Basel is a city in Switzerland. It is the headquarters of the Bureau of International Settlement (BIS), an organisation that promotes cooperation among central banks with the objective of financial stability and uniform banking rules. The BIS organises a meeting of the governors and senior officials of member nations' central banks every two months. The committee currently has 27 countries as members.
Basel rules are comprehensive supervisory norms developed by the Basel Committee on Banking Supervision (BCBS), a group of central banks. The Basel accord is a collection of BCBS agreements that primarily focus on risks to banks and the financial system.
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On paper the Basel norms are not binding in nature, however, a lot of the countries worldwide have regulations in place so as to prioritise these norms. These norms form the backbone of financial risk worldwide and therefore form an important basis for the operation of banks.
Usually banks adhere to Basel norms due to both the regulatory obligations of their respective central banks (which govern their basic requirements) and in order to prevent themselves from being caught in financial disasters such as the financial crisis of 2007-08 which had a detrimental impact on institutions providing financial services worldwide (more on some like Lehman brothers than others).
Just like other sets of regulations which are improved with time facilitated by innovations and the related increase in the scope of dangers, the Basel norms have also witnessed improvements with time and have become more and more elaborate as well as intricate in nature.
This blog discusses the 3 editions of Basel norms, commonly known as Basel I, Basel II and Basel III norms in an attempt to understand the steps taken by banks worldwide in an attempt to protect themselves from the four types of financial risks: credit risk, market risk, liquidity risk and operational risk.
Capital adequacy quickly became the major focus of the Basel Committee's efforts when the foundations for supervision of globally operating banks were built. The emergence of the Latin American debt crisis in the early 1980s increased the Basel Committee's fears that the capital ratios of the major international banks were worsening at a time when international risks were increasing.
Members of the Committee, backed by the G10 Governors, agreed to prevent the erosion of capital standards in their banking systems and strive toward greater convergence in capital adequacy measurement. As a result, there was general agreement on a weighted approach to risk measurement, both on and off the balance sheets of banks and the Basel Capital Accord was introduced in July 1988. Since it was the first set of rules introduced by the Basel Committee, it is commonly referred to as Basel I.
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In 1988, Basel I called for a minimum ratio of capital to risk-weighted assets or the capital adequacy ratio of 8% to be implemented by the end of 1992. In order to calculate this ratio, capital was classified into tier-1 capital or the core capital and tier-2 capital or the supplementary capital. Ultimately, this framework was introduced not only in member countries but also in virtually all countries with active international banks.
Congruent to its objective and the limited scope of risk analysis and financial instruments, Basel I was primarily focussed on credit risk. Basel II and III broadened the scope of the Basel norms by incorporating other aspects of risk management and enhancing the preexisting ones.
With an attempt to further enhance the limited scope of the Basel I accord, a revised framework was introduced by the committee in 2004. This revised framework is referred to as the Basel II accord. The need for such a revised framework arises primarily due to the financial innovation that had occurred in the past few years.
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As an effort to enhance the pre-existing framework, the Basel II accord comprised of the following three pillars:
Capital Adequacy Requirements (Minimum capital requirements, which sought to develop and expand the standardised rules set out in the 1988 Accord): Banks were required to continue maintaining the minimum capital adequacy requirement of 8% of risk-weighted assets but with a refined definition of the capital adequacy ratio. Additionally, the Basel II framework divides the capital into 3 tiers. The tier-3 capital includes short-term subordinate loans or the lower ranked loans which are repaid after other debts in case of bank liquidation.
Supervisory Review (Supervisory review of an institution’s capital adequacy and internal assessment process): Essentially, banks were required to incorporate better risk management techniques in order to tackle the three primary financial risks (credit risk, market risk and operational risk).
Market Discipline: (Effective use of disclosure as a lever to strengthen market discipline and encourage sound banking practices): As part of market discipline, banks were required to mandatorily disclose their Capital Adequacy Ratio, risk exposure, etc. to their respective central banks.
Certain shortcomings of the Basel II norms became apparent prior to the 2007-08 financial crisis. But it was the devastating experience of the crisis that highlighted the need for the Basel III norms.
The banking industry had too much debt and insufficient liquidity buffers when the financial crisis hit. Poor governance and risk management, as well as ineffective incentive systems, accompanied these flaws. Mispricing of credit and liquidity risks along with an excessive loan expansion, highlighted the catastrophic combination of these variables and left banks worldwide over-exposed to the 2007-08 financial crisis.
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With the goal of promoting a more resilient banking system by focusing on the four vital banking parameters- capital, leverage, funding and liquidity, the Basel III guidelines incorporated the following measures:
Stricter requirements for the quality and quantity of regulatory capital, in particular reinforcing the central role of common equity. The capital adequacy ratio is to be maintained at 12.9%. The minimum tier-1 capital ratio and the minimum tier-2 capital ratio have to be maintained at 10.5 % and 2 % of risk-weighted assets respectively.
An additional layer of common equity - the capital conservation buffer - that, when breached, restricts payouts to help meet the minimum common equity requirement. Banks are required to maintain a capital conservation buffer of 2.5%.
Countercyclical capital buffer, which places restrictions on participation by banks in system-wide credit booms with the aim of reducing their losses in credit busts. Counter-cyclical buffer is also to be maintained at 0-2.5%.
Leverage ratio - a minimum amount of loss-absorbing capital relative to all of a bank's assets and off-balance sheet exposures regardless of risk weighting. The leverage rate has to be at least 3 %. The leverage ratio is calculated by dividing a bank’s tier-1 capital to its average total consolidated assets.
Liquidity requirements - a minimum liquidity ratio, the Liquidity Coverage Ratio (LCR), intended to provide enough cash to cover funding needs over a 30-day period of stress; and a longer-term ratio, the Net Stable Funding Ratio (NSFR), intended to address maturity mismatches over the entire balance sheet. The minimum LCR and NSFR requirements are set at 100%.
Additional requirements for systemically important banks, including additional loss absorbency and strengthened arrangements for cross-border supervision and resolution.
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The Bottom Line
This blog discusses the role of the Basel Committee on Banking Supervision (BCBS), a group of central banks, in maintaining uniformity in the banking system worldwide and providing a reliable and dynamic risk management approach to protect banks from unforeseen circumstances of financial distress in the future.
Even though the Basel norms are not mandatory in nature, they form the backbone of the risk management structure of banks worldwide. They are promoted by central banks all over the world and not just belonging to the member nations of the Bureau of International Settlement (BIS).
Innovations continue to spur the financial world, specially technologically inclined ones and therefore, the Basel norms are dynamic in nature. The Basel committee continues to work towards the betterment of the banking system in an attempt to further enhance the regulations in an optimal manner.