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 assets. 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)
- =0+10+100
- = $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).
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Requirements
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.
Implementation
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 loan of 2008.
Basel I vs. Basel II
In June 1999, the committee decided to replace the 1988 accord for a new capital adequacy framework. This led to the establishment of the revised capital framework in 2004 called Basel II 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 institutes to make out the regulatory capital ratios.
Benefits
- 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.
Limitations
- It emphasizes more on book value 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 risk, while all other risks such as market and operational risks are excluded from the analysis.
- It does not differentiate between the debtors of different credit ratings and quality while assessing credit risk.
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