investment in foreign companies grew, the Bretton-Woods system began to break down.42 Powerful European nations created a Eurodollar market, which put the defined value of the dollar into question by allowing it to be traded in the open market.43 Currency exchange disabled the Bretton-Woods system, and the need for an internationally governable system to replace the dollar-centric gold standard became apparent.44

In 1988, the Basel Committee created a formulaic structure for international banks to regulate their risk and retain necessary capital assets (“Basel I”).45 The preliminary framework required capitalization of assets at eight percent of value, adjusted for risk based on categorization of similar assets.46 In other words, Basel I required banks to discount the value of less-risky assets before calculating their capitalization requirement.47 The Basel I framework required that assets subject to market risk be categorized based on the...

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