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What Is the Basel Accord?
The Basel Accords are crucial banking regulation frameworks formalized by the Basel Committee on Bank Supervision to ensure that banks worldwide maintain adequate capital. Spanning Basel I, II, and III, these accords respond to evolving economic challenges by enhancing the safety and soundness of financial institutions.
Key Takeaways
- The Basel Accords are international banking regulatory agreements developed to ensure banks maintain adequate capital to absorb unexpected losses.
- Basel I, introduced in 1988, categorized bank assets into risk categories, requiring banks to hold a minimum of 8% capital against risk-weighted assets.
- Basel II refined the approach with three pillars: minimum capital requirements, supervisory review, and market discipline through disclosure.
- Basel III, initiated after the 2008 financial crisis, introduced stringent capital and liquidity requirements for banks, removing Tier 3 capital considerations.
- The ongoing Basel III Endgame aims to further increase capital requirements for large banks to enhance stability and prevent future financial crises.
A Comprehensive Guide to the Basel Accord
The Basel Accords were developed over several years beginning in the 1980s. The BCBS was founded in 1974 as a forum for regular cooperation between its member countries on banking supervisory matters. The BCBS describes its original aim as enhancing “financial stability by improving supervisory know-how and the quality of banking supervision worldwide.” Later, the BCBS turned its attention to monitoring and ensuring the capital adequacy of banks and the banking system.
The Basel I accord was originally organized by central bankers from the G10 countries, who were at that time working toward building new international financial structures to replace the recently collapsed Bretton Woods system.
The meetings are named “Basel Accords” since the BCBS is headquartered in the offices of the Bank for International Settlements (BIS), which is located in Basel, Switzerland. Member countries include Australia, Argentina, Belgium, Canada, Brazil, China, France, Hong Kong, Italy, Germany, Indonesia, India, Korea, the United States, the United Kingdom, Luxembourg, Japan, Mexico, Russia, Saudi Arabia, Switzerland, Sweden, the Netherlands, Singapore, South Africa, Turkey, and Spain.
Basel I: Establishing Foundation for Global Banking Stability
The first Basel Accord, known as Basel I, was issued in 1988 and focused on the capital adequacy of financial institutions. The capital adequacy risk (the risk that an unexpected loss would hurt a financial institution) categorizes the assets of financial institutions into five risk categories: 0%, 10%, 20%, 50%, and 100%.
Under Basel I, banks that operate internationally must maintain capital (Tier 1 and Tier 2) equal to at least 8% of their risk-weighted assets. This ensures banks hold a certain amount of capital to meet obligations.
For example, if a bank has risk-weighted assets of $100 million, it is required to maintain capital of at least $8 million. Tier 1 capital is the most liquid and primary funding source of the bank, while Tier 2 capital includes less liquid hybrid capital instruments, loan-loss and revaluation reserves, as well as undisclosed reserves.
Basel II: Enhancing Risk Management
The second Basel Accord, called the Revised Capital Framework but better known as Basel II, served as an update of the original accord. It focused on three main areas: minimum capital requirements, supervisory review of an institution’s capital adequacy and internal assessment process, and the effective use of disclosure as a lever to strengthen market discipline and encourage sound banking practices, including supervisory review. Together, these areas of focus are known as the three pillars.
Basel II expanded bank regulatory capital from two to three tiers. The higher the tier, the fewer subordinated securities a bank is allowed to include in it. Each tier covers a set percentage of total regulatory capital and is used to calculate capital ratios.
Tier 3 capital, used for market, commodities, and currency risks from trading, is defined as tertiary capital. Tier 3 capital includes a greater variety of debt than tier 1 and tier 2 capital, but is of a much lower quality than either of the two. Under the Basel III accords, tier 3 capital was subsequently rescinded.
Basel III: Strengthening the Banking Sector Post-Crisis
After the 2008 Lehman Brothers collapse and financial crisis, the Basel Committee on Banking Supervision (BCBS) chose to strengthen the Accords. The BCBS considered poor governance and risk management, inappropriate incentive structures, and an overleveraged banking industry as reasons for the collapse. In November 2010, an agreement was reached regarding the overall design of the capital and liquidity reform package. This agreement is now known as Basel III.
Basel III is a continuation of the three pillars, along with additional requirements and safeguards. For example, Basel III requires banks to have a minimum amount of common equity and a minimum liquidity ratio. Basel III adds requirements for “systemically important banks,” those deemed “too big to fail.” In doing so, it eliminated tier 3 capital considerations.
The Basel III reforms have now been integrated into the consolidated Basel Framework, which comprises all of the current and forthcoming standards of the Basel Committee on Banking Supervision. Basel III tier 1 has now been implemented, and all but one of the 27 Committee member countries participated in the Basel III monitoring exercise held in June 2021.
Basel III Endgame: Finalizing Key Reforms for Enhanced Stability
The final stage of Basel III reforms, known as “Basel III Endgame,” is due to begin being rolled out in 2025. These latest proposed reforms, which were published in July 2023 with the intention of aligning U.S. bank capital rules with Basel III standards, will force banks to hold more capital, giving them an extra cushion in times of stress.
The rules, which will be phased in over three years with full compliance on July 1, 2028, will impact the bigger banks the most. The stiffest rules have been reserved for banks with $100 billion or more in assets, which covers 37 banks in the U.S. Community banks and smaller regional banks aren’t affected.
There has been a lot of backlash. JPMorgan chief executive Jamie Dimon complained that the regulation will increase capital requirements for already financially sound large banks by 20% to 25%, and that regular people will be the biggest victims.
Critics say the rules could limit lending, reduce the capital allocated to green projects, and make U.S. banks less competitive internationally. Proponents, meanwhile, argue that higher capital requirements are needed to prevent the possibility of bank failures and government bailouts.
Why Is Basel So Important?
The Basel Accords attempt to ensure that banks have enough money to survive. They aim to set standards for a safe and stable global banking system and prevent governments from bailing out banks that spend beyond their means with taxpayers’ money.
Why Did Basel I Fail?
The Basel I and Basel II reforms did not prevent the financial crisis and Great Recession of 2007 to 2009, resulting in even tighter controls. Other criticisms of Basel I, other than that it made less capital available for lending, were that it adopted too simple an approach to risk weighting, focused solely on credit risk, and overlooked other critical risks.
Who Set Up the Basel Accords?
The Basel Accords were set up by the Basel Committee on Bank Supervision (BCBS), created by central bank governors of the G10 countries in response to bank failures in Germany and the U.S. in the 1970s.
The Bottom Line
The Basel Accords, which include Basel I, II, and III, establish comprehensive banking regulation frameworks to safeguard financial stability. They focus on ensuring that banks have sufficient capital to absorb unexpected losses and prevent financial crises. Basel I set the stage with capital adequacy norms in 1988, and Basel III, emerging after the 2008 financial crisis, continues to address systemic risks with enhanced capital and liquidity standards. These accords are vital for mitigating risks in the global banking system and bolstering confidence in financial institutions.
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