Basel Accords

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  1. Basel Accords

The Basel Accords are a set of international banking regulations developed by the Basel Committee on Banking Supervision (BCBS). These accords aim to ensure the financial stability of the international banking system by establishing minimum capital requirements, supervisory standards, and risk management practices for banks. They are not legally binding treaties but are recommendations that national authorities are expected to implement through their own domestic legislation. Understanding the Basel Accords is crucial for anyone involved in financial markets, banking, or risk management. This article will delve into the history, components, and evolution of the Basel Accords, providing a comprehensive overview for beginners.

    1. History and Motivation

The impetus for the Basel Accords originated in the 1970s and 1980s, following a period of financial instability, notably the collapse of the German Herstatt Bank in 1974. This event exposed vulnerabilities in the international banking system, particularly concerning credit risk and cross-border supervision. The Herstatt Bank failure highlighted the need for greater international cooperation and a more consistent approach to banking regulation.

Prior to the Basel Accords, capital adequacy regulations varied significantly between countries. This created an uneven playing field and potentially encouraged banks to operate in jurisdictions with laxer rules – a phenomenon known as regulatory arbitrage. The BCBS, established in 1974, was formed by central bank governors from ten countries to address these issues. Its initial focus was on coordinating supervisory practices and developing minimum standards for capital adequacy.

    1. Basel I (1988)

The first set of accords, known as Basel I, was published in 1988. Its primary goal was to establish a standardized minimum capital requirement for international banks, linked to their credit risk exposure. It introduced a risk-weighted assets (RWA) framework, categorizing bank assets into different risk categories, each assigned a specific risk weight.

Key features of Basel I included:

  • **Capital Ratio:** A minimum capital ratio of 8% of risk-weighted assets was established. This meant banks were required to hold capital equivalent to at least 8% of their risk-weighted assets.
  • **Risk Weighting:** Assets were categorized into five risk weights:
   *   0% for cash and government bonds of developed countries.
   *   20% for claims on banks.
   *   50% for residential mortgages.
   *   100% for most corporate loans.
   *   150% for loans to less developed countries.
  • **Capital Definition:** Basel I defined capital as Tier 1 (core capital, including share capital and retained earnings) and Tier 2 (supplementary capital, including revaluation reserves and subordinated debt). Tier 1 capital was considered more loss-absorbing and therefore more important.
  • **Focus on Credit Risk:** Basel I largely focused on credit risk, neglecting other significant risks such as market risk and operational risk.

While Basel I was a significant step forward, it was criticized for being overly simplistic, not risk-sensitive enough, and encouraging moral hazard. The broad categorization of assets didn't adequately reflect the varying levels of risk within each category. For example, a high-quality corporate loan was treated the same as a more risky one.

    1. Basel II (2004)

Basel II, published in 2004, was a significant revision of the original accords, designed to address the shortcomings of Basel I. It introduced a more comprehensive and risk-sensitive approach to capital adequacy, encompassing three pillars:

  • **Pillar 1: Minimum Capital Requirements:** This pillar refined the risk-weighted assets framework, introducing more sophisticated methods for assessing credit risk. It allowed banks to choose between standardized approaches and more advanced internal models for calculating capital requirements. These models – using techniques like Value at Risk (VaR) – could better reflect the specific risk profiles of individual banks. It also introduced capital charges for market risk and operational risk.
  • **Pillar 2: Supervisory Review Process:** This pillar emphasized the importance of supervisory review and intervention. Supervisors were expected to assess banks' risk management processes, internal controls, and capital adequacy, and to take corrective action if necessary. This involved stress testing – simulating the impact of adverse economic scenarios on a bank’s capital position. Understanding technical analysis and fundamental analysis is helpful in stress testing.
  • **Pillar 3: Market Discipline:** This pillar aimed to enhance market transparency by requiring banks to disclose information about their risk exposures, capital adequacy, and risk management practices. The goal was to allow market participants to assess a bank's risk profile and to exert market discipline. This disclosure includes details on liquidity ratios and solvency ratios.

Basel II differentiated between approaches to calculating credit risk:

  • **Standardized Approach:** Banks used standardized risk weights assigned by regulators.
  • **Internal Ratings-Based (IRB) Approach:** Banks used their own internal models to assess the creditworthiness of borrowers and calculate capital requirements. This approach was further divided into Foundation IRB and Advanced IRB, depending on the extent to which banks could use their own models.

Basel II was viewed as a significant improvement over Basel I, but it was criticized for being complex and potentially pro-cyclical – meaning it could exacerbate economic downturns by requiring banks to reduce lending during periods of stress. The financial crisis of 2008 revealed further weaknesses in the framework.

    1. Basel III (2010-2019)

The Basel III framework was developed in response to the 2008 financial crisis. It aimed to strengthen the regulation, supervision, and risk management of banks, addressing the weaknesses exposed by the crisis. Basel III is not a single document but a series of amendments to the Basel II framework, implemented in phases from 2010 to 2019.

Key features of Basel III include:

  • **Higher and Better Quality Capital:** Basel III significantly increased the minimum capital requirements for banks, particularly Tier 1 capital. It also introduced stricter definitions of what qualifies as Tier 1 capital, focusing on common equity. This included a new capital buffer – the Capital Conservation Buffer – designed to absorb losses during periods of stress.
  • **Leverage Ratio:** A non-risk-based leverage ratio was introduced, limiting the amount of assets banks could hold relative to their Tier 1 capital. This ratio served as a backstop to the risk-weighted capital requirements, preventing banks from excessively increasing their leverage. This ratio is particularly relevant when analyzing market trends.
  • **Liquidity Standards:** Basel III introduced two key liquidity standards:
   *   **Liquidity Coverage Ratio (LCR):** Requires banks to hold sufficient high-quality liquid assets to cover their net cash outflows over a 30-day stress scenario.
   *   **Net Stable Funding Ratio (NSFR):** Requires banks to maintain a stable funding profile in relation to the composition of their assets and off-balance sheet activities.
  • **Countercyclical Buffer:** This buffer allows national regulators to require banks to hold additional capital during periods of excessive credit growth, helping to dampen lending booms and build up a cushion against future losses.
  • **Systemically Important Financial Institutions (SIFIs):** Basel III introduced stricter capital requirements for SIFIs – banks whose failure could pose a threat to the global financial system. These banks are subject to higher loss absorbency requirements.
  • **Revised Standardised Approaches:** Significant revisions to the standardised approaches for credit risk, operational risk, and credit valuation adjustment (CVA) risk.

Basel III represents a substantial overhaul of the regulatory framework for banks, making it more resilient to shocks and reducing the likelihood of future financial crises. However, it has also been criticized for being complex and potentially hindering economic growth. The implementation of Basel III has been uneven across countries, leading to concerns about regulatory arbitrage.

    1. Basel IV (Finalised in December 2023)

Often referred to as “Basel IV”, the finalised reforms represent a further evolution of the Basel III framework. They are not a complete overhaul but rather refinements to address remaining weaknesses and inconsistencies. The key objectives of Basel IV include:

  • **Reducing Variability in Risk-Weighted Assets:** The reforms aim to reduce the wide variation in how banks calculate their risk-weighted assets, which can lead to an uneven playing field.
  • **Enhancing the Standardised Approaches:** Significant revisions have been made to the standardised approaches for credit risk, operational risk, and CVA risk, making them more risk-sensitive.
  • **Output Floor:** A key element of Basel IV is the introduction of an output floor, which limits the extent to which banks can reduce their capital requirements using internal models. This ensures that internal models do not result in significantly lower capital requirements than those calculated using standardised approaches.
  • **Revised Operational Risk Framework:** A new standardised approach for operational risk replaces the existing approaches, which were found to be prone to manipulation.
  • **Credit Risk:** Revisions to the standardised approach for credit risk, including a more granular approach to risk weighting.

Basel IV is expected to increase capital requirements for many banks, particularly those that rely heavily on internal models. Its implementation is ongoing, with a deadline for full implementation set for January 1, 2028. Understanding technical indicators and chart patterns will become even more important for banks as they adjust to the new regulations.

    1. Impact and Criticisms

The Basel Accords have had a profound impact on the global banking system. They have increased capital adequacy, improved risk management practices, and enhanced transparency. However, they have also faced criticisms:

  • **Complexity:** The accords, particularly Basel II and III/IV, are incredibly complex, making them difficult to implement and supervise.
  • **Pro-cyclicality:** Concerns remain that the accords can exacerbate economic cycles.
  • **Implementation Challenges:** The uneven implementation of the accords across countries can create opportunities for regulatory arbitrage.
  • **Cost of Compliance:** The cost of complying with the accords can be significant for banks, particularly smaller institutions.
  • **Impact on Lending:** Some argue that the accords can lead to reduced lending, particularly to small and medium-sized enterprises (SMEs).

Despite these criticisms, the Basel Accords remain the cornerstone of international banking regulation. They have played a crucial role in strengthening the financial system and reducing the risk of future crises. Staying updated on the latest developments in financial regulation is vital for all stakeholders. The application of Elliott Wave Theory and Fibonacci retracements can help understand the impacts of these regulations on financial markets.



Financial Regulation Risk Management Banking Supervision Credit Risk Market Risk Operational Risk Capital Adequacy Liquidity Risk Financial Stability Basel Committee on Banking Supervision

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