Basel I: Overview, Rules, and Impact

Basel I is the first international framework of banking regulations developed by the Basel Committee on Banking Supervision (BCBS). Introduced in 1988, its purpose was to strengthen the stability of the international banking system by setting a minimum capital requirement tied to the riskiness of a bank’s assets.

Key points
– Introduced minimum capital requirement of 8% of risk-weighted assets (RWA).
– Emphasized reduction of credit risk through standardized risk weights for asset classes.
– Laid the foundation for later accords (Basel II and Basel III), which refined and expanded the standards.

How Basel I came about
– The BCBS, formed as a forum for global banking supervisors, issued Basel I in 1988 to create a common benchmark for capital adequacy among internationally active banks.
– The committee’s standards are not directly legally binding; national regulators implement them into local law and supervision.

Minimum capital requirement
– Banks must hold capital (Tier 1 + Tier 2) equal to at least 8% of their risk-weighted assets.
– Example: If a bank’s RWA = $100 million, required capital = $8 million.

Tier 1 and Tier 2 capital
– Tier 1: Core capital — common equity, disclosed reserves; most loss-absorbing and liquid.
– Tier 2: Supplementary capital — subordinated debt, some loan-loss reserves and hybrid instruments; less permanent than Tier 1.

Risk-weighted assets and categories
Basel I groups assets into fixed risk-weight categories. Each asset’s book value is multiplied by its risk weight to produce RWA.

Typical risk weights and examples:
– 0%: Cash, central bank reserves, and qualifying government debt.
– 10%–20%: Highly rated bank claims, development-bank debt, some short-term OECD exposures.
– 50%: Residential mortgages.
– 100%: Most private sector loans, corporate debt, long-term non-OECD bank claims, real estate and fixed assets.
– 150%: Assets with very high risk (e.g., exposures with very low external credit ratings).

Simple RWA calculation example:
– $50M government bonds (0%) → $0 RWA
– $30M residential mortgages (50%) → $15M RWA
– $20M corporate loans (100%) → $20M RWA
– Total RWA = $35M → Minimum capital at 8% = $2.8M

Advantages of Basel I
– Created an internationally recognized baseline for capital adequacy.
– Standardized a method for linking capital to asset risk, improving comparability across banks and jurisdictions.
– Prompted broader improvements in supervisory practices and encouraged further regulatory development.

Limitations and criticisms
– Overly simplistic: Fixed risk weights grouped diverse exposures into broad buckets that could misrepresent actual credit risk.
– Narrow focus: Primarily addressed credit risk and largely ignored market and operational risks, leaving gaps for institutions with substantial trading or complex activities.
– Incentive distortions: Fixed weights could encourage regulatory arbitrage—banks shifting exposures toward lower-weighted assets that might still carry substantial risk.
– Crisis performance: Basel I (and Basel II) did not prevent the global financial crisis (2007–2009), prompting significant reforms under Basel III.

Evolution after Basel I
– Basel II introduced more risk-sensitive approaches, expanded risk types (operational and market), and allowed internal risk models for capital measurement.
– Basel III further tightened capital, liquidity standards, and introduced new buffers, in response to lessons from the financial crisis.

Conclusion
Basel I was a landmark step toward harmonizing international banking supervision by establishing a clear minimum capital standard tied to asset risk. While its simplicity helped rapid adoption and comparability, its rigid risk weights and limited coverage of risk types necessitated subsequent accords (Basel II and Basel III) to address shortcomings and adapt to evolving banking practices.