CHAPTER 13
The Basel Accords

INTRODUCTION

The Basel Accords are multinational accords that set minimum capital requirements for banks. The Basel Accords were established by the BIS's Basel Committee on Banking Supervision in order to strengthen the soundness and stability of the international banking system. In this chapter we explore the Basel Accords, including Basel I, II, and III.

After you read this chapter you will be able to:

  • Describe the Basel Accords' approach.
  • Explain the importance of capital.
  • Understand credit risk, market risk, operational risk, and liquidity risk.
  • Describe Basel I, II, and III.

WHAT ARE THE BASEL ACCORDS?

The Basel Accords are multinational accords that set minimum capital requirements for banks. The Basel Accords were established by the BIS's Basel Committee on Banking Supervision, otherwise known as the “Basel Committee.”1

The Basel Accords have evolved over time.2 Basel I, the first of the Basel Accords, set the original minimum capital adequacy ratio requirements. Basel I was published in 1988 and implemented by the end of 1992. Basel I was amended several times. Basel II, which was proposed in 1999 and published in June 2004, revised Basel I's capital framework. Basel III, which was published in 2011, set additional revisions to the capital framework, which were agreed to following the financial crisis. Basel III's revisions to the capital framework added additional capital buffers, standards in relation to liquidity, and other new requirements.

THE APPROACH OF THE BASEL ACCORDS

The objectives of the Basel Accords are twofold:

  • To strengthen the soundness and stability of the international banking system
  • To do so in a manner that is both fair and consistent so as to reduce competitive inequality

Like any corporation, a bank consists of a portfolio of assets. A commercial bank's most important assets are the loans that it makes. A bank's assets are funded through accepting liabilities (i.e., through borrowing) and through capital. Capital consists of paid-in capital that is generated through issuing equity and retained earnings that are generated over time.

A bank will become insolvent if its assets drop below its liabilities. For example, consider a bank that has funded $10 billion in loans through borrowing $7 billion and raising capital of $3 billion. Should the loans decline in value to $6 billion, then the value of the bank's assets are less than its liabilities of $7 billion and the bank is insolvent. Assets can decline in value for one of a number of reasons. Three sources of risk to the value of a bank's assets that are addressed are as follows:

  1. Credit risk: The risk that a borrower will face financial distress, thereby lowering the value of the loan asset.
  2. Market risk: The risk that changes in market factors will lower the value of the bank's assets. For example, a bank's assets may be negatively impacted by changes in the risk-free rate of interest or in changes in exchange rates.
  3. Operational risk: The risk that a failure or inadequacy in the bank's processes, people, or systems will lower the value of the bank's assets. For example, a bank may face losses due to a lawsuit or a technology failure.

To address the fear that a bank will face insolvency should its assets fall below its liabilities, the Basel Accords specify minimum capital adequacy ratios that banks must maintain. Broadly, these are ratios of capital to assets. Capital is the difference between a bank's assets and liabilities. By definition, a bank with positive capital has assets that are greater than its liabilities. Hence, a minimum ratio of capital to assets acts as a “capital cushion” against the possibility of the bank's assets falling below its liabilities. Central to setting capital requirements is the specification of how capital and assets are measured. As we will explore in this chapter, the approach that is used by the Basel Accords to form capital adequacy ratios is a complex one, in which there are different tiers of capital and in which a bank's assets are risk-weighted so as to require a larger capital cushion for riskier assets than for less-risky assets.

Another type of risk that threatens the solvency of a bank is liquidity risk. Liquidity risk is the risk that a bank will not have sufficient liquidity to make the payments associated with its obligations. As we will explore in this chapter, the Basel Accords require that banks satisfy ratios to ensure sufficient liquidity.

BASEL I

Basel I set the original minimum capital adequacy ratio requirements. To understand the requirements, we first have to explore how three concepts are defined by the Basel Accords:

  1. Tier 1 capital: Tier 1 capital refers to the highest quality capital. It consists of permanent shareholders' equity (e.g., common shares) and disclosed reserves (e.g., retained earnings).
  2. Tier 2 capital: Tier 2 capital refers to other capital. It consists of undisclosed reserves that are not reported on the bank's balance sheet; revaluation reserves that are held against revaluations; general provisions or loan loss reserves that are held against presently unidentified future losses; and hybrid capital instruments that combine characteristics of debt and equity.
  3. Risk-weighted assets: A bank's assets can be risk-weighted so as to require a larger capital cushion for riskier assets than for less-risky assets. The weightings given to various asset classes are provided in Table 13.1.

Table 13.1 Basel I Risk Weights by Category of On-Balance-Sheet Asset3

Category Risk Weight
Cash 0
Claims on central governments and central banks denominated in national currency and funded in that currency 0
Other claims on OECD central governments and central banks 0
Claims collateralized by cash of OECD central-government securities or guaranteed by OECD central governments 0
Claims on domestic public-sector entities, excluding central government, and loans guaranteed by such entities 0, 10, 20, or 50% (at national discretion)
Claims on multilateral development banks and claims guaranteed by, or collateralized by, securities issued by such banks 20%
Claims on banks incorporated in the OECD and loans guaranteed by OECD-incorporated banks 20%
Claims on banks incorporated in countries outside the OECD with a residual maturity of up to one year and loans with a residual maturity of up to one year guaranteed by banks incorporated in countries outside the OECD 20%
Claims on nondomestic OECD public-sector entities, excluding central government, and loans guaranteed4 by such entities 20%
Cash items in process of collection 20%
Loans fully secured by mortgage on residential property that is or will be occupied by the borrower or that is rented 50%
Claims on the private sector 100%
Claims on banks incorporated outside the OECD with a residual maturity of over one year 100%
Claims on central governments outside the OECD (unless denominated in national currency and funded in that currency) 100%
Claims on commercial companies owned by the public sector 100%
Premises, plant, and equipment and other fixed assets 100%
Real estate and other investments (including nonconsolidated investment participations in other companies) 100%
Capital instruments issued by other banks (unless deducted from capital) 100%
All other assets 100%

Basel I requires that the ratio of a bank's Tier 1 capital to its risk-weighted assets be no less than 4% while the ratio of the combination of Tier 1 and Tier 2 capital be no less than 8%.

Originally, Basel I only focused on credit risk. In 1996, Basel I was amended to incorporate market risk as well. Markets risk incorporates risk of loss due to interest rate risk, equity position risk, foreign exchange risk, and commodities risk. The amendment requires banks to measure their market risk, multiply the resulting amount by 12.5, and add this amount to the bank's risk-weighted assets when calculating the capital adequacy ratios.

The 1996 amendment also introduces Tier 3 capital, which consists of short-term subordinated debt. Under the amendment, the use of Tier 3 capital is subject to a number of conditions. For example, Tier 3 capital can only be used in relation to market risk; hence, the Tier 1 capital and Tier 2 capital requirement for credit risk remained unchanged following the amendment.

BASEL II

Basel II revised Basel I's capital framework. Basel II is organized around three pillars as follows:

  • Pillar I: Minimum capital requirements
  • Pillar II: Supervisory review
  • Pillar III: Market discipline

Basel II is extensive. In this section we explore some—among many—of its features.

Pillar 1: Minimum Capital Requirements

Pillar 1 of Basel II strengthens the minimum capital requirements in a number of ways. For example, to make risk-weighting more reflective of the credit risk that banks face, Basel II permits banks to choose between either a standardized approach or an internal ratings-based approach. Under the standardized approach, risk-weightings are determined based on external credit assessments. Tables 13.2 and 13.3 present the risk-weightings for claims on sovereigns and their central banks, and corporates. Under the internal ratings-based approach, banks are permitted to determine risk-weightings based on internal measurement of credit risk, subject to supervisory approval.

Table 13.2 Basel II Standardized Approach Risk Weights for Sovereigns and Their Central Banks4

Rating Claims on Sovereigns and Their Central Banks
AAA to AA– 0%
A+ to A– 20%
BBB+ to BBB– 50%
BB+ to B– 100%
Below B– 150%
Unrated 100%

Table 13.3 Basel II Standardized Approach Risk Weights for Corporates5

Rating Claims on Sovereigns and Their Central Banks
AAA to AA– 20%
A+ to A 50%
BBB+ to BB– 100%
Below BB– 150%
Unrated 100%

Another example of Basel II's strengthening of minimum capital requirements is its requirement that banks measure their operational risk and, similar to the requirement in relation to market risk, multiply the resulting amount by 12.5 and add this amount to the bank's risk-weighted assets when calculating the capital adequacy ratios. Basel II also specifies various methods through which a bank can measure operational risk and market risk.

Pillar 2: Supervisory Review

Pillar 2 is supervisory review of the bank's internal assessment of its capital adequacy. Pillar 2 allows supervisors to address sources of risk not captured by Pillar 1. Basel II indicates that three main areas not captured by Pillar 1: factors not captured such as credit concentration risk; factors not taken into account such as business and strategic risk; and external factors such as the business cycle.6 Table 13.4 presents four key principles of supervisory review as detailed in Basel II.

Table 13.4 Basel II Key Principles of Supervisory Review7

Principle 1: Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.
Principle 2: Supervisors should review and evaluate banks' internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.
Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.
Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

Pillar 2 recognizes that supervision is not an exact science and that supervisions will reflect discretionary decision making. The supervisors must act in transparent and accountable fashion through making publicly available their criteria and through making public factors used to require capital above the regulatory minimum either across the banking sector or for an individual bank.

Pillar 3: Market Discipline

Pillar 3 encourages market discipline through setting minimum disclosures requirements. Pillar 3 details extensive qualitative and quantitative disclosures in relation to the corporate entity, capital structure, capital adequacy, credit risk, credit risk mitigation, counterparty credit risk, securitization, market risk, and operational risk, among other disclosures.

Basel II.5

Following the 2007–2008 financial crisis, the Basel Committee implemented additional revisions to the Basel Accords, known as Basel II.5. Basel II.5 includes changes in how banks keep positions in their “trading book” versus their “banking book”; changes to the measurement of market risk; changes to the supervisor review process and disclosure requirements for market risk; and changes in the treatment of illiquid assets.

BASEL III

Basel III provided extensive further revisions to the capital framework. In this section we explore some—among many—of its key features.

Under Basel III, the minimum capital ratios are strengthened. Basel III increases the ratio of a bank's Tier 1 capital to its risk-weighted assets from 4% to 6%; 4.5% of this 6% must be common equity. Basel III also sets a leverage ratio that does not risk-weight the bank's assets. The leverage ratio requires a minimum ratio of Tier 1 capital to assets of 3%. The leverage ratio is intended to provide a simple non-risk-based measure that can constrain the buildup of leverage, which can lead to destabilization when deleveraging occurs. Further, Basel III eliminates Tier 3 as acceptable capital when determining minimum ratios.

Basel III creates two additional buffers, the capital conservation buffer and the countercyclical buffer. The capital conservation buffer is an additional buffer of 2.5% common equity. Should a bank fail to meet this additional buffer, they are constrained in their distributions (such as dividends) but can continue to operate. The countercyclical buffer is an additional buffer that supervisors can demand to avoid the buildup of debt.

Basel III addresses liquidity risk through introducing two new liquidity ratios: the liquidity coverage ratio and the net stable funding ratio. The liquidity coverage ratio requires that the ratio of high-quality liquid assets to total net cashflows over the next 30 calendar days be greater than 100%. The net stable funding ratio requires that the ratio of available amount of stable funding to required amount of stable funding is greater than 100%.

Basel III also reforms risk coverage to ensure that all material risks are captured. These reforms are driven by the recognition that the 2007–2008 financial crisis was the failure to capture certain balance sheet risks, off-balance-sheet risks, and derivatives exposures.

THE CONTINUING EVOLUTION OF THE BASEL ACCORDS

The Basel Accords are far from perfect, as is demonstrated by their evolution over time. This is unsurprising. The challenges that the Basel Accords work to address are complex and impact many stakeholders across multiple jurisdictions. New risks and challenges arise over time, revealing gaps in regulation that were not previously addressed.

Yet some argue that the overall approach of the Basel Accords may be flawed. For example, academics Christopher Kobrak and Michael Troege note that the capital requirements mandated by the Basel Accords are less useful than is commonly perceived, as losses due to bank failures typically cannot be absorbed by even reasonably high capital requirements.8 They present data from the FDIC that shows that the average loss due to a bank failure in the United States during 1986 to 2000 was 24% of the bank's assets while the median loss was 19%. Further, Kobrak and Troege argue that banks can manipulate their capital adequacy ratios. They note that during the 1990s, Japanese banks used techniques through which to make their capital adequacy ratios satisfactory though they were in fact insolvent.

We will certainly see additional revisions to the capital framework in the future. Indeed, there is already talk of “Basel IV.”9

KEY POINTS

  • The Basel Accords are multinational accords that set minimum capital requirements for banks that were established by the BIS's Basel Committee on Banking Supervision.
  • The objectives of the Basel Accords are to strengthen the soundness and stability of the international banking system and to do so in a fair and consistent manner.
  • A bank will become insolvent if its assets drop below its liabilities. Three sources of risk to the value of a bank's assets are credit risk, market risk, and operational risk. The Basel Accords address these risks. A bank will also become insolvent if it does not have sufficient liquidity to make the payments associated with its obligations. The Basel Accords address liquidity risk as well.
  • Basel I requires that the ratio of a bank's Tier 1 capital to its risk-weighted assets be no less than 4% while the ratio of the combination of Tier 1 and Tier 2 capital be no less than 8%. It also requires banks to measure their market risk, multiply the resulting amount by 12.5, and add this amount to the bank's risk-weighted assets when calculating the capital adequacy ratios.
  • The three pillars of Basel II are minimum capital requirements; supervisory review; and market discipline. Pillar 1 strengthens the minimum capital requirements and includes a requirement related to operational risk. Pillar 2 requires supervisory review of the bank's internal assessment of its capital adequacy. Pillar 3 encourages market discipline through minimum disclosures requirements.
  • Basel III provided extensive further revisions to the capital framework, including strengthened minimum capital requirements; the introduction of a leverage ratio; the creation of the capital conservation buffer and the countercyclical buffer; the introduction of the liquidity coverage ratio and the net stable funding ratio; reformation of risk coverage, and other revisions.
  • The Basel Accords are far from perfect, as is demonstrated by their evolution over time. We will certainly see additional revisions to the capital framework in the future.

KNOWLEDGE CHECK

  1. Q13.1: Which committee created the Basel Accords?

  2. Q13.2: What are the objectives of the Basel Accords?

  3. Q13.3: When will a bank become insolvent?

  4. Q13.4: What risks does the Basel Accords address?

  5. Q13.5: What is Tier 1 capital?

  6. Q13.6: What is the purpose of risk-weighting assets?

  7. Q13.7: What are the three pillars of Basel II?

  8. Q13.8: What are the two additional buffers created by Basel III?

  9. Q13.9: What is the leverage ratio?

  10. Q13.10: How does Basel III address liquidity risk?

NOTES

..................Content has been hidden....................

You can't read the all page of ebook, please click here login for view all page.
Reset