What is the Basel Accord?
The Basel Accords are a series of three consecutive banking supervision agreements (Basel I, II and III) developed by the Basel Committee on Banking Supervision (BCBS).
The committee advises on banking and financial regulation, in particular on capital risk, market risk and operational risk. These agreements ensure that financial institutions have sufficient funds to absorb unexpected losses.
- Basel Accord refers to a series of three international banking supervisory conferences that set capital requirements and risk measures for global banks.
- These agreements are designed to ensure that financial institutions maintain sufficient capital in the accounts to meet their obligations and absorb unexpected losses.
- The latest agreement, Basel III, was reached in November 2010. Basel III requires banks to have a minimum number of common shares and a minimum liquidity ratio.
Learn about the Basel Accord
The Basel Accords have developed over several years starting in the 1980s. The BCBS was established in 1974 as a forum for regular cooperation among its member countries on banking supervision matters. BCBS described its original objective as “enhancing financial stability by improving global regulatory knowledge and the quality of banking supervision”. Later, the BCBS turned its attention to monitoring and ensuring the capital adequacy of banks and the banking system.
Basel I was originally organized by G10 central bankers as they worked to create a new international financial architecture to replace the recently collapsed Bretton Woods system.
These meetings are named “Basel Accords” because BCBS is headquartered at 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, South Korea, United States, United Kingdom, Luxembourg, Japan, Mexico, Russia, Saudi Arabia, Switzerland, Sweden, Netherlands, Singapore, South Africa, Turkey and Spain.
The first Basel Accord, Basel I, was published in 1988 and focused on the capital adequacy ratios of financial institutions. Capital adequacy risk (the risk that an unexpected loss will harm a financial institution) categorizes a financial institution’s assets into 5 risk categories – 0%, 10%, 20%, 50% and 100%.
Under Basel I, banks operating internationally must maintain capital (Tier 1 and Tier 2) equal to at least 8% of their risk-weighted assets. This ensures that the bank holds a certain amount of capital to meet its obligations.
For example, if a bank has $100 million in risk-weighted assets, it needs to maintain at least $8 million in capital. Tier 1 capital is the most liquid major source of funding for banks, and Tier 2 capital includes less liquid hybrid capital instruments, loan loss and revaluation provisions, and undisclosed provisions.
The second Basel Accord, known as the Revised Capital Framework but better known as Basel II, is an update to the original agreement. It focuses on three main areas: minimum capital requirements, regulatory scrutiny of institutional capital adequacy and internal assessment processes, and the effective use of disclosure as a lever to enhance market discipline and encourage good banking practices, including regulatory scrutiny. These focus areas are collectively referred to as the three pillars.
Basel II divides banks’ eligible regulatory capital into three tiers from two tiers. The higher the rating, the less subordinated securities the bank is allowed to include. Each tier must represent a certain minimum percentage of total regulatory capital and is used as a numerator in calculating the regulatory capital ratio.
The new Tier 3 capital is defined as Tier 3 capital, which many banks hold to support their market risk, commodity risk and foreign exchange risk from trading activities. Tier 3 capital includes a wider variety of debt than Tier 1 and Tier 2 capital, but its quality is much lower than either. Tier 3 capital was subsequently withdrawn under Basel III.
After the collapse of Lehman Brothers in 2008 and the ensuing financial crisis, BCBS decided to update and strengthen the agreement. BCBS cited poor governance and risk management, improper incentive structures and over-leveraged banking as the reasons for the collapse. In November 2010, an agreement was reached on the overall design of the capital and liquidity reform package. The agreement is now known as Basel III.
Basel III is a continuation of the three pillars with additional requirements and safeguards. For example, Basel III requires banks to have a minimum number of common shares and a minimum liquidity ratio. Basel III also includes additional requirements for what the agreement calls “systemically important banks” or those financial institutions deemed “too big to fail.” In doing so, it gets rid of tier 3 capital considerations.
The terms of Basel III were finalized in December 2017. But its implementation has been delayed due to the impact of the global crisis in 2020, and the reforms are now expected to take effect in January 2023.