During the development of the first capital accord it was determined that the main risk of a bank is credit risk. This is the risk that those who have to repay their loans to the bank, don’t. The maximum credit loss that a bank can suffer is equal to the value of all its outstanding loans and investments. This will never occur because it means that all the banks customers will have to go broke. Based on experience it was determined that no more than 8% of the amount of money lend to customers would fail in the most extreme circumstances. In other words 8% of regulatory capital should be present for the banks outstanding loans.

Because some loans have very secure collateral it was allowed to subtract some forms of collateral from the loan amount (outstanding amount) under BIS1. If an outstanding amount was three million and there was one million of cash collateral, the net loan over which capital should be calculated was two million. Furthermore some customers and loan types were considered less risky. For this reason these loans were risk weighted. Home mortgages are for instance rather save investments. For this reason these mortgages (under some conditions) are weighed at 50%. This means that a mortgage of two million is weighed at 50%. Thus regulatory capital must be retained for one million. This leads to a regulatory capital of 80,000 (8% of one million).

This system has a rather course risk sensitivity. Consider the following two corporate loans.
1. A corporate loan of two million to a multinational AA corporation, fully collateralized by machinery.
2. A corporate unsecured loan of two million to a paper company (no actual assets or income production capacity) in a tax haven.
In the BIS1 system an equal amount (160,000) of capital has to be retained for both deals, even though it is plain to see that the second loan is much riskier than the first.

BIS2 aims to improve the regular capitals sensitivity to the actual risk and to incorporate more risks than just credit risk.

A full description of BIS1 including all the rules for subtracting collateral and risk weighting assets is available in the BIS1 paper.

Author: Muller, J.J.