BASEL1

Basel I is the round oI deliberations by central bankers Irom around the world, and in 1988, the
Basel Committee (BCBS) in Basel, Switzerland, published a set oI minimal capital requirements
Ior banks. This is also known as the 1988 Basel Accord, and was enIorced by law in the Group
oI Ten (G-10) countries in 1992 . Basel I is now widely viewed as outmoded. Indeed, the world
has changed as Iinancial conglomerates, Iinancial innovation and risk management have
developed. ThereIore, a more comprehensive set oI guidelines, known as Basel II are in the
process oI implementation by several countries and new updates in response to the Iinancial
crisis commonly described as Basel III.
Main framework
Basel I, that is, the 1988 Basel Accord, primarily Iocused on credit risk. Assets oI banks were
classiIied and grouped in Iive categories according to credit risk, carrying risk weights oI zero
(Ior example home country sovereign debt), ten, twenty, IiIty, and up to one hundred percent
(this category has, as an example, most corporate debt). Banks with international presence are
required to hold capital equal to 8 oI the risk-weighted assets. However, large banks like
JPMorgan Chase Iound Basel I's 8 requirement to be unreasonable, and implemented credit
deIault swaps so that in reality they would have to hold capital equivalent to only 1.6 oI assets.
Since 1988, this Iramework has been progressively introduced in member countries oI G-10,
currently comprising 13 countries, namely, Belgium, Canada, France, Germany, Italy, Japan,
Luxembourg, Netherlands, Spain, Sweden, Switzerland, United Kingdom and the United States
oI America.
Most other countries, currently numbering over 100, have also adopted, at least in name, the
principles prescribed under Basel I. The eIIiciency with which they are enIorced varies, even
within nations oI the Group oI Ten.
BASEL2
Basel II is the second oI the Basel Accords, which are recommendations on banking laws and
regulations issued by the Basel Committee on Banking Supervision. The purpose oI Basel II,
which was initially published in June 2004, is to create an international standard that banking
regulators can use when creating regulations about how much capital banks need to put aside to
guard against the types oI Iinancial and operational risks banks Iace. Advocates oI Basel II
believe that such an international standard can help protect the international Iinancial system
Irom the types oI problems that might arise should a major bank or a series oI banks collapse. In
theory, Basel II attempted to accomplish this by setting up risk and capital management
requirements designed to ensure that a bank holds capital reserves appropriate to the risk the
bank exposes itselI to through its lending and investment practices. Generally speaking, these
rules mean that the greater risk to which the bank is exposed, the greater the amount oI capital
the bank needs to hold to saIeguard its solvency and overall economic stability.
Cb[ecLlve
1. Ensuring that capital allocation is more risk sensitive;
2. Separating operational risk Irom credit risk, and quantiIying both;
3. Attempting to align economic and regulatory capital more closely to reduce the scope Ior
regulatory arbitrage.
4. Basel II uses a "three pillars" concept (1) minimum capital requirements (addressing
risk), (2) supervisory review and (3) market discipline.
5. The Basel I accord dealt with only parts oI each oI these pillars. For example: with
respect to the Iirst Basel II pillar, only one risk, credit risk, was dealt with in a simple
manner while market risk was an aIterthought; operational risk was not dealt with at all.
Tbe first pillar
The Iirst pillar deals with maintenance oI regulatory capital calculated Ior three major
components oI risk that a bank Iaces: credit risk, operational risk, and market risk. Other risks
are not considered Iully quantiIiable at this stage.
The credit risk component can be calculated in three diIIerent ways oI varying degree oI
sophistication, namely standardized approach, Foundation IRB and Advanced IRB. IRB stands
Ior "Internal Rating-Based Approach".
For operational risk, there are three diIIerent approaches - basic indicator approach or BIA,
standardized approach or TSA, and the internal measurement approach (an advanced Iorm oI
which is the advanced measurement approach or AMA).
For market risk the preIerred approach is VaR (value at risk).
As the Basel 2 recommendations are phased in by the banking industry it will move Irom
standardised requirements to more reIined and speciIic requirements that have been developed
Ior each risk category by each individual bank. The upside Ior banks that do develop their own
bespoke risk measurement systems is that they will be rewarded with potentially lower risk
capital requirements. In Iuture there will be closer links between the concepts oI economic proIit
and regulatory capital.
Credit Risk can be calculated by using one oI three approaches:
1. Standardised Approach
2. Foundation IRB (Internal Ratings Based) Approach
3. Advanced IRB Approach
The standardized approach sets out speciIic risk weights Ior certain types oI credit risk. The
standard risk weight categories used under Basel 1 were 0 Ior government bonds, 20 Ior
exposures to OECD Banks, 50 Ior Iirst line residential mortgages and 100 weighting on
consumer loans and unsecured commercial loans. Basel II introduced a new 150 weighting Ior
borrowers with lower credit ratings. The minimum capital required remained at 8 oI risk
weighted assets, with Tier 1 capital making up not less than halI oI this amount.
Banks that decide to adopt the standardised ratings approach must rely on the ratings generated
by external agencies. Certain banks used the IRB approach as a result.
Tbe second pillar
The second pillar deals with the regulatory response to the Iirst pillar, giving regulators much
improved 'tools' over those available to them under Basel I. It also provides a Iramework Ior
dealing with all the other risks a bank may Iace, such as systemic risk, pension risk,
concentration risk, strategic risk, reputational risk, liquidity risk and legal risk, which the accord
combines under the title oI residual risk. It gives banks a power to review their risk management
system.
Internal Capital Adequacy Assessment Process (ICAAP) is the result oI Pillar II oI Basel II
accords
Tbe tbird pillar
This pillar aims to promote greater stability in the Iinancial system
Market discipline supplements regulation as sharing oI inIormation Iacilitates assessment oI the
bank by others including investors, analysts, customers, other banks and rating agencies. It leads
to good corporate governance. The aim oI pillar 3 is to allow market discipline to operate by
requiring lenders to publicly provide details oI their risk management activities, risk rating
processes and risk distributions.
It sets out the public disclosures that banks must make that lend greater insight into the adequacy
oI their capitalisation. When marketplace participants have a suIIicient understanding oI a bank`s
activities and the controls it has in place to manage its exposures, they are better able to
distinguish between banking organisations so that they can reward those that manage their risks
prudently and penalise those that do not.

Laurent Balthazar
Reviews
Palgrave Macmillan, 2 - 294 pages
The book covers topics related to banking regulation and credit risk modelling. The
proposed rules are presented and key issues regarding implementation of the accord
identified. The model used to calibrate the capital requirements under Basel 2 is
analyzed and projected forward to present what could be key new elements in the future
Basel 3 regulation. A CD-ROM is included to illustrate regulator models.
BaseI I

What Does ,80 Mean?
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 expIains ,80
The first accord was the Basel . t 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:

% - cash, central bank and government debt and any OECD government debt
%, 1%, 2% or 5% - public sector debt
2% - 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
5% - residential mortgages
1% - 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 $1 million, it is required to maintain capital of at least $8
million.
Main Characteristics of the New Accord Basel
The new accord (Basel ) consists oI three pillars:
1. Minimum capital requirement.
2. Supervisory review process.
3. Market discipline.
Taken together, the three pillars contribute to a higher level oI saIety and soundness in
the Iinancial system as characterized in the Iollowing diagram
1 The first Pillar: Minimum capital requirement
The deIinition oI capital in Basel 2 will not modiIy and that the minimum ratios oI capital
to risk-weighted assets including operational and market risks will remain 8 Ior total
capital. Tier 2 capital will continue to be limited to 100 oI Tier 1 capital. The main
changes will come Irom the inclusion oI the operational risk and the approaches to
Bank Soundness
Pillar
1
Pillar

Pillar
3
Market
Discipline
Minimum
Capital
Requirement
Supervisory
Review
Process
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measure the diIIerent kinds oI risks. The Iollowing diagram summarizes these
approaches.
Risk Based Capital Ratio Capital
Credit Risk Market Risk Operational Risk

While there were no changes in the approaches to measure the market risk there were
Iundamental changes in the approaches to measure the credit risk, which we will discuss
in section 3. Regarding the operational risk it is introduced Ior the Iirst time in this
accord.
In the standardized approach to credit risk, exposures to various types oI counter
parties, e.g. sovereigns, banks and corporates, will be assigned risk weights based on
assessments by external credit assessment institutions. To make the approach more risk
sensitive an additional risk bucket (50) Ior corporate exposures will be included.
Further, certain categories oI assets have been identiIied Ior the higher risk bucket
(150).
The 'Ioundation approach to internal ratings incorporates in the capital
calculation the banks` own estimates oI the probability oI deIault associated with the
obligor, subject to adherence to rigorous minimum supervisory requirements. Estimates
Approaches to measure Credit
Risk:
Standardized Approach a
modified version of the existing
approach).
oundation Internal Rating
Based Approach RB).
Advanced Internal Rating
oI additional risk Iactors to calculate the risk weights would be derived through the
application oI standardized supervisory rules. In the 'advance IRB approach, banks that
meet even more rigorous minimum requirements will be able to use a broader set oI
internal risk measures Ior individual exposures.
The Second Pillar: Supervisory Review Process
In Basel 1 the risk weight were Iixed and the implementation oI the accord was
straightIorward. In Basel the bank can choose Irom a menu oI approaches to measure
the credit, market and operational risks. This process oI choosing the approach requires
the review oI the availability oI the minimum requirements to implement the approach. In
addition to that, in IRB approaches the risk weight is computed Irom inputs Irom the
bank (like the probability oI deIault). It is necessary in this case to make sure that the
bank inputs are measured or estimated in an accurate and robust manner. Basel
committee suggests Iour principles to govern the review process:
Principle 1: Banks should have a process Ior assessing their overall capital in relation to
their risk proIile and a strategy Ior maintaining their capital levels.
Principle 2: Supervisors should review and evaluate banks` internal capital adequacy
assessments and strategies, as well as their ability to monitor and ensure their compliance
with regulatory capital ratios. Supervisors should take appropriate supervisory action iI
they are not satisIied with the results oI this process.
Principle 3: Supervisors should expect banks to operate above the minimum regulatory
capital ratios and should have the ability to require banks to hold capital in excess oI the
minimum.
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Principle 4: Supervisors should seek to intervene at an early stage to prevent capital Irom
Ialling below the minimum levels required to support the risk characteristics oI a
particular bank and should require rapid remedial action iI capital is not maintained or
restored.
3 The Third Pillar: Market Discipline
The third pillar in Basel aims to bolster market discipline through enhanced disclosure
by banks. EIIective disclosure is essential to ensure that market participants can better
understand banks` risk proIiles and the adequacy oI their capital positions. The new
Iramework sets out disclosure requirements and recommendations in several areas,
including the way a bank calculates its capital adequacy and its risk assessment methods.
The core set oI disclosure recommendations applies to all banks, with more detailed
requirements Ior supervisory recognition oI internal methodologies Ior credit risk,
mitigation techniques and asset securitization.
BASEL 3:
BASEL III is a new global regulatory standard on bank
capital adequacy and liquidity agreed by the members of the
Basel Committee on Banking Supervision
1]
The third of the
Basel Accords was developed in a response to the
deficiencies in financial regulation revealed by the global
financial crisis Basel III strengthens bank capital
requirements and introduces new regulatory requirements
on bank liquidity and bank leverage The OECD estimates
that the implementation of Basel III will decrease annual
GDP growBasel III will require banks to hold 4 of
common equity (up from 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 and (ii)
a discretionary countercyclical buffer, which allows national
regulators to require up to another 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 flows 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 stressth by 00 to 0Macroeconomic
Impact of Basel III
An OECD study
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released on 17 February 2011, estimates that the medium-term impact oI
Basel III implementation on GDP growth is in the range oI 0.05 to 0.15 percentage point per
annum. Economic output is mainly aIIected by an increase in bank lending spreads as banks pass
a rise in bank Iunding costs, due to higher capital requirements, to their customers. To meet the
capital requirements eIIective in 2015 (4.5 Ior the common equity ratio, 6 Ior the Tier 1
capital ratio), banks are estimated to increase their lending spreads on average by about 15 basis
points. The capital requirements eIIective as oI 2019 (7 Ior the common equity ratio, 8.5 Ior
the Tier 1 capital ratio) could increase bank lending spreads by about 50 basis points. The
estimated eIIects on GDP growth assume no active response Irom 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 oIIset by a reduction (or delayed increase) in monetary policy rates
by about 30 to 80 basis points.
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