Basel I

Basel Committee
The Basel Committee - initially named the Committee on Banking Regulations and Supervisory
Practices - was established by the central bank Governors of the Group of Ten countries at the
end of 1974 in the aftermath of serious disturbances in international currency and banking
markets (notably the failure of Bankhaus Herstatt in West Germany).
The Committee, headquartered at the Bank for International Settlements in Basel, was
established to enhance financial stability by improving the quality of banking supervision
worldwide, and to serve as a forum for regular cooperation between its member countries on
banking supervisory matters. The Committee's first meeting took place in February 1975, and
meetings have been held regularly three or four times a year since.
Since its inception, the Basel Committee has expanded its membership from the G10 to 45
institutions from 28 jurisdictions. Starting with the Basel Concordat, first issued in 1975 and
revised several times since, the Committee has established a series of international standards for
bank regulation, most notably its landmark publications of the accords on capital adequacy
which are commonly known as Basel I, Basel II and, most recently, Basel III.
 https://www.bis.org/bcbs/history.htm

Basel I: the Basel Capital Accord

Basel I refers to a set of international banking regulations created by the Basel Committee on
Bank Supervision (BCBS), which is based in Basel, Switzerland. The committee defines the
minimum capital requirements for financial institutions, with the primary goal of
minimizing credit risk. Basel I is the first set of regulations defined by the BCBS and is a part of
what is known as the Basel Accords, which now includes Basel II and Basel III. The accords’
essential purpose is to standardize banking practices all over the world.
( https://corporatefinanceinstitute.com/resources/knowledge/finance/basel-i/)

Bank Asset Classication System

The Bank Asset Classification System classifies a bank’s assets into five risk categories on the
basis of a risk percentage: 0%, 10%, 20%, 50%, and 100%. The assets are classified into
different categories based on the nature of the debtor, as shown below:
 0% Risk 10% Risk 20% Risk 50% Risk 100% Risk
Category Category Category Category Category
Cash, Central Development Residential Privet sector
Government bank debt of bank debts, OECD mortgages debt, non-OECD
debt, central bank countries bank debt, non- bank debt with
debt, and the debt with high OECD bank debt maturity over a
of governmental inflation in under one year of year, real state,
departments or the recent maturity, and non- plant and
organizations past OECD public equipment, and
sector debt capital
instruments
issued at other
banks

The BCBS regulations do not have legal force. Members are responsible for their
implementation in their home countries. Basel I originally called for the minimum capital ratio of
capital to risk-weighted assets (RWA) of 8% (of which the core capital element will be at least
4%) to be implemented by the end of 1992. In September 1993, the BCBS issued a statement
confirming that G10 countries' banks with material international banking business were meeting
the minimum requirements set out in Basel I.
According to the BCBS, the minimum capital ratio framework was introduced in member
countries and in virtually all other countries with active international banks.

The tier 1 capital ratio = tier 1 capital / all RWA

The total capital ratio = (tier 1 + tier 2 capital) / all RWA
Leverage ratio = total capital/average total assets

Benefits of Basel I
 Significant increase in Capital Adequacy Ratios of internationally active banks
 Competitive equality among internationally active banks
 Augmented management of capital
 A benchmark for financial evaluation for users of financial information
 
Limitations
 Other kinds of risk, such as market risk, operational risk, liquidity risk, etc. were not
taken into consideration.
 Emphasis is put on the book values of assets rather than the market values.
Basel II

Basel II is the second set of international banking regulations defined by the Basel Committee on
Bank Supervision (BCBS). It is an extension of the regulations for minimum capital
requirements as defined under Basel I.

The Basel ii framework sets out the details for measuring capital adequacy and the minimum
standard to be achieved which the national supervisory authorities represented on the Committee
will propose for adoption in their respective countries.
This Framework and the standards it contains have been endorsed by the Central Bank
Governors and Heads of Banking Supervision of the Group of Ten countries. The Committee
expects its members to move forward with the appropriate adoption procedures in their
respective countries.
The purpose of Basel II 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 of
financial and operational risks banks face.

History of Basel II
The efforts of the Basel Committee on Banking Supervision to revise the standards governing the
capital adequacy of internationally active banks achieved a critical milestone in the publication
of an agreed text in June 2004.
In November 2005, the Committee issued an updated version of the revised
Framework incorporating the additional guidance set forth in the Committee's paper The
Application of Basel II to Trading Activities and the Treatment of Double Default Effects .
On 4 July 2006, the Committee issued a comprehensive version of the Basel II Framework. Solely
as a matter of convenience to readers, this comprehensive document is a compilation of the June
2004 Basel II Framework, the elements of the 1988 Accord that were not revised during the Basel
II process, the 1996 Amendment to the Capital Accord to Incorporate Market Risks , and the 2005
paper on the Application of Basel II to Trading Activities and the Treatment of Double Default Effects .
No new elements have been introduced in this compilation.
The Basel Committee on Banking Supervision issued for public comment Guidelines for
Computing Capital for Incremental Risk in the Trading Book  as well as Proposed Revisions to the Basel II
market risk framework. The proposed incremental risk charge would capture price changes due to
defaults as well as other sources of price risk, such as those reflecting credit migrations and
significant moves of credit spreads and equity prices. The Basel Committee also proposes
improvements to the Basel II Framework concerning internal value-at-risk models. It has further
aligned the language with respect to prudent valuation for positions subject to market risk with
existing accounting guidance. In addition, it has clarified that regulators will retain the ability to
require adjustments to current value beyond those required by financial reporting standards, in
particular where there is uncertainty around the current realisable value of a position due to
illiquidity. The Committee welcomes comments from the public on all aspects of these
consultative papers by 15 October 2008.

The Basel Committee issued a final package of measures to enhance the three pillars of the Basel
II framework and to strengthen the 1996 rules governing trading book capital. These measures
were originally published for public consultation in January 2009.
Pillars of Basel II
The Basel II Accord makes it mandatory for financial institutions to use standardized
measurements for credit, market risk, and operational risk. However, different levels of
compliance allow financial institutions to pursue advanced risk management approaches to free
up capital for investment. The Basel II framework operates under three pillars:

1. Minimum capital requirements

2. Supervisory review
3. Market discipline

Pillar-1: Minimum capital requirements

The first pillar deals with maintenance of regulatory capital calculated for three major components of
risk that a bank faces: credit risk, operational risk, and market risk. Other risks are not considered
fully quantifiable at this stage.
Credit Risk
1. A credit risk is risk of default on a debt that may arise from a borrower failing to make required
payments.[1] In the first resort, the risk is that of the lender and includes lost principal and interest,
disruption to cash flows, and increased collection costs. The loss may be complete or partial. In an
efficient market, higher levels of credit risk will be associated with higher borrowing costs. Because
of this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels
based on assessments by market participants.
The credit risk component can be calculated in three different ways of varying degree of
sophistication, namely standardized approach, Foundation IRB, Advanced IRB. IRB stands for
"Internal Rating-Based Approach".

2. Operational risk is "the risk of a change in value caused by the fact that actual losses, incurred
for inadequate or failed internal processes, people and systems, or from external events (including
legal risk), differ from the expected losses". This positive definition, adopted by the
European Solvency II Directive for insurers, is a variation from that adopted in the Basel
II regulations for banks.[1][2] Before, operational risk was negatively defined in Basel I, namely that
operational risk are all risks which are not market risk and not credit risk. Some banks have therefore
also used the term operational risk synonymously with non-financial risks.[3]

For operational risk, there are three different approaches – basic indicator approach or
BIA, standardized approach or TSA, and the internal measurement approach (an advanced form of
which is the advanced measurement approach or AMA).
Market risk is the risk of losses in positions arising from movements in market prices. There is no
unique classification as each classification may refer to different aspects of market risk. For market
risk the preferred approach is VaR (value at risk).

approaches for operational risk

1. Standardized approach

The standardized approach is suitable for banks with a smaller volume of operations and a simpler
control structure. It involves the use of credit ratings from external credit assessment institutions for
the evaluation of the creditworthiness of a bank’s debtor.

2. Foundation Internal Ratings-based approach (FIRB): In FIRB, banks use their own
assessments of parameters such as the Probability of Default, while the assessment methods of
other parameters, mainly risk components such as Loss Given Default and Exposure at Default, are
determined by the supervisor.

3. Advanced Internal Ratings-based approach (AIRB): Under the AIRB approach, banks use their
own assessments for all risk components and other parameters.

Pillar-2: Supervisory review

The supervisory review process of the New Accord is intended not only to ensure
that banks have adequate capital to support all the risks in their business, but also to
encourage banks to develop and use better risk management techniques in monitoring and
managing their risks.

The supervisory review process is based on four key principles:

Principle 1: Banks should have a process for assessing their overall capital adequacy in relation
to their risk profile and a strategy for 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 if they are not
satisfied with the result of 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 of the minimum.
Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling
below the minimum levels required to support the risk characteristics of a particular bank and
should require rapid remedial action if capital is not maintained or restored.

Pillar-3: Market discipline