Basel I

It is a series of guidelines to regulate the banking sector.

Basel 1 was created by the International Basel Committee on Bank Supervision- BCBS in 1988 in Basel, Switzerland, as a series of guidelines to regulate the banking sector in a country that specified particular measures to reduce credit risk exposed by any institution.

It was the first of the three sets of regulatory guidelines known as Basel 1, 2, & 3, separately and collectively as the Basel Accords, and Basel 1, known as the 1988 Basel Accord. Its focus was on credit risk, mainly achieved by establishing a classification system for the bank's assets.

It was in the form of simplistic efforts to regulate the countries' financial sectors. Banks that were undercapitalized in the past responded to this framework by improving their capital ratios in order to comply with the set of guidelines and criteria.

Its aim was to introduce a standardized concept for capital adequacy worldwide and bring banks' attention, as well as the financial industry, to the importance of capital management.

It was organized by the central bankers of the G10 countries who were building at that time new financial structures to replace the recently collapsed Bretton Woods system. Basel1 was enforced by law in the Group of Ten countries- G10 in the year 1992.

The G10 countries concept was established when the ten wealthiest International Monetary Funds-IMF member countries agreed to participate in General Agreements to Borrow-GAB.

GAB was created in 1962 when the governments of eight IMF member countries: Canada, France, Belgium, Japan, Italy, Netherlands, U.K, U.S.A, along with the central banks of Sweden and Germany, agreed to provide resources to the IMF.

In 1971, G10 Forum was made to allow members to discuss and create different agreements, including The Smithsonian Agreement "and the" Bretton Woods system, and then replaced with a fixed exchange rate system with a floating exchange rate.

Although there consisted of 13 countries of "the" G10 in 2013: Switzerland, Sweden, the U.K, the U.S.A, Spain, Luxemburg, Netherlands, Japan, Germany, Italy, France, Canada, and Belgium, more than 100 countries adopted these principles to have international banking business.

Nevertheless, the extent of efficiency implications for these guidelines varies across countries, even in the G10 countries group.

History Background

BCBS was formed in response to the unorganized dealing with the liquidity of the Herstatt Bank in Cologne, Germany, in the year 1974, where many banks released the D-Marks/ Deutschmarks to this bank in exchange for dollar payments delivered to Franklin National Bank of New York.

Because of differences in time zones, a lag in payments for the counterparty banks occurred, causing German Regulators to liquidate this bank before these dollar payments took place in the Bank of New York, resulting in huge losses in foreign exchanges.

Therefore, the G10 called for looking at the disruptions in international financial markets and forming International BCBS in late the same year 1974 under the Bank for International Settlements- BIS in Basel, Switzerland, created in 1930.

BCBS was initially called Banking Regulations and Supervisory Practices and renamed in recognition of the town where it was first made. The first meeting was in 1975, and it is held regularly 3 to 4 times yearly.

It is a closely associated international committee established to develop financial and banking regulations "standards." In 2019, it expanded its membership to be made up of 45 members from 28 jurisdictions of central banks and banking authorities.

It concerns addressing global financial and banking challenges and helping the national banking and financial markets supervisory bodies to adopt a globalized and unified approach to solving these problems.

The committee has its own agendas, governance style, and reporting lines which the central banks of G10 countries monitor.

As mentioned earlier about the collapse of the Bretton Woods system and G10 response, by the end of WW2, the World Bank and International Monetary Fund- IMF was established under this system in the year 1944 though it was perceived as an irrelevant entity, BIS still exists.

BIS was created as an international financial institution that provides banking services to the national central banks, fosters the global financial sector, and acts as a banker to the central banks. It is known as a central bank for central banks.

It is owned and governed by a board of 63 national banks with ownership stakes and six countries with permanent seats. It discusses the regulations and monetary policies and offers independent economic analyses.

Purpose, Aims, and Requirements  

Basel1 aims at setting minimum capital requirements for the different major financial institutions in a country to mitigate risk where the international operating banks are required to maintain at least a minimum capital requirement of 8% on hand based on their Risk-Weighted Assets- RWA.

RWA refers to the bank's exposures to its assets or off-balance sheet- OBS, which are weighted based on their risk level. Calculating these types of assets is used in determining capital requirements and Capital Adequacy Ratio-CAR.

Because of such a bank's exposure to OBS, it is required to report these items: letter of credit, derivatives, and unused commitments as they are connected with RWA and reported to the regulators of a country.

OBS or incognito leverage refers to a bank's asset, financing, or debt activity that is not composed of this bank's balance sheet. Assets are managed as part of the offered services by the bank that belongs to individual clients in a direct or trust form.

Thus, a bank must maintain adequate capital (Tier1 and Tier2 capital) to meet any of its obligations that are equal to at least 8% of its RWA.

Tier 1 capital includes the most liquid assets: shareholders' equity, retained earnings, and disclosed reserves that represent the core funding source for the bank. Bank uses the money under this tier to grow and operate on a regular basis as it is considered the bank's strength.

Tier 2 capital includes less liquid hybrid capital instruments, revelation reserves, loan losses, and undisclosed reserves. It is less credible than Tier 1 capital because it is more difficult to do the calculation and liquidate. It is considered a bank's supplementary capital.

CAR or Capital to RWA Ratio-CRAR implies a bank's capital to its risk ratio. This indicator is helpful to ensure that the bank is able to absorb a sufficient amount of losses and comply with statutory capital requirements.

It is a measure of the bank's capital expressed in terms of the percentage of the credit risk exposure. It aims at protecting depositors' rights and providing a high degree of efficiency and stability in the financial system overall of a country and globally.

Usually, two types of capital are measured, Tier 1 is able to absorb losses without affecting a bank to stop its trading activity, and Tier 2 is able to absorb losses when a bank is winding up/in the process of liquidating, so it is a less secure and lower standard than Tier1.

Additionally, Basel1 aims at setting a sufficient amount of capital adequacy that refers to the risk arising from unexpected loss resulting in a negative impact on those institutions. It classified assets into different five categories: 0%, 10%, 20%, 50%, and 100%.

Usually, the bank classification system specifies particular assets for each type based on the nature of the debtor. These classifications reflect a free risk asset of 0% to risky ones of 100% that include:

  1. 0%: cash, central bank debt, government debt, and governmental organizations and departments' debt 
  2. 10%: central banks debt of countries that have a high percentage of inflation recently
  3. 20%: OECD bank debt, bank's development debt, non-OECD public sector debt, non-OECD bank debt of a 1-year maturity

*OECD refers to Organization For Economic Cooperation and Development

  1. 50%: residential mortgages
  2. 100%: debt of private sector, capital instruments issued by other banks, real estate, plant and equipment, and non-OECD bank debt of over a one-year maturity

Formula and Required Calculations

Calculating the CAR should be done through this formula below, which comprises Tier 1 and Tier 2 and are divided by the Weighted Risk Assets.

CAR = Tier1 + Tier2 / RWA

Tier1 includes: Common Equity Tier-CET1 and Additional Tier-AT1, and calculation is done by dividing the Tier 1 capital by the total of risk-weighted assets.

Tier 1 Capital Ratio= Tier1 capital / Total RWA

The formulas above help a bank to better understand what they have to avoid any financial losses.

It is intended to measure the financial healthiness of a bank, and it is composed of shareholder's equity and retained earnings which are reflected on the financial statements. It is easier to calculate it without error and more reliable because of the asset's liquidation nature.   

Tier2 includes revaluation reserves, general provisions, hybrid capital instruments, and subordinated debt. It has two levels, the upper level composed of securities with no maturity date and the lower level intended for subordinated debts and to calculate it:

Tier2 Capital Ratio = Tier2 capital / RWA

It is considered riskier because it is difficult for a bank to measure it when it needs liquidation.

Note that central banks of the countries usually draft their formulas for asset risk weights in accordance with the Basel Committee guidelines.

Banks are obliged to meet these three requirements under the full Basel Framework:

  1. Under Tier 1, common equity must be a minimum of 4.5% of RWA, where the capital conservation cushion is set at 2.5% of RWA.
  2. Under Tier 1, the capital must be a minimum of 6% of RWA.
  3. Thus, Total capital must be a minimum of 8% of RWA.

Additionally, the weighted risk approach was urged by the committee to be utilized in calculating the capital of banks because of

  • It offers a simpler method to compare banks located in different geographies
  • It helps in including OBS items easily when calculating capital adequacy
  • It allows banks to not be postponed in holding low-risk liquid assets in their books

RWA represents a sum of assets that a bank holds weighted by risk, and it includes different classes of assets: cash, debentures, and bonds, where each class has its own risk level as weighting risk depends on the extent of the assets' value reduction.

In the end, Basel1 regulations intended to improve the safety and stability of the banking system globally by establishing international standards that tell banks the holden capital amount that banks should carry in their reserves.

Differences Between Basel 2 and Basel 3

As mentioned earlier, the aim of Basel 1 is to provide banks with guidelines about the minimum requirement of capital that they must hold in their reserves based on the risk degree of their different classes of assets.

Though it has the least risk focus perspective out of the 3 Basel Accords as it only considers credit risk, it has a backward perspective in which it only focuses on the assets that compose the present portfolio of a bank.

Where Basel 2 rectified those guidelines in Basel 1 and added on new requirements. By setting new supervisory duties and strengthening the minimum capital requirements. This is achieved through establishing a three pillars approach for managing risk.

It includes different types of risks in its evaluation: reputation, strategic, and operational risks. It has a forward perspective as it concerns calculating the capital based on risk sensitivity.

Basel 3 further rectified those guidelines, especially in parts where the lessons learned from the worldwide Financial Crisis 2007- 2008. This is done by setting an additional buffer of equity to be managed by the banks. It includes liquidity risk evaluation plus the risks assessed in Basel2.

It also has a forward approach for which it follows a macroeconomic environment assessment approach along with the independent bank's criteria.

Thus, it is clear that the Basel framework is extended to calculate risk by measuring different types of financial risks: credit risk, market risk, and operational risk, and allowing banks to follow different approaches where some are subject to supervisory approval.

Generally, the difference between each in the Basel framework depends on the objectives that are intended to be achieved and established to regulate the banking sector and financial institutions globally.

Although each has separate and different standards and calculation requirements, all three accords are intended to manage and control the different types of risks exposed by the banks in alignment with the changes that occur in the international environment.

Advantages and Disadvantages of Basel I 

Basel 1 resulted in an increase in capital adequacy ratio for international banks after implementing it boosted the capital management practices and helped them to have competitive equality across them.

It provides a benchmark regarding financial information for its users and helps to bring and enhance the financial stability of the banking sector worldwide.

Because of globalization and the introduction of the interdependence of banks internationally, Basel1 was introduced to relive the economies of different countries and strengthen these practices to avoid failure and bankruptcy.

As mentioned earlier, history and the G10 call for more robust standards and regulations that help banks stand still and absorb any financial or economic shock. In the end, the Basel framework was established to manage those banks that are operating internationally.

However, Basel 1 did not cover other types of risks as mentioned earlier in the differences between the 3, which resulted in an insufficient assessment of the bank's practices and management performance overall because it offers a partial and poor risk management system.

Also, it aims only to examine the book value of assets rather than the market value that gives insights into the value of a bank within its sector based on different variables.

It lacks strong and proper corporate governance and regulatory restrictions that affect the liquidity management practices and increase capital structure leverage. As such, factors play a key role in the occurrence of the financial crisis, and that is the main reason for Basel 3 to come.

As a result, due to the perspective that Basel 1 was too broad in its scope and simple in its rules and regulations, Basel 2 and 3 were introduced to improve the international banking performance sector and reduce the occurrence of any financial crisis.

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Researched and authored by Noor H | LinkedIn

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