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Definition of 'Basel I'

A set of international banking regulations put forth by the Basel Committee on Bank Supervision, which set out the minimum capital requirements of financial institutions with the goal of minimizing credit risk. Banks that operate internationally are required to maintain a minimum amount (8%) of

capital based on a percent of risk-weighted assets.

Investopedia explains 'Basel I'


The first accord was the Basel I. It was issued in 1988 and focused mainly on credit risk by creating a bank asset classification system. This classification system grouped a bank's assets into five risk categories: 0% - cash, central bank and government debt and any OECD government debt 0%, 10%, 20% or 50% - public sector debt 20% - development bank debt, OECD bank debt, OECD securities firm debt, non-OECD bank debt (under one year maturity) and non-OECD public sector debt, cash in collection 50% - residential mortgages 100% - private sector debt, non-OECD bank debt (maturity over a year), real estate, plant and equipment, capital instruments issued at other banks The bank must maintain capital (Tier 1 and Tier 2) equal to at least 8% of its risk-weighted assets. For example, if a bank has risk-weighted assets of $100 million, it is required to maintain capital of at least $8 million.

How Basel 1 Affected Banks


From 1965 to 1981 there were about eight bank failures (or bankruptcies) in the United States. Bank failures were particularly prominent during the '80s, a time which is usually referred to as the "savings and loan crisis." Banks throughout the world were lending extensively, while countries' external indebtedness was growing at an unsustainable rate. (For related reading, see Analyzing A Bank's Financial Statements.)

As a result, the potential for the bankruptcy of the major international banks because grew as a result of low security. In order to prevent this risk, the Basel Committee on Banking Supervision, comprised of central banks and supervisory authorities of 10 countries, met in 1987 in Basel, Switzerland.

The committee drafted a first document to set up an international 'minimum' amount of capital that banks should hold. This minimum is a percentage of the total capital of a bank, which is also called the minimum risk-based capital adequacy. In 1988, the Basel I Capital Accord (agreement) was created. The Basel II Capital Accord follows as an extension of the former, and was implemented in 2007. In this article, we'll take a look at Basel I and how it impacted the banking industry.

The Purpose of Basel I In 1988, the Basel I Capital Accord was created. The general purpose was to:

1. Strengthen the stability of international banking system.

2. Set up a fair and a consistent international banking system in order to decrease competitive inequality among international banks.

The basic achievement of Basel I has been to define bank capital and the so-called bank capital ratio. In order to set up a minimum risk-based capital adequacy applying to all banks and governments in the world, a general definition of capital was required. Indeed, before this international agreement, there was no single definition of bank capital. The first step of the agreement was thus to define it.

Two-Tiered Capital Basil I defines capital based on two tiers:

1. Tier 1 (Core Capital): Tier 1 capital includes stock issues (or share holders equity) and declared reserves, such as loan loss reserves set aside to cushion future losses or for smoothing out income variations.

2. Tier 2 (Supplementary Capital): Tier 2 capital includes all other capital such as gains on investment assets, long-term debt with maturity greater than five years and hidden reserves (i.e. excess allowance for losses on loans and leases). However, short-term unsecured debts (or debts without guarantees), are not included in the definition of capital.

Credit Risk is defined as the risk weighted asset (RWA) of the bank, which are banks assets weighted in relation to their relative credit risk levels. According to Basel I, the total capital should represent at least 8% of the bank's credit risk (RWA). In addition, the Basel agreement identifies three types of credit risks:

The on-balance sheet risk (see Figure 1 for example). The trading off-balance sheet risk. These are derivatives, namely interest rates, foreign exchange, equity derivatives and commodities. The non-trading off-balance sheet risk. These include general guarantees, such as forward purchase of assets or transaction-related debt assets.

RBCC - Breakout Gains! Let's take a look at some calculations related to RWA and capital requirement. Figure 1 displays predefined categories of on-balance sheet exposures, such as vulnerability to loss from an unexpected event, weighted according to four relative risk categories.

Figure 1: Basel's Classification of risk weights of on-balance sheet assets

As shown in Figure 2, there is an unsecured loan of $1,000 to a non-bank, which requires a risk weight of 100%. The RWA is therefore calculated as RWA=$1,000 100%=$1,000. By using Formula 2, a minimum 8% capital requirement gives 8% RWA=8% $1,000=$80. In other words, the total capital holding of the firm must be $80 related to the unsecured loan of $1,000. Calculation under different risk weights for different types of assets are also presented in Table 2.

Figure 2: Calculation of RWA and capital requirement on-balance sheet assets

Market risk includes general market risk and specific risk. The general market risk refers to changes in the market values due to large market movements. Specific risk refers to changes in the value of an individual asset due to factors related to the issuer of the security. There are four types of economic variables that generate market risk. These are interest rates, foreign exchanges, equities and commodities. The market risk can be calculated in two different manners: either with the standardized Basel model or with internal value at risk (VaR) models of the banks. These internal

models can only be used by the largest banks that satisfy qualitative and quantitative standards imposed by the Basel agreement. Moreover, the 1996 revision also adds the possibility of a third tier for the total capital, which includes short-term unsecured debts. This is at the discretion of the central banks. (For related reading, see Get To Know The Central Banks and What Are Central Banks?)

Pitfalls of Basel I Basel I Capital Accord has been criticized on several grounds. The main criticisms include the following:

Limited differentiation of credit risk There are four broad risk weightings (0%, 20%, 50% and 100%), as shown in Figure1, based on an 8% minimum capital ratio.

Static measure of default risk The assumption that a minimum 8% capital ratio is sufficient to protect banks from failure does not take into account the changing nature of default risk.

No recognition of term-structure of credit risk The capital charges are set at the same level regardless of the maturity of a credit exposure. Simplified calculation of potential future counterparty risk The current capital requirements ignore the different level of risks associated with different currencies and macroeconomic risk. In other words, it assumes a common market to all actors, which is not true in reality.

Lack of recognition of portfolio diversification effects In reality, the sum of individual risk exposures is not the same as the risk reduction through portfolio diversification. Therefore, summing all risks might provide incorrect judgment of risk. A remedy would be to create an internal credit risk model - for example, one similar to the model as developed by the bank to calculate market risk. This remark is also valid for all other weaknesses. Advertisment - Article continues below.

These listed criticisms have led to the creation of a new Basel Capital Accord, known as Basel II, which added operational risk and also defined new calculations of credit risk. Operational risk is the risk of loss arising from human error or management failure. Basel II Capital Accord was implemented in 2007.

Conclusion

The Basel I Capital Accord aimed to assess capital in relation to credit risk, or the risk that a loss will occur if a party does not fulfill its obligations. It launched the trend toward increasing risk modeling research; however, its over-simplified calculations, and classifications have simultaneously called for its disappearance, paving the way for the Basel II Capital Accord and further agreements as the symbol of the continuous refinement of risk and capital. Nevertheless, Basel I, as the first international instrument assessing the importance of risk in relation to capital, will remain a milestone in the finance and banking history.

BASEL III is a global regulatory standard on bank capital adequacy, stress testing and market liquidity risk agreed upon by the members of the Basel Committee on Banking Supervision in 2010-11.
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This, the third of the Basel Accords (see Basel I, Basel II) was developed in response to the deficiencies in financial regulation revealed by the late-2000s financial crisis. Basel III strengthens bankcapital requirements and introduces new regulatory requirements on bank liquidity and bank leverage. For instance, the change in the calculation of loan risk in Basel II which some consider a causal factor in the credit bubble prior to the 2007-8 collapse: in Basel II one of the principal factors of financial risk management was out-sourced to companies that were not subject to supervision: credit rating agencies. Ratings of creditworthiness and of bonds, financial bundles and various other financial instruments were conducted without supervision by official agencies, leading to AAA ratings onmortage-backed securities, credit default swaps and other instruments that proved in practice to be extremely bad credit risks. In Basel III a more formal scenario analysis is applied (three official scenarios from regulators, with ratings agencies and firms urged to apply more extreme ones). The OECD estimates that the implementation of Basel III will decrease annual GDP growth by 0.05 to 0.15 percentage point.
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. Outside the banking industry itself, criticism was muted. Bank directors would

be required to know market liquidity conditions for major asset holdings, to strengthen accountability for any major losses.
Contents
[hide]

1 Overview 2 Summary of proposed changes

2.1 US implementation

3 Macroeconomic Impact of Basel III

4 Key dates

o o o

4.1 Capital Requirements 4.2 Leverage Ratio 4.3 Liquidity Requirements

5 Studies on Basel III 6 See also 7 References 8 External links

[edit]Overview Basel III will require banks to hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) of risk-weighted assets (RWA). Basel III also introduces additional capital buffers, (i) a mandatory capital conservation buffer of 2.5% and (ii) a discretionary countercyclical buffer, which allows national regulators to require up to another 2.5% of capital during periods of high credit growth. In addition, Basel III introduces a minimum 3% leverage ratio and two required liquidity ratios. The Liquidity Coverage Ratio requires a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days; the Net Stable Funding Ratio requires the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress. [edit]Summary
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of proposed changes

First, the quality, consistency, and transparency of the capital base will be raised. Tier 1 capital: the predominant form of Tier 1 capital must be common shares and retained earnings Tier 2 capital instruments will be harmonised Tier 3 capital will be eliminated.
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Second, the risk coverage of the capital framework will be strengthened. Promote more integrated management of market and counterparty credit risk Add the CVA (credit valuation adjustment)-risk due to deterioration in counterparty's credit rating Strengthen the capital requirements for counterparty credit exposures arising from banks derivatives, repo and securities financing transactions Raise the capital buffers backing these exposures Reduce procyclicality and Provide additional incentives to move OTC derivative contracts to central counterparties (probably clearing houses)

Provide incentives to strengthen the risk management of counterparty credit exposures Raise counterparty credit risk management standards by including wrong-way risk

Third, the Committee will introduce a leverage ratio as a supplementary measure to the Basel II riskbased framework. The Committee therefore is introducing a leverage ratio requirement that is intended to achieve the following objectives: Put a floor under the build-up of leverage in the banking sector Introduce additional safeguards against model risk and measurement error by supplementing the risk based measure with a simpler measure that is based on gross exposures.

Fourth, the Committee is introducing a series of measures to promote the build up of capital buffers in good times that can be drawn upon in periods of stress ("Reducing procyclicality and promoting countercyclical buffers"). The Committee is introducing a series of measures to address procyclicality: Dampen any excess cyclicality of the minimum capital requirement; Promote more forward looking provisions; Conserve capital to build buffers at individual banks and the banking sector that can be used in stress; and Achieve the broader macroprudential goal of protecting the banking sector from periods of excess credit growth. Requirement to use long term data horizons to estimate probabilities of default, downturn loss-given-default estimates, recommended in Basel II, to become mandatory Improved calibration of the risk functions, which convert loss estimates into regulatory capital requirements. Banks must conduct stress tests that include widening credit spreads in recessionary scenarios. Promoting stronger provisioning practices (forward looking provisioning): Advocating a change in the accounting standards towards an expected loss (EL) approach (usually, EL amount := LGD*PD*EAD).
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Fifth, the Committee is introducing a global minimum liquidity standard for internationally active banks that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio called the Net Stable Funding Ratio. (In January 2012, the oversight panel of the Basel Committee on Banking Supervision issued a statement saying that regulators will allow banks to dip below their required liquidity levels, the liquidity coverage ratio, during periods of stress. )
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The Committee also is reviewing the need for additional capital, liquidity or other supervisory measures to reduce the externalities created by systemically important institutions.

As on Sept 2010, Proposed Basel III norms ask for ratios as: 7-9.5%(4.5% +2.5%(conservation buffer) + 0-2.5%(seasonal buffer)) for Common equity and 8.5-11% for tier 1 cap and 10.5 to 13 for total capital (Proposed Basel III Guidelines: A Credit Positive for Indian Banks)' [edit]US

implementation

The US Federal Reserve announced in December 2011 that it would implement substantially all of the Basel III rules. [1]. It summarized them as follows [2], and made clear they would apply not only to banks but to all institutions with more than US$50 billion in assets: "Risk-based capital and leverage requirements" including first annual capital plans, conduct stress tests, and capital adequacy "including a tier one common risk-based capital ratio greater than 5 percent, under both expected and stressed conditions" - see scenario analysis on this. A risk-based capital surcharge Market liquidity, first based on the US's own "interagency liquidity risk-management guidance issued in March 2010" that require liquidity stress tests and set internal quantitative limits, later moving to a full Basel III regime - see below. The Federal Reserve Board itself would conduct tests annually "using three economic and financial market scenarios." Institutions would be encouraged to use at least five scenarios reflecting improbable events, and especially those considered impossible by management, but no standards apply yet to extreme scenarios. Only a summary of the three official Fed scenarios "including company-specific information, would be made public" but one or more internal company-run stress tests must be run each year with summaries published. Single-counterparty credit limits to cut "credit exposure of a covered financial firm to a single counterparty as a percentage of the firm's regulatory capital. Credit exposure between the largest financial companies would be subject to a tighter limit." "Early remediation requirements" to ensure that "financial weaknesses are addressed at an early stage". One or more "triggers for remediation--such as capital levels, stress test results, and riskmanagement weaknesses--in some cases calibrated to be forward-looking" would be proposed by the Board in 2012. "Required actions would vary based on the severity of the situation, but could include restrictions on growth, capital distributions, and executive compensation, as well as capital raising or asset sales."

It was unclear as of December 2011 how these rules would apply to insurance, hedge funds and other large financial players. The announced intent was "to limit the dangers of big financial firms being heavily intertwined" [3]. [edit]Macroeconomic An OECD study
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Impact of Basel III

released on 17 February 2011, estimates that the medium-term impact of Basel III

implementation on GDP growth is in the range of 0.05 to 0.15 percentage point per year. Economic output is mainly affected by an increase in bank lending spreads as banks pass a rise in bank funding costs, due to higher capital requirements, to their customers. To meet the capital requirements effective in 2015 (4.5% for the common equity ratio, 6% for the Tier 1 capital ratio), banks are estimated to increase their lending spreads on average by about 15 basis points. The capital requirements effective as of 2019 (7% for the common equity ratio, 8.5% for the Tier 1 capital ratio) could increase bank lending spreads by about 50 basis points. The estimated effects on GDP growth assume no active response from monetary policy. To the extent that monetary policy will no longer be constrained by the zero lower bound, the Basel III impact on economic output could be offset by a reduction (or delayed increase) in monetary policy rates by about 30 to 80 basis points.
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Basel III is an opportunity as well as a challenge for banks. It can provide a solid foundation for the next developments in the banking sector, and it can ensure that past excesses are avoided. Basel III is changing the way that banks address the management of risk and finance. The new regime seeks much greater integration of the finance and risk management functions. This will probably drive the convergence of the responsibilities of CFOs and CROs in delivering the strategic objectives of the business. However, the adoption of a more rigorous regulatory stance might be hampered by a reliance on multiple data silos and by a separation of powers between those who are responsible for finance and those who manage risk. The new emphasis on risk management that is inherent in Basel III requires the introduction or evolution of a risk management framework that is as robust as the existing finance management infrastructures. As well as being a regulatory regime, Basel III in many ways provides a framework for true enterprise risk management, which involves covering all risks to the business. [edit]Key
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dates
Requirements
Milestone: Capital Requirement

[edit]Capital Date

2013 Minimum capital requirements: Start of the gradual phasing-in of the higher minimum capital requirements.

2015 Minimum capital requirements: Higher minimum capital requirements are fully implemented.

2016 Conservation buffer: Start of the gradual phasing-in of the conservation buffer.

2019 Conservation buffer: The conservation buffer is fully implemented. [edit]Leverage Date

Ratio
Milestone: Leverage Ratio

2011 Supervisory monitoring: Developing templates to track the leverage ratio and the underlying components.

2013

Parallel run I: The leverage ratio and its components will be tracked by supervisors but not disclosed and not mandatory.

2015 Parallel run II: The leverage ratio and its components will be tracked and disclosed but not mandatory.

2017

Final adjustments: Based on the results of the parallel run period, any final adjustments to the leverage ratio.

2018 Mandatory requirement: The leverage ratio will become a mandatory part of Basel III requirements. [edit]Liquidity Date

Requirements
Milestone: Liquidity Requirements

2011 Observation period: Developing templates and supervisory monitoring of the liquidity ratios.

2015 Introduction of the LCR: Introduction of the Liquidity Coverage Ratio (LCR).

2018 Introduction of the NSFR: Introduction of the Net Stable Funding Ratio (NSFR).

[edit]Studies

on Basel III

In addition to articles used for references (see References), this section lists links to recent high-quality publicly-available studies on Basel III. This section may be updated frequently as Basel III is currently under development. Date Source Article Title / Link Comments

Dec OECD: Economics 2011 Department

Systemically Important Banks

OECD analysis on the failure of bank regulation and markets to discipline systemically important banks.

BNP Paribas: Jun Basel III: no Achilles' Economic Research 2011 spear Department

BNP Paribas' Economic Research Department study on Basel III.

Feb OECD: Economics 2011 Department

Macroeconomic Impact OECD analysis on the macroeconomic impact of Basel III. of Basel III

Jan Moody's Analytics 2011

Basel III New Capital and Basel III standards, key elements of new regulations, Liquidity Standards framework, and key implementation dates. FAQs

OECD Journal: May Financial Market 2010 Trends

Thinking Beyond Basel III

OECD study on Basel I, Basel II and III.

May Bloomberg 2010 BusinessWeek

Bair said regulators around the world need to work together FDICs Bair Says Europe on the next round of capital standards for banks ... the next Should Make Banks Hold round of international standards, known as Basel III, which More Capital Bair said must meet very aggressive goals.

May Reuters 2010

FACTBOX-G20 progress on financial regulation

Finance ministers from the G20 group of industrial and emerging countries meet in Busan, Korea, on June 45 to review pledges made in 2009 to strengthen regulation and learn lessons from the financial crisis.

May The Economist 2010

The banks battle back A behind-the-scenes brawl over new capital and liquidity rules

"The most important bit of reform is the international set of rules known as Basel 3, which will govern the capital and liquidity buffers banks carry. It is here that the most vicious and least public skirmish between banks and their regulators is taking place."