Basel Accord

What are the Basel Accords?

The Basel Accord is the group of regulations set up by the Basel Committee on Banking and Supervision (BCBS). These banking regulations were not brought about at a single time. It is a process of several years. These banking regulations developed between 1980 to 2011. Various changes and alterations were implemented throughout the years.

These regulations were brought into existence to manage Market and credit risk at an international level. The regulations mainly aimed at strengthening banks to stand through periods of economic Recession and fulfil all their financial duties. It also aimed at bringing forth risk management, governance and transparency in dealing.

Basel I, Basel II and Basel III make up the Basel Accord.

Basel I

Basel I focuses on credit risk along with risk-weighted assets (RWA). Assets under Basel I are classified based on the level of risk with it. Risk is classified with 0% being the lowest to 100% being the highest. Tier 1 Capital suggest a capital of a more permanent type which should make up for 50% of the Bank’s total capital base. Tier 2 capital is quite of a fluctuating nature.

Under Basel, the asset classification system for banks categorises assets into 5 risk categories. These assets are classified based on the nature of the debtor. This is based on risk percentage like 0%, 10%, 20%, 50% and 100%. It is mentioned below:

1. 0% Risk Category includes cash, government, debt, central bank debt and debt of governmental departments or organisations.
2. 10% risk category includes debt of countries with high Inflation recently or in the recent past.
3. 20% risk category includes development bank debts, OECD bank debt, non-OECD bank debt and debt under one year of maturity. It also includes non-OECD public sector debt.
4. 50% risk category includes residential mortgages
5. 100% risk category includes private sector debts, non-OECD bank debt with maturity over a year, Real Estate, plant and equipment. It also includes capital instruments issued at other banks.

Basel II

Basel II says that the banks with riskier assets should have more capital on hand than those with safer assets. It also states that companies publish details of risky investments and risk management.

Three Pillars of Basel II

Basel II has three pillars minimal capital requirements, regulatory supervision and market discipline.

Pillar 1: The minimal capital requirement takes into consideration the operational risks along with credit risks which are associated with risk-weighted assets (RWA). It takes into account a specific asset’s risk profile with specific characteristics.

Pillar 2 i.e. regulatory supervision takes into account the banks’ capital adequacy for covering all risks they can face in their operations. It makes sure to see whether the banks are taking the right measures and covers all risks associated.

Pillar 3 i.e. market discipline makes it compulsory for companies to disclose their market information. This is done so that uses who are Investing in these financial institutions can make relevant informed trading decisions and ensure market discipline. It allows the public to know about the bank’s risk exposures, risk assessments processes among others.

Basel III

Basel III is the third part of the Basel records and is a continuous process to help the banks to take risks. However, the risks should not be more than they can Handle.

In 2008, a global financial crisis on banks led to the introduction of Basel III. This could improve a bank’s ability to handle any shock from Financial Stress. Strengthening transparency and disclosure was important. Since Basel III, the Basel Committee on Banking Supervision has expanded membership. Now 45 members are part of the committee.

Pillars of Basel III

1. Minimum Capital Requirements

In 2015, the Tier 1 capital requirement increased from 4% in Basel II to 6% in Basel III. This includes 4.5% of common equity tier 1 and an extra 1.5% of additional Tier 1 capital.

2. Leverage Ratio

Basel III has brought in a non-risk leverage ratio. This was to serve as a backdrop to risk-based capital requirements. Basically, banks, in general, are required to hold a leverage ratio in excess of 3%. This is calculated dividing Tier 1 capital by the average total of consolidated bank assets.

3. About Liquidity

The introduction of Basel III also roped in two liquidity ratios i.e. Liquidity Coverage Ratio and Net Stable Funding Ratio. This ratio requires the banks to have high liquidity assets, which can stand amid 30-day stressed scenario.