Question

Clearly identify the significance of Basel I, II, III Accords.

Answer 1

• The Basel Accords are three series of banking regulations set by the BCBS.
• The accords are designed to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses.
• The latest accord is Basel III, which was agreed in November 2010. Basel III requires banks to have a minimum amount of common equity and a minimum liquidity ratio.

Basel I

Basel I is the first in the series of regulations issued by the BCBS and was enacted in 1988 to improve banking stability. It weighed the capital owned by a bank against the credit risk it faced. Basel I defined the bank capital ratio and set the ball rolling for solvency monitoring and reporting. The main highlights of this accord are listed below:

1. Assets of financial institutions are broadly divided into five risk categories (0%, 10%, 20%, 50% and 100%).
2. Banks that operate internationally are required to have a minimum of 8% capital to risk-weighted assets.

   Basel II

   The Basel II framework, also called the Revised Capital Framework, aimed to build up on the foundation laid down by Basel I. It has three pillars:

3. Minimum Capital Requirements: This Basel Accord further refined the definition of risk-weighted assets and provided guidelines for calculation of minimum regulatory capital ratios dividing the eligible regulatory capital of a bank into tiers.
4. Supervisor Review: This pillar laid down guidelines for national regulatory authorities to deal with risks such as systemic risk, liquidity risk and legal risk.
5. Market Discipline: The last and final pillar requires disclosures by banks regarding their risk exposures, capital adequacy and the overall risk assessment process.

   Basel III

   Basel III introduced much tighter capital requirements than Basel I and Basel II to address the weaknesses in the previous accord. One of the most evident problems with Basel II was that it did not moderate the imprudent lending activities of banking institutions.

   Major changes from Basel II:

6. Minimum Capital Requirements: Although the overall regulatory capital requirement was unaltered at 8%, the Common Equity Tier 1 capital requirement was raised from 4% to 4.5% and minimum Tier 1 capital was raised from 4% to 6%.
7. Leverage and Liquidity: To make sure that banks have ample liquidity during financial stress and to protect them from disproportionate borrowing, an upper limit of 3% was introduced for the leverage ratio (computed as Tier 1 capital divided by the total of on and off-balance sheet assets less intangible assets).
8. Countercyclical Measures: To ensure that the banks' regulatory capital was in sync with the cyclical changes in their balance sheets, new guidelines were introduced requiring banks to set aside additional capital in times of credit expansion and relaxing the capital requirements during credit contraction.
9. Bucketing System: Basel III also established the bucketing system in which banks were grouped together and assigned to buckets according to their size, complexity and importance to the overall economy. Guidelines were defined for identifying and regularly updating a list of Systematically Important Banks and subjecting them to higher capital requirements.