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Submitted by:
Adrian Corpin
Jun Rey Empleo
Mark Jofer Escarza
Mark Jhonpaul Gertes
Milko Gilo
John Carlo Mercado
BASEL I
Basel I is a set of international banking regulations put forth by the Basel Committee on Bank
Supervision (BCBS) that sets out the minimum capital requirements of financial institutions with
the goal of minimizing credit risk. Banks that operate internationally are required to maintain a
minimum amount (8%) of capital based on a percent of risk-weighted assets. Basel I is the first
of three sets of regulations known individually as Basel I, II and III and together as the Basel
Accords.
Implementation of Basel I
The BCBS regulations do not have legal force. Members are responsible for their
implementation in their home countries. Basel I originally called for the minimum capital ratio of
capital to risk-weighted assets of 8% to be implemented by the end of 1992. In September 1993,
the BCBS issued a statement confirming that G10 countries' banks with material international
banking business were meeting the minimum requirements set out in Basel I.
According to the BCBS, the minimum capital ratio framework was introduced in member
countries and in virtually all other countries with active international banks.
From 1965 to 1981 there were about eight bank failures (or bankruptcies) in the United States.
Bank failures were particularly prominent during the '80s, a time which is usually referred to as
the "savings and loan crisis." Banks throughout the world were lending extensively, while
countries' external indebtedness was growing at an unsustainable rate.
As a result, the potential for the bankruptcy of the major international banks because grew as a
result of low security. In order to prevent this risk, the Basel Committee on Banking Supervision,
comprised of central banks and supervisory authorities of 10 countries, met in 1987 in Basel,
Switzerland.
The committee drafted a first document to set up an international 'minimum' amount of capital
that banks should hold. This minimum is a percentage of the total capital of a bank, which is also
called the minimum risk-based capital adequacy. In 1988, the Basel I Capital Accord (agreement)
was created. The Basel II Capital Accord follows as an extension of the former, and was
implemented in 2007. In this article, we'll take a look at Basel I and how it impacted the banking
industry.
Two-Tiered Capital
Basil I defines capital based on two tiers:
1. Tier 1 (Core Capital): Tier 1 capital 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.
2. Tier 2 (Supplementary Capital): Tier 2 capital includes all other capital such as gains on
investment assets, long-term debt with maturity greater than five years and hidden reserves (i.e.
excess allowance for losses on loans and leases). However, short-term unsecured debts (or debts
without guarantees), are not included in the definition of capital.
Credit Risk is defined as the risk weighted asset (RWA) of the bank, which are banks assets
weighted in relation to their relative credit risk levels. According to Basel I, the total capital
should represent at least 8% of the bank's credit risk (RWA). In addition, the Basel agreement
identifies three types of credit risks:
The on-balance sheet risk
The trading off-balance sheet risk. These are derivatives, namely interest rates, foreign
exchange, equity derivatives and commodities.
The non-trading off-balance sheet risk. These include general guarantees, such as forward
purchase of assets or transaction-related debt assets.
Let's take a look at some calculations related to RWA and capital requirement. Figure 1 displays
predefined categories of on-balance sheet exposures, such as vulnerability to loss from an
unexpected
event,
weighted
according
to
four
relative
risk
categories.
exchanges, equities and commodities. The market risk can be calculated in two different
manners: either with the standardized Basel model or with internal value at risk (VaR) models of
the banks. These internal models can only be used by the largest banks that satisfy qualitative
and quantitative standards imposed by the Basel agreement. Moreover, the 1996 revision also
adds the possibility of a third tier for the total capital, which includes short-term unsecured debts.
This is at the discretion of the central banks.
Pitfalls of Basel I
Basel I Capital Accord has been criticized on several grounds. The main criticisms include the
following:
Limited differentiation of credit risk
There are four broad risk weightings (0%, 20%, 50% and 100%), as shown in Figure1, based on
an 8% minimum capital ratio.
Static measure of default risk
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.
No recognition of term-structure of credit risk
The capital charges are set at the same level regardless of the maturity of a credit exposure.
Simplified calculation of potential future counterparty risk
The current capital requirements 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.
Lack of recognition of portfolio diversification effects
In reality, the sum of individual risk exposures is not the same as the risk reduction through
portfolio diversification. Therefore, summing all risks might provide incorrect judgment of risk.
A remedy would be to create an internal credit risk model - for example, one similar to the model
as developed by the bank to calculate market risk. This remark is also valid for all other
weaknesses.
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.
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 fulfil its obligations. It launched the trend toward increasing risk
BASEL II
-Basel II is an international business standard that requires financial institutions to
maintain enough cash reserves to cover risk incurred by operation. It aims to
determine how much capital that banks should have in place for the types of risk
they face in their lending and investment activities.
-It also prevents the loss of money of the depositor and cover the loss from the
borrowers default.
Example:
Borrow
Deposit
er
or
1000ph
The
Depositor deposited 1000php to the bank, and the bank loaned 1000ph
the depositors
deposit to lend to the borrower.
Ban
k
Borrow
Ban
er
kwas a 200php default. The bank is
But800ph
the borrower only paid 800php, so there
obliged to pay the 200php default by using its reserve.
Capital Components:
1.Tier 1 Capital: Common Equity (i.e. stock + RE) plus non-redeemable noncumulative preferred stock.
2. Tier 2 Capital (supplementary capital): cumulative preferred stock, subordinated
debt with maturity of > 5 years, and long term debentures.
1.3- Operational Risk- Non-financial risk. Usually incidents that may affect
banks operation.
Introduction
Basel III is a set of precautionary measures imposed on banks and are made to protect the
economy from financial crises similar to that of recent years. Principally they aim to ensure
banks accept a level of responsibility for the financial economy they operate within and to act as
a safeguard against further collapse.
Tier 1 capital includes equity instruments that have discretionary dividends and no maturity,
while additional Tier 1 capital comprises securities that are subordinated to most subordinated
debt, have no maturity, and their dividends can be cancelled at any time. Tier 2 capital consists of
unsecured subordinated debt with an original maturity of at least five years.
Basel III left the guidelines for risk-weighted assets largely unchanged from Basel II. Riskweighted assets represent a bank's assets weighted by coefficients of risk set forth by Basel III.
The higher the credit risk of an asset, the higher its risk weight. Basel III uses credit ratings of
certain assets to establish their risk coefficients.
In comparison to Basel II, Basel III strengthened regulatory capital ratios, which are computed as
a percent of risk-weighted assets. In particular, Basel III increased minimum Common Equity
Tier 1 capital from 4% to 4.5%, and minimum Tier 1 capital from 4% to 6%. The overall
regulatory capital was left unchanged at 8%.
Countercyclical Measures
Basel III introduced new requirements with respect to regulatory capital for large banks to
cushion against cyclical changes on their balance sheets. During credit expansion, banks have to
set aside additional capital, while during the credit contraction, capital requirements can be
loosened. The new guidelines also introduced the bucketing method, in which banks are grouped
according to their size, complexity and importance to the overall economy. Systematically
important banks are subject to higher capital requirements.
The deposits that come from the customers flow through the banks to the investments that the
bank is going to make in a business. The investments are the loans to the borrowing customer.
Although highly technical, the principle underlying Basel III is clear and simple. Namely, the
financial community is there to serve the broader economic community. A strong and resilient
banking system is the foundation for sustainable economic growth, as banks are at the center of
the credit intermediation process between savers and investors, Basel III points out. Banks
provide critical services to consumers, small and medium-sized enterprises, large corporate firms
and governments who rely on them to conduct their daily business, both at a domestic and
international level.
How will it work?
The detailed provisions of Basel III are purpose-designed to render the financial sector as
immune as possible from future upheavals both from within and outside national borders. Thus
the new standards are based on micro prudential reforms at the level of individual banks and
macro prudential reforms across the entire banking sector. And they start with the integrity of
their capital base. Individual banks must in future hold more, high-quality capital to protect them
against unexpected losses to help them ride through any traumas in the financial markets. These
take the form of fatter buffers for capital or equity, cash and liquid assets than were required
under Basel IIIs predecessor, Basel II which the BIS admits was not tough enough.
= 0%
- January 1, 2016
= 0.625%
- January 1, 2017
= 1.25%
- January 1, 2018
= 1.875%
- January 1, 2019
= 2.5%
Second, management of risk. Among other measures all banks must conduct much more rigorous
analysis of the risk inherent in certain securities such as complex debt packages.
Third, leverage. Aiming to reduce the ratio of assets that banks, especially the biggest, built up in
relation to deposits, Basel III sets much tougher standards than before. In future banks must
include off-balance sheet exposures when they measure leverage. The ratio of core tier one
capital to a banks total assets, with no risk adjustment, may not exceed three percent.
Ex.
With the mandatory Leverage Ratio of (T1 to total assets) 3%. When you put 3,000,000 as the
Tier 1 Capital your Total Assets would not go beyond a hundred million. It can only go into
100,000,000. Which means it is limiting the banks freedom to keep adding assets with regard to
capital.
Fourth, market discipline. To improve the industrys and shareholders understanding of the risks
banks may be running, they must make far more complete disclosures than before the crisis. This
particularly applies to their exposure to off-balance sheet vehicles, how they are reported in the
accounts, and how banks calculate their capital ratios under the new regulations.
Basel III states that in every loans, there are associated risks. The loans are weighted to arrive at
a total amount of risk-weighted assets. In the first illustration, some are weighted at 100%, some
are 50%, and some are 5%. In this instance, a 200B of loans can give us a 100,000,000,000
worth of risk-weighted assets.
In many years, we may see balance sheet grow significantly. The Basel III insist on limiting this
and even stimulates banks to take initiatives to reduce them. The way to impose this is by
limiting the activities of the banks compared to its capital. For this, leverage ratio has been
developed.
The third element of Basel III is liquidity. What is liquidity for a bank? A bank receives deposits
and grants loans. Everyday, a bank disposes a certain amount of cash through its activity of
collecting deposits and by providing cash to clients while granting loans. It is very likely that the
bank will not be equilibrium at the end of the day if its deposits are higher than loans or if the
loans are higher than deposits. It is very necessary for a bank to maintain its balance between
loans and deposits. To make this happen, Basel III has developed a certain regulation. There
should be a stress test at the end of each period to know if the bank has balanced its loans and
deposits.
The main challenge for a bank is for it to maintain its deposits over its loans. Banks are always
facing a profitability challenge. Revenues from cross-selling will be welcomed and of top of this
cross-selling will be required to manage the equilibrium loans and deposits. However, this crossselling also leads to more operational intimacy. While balancing the deposits and loans, the
cross-selling will also be key. The operational intimacy this will bring will help to retain the
required liquidity levels for the stress test. Its necessary for a bank to have its complementary
activities of granting loans and collecting deposits. Cash management and Factoring is a great
example for this.