What is Basel I?

What is Basel I?

Basel I was established in 1988 by the Basel Committee on Banking Supervision (BCBS), a group of central bankers and regulators from around the world. The committee recognized the need for a consistent global regulatory approach to enable banks to compete internationally on an equal footing. Discussions led to the creation of the Basel Capital Accord (later known as Basel I) which began to set uniform capital risk measurements which could be adopted by financial institutions.

This accord became the one of a series of evolving banking directives designed to stabilize and enhance fair competition within international financial markets.

The History of Basel I

Basel I was introduced to address two main issues in the increasingly globalized financial system of the late 1980s:

1)      Capital Adequacy of Counterparty Banks

There was a need for a coherent and systematic regulatory framework to easily understand the capital adequacy of a counterparty bank operating in another country. This was essential for ensuring that banks had sufficient capital to cover potential losses and maintain stability in the financial system.

2)      Level Playing Field in Global Markets

Basel I aimed to put banks on a level playing field when competing to make loans in the global markets. By standardizing the capital requirements, it ensured that banks from different countries were subject to similar regulatory standards, preventing competitive imbalances.

Risk-weighted assets

Basel I focused on the credit risk that banks faced from their loan portfolios and was first finalized in 1988, with implementation by US banks to be completed in 1992. This first Basel Accord focused on credit risk in banking and introduced the concept of risk-weighted assets (RWA).

Under Basel I objective, a bank’s assets, broadly its loan portfolio, were classified based on their risk levels, with weights ranging from 0 to 100%. The riskier the assets, the more regulatory capital, based on shareholders’ equity, needed to be held. This capital served as a buffer for liability holders if assets lose value, with riskier assets having a higher chance of incurring losses.

Requirements for Basel I

Initially, under Basel I, banks were required by regulators to hold a minimum amount of capital. RWAs were used to link the minimum capital required with the risk profile of the bank’s lending activities and other assets.

Different asset classes held by banks carried different risk weights. For example, cash and government bonds, which have no material credit risk, had a 0% weighting. When this 0% risk weighting is multiplied by the amount of cash and government bond positions (40 and 100 respectively), the RWA is 0, meaning no capital buffer is needed for these assets. This is logical since the risk of losing money from credit defaults on these assets is assumed to be 0, so no capital needs to be held.

The Benefits of Basel I

Basel I helped banks become better organized by directing management’s attention to the amount of regulatory capital required. Issuing riskier loans meant more capital needed to be held, potentially reducing the bank’s ability to pay dividends to shareholders.

Market Risk Amendment

Basel I saw further amendments to its directive, notably the Market Risk Amendment in 1996. This was significant as it marked the first time that financial institutions were allowed to use internal models and in-house systems to gauge market risk capital requirements. The benefit of this was shifting the calculations and risk assessing over to the banks themselves, rather than a regulator.

Criticism of Basel I

The main criticism of Basel I was its risk weighting was too simplistic. It ended up penalizing banks who engaged in high quality lending to corporates and benefiting banks who lent to much weaker credit quality counterparties since most loans had the same risk weighting and attracted the same capital charge. The large commercial banks saw margins being eroded, resulting in many migrating to investment banking in the 1990s.

To address these weaknesses and as banks adapted to exploit them, further versions were released: Basel II in 2004 and Basel III in 2010. To read more about these evolutions of Basel I, download the cheat sheet.

Conclusion

Basel I marked the beginning of what became a series of pillars aimed at improving regulation and reducing risk within the global financial markets. By September 1993 the Basel Committee confirmed that all banks with significant international exposure in the G10 countries had adhered to its accord. This meant that there was now a minimum ratio of 8% capital to risk-weighted assets within these banks.

Download the cheat sheet highlighting the goal of Basel I in the free resources section.