THE BASEL ACCORDS.

Due to evidence from research of the benefits and costs of imposing capital requirements on financial
service firms, the regulatory community has recently taken vital steps to strengthen government’s role in
assessing how much capital and their closest financial institution really need and as well ensuring that
they comply with government imposed capital requirements.

In 1988 the Federal reserve board, for US, and representatives from other leading countries like Belgium,
Canada, France, Germany, Italy, Japan, the Netherlands, Spain, Sweden, Switzerland, the UK and
Luxemburg announced agreement on new capital standards referred to as Basel Agreement, named after
a city in Switzerland where this agreement was arrived at. It was approved in July 1988 and its rules were
designed to encourage leading banks around the world to:

 Keep their capital positions strong,

 Reduce inequalities in capital requirements among different countries to promote fair

competition,

 Catch up with recent changes in the financial services and financial innovation like expansion of
off-balance sheet commitments.

Basel I.

These are the original Basel capital requirements in which various sources of bank capital were divided
into two tiers:

Tier 1 capital (Core capital) – Comprises of common stock (ordinary shares) and surplus, retained
earnings (undivided profits), qualifying noncumulative preferred stock, minority interest in equity
accounts of consolidated subsidiaries and selected identifiable intangible assets less goodwill and other
intangible assets.

Tier 2 capital (Supplemental capital) – Includes the allowances (provisions) for loan and lease losses,
subordinated debt capital instruments, mandatory convertible debt, intermediate term preferred stock,
cumulative perpetual preferred stock with unpaid dividends and equity notes & other long term capital
instruments that combine both equity and debt features.

To ascertain the bank’s total regulatory capital regulators will sum tier 1 and tier 2 capitals and from the
sum the following will be deducted:

 Investments in unconsolidated subsidiaries,

 Capital securities held by the bank that were issued by other depository institutions and held
under reciprocity agreements,

 Activities pursued by savings and loans associations that may have been acquired by a banking
organization and not permissible for national banks,

 Any other deductions as demanded from time to time by the regulatory supervisors.
As per Basel I, for a bank to be adequately capitalized it must have:

1. A ratio of core capital (Tier 1) to total risk-weighted assets of at least 4%.

2. A ratio of total capital (Tier 1 + Tier 2) to total risk-weighted assets of at least 8% with the
amount of Tier 2 capital limited to 100% of Tier 1 capital.