The Basel Accords are a series of three sequential banking regulation agreements (Basel I, II, and III) set by the Basel Committee on Bank Supervision (BCBS).
The Committee provides recommendations on banking and financial regulations, specifically, concerning capital risk, market risk, and operational risk. The accords ensure that financial institutions have enough capital on account to absorb unexpected losses.
Key Takeaways
- The Basel Accords refer to a series of three international banking regulatory meetings that established capital requirements and risk measurements for global banks.
- The accords are designed to ensure that financial institutions maintain enough capital on account to absorb unexpected losses.
- The latest accord, Basel III, was agreed upon in November 2010. Basel III requires banks to have a minimum amount of common equity and a minimum liquidity ratio.
The Journey of Basel Accords
The Basel Accords were developed starting in the 1980s. The BCBS was founded in 1974, initially aiming to enhance global financial stability by improving supervisory knowledge and the quality of banking supervision worldwide. Later, their focus shifted to ensuring the capital adequacy of banks and the banking system.
Basel I
The first Basel Accord, known as Basel I, was issued in 1988, focusing on the capital adequacy of financial institutions. The accord categorizes the assets of financial institutions into five risk categories—0%, 10%, 20%, 50%, and 100%. Banks operating internationally must maintain capital (Tier 1 and Tier 2) equal to at least 8% of their risk-weighted assets, ensuring they hold enough 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
Basel II, known as the Revised Capital Framework, served as an update to Basel I, focusing 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 to strengthen market discipline. These areas are known together as the three pillars.
Basel II expanded the eligible regulatory capital from two to three tiers. The new Tier 3 capital includes debt to support market risk, commodities risk, and foreign currency risk derived from trading activities. However, Tier 3 capital was of much lower quality than Tier 1 or Tier 2 and was subsequently rescinded under Basel III.
Basel III
Following the financial crisis and the collapse of Lehman Brothers in 2008, the BCBS updated and strengthened the Accords, leading to Basel III. This accord, agreed upon in November 2010, introduced additional requirements and safeguards. For example, it mandates a minimum amount of common equity and a minimum liquidity ratio. Basel III also includes additional requirements for systemically important banks, those considered “too big to fail.”
The Basel III reforms are now part of the consolidated Basel Framework. Basel III tier 1 has been implemented, and the final Basel III framework includes phase-in provisions for the output floor, starting at 50% from January 2023 and fully phased in at 72.5% by January 2028. These additional measures have also been called Basel 3.1 or Basel IV.
Related Terms: capital risk, market risk, operational risk, Tier 1 capital, Tier 2 capital.
