Basel Accord, Merits and Weaknesses of Basel norms

The Basel Accord, also known as the Basel framework or Basel agreements, is a series of international banking regulations issued by the Basel Committee on Banking Supervision (BCBS). The BCBS is a committee of banking supervisory authorities from major industrialized countries, established by the central bank governors of the Group of Ten (G10) countries in 1974. The primary objective of the Basel Accord is to promote financial stability and enhance the soundness of the global banking system by establishing minimum capital requirements and supervisory standards for banks.

There have been three main iterations of the Basel Accord, known as Basel I, Basel II, and Basel III:

Basel I (1988):

Basel I, officially titled “The International Convergence of Capital Measurement and Capital Standards,” was the first version of the Basel Accord. It was introduced in 1988 and came into effect in 1992. Basel I focused on standardizing the way banks calculated their capital requirements, with the intention of ensuring that banks held adequate capital to cover credit risk.

Under Basel I, banks were required to maintain a minimum capital adequacy ratio (CAR) of 8% of their risk-weighted assets (RWAs). The CAR was calculated by dividing a bank’s total capital (Tier 1 and Tier 2 capital) by its RWAs, which were based on the credit risk associated with different types of assets held by the bank. The risk weights were determined by regulators, and they varied based on the perceived riskiness of the assets.

While Basel I provided a foundation for international capital regulations, it had limitations. It primarily focused on credit risk and did not adequately account for other risks like operational risk or market risk. Moreover, it was criticized for being too simplistic and not adequately reflecting the varying risk profiles of different assets.

Basel II (2004):

Recognizing the limitations of Basel I, the Basel Committee introduced Basel II in 2004 to address some of the shortcomings and enhance the risk sensitivity of capital requirements. Basel II was formally titled “International Convergence of Capital Measurement and Capital Standards: A Revised Framework.”

Basel II introduced three pillars to strengthen banking supervision and risk management:

1. Pillar 1: Minimum Capital Requirements – This pillar aimed to enhance the risk sensitivity of capital requirements. It introduced three types of risk categories: credit risk, operational risk, and market risk. Banks were required to calculate capital requirements for each risk category based on more sophisticated models and approaches, considering the specific risk profiles of their assets and operations.
2. Pillar 2: Supervisory Review Process – This pillar emphasized the importance of banks’ internal risk management processes and required supervisors to conduct a comprehensive assessment of a bank’s risk management framework. Banks were expected to have robust risk management systems in place, and supervisors had the authority to require additional capital beyond the minimum requirements if deemed necessary.
3. Pillar 3: Market Discipline – Basel II encouraged banks to enhance their disclosure practices to provide greater transparency to stakeholders, including investors and the public. The idea was to improve market discipline and allow stakeholders to better assess a bank’s risk profile and capital adequacy.

While Basel II represented a significant improvement over Basel I, it was complex and required sophisticated risk measurement and management systems. It also faced criticism for not adequately addressing pro-cyclicality (where capital requirements could amplify economic cycles) and the challenges of comparing risk models across different banks and jurisdictions.

Basel III (2010 and subsequent revisions):

Building upon the lessons from the 2008 global financial crisis, the Basel Committee introduced Basel III as a comprehensive package of reforms aimed at strengthening the global banking system’s resilience.

Basel III reforms were phased in over several years and covered a wide range of areas, including capital requirements, liquidity standards, leverage ratios, and countercyclical measures. Some key elements of Basel III include:

1. Higher Capital Requirements: Basel III increased the minimum common equity Tier 1 (CET1) capital requirement and introduced a capital conservation buffer and a countercyclical buffer. This meant that banks were required to hold more high-quality capital to absorb losses during economic downturns.
2. Liquidity Coverage Ratio (LCR): Basel III introduced the LCR, which mandated banks to maintain sufficient high-quality liquid assets to cover their expected net cash outflows over a 30-day stress period. The LCR aimed to ensure that banks could withstand short-term liquidity disruptions.
3. Net Stable Funding Ratio (NSFR): Basel III introduced the NSFR, which requires banks to maintain a stable funding profile over a one-year period to reduce their reliance on short-term funding.
4. Leverage Ratio: Basel III introduced a non-risk-based leverage ratio, which was designed to serve as a backstop to the risk-weighted capital requirements. The leverage ratio ensures that banks do not become excessively leveraged, irrespective of their risk models.
5. Capital Requirements for Systemically Important Banks: Basel III introduced additional capital surcharges for global systemically important banks (G-SIBs) to account for their systemic importance and potential impact on the financial system if they were to fail.
6. Stress Testing: Basel III mandated banks to conduct regular stress tests to assess their resilience under adverse economic conditions.

Merits of Basel Norms:

• Enhanced Financial Stability: One of the primary objectives of the Basel norms is to promote financial stability in the banking sector. By setting minimum capital requirements and risk management standards, the norms ensure that banks maintain adequate capital buffers to withstand financial shocks and economic downturns. This has contributed to greater stability and resilience in the global banking system.
• Risk Sensitivity: Basel II and Basel III introduced risk-sensitive approaches to calculate capital requirements, taking into account the specific risk profiles of banks’ assets and operations. This approach encourages banks to adopt more sophisticated risk measurement models, making capital requirements better aligned with actual risks. It promotes efficient allocation of capital and encourages banks to improve risk management practices.
• Improved Supervisory Oversight: Basel II and Basel III introduced the Pillar 2 framework, which emphasizes the importance of supervisory review and intervention. This enhanced supervisory oversight helps identify potential risks and weaknesses in banks’ risk management practices, enabling timely corrective actions to be taken. It provides an additional layer of protection against systemic risks.
• Liquidity Standards: Basel III introduced liquidity standards such as the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). These standards ensure that banks maintain sufficient liquid assets to withstand short-term liquidity disruptions and maintain stable funding profiles over the longer term. This promotes better liquidity risk management and reduces the likelihood of bank runs.
• Global Consistency: The Basel norms are internationally agreed-upon standards, leading to a level playing field for banks operating across different jurisdictions. This promotes consistency and harmonization of banking regulations, making it easier for banks to operate globally and reducing regulatory arbitrage.

Weaknesses of Basel Norms:

• Complexity: Basel II and Basel III are significantly more complex than Basel I. The risk-sensitive approaches and the need for advanced risk measurement models have made compliance more challenging, especially for smaller banks with limited resources. Complexity can lead to increased compliance costs and difficulties in comparing the risk profiles of different banks.
• Pro-Cyclicality: Critics argue that Basel II and Basel III can exacerbate pro-cyclicality, meaning that during economic downturns, capital requirements may increase, making it more challenging for banks to lend, thereby amplifying the downturn. The reliance on market-based indicators and historical data in risk models can accentuate this pro-cyclicality effect.
• Data and Model Risk: Risk-sensitive approaches in Basel II and Basel III depend on accurate and reliable data, as well as sound risk measurement models. Banks may face challenges in sourcing high-quality data, and models can be subject to limitations or vulnerabilities, leading to potential inaccuracies in risk assessments.
• Regulatory Arbitrage: Despite efforts to harmonize regulations, there is still the potential for regulatory arbitrage, where banks might exploit differences in regulations across jurisdictions to gain a competitive advantage. Some banks may choose to operate in jurisdictions with less stringent regulations to reduce compliance burdens.
• Impact on Small and Medium-Sized Banks: The Basel norms, particularly Basel III, can disproportionately impact smaller banks that may not have the resources to comply with the complex risk measurement and capital requirements. This could potentially lead to consolidation in the banking sector and reduce diversity in the financial system.
• Lack of Consideration for Systemic Risks: Critics argue that the Basel norms do not adequately address systemic risks arising from interconnectedness among financial institutions and the potential for contagion effects during financial crises. Addressing systemic risks requires broader macroprudential measures beyond the scope of Basel regulations.