Basel Framework Summary

 

While the BCBS was established in 1974, it was not until 1988 that the first set of Basel requirements was agreed and issued. Since then, the structure and scope of the standards and guidelines issued have increased substantially.

1988: Basel I

Basel, I was issued in 1988, though it was not fully implemented until 1992. It was intended to be applied to internationally active banks but was adopted by many other banks and regulators (being implemented in over 100 countries). Its core requirement was the establishment of a minimum capital adequacy ratio (CAR) – the amount of capital a bank should have as a percentage of its total risk exposure (risk-weighted assets or RWAs). The agreed minimum for CAR was 8%.

CAR =(Regulatory Capital/RWAs) ≥ 8%

Calculating RWAs involves applying a risk weight to the nominal value of an exposure.

RWA = Exposure × Risk Weight

For a portfolio of N exposures:

RWAs = RWA_A + RWA_B +…+RWA_N 

Risk weights varied depending on the asset, with higher weights for higher risk assets. For example, on-balance sheet OECD government exposures were assigned a 0% risk weighting, OECD bank exposures weighted at 20%, and corporate exposures weighted at 100%.

While better than the previous regime (no minimum requirements), the risk weights were quite crude – all corporate exposures were effectively risk-weighted at 100%, irrespective of riskiness. Further, only credit risk was covered. 

1996: Market Risk Amendment

In 1996, the Basel requirements were expanded to cover market risk with the publication of the Market Risk Amendment, which came into force in 1998. This addressed:

• General and specific risks about interest rate related instruments and equities in a bank’s trading book
• Foreign exchange risk and commodities risk throughout a bank

Banks were permitted to calculate capital requirements for their market risk exposures using either a standardized method or an internal models approach. In practice, only the most sophisticated banks had sufficient resources and data to develop and obtain approval for internal models – but even then, they used the standardized method to calculate capital for some market risk exposures.

The provisions of the Market Risk Amendment were incorporated subsequently into the Basel II framework.

2006: Basel II 

To address criticisms of Basel I – such as OECD bank exposures attracting less regulatory capital than any corporate exposure – A more comprehensive framework was required. Basel II, initially published in 2004, was finalized in 2006. Its aims were to:

• Create a more risk-sensitive framework
• Capture more comprehensively the risks to which a bank is exposed, including operational risk, credit risk, and market risk
• Strengthen risk management, governance, and transparency

Basel II retained certain features of Basel I, including the 8% minimum CAR, but it made risk weightings more risk-sensitive and introduced the "three pillars" framework:

• Pillar 1: Minimum capital requirements
• Pillar 2: Supervisory review
• Pillar 3: Market discipline

This framework was subsequently carried over into Basel III.

2007–2009: Financial Crisis

While the aim of Basel II was to improve the ability of banks to absorb losses, the financial crisis showed that: 

• Banks were far more exposed to risk than they – or their regulators – imagined.
• Capital resources were insufficient to absorb the losses that actually occurred.
• There were significant revealed weaknesses in the regulatory framework.

Given that Basel II was only finalized in 2006, and banks had only just started implementing the requirements, the financial crisis should not be blamed on Basel II. Weaknesses in the framework were, however, a contributory factor to the impact of the crisis. A further issue was that banking supervisors often adopted a hands-off, rather than an intrusive, approach to supervision.

Not surprisingly, a significant review of Basel II quickly followed the crisis, resulting in some interim changes often referred to as Basel 2.5.

2009: Basel 2.5

In 2009, the BCBS published revisions to the Basel II market risk framework. These changes largely addressed issues relating to the calculation of market risk, where issues included: 

• Weaknesses in banks’ internal value at risk (VaR) models used to estimate the market risk
• Banks’ ability to arbitrage capital requirements for their banking and trading books
• Inadequate assumptions about market valuations and liquidity
  

The Basel 2.5 enhancements include:

• A revised definition of the trading book
• The introduction of a stressed VaR measure
• An incremental default risk charge to cover default and migration risk
• A revised treatment for the correlation trading portfolio
• Enhanced internal model requirements
• Enhanced backtesting requirements

Some changes were also made to the treatment of securitizations and to Pillar 2 and 3 requirements.
These interim Basel 2.5 measures were subsequently incorporated into Basel III, though further changes/enhancements were included as part of Basel III.

2013 Onward: Basel III

Between 2010 and 2012, the BCBS published several documents that set out the key elements of Basel III. The requirements entered into force in 2013, but with extended transitional arrangements in many cases.

Most of Basel III took the form of enhancements or amendments to Basel II/Basel 2.5, much of which was retained. The areas addressed by Basel III included capital standards, leverage and liquidity ratios, and globally systemically important banks (G-SIBs).

Phase-in arrangements allowed banks until January 2019 to fully implement Basel III (with a few exceptions). There were two main reasons for this. First, banks were in recovery mode following the crisis and it took time to deleverage/de-risk balance sheets, raise new capital, revamps business strategies, and enhance risk management capabilities. Second, some aspects of the new requirements, notably concerning the leverage and liquidity ratios, were not finalized until after 2013.

In practice, many banks adopted Basel III quite quickly, particularly those less affected by the financial crisis as well as those in major economies. Others were slower to comply. Implementation has not yet been achieved – banks in some African countries, for example, are still operating to Basel II requirements or local variants.

To address several issues that were not finalized when Basel III requirements were first set out, as well as issues that emerged during implementation, the BCBS published some final changes to Basel III in December 2017. These are subject to phase-in arrangements that stretch out to 2027.

Context & Background to Basel III

Three Pillars Framework

Basel, I set minimum capital requirements for credit risk, with market risk added in the mid-1990s. The simple nature of this framework was useful for implementation, but the degree of latitude afforded to local regulators resulted in inconsistent application of rules in different jurisdictions. Further, the increase in the size and complexity of banks and financial products gave rise to new risks that were not covered by Basel I, while a lack of transparency made it difficult for third parties to determine the risk of lending to individual banks.
These and other issues led to the development of the three pillars framework in Basel II, which was retained in Basel III (with some changes to address weaknesses evident from the financial crisis).

Pillar 1: Minimum Capital Requirements:Pillar 1 focuses on the minimum capital requirements that banks must hold to cover their exposure to credit, market, and operational risk.

Pillar 2: Supervisory Review: Pillar 2 obliges banks to assess their compliance with capital adequacy requirements. Supervisors then review and challenge such assessments.

Pillar 3: Market Discipline: Pillar 3 requires banks to publish information about their risk exposures, capital adequacy, and risk management practices.