The Basel Accords are the set of recommendations for effective supervision of the banking sector introduced by the Basel Committee on Banking Supervision (BCBS). Currently, there are three accords of Basel i.e. Basel I, Basel II, and Basel III.
The Basel Committee
The Basel committee, also known as The Basel Committee on Banking Supervision (BCBS) is a cooperative council of banking authorities which was set up at the end of 1974 by the governors of central bank of G-10 countries. It was mainly introduced after various difficulties in currency exchange and banking sectors and mainly due to the bankruptcy of cologne based bank- Herstatt (History of Basel comittee, 2016). The key purpose of the team was to coordination and synchronization of the banking standards among its participant states. As the founding document (Bank of International Settlements, 1988) states, the accords are just an agreement and not a legally binding document within its member countries. Their member countries are free to implement or reject the standards recommended by the Basel committee.
The Basel Committee’s work
According to (Bank of Internation settlements, 2017) the work done by the Basel Committee are mainly focused on following fields:
Exchange of information on developments in the banking and financial sectors Sharing of supervisory issues, approaches and techniques to promote common understanding and to improve cross-border cooperationIntroduction and continuous upgrade of the global standards of banking supervisionDeal with pitfalls in supervision and regulation that can pose risks to monetary stabilityMonitor its member countries and beyond to ensure their effective, consistent and timely implementation of the Basel Standards.Consultation with bank supervisory authorities beyond the members of BCBS in order to receive inputs regarding continuous upgrade of the BCBS standards and implementation of its own banking standards beyond the member countries of BCBS.Coordination and cooperation with other financial organizations
The International Convergence of Capital Measurements and Capital Standards, which is informally known as “BASEL I” was the first accord introduced among the series of Basel Accords. It was introduced in July of 1988, after six years of long and careful discussion and the final agreement between 12 member countries of BCBS committee. The accord mainly talks about credit risk and appropriate assignment of weights to risk associated with assets. The regulations in the accord were proposed to define a minimum capital level however the national authorities were allowed to adopt stronger requirements. The Accord proposed the minimum ratio of capital to risk-weighted assets be at least 8% and recommended to be implemented till the end of 1992.
The Basel accord is divided into four pillars. The first pillar is known as The Constituents of Capital. The accord recognizes capital reserves according to its quality into two tiers i.e. Tier 1 capital and Tier 2 capital. “Tier 1 Capital,” consisted only of disclosed cash reserves and paid up capital (stocks and preferred shares). Tier 2 Capital however was not clearly defined. This capital could include general provisions created to cover future potential losses, holdings of subordinated debt which had to be a maximum of 50% of the Tier 1 capital, fully paid up hybrid instrument holdings, reserves created from assets revaluations and other undisclosed reserves. To comply with the Basel Accord, the quantity (in dollar terms) of Tier 1 and Tier 2 capital had to be equal.
After the determination of capital, the second pillar of the Basel I Accord known as “the risk weights” defined a number of factors that would classify the assets of balance sheet amounts according to their assumed credit risk level. The risk levels were divided into five different categories. These five risk levels encompassed all assets of a bank’s balance sheet. The first level categorized assets as riskless and weighted them at 0%. Such assets according to Basel I were cash and cash reserves held by a bank, claims on OECD central governments and other claims on OECD central governments funded and denominated in national currency. The second risk level categorized assets as low risk assets and weighted them at 20%. Securities in this category included claims on OECD banks and multilateral development bank, claims on public sectors incorporated in the OECD, claims on non-OECD bank with a residual maturity of less than 1 year. The third level categorized assets into moderate risk assets and weighted them as 50%. This category however included only residential mortgage loans. The fourth level categorized assets as high risk assets and weighted them at 100% of an asset’s value, and included all other claims such as a bank’s claims on the corporate sector, claim on non-OECD bank with a maturity of more than 1 year, fixed assets of the bank, and all other assets. The fifth level could be categorized into a variable risk category and included claims on non-central government and public-sector entities. The entities in this category did not have a fixed weight however they could be valued at 0, 10, 20, or 50% depending on discretion of the national supervisory authority of the respective member states.
The third pillar is known as “A Target Standard Ratio” defines the minimum standard expected from the bank at the end of the financial period. It recommends the ratio of capital to risk weighted assets be set at 8% which has to be covered by capital reserves from Tier 1 and Tier 2 capital. Also, 4% of a bank’s risk-weighted assets had to be covered by tier 1 capital.
The fourth pillar is known as “Transitional and Implementing Agreements” and it sets the grounds for the implementation of the Basel Accords. Each country’s supervising authority is recommended to perform strong surveillance and employ various mechanisms to ensure the proper implementation of Basel Accords. More over this pillar also provides “transition weights” which allows banks over a period of four years to fully comply with the standards of the Basel accord.