Basel Accord 1 refers to a set of recommendations published in 1988 by the Basel Committee, a committee gathering the central bankers of the G 10 countries under the authority of the Bank of international regulations, in Basel. It is also known as the 1988 Basel Agreement, which is focusing mainly on credit risk by creating a bank asset classification system.
The purposes of Basel accord 1 are as following:
Standardize the computation of risk based capital across banks and across countries.
Strengthen the stability of international banking system.
Set up a fair and a consistent international banking system in order to decrease competitive inequality among international banks.
According to Balin (2008), The Basel I Accord divides itself into four "pillars."
The first "pillar" is the Constituents of Capital, identifies both what types of on-hand capital are categorized as a bank's reserves and how much of each type of reserve capital a bank can hold.
Basel 1 defines capital based on two tiers, which are tier 1 (Core Capital) and tier 2 (Supplementary Capital). Tier 1 capital, which is an essential measure of capital adequacy, includes stock issues (or shareholders equity) and declared reserves, such as loan loss reserves set aside to cushion future losses or for smoothing out income variations. Preference share capital is normally included, subject to requirements that vary between countries. However, preference shares that are cumulative, redeemable, or on which the dividend payments are not discretionary are excluded.
Tier 2 Capital is a bit more dubiously defined. This capital can include hidden reserves created to cover potential loan losses, holdings of subordinated debt, long-term debt with maturity greater than five years, hybrid debt/equity instrument holdings, and potential gains from the sale of assets purchased through the sale of bank stock. However, short-term unsecured debts (or debts without guarantees), are not included in the definition of capital.
There are some limitations and restrictions that are implemented towards the capitals. The total of tier 2 elements is limited to a maximum of 100 percent of the total tier 1 elements. Subordinated term debt is limited to a maximum of 50 percent of tier 1 elements while the loan-loss reserves limited to a maximum of 1.25 percentage points. Lastly, the asset revaluation reserves that take the form of latent gains on unrealized securities are all subject to a discount of 55 percent.
The second "pillar" of the Basel I Accord, Risk Weighting, creates a comprehensive system to risk weight a bank's assets, or in other words, its loan book. This classification system grouped a bank's assets into five risk categories, as shown in table 1. The basic purpose of the capital guidelines is to relate a bank's capital to its profile so that high-risk activities require relatively more bank capital.
Table 1 : Risk weighted categories in Basel 1
Risk Weight
Asset Class
0%
Cash, central bank and government debt and any Organization for Economic Co-operation and Development (OECD) government debt
0%,10%,20% or 50%
Public sector debt
20%
Development bank debt, OECD bank debt, OECD securities firm debt, non-OECD bank debt (under one year maturity) and non-OECD public sector debt, cash in collection
50%
Residential mortgages
100&
Private sector debt, non-OECD bank debt (maturity over a year), real estate, plant and equipment, capital instruments issued at other banks.
The risk weightings applied to off-balance -sheet activities are slightly more complicated because the off-balance-sheet exposure amount must be adjusted to reflect their potential on-balance-sheet exposure. Off-balance sheet amounts must be converted to on0balance0sheet amounts using a conversion factor. The conversion factor is a percentage that reflects the percentage of the off-balance sheet exposure that potentially end-up on the balance sheet. The current risk weights and conversion factors for sample off-balance-sheet activities are shown in table 1.2.
Table 1.2 Risk Weights and Conversion Ratios for Selected Off-Balance-Sheet Activities
Weight (%)
Conversion Factor
0
0
50
0
50
0.005
50
0.01
50
0.05
100
0.2
100
0.5
100
1
The third "pillar" will b talking about the Targeted Standard Ratio, links the first and second pillars of the Basel Accord 1. It sets a universal standard ratio whereby 8% of a bank's risk-weighted assets must be covered by Tier 1 and Tier 2 capital reserves. Furthermore, the ratio of Tier 1 capital to risk-weighted assets must be at least 4%. This ratio is seen as "minimally adequate" to protect against credit risk in deposit insurance-backed international banks in all Basel Committee member states.
The fourth "pillar," Transitional and Implementing Agreements, sets the stage for the implementation of the Basel Accords. Each country's central bank is requested to create strong surveillance and enforcement mechanisms to ensure the Basel Accords are followed, and transition weights are given so that Basel Committee banks can adapt over a four-year period to the standards of the accord.
The Basel Accord was broadly implemented by states not in the G-10, a process encouraged by the Basel Committee and facilitated by the web of relationships established by the committee with various other international groups of banking supervisors.
Implementation
Basel I's adaptation and implementation occurred rather smoothly in the Basel Committee states. With the exception of Japan (which, due to the severity of its banking crisis in the late 1980s, could not immediately adopt Basel I's recommendations), all Basel Committee members implemented Basel I's recommendations-including the 8% capital adequacy target-by the end of 1992. Japan later harmonized its policies with those if Basel I in 1996. Although they were not intended to be included in the Basel I framework, other emerging market economies also adopted its recommendations. In contrast to the pointed warnings written into Basel I against implementation in industrializing countries, the adoption of Basel I standards was seen by large investment banks as a sign of regulatory strength and financial stability in emerging markets, causing capital-hungry states such as Mexico to assuage to Basel I in order to receive cheaper bank financing. By 1999, nearly all countries, including China, Russia, and India, had-at least on paper-implemented the Basel Accord.
Cirticism
There are several sources of criticisms on Basel Accord 1. One vein of criticism concentrates on perceived omissions in the Accord. Because Basel I only covers credit risk and only targets G-10 countries, Basel I is seen as too narrow in its scope to ensure adequate financial stability in the international financial system. Capital adequacy depends on credit risk, while other risks (e.g. market and operational) are excluded from the analysis. The assumption that a minimum 8% capital ratio is sufficient to protect banks from failure does not take into account the changing nature of default risk. Besides, the capital requirements of Basel 1 ignore the different level of risks associated with different currencies and macroeconomic risk. In other words, it assumes a common market to all actors, which is not true in reality.
The third group critical of Basel I concentrates on the misaligned incentives the Accord gives to banks. Due to the wide breath and absoluteness of Basel I's risk weightings, banks have found ways to "wiggle" around Basel I's standards to put more risk on their loan books than what was intended by the framers of the Basel Accord. The regulatory measure of bank risk as stipulated by the risk weights can differ substantially from the actual risk the bank faces. This resulted in regulatory arbitrage, a practice In which banks keep on their books assets that have the same risk-based capital requirement but are relatively risky. Also, Basel I's omission of market discipline is seen to limit the accord's ability to influence countries and banks to follow its guidelines.
Besides that, Basel Accord 1 agreement could not keep up with the rapid pace of innovation occurring in the banking industry, which tends to make old regulations obsolete in a hurry. A new regulatory system was required that would allow for adjustments in bank capital based on the relative amounts and types of risk that each bank actually face. Therefore, it was facing inadequate assessment of risks and effects of the use of new financial instruments, as well as risk mitigation techniques.
The final source of Basel I's criticisms relate to its application to emerging markets. Although Basel I was never intended to be implemented in emerging market economies, its application to these economies under the pressure of the international business and policy communities created foreseen and unforeseen distortions within the banking sectors of industrializing economies. (Balin, 2009)
Conclusion
The Basel I Capital Accord aimed to assess capital in relation to credit risk, or the risk that a loss will occur if a party does not fulfill its obligations. It launched the trend toward increasing risk modeling research; however, its over-simplified calculations, and classifications have simultaneously called for its disappearance. These listed criticisms have led to the creation of a new Basel Capital Accord, known as Basel II, which added operational risk and also defined new calculations of credit risk. Operational risk is the risk of loss arising from human error or management failure. Basel II Capital Accord was implemented in 2007. Nevertheless, Basel I, as the first international instrument assessing the importance of risk in relation to capital, will remain a milestone in the finance and banking history.
