Basel I

Quick Summary of Basel I

A document written in 1988 by the Basel Committee on Banking Supervision, which recommends certain standards and regulations for banks. The main recommendation of this document is that in order to lower credit risk, banks should hold enough capital to equal at least 8% of its risk-weighted assets. Most countries have implemented some version of this regulation.

Basel I is the name commonly applied to the 1988 Basel Capital Accord, a set of international capital requirements for banks. Developed by the Basel Committee, these became law in G-10 countries in 1992, with Japanese banks permitted an extended transition period. Basel I was supplanted by Basel II in the mid-2000s. Basel III replaced Basel II following the 2008 financial crisis.

To understand the scope of the Basel I, we need to clarify what we mean by “bank.” Some jurisdictions distinguish between banks and securities firms, and the Basel accord applied only to the former.

Under its Glass-Steagall Act, the United States had long distinguished between commercial banks and securities firms (investment banks or broker-dealers). Following World War II, Japan adopted a similar legal distinction. The United Kingdom also distinguished between banks and securities firms, although this was more a matter of custom than law. By comparison, Germany and other European countries had a tradition of universal banking, which made no distinction between banks and securities firms.

Basel I primarily addressed banking in the sense of deposit-taking and lending (commercial banking under then US law), so its focus was credit risk. Banks were subject to an 8% capital requirement. Specifically, they would calculate measures for

• capital, and
• credit risk.

with a requirement that:

Under Basel I, a bank’s capital was defined as comprising two tiers. Tier 1 (“core”) capital included the book value of common stock, non-cumulative perpetual preferred stock and published reserves from post-tax retained earnings. Tier 2 (“supplementary”) capital was deemed of lower quality. It included, subject to various conditions, general loan loss reserves, long-term subordinated debt and cumulative and/or redeemable preferred stock. A maximum of 50% of a bank’s capital could comprise tier 2 capital.

Credit risk was calculated as the sum of risk-weighted asset values. Generally, G-10 government debt was weighted 0%, G-10 bank debt was weighted 20%, and other debt, including corporate debt and the debt of non-G-10 governments, was weighted 100%. Additional rules applied to mortgages, local government debt in G-10 countries, and contingent obligations, such as letters of credit or derivatives.

In the early 1990s, the Basel Committee decided to update Basel I to include bank capital requirements for market risk. This would have implications for non-bank securities firms.

Any capital requirements the Basel Committee adopted for banks’ market risk would be incorporated into future updates of Europe’s Capital Adequacy Directive (CAD) and thereby apply to Britain’s non-bank securities firms. If the same framework were extended to non-bank securities firms outside Europe, then market risk capital requirements for banks and securities firms could be harmonized globally. In 1991, the Basel Committee entered discussions with the International Organization of Securities Commissions (IOSCO) to jointly develop such a framework. IOSCO is the primary international organization representing securities regulators. The two organizations formed a technical committee, and work commenced in January 1992.

Because of the fundamental differences between banks and securities firms (see the article regulatory capital), the initiative soon ran into trouble. Europe’s draft CAD regulations already applied uniform capital standards to banks and securities firms. They had to because Europe’s universal banks were both banks and securities firms. Many European regulators wanted the Basel-IOSCO initiative to adopt rules similar to the draft CAD. This would have required that the SEC abandon its own long-established Uniform Net Capital Rule (UNCR) for securities firms in favor of the weaker European rules.

Richard Breeden was chairman of the SEC and chairman of the Basel-IOSCO technical committee. Ultimately, he baulked at discarding the SEC’s rules. An analysis by the SEC indicated that the European approach might reduce capital requirements for US securities firms by 70% or more. Permitting such a reduction, simply to harmonize banking and securities regulations, seemed imprudent. The Basel-IOSCO initiative had failed. In the United States, banking and securities capital requirements were to remain distinct.

In April 1993, following the failure of the Basel-IOSCO initiative, the Basel Committee released a package of proposed amendments to Basel I. Primarily, these proposed minimum capital requirements for banks’ market risk. The proposal generally conformed to Europe’s CAD. Banks would be required to identify a trading book and hold capital for trading book market risks and organization-wide foreign exchange exposures. Capital charges for the trading book would be based upon a crude value-at-risk (VaR) measure loosely consistent with a 10-day 95% VaR metric. Similar to a “building block” value-at-risk measure used by Europe’s CAD, this partially recognized hedging effects but ignored diversification effects.

In addition to capital for credit risk, banks would now be required to hold capital equal to the calculated value-at-risk. If we define market risk as value-at-risk/8%, the proposed amendment required that banks hold capital such that:

The proposal also liberalized the definition of capital by adding a third tier. Tier 3 capital comprised short-term subordinated debt, but it could only be used to cover market risk.

The committee received numerous comments on this proposal. Commentators perceived the crude value-at-risk measure as a step backwards. Many banks were already using proprietary value-at-risk measures. Most of these modelled diversification effects, and some recognized portfolio non-linearities. Commentators wondered if, by embracing a crude value-at-risk measure, regulators might stifle innovation in risk measurement technology.

In April 1995, the Basel Committee released a revised proposal. This made a number of changes, including the extension of market risk capital requirements to cover organization-wide commodities exposures. An important provision allowed banks to use either a regulatory building-block value-at-risk measure or their own proprietary value-at-risk measure for computing capital requirements. The use of a proprietary measure required the approval of regulators. A bank would have to have an independent risk management function and satisfy regulators that it was following acceptable risk management practices. Regulators would also need to be satisfied that the proprietary value-at-risk measure was sound. Proprietary measures would need to support a 10-day 99% VaR metric and be able to address the non-linear exposures of options. Diversification effects could be recognized within broad asset categories—fixed income, equity, foreign exchange and commodities—but not across asset categories. Market risk capital requirements were set equal to the greater of:

• the previous day’s value-at-risk, or
• the average value-at-risk over the previous sixty business days, multiplied by a factor of at least 3.

The original value-at-risk measure—which was now called the “standardized” measure—was changed modestly from the 1993 proposal. It may reasonably be interpreted as still reflecting a 10-day 95% VaR metric. Extra capital charges were added in an attempt to recognize non-linear exposures.

The Basel Committee’s new proposal was adopted in 1996 as an amendment to Basel I. It is known as the 1996 amendment. It went into effect in 1998.

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