Basel Accords: Basel 1, Basel 2, Basel 3

The Basel Accords refer to the banking supervision accords (recommendations on banking regulations) issued by the Basel Committee on Banking Supervision (BCBS).

In 1988, the Basel Committee published a set of minimum capital requirements for banks. This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten (G-10) countries in 1992. A new set of rules known as Basel II was developed and published in 2004 to supersede the Basel I accords. Basel III was a set of enhancements to in response to the financial crisis of 2007–2008. It does not supersede either Basel I or II but focuses on reforms to the Basel II framework to address specific issues, including related to the risk of a bank run.

Why is it called Basel?

The regulatory standards published by the committee are commonly known as Basel Accords.They are called the Basel Accords as the BCBS maintains its secretariat at the Bank for International Settlements in Basel, Switzerland and the committee normally meets there. The Basel Accords is a set of recommendations for regulations in the banking industry.

Basel Accords

• Basel-I
  • It was introduced in 1988 and focused almost entirely on credit risk.
  • It defined capital and structure of risk weights for banks.
  • The minimum capital requirement was fixed at 8% of risk weighted assets (RWA).
  • India adopted Basel-I guidelines in 1999.
• Basel-II
  • In 2004, Basel II guidelines were published by BCBS.
  • These were the refined and reformed versions of Basel I accord.
  • The guidelines were based on three parameters, which are known as pillars.
    • Capital Adequacy Requirements: Banks should maintain a minimum capital adequacy requirement of 8% of risk assets
    • Supervisory Review: According to this, banks were needed to develop and use better risk management techniques in monitoring and managing all the three types of risks that a bank faces, viz. credit, market and operational risks.
    • Market Discipline: This needs increased disclosure requirements. Banks need to mandatorily disclose their CAR, risk exposure, etc to the central bank.

Basel 3

Basel III is the third Basel Accord, a framework that sets international standards for bank capital adequacy, stress testing, and liquidity requirements. Augmenting and superseding parts of the Basel II standards, it was developed in response to the deficiencies in financial regulation revealed by the financial crisis of 2007–08. It is intended to strengthen bank capital requirements by increasing minimum capital requirements, holdings of high quality liquid assets, and decreasing bank leverage.

Basel III was published by the Basel Committee on Banking Supervision in November 2010, and was scheduled to be introduced from 2013 until 2015; however, implementation was extended repeatedly.

The new standards that come into effect in January 2023, that is, the Fundamental Review of the Trading Book (FRTB) and the Basel III: Finalising post-crisis reforms, are sometimes referred to as Basel IV. However, the secretary general of the Basel Committee said, in a 2016 speech, that he did not believe the changes are substantial enough to warrant that title and the Basel Committee refer to only three Basel Accords.

Objectives of Basel 3

Basel III aims to strengthen the requirements in the Basel II regulatory standards for banks. In addition to increasing capital requirements, it introduces requirements on liquid asset holdings and funding stability, thereby seeking to mitigate the risk of a run on the bank.

CET1 capital requirements

The original Basel III rule from 2010 required banks to fund themselves with 4.5% of Common Equity Tier 1 (CET1) (up from 2% in Basel II) of risk-weighted assets (RWAs). Since 2015, a minimum CET1 ratio of 4.5% must be maintained at all times by the bank. This ratio is calculated as follows:

The minimum Tier 1 capital increases from 4% in Basel II to 6%, applicable in 2015, over RWAs. This 6% is composed of 4.5% of CET1, plus an extra 1.5% of Additional Tier 1 (AT1).

CET1 capital comprises shareholders equity (including audited profits), less deductions of accounting reserve that are not believed to be loss absorbing “today”, including goodwill and other intangible assets. To prevent the potential of double-counting of capital across the economy, bank’s holdings of other bank shares are also deducted.

Furthermore, Basel III introduced two additional capital buffers:

• A mandatory “capital conservation buffer”, equivalent to 2.5% of risk-weighted assets, phased in from 2017 and fully effective from 2019.
• A discretionary “counter-cyclical buffer” allowing national regulators to require up to an additional 2.5% of RWA as capital during periods of high credit growth. This must be met by CET1 capital.

Leverage ratio

Basel III introduced a minimum “leverage ratio” from 2018 based on a leverage exposure definition published in 2014.

The ratio is calculated by dividing Tier 1 capital by the bank’s leverage exposure. The leverage exposure is the sum of the exposures of all on-balance sheet assets, ‘add-ons’ for derivative exposures and securities financing transactions (SFTs), and credit conversion factors for off-balance sheet items. The banks are expected to maintain a leverage ratio in excess of 3% under Basel III.

Liquidity requirements

Basel III introduced two required liquidity/funding ratios.

• The “Liquidity Coverage Ratio”, which requires banks to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days under a stressed scenario. Mathematically it is expressed as follows:

• The Net Stable Funding Ratio requires banks to hold sufficient stable funding to exceed the required amount of stable funding over a one-year period of extended stress.

Tier 1 Capital vs. Tier 2 Capital

• Banks have two main silos of capital that are qualitatively different from one another.
  • Tier 1: It refers to a bank’s core capital, equity, and the disclosed reserves that appear on the bank’s financial statements.
    • In the event that a bank experiences significant losses, Tier 1 capital provides a cushion that allows it to weather stress and maintain a continuity of operations.
  • Tier 2: It refers to a bank’s supplementary capital, such as undisclosed reserves and unsecured subordinated debt instruments that must have an original maturity of at least five years.
• Tier 2 capital is considered less reliable than Tier 1 capital because it is more difficult to accurately calculate and more difficult to liquidate.