Basel Accords
What are the Basel Accords?
The Basel Accords are a set of banking regulation recommendations that the risk management practices for active financial institutions in the international arena.
The stated aims of the accord are to:
- Improve the banking sector's ability to absorb shocks that arise from financial and economic stress, whatever the source
- Improve risk management and governance
- Strengthen banks' transparency and disclosures.
Although the BIS introduced the Basel Accord to be implemented globally, different global regions, for example, the United States, and European Union, and countries within regions, are allowed to customize the BIS regulations to comply with their own regulator(s) individual requirements, if these customizations are within the BIS Accord.[1]
History of the Basel Accords[2]
- Basel I: The first Basel Accord, known as Basel I, was issued in 1988 and focuses on the capital adequacy of financial institutions. The capital adequacy risk (the risk that a financial institution will be hurt by an unexpected loss), categorizes the assets of financial institutions into five risk categories (0%, 10%, 20%, 50%, and 100%). Under Basel I, banks that operate internationally are required to have a risk weight of 8% or less.
- Basel II: The second Basel Accord, called Revised Capital Framework but better known as Basel II, served as an update of the original accord. It focuses on three main areas: minimum capital requirements, supervisory review of an institution's capital adequacy and internal assessment process, and 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 III: In the wake of the Lehman Brothers collapse of 2008 and the ensuing financial crisis, the BCBS decided to update and strengthen the Accords. It saw poor governance and risk management, inappropriate incentive structures, and overleveraged banking industry as reasons for the collapse. In July 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, including requiring 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 colloquially called "too big to fail." The implementation of Basel III has been gradual and began in January 2013. It is expected to be completed by Jan. 1, 2019.
- Basel IV: Basel IV is the informal name for a set of proposed banking reforms building on the international banking accords known as Basel I, Basel II, and Basel III. It is also referred to as Basel 3.1. It is scheduled to begin implementation on Jan. 1, 2023.
The Need for Basel Accords[3]
In the 1980s, the rate of bank failures in the United States was increasing at an appalling rate. This was primarily due to the Savings and Loan (S&L) Crisis and the fact that banks had been lending recklessly. As a result, the external debt of a lot of countries had been growing at an unsustainable rate and the probability of major international banks going belly up was alarmingly high. The banking industry was going through turmoil and was terribly in need of a framework to bring some order amidst the chaos. To prevent all hell from breaking loose, representatives from central banks and supervisory authorities of 10 countries, known as the Basel Committee on Banking Supervision (BCBS), met in 1987 in Basel, Switzerland to issue guidelines relating to capital and risk management activities of global banking institutions. This was the beginning of the Basel Accords.
How to support the Basel Accord[4]
The ability of a financial institution to deem itself Basel compliant involves a complex list of tasks and actions. The Basel Accord has evolved over a number of decades now and requires a financial institution to quantify the risk of its assets and provide a buffer in the form of a capital requirement to be available if such risks are even partially realized. While stated simply, the requirements have changed over time, and involve the ability to aggregate financial information using specific categories and classifications of asset and risk, and performing complex calculations of risk factors to quantify both exposure and risk in the financial institution’s books.
Such a substantial undertaking involves multiple parts of the organization, which need to understand the underlying business needs, specify the ongoing operational and reporting requirements and probe the capability of the underlying information systems to support such requirements.
By creating a data warehouse of atomic information about the bank’s assets, customers, counterparties, and resources, the bank allows an integrated view of its business to emerge. A major challenge consists of ensuring the accuracy and availability of detailed information requirements for Basel compliance.
It is often a major struggle for banks to understand and specify the entirety of what is required. The Basel publications by the Basel Committee on Banking Supervision (BCBS) provide a description of the reasons behind the requirements, and are subject to consultative refinement; the final requirements for any aspect of Basel emerge after a succession of documents have been published, and are often lengthy, wordy documents, rather than a clear specification of data requirements. Banks are also subject to local refinements by the supervising bank of their jurisdiction. What is required in such an undertaking is a way to translate the multiple and layered sets of publications into a clear set of information requirements, and from this to set about supporting the required data elements in a consolidated way.
The Future of the Basel Accords [5]
Following Basel III, the banking system has been able to raise billions of dollars in regulatory capital, hire thousands of extra regulatory and compliance personnel and shed off trillions of dollars of risky assets. This has resulted in lean and efficient global banking machinery. However, although the Basel III guidelines have tackled most of the shortfalls of the previous accord, the banking environment is constantly evolving and new kinds of risks keep emerging every now and then.
Not so long ago, the Banking industry fell in love with the Tech industry and together they gave birth to the FinTech industry. This industry is highly unregulated at the moment and lacks proper supervision. In recent years, slowly but steadily people have been moving their money from traditional brick-and-mortar banks to these internet-only digital banks. With online banks, cryptocurrencies, and the Internet of Things (IoT) coming into the picture, it is becoming harder and harder to decipher which firms qualify as a bank and which ones are just tech firms. Also, with the growing role of technology in banks comes an exponentially higher amount of cyber risk associated with their banking activities. Although it is too early to say what Basel IV would look like, it would be great to have some guidelines accounting for cyber risk and encouraging higher disclosure of reserves and other financial statistics.
The Basel Committee on Banking Supervision (“BCBS”) officially unveiled the new recommendations for setting the capital requirements for the banking sector, commonly dubbed “Basel IV” in December of 2022. The new regulation will include reforms in the standardized approach for credit risk, the IRB approach, the quantification of CVA risk and operational risk approaches, enhancements to the leverage ratio framework, and the finalization of the output floor. Deloitte has put together a placemat that highlights and elaborates on the key changes from Basel III to “Basel IV”.
See Also
IT Governance
Enterprise Risk Management (ERM)
Compliance
Data Governance
Corporate Governance
Risk Assessment
Risk Assessment Framework (RAF)
References