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Introduction

Basel

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The Basel Accords are the set of recommendations for effective
supervision of the banking sector introduced by the Basel Committee on Banking Supervision (BCBS). Currently, there are three accords of Basel i.e. Basel I, Basel
II, and Basel III.

The Basel Committee

 

The Basel committee, also
known as The Basel Committee on Banking Supervision (BCBS) is a cooperative
council of banking authorities which was set up at the end of 1974 by the
governors of central bank of G-10 countries. It was mainly introduced after
various difficulties in currency exchange and banking sectors and mainly due to
the bankruptcy of cologne based bank- Herstatt (History of Basel comittee, 2016). The key purpose of
the team was to coordination and synchronization of the banking standards among
its participant states. As the founding document (Bank of International Settlements, 1988) states, the accords
are just an agreement and not a legally binding document within its member
countries. Their member countries are free to implement or reject the standards
recommended by the Basel committee.

 

The Basel Committee’s work

According to (Bank of Internation settlements, 2017) the work done by the
Basel Committee are mainly focused on following fields:

Exchange of  information on
developments in the banking and financial sectors Sharing of supervisory
issues, approaches and techniques to promote common understanding
and to improve cross-border cooperationIntroduction and
continuous upgrade of the global standards of banking supervisionDeal with pitfalls in supervision and regulation that can pose
risks to monetary stabilityMonitor its member countries and beyond to ensure their effective,
consistent and timely implementation of the Basel Standards.Consultation with bank
supervisory authorities beyond the members of BCBS in order to receive inputs regarding continuous
upgrade of the BCBS standards and implementation of its own banking
standards beyond the member countries of BCBS.Coordination and cooperation with other
financial organizations

 

BASEL
I

The International
Convergence of Capital Measurements and Capital Standards, which is informally known as “BASEL I” was
the first accord introduced among the series of Basel Accords. It was
introduced in July of 1988, after six years of long and careful discussion and
the final agreement between 12 member countries of BCBS committee. The accord
mainly talks about credit risk and appropriate assignment of weights to risk
associated with assets. The regulations in the accord were proposed to define a
minimum capital level however the national authorities were allowed to adopt
stronger requirements. The Accord proposed the minimum ratio of capital to
risk-weighted assets be at least 8% and recommended to be implemented till the
end of 1992.

The accord

The
Basel accord is divided into four pillars. The first pillar is known as The Constituents of
Capital. The accord recognizes capital reserves according to its quality into
two tiers i.e. Tier 1 capital and Tier 2 capital. “Tier 1 Capital,” consisted
only of disclosed cash reserves and paid up capital (stocks and preferred shares).
Tier 2 Capital however was not clearly defined. This capital could include
general provisions created to cover future potential losses, holdings of
subordinated debt which had to be a maximum of 50% of the Tier 1 capital, fully
paid up hybrid instrument holdings, reserves created from assets revaluations
and other undisclosed reserves. To comply with the Basel Accord, the quantity
(in dollar terms) of Tier 1 and Tier 2 capital had to be equal.

 

After the determination of capital, the second pillar
of the Basel I Accord known as “the risk weights” defined a number of factors
that would classify the assets of balance sheet amounts according to their assumed
credit risk level. The risk levels were divided into five different categories.
These five risk levels encompassed all assets of a bank’s balance sheet. The
first level categorized assets as riskless and weighted them at 0%. Such assets
according to Basel I were cash and cash reserves held by a bank, claims on OECD
central governments and other claims on OECD central governments funded and denominated
in national currency. The second risk level categorized assets as low risk
assets and weighted them at 20%. Securities in this category included claims on
OECD banks and multilateral development bank, claims on public sectors
incorporated in the OECD, claims on non-OECD bank with a residual maturity of
less than 1 year. The third level categorized assets into moderate risk assets
and weighted them as 50%. This category however included only residential
mortgage loans. The fourth level categorized assets as high risk assets and
weighted them at 100% of an asset’s value, and included all other claims such
as a bank’s claims on the corporate sector, claim on non-OECD bank with a
maturity of more than 1 year,  fixed
assets of the bank, and all other assets. The fifth level could be categorized
into a variable risk category and included claims on non-central government and
public-sector entities. The entities in this category did not have a fixed
weight however they could be valued at 0, 10, 20, or 50% depending on discretion
of the national supervisory authority of the respective member states.

 

The third pillar is known as “A Target Standard
Ratio” defines the minimum standard expected from the bank at the end of
the financial period. It recommends the ratio of capital to risk weighted
assets be set at 8% which has to be covered by capital reserves from Tier 1 and
Tier 2 capital. Also, 4% of a bank’s risk-weighted assets had to be covered by
tier 1 capital.

 

The fourth pillar is known as “Transitional and
Implementing Agreements” and it sets the grounds for the implementation of
the Basel Accords. Each country’s supervising authority is recommended to
perform strong surveillance and employ various mechanisms to ensure the proper
implementation of Basel Accords. More over this pillar also provides
“transition weights” which allows banks over a period of four years to fully
comply with the standards of the Basel accord.

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