The Regulatory Framework: Basel, Solvency II, and the Lessons of 2008

Capital adequacy regulation is the institutional translation of a statistical problem. Society needs banks to stay solvent through financial storms; the regulatory answer is to require them to hold equity capital large enough to absorb the losses that could materialise at some tail quantile of their loss distribution. What quantile? What horizon? How should exposures be aggregated across risk types? The answers to these questions — encoded in the Basel Accords for banks and Solvency II for European insurers — have shaped the demand for quantitative risk models since the mid-1990s.

This note traces that institutional history: from Basel I's crude risk-weight buckets to Basel III's Expected-Shortfall-based trading-book charge, and from Solvency I's volume-based rules to Solvency II's internal-model-based SCR. It then analyses the 2007–9 financial crisis as a case study in what happens when regulatory incentives and model assumptions interact badly.

• describe the Basel three-pillar concept (Pillar 1: capital charges, Pillar 2: supervisory review, Pillar 3: disclosure);
• explain what a risk-weighted asset is and how the capital ratio is computed;
• contrast the standardised approach and the IRB approach to credit risk capital;
• state the Basel market risk capital charge: 99% ten-day VaR, multiplied by a scaling factor;
• describe the Solvency II solvency capital requirement (SCR) and how it differs from the Basel framework;
• identify at least three mechanisms by which regulatory design amplified the 2007–9 crisis;
• explain what "regulatory capital arbitrage" means and give one concrete example.

1. 1. The purpose of prudential regulation
2. 1. The Basel framework
3. 1. The Solvency II framework
4. 1. The lessons of 2007–9