Why BASEL?

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.

The Committee was formed in response to the messy liquidation of a Cologne-based bank (Herstatt) in 1974. On 26 June 1974, a number of banks had released Deutsche Mark (German Mark) to the Bank Herstatt in exchange for dollar payments deliverable in New York. On account of differences in the time zones, there was a lag in the dollar payment to the counter-party banks, and during this gap, and before the dollar payments could be effected in New York, the Bank Herstatt was liquidated by German regulators. This incident prompted the G-10 nations to form towards the end of 1974, the Basel Committee on Banking Supervision, under the auspices of the Bank of International Settlements (BIS) located in Basel, Switzerland.

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

Bank for International Settlements (BIS)

The mission of the Bank for International Settlements (BIS) is to serve central banks in their pursuit of monetary and financial stability, to foster international cooperation in those areas and to act as a bank for central banks.

In broad outline, the BIS pursues its mission by:

promoting discussion and facilitating collaboration among central banks; supporting dialogue with other authorities that are responsible for promoting financial stability; conducting research on policy issues confronting central banks and financial supervisory authorities; acting as a prime counterparty for central banks in their financial transactions; and serving as an agent or trustee in connection with international financial operations. The head office is in Basel, Switzerland and there are two representative offices: in the Hong Kong Special Administrative Region of the People's Republic of China and in Mexico City. Established on 17 May 1930, the BIS is the world's oldest international financial organisation. As its customers are central banks and international organisations, the BIS does not accept deposits from, or provide financial services to, private individuals or corporate entities. The BIS strongly advises caution against fraudulent schemes.

About the Basel Committee

The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. It seeks to do so by exchanging information on national supervisory issues, approaches and techniques, with a view to promoting common understanding. At times, the Committee uses this common understanding to develop guidelines and supervisory standards in areas where they are considered desirable. In this regard, the Committee is best known for its international standards on capital adequacy; the Core Principles for Effective Banking Supervision; and the Concordat on cross-border banking supervision. The Committee's members come from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. The present Chairman of the Committee is Mr Stefan Ingves, Governor of Sveriges Riksbank.

Main Expert Sub-Committees

The Committee's work is organised under four main sub-committees:

The Standards Implementation Group The Policy Development Group The Accounting Task Force The Basel Consultative Group

The Standards Implementation Group(SIG) was originally established to share information and promote consistency in implementation of the Basel II Framework. In January 2009, its mandate was broadened to concentrate on implementation of Basel Committee guidance and standards more generally. It is chaired by Mr Jos Mara Roldn, Director General of Banking Regulation at the Bank of Spain. Currently the SIG has four subgroups or task forces that work on specific implementation issues. The Standards Monitoring Procedures Task Force supports the implementation of Basel Committee standards and guidelines by developing tools and procedures that help promote greater effectiveness and consistency in standards monitoring and implementation. The Task Force is chaired by Mr Ben Gully, Managing Director of the Basel Implementation Division at the Office of the Superintendent of Financial Institutions, Canada.

The primary objective of the Policy Development Group (PDG) is to support the Committee by identifying and reviewing emerging supervisory issues and, where appropriate, proposing and developing policies that promote a sound banking system and high supervisory standards. The group is chaired by Mr Stefan Walter, Secretary General of the Basel Committee. Seven working groups report to the PDG: the Risk Management and Modelling Group (RMMG), the Research Task Force (RTF), the Working Group on Liquidity, the Definition of Capital Subgroup, the Capital Monitoring Group, the Trading Book Group (TBG) and the Cross-border Bank Resolution Group. The Accounting Task Force(ATF) works to help ensure that international accounting and auditing standards and practices promote sound risk management at banks, support market discipline through transparency, and reinforce the safety and soundness of the banking system. To fulfil this mission, the

task force develops prudential reporting guidance and takes an active role in the development of international accounting and auditing standards. Ms Sylvie Mathrat, Deputy Director General, Bank of France, chairs the ATF.

The Basel Consultative Group(BCG) provides a forum for deepening the Committee's engagement with supervisors around the world on banking supervisory issues. It facilitates broad supervisory dialogue with non-member countries on new Committee initiatives early in the process by gathering senior representatives from various countries, international institutions and regional groups of banking supervisors that are not members of the Committee. The BCG is chaired by Mr Karl Cordewener, Deputy Secretary General of the Basel Committee.

Basel I
Basel I is the round of deliberations by central bankers from around the world, and in 1988, the Basel Committee (BCBS) in Basel, Switzerland, published a set of minimal capital requirements for banks. This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten (G-10) countries in 1992 . Indeed, the world has changed as financial conglomerates, financial innovation and risk management have developed. Therefore, a more comprehensive set of guidelines, known as Basel II are in the process of implementation by several countries and new updates in response to the financial crisis commonly described as Basel III.

Main framework
Basel I, that is, the 1988 Basel Accord, primarily focused on credit risk. Assets of banks were classified and grouped in five categories according to credit risk, carrying risk weights of zero (for example home country sovereign debt), ten, twenty, fifty, and up to one hundred percent (this category has, as an example, most corporate debt). Banks with international presence are required to hold capital equal to 8 % of the risk-weighted assets. However, large banks like JPMorgan Chase found Basel I's 8% requirement to be unreasonable, and implemented credit default swaps so that in reality they would have to hold capital equivalent to only 1.6% of assets. Since 1988, this framework has been progressively introduced in member countries of G-10, currently comprising 13 countries, namely, Belgium, Canada, France, Germany, Italy, Japan,Luxembourg, Netherlands, Spain, Sweden, Swit zerland, United Kingdom and the United States of America.

The Purpose of Basel I

In 1988, the Basel I Capital Accord was created. The general purpose was to: 1. Strengthen the stability of international banking system. 2. Set up a fair and a consistent international banking system in order to decrease competitive inequality among international banks.

The basic achievement of Basel I has been to define bank capital and the so-called bank capital ratio. In order to set up a minimum risk-based capital adequacy applying to all banks and governments in the world, a general definition of capital was required. Indeed, before this international agreement, there was no single definition of bank capital. The first step of the agreement was thus to define it.

Two-Tiered Capital
Basel I defines capital based on two tiers:

1. Tier 1 (Core Capital): Tier 1 capital includes stock issues (or share holders 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.

Figure 1: Basel's Classification of risk weights of on-balance sheet assets

As shown in Figure 2, there is an unsecured loan of $1,000 to a non-bank, which requires a risk weight of 100%. The RWA is therefore calculated as RWA=$1,000 100%=$1,000. By using Formula 2, a minimum 8% capital requirement gives 8% RWA=8% $1,000=$80. In other words, the total capital holding of the firm must be $80 related to the unsecured loan of $1,000.

Calculation under different risk weights for different types of assets are also presented in Table 2.

Figure 2: Calculation of RWA and capital requirement on-balance sheet

Market risk includes general market risk and specific risk. The general market risk refers to changes in the market values due to large market movements. Specific risk refers to changes in the value of an individual asset due to factors related to the issuer of the security. There are four types of economic variables that generate market risk. These are interest rates, foreign 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.