BASEL ACCORDS I, II, III

SUBMITTED BY
NAZISH KHALID














THE BASEL COMMITTEE: After two major international bank failures in 1974 a standing
committee of bank supervisory authorities Basel Committee on Banking Supervision - BCBS in
the G-10 countries was created, with a permanent secretariat in Basel. Its main purpose was to assure
that international banks did not escape the supervisory authority which typically is restricted to a
particular country, and to ensure that foreign branches and subsidiaries were adequately regulated,
since there had been cases where a subsidiaries experienced a bank run but the central bank of the
country where the main bank was situated refused to assist.
BASEL I
The Basel Accord I, 1988 established a single system of capital adequacy standards for the
international banks of the participating countries and focuses on credit risk by dening capital
requirements by the function of a banks on- and off-balance sheet positions. The two stated main
objectives of the initiative were:
1) To strengthen the soundness and stability of the international banking system.
2) To diminish existing sources of competitive inequality among international banks.
The main principle was to assign to both on-balance and off-balance sheet items a weight that was a
function of their estimated risk level, and to require a capital level equivalent to 8 percent of those
weighted assets. Here capital should be understood as consisting of tier 1 and tier 2 capital:
Tier 1 or core capital consists of equity, disclosed reserves, retained earnings, less goodwill and
other deductions, and
Tier 2 or supplementary capitals are loan loss allowances, undisclosed reserves, general loss
reserves etc.
The risk weighted assets are found by sorting the assets by credit type and assigning lower weights
to more creditworthy assets:
Risk-Weight
Category
Types of Assets Included in the Risk Category
0% cash, gold, bonds issued by OECD governments,
20%
bonds issued by agencies of OECD governments (as e.g. export credit guarantee
agencies), local (municipal) governments and insured mortgages,
50% Loans secured by mortgages on residential property uninsured mortgages,
100%
All corporate loans and claims by non-OECD banks or government debts, equity
and property.
BASEL II
The Basel II was prepared by the BCBS and released in 2004, intended to serve as framework for the
international convergence of supervision of the banking system. It is the second of the Basel
Accords. This new framework is a set of recommendations for banking governance and supervision
which is not mandatory not even for the members of the BCBS, but that intends to serve as
guidelines for firms and regulators to improve their controls and management. The main goals of the
Basel II framework are to make the capital allocation more risk sensitive, and align the economic
and the regulatory capital among others. This accord consists of 3 pillars.
Pillar 1: Minimum capital requirements
The First Pillar deals with maintenance of regulatory capital calculated for three major components
of risk that a bank faces: Credit Risk, Operational Risk and Market Risk.
1) The Credit Risk component can be calculated in three different ways of varying degree of
sophistication, namely Standardized Approach, Foundation IRB and Advanced IRB. IRB stands
for "Internal Rating Based Approach".
2) For Operational Risk, there are three different approaches - Basic Approach, Standardized
Approach, and Advanced Measurement Approach or AMA.
3) For Market Risk the preferred approach is VaR (Value at Risk).
The pillar 1 uses two concepts:
1) Regulatory Capital is the net worth as defined by rules adopted by a regulatory agency, which
may be different than capital calculated under generally accepted accounting principles.
2) Risk-Weighted Assets is a concept that weights the firms assets according to their riskiness and
potential for default. It is calculated multiplying the capital requirement by 12.5.
Pillar 2: Supervisory review
It deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over
those available to them under Basel I. It also provides a framework for dealing with all the other
risks (residual risk) a bank may face, such as reputation risk, liquidity risk legal risk.
Pillar 3: Market discipline
The third pillar greatly increases the disclosures that the bank must make. This is designed to allow
the market to have a better picture of the overall risk position of the bank and to allow the
counterparties of the bank to price and deal appropriately.
BASEL III
Basel III" is a comprehensive set of reform measures, developed by the Basel Committee on
Banking Supervision, to strengthen the regulation, supervision and risk management of the
banking sector. These measures aim to:
Improve the banking sector's ability to absorb shocks arising from financial and economic
stress, whatever the source
Improve risk management and governance
Strengthen banks' transparency and disclosures.
The main points of Basel III can be summarized as follows:
1) Increased capital reserves: In addition to the existing system of capital regulation, two new
items are added, namely
Capital conservation buffer: was established to ensure that banks build up capital buffers
outside periods of financial stress that can be drawn down when losses are incurred. The
minimum amount of the conservation buffer is 2.5% of the banks risk-weighted assets. The
capital held in this buffer must be tier 1 capital.
Countercyclical buffer policy was approved to determine when excess credit growth poses a
risk to the stability of the financial system. The governors agreed that the countercyclical
buffer should be between 0 and 2.5 % of total risk-weighted assets consisting of common
equity or other fully loss absorbing capital.
2) Leverage rule: It is aimed to prevent too small capital reserves even in cases where assets have
low risk and therefore would not give rise to building up reserves. It has two objectives:
Constrain the buildup of leverage in the banking sector, helping to avoid the destabilizing and
deleveraging processes which can damage the broader financial system and the economy; and
Reinforce the risk-based requirements with a simple non-risk-based backstop measure based
on gross exposure.
3) Liquidity rules: High quality assets should be large enough to cover one month net cash out-
flow. The committee developed two minimum standards for funding liquidity. First, there is a
30-day liquidity coverage ratio, consisting mostly of government securities and cash, which
would promote short-term resilience to potential liquidity disruptions. The second is a long-term
structural ratio to address liquidity mismatches and provide incentives for banks to use stable
sources to fund their operations.

DIFFERENCE BETWEEN BASEL II AND III
Basel III is an enhancement over Basel II brought out with the experience of global financial
turmoil - the enhancements are primarily under two heads primarily one is capital and other is
liquidity
Capital: there is a minimum prescription of capital by way of common equity under Basel III.
That is to say all the capital that was reckoned under Basel II will not be eligible for such
reckoning. Ex capital debt instruments with step up option after certain period are not eligible.
Deduction from the capital was earlier considered from tier i and tier ii equally. Under Basel III
deductions will be made from tier 1 capital only. Counter cyclical buffer for rainy day is
introduced under Basel III. Further additional capital for systematically important financial
institutions (SIFI) introduced so that large FIs gauge risks properly and not ignite contagion risk
for the system. Liquidity in order to improve the liquidity within as also across the system lcr
(liquidity coverage ratio) and NSLR (net stable funding ratio) are introduced