The first accord was the Basel I. It was issued in 1988 and focused mainly on credit risk by creating a bank asset classification system. This classification system grouped a bank's assets into five risk categories:
0% - cash, central bank and government debt and any OECD government debt
0%, 10%, 20% or 50% - public sector debt
20% - development bank debt, OECD bank debt, OECD securities firm debt, non-OECD bank debt (under one year maturity) and non-OECD public sector debt, cash in collection
50% - residential mortgages
100% - private sector debt, non-OECD bank debt (maturity over a year), real estate, plant and equipment, capital instruments issued at other banks
The bank must maintain capital (Tier 1 and Tier 2) equal to at least 8% of its risk-weighted assets. For example, if a bank has risk-weighted assets of $100 million, it is required to maintain capital of at least $8 million.
Basel II is the second of the Basel Accords and published in June 2004, was intended to amend international standards that controlled how much capital banks need to hold to guard against the financial and operational risks banks face. These rules sought to ensure that the greater the risk to which a bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and economic stability. Capital adequacy, risk management and disclosure requirements -
- use of external ratings agencies to set the risk weights for corporate, bank and sovereign claims.
- Operational risk has been defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputation risk, whereby legal risk includes exposures to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements. There are complex methods to calculate this risk.
- disclosure requirements allow market participants assess the capital adequacy of the institution based on information on the scope of application, capital, risk exposures, risk assessment processes, etc.
It is widely felt that the shortcoming in Basel II norms is what led to the global financial crisis of 2008. That is because Basel II did not have any explicit regulation on the debt that banks could take on their books, and focused more on individual financial institutions, while ignoring systemic risk. In short Basel III is a global, voluntary regulatory framework on bank capital adequacy, stress testing and market liquidity risk. It was agreed upon by the members of the Basel Committee on Banking Supervision in 2010–11. Basel III norms -
- The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz. capital, leverage, funding and liquidity.
- Requirements for common equity and Tier 1 capital will be 4.5% and 6%, respectively.
- The liquidity coverage ratio(LCR) will require banks to hold a buffer of high quality liquid assets sufficient to deal with the cash outflows encountered in an acute short term stress scenario as specified by supervisors. The minimum LCR requirement will be to reach 100% on 1 January 2019. This is to prevent situations like "Bank Run".
- Leverage Ratio > 3%:The leverage ratio was calculated by dividing Tier 1 capital by the bank's average total consolidated assets;.