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BASEL1 Basel I is the round of deliberations by central bankers from around the world, and in 1988, the Basel

Committee (BCBS) in Basel, Switzerland, published a set of minimal capital requirements for banks. This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten (G-10) countries in 1992 . Basel I is now widely viewed as outmoded. Indeed, the world has changed as financial conglomerates, financial innovation and risk management have developed. Therefore, a more comprehensive set of guidelines, known as Basel II are in the process of implementation by several countries and new updates in response to the financial crisis commonly described as Basel III.

Main framework
Basel I, that is, the 1988 Basel Accord, primarily focused on credit risk. Assets of banks were classified and grouped in five categories according to credit risk, carrying risk weights of zero (for example home country sovereign debt), ten, twenty, fifty, and up to one hundred percent (this category has, as an example, most corporate debt). Banks with international presence are required to hold capital equal to 8 % of the risk-weighted assets. However, large banks like JPMorgan Chase found Basel I's 8% requirement to be unreasonable, and implemented credit default swaps so that in reality they would have to hold capital equivalent to only 1.6% of assets. Since 1988, this framework has been progressively introduced in member countries of G-10, currently comprising 13 countries, namely, Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Spain, Sweden, Switzerland, United Kingdom and the United States of America. Most other countries, currently numbering over 100, have also adopted, at least in name, the principles prescribed under Basel I. The efficiency with which they are enforced varies, even within nations of the Group of Ten. BASEL2 Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II, which was initially published in June 2004, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. Advocates of Basel II believe that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. In theory, Basel II attempted to accomplish this by setting up risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability.

1. Ensuring that capital allocation is more risk sensitive; 2. Separating operational risk from credit risk, and quantifying both; 3. Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage. 4. Basel II uses a "three pillars" concept (1) minimum capital requirements (addressing risk), (2) supervisory review and (3) market discipline. 5. The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk was not dealt with at all.
The first pillar

The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk, and market risk. Other risks are not considered fully quantifiable at this stage. The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach, Foundation IRB and Advanced IRB. IRB stands for "Internal Rating-Based Approach". For operational risk, there are three different approaches - basic indicator approach or BIA, standardized approach or TSA, and the internal measurement approach (an advanced form of which is the advanced measurement approach or AMA). For market risk the preferred approach is VaR (value at risk). As the Basel 2 recommendations are phased in by the banking industry it will move from standardised requirements to more refined and specific requirements that have been developed for each risk category by each individual bank. The upside for banks that do develop their own bespoke risk measurement systems is that they will be rewarded with potentially lower risk capital requirements. In future there will be closer links between the concepts of economic profit and regulatory capital. Credit Risk can be calculated by using one of three approaches: 1. Standardised Approach 2. Foundation IRB (Internal Ratings Based) Approach 3. Advanced IRB Approach The standardized approach sets out specific risk weights for certain types of credit risk. The standard risk weight categories used under Basel 1 were 0% for government bonds, 20% for exposures to OECD Banks, 50% for first line residential mortgages and 100% weighting on

consumer loans and unsecured commercial loans. Basel II introduced a new 150% weighting for borrowers with lower credit ratings. The minimum capital required remained at 8% of risk weighted assets, with Tier 1 capital making up not less than half of this amount. Banks that decide to adopt the standardised ratings approach must rely on the ratings generated by external agencies. Certain banks used the IRB approach as a result.
The second pillar

The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk and legal risk, which the accord combines under the title of residual risk. It gives banks a power to review their risk management system. Internal Capital Adequacy Assessment Process (ICAAP) is the result of Pillar II of Basel II accords
The third pillar

This pillar aims to promote greater stability in the financial system Market discipline supplements regulation as sharing of information facilitates assessment of the bank by others including investors, analysts, customers, other banks and rating agencies. It leads to good corporate governance. The aim of pillar 3 is to allow market discipline to operate by requiring lenders to publicly provide details of their risk management activities, risk rating processes and risk distributions. It sets out the public disclosures that banks must make that lend greater insight into the adequacy of their capitalisation. When marketplace participants have a sufficient understanding of a banks activities and the controls it has in place to manage its exposures, they are better able to distinguish between banking organisations so that they can reward those that manage their risks prudently and penalise those that do not.

Laurent Balthazar

0 Reviews Palgrave Macmillan, 2006 - 294 pages The book covers topics related to banking regulation and credit risk modelling. The proposed rules are presented and key issues regarding implementation of the accord identified. The model used to calibrate the capital requirements under Basel 2 is analyzed and projected forward to present what could be key new elements in the future Basel 3 regulation. A CD-ROM is included to illustrate regulator models.

Basel I

What Does Basel I Mean? A set of international banking regulations put forth by the Basel Committee on Bank Supervision, which set out the minimum capital requirements of financial institutions with the goal of minimizing credit risk. Banks that operate internationally are required to maintain a minimum amount (8%) of capital based on a percent of risk-weighted assets.

Investopedia explains Basel I The first accord was the Basel I. It was issued in 1988 and focused mainly on credit risk by creating a bank asset classification system. This classification system grouped a bank's assets into five risk categories: 0% - cash, central bank and government debt and any OECD government debt 0%, 10%, 20% or 50% - public sector debt 20% - development bank debt, OECD bank debt, OECD securities firm debt, non-OECD bank debt (under one year maturity) and non-OECD public sector debt, cash in collection 50% - residential mortgages 100% - private sector debt, non-OECD bank debt (maturity over a year), real estate, plant and equipment, capital instruments issued at other banks The bank must maintain capital (Tier 1 and Tier 2) equal to at least 8% of its risk-weighted assets. For example, if a bank has risk-weighted assets of $100 million, it is required to maintain capital of at least $8 million.

2. Main Characteristics of the New Accord Basel 2

The new accord (Basel 2) consists of three pillars: 1. Minimum capital requirement. 2. Supervisory review process. 3. Market discipline. Taken together, the three pillars contribute to a higher level of safety and soundness in the financial system as characterized in the following diagram

2.1 The first Pillar: Minimum capital requirement

The definition of capital in Basel 2 will not modify and that the minimum ratios of capital to risk-weighted assets including operational and market risks will remain 8% for total capital. Tier 2 capital will continue to be limited to 100% of Tier 1 capital. The main changes will come from the inclusion of the operational risk and the approaches to

Bank Soundness
Pillar 1 Pillar 2 Pillar 3 Market Discipline Minimum Capital Requirement Supervisory Review Process 7 measure the different kinds of risks. The following diagram summarizes these approaches. Risk Based Capital Ratio Capital Credit Risk Market Risk Operational Risk While there were no changes in the approaches to measure the market risk there were fundamental changes in the approaches to measure the credit risk, which we will discuss in section 3. Regarding the operational risk it is introduced for the first time in this accord. In the standardized approach to credit risk, exposures to various types of counter parties, e.g. sovereigns, banks and corporates, will be assigned risk weights based on assessments by external credit assessment institutions. To make the approach more risk sensitive an additional risk bucket (50%) for corporate exposures will be included. Further, certain categories of assets have been identified for the higher risk bucket (150%). The foundation approach to internal ratings incorporates in the capital calculation the banks own estimates of the probability of default associated with the obligor, subject to adherence to rigorous minimum supervisory requirements. Estimates Approaches to measure Credit Risk: Standardized Approach (a modified version of the existing approach). Foundation Internal Rating Based Approach (IRB). Advanced Internal Rating

of additional risk factors to calculate the risk weights would be derived through the application of standardized supervisory rules. In the advance IRB approach, banks that meet even more rigorous minimum requirements will be able to use a broader set of internal risk measures for individual exposures.

2.2 The Second Pillar: Supervisory Review Process

In Basel 1 the risk weight were fixed and the implementation of the accord was straightforward. In Basel 2 the bank can choose from a menu of approaches to measure the credit, market and operational risks. This process of choosing the approach requires the review of the availability of the minimum requirements to implement the approach. In addition to that, in IRB approaches the risk weight is computed from inputs from the bank (like the probability of default). It is necessary in this case to make sure that the bank inputs are measured or estimated in an accurate and robust manner. Basel committee suggests four principles to govern the review process: Principle 1: Banks should have a process for assessing their overall capital in relation to their risk profile and a strategy for maintaining their capital levels. Principle 2: Supervisors should review and evaluate banks internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the results of this process. Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum. 9 Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

2.3 The Third Pillar: Market Discipline

The third pillar in Basel 2 aims to bolster market discipline through enhanced disclosure by banks. Effective disclosure is essential to ensure that market participants can better understand banks risk profiles and the adequacy of their capital positions. The new framework sets out disclosure requirements and recommendations in several areas, including the way a bank calculates its capital adequacy and its risk assessment methods. The core set of disclosure recommendations applies to all banks, with more detailed requirements for supervisory recognition of internal methodologies for credit risk, mitigation techniques and asset securitization. BASEL 3:

BASEL III is a new global regulatory standard on bank capital adequacy and liquidity agreed by the members of the Basel Committee on Banking Supervision.[1] The third of the Basel Accords was developed in a response to the deficiencies in financial regulation revealed by the global financial crisis. Basel III strengthens bank capital

requirements and introduces new regulatory requirements on bank liquidity and bank leverage. The OECD estimates that the implementation of Basel III will decrease annual GDP growBasel III will require banks to hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) of risk-weighted assets (RWA). Basel III also introduces additional capital buffers, (i) a mandatory capital conservation buffer of 2.5% and (ii) a discretionary countercyclical buffer, which allows national regulators to require up to another 2.5% of capital during periods of high credit growth. In addition, Basel III introduces a minimum 3% leverage ratio and two required liquidity ratios. The Liquidity Coverage Ratio requires a bank to hold sufficient high-quality liquid assets to cover its total net cash flows over 30 days; the Net Stable Funding Ratio requires the available amount of stable funding to exceed the required amount of stable funding over a oneyear period of extended by 0.05 to 0Macroeconomic Impact of Basel III
An OECD study [2] released on 17 February 2011, estimates that the medium-term impact of Basel III implementation on GDP growth is in the range of 0.05 to 0.15 percentage point per annum. Economic output is mainly affected by an increase in bank lending spreads as banks pass a rise in bank funding costs, due to higher capital requirements, to their customers. To meet the capital requirements effective in 2015 (4.5% for the common equity ratio, 6% for the Tier 1 capital ratio), banks are estimated to increase their lending spreads on average by about 15 basis points. The capital requirements effective as of 2019 (7% for the common equity ratio, 8.5% for the Tier 1 capital ratio) could increase bank lending spreads by about 50 basis points. The estimated effects on GDP growth assume no active response from monetary policy. To the extent that monetary policy will no longer be constrained by the zero lower bound, the Basel III impact on economic output could be offset by a reduction (or delayed increase) in monetary policy rates by about 30 to 80 basis points.[7]
.15 percentage point.