From 1965 to 1981 there were about eight bank failures (or bankruptcies) in the United States. Bank failures were particularly prominent during the 1980s, an era that is often referred to as the "savings and loan crisis." Banks throughout the world were lending extensively, while countries' external indebtedness was growing at an unsustainable rate. (See also: Analyzing a Bank's Financial Statements.)
As a result, the potential for the bankruptcy of the major international banks because grew as a result of low security. In order to prevent this risk, the Basel Committee on Banking Supervision, comprised of central banks and supervisory authorities of 10 countries, met in 1987 in Basel, Switzerland.
The committee drafted a first document to set up an international "minimum amount" of capital that banks should hold. This minimum is a percentage of the total capital of a bank, which is also called the minimum risk-based capital adequacy. In 1988, the Basel I Capital Accord was created. The Basel II Capital Accord follows as an extension of the former, and was implemented in 2007. In this article, we'll take a look at Basel I and how it impacted the banking industry.
The Purpose of Basel I
In 1988, the Basel I Capital Accord was created. The general purpose was to:
- Strengthen the stability of international banking system.
- Set up a fair and a consistent international banking system in order to decrease competitive inequality among international banks.
The basic achievement of Basel I has been to define bank capital and the so-called bank capital ratio. In order to set up a minimum risk-based capital adequacy applying to all banks and governments in the world, a general definition of capital was required. Indeed, before this international agreement, there was no single definition of bank capital. The first step of the agreement was thus to define it.
The Basel I agreement defines capital based on two tiers:
- Tier 1 (Core Capital): Tier 1 capital includes stock issues (or shareholder equity) and declared reserves, such as loan loss reserves set aside to cushion future losses or for smoothing out income variations.
- Tier 2 (Supplementary Capital): Tier 2 capital includes all other capital such as gains on investment assets, long-term debt with maturity greater than five years and hidden reserves (i.e., excess allowance for losses on loans and leases). However, short-term unsecured debts (or debts without guarantees), are not included in the definition of capital.
Credit risk is defined as the risk weighted asset, or RWA, of the bank, which are a bank's assets weighted in relation to their relative credit risk levels. According to Basel I, the total capital should represent at least 8% of the bank's credit risk (RWA). In addition, the Basel agreement identifies three types of credit risks:
- The on-balance-sheet risk (see Figure 1)
- The trading off-balance-sheet risk: These are derivatives, namely interest rates, foreign exchange, equity derivatives and commodities.
- The non-trading off-balance-sheet risk: These include general guarantees, such as forward purchase of assets or transaction-related debt assets.
Let's take a look at some calculations related to RWA and capital requirement. Figure 1 displays predefined categories of on-balance-sheet exposures, such as vulnerability to loss from an unexpected event, weighted according to four relative risk categories.
Figure 1: Basel's Classification of risk weights of on-balance-sheet assets
As shown in Figure 2, there is an unsecured loan of $1,000 to a non-bank, which requires a risk weight of 100%. The RWA is therefore calculated as RWA = $1,000 × 100% = $1,000. By using Formula 2, a minimum 8% capital requirement gives 8% × RWA = 8% × $1,000 = $80. In other words, the total capital holding of the firm must be $80 related to the unsecured loan of $1,000. Calculation under different risk weights for different types of assets are also presented in Table 2.
Figure 2: Calculation of RWA and capital requirement on-balance-sheet assets
Market risk includes general market risk and specific risk. The general market risk refers to changes in the market values due to large market movements. Specific risk refers to changes in the value of an individual asset due to factors related to the issuer of the security. There are four types of economic variables that generate market risk. These are interest rates, foreign exchanges, equities and commodities. The market risk can be calculated in two different manners: either with the standardized Basel model or with internal value at risk (VaR) models of the banks. These internal models can only be used by the largest banks that satisfy qualitative and quantitative standards imposed by the Basel agreement. Moreover, the 1996 revision also adds the possibility of a third tier for the total capital, which includes short-term unsecured debts. This is at the discretion of the central banks. (See also: Get To Know the Central Banks and What Are Central Banks?)
Pitfalls of Basel I
The Basel I Capital Accord has been criticized on several grounds. The main criticisms include the following:
- Limited differentiation of credit risk: There are four broad risk weightings (0%, 20%, 50% and 100%), as shown in Figure 1, based on an 8% minimum capital ratio.
- Static measure of default risk: The assumption that a minimum 8% capital ratio is sufficient to protect banks from failure does not take into account the changing nature of default risk.
- No recognition of term-structure of credit risk: The capital charges are set at the same level regardless of the maturity of a credit exposure.
- Simplified calculation of potential future counterparty risk: The current capital requirements ignore the different level of risks associated with different currencies and macroeconomic risk. In other words, it assumes a common market to all actors, which is not true in reality.
- Lack of recognition of portfolio diversification effects: In reality, the sum of individual risk exposures is not the same as the risk reduction through portfolio diversification. Therefore, summing all risks might provide an incorrect judgment of risk. A remedy would be to create an internal credit risk model—for example, one similar to the model as developed by the bank to calculate market risk. This remark is also valid for all other weaknesses.
These listed criticisms have led to the creation of a new Basel Capital Accord, known as Basel II, which added operational risk and also defined new calculations of credit risk. Operational risk is the risk of loss arising from human error or management failure. The Basel II Capital Accord was implemented in 2007.
The Bottom Line
The Basel I agreement aimed to assess capital in relation to credit risk, or the risk that a loss will occur if a party does not fulfill its obligations. It launched the trend toward increasing risk modeling research, but its oversimplified calculations and classifications brought about calls for its revision, paving the way for Basel II and further agreements as a symbol of the continuous refinement of risk and capital. Nevertheless, Basel I, as the first international instrument assessing the importance of risk in relation to capital, will remain a milestone in finance and banking history.