Basel Accord and Framework

History of Bank Regulation

• Pre-1988
• 1988: BIS Accord (Basel I)
• 1996: Amendment to BIS Accord
• 1999: Basel II first proposed
• Basel III in response to the recent global
financial crisis

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 Pre-1988
• Banks were regulated using balance sheet measures
such as the ratio of capital to assets
• Definitions and required ratios varied from country
to country
• Enforcement of regulations varied from country to
country
• Bank leverage increased in 1980s
• Off-balance sheet derivatives trading increased
• LDC debt was a major problem
• Basel Committee on Bank Supervision(BCBS) set up

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 Basel Committee on Banking
Supervision (BCBS)
• The Basel Committee on Banking Supervision (BCBS) is
a committee of banking supervisory authorities that
was established by the central bank governors of the
Group of Ten Countries in 1975.

• BCBS's recommendation on banking laws & regulations

are called Basel Accounts.

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 1988: BIS Accord
(Basel I)
• Capital regulations under Basel I came into
effect in December 1992 (after development
and consultations since 1988).
• The aims were:
– to require banks to maintain enough capital to
absorb losses without causing systemic
problems,
– to level the playing field internationally (to
avoid competitiveness conflicts).
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 1996 Amendment
• Implemented in 1998

• Requires banks to measure and hold capital

for market risk for all instruments in the
trading book including those off balance
sheet (This is in addition to the BIS Accord
credit risk capital)

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 Problem with Basel I
• Regulatory arbitrage was rampant

• Basel I gave banks the ability to control the amount of

capital they required by shifting between on-balance sheet
assets with different weights, and by securitising assets and
shifting them off balance sheet – a form of
disintermediation

• Banks quickly accumulated capital well in excess of the

regulatory minimum and capital requirements, which, in
effect, had no constraining impact on bank risk taking.

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 Basel II
• Implemented in 2007

• Three pillars
– New minimum capital requirements for credit
and operational risk
– Supervisory review: more thorough and
uniform
– Market discipline: more disclosure

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 Basel II: Pillar 1
• Pillar 1 of the Basel II system defines minimum
capital to buffer unexpected losses.

• Total RWA (risk weighted assets) are based on a

complex system of risk weighting that applies to
– ‘credit’
– ‘market’ (MR)
– ‘operational’ risk (OR)

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 Problems With Basel II

• Portfolio invariance.
• Single global risk factor.
• Financial system “promises” are not treated
equally—regulatory arbitrage facilitated by
“complete markets” in credit (the CDS market
particularly).
• Pro-cyclicality.
• Subjective inputs.
• Unclear and inconsistent definitions.

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Regulation of the financial markets is a never-ending process of modification,
improvement and extension. Nowhere is this clearer than in the case of the
Basel Accords.

Basel Basel Basel Basel

I II III IV ?

1988 2004 2008 ????

To establish a More reliance on Further fine Regulators are

minimum level of bank's internal tuning of capital set to rework risk
bank capital model of risk to and liquidity weightings and
based on risk- set capital requirements. drive standards
weighting of requirements Focus is on the to be simpler.
various numerator in the Focus it on the
capital ratio. denominator-the
calculation of
risk-weighted
assets (RWA)
 Basel I: Overview

• Basel I is the round of deliberations by central bankers from

around the world, and in 1988, the Basel Committee (BCBS),
published a set of minimal capital requirements for banks.

• Also Known as the 1988 Basel Accord, it was enforced by law

in the Group of Ten (G-10) countries in 1992

• Assets of banks were classified and grouped in 5 categories

according to credit risk, carrying risk weight of 0, 10, 20, 50,
and 100%
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 Basel II : Why is it needed?

• The purpose of Basel II, initially published in June 2004, 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

• It is believed that such an international standard can help

protect the international financial system from problems
that might arise should a major bank or a series of banks
collapse
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Basel II, Pillar 1
Pillar 1 deals with maintenance of regulatory capital
calculated for three major components of risk that a
bank faces

i) Credit ii) Operational iii) Market

Risk Risk Risk
Basel II, Pillar 1 : Credit risk

Credit Risk component can be calculated in three

different ways of varying degree of sophistication:

Standardized
Approach

Foundation
IRB

Advanced
IRB

IRB stands for "Internal Rating-Based Approach".

Basel II, Pillar 1 : Operational Risk

Operational risk basic indicator approach is based on

annual revenue of the Financial Institution
Standardized approach or TSA is based on annual
revenue of each of the broad business lines of the
Financial Institution
Internal measurement approach based on the
internally developed risk measurement framework of
the bank (eg Scorecard)
Basel II, Pillar 1 : Market Risk
Market Risk preferred approach is VaR (value of risk)
E.g. if a portfolio of stocks has a one-day 5% VaR of
$1 million, there is a 0.05 probability that the portfolio
will fall in value by more than $1 million over a one
day period, assuming market are normal and there is
no trading
Basel II, Pillar 2 : Residual risks
Deals with the regulatory response to the first pillar,
giving regulators much improved 'tools' over those
available to them under Basel I
Provides a framework for dealing with all the other
risks a bank may face (systematic risk, strategic risk,
reputation risk, liquidity risk, legal risk) which the
accord combines under the title of residual risk.
Basel II, Pillar 3
Greatly increases the disclosures that the bank must
make.
Designed to allow the market to have a better picture
of the overall risk position of the bank and to allow
the counterparties of the bank to price and deal
appropriately.
Disclosure means the giving out of information, either
voluntarily or to be in compliance with legal
regulations or workplace rules.
Basel III
Summary of Basel I, II, and III

Basel I Basel II Basel III

• Considers only • Considers Market • Enhancement of

Market and Credit Credit Operational the 3 Pillars of
Risk Risks Basel II
• Minimum level of • 3 Pillars • Liquidity &
capital is based on • Minimum leverage
a single risk Capital Management
weight for each of Requirement • Liquidity Coverage
a limited number • Supervisory Ratio(LCR)
of asset classes Review Process • Net Stable Funding
• Disclosure and Ratio (NSFR)
Market • Leverage Ratio
Discipline
Summary of Basel I, II, and III

• Basel I increased the overall level of capital in financial

markets

• Basel II aims to redistribute capital with the overall capital

maintained at the same level on an average, but with a more
efficient allocation of capital

• Basel III has a target to increase the government bond share

in the banks capital and solve their liquidity problems

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Summary of Basel I, II, and III

• Basel I (1988), II (2004 , and III (2010) are recommendations

on banking laws and regulations by the Basel Committee on
Banking Supervision
• Basel II has been adopted broadly by most countries. Basel
III reflects a response to the 2008-2009 crisis.
• Bank capital relative to risk-weighted assets is a major focus
of the Accords, to limit incentives to excessive risk-taking
and leveraging, and to help protect depositors. Liquidity
requirements were added in Basel III.

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