Question

Basel I and Basel II. Compare and contrast these two International agreements. Explain their objectives, scope and power of enforcement. In your opinion are there any valid arguments for or against these agreements?

Answer 1

BASEL I

• In 1988, the Basel Committee on Banking Supervision (BCBS) in Basel, Switzerland, published a set of minimum capital requirements for banks.These were known as Basel I.
• It focused almost entirely on credit risk (default risk) - the risk of counter party failure. It defined capital requirement and structure of risk weights for banks.
• Under these norms: Assets of banks were classified and grouped in five categories according to credit risk, carrying risk weights of 0%(Cash, Bullion, Home Country Debt Like Treasuries), 10%, 20%, 50% and100% and no rating.
• Banks with an international presence are required to hold capital equal to 8% of their risk-weighted assets (RWA) - At least, 4% in Tier I Capital (Equity Capital + retained earnings) and more than 8% in Tier I and Tier II Capital by the end of 1992.
• One of the major role of Basel norms is to standardize the banking practice across all countries. However, there are major problems with definition of Capital and Differential Risk Weights to Assets across countries, like Basel standards are computed on the basis of book-value accounting measures of capital, not market values.  Accounting practices vary significantly across the G-10 countries and often produce results that differ markedly from market assessments.
• Other problem was that the risk weights do not attempt to take account of risks other than credit risk, viz., market risks, liquidity risk and operational risks that may be important sources of insolvency exposure for banks.

Basel II:

• Basel II is a set of international banking regulations put forth by the Basel Committee on Bank Supervision, which leveled the international regulation field with uniform rules and guidelines.
• Basel II expanded rules for minimum capital requirements established under Basel I, the first international regulatory accord, and provided framework for regulatory review, as well as set disclosure requirements for assessment of capital adequacy of banks.
• The main difference between Basel II and Basel I is that Basel II incorporates credit risk of assets held by financial institutions to determine regulatory capital ratios.
• So, Basel II was introduced in 2004, laid down guidelines for capital adequacy (with more refined definitions), risk management (Market Risk and Operational Risk) and disclosure requirements.
• Basel II is a second international banking regulatory accord that is based on three main pillars:

a. minimal capital requirements,

b. regulatory supervision and

c. market discipline.

• Minimal capital requirements play the most important role in Basel II and obligate banks to maintain minimum capital ratios of regulatory capital over risk-weighted assets.
• Basel II provides guidelines for calculation of minimum regulatory capital ratios and confirms the definition of regulatory capital and 8% minimum coefficient for regulatory capital over risk-weighted assets.
• Basel II divides the eligible regulatory capital of a bank into three tiers. The higher the tier, the less subordinated securities a bank is allowed to include in it. Each tier must be of certain minimum percentage of the total regulatory capital and is used as a numerator in the calculation of regulatory capital ratios.
• Tier 1 capital is the most strict definition of regulatory capital that is subordinate to all other capital instruments, and includes shareholders' equity, disclosed reserves, retained earnings and certain innovative capital instruments. Tier 2 is Tier 1 instruments plus various other bank reserves, hybrid instruments, and medium- and long-term subordinated loans. Tier 3 consists of Tier 2 plus short-term subordinated loans.
• Basel II is refining the definition of risk-weighted assets, which are used as a denominator in regulatory capital ratios, and are calculated by using the sum of assets that are multiplied by respective risk weights for each asset type. The riskier the asset, the higher its weight. The notion of risk-weighted assets is intended to punish banks for holding risky assets, which significantly increases risk-weighted assets and lowers regulatory capital ratios.
• The main innovation of Basel II in comparison to Basel I is that it takes into account the credit rating of assets in determining risk weights. The higher the credit rating, the lower risk weight.
• Regulatory supervision is the second pillar of Basel II that provides the framework for national regulatory bodies to deal with various types of risks, including systemic risk, liquidity risk and legal risks.
• The market discipline pillar provides various disclosure requirements for banks' risk exposures, risk assessment processes and capital adequacy, which are helpful for users of financial statements.