The Evolution of Basel Bank Capital Adequacy.

Uncategorized

BST Consulting Limited

October 27, 2022

The Basel Committee and the Basel Regulations

The Basel Committee on Banking Supervision (BCBS) is an international body that sets global standards for banking regulations. The main risks covered under the Basel Accords are credit, market, operational, and liquidity risks. In addition, they are a collection of principles and guidelines designed to ensure that banks remain solvent and continue operating in times of financial difficulty.

The BCBS writes regulations for international banks; national governments then implement these. Basel I, II, and III are the regulations that form the basis of today’s regulatory framework. They were first published in 1988, 2004, and 2010, respectively. The BCBS published the Basel IV in 2017 after a series of improvements were made to enhance the financial stability framework globally. These standards are based on the recommendations of academics, lawyers, economists, and regulators who have agreed upon them to improve market efficiency while maintaining sound risk management practices across global financial institutions.

Who is bound by the Basel Regulations?

The Basel regulations apply to banks and financial institutions. The legal status of the business and its role in the financial system defines it.

Banks: A bank is an entity that accepts deposits from savers and provides them with a range of financial services such as lending money or buying securities on behalf of customers.
Financial institutions: A financial institution includes any entity other than a bank (such as investment banks) that manages client assets or provides additional services to its clients.

Basel I

Basel I is a banking supervision document created by the G-10 countries in 1988, which sets out the minimum capital requirements of financial institutions to minimise credit risk. It was intended to cover large internationally active banks that were not covered under traditional capital adequacy standards.

In 2006, the Banking Committee issued a comprehensive set of revisions to these standards known as Basel II. These updates aimed to improve financial institutions’ capital requirements and liquidity buffers while maintaining the same regulatory framework.

Basel I was the first significant revision of the Bank for International Settlements’ (BIS) framework for bank capital adequacy. It was based on risk-based rather than credit-based approaches to determining bank capital requirements. The original framework set a minimum requirement for total leverage ratios that required that all financial institutions hold capital against their assets (leverage). This meant that if you had an asset with a value of $100 and debt equal to 80% of that amount ($80), your total leverage ratio would be 20% ($20). This may seem like common sense today, but at the time, many people thought this approach was too strict or even absurd—and they were right!

The new Basel rules created several distinct categories of risk:

Systematic Risk – The degree to which market outcomes are uncertain because they affect all firms within an industry; also called “market price risk.”
Unsystematic Risk – A measure explicitly used as part of a model; typically refers only to idiosyncratic factors affecting individual firms’ performance

Basel II

The Basel committee introduced the Basel II framework in 2004 to develop a framework that further strengthens the soundness and stability of the international banking system while maintaining sufficient consistency that capital adequacy regulation will not be a significant source of competitive inequality among internationally active banks.

Basel II is a set of regulations for banks that was designed to improve risk management processes and practices within financial institutions. These regulations aimed to reduce risk to ensure banks could withstand even greater market pressures.

Basel II is a significant step toward integrating different markets and financial systems to reduce risk.

Basel II was introduced to combat regulatory arbitrage and to exploit and improve bank risk management systems. It is much more complex and risk-sensitive than Basel I. Basel II treats exposures unequally depending on the exposure characteristics. It also treats banks unequally depending on the sophistication of their risk management systems.

The Basel II Accord was developed based on three pillars.

Pillar I is about Minimum capital requirements for credit risk and operational risk.
Pillar II is about the Supervisory review process.
Pillar III is about Market discipline

The Basel II framework set three minimum capital requirements to safeguard depositors and promote the stability and efficiency of the banking system by addressing:

Credit risk – This is defined as the risk that a borrower will default on a loan. To address this risk, banks must hold sufficient capital to cover expected losses from credit exposures in their portfolio.
Market Risk – This refers to the effects of adverse market conditions changes on a bank’s assets. Banks must hold enough capital against their asset base to continue operating through periods of adverse economic conditions without requiring additional support from other sources (i.e., government bailout).
Operational Risk – The objective here is not only to protect depositors but also other stakeholders, such as shareholders and creditors, who could lose money if something goes wrong with operations at one or more banks within an industry group.

Pillar I

Pillar I is about Minimum capital requirements for credit risk and operational risk. In addition, pillar I covers credit risk, the risk of loss from lending money to a borrower.

There are three types of assets that banks must have:

Cash or liquid assets that can be converted quickly into cash (i.e., cash)
Non-cash investments such as stocks, bonds, and real estate holdings
Securitisation instruments such as mortgage-backed securities

Pillar II

The Pillar II process is called the supervisory review process. The supervisory review process aims to ensure that standards are met, and that appropriate actions are taken when they are not met.

Pillar III

Pillar III is about Market discipline.

Market discipline is a process designed to encourage banks to manage their risks better. It is achieved by making banks accountable to their shareholders, creditors, and regulators.

The Basel Committee on Banking Supervision has set out five principles for managing these risks:

Market discipline (the riskiest assets have the highest incentives for market participants).
Risk-based capital requirements.
Stress tests.
Capital buffers (to protect against losses); and finally, the most important one –
Asset liability management (ALM) includes risk mitigation activities and capital raising measures when needed.

Basel III

The Basel III framework is central to the Basel Committee’s response to the global financial crisis. It addresses several shortcomings in the pre-crisis regulatory framework. It provides a foundation for a resilient banking system to help avoid building systemic vulnerabilities. Moreover, the framework allows the banking system to support the real economy through the economic cycle. It also introduced new global regulatory standards on Bank Capital Adequacy and Liquidity, emphasising capital adequacy.

Basel III aims to strengthen the banking sector’s regulation, supervision, and risk management. The members of the Basel Committee on Banking Supervision agreed upon by the Basel III in 2010–11 and it was scheduled to be introduced from 2013 until 2015. However, its implementation was extended to March 31st, 2019, in response to concerns over economic conditions.

Basel III presents a set of requirements for banks designed to ensure they have sufficient capital buffers to withstand shock events such as extreme market volatility or sudden swings in credit quality.

This includes implementing several measures that will help improve their risk management practices, including:

Setting limits on the amount of capital available to banks (or “capital adequacy requirements” or CAR).
Specifying how much capital an individual bank needs to have to avoid being deemed ‘too big’ by regulators.

The Basel III reforms were developed in response to the deficiencies in financial regulation revealed by the fiscal crisis of 2007–08, which highlighted the need for banks to hold more capital to absorb unexpected losses.

In June 2017, a few revisions were made to the regulatory phase-in period for minimum requirements for banks’ market risk.

In December 2017, there were some revisions regarding the regulatory treatment of sovereign exposures. The Basel Committee on Banking Supervision clarified the regulatory treatment of sovereign exposures in a document called “Basel III Risk-Based Capital Framework: International Standards Market Risk Measurement and Treatment Revised Framework”. The revisions were made in response to comments received during two public consultations in October 2016 and November 2016, respectively; they also reflected developments made since the publication of the Bank for International Settlements’ (BIS) definitive version of its market risk measurement model.

One of the key elements of Basel III is the Capital Adequacy Requirements.

Note: No changes were introduced to the existing Basel II RWA calculation in Basel III.

The differences between Basel I, II and III

	Basel I	Basel II	Basel III
General	The primary purpose of Basel I was to specify a minimum capital requirement for banks.	Basel II was created to enhance the minimum capital requirement and to introduce supervisory obligations.	Basel III concentrated on defining an additional equity buffer that banks must hold.
Risk Focus	Of the three accords, Basel I has the lowest risk emphasis.	A three-pillar risk management strategy was introduced by Basel II.	Basel III added the liquidity risk assessment and the other risks outlined in Basel II.
Risk Considered	In Basel I, only credit risk is considered.	Basel II entails various risks, including reputational, operational, and strategic risks.	Along with the risks addressed by Basel II, Basel III also addresses liquidity risks.
Future Risk Predictability	Basel I is backwards-looking since it only took the assets in banks’ current portfolios into account.	Basel II is more forward-looking than Basel I since the capital calculation considers risk.	Basel III is prospective since it considers the specific bank criteria and the macroeconomic context.

The differences between the Basel I, II and III accords are mainly brought about by the variances in the goals that each accord was created to accomplish. All three are managed in such a way to control banking risks considering the quickly shifting global business environments, despite the stark differences in the norms and regulations they presented. As globalisation has advanced, banks all around the world are interconnected. Due to the enormous sums of money involved, disastrous situations can occur if banks take uncalculated risks. The harmful effects can quickly spread to numerous countries. The most recent illustration of this is the financial crisis that began in 2008 and resulted in a substantial economic loss.

Basel IV

Basel IV is the culmination of Basel III. This reform package took more than ten years to design and was broken into two parts. The Basel Committee approved the final elements of the Basel III reform package in December 2017. Basel IV introduced new guidelines for operational risk, credit risk, and a credit valuation adjustment.

Additionally, it added an output ceiling, updated the leverage ratio definition, and applied it to internationally significant banks. The first phase of the rules was scheduled to take effect on January 1st, 2022. The reforms to bank regulation were created to create more-resilient banking systems and improve financial stability. The regulations would have also increased the accuracy and consistency of risk measurement and capital requirements by tightening loan loss provisions.

Basel IV implementation was initially planned to begin on January 1st, 2022, with a phase-in of the production floor until January 1st, 2027. However, in response to the pandemic, the BCBS delayed Basel IV’s implementation schedule in March 2020 by a year, from January 1st, 2022, to January 1st, 2023.

How to calculate Risk-Weighted Assets

The Basel Committee on Banking Supervision (BCBS) has set rules for calculating risk-weighted assets and capital ratios. These are known as the Basel III requirements, which came into effect in 2011. The BCBS’ analysis of these requirements was conducted over several years, starting in 2008.

The first step is to calculate the risk-weighted assets. This involves determining how much money you have invested with each type of financial institution (banks, insurers, and other firms). You then take this figure and divide it by your total assets (including cash but excluding any items such as loans or shares held by investors) to give you a measure called “risk-weighted asset” (RWA).

This can be used as one measure of how risky an investment is. For example, if someone invests £1 million in an account with Barclays Plc but only uses half that amount each year, their savings would have been classified as “minimal risk” because they have only had access to half their money during those 12 months.

How to calculate RWA explained.

How do the Basel Regulations impact the average consumer?

We already understand how the Basel regulations affect banking systems and financial services, but how do they affect the consumer? This is quite simple.

These banks hold your funds. Through these banks, you make your investments. Your money is safer when they take actions to reduce risk or improve transparency through disclosure.

Conclusion

In conclusion, it is necessary to understand that Basel I-IV regulations are essential to the regulatory framework for banks and other financial institutions worldwide. It helps banks maintain a sound financial system by ensuring minimum capital requirements and risk management.

Post Tags :