Is Your Institution Basel Compliant for 2020?

Basel is 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 I

Basel I (aka Basel 1) created a bank asset classification system and focuses on credit risk. This classification system groups banks assets in five risk categories. Banks must maintain Tier 1 and Tier 2 capital equal to a minimum of 8% of risk-weighted assets. Basel I is now viewed as outdated and has been replaced by Basel II.


Basel II

Basel II is the second of the Basel Accords, which are banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II, which was initially published in June 2004, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face.

Unlike Basel I, where focus was mainly on credit risk, Basel II creates standards and regulations on how much capital banks must have put aside. Banks need store capital to reduce the risks associated with investing and lending practices. Basel II is built on a three-pillar system:

Pillar I: Minimum Capital Requirements
Pillar II: Supervisory Review Process
Pillar III: Market Discipline Requirements

The following financial institutions must comply with Basel II:
Commercial banks
Savings banks
Credit Institutions
Investment firms
Management companies for UCITs

Pillar I: 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. Minimum capital requirements are:

Tier 1 capital ratio - 4%
Core Tier 1 capital ratio - 2%

The difference between the total capital requirement of 8.0% and the Tier 1 requirement can be met with Tier 2 capital.

Pillar II: Supervisory Review Process

The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as 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. It gives banks a power to review their risk management system.

Pillar III: Market Discipline Requirements

The aim of pillar 3 is to allow market discipline to operate by requiring lenders to publicly provide details of their risk management activities, risk rating processes and risk distributions. It sets out the public disclosures that banks must make that lend greater insight into the adequacy of their capitalisation.


Basel III

Basel III was developed in a response to the deficiencies in financial regulation revealed by the global financial crisis. Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage.

Basel III builds on the Basel I and Basel II and seeks to improve bank ability to deal with financial and economic stress, improve risk management and improve transparency. A focus of Basel III is to foster greater resilience at the individual bank level in order to reduce the risk of system wide shocks. The difference between the total capital requirement of 8.0% and the Tier 1 requirement can be met with Tier 2 capital.

Basel III strengthens the three Basel II pillars, particularly Pillar 1 with enhanced minimum capital and liquidity requirements. Pillar 2 under Basel III calls for enhanced supervisory review process for risk management and capital planning. Pillar 3 under Basel III calls for enhanced risk disclosure and market discipline.

Changes from Basel II include:

Tier 1 Capital Ratio - 6%
Core Tier 1 capital ratio - 4.5%