Basel Accords: History, Reforms, and Impact

The Basel Accords have a rich history that dates back to 1988, when the first accord was signed in Basel, Switzerland. This marked a significant shift in global banking regulations.

The first Basel Accord, also known as Basel I, aimed to establish a set of minimum capital requirements for banks to ensure their stability and soundness. It introduced the concept of risk-weighted assets, which is still a cornerstone of banking regulations today.

The Basel Accords have undergone significant reforms over the years, with the second accord (Basel II) introduced in 2004, and the third accord (Basel III) implemented in 2010. These reforms aimed to strengthen banks' capital and liquidity requirements, as well as improve risk management practices.

Basel III introduced new requirements for banks to hold a minimum of 7% of their risk-weighted assets in common equity and retained earnings, and to maintain a liquidity coverage ratio of 100%.

The Basel Accords have a rich history that dates back to the 1970s. The Committee's work aimed to close gaps in international supervisory coverage, ensuring that no banking establishment would escape supervision.

The Concordat, issued in 1975, set out principles for sharing supervisory responsibility between host and parent authorities. This was a major step towards international cooperation.

In 1983, the Concordat was revised and re-issued as Principles for the supervision of banks' foreign establishments. This revision aimed to improve the supervision of international banking groups.

A supplement to the Concordat was issued in 1990, focusing on the exchange of information between supervisors. This was a crucial step in improving the flow of prudential information.

The Committee released a report in 1996 on The supervision of cross-border banking, which presented proposals for overcoming impediments to effective consolidated supervision. This report helped forge relationships between supervisors in home and host countries.

The Core principles for effective banking supervision were first published in 1997, setting out 25 basic principles for a supervisory system to be effective. After several revisions, the document now includes 29 principles.

Here's a brief timeline of key events:

The Basel Accords were a result of central bankers' deliberations from major countries, leading to the Basel Capital Accord published in 1988, which covered capital requirements for credit risk.

The Accord was enforced by law in the Group of Ten (G-10) countries by 1992, setting a minimum ratio of capital to risk-weighted assets of 8% to be implemented by the end of 1992.

The Basel Capital Accord was designed to halt the erosion of capital standards in banking systems and to work towards greater convergence in the measurement of capital adequacy.

The Accord was amended in November 1991 to more precisely define the general provisions or general loan loss reserves that could be included in the capital adequacy calculation.

In April 1995, another amendment was issued to recognise the effects of bilateral netting of banks' credit exposures in derivative products and to expand the matrix of add-on factors.

The Committee also refined the framework to address risks other than credit risk, issuing the Market Risk Amendment in January 1996, which incorporated market risks and allowed banks to use internal models as a basis for measuring market risk capital requirements.

The Market Risk Amendment took effect at the end of 1997 and included both a standardised approach and a modelled approach, the latter based on value at risk.

The Basel Accords were put in place to respond to the financial crisis of 2007-2008. The Basel III reforms were published in 2010/11 to address the crisis.

The Basel Committee set new definitions of capital, higher capital ratio requirements, and a leverage ratio requirement as a "back stop" measure. This was a crucial step in stabilizing the banking system.

A key aspect of Basel III was the introduction of risk-based capital requirements (RWAs) for CVA risk and interest rate risk in the banking book. This was a first for the banking industry.

The Basel Committee also published regulatory standards for the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). These standards aimed to improve the resilience of banks to liquidity shocks.

In subsequent years, the Basel Committee updated the standards for market risk, based on a "Fundamental Review of the Trading Book" (FRTB). This review aimed to improve the way banks measure and manage market risk.

Here are the key areas covered by the Basel III: Finalising post-crisis reforms standards:

The banking sector had liquidity problems even before the collapse of Lehman Brothers in 2008. The Basel decisions are constantly evolving, but banking systems will only stabilize if the guidelines are followed.

The Basel Committee presented another agreement on comprehensive capital planning and liquidity reforms in September 2010. This agreement was called Basel III.

The Basel Accords have undergone significant reforms and implementations over the years. The Basel Committee on Banking Supervision (BCBS) monitors members' implementation of Basel standards, publishing semiannual reports on progress and conducting peer reviews to assess consistency and completeness.

The BCBS uses the Regulatory Consistency Assessment Programme (RCAP) to monitor the timely adoption of Basel III standards. This programme consists of two workstreams: one to monitor the adoption of Basel III standards and another to assess consistency and completeness of adopted standards.

The RCAP publishes semiannual reports on members' progress and regular updates to G20 Leaders. Between 2012 and 2016, the Committee reviewed all member jurisdictions' implementation of the risk-based capital framework, and many jurisdictions improved the consistency of their domestic regulations with Basel requirements.

The Basel III: Finalising post-crisis reforms standards cover six areas, including the standardised approach for credit risk (SA-CR), internal ratings based approach (IRB) for credit risk, and operational risk - A standardised approach for operational risk for a bank based on income and historical losses.

The BCBS released the final version of its "Supervisory Framework for Measuring and Controlling Large Exposures" (SFLE) in April 2014. This framework builds on longstanding BCBS guidance on credit exposure concentrations.

Key implementation milestones include:

The Basel Committee agreed on changes to global capital requirements in 2017, which are so far-reaching that they are increasingly seen as an entirely new framework, often referred to as Basel IV, also known as Basel 3.1.

The Basel Accords are a set of regulatory standards that aim to improve the stability of the global financial system. The first step towards this goal was taken in 1999 when the Committee proposed a new capital framework to replace the 1988 Accord.

The new framework, known as Basel II, was released in June 2004 and consisted of three pillars. These pillars are minimum capital requirements, supervisory review of an institution's capital adequacy, and effective use of disclosure.

Basel II introduced a more risk-sensitive approach to capital requirements, which aimed to reward and encourage continued improvements in risk measurement and control. This framework was designed to improve the way regulatory capital requirements reflect underlying risks.

The Basel Committee consulted extensively with banking sector representatives, supervisory agencies, central banks, and outside observers to develop this new framework. The Committee published a comprehensive document in June 2006, which integrated the June 2004 text with the July 2005 text on the treatment of banks' trading books.

The new framework was designed to address the financial innovation that had occurred in recent years. It introduced capital requirements for operational risk for the first time.

The ratio of equity and credit under Basel II is 8%. The standards were revised several times during subsequent years.

Bank regulators in the United States required banks to follow the more conservative approach, either Basel I or Basel II. However, Basel II standards were criticised for allowing banks to take on too much risk with too little capital.

Here are the three pillars of Basel II:

Risk management is a crucial aspect of the Basel Accords, and there are several key developments that have been implemented in recent years. A new framework for exposures to CCPs was introduced in 2017.

The standardised approach for counterparty credit risk (SA-CCR) replaced the Current exposure method in 2017, and it's used to measure the potential future exposure of derivative transactions in the leverage exposure measure and non-modelled Risk Weighted Asset calculations. This change aimed to provide a more accurate assessment of credit risk.

To limit large exposure to external and internal counterparties, a framework was implemented in 2018.

Cet1 is a crucial component of a bank's capital structure. It stands for Common Tier 1 capital, which comprises shareholders' equity, including audited profits, less certain deductions.

The deductions include accounting reserves that are not believed to be loss-absorbing "today", such as goodwill and other intangible assets. This helps prevent double-counting of capital across the economy.

Banks must maintain a minimum CET1 ratio of 4.5% at all times, calculated by dividing CET1 capital by risk-weighted assets (RWAs). This is a fundamental requirement under Basel III.

A mandatory "capital conservation buffer" or "stress capital buffer requirement" is also in place, equivalent to at least 2.5% of RWAs. National regulators may require this buffer to be higher based on stress test results.

In some cases, a "counter-cyclical buffer" of up to an additional 2.5% of RWA as capital may be required during periods of high credit growth. This must be met by CET1 capital.

Here's a summary of the CET1 requirements:

In the U.S., an additional 1% is required for globally systemically important financial institutions.

The leverage ratio is a crucial aspect of risk management in banking. It's calculated by dividing Tier 1 capital by the bank's leverage exposure.

The leverage ratio is used to ensure that banks have sufficient capital to cover potential losses. Basel III introduced a minimum leverage ratio of 3%. This means that banks must maintain a certain level of capital relative to their exposure.

In the US, there's another leverage ratio requirement, the supplemental leverage ratio, which is defined as Tier 1 capital divided by total assets. It must be above 3.0%. Large banks and systemically important financial institutions are required to have a minimum leverage ratio of 5%.

The leverage ratio timeline is a key part of understanding its implementation. Here's a brief overview:

The UK has its own leverage ratio requirement, with a minimum of 3.25% for banks with deposits greater than £50 billion. This higher minimum reflects the PRA's differing treatment of the leverage ratio, which excludes central bank reserves in 'Total exposure' of the calculation.

Liquidity is a crucial aspect of risk management, especially for banks. Banks need to hold sufficient high-quality liquid assets to cover their total net cash outflows over a specified period.

The liquidity coverage ratio (LCR) is a required liquidity/funding ratio introduced by Basel III. It requires banks to hold sufficient high-quality liquid assets to cover their total net cash outflows over 30 days under a stressed scenario.

The LCR consists of two parts: the numerator is the value of high-quality liquid assets (HQLA), and the denominator consists of the total net cash outflows over a specified stress period. Total expected cash outflows minus total expected cash inflows make up the denominator.

Regulators can allow banks to dip below their required liquidity levels per the LCR during periods of stress. This flexibility is essential for banks to manage their liquidity effectively.

Here's a brief timeline of liquidity requirements:

Banks with at least $250 billion in total assets or at least $10 billion in on-balance sheet foreign exposure are subject to stricter definitions of HQLA and total net cash outflows under the U.S. liquidity coverage ratio.

A new framework for exposures to CCPs was introduced in 2017, which replaced the Current exposure method with the standardised approach for counterparty credit risk (SA-CCR).

SA-CCR is used to measure the potential future exposure of derivative transactions in the leverage exposure measure and non-modelled Risk Weighted Asset calculations.

A framework for limiting large exposure to external and internal counterparties was implemented in 2018, aiming to reduce the risk of significant losses due to a single counterparty.

In the UK, the Bank of England was in the process of implementing the Basel III framework on large exposures as of 2024, which will further regulate large exposures to external and internal counterparties.

Interest Rate Risk in the Banking Book can be a challenge for banks to manage. New rules for interest rate risk in the banking book became effective in 2018.

Banks are required to calculate their exposures based on "economic value of equity" (EVE). This involves assessing their financial situation under a set of prescribed interest rate shock scenarios.

Banks must take a proactive approach to managing their interest rate risk. This includes regularly reviewing and updating their risk management strategies to ensure they are prepared for potential changes in interest rates.

Calculating exposures based on EVE helps banks to better understand their financial vulnerability to interest rate changes.

A domain-centric approach is key to effective risk management in the banking industry. This involves having a thorough understanding of the banking domain and applicable regulatory mandates.

Digital technologies can assist and augment manual efforts in risk management. A combination of a domain-centric approach and digital solutions can provide the best strategy.

Anaptyss leverages its exclusive Digital Knowledge Operations framework and deep-domain expertise to help banks meet the Basel standards and compliance. This expertise is crucial in developing effective control frameworks and internal policies.

To enhance your Enterprise Risk Management (ERM) today, consider the following key areas: ERM, Model Risk Management, and Credit Portfolio Management. These areas are critical in identifying and mitigating potential risks.

Here are some key areas to focus on:

A comprehensive understanding of the risk management lifecycle and risk management strategies is essential. This includes developing a risk management framework that aligns with the organization's goals and objectives.

By adopting a domain-centric approach and leveraging digital solutions, banks can effectively manage risks and comply with regulatory requirements. This is particularly important in the financial sector, which is one of the most risk-prone industries.