BASEL I and BASEL II: HISTORY OF

AN EVOLUTION
 Importance
• The banking industry is the lifeline of any economy. It is one of the most
important pillars of the financial sector. Development of any country is highly
dependent on the performance of the banking industry. For an economy to
remain healthy and going, it is important that the banking system grows fast
and yet be stable.

Due to the importance in the financial stability of the country, banks are
highly regulated in most of the countries.

The collapse of financial institution in one country can also lead to

sequential collapse of financial institutions in other countries. Hence to
regulate the banking system, Basel Accord has been set up by the Basel
Committee on Banking Supervision (BCBS), a committee created by Bank
for International Settlements (BIS)
 BIS
• Bank for International Settlements (BIS):
The Bank for International Settlements is an international financial institution
owned by central banks which encourages international monetary and
financial cooperation and serves as a bank for central banks. It carries out
its work through its meetings, programmes and through the Basel
Process.The customers of the BIS are central banks and international
organizations. As a bank, the BIS doesnot accept deposits from, or provide
financial services to, private individuals or corporate entities.

• Lets browse :https://www.bis.org/

• Headquartered in Basel, Switzerland, the Bank for International Settlements
 (BIS) is a bank for central banks. Founded in 1930, the Bank for
International Settlements is the oldest global financial institution and
operates under the auspices of international law. 
 BCBS
• Basel Committee on Banking Supervision (BCBS)
To help promote monetary and financial stability, the Basel Committee on
Banking Supervision was set up by BIS in 1974. It was designed as a
medium for regular cooperation between its member countries on banking
supervisory matters. In 1980's the committee created a multinational accord
to strengthen the stability of the international banking system. A capital
measurement system commonly referred to as the Basel Capital Accord
was released to Banks in 1988. Ultimately this framework was introduced
not only in member countries but in all countries with active International
Banks.
 What are Basel Accords?

• The Basel accords are a set of recommendations for regulations in banking

industry. The Basel Committee consists of central bankers from several
countries who often met at Basel, Switzerland and they have come up with
set of rules and regulations for the banking industry.

Initially there were Central bankers from only 10 countries but now it has
extended to all G 20 countries and even beyond that. So far there has been
three versions of Basel Accords : Basel I (1988), Basel II (2004) and Basel
III (2010).
 THE FIRST BASEL ACCORD

The first Basel Accord (Basel-I) was completed

in 1988
 Basel - I
This was the first basel accord, which was meant for only Capital
Requirement of the banks. Many a times because of defaults or customers
defaulting in the payments of loans, the banks face a huge loss of money
and there is a problem of capital.

Without money the banks go bankrupt and become insolvent, i.e the bank
cannot exist anymore and hence it has to be rescued by the government or
any other organization. So the emphasis of Basel I was on Capital
requirement, hence determining the capital a bank should always hold in
order to avoid the lending risk, i.e when people default on their loans, the
bank can avoid insolvency.
 1988 BASEL ACCORD (BASEL-I)

1)The purpose was to prevent international banks from

building business volume without adequate capital
backing
2) The focus was on credit risk
3) Set minimum capital standards for banks
• Law:
The banks had to set aside atleast 8% of the
capital against the nominal size of their Loan.
Nominal size of the loan is also known as
Risk Weighted Asset (RWA). So according to
the Basel I law, 8% of the RWA has to be
kept with the bank in order to prevent
insolvency.
 BASEL-I CAPITAL REQIREMENTS

• Capital was set at 8% and was adjusted by a

loan’s credit risk weight
• Credit risk was divided into 5 categories: 0%,
10%, 20%, 50%, and 100%
– Commercial loans, for example, were
assigned to the 100% risk weight category
• Risk Weights:
It is defined as the % of assets under Risk.
All assets of the bank donot carry the same amount of risk. For example, if
a bank provides loan to the Government the risk is much less compared to
when provided to a private party. A government bond has much lesser risk
when compared to an equity. Hence the assets of the bank has been
classified into different categories and different risk weight has been
assigned.
 CORE & SUPPLEMENTARY CAPITAL

1) Core Capital (Tier I Capital)

i) Paid Up Capital
ii) Disclosed Reserves (General and Legal Reserves)
2) Supplementary Capital (Tier II Capital)
i) General Loan-loss Provisions
ii) Undisclosed Reserves (other provisions against
probable losses)
iii) Asset Revaluation Reserves
iv) Subordinated Term Debt (5+ years maturity)
v) Hybrid (debt/equity) instruments
RISK WEIGHT CATEGORIES IN BASEL-I
(1)
0% Risk Weight:
• Cash,
• Claims on central governments and central
banks denominated in national currency and
funded in that currency.
RISK WEIGHT CATEGORIES IN BASEL-I
(2)
20% Risk Weight
• Claims on multilateral development banks and claims
guaranteed or collateralized by securities issued by such
banks
• Claims on, or guaranteed by, banks incorporated in the
OECD
• Claims on, or guaranteed by, banks incorporated in
countries outside the OECD with residual maturity of up
to one year
• Claims on non-domestic OECD public-sector entities,
excluding central government, and claims on guaranteed
securities issued by such entities
• Cash items in the process of collection
RISK WEIGHT CATEGORIES IN BASEL-I
(3)
50 % Risk Weight

• Loans fully securitized by mortgage on residential

property that is or will be occupied by the borrower or
that is rented.
 RISK WEIGHT CATEGORIES IN BASEL-I
(4)
100% Risk Weight
• Claims on the private sector
• Claims on banks incorporated outside the OECD with
residual maturity of over one year
• Claims on central governments outside the OECD
(unless denominated and funded in national currency)
• Claims on commercial companies owned by the public
sector
• Premises, plant and equipment, and other fixed assets
• Real estate and other investments
• Capital instruments issued by other banks (unless
deducted from capital)
• All other assets
 THE PROBLEM WITH THE RISK
WEIGHTS
• Risk weights were based on what the parties to the Accord negotiated
rather than on the actual risk of each asset
– Risk weights did not flow from any particular insolvency probability
standard. The counterparty could be a very big organization like Apple,
Microsoft etc or it could be a very small company or one with not a very
good cashflow, like a small tea selling company or a small restruant.
Now when a big company like Microsoft when compared to a small
restruant in a city, the credit worthiness of the parties will differ a lot. So
there was no classification or any strict rule classifying the
counterparties. There was no segmentation rule set out. Although the
banks do segment these counter parties into different groups but there
was no rule set out in Basel I.
 OPERATIONAL AND OTHER RISKS

• The requirements did not explicitly account for

operating and other forms of risk that may also
be important
– Except for trading account activities, the capital
standards did not account for hedging, diversification,
and differences in risk management techniques
 1993 PROPOSAL: STANDARD MODEL

• Total Risk= Credit Risk+ Market Risk

• Market Risk= General Market Risk+ Specific
Risk
• General Market Risk= Interest Rate Risk+
Currency Risk+ Equity Price Risk + Commodity
Price Risk
• Specific Risk= Instruments Exposed to Interest
Rate Risk and Equity Price Risk
 EXAMPLES OF CAPITAL ARBITRAGE

• Assume a bank has a portfolio of commercial loans with the

following ratings and internally generated capital requirements
– AA-A: 3%-4% capital needed
– B+-B: 8% capital needed
– B- and below: 12%-16% capital needed
• Under Basel-I, the bank has to hold 8% risk-based capital
against all of these loans
• To ensure the profitability of the better quality loans, the bank
engages in capital arbitrage--it securitizes the loans so that
they are reclassified into a lower regulatory risk category with
a lower capital charge
• Lower quality loans with higher internal capital charges are
kept on the bank’s books because they require less risk-based
capital than the bank’s internal model indicates
BASEL-II
• Basel II
It was the second of the basel accords, and was published in 2004. Basel II accord made
it mandatory for the banks to set aside sufficient capital to be able to withstand any
losses resulting from credit risk, market risk and operational risk. In the Basel I, all we
had to worry was the loss arising from the credit risk, i.e, the loss arising from the
defaulting of the customers. In the Basel II, market risk and operational risk were
introduced. Market Risk arises from the movement of the market.

The bank holds lot of positions inn the capital market because of which the bank can
incur a lot of losses. Operational risk is because of bad incidences like fraud or any kind
of natural cataustrophe or any kind of issue with the local or foreign government where
the bank is operating. Loss happening because of any of these three risk will have to be
taken into consideration while calculating the capital requirement, unlike the Basel I
where there was only credit risk.

It also put emphasis on Risk management process followed in bank which was not the
case prior to that. Regulators now can intervene into how the management structure is or
how the management structure has been put into action within the bank or how the bank
really measures or quantifies the risk.
Pillar 1 - minimum capital requirements (addressing risk)The first pillar deals with ongoing
maintenance of regulatory capital that is required to safeguard against the three major
components of risk that a bank faces - Credit Risk, Operational Risk, and Market Risk

• Credit Risk component can be calculated in three different ways of varying degree

of sophistication, namely Standardized Approach, Foundation Internal Rating-
Based (IRB) Approach, and Advanced IRB Approach.
• For Operational Risk, there are three different approaches:
• Basic Indicator Approach (BIA)
• Standardized Approach (STA)
• Internal Measurement Approach, an advanced form of which is the Advanced
Measurement Approach (AMA)
• For Market Risk, Basel II allows for Standardized and Internal approaches. The
preferred approach is Value at Risk (VaR).
• As the Basel II recommendations are phased in by the banking industry, it moves
from standardized requirements to more refined and specific requirements that are
tailored for each risk category by each individual bank. The benefit for banks that
do develop their own bespoke risk measurement systems is that they are
rewarded with potentially lower risk capital requirements
Pillar 2 - supervisory review

• This is a regulatory response to the first pillar, giving

regulators better 'tools' over those previously available. It
also provides a framework for dealing with Pension Risk,
Systemic Risk, Concentration Risk, Strategic Risk,
Reputational Risk, Liquidity Risk, and Legal Risk, which
the accord combines under the title of Residual Risk.
 Pillar 3 - market discipline
• This pillar aims to encourage market discipline by developing a set of disclosure
requirements, which allow market participants to assess key pieces of
information on the scope of application, capital, risk exposures, risk assessment
processes, and hence the capital adequacy of the institution.
• Market Discipline supplements regulation, as sharing of information facilitates
assessment of the bank by others (including investors, analysts, customers,
other banks, and rating agencies) which leads to good corporate governance.
• By providing disclosures that are based on a common framework, the market is
effectively informed about a bank’s exposure to those risks, and provides a
consistent and understandable disclosure framework that enhances
comparability. These disclosures are required to be made at least twice a year,
apart from qualitative disclosures that provide a summary of the general risk
management objectives and policies, which can be made annually. Institutions
are also required to create a formal policy on what will be disclosed and controls
around them along with the validation and frequency of these disclosures. In
general, the disclosures under Pillar 3 apply to the top consolidated level of the
banking group to which the Basel II framework applies.
 Basel III
• Originally published in December 2010 in response to
the global financial crisis and is expected to be phased
in between 2013 and 2019
• To strengthen the regulation, supervision and risk
management of the banking sector
• Raises both the quality and quantity of required
regulatory capital bases
• Improve the banking sector's ability to absorb shocks
arising from financial and economic stress
• Enhances the risk coverage of the Basel II capital
framework to capture on- and off-balance sheet risks
• Also strengthens the consistency and transparency of
the capital base for commercial banks by defining and
limiting the types of capital instruments they use
• Capital requirements
• The Basel III rule introduced the following measures to strengthen the capital
requirement and introduced more capital buffers:
• Capital Conservation Buffer is designed to absorb losses during periods of
financial and economic stress. Financial institutions will be required to hold a
capital conservation buffer of 2.5% to withstand future periods of stress,
bringing the total common equity requirement to 7% (4.5% common equity
requirement and the 2.5% capital conservation buffer). The capital
conservation buffer must be met exclusively with common equity. Financial
institutions that do not maintain the capital conservation buffer faces
restrictions on payouts of dividends, share buybacks, and bonuses.
• Countercyclical Capital Buffer is a countercyclical buffer within a range of
0% and 2.5% of common equity or other fully loss absorbing capital is
implemented according to national circumstances. This buffer serves as an
extension to the capital conservation buffer.
• Higher Common Equity Tier 1 (CET1) constitutes an increase from 2% to
4.5%. The ratio is set at:
– 3.5% from 1 January 2013
– 4% from 1 January 2014
– 4.5% from 1 January 2015
 Capital Requirement
• Minimum Total Capital Ratio remains at
8%. The addition of the capital
conservation buffer increases the total
amount of capital a financial institution
must hold to 10.5% of risk-weighted
assets, of which 8.5% must be tier 1
capital. Tier 2 capital instruments are
harmonized and tier 3 capital is abolished.
 Leverage ratio
• Basel III introduced a minimum "leverage ratio". The
leverage ratio was calculated by dividing Tier 1 capital by
the bank's average total consolidated assets; the banks
were expected to maintain a leverage ratio in excess of
3% under Basel III. In July 2013, the US Federal
Reserve Bank announced that the minimum Basel III
leverage ratio would be 6% for 8 SIFI banks and 5% for
their bank holding companies.
 Liquidity requirements

• Basel III introduced two required liquidity ratios:Liquidity

Coverage Ratio (LCR) ensures that sufficient levels of
high-quality liquid assets are available for one-month
survival in a severe stress scenario.
• Net Stable Funding Ratio (NSFR) promotes resilience
over long-term time horizons by creating more incentives
for financial institutions to fund their activities with more
stable sources of funding on an ongoing structural basis.
Analysis of Basel II and Basel
III
•
The Basel III framework prescribes higher ratio in comparison to Basel II
Minimum Capital Requirement : 8% under Basel II increased to 10.50%
under Basel III
• Common Equity Tier 1 (CET1) : 2% under Basel II increased to (4.50% to
7.00%) under Basel III
• Tier I capital : 4% under Basel II increased to 6% under Basel III
• Capital Conservation Buffers : none under Basel II increased to 2.50%
under Basel IIIf) Leverage ratio under Basel IIfrom none to 3.00% under
Basel III
• Countercyclical Buffer : none under Basel II to (0% to 2.50%) under Basel III