What is Basel I?
Basel I refers to a set of international banking regulations created by the Basel Committee on Bank Supervision (BCBS), which is based in Basel, Switzerland. The committee defines the minimum capital requirements for financial institutions, with the primary goal of minimizing credit risk. Basel I is the first set of regulations defined by the BCBS and is part of what is known as the Basel Accords, which now includes Basel II and Basel III. The accords’ essential purpose is to standardize banking practices all over the world.
Basel I was developed to mitigate risk to consumers, financial institutions, and the economy at large. Basel II, brought forth some years later, lessened the capital reserve requirements for banks. That came under some criticism, but because Basel II did not supersede Basel I, many banks continued to operate under the original Basel I framework, later supplemented by Basel III addendums.
Perhaps the greatest legacy of Basel I was that it contributed to the ongoing adjustment of banking regulations and best practices, paving the way for further protective measures.
Basel I Framework
Basel I, that is, the 1988 Basel Accord, is primarily focused on credit risk and appropriate risk-weighting of assets. Assets of banks were classified and grouped into five categories according to credit risk, carrying risk weights of 0% (for example cash, bullion, a home country debt like Treasuries), 20% (securitizations such as mortgage-backed securities (MBS) with the highest AAA rating), 50% (municipal revenue bonds, residential mortgages), 100% (for example, most corporate debt), and some assets are given no rating. Banks with an international presence are required to hold capital equal to 8% of their risk-weighted assets (RWA).
The tier 1 capital ratio = tier 1 capital / all RWA
The total capital ratio = (tier 1 + tier 2 capital) / all RWA
Leverage ratio = total capital/average total assets
Banks are also required to report off-balance-sheet items such as letters of credit, unused commitments, and derivatives. These all factor into the risk-weighted assets, which are reported to regulators. In the United States, the report is typically submitted to the Federal Reserve Bank as HC-R for the bank-holding company and submitted to the Office of the Comptroller of the Currency (OCC) as RC-R for just the bank.
From 1988 this framework was progressively introduced in member countries of G-10, comprising 13 countries as of 2013: Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Spain, Sweden, Switzerland, United Kingdom, and the United States.
Over 100 other countries also adopted, at least in name, the principles prescribed under Basel I. The efficacy with which the principles are enforced varies, even within the nations of the Group.
Requirements for Basel I
The Basel I classification system groups a bank's assets into five risk categories, labeled with the percentages 0%, 10%, 20%, 50%, and 100%. A bank's assets are assigned to these categories based on the nature of the debtor.
The 0% risk category consists of cash, central bank and government debt, and any Organisation for Economic Co-operation and Development (OECD) government debt. Public sector debt can be placed in the 0%, 10%, 20%, or 50% categories, depending on the debtor.
Development bank debt, OECD bank debt, OECD securities firm debt, non-OECD bank debt (under one year of maturity), non-OECD public sector debt, and cash in the collection all fall into the 20% category. The 50% category is for residential mortgages, and the 100% category is represented by private sector debt, non-OECD bank debt (maturity over a year), real estate, plant and equipment, and capital instruments issued at other banks.
The bank must maintain capital (referred to as Tier 1 and Tier 2 capital) equal to at least 8% of its risk-weighted assets. This is meant to ensure that banks hold an adequate amount of capital to meet their obligations. For example, if a bank has risk-weighted assets of $100 million, it is required to maintain a capital of at least $8 million. Tier 1 capital is the most liquid type and represents the core funding of the bank, while Tier 2 capital includes less liquid hybrid capital instruments, loan-loss and revaluation reserves, as well as undisclosed reserves.
Understanding Basel I - Examples
Let us consider the following examples to understand the Basel I norms thoroughly:
Let’s say a bank has a cash reserve of $200, $50 as a home mortgage, and $100 as loans given out to different companies. The risk-weighted assets as per the set norms will be as follows: –
=($200*0) +($50*0.2) +($100*1)
Therefore, according to Basel I, this bank has to maintain a minimum of 8% of $110 as a minimum capital (and at least 4% in tier 1 capital).
Russia did not have an organized banking system before the central bank of the nation stripped the licenses of many banks out there based on the Basel Accords before 2017. The Basel Accords were introduced in the 1980s in Switzerland in the presence of central bankers and finance ministers. It has been upgraded to the Basel-III post the Great Recession period of 2008-09. This led to the bankruptcy of several private banks, keeping only the deserved ones to operate across the country.