A Brief History of Basel Accords: Basel I, II and III

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March 07, 2017
Money is a necessary evil. Fortunately or unfortunately, most of it is managed by the biggest banks across the globe. This is the reason why we need an infallible banking system that we can always count on. However, sometimes the financial system becomes too vulnerable to its own imperfections and this often leads to a complete failure of the system. The financial crisis of 2008 is the most recent example of such a debacle. 

Why Basel III regulations were required (Image Courtesy: about.com)

The financial services industry needs a clearly defined set of regulatory guidelines to keep functioning in a smooth manner. These guidelines not only help in establishing trust in the financial system and the intermediaries involved but also make sure that these financial institutions have the ability to pay off their liabilities in times of financial distress.

What are Basel Accords?

Basel accords are sets of regulations (Basel I, II and III) for the Banking sector set by the Basel Committee on Banking Supervision. The purpose of these accords is to improve the worldwide bank regulatory framework.

Basel Committee on Banking Supervision (BCBS)

The Basel Committee on Banking Supervision, established in 1974, provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. The Committee's members come from Argentina, Australia, Belgium, Brazil, Canada, China, European Union, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States.
BCBS Member Countries

Why did we ever need a Basel Accord?

In the 1980s, the rate of bank failures in the United States was increasing at an appalling rate. This was primarily due to the Savings and Loan (S&L) Crisis and the fact that banks had been lending recklessly. As a result, the external debt of a lot of countries had been growing at an unsustainable rate and the probability of major international banks going belly up was alarmingly high. The banking industry was going through a turmoil and was terribly in need of a framework to bring some order amidst the chaos. To prevent all hell from breaking loose, representatives from central banks and supervisory authorities of 10 countries, known as the Basel Committee on Banking Supervision (BCBS), met in 1987 in Basel, Switzerland to issue guidelines relating to capital and risk management activities of global banking institutions. This was the beginning of the Basel Accords.

Basel I

Basel I is the first in the series of regulations issued by the BCBS and was enacted in 1988 to improve banking stability. It weighed the capital owned by a bank against the credit risk it faced. Basel I defined the bank capital ratio and set the ball rolling for solvency monitoring and reporting. The main highlights of this accord are listed below:
  1. Assets of financial institutions are broadly divided into five risk categories (0%, 10%, 20%, 50% and 100%). 
  2. Banks that operate internationally are required to have a minimum of 8% capital to risk-weighted assets.

Signs of a fragile banking system (Image Courtesy: Washington Post)
Even though Basel I was the first step towards an internationally accepted assessment of risk-weighted assets, it had a few shortcomings:
  • The categorization of credit risk was very generic as the risk was simply assigned to one of the four categories (10%, 20%, 50% and 100%).
  • A static measure of 8% capital ratio did not take into account the changing nature of the default risk of financial institutions.
  • The maturity of credit exposure was not considered and duration of credit instruments was not accounted for.
  • There was no differentiation of counterparty risk for different kinds of borrowers.
  • It did not provide any relaxation for diversification of the portfolio.

Basel II

The Basel II framework, also called the Revised Capital Framework, aimed to build up on the foundation laid down by Basel I. It has three pillars:
  1. Minimum Capital Requirements: This Basel Accord further refined the definition of risk-weighted assets and provided guidelines for calculation of minimum regulatory capital ratios dividing the eligible regulatory capital of a bank into tiers.
  2. Supervisor Review: This pillar laid down guidelines for national regulatory authorities to deal with risks such as systemic risk, liquidity risk and legal risk.
  3. Market Discipline: The last and final pillar requires disclosures by banks regarding their risk exposures, capital adequacy and the overall risk assessment process.
Basel II was much more comprehensive in its risk definition and provided a really good framework based on the three pillars. However, even this was not perfect. Between 1998 and 2008, the volume of credit default swaps being sold in the industry kept growing exponentially and snowballed to roughly $55 trillion, a significant proportion of which was made up of below investment-grade securities. This led to a complete meltdown of the financial system and the disintegration of global behemoths such as Lehman Brothers. The financial crisis of 2008 was a wake-up call for the international financial services industry. It was the perfect illustration of how the entire banking industry can go from boom to bust in just a matter of days.
The subprime crisis in a nutshell (Image Courtesy: Santa Cruz Live)

Basel III

Basel III introduced much tighter capital requirements than Basel I and Basel II to address the weaknesses in the previous accord. One of the most evident problems with Basel II was that it did not moderate the imprudent lending activities of banking institutions. 
Major changes from Basel II:
  1. Minimum Capital Requirements: Although the overall regulatory capital requirement was unaltered at 8%, the Common Equity Tier 1 capital requirement was raised from 4% to 4.5% and minimum Tier 1 capital was raised from 4% to 6%.
  2. Leverage and Liquidity: To make sure that banks have ample liquidity during financial stress and to protect them from disproportionate borrowing, an upper limit of 3% was introduced for the leverage ratio (computed as Tier 1 capital divided by the total of on and off-balance sheet assets less intangible assets).
  3. Countercyclical Measures: To ensure that the banks' regulatory capital was in sync with the cyclical changes in their balance sheets, new guidelines were introduced requiring banks to set aside additional capital in times of credit expansion and relaxing the capital requirements during credit contraction.
  4. Bucketing System: Basel III also established the bucketing system in which banks were grouped together and assigned to buckets according to their size, complexity and importance to the overall economy. Guidelines were defined for identifying and regularly updating a list of Systematically Important Banks and subjecting them to higher capital requirements. 

Looking Ahead: What to expect?

Following Basel III, the banking system has been able to raise billions of dollars in regulatory capital, hire thousands of extra regulatory and compliance personnel and shed off trillions of dollars of risky assets. This has resulted in a lean and efficient global banking machinery. However, although the Basel III guidelines have tackled most of the shortfalls of the previous accord, the banking environment is constantly evolving and new kinds of risks keep emerging every now and then.
Not so long ago, the Banking industry fell in love with the Tech industry and together they gave birth to the FinTech industry. This industry is highly unregulated at the moment and lacks proper supervision. In recent years, slowly but steadily people have been moving their money from traditional brick and mortar banks to these internet-only digital banks. With online banks, cryptocurrencies and the Internet of Things (IoT) coming into the picture, it is becoming harder and harder to decipher which firms qualify as a bank and which ones are just tech firms. Also, with the growing role of technology in banks comes an exponentially higher amount of cyber risk associated with their banking activities. 
Although it is too early to say what Basel IV would look like, it would be great to have some guidelines accounting for cyber risk and encouraging higher disclosure of reserves and other financial statistics.