ARIANNE MAE D.

ALBAY
MBA 321

BASEL ACCORD AGREEMENT

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.

BASEL I

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

Basil I defines capital based on two tiers:

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.

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.
ARIANNE MAE D. ALBAY
MBA 321

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.

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.
ARIANNE MAE D. ALBAY
MBA 321

EFFECTS ON FINANCIAL INSTITUTIONS

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, paving the way for the Basel II Capital Accord
and further agreements as the symbol of the continuous refinement of risk and capital.
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.

BASEL II

Basel II is a set of international banking regulations put forth by the Basel Committee on
Bank Supervision, which leveled the international regulation field with uniform rules and
guidelines. Basel II expanded rules for minimum capital requirements established under Basel I,
the first international regulatory accord, and provided framework for regulatory review, as well
as set disclosure requirements for assessment of capital adequacy of banks. The main difference
between Basel II and Basel I is that Basel II incorporates credit risk of assets held by financial
institutions to determine regulatory capital ratios.

The new approach would be built on three “pillars” – the first, a set of formulas for
determining regulatory capital requirements; the second, a set of principles for the exercise of
supervisory oversight; and the third, a set of disclosure requirements intended to enhance market
discipline.

Pillar I basically sets out three means for calculating capital requirements:

1. The “standardized” approach – essentially, a set of refinements to the Basel I risk buckets
-- which provides for the use of external ratings in certain circumstances, and gives some
weight to risk mitigation devices.
2. The “foundation internal ratings-based (IRB)” approach, which sets forth a methodology
for using a bank’s own internal risk rating system, including its calculated probabilities of
ARIANNE MAE D. ALBAY
MBA 321

default (PD), as a base for calculating capital, using a factor for loss given default (LGD)
provided by supervisors.
3. The “advanced IRB” approach, which bases capital calculations on the bank’s own
supervisory-validated credit risk rating systems, including bank-calculated PDs and
LGDs.

In each of the three approaches there would be a separate calculation for determining capital
to cover operational risk

EFFECTS ON FINANCIAL INSTITUTIONS

Banks would be able to choose between a basic approach based on gross income of the
company, a standardized approach that looks at gross income within individual business lines,
and an internal models-based advanced measurement approach.

Basel II has multiple approaches for different types of risk. It has multiple approaches for
securitization and for credit risk mitigants (such as collateral). It also contains formulas that
require a financial engineer.

Some countries have implemented basic versions of the new accord, but in the United
States, Basel II is seeing a painful, controversial and prolonged deployment (even as large banks
have been working for years to meet its terms). Many of the problems are inevitable: The
agreement tries to coordinate bank capital requirements across countries and across bank sizes.
International coherence is hard enough, but so is scaling the requirements - in other words, it is
very hard to design a plan that does not give advantage to a banking giant over a smaller regional
bank.

BASEL III

Basel III is a set of proposed changes to international capital and liquidity requirements
and some other related areas of banking supervision. It is the second major revision to an original
set of rules, now known as Basel I, which was promulgated by the Basel Committee in 1988. The
ARIANNE MAE D. ALBAY
MBA 321

Basel accords are not formal treaties and the members of the committee do not always fully
implement the rules in national law and regulation.

The Basel III rules are a regulatory framework designed to strengthen financial
institutions by placing guidelines pertaining to leverage ratios, capital requirements and liquidity.
For investors in the banking sector, they create confidence that some of the mistakes made by
banks that caused and contributed to the financial crisis in 2007-2008 will not be repeated.

Basel III is designed to be a voluntary effort and was finalized with input and feedback
from banks and financial regulators. Many countries have integrated aspects of Basel III into
their own domestic regulatory statutes for banks. One of the lessons of the financial crisis was
that banks with high leverage ratios need to be appropriately regulated instead of self-regulating.
These were the banks that were the most distressed during 2007-2008.

EFFECTS ON FINANCIAL INSTITUTIONS

If everyone accepts that banks and the financial system would be safer as a result of these
changes, but that this would come at the cost of slower economic growth in most years due to
higher credit costs and reduced availability.

For bank investors, this increases confidence in the strength and stability of
banks' balance sheets. Banking will be safer, but more expensive, with extensive ramifications
throughout the economy. By reducing leverage and imposing capital requirements, it reduces
banks' earning power in good economic times. Nevertheless, it makes banks safer and better able
to survive and thrive under financial stress.

Financial institutions tend to grow fast during periods of economic expansion. However,
during downturns, many go bust. Basel III would force them to add to long-term reserves and
capital during good times, cushioning the inevitable distress when conditions turn negatively.

REFERENCE: https://www.investopedia.com/terms/b/basel_accord.asp