Basel I
DEFINITION OF 'BASEL I'
A set of international banking regulations put forth by the Basel Committee on Bank Supervision, which set 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Basel II is the second of the Basel Accords, (now extended and partially superseded[clarification needed] by Basel III), which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision.
BREAKING DOWN 'Basel I'
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, initially 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. Basel II attempted to accomplish this by establishing risk and capital management requirements to ensure that a bank has adequate capital for the risk the bank exposes itself to through its lending, investment and trading activities. One focus was to maintain sufficient consistency of regulations so to limit competitive inequality amongst internationally active banks.

Basel II was implemented in the years prior to 2008, and was only to be implemented in early 2008 in most major economies;[1][2][3] that year's Financial crisis intervened before Basel II could become fully effective. As Basel III was negotiated, the crisis was top of mind and accordingly more stringent standards were contemplated and quickly adopted in some key countries including in Europe and the USA.
Objective
The final version aims at:

Ensuring that capital allocation is more risk sensitive;
Enhance disclosure requirements which would allow market participants to assess the capital adequacy of an institution;
Ensuring that credit risk, operational risk and market risk are quantified based on data and formal techniques;
Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.
While the final accord has at large addressed the regulatory arbitrage issue, there are still areas where regulatory capital requirements will diverge from the economic capital.

The accord in operation: Three pillars
Basel II uses a "three pillars" concept – (1) minimum capital requirements (addressing risk), (2) supervisory review and (3) market discipline.

The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk was not dealt with at all.

The first pillar: Minimum capital requirements
The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk, and market risk. Other risks are not considered fully quantifiable at this stage.

The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach, Foundation IRB, Advanced IRB and General IB2 Restriction. IRB stands for "Internal Rating-Based Approach".
For operational risk, there are three different approaches – basic indicator approach or BIA, standardized approach or TSA, and the internal measurement approach (an advanced form of which is the advanced measurement approach or AMA).
For market risk the preferred approach is VaR (value at risk).
As the Basel II recommendations are phased in by the banking industry it will move from standardised requirements to more refined and specific requirements that have been developed for each risk category by each individual bank. The upside for banks that do develop their own be spoke risk measurement systems is that they will be rewarded with potentially lower risk capital requirements. In the future there will be closer links between the concepts of economic and regulatory capital.

The second pillar: Supervisory review
This is a regulatory response to the first pillar, giving regulators better 'tools' over those previously available. It also provides a framework for dealing with systemic risk, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk and legal risk, which the accord combines under the title of residual risk. Banks can review their risk management system.

The Internal Capital Adequacy Assessment Process (ICAAP) is a result of Pillar 2 of Basel II accords.

The third pillar: The Market Discipline
This pillar aims to complement the minimum capital requirements and supervisory review process by developing a set of disclosure requirements which will allow the market participants to gauge the capital adequacy of an institution.

Market discipline supplements regulation as sharing of information facilitates assessment of the bank by others, including investors, analysts, customers, other banks, and rating agencies, which leads to good corporate governance. The aim of Pillar 3 is to allow market discipline to operate by requiring institutions to disclose details on the scope of application, capital, risk exposures, risk assessment processes, and the capital adequacy of the institution. It must be consistent with how the senior management, including the board, assess and manage the risks of the institution.

When market participants have a sufficient understanding of a bank's activities and the controls it has in place to manage its exposures, they are better able to distinguish between banking organizations so that they can reward those that manage their risks prudently and penalize those that do not.

These disclosures are required to be made at least twice a year, except qualitative disclosures providing a summary of the general risk management objectives and policies which can be made annually. Institutions are also required to create a formal policy on what will be disclosed and controls around them along with the validation and frequency of these disclosures. In general, the disclosures under Pillar 3 apply to the top consolidated level of the banking group to which the Basel II framework applies.
Basel II and the global financial crisis[edit]
The role of Basel II, both before and after the global financial crisis, has been discussed widely. While some argue that the crisis demonstrated weaknesses in the framework,[3] others have criticized it for actually increasing the effect of the crisis.[16] In response to the financial crisis, the Basel Committee on Banking Supervision published revised global standards, popularly known as Basel III.[17] The Committee claimed that the new standards would lead to a better quality of capital, increased coverage of risk for capital market activities and better liquidity standards among other benefits.

Nout Wellink, former Chairman of the BCBS, wrote an article in September 2009 outlining some of the strategic responses which the Committee should take as response to the crisis.[18] He proposed a stronger regulatory framework which comprises five key components: (a) better quality of regulatory capital, (b) better liquidity management and supervision, (c) better risk management and supervision including enhanced Pillar 2 guidelines, (d) enhanced Pillar 3 disclosures related to securitization, off-balance sheet exposures and trading activities which would promote transparency, and (e) cross-border supervisory cooperation. Given one of the major factors which drove the crisis was the evaporation of liquidity in the financial markets,[19] the BCBS also published principles for better liquidity management and supervision in September 2008.[20]

A recent OECD study[21] suggest that bank regulation based on the Basel accords encourage unconventional business practices and contributed to or even reinforced adverse systemic shocks that materialised during the financial crisis. According to the study, capital regulation based on risk-weighted assets encourages innovation designed to circumvent regulatory requirements and shifts banks' focus away from their core economic functions. Tighter capital requirements based on risk-weighted assets, introduced in the Basel III, may further contribute to these skewed incentives. New liquidity regulation, notwithstanding its good intentions, is another likely candidate to increase bank incentives to exploit regulation.

Think-tanks such as the World Pensions Council (WPC) have also argued that European legislators have pushed dogmatically and naively for the adoption of the Basel II recommendations, adopted in 2005, transposed in European Union law through the Capital Requirements Directive (CRD), effective since 2008. In essence, they forced private banks, central banks, and bank regulators to rely more on assessments of credit risk by private rating agencies. Thus, part of the regulatory authority was abdicated in favor of private rating agencies.[22]

Long before the implementation of Basel II George W. Stroke and Martin H. Wiggers pointed out, that a global financial and economic crisis will come, because of its systemic dependencies on a few rating agencies.[23] After the breakout of the crisis Alan Greenspan agreed to this opinion in 2007.[24] At least the Financial Crisis Inquiry Report confirmed this point of view in 2011.
Basel III (or the Third Basel Accord) 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, and was scheduled to be introduced from 2013 until 2015; however, changes from 1 April 2013 extended implementation until 31 March 2018 and again extended to 31 March 2019.[1][2] The third installment of the Basel Accords (see Basel I, Basel II) was developed in response to the deficiencies in financial regulation revealed by the financial crisis of 2007–08. Basel III was supposed to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage.
Overview
Unlike Basel I and Basel II, which focus primarily on the level of bank loss reserves that banks are required to hold, Basel III focuses primarily on the risk of a run on the bank by requiring differing levels of reserves for different forms of bank deposits and other borrowings. Therefore Basel III does not, for the most part, supersede the guidelines known as Basel I and Basel II; rather, it will work alongside them.

Key principles
Capital requirements
The original Basel III rule from 2010 required banks to hold 4.5% of common equity (up from 2% in Basel II) of risk-weighted assets (RWAs). Since 2015, a minimum Common Equity Tier 1 (CET1) ratio of 4.5% must be maintained at all times by the bank.[3] This ratio is calculated as follows: \frac{\mbox{CET1}}{\mbox{RWAs}} \geq 4.5%
The minimum Tier 1 capital increases from 4% in Basel II to 6%,[4] applicable in 2015, over RWAs.[5] This 6% is composed of 4.5% of CET1, plus an extra 1.5% of Additional Tier 1 (AT1).

Furthermore, Basel III introduced two additional capital buffers:
A mandatory "capital conservation buffer", equivalent to 2.5% of risk-weighted assets. Considering the 4.5% CET1 capital ratio required, banks have to hold a total of 7% CET1 capital, from 2019 onwards.
A "discretionary counter-cyclical buffer", allowing national regulators to require up to an additional 2.5% of capital during periods of high credit growth. The level of this buffer ranges between 0% and 2.5% of RWA and must be met by CET1 capital.

Leverage ratio
Basel III introduced a minimum "leverage ratio". This is a non-risk-based leverage ratio and is calculated by dividing Tier 1 capital by the bank's average total consolidated assets (sum of the exposures of all assets and non-balance sheet items).[6][7] The banks are expected to maintain a leverage ratio in excess of 3% under Basel III.

\frac{\mbox{Tier 1 Capital}}{\mbox{Total exposure}} \geq 3%
In July 2013, the U.S. Federal Reserve announced that the minimum Basel III leverage ratio would be 6% for 8 Systemically important financial institution (SIFI) banks and 5% for their insured bank holding companies.[8]

Liquidity requirements
Basel III introduced two required liquidity ratios.[9]

The "Liquidity Coverage Ratio" was supposed to require a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days. Mathematically it is expressed as follows: LCR=\frac{\mbox{High quality liquid assets}}{\mbox{Total net liquidity outflows over 30 days}} \geq 100%
The Net Stable Funding Ratio was to require the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.
U.S. version of the Basel Liquidity Coverage Ratio requirements
On 24 October 2013, the Federal Reserve Board of Governors approved an interagency proposal for the U.S. version of the Basel Committee on Banking Supervision (BCBS)'s Liquidity Coverage Ratio (LCR). The ratio would apply to certain U.S. banking organizations and other systemically important financial institutions. The comment period for the proposal is scheduled to close by 31 January 2014

The United States' LCR proposal came out significantly tougher than BCBS’s version, especially for larger bank holding companies. The proposal requires financial institutions and FSOC designated nonbank financial companies to have an adequate stock of high-quality liquid assets (HQLA) that can be quickly liquidated to meet liquidity needs over a short period of time.

The LCR consists of two parts: the numerator is the value of HQLA, and the denominator consists of the total net cash outflows over a specified stress period (total expected cash outflows minus total expected cash inflows).
The Liquidity Coverage Ratio applies to U.S. banking operations with assets of more than $10 billion. The proposal would require:

Large Bank Holding Companies (BHC) – those with over $250 billion in consolidated assets, or more in on-balance sheet foreign exposure, and to systemically important, non-bank financial institutions;[13] to hold enough HQLA to cover 30 days of net cash outflow. That amount would be determined based on the peak cumulative amount within the 30-day period.
Regional firms (those with between $50 and $250 billion in assets) would be subject to a "modified" LCR at the (BHC) level only. The modified LCR requires the regional firms to hold enough HQLA to cover 21 days of net cash outflow. The net cash outflow parameters are 70% of those applicable to the larger institutions and do not include the requirement to calculate the peak cumulative outflows.
Smaller BHCs, those under $50 billion, would remain subject to the prevailing qualitative supervisory framework.
The U.S. proposal divides qualifying HQLAs into three specific categories (Level 1, Level 2A, and Level 2B). Across the categories the combination of Level 2A and 2B assets cannot exceed 40% HQLA with 2B assets limited to a maximum of 15% of HQLA.

Level 1 represents assets that are highly liquid (generally those risk-weighted at 0% under the Basel III standardized approach for capital) and receive no haircut. Notably, the Fed chose not to include GSE-issued securities in Level 1, despite industry lobbying, on the basis that they are not guaranteed by the "full faith and credit" of the U.S. government.
Level 2A assets generally include assets that would be subject to a 20% risk-weighting under Basel III and includes assets such as GSE-issued and -guaranteed securities. These assets would be subject to a 15% haircut which is similar to the treatment of such securities under the BCBS version.
Level 2B assets include corporate debt and equity securities and are subject to a 50% haircut. The BCBS and U.S. version treats equities in a similar manner, but corporate debt under the BCBS version is split between 2A and 2B based on public credit ratings, unlike the U.S. proposal. This treatment of corporate debt securities is the direct impact of the Dodd–Frank Act's Section 939, which removed references to credit ratings, and further evidences the conservative bias of U.S. regulators’ approach to the LCR.
The proposal requires that the LCR be at least equal to or greater than 1.0 and includes a multiyear transition period that would require: 80% compliance starting 1 January 2015, 90% compliance starting 1 January 2016, and 100% compliance starting 1 January 2017.

Lastly, the proposal requires both sets of firms (large bank holding companies and regional firms) subject to the LCR requirements to submit remediation plans to U.S. regulators to address what actions would be taken if the LCR falls below 100% for three or more consecutive days.

Analysis of Basel III impact
In the United States higher capital requirements resulted in contractions in trading operations and the number of personnel employed on trading floors.

Macroeconomic impact
An OECD study released on 17 February 2011, estimated that the medium-term impact of Basel III implementation on GDP growth would be in the range of −0.05% to −0.15% per year. Economic output would be mainly affected by an increase in bank lending spreads, as banks pass a rise in bank funding costs, due to higher capital requirements, to their customers. To meet the capital requirements originally effective in 2015 banks were estimated to increase their lending spreads on average by about 15 basis points. Capital requirements effective as of 2019 (7% for the common equity ratio, 8.5% for the Tier 1 capital ratio) could increase bank lending spreads by about 50 basis points. The estimated effects on GDP growth assume no active response from monetary policy. To the extent that monetary policy would no longer be constrained by the zero lower bound, the Basel III impact on economic output could be offset by a reduction (or delayed increase) in monetary policy rates by about 30 to 80 basis points.

Criticism
Think tanks such as the World Pensions Council have argued that Basel III merely builds on and further expands the existing Basel II regulatory base without fundamentally questioning its core tenets, notably the ever-growing reliance on standardized assessments of "credit risk" marketed by two private sector agencies- Moody's and S&P, thus using public policy to strengthen anti-competitive duopolistic practices. The conflicted and unreliable credit ratings of these agencies is generally seen as a major contributor to the US housing bubble.

Opaque treatment of all derivatives contracts is also criticized. While institutions have many legitimate ("hedging", "insurance") risk reduction reasons to deal in derivatives, the Basel III accords: treat insurance buyers and sellers equally even though sellers take on more concentrated risks (literally purchasing them) which they are then expected to offset correctly without regulation do not require organizations to investigate correlations of all internal risks they own do not tax or charge institutions for the systematic or aggressive externalization or conflicted marketing of risk - other than requiring an orderly unravelling of derivatives in a crisis and stricter record keeping
Since derivatives present major unknowns in a crisis these are seen as major failings by some critics [33] causing several to claim that the "too big to fail" status remains with respect to major derivatives dealers who aggressively took on risk of an event they did not believe would happen - but did. As Basel III does not absolutely require extreme scenarios that management flatly rejects to be included in stress testing this remains a vulnerability. Standardized external auditing and modelling is an issue proposed to be addressed in Basel 4 however.

A few critics argue that capitalization regulation is inherently fruitless due to these and similar problems and - despite an opposite ideological view of regulation - agree that "too big to fail" persists.[34]

Basel III has been criticized similarly for its paper burden and risk inhibition by banks, organized in the Institute of International Finance, an international association of global banks based in Washington, D.C., who argue that it would "hurt" both their business and overall economic growth. The OECD estimated that implementation of Basel III would decrease annual GDP growth by 0.05–0.15%,[29][35] blaming the slow recovery from the financial crisis of 2007–08 on the regulation.[36][37] Basel III was also criticized as negatively affecting the stability of the financial system by increasing incentives of banks to game the regulatory framework.[38] The American Bankers Association,[39] community banks organized in the Independent Community Bankers of America, and some of the most liberal Democrats in the U.S. Congress, including the entire Maryland congressional delegation with Democratic Senators Ben Cardin and Barbara Mikulski and Representatives Chris Van Hollen and Elijah Cummings, voiced opposition to Basel III in their comments to the Federal Deposit Insurance Corporation,[40] saying that the Basel III proposals, if implemented, would hurt small banks by increasing "their capital holdings dramatically on mortgage and small business loans".[41]

Others[who?] have argued that Basel III did not go far enough to regulate banks as inadequate regulation was a cause of the financial crisis.[42] On 6 January 2013 the global banking sector won a significant easing of Basel III Rules, when the Basel Committee on Banking Supervision extended not only the implementation schedule to 2019, but broadened the definition of liquid assets.[43]

Basel Accord
DEFINITION OF 'BASEL ACCORD'
A set of agreements set by the Basel Committee on Bank Supervision (BCBS), which provides recommendations on banking regulations in regards to capital risk, market risk and operational risk. The purpose of the accords is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses.

BREAKING DOWN 'BASEL ACCORD'
The first Basel Accord, known as Basel I, was issued in 1988 and focuses on the capital adequacy of financial institutions. The capital adequacy risk, (the risk that a financial institution will be hurt by an unexpected loss), categorizes the assets of financial institution into five risk categories (0%, 10%, 20%, 50%, 100%). Banks that operate internationally are required to have a risk weight of 8% or less.

The second Basel Accord, known as Basel II, is to be fully implemented by 2015. It focuses on three main areas, including minimum capital requirements, supervisory review and market discipline, which are known as the three pillars. The focus of this accord is to strengthen international banking requirements as well as to supervise and enforce these requirements.

Basel Committee on Banking Supervision
The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide.

The Committee's members come from Argentina, Australia, Belgium, Brazil, Canada, China, European Union, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. The present Chairman of the Committee is Mr Stefan Ingves, Governor of Sveriges Riksbank.

Public consultation is an integral element of the Basel Committee's standard setting process. See the list of the Committee's proposals that are currently open for comment.