Basel Accords: Purpose, Pillars, History, and Member Countries
The Basel Accords are a series of three sequential banking regulation agreements (Basel I, II, and III) set by the Basel Committee on Bank Supervision (BCBS).
The Committee explicitly recommends banking and financial regulations concerning capital, market, and operational risks. The accords ensure that financial institutions have enough capital to absorb unexpected losses.
Understanding the Basel Accords
The Basel Accords were developed over several years, beginning in the 1980s. The BCBS was founded in 1974 as a forum for regular cooperation between member countries on banking supervisory matters. The BCBS describes its original aim as enhancing “financial stability by improving supervisory know-how and the quality of banking supervision worldwide.” Later, the BCBS turned its attention to monitoring and ensuring the capital adequacy of banks and the banking system.
Central bankers initially organized the Basel I accord with the G10 countries, working toward building new international financial structures to replace the recently collapsed Bretton Woods system.
The meetings are named “Basel Accords” since the BCBS is headquartered in the Bank for International Settlements (BIS) offices in Basel, Switzerland. Member countries include Australia, Argentina, Belgium, Canada, Brazil, China, France, Hong Kong, Italy, Germany, Indonesia, India, Korea, the United States, the United Kingdom, Luxembourg, Japan, Mexico, Russia, Saudi Arabia, Switzerland, Sweden, the Netherlands, Singapore, South Africa, Turkey, and Spain.
Basel I
The first Basel Accord, known as Basel I, was issued in 1988 and focused on the capital adequacy of financial institutions. The capital adequacy risk (the risk that an unexpected loss would hurt a financial institution) categorizes the assets of financial institutions into five risk categories: 0%, 10%, 20%, 50%, and 100%.
Under Basel I, international banks must maintain capital (Tier 1 and Tier 2) equal to at least 8% of their risk-weighted assets. This ensures banks hold a certain amount of capital to meet obligations.
For example, if a bank has risk-weighted assets of $100 million, it is required to maintain capital of at least $8 million. Tier 1 capital is the bank’s most liquid and primary funding source, and Tier 2 capital includes less liquid hybrid capital instruments, loan-loss and revaluation reserves, and undisclosed reserves.
Basel II
The second Basel Accord, called the Revised Capital Framework but better known as Basel II, served as an update of the original Accord. It focused on three main areas: minimum capital requirements, supervisory review of an institution’s capital adequacy and internal assessment process, and the effective use of disclosure as a lever to strengthen market discipline and encourage sound banking practices, including supervisory review. Together, these areas of focus are known as the three pillars.
Basel II divided the eligible regulatory capital of a bank into three tiers. The higher the tier, the less subordinated securities a bank is allowed to include in it. Each tier must be a certain minimum percentage of the total regulatory capital and is used as a numerator in calculating regulatory capital ratios.
The new tier 3 capital is defined as tertiary capital, which many banks hold to support their markets, commodities, and foreign currency risks derived from trading activities. Tier 3 capital includes a greater variety of debt than tier 1 and tier 2 capital but is much lower quality than either. Under the Basel III accords, Tier 3 capital was subsequently rescinded.
Basel III
In the wake of the Lehman Brothers collapse in 2008 and the ensuing financial crisis, the BCBS decided to update and strengthen the Accords. The BCBS considered poor governance and risk management, inappropriate incentive structures, and an overleveraged banking industry as reasons for the collapse. In November 2010, an agreement was reached regarding the overall design of the capital and liquidity reform package. This agreement is now known as Basel III.
Basel III continues the three pillars, along with additional requirements and safeguards. For example, Basel III requires banks to have a minimum amount of common equity and a minimum liquidity ratio. Basel III also includes additional requirements for what the Accord calls “systemically important banks,” or those financial institutions considered “too big to fail.” In doing so, it got rid of Tier 3 capital considerations.
The Basel III reforms have now been integrated into the consolidated Basel Framework, which comprises all of the current and forthcoming standards of the Basel Committee on Banking Supervision. Basel III Tier 1 has now been implemented, and all but one of the 27 Committee member countries participated in the Basel III monitoring exercise held in June 2021. The final Basel III framework includes phase-in provisions for the output floor, which will start at 50% on January 1, 2023, rise in annual steps of 5%, and be fully phased in at the 72.5% level in January 2028. These 2023-onward measures have been referred to as Basel 3.1 or Basel IV.
Conclusion
- The Basel Accords refer to three international banking regulatory meetings that established global banks’ capital requirements and risk measurements.
- The accords are designed to ensure that financial institutions maintain enough capital to meet their obligations and absorb unexpected losses.
- The latest Accord III was agreed upon in November 2010. Basel III requires banks to have a minimum amount of common equity and a minimum liquidity ratio.
