What Are the Basel Accords?
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What Are the Basel Accords?

The Basel Accords, established by the Basel Committee on Bank Supervision (BCBS), consist of three sequential banking regulation agreements (Basel I, II, and III). These accords offer recommendations on capital risk, market risk, and operational risk, ensuring sufficient capital reserves in financial institutions to absorb unforeseen losses.

Basics

The Basel Accords encompass a trio of global banking regulatory meetings, defining capital requirements and risk assessments for international banks. These accords aim to guarantee that financial institutions possess adequate capital reserves to fulfill obligations and cope with unforeseen losses. The most recent of these, Basel III, was ratified in November 2010 and mandates banks to maintain a minimum amount of common equity and a minimum liquidity ratio.

Basel Accords: A Comprehensive Insight

The Basel Accords, spanning from the 1980s, emerged through the cooperation of the BCBS, a forum for banking supervision among member countries since 1974. Initially, their aim was to enhance global financial stability through improved supervisory practices. Later, their focus shifted to ensuring banks' capital adequacy and monitoring the banking system. Basel I was initiated by G10 central bankers, seeking to establish new international financial structures after the collapse of the Bretton Woods system.

The name "Basel Accords" derives from the BCBS being headquartered in Basel, Switzerland, within the offices of the Bank for International Settlements (BIS). The membership includes prominent countries like the United States, United Kingdom, Japan, and others, uniting to oversee financial stability and strengthen banking supervision worldwide.

Basel I: A Look Back

In 1988, the first Basel Accord, Basel I, concentrated on financial institutions' capital adequacy. It grouped assets into risk categories (0%, 10%, 20%, 50%, and 100%) to gauge capital adequacy risk—the potential impact of unexpected losses on institutions.

According to Basel I, international banks must maintain capital (Tier 1 and Tier 2) equivalent to at least 8% of their risk-weighted assets, ensuring they possess sufficient capital to meet obligations.

For instance, a bank with $100 million risk-weighted assets must hold at least $8 million in capital. Tier 1 capital, the most liquid funding source, and Tier 2 capital, comprising hybrid capital instruments and reserves, supplement this requirement.

Basel II: An Updated Framework

Basel II, also known as the Revised Capital Framework, built on the original accord, addressing three core areas: minimum capital requirements, supervisory review of capital adequacy, and market discipline through disclosure. These three areas are collectively referred to as the three pillars.

The new accord introduced a division of eligible regulatory capital into three tiers. Each tier has a specific minimum percentage of the total regulatory capital and contributes to the calculation of regulatory capital ratios.

Tier 3 capital, considered tertiary capital, served to support market risk, commodities risk, and foreign currency risk arising from trading activities. It included a wider range of debt compared to tiers 1 and 2 but of lower quality. Subsequently, under the Basel III accords, tier 3 capital was discontinued.

Basel III: Strengthening Financial Resilience

Following the 2008 Lehman Brothers collapse and the subsequent financial crisis, the BCBS took action to update and enhance the Accords. Identified factors contributing to the collapse included poor governance, risky incentive structures, and excessive leverage within the banking sector. In November 2010, Basel III emerged as the comprehensive capital and liquidity reform package.

Basel III builds upon the three pillars of the previous accords and introduces new requirements and safeguards. Among these, it mandates a minimum amount of common equity and a liquidity ratio for banks. Basel III also addresses "systemically important banks," those deemed "too big to fail," and eliminates tier 3 capital considerations.

The reforms have been consolidated into the Basel Framework, encompassing all current and upcoming standards of the Basel Committee on Banking Supervision. Basel III tier 1 has been implemented, with all but one of the 27 Committee member countries participating in the June 2021 monitoring exercise. The final Basel III framework includes phase-in provisions for the output floor, gradually reaching 72.5% from January 2028. The measures from 2023 onward have been referred to as Basel 3.1 or Basel IV.

Conclusion

The Basel Accords, consisting of Basel I, II, and III, focus on capital and risk requirements for financial institutions to absorb unexpected losses. Basel I, initiated in 1988, mandated banks to hold capital equal to 8% of risk-weighted assets. Basel II introduced the three pillars, addressing minimum capital, supervisory review, and market discipline through disclosure. Basel III, ratified in 2010, strengthened financial resilience, mandating a minimum amount of common equity and liquidity ratio for banks. The accords have significantly shaped global banking, promoting stability and accountability.

Basel Accords
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