Settlements (BIS) guide- lines, known as the Basel rules. Although the BIS is not a regulatory body per se and its pronouncements carry no legislative weight, to maintain investors and public confidence national authorities endeavor to demon- strate that they follow the Basel rules at a minimum. The purpose of this chapter is to outline the main elements of the Basel rules, which are in the process of being updated and modernized as Basel II. Money market participants are cognizant of the basic tenets of the rules, so as to optimize their asset allocation as well as their hedging policy. Derivatives for instance require a significantly lower level of cap- ital allocation than cash products, which (along with their liquidity) is a primary reason for their use as hedging instruments. In addition, the credit quality of a banks counterparty also affects significantly the level of capital charge, and regulatory rules influence a banks lending policy and counterparty limit settings. All banks have internal rules dictating the extent of lending, across all money market products, to their coun-     297     terparties. Capital allocation, targeted rates of return (which are a func- tion of capital costs), and extent of counterparty risk aversion all dictate the extent to which funds may be lent to counterparties of various credit ratings. This chapter reviews the main aspects of the capital rules and also introduces the Basel II proposals, and how credit risk exposure deter- mines the extent of capital allocation. It also indicates the interplay between the money market desk and longer-term traders whose capital allocation requirements are greater. This will enable the money market participant to place his/her operations in the context of banking specifi- cally and capital markets business generally.       BANKING REGULATORY CAPITAL REQUIREMENTS   Banks and financial institutions are subject to a range of regulations and controls, a primary one of which is concerned with the level of capital that a bank holds, and that this level is sufficient to provide a cushion for the activities that the bank enters into. Typically an institution is subject to regulatory requirements of its domestic regulator, but may also be sub- ject to cross-border requirements such as the European Unions Capital Adequacy Directive.1A capital requirements scheme proposed by a com- mittee of central banks acting under the auspices of the Bank for Interna- tional Settlements (BIS) in 1988 has been adopted universally by banks