What Are the Basel Accords?
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 provides recommendations on banking and financial regulations, specifically, concerning capital risk, market risk, and operational risk. The accords ensure that financial institutions have enough capital on account to absorb unexpected losses.
- The Basel Accords refer to a series of three international banking regulatory meetings that established capital requirements and risk measurements for global banks.
- The accords are designed to ensure that financial institutions maintain enough capital on account to meet their obligations and also absorb unexpected losses.
- The latest accord, Basel III, was agreed upon in November 2010. Basel III requires banks to have a minimum amount of common equity and a minimum liquidity ratio.
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 its member countries on banking supervisory matters. The BCBS describes its original aim as the enhancement of "financial stability by improving supervisory knowhow 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.
The Basel I accord was originally organized by central bankers from the G10 countries, who were at that time 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 offices of the Bank for International Settlements (BIS) located 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.
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, banks that operate internationally 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 most liquid and primary funding source of the bank, and tier 2 capital includes less liquid hybrid capital instruments, loan-loss, and revaluation reserves as well as undisclosed reserves.
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 from two into three tiers. The higher the tier, the less subordinated securities a bank is allowed to include in it. Each tier must be of a certain minimum percentage of the total regulatory capital and is used as a numerator in the calculation of regulatory capital ratios.
The new tier 3 capital is defined as tertiary capital, which many banks hold to support their market risk, commodities risk, and foreign currency risk, derived from trading activities. Tier 3 capital includes a greater variety of debt than tier 1 and tier 2 capital but is of a much lower quality than either of the two. Under the Basel III accords, tier 3 capital was subsequently rescinded.
In the wake of the Lehman Brothers collapse of 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 is a continuation of 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 that are considered "too big to fail." In doing so, it got rid of tier 3 capital considerations.
The terms of Basel III were eventually finalized in December 2017. However, its implementation has been delayed, due to the impact of COVID-19, and the reforms are now expected to take effect in January 2023.