Basel I

What is Basel I?

Basel I, also known as the 1988 Basel accord, is the standard set of banking regulations on the minimum capital requirement for banks based on certain percentages of risk-weighted assets. These rules are adopted and implemented to minimize credit risk.

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The banks that operate internationally must maintain a minimum capital of 8% on 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.read more. So far, three sets of regulations have been introduced, of which Basel I norms were first followed by Basel II and Basel III. Together,  all of them are called Basel Accords. These norms build confidence among international investors, customers, the government, and other stakeholders.

Basel I Explained

The Basel I accord primarily focuses on risk-weighted assets and credit risk. Here the assets are classified based on the 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. Banks’ capital is classified under 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 bank’s total capital base.

In contrast, tier-II capital is fluctuating and more temporary. 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 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.read more of 2008.

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Capital Requirements

The capital requirements of the banks depend on asset classification, which is one of the most vital parameters comprising the risk-weighing system of the accord. The Basel I pillars classify a 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: –

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• 0% category comprises the central bank, cash, government debt, a home country debt like treasuries, and any OECD government debt;
• 10% category comprises public sector debt;
• 20% category includes securitizations such as mortgage-backed securitiesMortgage-backed SecuritiesA mortgage-backed security (MBS) is a financial instrument backed by collateral in the form of a bundle of mortgage loans. The investors are benefitted from periodic payment encompassing a specific percentage of interest and principle. However, they also face several risks like default and prepayment risks.read more with the highest AAA ratings;
• 50% includes residential mortgages, municipal revenue bonds;
• 100% includes most corporate debt and private sectorPrivate SectorThe private sector is a section of the national economy that the government does not own. The business conducted under this sector is carried out by companies or entrepreneurs who focus on profit maximization and customer satisfaction.read more 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, it must maintain a capital of about $16 million.

Examples

Let us consider the following examples to understand the Basel I norms thoroughly:

Example 1

Let’s 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, according to Basel I, this bank has to maintain a minimum of 8% of $110 as a minimum capital (and at least 4% in tier 1 capital).

Example 2

Russia did not have an organized banking system before the central bank of the nation stripped the licenses of many banks out there based on the Basel Accords before 2017. The Basel Accords were introduced in the 1980s in Switzerland in the presence of central bankers and finance ministers. It has been upgraded to the Basel-III post the Great Recession period of 2008-09. This led to the bankruptcy of several private banks, keeping only the deserved ones to operate across the country.

Advantages & Disadvantages

Basel I managed to make banking services well-organized, well-managed, and well-regulated, thereby becoming a necessary regulation for the banks. However, it had some loopholes, which led to the modifications. These changes in guidelines and requirements resulted in the introduction of the next two provisions – Basel II and Basel III.

Let us have a quick look at the pros and cons of this Basel accord:

Benefits

• After the accord’s implementation, there has been a significant increase in capital adequacy ratios in internationally active banks. It removed a source of competitive inequality that 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.
• 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 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.read more rather than market value.
• The accord could not adequately assess the risks and effects of new financial instrumentsFinancial InstrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more and risk mitigation techniques.
• Basel I is based on capital adequacy, which 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.read more, 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. read more are excluded from the analysis.
• It does not differentiate between the debtors of different credit ratings and quality while assessing credit risk.

Basel I vs. Basel II

In June 1999, the committee replaced 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.read more 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.read more that consists of three pillars mentioned as follows: –

1. Minimum capital requirements
2. Effective disclosure as a medium for strengthening market discipline and for sound banking practices.
3. The 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. read more to make out the regulatory capital ratios.

Frequently Asked Questions (FAQs)

Recommended Articles

This has been a guide to what is Basel I. We explain vs Basel II and capital requirements per the accord along with advantages, disadvantages, and examples. You may learn more about financing from the following articles –

• Contingency Reserve
• Bank Reserve
• Bank Capital
• Commercial Bank