1974: Formation of BCBS

In the wake of the collapse of the Bretton Woods system of international monetary management, policymakers from the G10 countries formed the Basel Committee on Banking Supervisions (BCBS) in an effort to build a new international financial structure. The Basel Accords (Basel I, II, III, and IV) are highly influential policy recommendations published by the BCBS. These accords are not legally binding unless adopted by national policymakers and form the basis of capital requirement guidelines for financial institutions in countries that have adopted BCBS policies.

 

 

1988: Basel I Initial Policy Created

This policy recommendation focused on credit risk by creating a bank asset classification system. This system grouped a bank’s assets into five risk categories based on the nature of the debtor. These assets, called risk weighted assets (RWAs), could then be analyzed to assess leverage ratios and minimum capital requirements.

 

 

1992: Basel I Implemented

In G10 countries to varying degrees.

 

 

2004: Basel II Introduced by BCBS

Introduced the “three pillars” concept, refined the definition of a risk-weighted asset, and divided the eligible regulatory capital of a bank into three tiers.

Three Pillars

• Pillar 1 – Minimum capital requirements: compels banks to maintain minimum capital ratios of regulatory capital over risk-weighted assets.

• Pillar 2 – Supervisory review: framework for national regulatory bodies to deal with various types of risks, including systemic risk, liquidity risk and legal risk.

• Pillar 3 – Market discipline: special disclosure requirements used to analyze a bank’s risk exposures, risk assessment processes and capital adequacy.

Capital Tiers

Tier 1 capital = strictest definition of regulatory capital and includes shareholders’ equity, disclosed reserves, retained earnings and certain innovative capital instruments. 

Tier 2 = Tier 1 instruments + various other bank reserves, hybrid instruments, and medium- and long-term subordinated loans. 

Tier 3 = Tier 2 + short-term subordinated loans.

Risk Weighted Assets

Risk weighted assets are the denominator in regulatory capital ratios and are calculated by using the sum of different assets that are multiplied by the respective risk weights for each asset type. The riskier the asset, the higher its weight.

 

 

2008: Financial Crisis

Basel II was in the process of being implemented when the process was interrupted by the 2008 financial crisis.

 

 

2009: Basel III Upgrades Basel II

Basel III was created to improve parts of Basel II that were now seen as deficient after the financial crisis. Policymakers felt that by increasing both the quantity and quality of regulatory capital and liquidity in financial institutions, the overall stability of the financial system could be improved.

Minimum Capital Requirements

Basel III lays out stricter capital requirements compared to Basel I and II. A bank’s regulatory capital in Tier 2 and Tier 3 remained the same, but Tier 1 was subdivided into Common Equity Tier 1 and additional Tier 1 capital.

Credit Expansion and Detraction Requirements

This policy introduced certain requirements for regulatory capital, specifically for large banks to cushion against the ups and downs created during credit expansion and credit contraction.

 

 

2016: Basel IV Unveiled

The BCBS published a set of large-scale amendments to the Basel III framework, known throughout the industry as Basel IV, that are to be implemented by 2027. Basel IV creates weighty implementation challenges in the areas of:

• calculating risk weighted assets, regardless of risk type and irrespective of whether standardized approach or internal models are used;

• increasing risk sensitivity under the standardized approach (SA) for credit risk, counter-party risk, securitizations, market risk, CVA, operations risk, and disclosure;

• the internal rating based (IRB) approach framework that is likely to increase capital requirements for the affected exposure; and

• improvements to data and IT architecture.