What is Basel I?
Basel I, also known as 1988 Basel accord, are the standard sets of banking regulations on minimum capital requirement for banks that is based on certain percentages of risk-weighted assets with the goal to minimize credit risk.
The banks which operate internationally are required to maintain a minimum capital of 8% on the basis of risk-weighted assetsRisk-weighted AssetsRisk-weighted asset refers to the minimum amount that a bank or any other financial institution must maintain to avoid insolvency or bankruptcy risk. The risk associated with each bank asset is analyzed individually to figure out the total capital requirement.. So far, three sets of regulations have been formed, of which Basel I is the first one, and together all of them are called Basel accords. These norms set help in building confidence among international investors, customers, government, and other stakeholders.
Example of Basel I
Let say a bank has a cash reserve of $200, $50 as a home mortgage, and $100 as loans given out to different companies. The risk-weighted assets as per the set norms will be as follows: –
- =($200*0) +($50*0.2) +($100*1)
- = $110.
Therefore, this bank has to maintain, according to Basel I, a minimum of 8% of $110 as a minimum capital (and at least 4% in tier 1 capital).
This classifies bank’s assets into five categories based on risk in the form of a percentage, that is, 0%,10%,20%,50%, and 100%. The nature of the debtor decides the category where bank assets are to be categorized. Some common examples are as follows: –
- 0% category comprises of the central bank, cash, government debt, a home country debt like treasuries and any OECD government debt;
- 10% category comprises of public sector debt;
- 20% category includes securitizations such as mortgage-backed securities with the highest AAA ratings;
- 50% includes residential mortgages, municipal revenue bonds;
- 100% includes most corporate debt and private sector debt, real estate sector, non-OECD bank debt where maturity term is over a year.
The bank needs to maintain capital (Tier 1 and Tier 2) equal to 8% of the risk-weighted assets under which category it falls. For example, if a bank has risk-weighted assets of over $200 million, then it is required to maintain the capital of about at least $16 million.
The Basel I accord primarily focuses on risk-weighted assets and credit risk. Here the assets are classified based on risks associated with them. The risk may range from 0% to 100%. Under this charter, the committee members agree to implement a full Basel accord with active members. Under the Regulatory Consistency Assessment Programme (RCAP), the committee publishes semi-annual reports on members’ progress in implementing the Basel standards. They also keep updating all the G-20 countries involved as members. Capital of banks is classified under two categories in Basel I accord i.e., tier I and tier II. Tier I capital is the capital, which is more permanent and makes up at least 50% of the total capital base of the bank, whereas tier II capital is fluctuating in nature and more temporary in nature. Members of the Basel accord must implement this regulation in their home countries. This accord lowers the bank’s risk profile and drives investment back into banks those were distrusted post subprime loanSubprime LoanSubprime loans are given to entities and individuals by the bank, usually on a rate of interest much higher than the market, which has a significant amount of risk involved regarding its repayment in the specified amount of time. of 2008.
Basel I vs. Basel II
In June 1999, the committee decided to replace the 1988 accord for a new capital adequacyCapital AdequacyThe capital adequacy ratio measures the bank's financial ability to pay off its obligations. The capital-to-risk weighted assets ratio (CRAR) is evaluated as the percentage of the bank's capital to its risk-weighted assets. Bank's capital is the aggregate of tier 1 and tier 2 capital. framework. This led to the establishment of the revised capital framework in 2004 called Basel IIBasel IIBasel II is the second set of regulations concerning Minimum Capital Requirement, Supervisory Review, Role and Market Discipline, and Disclosure. The Basel Committee on Bank Supervision developed the regulations for international banks in order to ensure a transparent and risk-free banking environment. that consists of three pillars mentioned as follows: –
- Minimum capital requirements
- Effective use of disclosure as a medium for strengthening market discipline and for sound banking practices.
- Internal assessment process and review of an institution’s capital adequacy.
The main difference between both the regulations is that Basel II incorporates the credit risk held by financial institutesFinancial InstitutesFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. to make out the regulatory capital ratios.
- After the implementation of the accord, there has been a significant increase in capital adequacy ratios in internationally active banks and also removed a source of competitive inequality which arose from the differences in national capital requirements.
- It helped to strengthen the stability of the banking system internationally.
- It augmented the management of the nation’s capital.
- As compared to another set BASEL, it has a relatively more simple structure.
- It provides a benchmark for the assessment by the participants of the market since it is adopted worldwide.
- It emphasizes more on book valueBook ValueThe book value formula determines the net asset value receivable by the common shareholders if the company dissolves. It is calculated by deducting the preferred stocks and total liabilities from the total assets of the company. rather than market value.
- The accord could not adequately assess the risks and effects of new financial instruments and risk mitigation techniques.
- Capital adequacy on which Basel I is based just depends on credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection., while all other risks such as market and operational risksOperational RisksOperational risk is the business uncertainty a company comes across in the industry while executing its everyday business operations. Such risks arise due to internal system breakdown, technical issues, external factors, managerial problems, human errors or information gap. are excluded from the analysis.
- It does not differentiate between the debtors of different credit ratings and quality while assessing credit risk.
This has been a guide to Basel I and its definition. Here we discuss the example, requirements, and implementation of Basel I, along with benefits and limitations. You may learn more about financing from the following articles –