The Basel Committee on Banking Supervision, composed of banking regulators from most industrialized countries, issues non-binding recommendations with the intent of harmonizing international capital and liquidity requirements to prevent regulatory arbitrage. The Basel I capital requirements introduced a single risk weight for all types of assets at 8%. This led to inefficiencies as riskier portfolios carried the same risk weight as safer portfolios. Basel II introduced differentiated risk weights and the three pillars: Pillar 1, minimum capital requirements (target at an average 8% including operational risk charge); pillar 2, supervisory review process with stress tests; and pillar 3, market discipline via disclosure. The main drawback of Basel II is the pro-cyclicality introduced by lower risk weights in good times and higher risk weights as asset and equity valuations deteriorate. Basel III aims at addressing these shortcomings by introducing countercyclical, dynamic loan loss provisioning based on expected losses and forcing banks to raise more and higher quality capital. On July 26, 2010, central bank governors and heads of supervision reached a broad agreement on the overall design of the capital and liquidity reform package. On September 6, 2010, news was leaked that the Tier 1 and Tier 2 capital ratio would be raised from its current level of 8% to 16%, although that number can be relaxed when the economy is performing poorly.
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