Saturday, September 24, 2011

Basel Accords for Banks- Basel I

What are Basel Accords?

The Basel Accords  refer to the banking supervision Accords (recommendations on banking laws and regulations) -- Basel I and Basel II issued and Basel III -- by the Basel Committee on Banking Supervision (BCBS). They are called the Basel Accords as the BCBS maintains its secretariat at the Bank for International Settlements in BaselSwitzerland and the committee normally meets there.

Background for formation of  Basel Committee:

The Committee was formed in response to the messy liquidation of a Cologne-based bank (Herstatt) in 1974. On 26 June 1974, a number of banks had released Deutsche Mark (German Mark) to the Bank Herstattin exchange for dollar payments deliverable in New York. On account of differences in the time zones, there was a lag in the dollar payment to the counter-party banks, and during this gap, and before the dollar payments could be effected in New York, the Bank Herstatt was liquidated by German regulators.

This incident prompted the G-10 nations to form towards the end of 1974, the Basel Committee on Banking Supervision, under the auspices of the Bank of International Settlements (BIS) located in Basel,Switzerland.

Basel Committee on Banking Supervision:(BCBS)

The Basel committee on banking supervision is a committee established by the Central Bank governors of the G10 Member countries in 1975.  It consists of senior representatives of Bank supervisory authorities and central Banks from Belgium, Canada, France, Germany, Italy, Japan, Luxemburg, Netherlands, Sweden, Switzerland, the United Kingdom and the United States.  

The committee normally meets once in three months at the Bank for International Settlements in Basel. 

The Basel committee provide broad policy guidelines that G10 member country’s Central Bank can use to determine the supervisory policies and regulations they impose on the Banks in their domain.  The guidelines prescribed by the committee are not binding, but they are generally adopted by supervisors (Central Banks/Government) world wide.  As the formulation of Basel committee is the brain child of G10 member countries and the representatives of G10 countries are the major constituents of the committee, the G10 member countries readily adopt the standards straight away.  Other countries take their own time to implement the recommendations with or without variations.

Basel Committee Accord I or The 1988 Accord:

The recommendations of the Basel committee as implemented at present in many countries were published in 1988 and hence it is popularly called 1988 accord.  

Basel I, that is, the 1988 Basel Accord, primarily focused on credit risk.

The committee prescribed end-1992 as the deadline for implementation in G10 countries.  At the time of the accord, it was felt that the Capital of the Banks world wide as a proportion to their assets was dangerously low.  It was felt that Capital is necessary for Banks as a cushion against losses and hence a standard on ‘Minimum Capital requirements’ is absolutely necessary. However, there was no standard/regulation then on minimum capital requirements.  Banks at that time increased indiscriminately their deposits and consequently the asset size also increased.  This was found out to be an easy way to enhance the profitability.  However, the disproportionate increase in the size of the balance sheet carried an inherent risk.

Capital Requirements under Basel I:

In this scenario, the 1988 accord prescribed the Minimum capital requirements at 8% on a basket of assets(since increased to 9%).  The asset value is to be measured in different ways according to their risk.  The capital is set in two tiers.  Tier 1 capital is shareholders’ equity and un encumbered reserves and provisions.  Tier 2 is additional internal and external resources available to the Banks. 

Asset buckets:  

The Banks have to keep at least 50% of their capital in Tier-1 form.  The basket of assets are classified into four buckets based on the potential risk of each debtor(borrower) category.  The buckets are 0%, 20%, 50% and 100%. 

Some assets like government treasury bills and bonds are coming under 0% category. 
Claims on Banks come under 20% category.

Virtually all non-bank private sector come under 100% category. 

The off-balance sheet exposures like guarantees, forward claims etc., are to be converted into a credit equivalent amount through certain conversion features.  The credit equivalent amount is weighted according to the counterparty’s risk weighting

The 1988 accord as aforesaid prescribes that the Banks shall hold minimum capital of 8% of the risk weighted assets balance.  This means that a Bank’s holding of treasury bills or bonds does not require any capital because they come under 0% risk weight category.   Balance held with other Banks require capital of 1.6% (20% risk weight – 8% minimum capital requirement) of such balance, the loans and advances to private sector require Banks to maintain capital equivalent to 8% on such loans balance.

Impact of 1988 accord:    

The principal purposes of the accord viz., to ensure adequate level of capital in the Banking system and to create a more level playing field is achieved.  No longer can the Banks keep building business volumes without adequate capital backing.  The 1988 accord has more or less been accepted as a world standard since 1990s and more than 100 countries have adopted 1988 accord to their Banking system.

 Limitations of 1988 accord:  

The following limitations of the 1988 Accord were noticed.

1.  The credit risk or counter party risk is inadequately defined.  There are only 4 buckets for risk weights.  All the private sector non-bank borrowers are coming under 100% category.  Therefore, for example, there is no differentiation of risk weight between a AAA rated high quality private sector counter party and a small time street corner shop.

2.    It is a well settled risk theorem that the maturity of the asset and risk are directly proportional.  Banks have adequate experience on the principle that longer the maturity of the asset, the more is the riskBut 1988 accord prescribes the same level of risk weight irrespective of the maturity of the credit exposure.

3.    With the adoption of technology and massive computerization, it is speculated that the next decade will witness more loss in technology front (operational risk) than the loss on counter party defaults (credit risk).  However, the 1988 accord has not prescribed any capital charge for operational risk while credit risk is dealt in extensively.

4.  The risk weights based on counter party type does not recognize the portfolio diversification effects

5.    Collaterals and guarantees etc., reduce the credit risk.  However, the 1988 accord does not recognize these credit risk mitigation techniques as irrespective of the collateral value or guarantees, the asset value has to be placed in the respective bucket based on the counter party type.

Since 1988, this framework has been progressively introduced in member countries of G-10, currently comprising 13 countries, namely, BelgiumCanadaFranceGermanyItalyJapanLuxembourgNetherlands,SpainSwedenSwitzerlandUnited Kingdom and the United States of America.
Most other countries, currently numbering over 100, have also adopted, at least in name, the principles prescribed under Basel I. The efficiency with which they are enforced varies, even within nations of the Group of Ten.
Basel I is now widely viewed as outmoded. Indeed, the world has changed as financial conglomerates, financial innovation and risk management have developed. Therefore, a more comprehensive set of guidelines, known as Basel II are in the process of implementation by several countries and new updates in response to the financial crisis commonly described as Basel III( Source: )


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