BASEL I, II AND III

Submitted by:
Adrian Corpin
Jun Rey Empleo
Mark Jofer Escarza
Mark Jhonpaul Gertes
Milko Gilo
John Carlo Mercado

BASEL I
Basel I is a set of international banking regulations put forth by the Basel Committee on Bank
Supervision (BCBS) that sets out the minimum capital requirements of financial institutions with
the goal of minimizing credit risk. Banks that operate internationally are required to maintain a
minimum amount (8%) of capital based on a percent of risk-weighted assets. Basel I is the first
of three sets of regulations known individually as Basel I, II and III and together as the Basel
Accords.

BREAKING DOWN 'Basel I'

The BCBS was founded in 1974 as an international forum where members could cooperate on
banking supervision matters. The BCBS aims to enhance "financial stability by improving
supervisory know-how and the quality of banking supervision worldwide." This is done through
regulations known as accords. Basel I was the first accord. It was issued in 1988 and focused
mainly on credit risk by creating a bank asset classification system.

Bank Asset Classification System

The Basel I classification system groups a bank's assets into five risk categories, classified as
percentages: 0%, 10%, 20%, 50% and 100%. A bank's assets are placed into a category based on
the nature of the debtor.
The 0% risk category is comprised of cash, central bank and government debt, and any
Organization for Economic Cooperation and Development (OECD) government debt. Public
sector debt can be placed in the 0%, 10%, 20% or 50% category, depending on the debtor.
Development bank debt, OECD bank debt, OECD securities firm debt, non-OECD bank debt
(under one year of maturity), non-OECD public sector debt and cash in collection comprises the
20% category. The 50% category is residential mortgages, and the 100% category is represented
by private sector debt, non-OECD bank debt (maturity over a year), real estate, plant and
equipment, and 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.

Implementation of Basel I
The BCBS regulations do not have legal force. Members are responsible for their
implementation in their home countries. Basel I originally called for the minimum capital ratio of
capital to risk-weighted assets of 8% to be implemented by the end of 1992. In September 1993,
the BCBS issued a statement confirming that G10 countries' banks with material international
banking business were meeting the minimum requirements set out in Basel I.

According to the BCBS, the minimum capital ratio framework was introduced in member
countries and in virtually all other countries with active international banks.
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. In this article, we'll take a look at Basel I and how it impacted the banking
industry.

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
Basil I defines capital based on two tiers:
1. 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.
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 onbalance 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 assets
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.

Conclusion
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 fulfil its obligations. It launched the trend toward increasing risk

modelling 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 an international business standard that requires financial institutions to
maintain enough cash reserves to cover risk incurred by operation. It aims to
determine how much capital that banks should have in place for the types of risk
they face in their lending and investment activities.
-It also prevents the loss of money of the depositor and cover the loss from the
borrowers default.
Example:

Borrow
Deposit
er
or
1000ph
The
Depositor deposited 1000php to the bank, and the bank loaned 1000ph
the depositors
deposit to lend to the borrower.

Ban
k

Borrow
Ban
er
kwas a 200php default. The bank is
But800ph
the borrower only paid 800php, so there
obliged to pay the 200php default by using its reserve.

Goals of Basel II:

1. Make regulatory capital more risk sensitive.
2. Promote enhanced risk management practices among large, internationally
active banks.
3.Improve the consistency of bank capital requirements internationally.

Capital Components:
1.Tier 1 Capital: Common Equity (i.e. stock + RE) plus non-redeemable noncumulative preferred stock.
2. Tier 2 Capital (supplementary capital): cumulative preferred stock, subordinated
debt with maturity of > 5 years, and long term debentures.

Three Pillars of Basel II

1. Minimum Capital requirement 8% of risk weighted assets (RWA)=0.08(credit
RWA + Market RWA + Operational RWA)
1.1- Credit Risk- Risk of default of a borrowed loan.
1.2- Market Risk- Risk of banks other financial transactions
the

1.3- Operational Risk- Non-financial risk. Usually incidents that may affect
banks operation.

Determining the risk weighting assets (RWA).

-Credit risk weight of asset = .08(Risk weighted asset value)

-Market Risk Capital= (k x VaR) + SRC
- k = Multiplicative factor, k > 3
- VaR = Value at risk. The greater of previous days VaR and average Var over the
last 60 days. VaR is based on a 10-day horizon with 99% Confidence Interval. It is
the loss that has a 1% chance of being exceeded over a 10-day period
- SRC = Specific Risk Charge. Capital charge for company-specific risk
-Operation Risk Risk of loss from failure in the internal procedures of a business.
May also be the result of external hazards such as theft, fire, and natural disaster.

2. Supervisory Review- allows regulators the discretion to consider local

conditions in their implementation of the Basel Rules.
Four key principles of supervisory review:
*Banks should have a process for accessing their overall capital adequacy based on
their risk profile.
* Supervisors should review and evaluate banks internal capital adequacy
assessment and strategies.
* Supervisors should expect banks to operate above the minimum regulatory
standards.
* Supervisors should intervene at an early age to prevent capital from falling below
minimum levels.

3. Market Discipline- Requires banks to fully disclose their risk assessment

procedures and capital adequacy.
Examples of items to disclose:
1. Total amount of Tier 1 and Tier 2 capital.
2.List of instruments constituting Tier 1 capital.
3. Capital requirements for credit risk, market risk and operation risk.
4. Design of risk management activities

Introduction
Basel III is a set of precautionary measures imposed on banks and are made to protect the
economy from financial crises similar to that of recent years. Principally they aim to ensure
banks accept a level of responsibility for the financial economy they operate within and to act as
a safeguard against further collapse.

What is Basel III?

The set of measures known as Basel III were designed with a much broader purpose than merely
strengthening the worlds banks. The Basel III reforms arose from the common realization by the
worlds leading politicians, central bankers, business leaders, academics and social organizations
that entire national economies and the material well-being of citizens had been put at risk by the
high-risk behavior of a handful of major banking institutions mainly located in USA,
Switzerland, UK and some European nations.
They had grown so big relative to the size of their national economies that they had become too
big to fail. That is, if they were not rescued whatever the cost, their collapse would cause even
more severe economic damage through job losses, housing repossessions, reduced GDP and
lending of credit than actually occurred. Further, the burden of saving these giant institutions cost
ordinary taxpayers heavily.
All these factors combined to trigger what has become known as the Great Recession, the most
severe economic crisis in 80 years. Thus Basel III, one of the biggest responses to crisis, is
specifically designed to make sure that the banking sector supports and underpins the worlds
economies rather than threatens them.
Although at first the industry lobbied aggressively against certain aspects of the Basel III
reforms, theres mounting evidence that it sees the requirements as beneficial in the long term.
This is because they enhance the robustness of individual banks while helping rehabilitate the
industrys reputation among the investment community, depositors and law-makers.
Essentially, Basel III and related measures by national and supranational regulators will force the
banks to maintain a much bigger capital base in effect, a foundation stone of solid assets
designed to withstand sudden market disruption. In general Basel III will force banks to become
smaller relative to the size of their national economies. Lower levels of leverage the ratio of
capital to assets will become obligatory. And they must have greater stores of spare cash on
hand to tide them over temporary difficulties.
The cumulative result is that banks will be forced to adopt a more responsible outlook that
reflects on their contribution to society at large as well as to internal goals. For instance, bonuses
will only be paid out for longer-term, sustainable performance rather than for short-lived profits.
Perhaps most importantly, Basel III outlines that banks small and large have been warned to
devise a system for closing their doors without help from taxpayers if they get themselves into
trouble.
Basel III is part of the continuous effort to enhance the banking regulatory framework. It builds
on the Basel I and Basel II documents, and seeks to improve the banking sector's ability to deal
with financial stress, improve risk management, and strengthen the banks' transparency. A focus
of Basel III is to foster greater resilience at the individual bank level in order to reduce the risk of
system-wide shocks.

Minimum Capital Requirements

Basel III introduced tighter capital requirements in comparison to Basel I and Basel II. Banks'
regulatory capital is divided into Tier 1 and Tier 2, while Tier 1 is subdivided into Common
Equity Tier 1 and additional Tier 1 capital. The distinction is important because security
instruments included in Tier 1 capital have the highest level of subordination. Common Equity

Tier 1 capital includes equity instruments that have discretionary dividends and no maturity,
while additional Tier 1 capital comprises securities that are subordinated to most subordinated
debt, have no maturity, and their dividends can be cancelled at any time. Tier 2 capital consists of
unsecured subordinated debt with an original maturity of at least five years.
Basel III left the guidelines for risk-weighted assets largely unchanged from Basel II. Riskweighted assets represent a bank's assets weighted by coefficients of risk set forth by Basel III.
The higher the credit risk of an asset, the higher its risk weight. Basel III uses credit ratings of
certain assets to establish their risk coefficients.
In comparison to Basel II, Basel III strengthened regulatory capital ratios, which are computed as
a percent of risk-weighted assets. In particular, Basel III increased minimum Common Equity
Tier 1 capital from 4% to 4.5%, and minimum Tier 1 capital from 4% to 6%. The overall
regulatory capital was left unchanged at 8%.

Countercyclical Measures
Basel III introduced new requirements with respect to regulatory capital for large banks to
cushion against cyclical changes on their balance sheets. During credit expansion, banks have to
set aside additional capital, while during the credit contraction, capital requirements can be
loosened. The new guidelines also introduced the bucketing method, in which banks are grouped
according to their size, complexity and importance to the overall economy. Systematically
important banks are subject to higher capital requirements.

Leverage and Liquidity Measures

Additionally, Basel III introduced leverage and liquidity requirements to safeguard against
excessive borrowings and ensure that banks have sufficient liquidity during financial stress. In
particular, the leverage ratio, computed as Tier 1 capital divided by the total of on and offbalance assets less intangible assets, was capped at 3%.

There are 2 required Liquidity Ratios:

Liquidity Coverage Ratio to ensure the banks have sufficient High Quality Liquid Assets to
cover total net cash flows over 30 days.
Net Stable Funding Ratio To ensure the banks maintain sufficient long term, stable sources of
funding (customer deposits, 1.t. loans and equity) to cover their 1.t. assets (loan borrowing
customers).
. Ratio is % 1.t. assets (loans to borrowers) funded by long term, stable funding sources.
There are Liquidity Problems that banks faces stand from the maturity in balances between the
Key Source of Bank Funds, which are Customer Deposits and the Primary investments that
Banks Make with these Customer Deposits.
Ex.

The deposits that come from the customers flow through the banks to the investments that the
bank is going to make in a business. The investments are the loans to the borrowing customer.

What are the main principles?

The worlds banking sector is involved in an obligatory flight to quality under the package of
reforms known as Basel III designed to eliminate or at least greatly reduce the danger of
another financial crisis. Produced by the Bank for International Settlements the central
bankers bank based in Basel, Switzerland, they are intended to make the worlds banks and
especially the systemically important institutions known as Sifis stronger and safer. These farreaching global standards must be fully implemented by 2019.
As the BIS points out, it was the interconnectedness and vulnerability of the sector that
precipitated the crisis. One of the main reasons the economic and financial crisis became so
severe was that the banking sectors of many countries had built up excessive on and off-balance
sheet leverage, it says. This was accompanied by a gradual erosion of the level and quality of
the capital base. At the same time, many banks were holding insufficient liquidity buffers. The
banking system therefore was not able to absorb the resulting systemic trading and credit losses.
Overall the purpose of the Basel III package, which was first unveiled in 2010 and modified in
late 2011, is to ensure that the financial sector remains in a position to fulfil its primary function
of providing credit to individuals and businesses. The objective of the reforms is to improve the
banking sectors ability to absorb shocks arising from financial and economic stress, whatever
the source, thus reducing the risk of spillover from the financial sector to the real economy,
says the BIS.
Also included in the package is the so-called shadow banking system such as hedge funds,
insurance companies and other significant firms that were linked with the front-line banks
through often complex and little-understood transactions.

Although highly technical, the principle underlying Basel III is clear and simple. Namely, the
financial community is there to serve the broader economic community. A strong and resilient
banking system is the foundation for sustainable economic growth, as banks are at the center of
the credit intermediation process between savers and investors, Basel III points out. Banks
provide critical services to consumers, small and medium-sized enterprises, large corporate firms
and governments who rely on them to conduct their daily business, both at a domestic and
international level.
How will it work?
The detailed provisions of Basel III are purpose-designed to render the financial sector as
immune as possible from future upheavals both from within and outside national borders. Thus
the new standards are based on micro prudential reforms at the level of individual banks and
macro prudential reforms across the entire banking sector. And they start with the integrity of
their capital base. Individual banks must in future hold more, high-quality capital to protect them
against unexpected losses to help them ride through any traumas in the financial markets. These
take the form of fatter buffers for capital or equity, cash and liquid assets than were required
under Basel IIIs predecessor, Basel II which the BIS admits was not tough enough.

There are four main elements in the package.

First, capital. Banks must hold core tier one capital the highest-quality assets equal to seven
percent of their assets after theyve been adjusted for risk. The biggest institutions the so-called
systemically important financial banks must carry an extra 1-2.5 percent in capital, giving them
a total of up to 9.5 percent of risk-weighted assets. If they dont, they face restrictions on the
payment of bonuses and dividends that might otherwise affect the firms overall integrity. If the
bank is thought to be failing or non-viable, the capital can be written off or converted to
common shares at the discretion of the local regulator. The purpose of this is to force losses on
shareholders rather than on taxpayers. Also, a countercyclical buffer can be required to further
shock-proof a firm. If authorities judge a bank has put itself in danger by lending too much, they
can order it to boost common equity by up to 2.5 percent.
Ex.
The buffer will be phased in from January 2016 will be fully effective in January 2019
- Before 2016

= 0%

- January 1, 2016

= 0.625%

- January 1, 2017

= 1.25%

- January 1, 2018

= 1.875%

- January 1, 2019

= 2.5%

Second, management of risk. Among other measures all banks must conduct much more rigorous
analysis of the risk inherent in certain securities such as complex debt packages.
Third, leverage. Aiming to reduce the ratio of assets that banks, especially the biggest, built up in
relation to deposits, Basel III sets much tougher standards than before. In future banks must

include off-balance sheet exposures when they measure leverage. The ratio of core tier one
capital to a banks total assets, with no risk adjustment, may not exceed three percent.
Ex.
With the mandatory Leverage Ratio of (T1 to total assets) 3%. When you put 3,000,000 as the
Tier 1 Capital your Total Assets would not go beyond a hundred million. It can only go into
100,000,000. Which means it is limiting the banks freedom to keep adding assets with regard to
capital.

Fourth, market discipline. To improve the industrys and shareholders understanding of the risks
banks may be running, they must make far more complete disclosures than before the crisis. This
particularly applies to their exposure to off-balance sheet vehicles, how they are reported in the
accounts, and how banks calculate their capital ratios under the new regulations.

Here is an illustration of Basel III:

Basel III states that in every loans, there are associated risks. The loans are weighted to arrive at
a total amount of risk-weighted assets. In the first illustration, some are weighted at 100%, some
are 50%, and some are 5%. In this instance, a 200B of loans can give us a 100,000,000,000
worth of risk-weighted assets.
In many years, we may see balance sheet grow significantly. The Basel III insist on limiting this
and even stimulates banks to take initiatives to reduce them. The way to impose this is by
limiting the activities of the banks compared to its capital. For this, leverage ratio has been
developed.
The third element of Basel III is liquidity. What is liquidity for a bank? A bank receives deposits
and grants loans. Everyday, a bank disposes a certain amount of cash through its activity of
collecting deposits and by providing cash to clients while granting loans. It is very likely that the
bank will not be equilibrium at the end of the day if its deposits are higher than loans or if the
loans are higher than deposits. It is very necessary for a bank to maintain its balance between
loans and deposits. To make this happen, Basel III has developed a certain regulation. There

should be a stress test at the end of each period to know if the bank has balanced its loans and
deposits.
The main challenge for a bank is for it to maintain its deposits over its loans. Banks are always
facing a profitability challenge. Revenues from cross-selling will be welcomed and of top of this
cross-selling will be required to manage the equilibrium loans and deposits. However, this crossselling also leads to more operational intimacy. While balancing the deposits and loans, the
cross-selling will also be key. The operational intimacy this will bring will help to retain the
required liquidity levels for the stress test. Its necessary for a bank to have its complementary
activities of granting loans and collecting deposits. Cash management and Factoring is a great
example for this.