BASEL ACCORDS
Introduction to Basel Banking Regulations
Banking is a highly regulated industry because banks play a crucial role in the economy. If
banks fail, it can lead to economic crises. To ensure banks operate safely, international
guidelines have been created to regulate how much money banks must keep as reserves
(capital) to absorb losses. These regulations are set by the Basel Committee on Banking
Supervision (BCBS), which was formed in 1975 under the Bank for International Settlements
(BIS).
The Basel Accords are international banking regulations that set minimum capital
requirements for banks to maintain financial stability. The regulations evolved over time to
address weaknesses in the financial system.
Basel I (1988) - The First Global Banking Regulation
The Basel I Accord was introduced in 1988 to ensure that banks had enough capital to
absorb risks. Before Basel I, different countries had their own banking rules, making global
banking inconsistent.
Key Features of Basel I:
1. Minimum Capital Requirement: Banks had to maintain at least 8% of their risk-
weighted assets as capital.
2. Risk Categorization: Loans and investments were classified into different risk groups
(0%, 20%, 50%, 100%) based on their credit risk.
o Government bonds (low risk): 0% risk weight.
o Interbank loans (moderate risk): 20% risk weight.
o Mortgages (medium risk): 50% risk weight.
o Corporate loans (high risk): 100% risk weight.
3. Types of Capital: Basel I divided bank capital into Tier 1 (core capital like equity) and
Tier 2 (supplementary capital like subordinated debt).
4. Credit Risk Focus: The main focus was on protecting banks from credit risk (the risk of
borrowers not repaying loans).
Criticism of Basel I:
It was too simple and didn’t account for different types of risks (like operational and
market risk).
Banks manipulated the system by moving risky assets off their balance sheets to
avoid capital requirements.
It didn’t account for securitization, which later contributed to the 2008 financial crisis.
To address these issues, Basel II was introduced.
Basel II (2004) - More Advanced Risk Management
To improve upon Basel I, Basel II was introduced in 2004 with a more risk-sensitive
approach.
Key Features of Basel II:
Basel II is built on three pillars:
1. Minimum Capital Requirements (Pillar 1):
o It improved risk measurement by adding operational risk (losses due to system
failures or fraud) alongside credit risk and market risk.
o Introduced two new approaches for calculating capital requirements:
Standardized Approach: Uses external credit ratings (from agencies like
Moody’s, S&P).
Internal Ratings-Based Approach (IRB): Allows banks to use their own
models to assess risk.
2. Supervisory Review (Pillar 2):
o Regulators would evaluate banks’ risk management systems and require extra
capital if necessary.
3. Market Discipline (Pillar 3):
o Banks had to disclose more information to the public about their financial
health to ensure transparency.
Benefits of Basel II:
More accurate risk assessment.
Encouraged better risk management practices.
Allowed large banks to use internal models to measure risk.
Criticism of Basel II:
Complex and expensive: Small banks couldn’t afford to implement advanced risk
models.
Depended too much on credit rating agencies: Ratings were sometimes inaccurate,
leading to financial crises.
Did not prevent the 2008 financial crisis: Banks took excessive risks despite Basel II
guidelines.
2008 Financial Crisis and the Need for Basel III
The 2008 global financial crisis showed that Basel II wasn’t strong enough to prevent
economic collapses. Many banks didn’t have enough capital to handle sudden financial
shocks. This led to the development of Basel III, which introduced stricter capital and
liquidity rules.
Conclusion
The Basel framework has been crucial in making the banking system safer and more stable.
However, each version has had its strengths and weaknesses. While Basel I introduced a
global standard, Basel II improved risk measurement but failed to prevent the 2008 crisis.
The evolution continues with Basel III, aiming to make banks even more resilient.
Let me know if you need any specific details, tables, or numbers explained further! 😊
