Basel I
The Basel Accords are some of the most influential—and misunderstood—agreements in modern international finance. Drafted in 1988 and 2004, Basel I and II have ushered in a new era of international banking cooperation. Through quantitative and technical benchmarks, both accords have helped harmonize banking supervision, regulation, and capital adequacy standards across the eleven countries of the Basel Group and many other emerging market economies. On the other hand, the very strength of both accords—their quantitative and technical focus—limits the understanding of these agreements within policy circles, causing them to be misinterpreted and misused in many of the world’s political economies. Moreover, even when the Basel accords have been applied accurately and fully, neither agreement has secured long-term stability within a country’s banking sector. Therefore, a full understanding of the rules, intentions, and shortcomings of Basel I and II is essential to assessing their impact on the international financial system. This paper aims to do just that—give a detailed, non-technical assessment of both Basel I and Basel II, and for both developed and emerging markets, show the status, intentions, criticisms, and implications of each accord.
Basel I
Soon after the creation of the Basel Committee, its eleven member states (known as the G-10) began to discuss a formal standard to ensure the proper capitalization of internationally active banks. During the 1970s and 80s, some international banks were able to “skirt” regulatory authorities by exploiting the inherent geographical limits of national banking legislation. Moreover, internationally active banks also encouraged a regulatory “race to the bottom,” where they would relocate to countries with less strict regulations. With the end of the petrodollar boom and the ensuing banking crises of the early 1980s, this desire for a common banking capitalization standard came to the forefront of the agendas of the Basel Committee’s member states. Six years of deliberations followed; in July of 1988, the G-10 (plus Spain) came to a final agreement: The International Convergence of Capital Measurements and Capital Standards, known informally as “Basel I.”
Scope
It should first be noted that Basel I was created to promote the harmonization of regulatory and capital adequacy standards only within the member states of the Basel Committee. All the states of the G-10 are considered developed markets by most (if not all) international organizations, and therefore, the standards set forth in Basel I are tailored to banks operating within such markets. The agreement expressly states that it is not intended for emerging market economies, and due to the unique risks and regulatory concerns in these economies, should not be seen as the “optimal” emerging market banking reform. In sum, because Basel I gives considerable regulatory leeway to state central banks, views domestic currency and debt as the most reliable and favourable financial instruments, sees FDIC-style depositor insurance as risk-abating, and uses a “maximum” level of risk to calculate its capital requirements that is only appropriate for developed economies, its implementation could create a false sense of security within an emerging economy’s financial sector while creating new, less obvious risks for its banks.
Secondly, it should also be noted that Basel I was written only to provide adequate capital to guard against risk in the creditworthiness of a bank’s loan book. It does not mandate capital to guard against risks such as fluctuations in a nation’s currency, changes in interest rates, and general macroeconomic downturns. Due to the great variability of these risks across countries, the Basel Committee decided not to draft general rules on these risks—it left these to be evaluated on a case-by-case basis within the G10 member states.
Thirdly, Basel I overtly states that it only proposes minimum capital requirements for internationally active banks, and invites sovereign authorities and central banks alike to be more conservative in their banking regulations. Moreover, it warns its readers that capital adequacy ratios cannot be viewed in isolation and as the ultimate arbiters of a bank’s solvency.
Pillars of Basel I
The Basel I Accord divides itself into four “pillars.” These have been discussed as follows. As would be analysed later, these norms were not void of limitations.
Pillar I - The Constituents of Capital
The first, known as The Constituents of Capital, defines both what types of on-hand capital are counted as a bank’s reserves and how much of each type of reserve capital a bank can hold. The accord divides capital reserves into two tiers. Capital in the first tier, known as “Tier 1 Capital,” consists of only two types of funds—disclosed cash reserves and other capital paid for by the sale of bank equity, i.e. stock and preferred shares. Tier 2 Capital is a bit more ambiguously defined. This capital can include reserves created to cover potential loan losses, holdings of subordinated debt, hybrid debt/equity instrument holdings, and potential gains from the sale of assets purchased through the sale of bank stock. To follow the Basel Accord, banks must hold the same quantity (in dollar terms) of Tier 1 and Tier 2 capital.
Pillar 2 - Risk Weighting
The second “pillar” of the Basel I Accord, Risk Weighting, creates a comprehensive system to risk-weight a bank’s assets, or in other words, its loanbook. Five risk categories encompass all assets on a bank’s balance sheet. The first category weights assets at 0%, effectively characterizing these assets as “riskless.” Such “riskless” assets are defined by Basel I as cash held by a bank, sovereign debt held and funded in domestic currency, all OECD debt, and other claims on OECD central governments. The second risk category weights assets at 20%, showing that instruments in this category are of low risk. Securities in this category include multilateral development bank debt, bank debt created by banks incorporated in the OECD, non-OECD bank debt with a maturity of less than one year, cash items in collection, and loans guaranteed by OECD public sector entities. The third, “moderate risk” category only includes one type of asset—residential mortgages—and weights these assets at 50%. The fourth, “high risk” category is weighted at 100% of an asset’s value, and includes a bank’s claims on the private sector, non-OECD bank debt with a maturity of more than one year, claims on non-OECD dollar-denominated debt or Eurobonds, equity assets held by the bank, and all other assets. The fifth, “variable” category encompasses claims on domestic public sector entities, which can be valued at 0, 10, 20, or 50% depending on the central bank’s discretion.
Pillar III - A Target Standard Ratio
The third “pillar,” A Target Standard Ratio, unites the first and second pillars of the Basel I Accord. It sets a universal standard whereby 8% of a bank’s risk-weighted assets must be covered by Tier 1 and Tier 2 capital reserves. Moreover, Tier 1 capital must cover 4% of a bank’s risk-weighted assets. This ratio is seen as “minimally adequate” to protect against credit risk in deposit insurance-backed international banks in all Basel Committee member states.
Pillar IV - Transitional and Implementing Agreements
The fourth “pillar,” Transitional and Implementing Agreements, sets the stage for the implementation of the Basel Accords. Each country’s central bank is requested to create strong surveillance and enforcement mechanisms to ensure the Basel Accords are followed, and “transition weights” are given so that Basel Committee banks can adapt over a four-year period to the standards of the accord.
Implementation
Basel I’s adaptation and implementation occurred rather smoothly in the Basel Committee states. With the exception of Japan (which, due to the severity of its banking crisis in the late 1980s, could not immediately adopt Basel I’s recommendations), all Basel Committee members implemented Basel I’s recommendations—including the 8% capital adequacy target—by the end of 1992. Japan later harmonized its policies with those if Basel I in 1996. Although they were not intended to be included in the Basel I framework, other emerging market economies also adopted its recommendations. In contrast to the pointed warnings written into Basel I against implementation in industrializing countries, the adoption of Basel I standards was seen by large investment banks as a sign of regulatory strength and financial stability in emerging markets, causing capital-hungry states such as Mexico to assuage to Basel I in order to receive cheaper bank financing. By 1999, nearly all countries, including China, Russia, and India, had—at least on paper—implemented the Basel Accord.
Criticism
Criticism of Basel I come from four primary sources. * One vein of criticism concentrates on perceived omissions in the Accord. Because Basel I only covers credit risk and only targets G-10 countries, Basel I is seen as too narrow in its scope to ensure adequate financial stability in the international financial system. Also, Basel I’s omission of market discipline is seen to limit the accord’s ability to influence countries and banks to follow its guidelines. * The second group of criticisms deals with the way in which Basel I was publicized and implemented by banking authorities. The inability of these authorities to translate Basel I’s recommendations properly into “layman’s terms” and the strong desire to enact its terms quickly caused regulators to over-generalize and oversell the terms of Basel I to the G-10’s public. This, in turn, created the misguided view that Basel I was the primary and last accord a country needed to implement to achieve banking sector stability. While G-10 regulators saw this result as rather benign because they already had most of the known regulatory foundations for long-term growth in place, they did not realize that the “oversale” of Basel I would influence large private banks in such a way that they would begin to demand that emerging market economies follow Basel I. * The third group critical of Basel I concentrates on the misaligned incentives the Accord gives to banks. Due to the wide breath and absoluteness of Basel I’s risk weightings, banks have found ways to “wiggle” around Basel I’s standards to put more risk on their loanbooks than what was intended by the framers of the Basel Accord. Banks can cosmetically maintain a low risk profile under Basel I while taking on increasing amounts of risk through the sale and resale of short-run non-OECD bank debt. Because short-run bank debt created by non-OECD banks is weighted at 20% and long-run debt in this category is weighted at 100%, banks can “swap” their long-term debt holdings for a string of short-run debt instruments. Therefore, the risk associated with holding longer-term debt—namely, the risk of default in volatile emerging markets—remains, while the bank’s risk weighting is reduced. * The final source of Basel I’s criticisms relate to its application to emerging markets. Although Basel I was never intended to be implemented in emerging market economies, its application to these economies under the pressure of the international business and policy communities created foreseen and unforeseen distortions within the banking sectors of industrializing economies. One of thr consequence of Basel I is a side-effect of the way it risk-weights bank debt: because short-run non-OECD bank debt is risk-weighted at a lower relative riskiness than long-term debt, Basel I has encouraged international investors to move from holding long-run emerging market bank debt to holding short-run developing market instruments. This has amplified the risk of “hot money” in emerging markets and has created more volatile emerging market currency fluctuations.

Basel II
In response to the aforementioned criticisms of Basel I, the Basel Committee decided in 1999 to propose a new, more comprehensive capital adequacy accord. This accord, known formally as A Revised Framework on International Convergence of Capital Measurement and Capital Standards and informally as “Basel II” greatly expands the scope, technicality, and depth of the original Basel Accord. While maintaining the “pillar” framework of Basel I, each pillar is greatly expanded in Basel II to cover new approaches to credit risk, adapt to the securitization of bank assets, cover market, operational, and interest rate risk, and incorporate market-based surveillance and regulation.

Pillar I Minimum Capital Requirements
The first “pillar,” known again as Minimum Capital Requirements, shows the greatest amount of expansion since Basel I. In response to Basel I’s critics, Basel II creates a more sensitive measurement. of a bank’s risk-weighted assets and tries to eliminate the loopholes in Basel I that allow banks to take on additional risk while cosmetically assuaging to minimum capital adequacy requirements. Its first mandate is to broaden the scope of regulation to include assets of the holding company of an internationally active bank. This is done to avoid the risk that a bank will “hide” risk-taking by transferring its assets to other subsidiaries and also to incorporate the financial health of the entire firm in the calculation of capital requirements for its subsidiary bank. Next, the first “pillar” provides three methodologies to rate the riskiness of a bank’s assets. Credit Risk—the Standardized Approach
The first of these methodologies, the “standardized” approach, extends the approach to capital weights used in Basel I to include market-based rating agencies. Sovereign claims are now discounted according to the credit rating assigned to a sovereign’s debt by an “authorized” rating institution. The following table summarizes the weightage assignment in this approach.

1. Option 1A = Risk weights based on risk weight of the country. 2. Option 2a = Risk weight based on assessment of individual bank 3. Option 2b = Risk weight based on assessment of individual banks with claims of original maturity of less than 6 months.
Non-performing assets: 4. If specific provision is less than 20%, 150% 5. If specific provision is more than 20%, 100%
Credit Risk—the Internal Ratings Based Approaches
Beyond the “standardized” approach, Basel II proposes—and incentivizes—two alternate approaches toward risk-weighting capital, each known as an Internal Ratings Based Approach, or IRB. These approaches encourage banks to create their own internal systems to rate risk with the help of regulators. Aback estimates each borrower’s creditworthiness and the results are translated into estimates of a future potential loss amount, which form the basis of mini-mum capital requirements.

The risk components include measures of – 1. Probability of Default (PD) 2. Loss Given Default (LGD), 3. Exposure at Default (EAD) and 4. Effective Maturity (M)
Both IRB approaches give regulators and bankers significant benefits. Firstly, they encourage banks to take on customers of all types with lower probabilities of default by allowing these customers lower risk weightings. These low risk weightings translate into lower reserve requirements, and ultimately, higher profitability for a bank. Also, the IRB approaches allow banks to engage in self-surveillance: excessive risk-taking will force them to hold more cash on hand, causing banks to become unprofitable.
Operational Risk
Secondly, Basel II extends its scope into the assessment of and protection against operational risks. To calculate the reserves needed to adequately guard against failures in internal processes, the decision-making of individuals, equipment, and other external events, Basel II proposes three mutually exclusive methods.
Basic Indicator Approach
Under the basic indicator approach, Banks are required to hold capital for operational risk equal to the average over the previous three years of a fixed per-centage (15% - denoted as alpha) of annual gross income. Gross income is defined as net interest income plus net non-interest income, excluding realized profit/losses from the sale of securities in the banking book and extraordinary and irregular items.
Standardized Approach
Under the standardized approach, bank’s activities are divided into eight business lines. Within each business line, gross income is considered as a broad indicator for the likely scale of operational risk. Capital charge for each business line is calculated by multiplying gross income by a factor (denoted beta) assigned to that business line. Total capital charge is calculated as the three-year average of the simple summations of the regulatory capital across each of the business line in each year. The values of the betas prescribed for each business line are as under:

Advanced Measurement Approach
Under advanced measurement approach, the regulatory capital will be equal to the risk measures generated by the bank’s internal risk measurement system using the prescribed quantitative and qualitative criteria.
Market Risk
The last risk evaluated in Pillar I of the Basel II accords attempts to quantify the reserves needed to be held by banks due to market risk, i.e. the risk of loss due to movements in asset prices. As per the guidelines, minimum capital requirement is expressed in terms of two separately calculated charges: * Specific Risk * General Market Risk
Specific Risk
Capital charge for specific risk is designed to protect against an adverse movement in price of an individual security due to factors related to individual issuer. This is similar to credit risk. The specific risk charges are divided into various categories such as investments in Govt securities, claims on Banks, investments in mortgage backed securities, securitized papers etc. and capital charge for each category specified.
General Market Risk
Capital charge for general market risk is designed to capture the risk of loss arising from changes in market interest rates. The Basel Committee suggested two broad methodologies for computation of capital charge for market risk, i.e., Standardized Method and Internal Risk Management Model Method. As Banks in India are still in a nascent stage of developing internal risk management models, in the guidelines, it is proposed that to start with, the Banks may adopt the Standardized Method. Again, under Standardized Method, there are two principle methods for measuring market risk – maturity method and duration method. Risk Weightage Assignment according to maturity is given as follows.

As duration method is a more accurate method of measuring interest rate risk, RBI prefers that Banks measure all of their general market risk by calculating the price sensitivity (modified duration) of each position separately. For this purpose detailed mechanics to be followed, time bands, assumed changes in yield etc. have been provided by RBI.
Capital Charge for Equities
Capital charge for specific risk will be 9% of the Bank’s gross equity position. The general market risk charge will also be 9%. Thus the Bank will have to maintain capital equal to 18% of investment in equities (twice the present minimum requirement).
Capital Charge for Foreign Exchange Risk
Foreign exchange open position and gold open position are at present risk weighted at 100%. Capital charge for foreign exchange and gold open position would continue to be computed at 9% as hitherto.
Risk Aggregation The capital charge for specific risk, general market risk and equity and forex position will be added up and the resultant figure will be multi-plied by 11.11 (inverse of 9%) to arrive at the notional risk weighted assets.
Total Capital Adequacy
Once a bank has calculated the reserves it needs on hand to guard against operational and market risk and has adjusted its asset base according to credit risk, it can calculate the on-hand capital reserves it needs to achieve “capital adequacy” as defined by Basel II. Because of the wide range of methodologies used by banks and the diversity of bank loanbooks, Basel II allows a great deal of variation in its calculated reserve requirements. Additionally, no change is given to the requirement that Tier 2 capital reserves must be equal to the amount of Tier 1 capital reserves. In sum, a bank’s needed reserves for “capital adequacy” is calculated as follows:
Reserves = .08 * Risk Weighted Assets + Operational Risk Reserves + Market Risk Reserves
Pillar II - Supervisory ReviewProcess 1. Supervisory review process has been introduced to ensure not only that banks have adequate capital to support all the risks, but also to encourage them to develop and use better risk management techniques in monitoring and managing their risks. The process has four key principles 2. Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for monitoring their capital levels. 3. Supervisors should review and evaluate bank’s internal capital adequacy assessment and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. 4. Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum. 5. Supervisors should seek to intervene at an early stage to prevent capital from falling below minimum level and should require rapid remedial action if capital is not mentioned or restored. Pillar III – Market Discipline
Market discipline imposes strong incentives to banks to con-duct their business in a safe, sound and effective manner. It is proposed to be effected through a series of disclosure requirements on capital, risk exposure etc. so that market participants can assess a bank’s capital adequacy. These disclosures should be made at least semi-annually and more frequently if appropriate. Qualitative disclosures such as risk management objectives and policies, definitions etc. may be published annually.
Issues and Challenged for Basel II in India
While there is no second opinion regarding the purpose, necessity and usefulness of the proposed new accord – the techniques and methods suggested in the consultative document would pose considerable implementational challenges for the banks especially in a developing country like India.
Capital Requirement: The new norms will almost invariably increase capital requirement in all banks across the board. Although capital requirement for credit risk may go down due to adoption of more risk sensitive models – such advantage will be more than offset by additional capital charge for operational risk and increased capital requirement for market risk.
Profitability Competition among banks for highly rated corporates needing lower amount of capital may exert pressure on already thinning interest spread. Further, huge implementation cost may also impact profitability for smaller banks.
Risk Management Architecture The new standards are an amalgam of international best practices and calls for introduction of advanced risk management system with wider application throughout the organization. It would be a daunting task to create the required level of technological architecture and human skill across the institution.
Rating Requirement: Although there are a few credit rating agencies in India – the level of rating penetration is very low. A study revealed that in 1999, out of 9640 borrowers enjoying fund-based working capital facilities from banks – only 300 were rated by major agencies. Further, rating is a lagging indicator of the credit risk and the agencies have poor track record in this respect. There is a possibility of rating blackmail through unsolicited rating. More overrating in India is restricted to issues and not issuers. Encouraging rating of issuers would be a challenge.
Absence of Historical Database: Computation of probability of default, loss given default, migration mapping and supervisory validation require creation of historical database, which is a time consuming process and may require initial support from the supervisor.
Incentive to Remain Unrated: In case of unrated sovereigns, banks and corporates the prescribed risk weight is 100%, whereas in case of those entities with lowest rating, the risk weight is 150%. This may create incentive for the category of counterparties, which anticipate lower rating to remain unrated.
Disclosure Regime: Pillar 3 purports to enforce market discipline through stricter disclosure requirement. While admitting that such disclosure may be useful for supervisory authorities and rating agencies – the expertise and ability of the general public to comprehend and interpret disclosed information is open to question. Moreover, too much disclosure may cause information overload and may even damage financial position of bank.
Disadvantage for Smaller Banks: The new framework is very complex and difficult to understand. It calls for revamping the entire management information system and allocation of substantial resources. Therefore, it may be out of reach for many smaller banks. As Moody’s Investors Services puts it, “It is unlikely that these banks will have the financial resources, intellectual capital, skills and large scale commitment that larger competitors have to build sophisticated systems to allocate regulatory capital optimally for both credit and operational risks.”
Discriminatory against Developing Countries: Developing counties have high concentration of lower rated borrowers. The calibration of IRB has lesser incentives to lend to such borrowers. This, along with withdrawal of uniform risk weight of 0% on sovereign claims may result in overall reduction in lending by internationally active banks in developing countries and increase their cost of borrowing.

Basel III
Basel III proposes many new capital, leverage and liquidity standards to strengthen the regulation, supervision and risk management of the banking sector. The capital standards and new capital buffers will require banks to hold more capital and higher quality of capital than under current Basel II rules. The new leverage ratio introduces a non-risk based measure to supplement the risk-based minimum capital requirements. The new liquidity ratios ensure that adequate funding is maintained in case of crisis.

The proposed Basel III guidelines seek to improve the ability of banks to withstand periods of economic and financial stress by prescribing more stringent capital and liquidity requirements for them. Many view the suggested capital requirement as a positive for banks as it raises the minimum core capital stipulation, introduces counter-cyclical measures, and enhances banks‟ ability to conserve core capital in the event of stress through a conservation capital buffer. The prescribed liquidity requirements, on the other hand, are aimed at bringing in uniformity in the liquidity standards followed by banks globally. This requirement would help banks better manage pressures on liquidity in a stress scenario.
The capital requirement as suggested by the proposed Basel III guidelines would necessitate Indian banks raising Rs. 600000 crore in external capital over next nine years, besides lowering their leveraging capacity. It is the public sector banks that would require most of this capital, given that they dominate the Indian banking sector. Nevertheless, Indian banks may still find it easier to make the transition to a stricter capital requirement regime than some of their international counterparts since the regulatory norms on capital adequacy in India are already more stringent, and also because most Indian banks have historically maintained their core and overall capital well in excess of the regulatory minimum.
Phased Implementation

Proposed Regulation

Capital Conservation Buffer
The Basel committee suggests that a new buffer of 2.5% of risk weighted assets (over the minimum core capital requirement of 4.5%) be created by banks. Although the committee does not view the capital conservation buffer as a new minimum standard, considering the restrictions imposed on banks and also because of reputation issues, 7% is likely to become the new minimum capital requirement.
It can be dipped into in times of stress to meet the minimum regulatory requirement on core capital.
Countercyclical Buffer
The Basel committee has suggested that the countercyclical buffer, constituting of equity or fully loss absorbing capital, could be fixed by the national authorities concerned once a year and that the buffer could range from 0% to 2.5% of risk weighted assets, depending on changes in the credit-to-GDP ratio. The primary objective of having a countercyclical buffer is to protect the banking sector from system-wide risks arising out of excessive aggregate credit growth. This could be achieved through a pro-cyclical build up of the buffer in good times.
Comparison on Capital Requirement * Overall, with the Basel III being implemented, the regulatory capital requirement for Indian banks could go up substantially in the long run. * Indian banks are subjected to more stringent capital adequacy requirements than their international counterparts. For instance, the common equity requirement for Indian banks is 3.6% , as against the 2% . * Mentioned in the Basel document. At the same time, the total capital adequacy requirement for Indian banks is 9%, as against the 8% recommended under Basel II. Moreover, on an aggregate basis, the capital adequacy position of Indian banks is comfortable, and being so, they may not need substantial capital to meet the new norms.