Basel – I | Trade Samaritan

Basel – I

Basel, a city of Switzerland is the headquarters of Bureau of International Settlement (BIS). BIS encourages movement among central banks with a common goal. These goals intend to bring in financial stability and common standards of banking regulation.

 

From 1965 to 1981 United States witnessed about 8 banks failure on account of excessive lending. More and more banks were standing at the brink of bankruptcy. In order to address this situation, Central banks of 10 countries joined hands to formulate the Basel Committee on Bank Supervision (BCBS). And after several rounds of deliberation, in 1988 this committee published what is known as Basel I which in 1992 was enforced as law by 10 countries. There are currently 27 nations in the committee known as Basel Committee on Bank Supervision (BCBS).

Capital adequacy of the bank has always been the biggest concern in terms of retaining solvency.

At this point it is important to understand the difference between solvency and liquidity.

A bank is considered to be solvent if its assets exceed its liabilities whereas the bank’s liquidity depends upon how quick can the bank convert it’s assets into cash. A bank could be solvent IE have an asset value higher than its liabilities but lack liquidity, the failure of Bear Sterns was the result of its illiquid and bad quality assets.

The primary function of Basel I is to define the minimum capital requirements for the banks.

Basel I defines bank’s capital in 2 tiers

  • Tier 1 to include stock and reserves.
  • Trier 2 to include other capital such as gains on investment and long term debt (> 5 years).

The capital requirement is based on the credit risk and accordingly a risk weight assigned to the asset. Assets of the bank were classified and grouped into 4 categories of credit risk weights, 0, 20, 50 and 100. And the minimum regulatory capital requirement under Basel I has been set at flat 8%.

 

Risk Weight Asset Type
0% Cash, Bullion/Gold, Home country Treasury Debt
20% Securities
50% Municipal bonds, Residential Mortgages
100% Other claims such as Corporate Debt, Equities, Plant and Equipment, Real Estate

The regulatory capital requirement as per Basel I will be calculated as below:

Risk Weighted Assets (RWA) = Balance Sheet exposure (asset value) X Risk weight (assigned)

Regulatory Capital requirement = 8% X RWA

Or

Regulatory Capital/ Risk weighted assets =/ > 8%

Let us look at some examples to understand the requirement:

  • Money Bank lends USD 100 M to Shoe Corporate for 1 year.
  • Capital requirement for Money Bank = USD 100 M X 100% X 8% = USD 8 M
  • Money Bank lends USD 100 M to Penny Bank for 1 year
  • Capital requirement for Money Bank = USD 100 M X 20% X 8% = USD 1.6 M

Banks are also required to assign risk weight and retain minimum capital for off balance sheet assets such as Letter of credits, Bonds, Guarantees, Standby letter of credit and Bankers acceptance.

There are some drawbacks of Basel I such as fixation on credit risk and market risk which is not representative of economic risk, one-size-fits-all approach and that it over looks the liquidity aspect. Moreover assigning weights to the assets is more of a subjective exercise. Basel I regulation did attempt to minimize the insolvency related risk in the banking industry by introducing Capital Adequacy ratio (CAR) that must be held as a percentage of risk weighted assets. It created an internationally recognized standard which contributed to the financial stability through leveling and was also relatively simple to adopt.

Since its implementation in 1988, Basel I was eventually adopted by over 100 countries, the success rate depends on the regulatory bodies hence varies from country to country. Basel I is a valuable milestone in the industry of finance and banking which then paved the way for subsequent reforms such as Basel II and Basel III. In the forthcoming articles of this series we will be looking at Basel II and Basel III so stay tuned..

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