Basel Norms (Basel1/Basel2/Basel3) - part2

This part will discuss problems discovered by BCBS after Basel 1 implementation

After the formation of BCBS in 1974, it started working toward different aspects of the banking sector all over the world and observed some major challenges, few of these were

• High-Risk Loans - in those times banks didn't have adequate capital to mitigate the potential default
• Window dressing - is a technique used by companies and financial institutions to manipulate financial statements and reports to show more favorable results for a particular period
• Problem with off-balance sheet items - actual risk-adjusted total assets not visible

So in the year 1988, the Basel committee put forward its first guideline to set the international risk-based capital adequacy standards. These norms are Basel 1 accords, now this standard entirely addressed the capital risk, which was classified as the main risk

Basel 1 Accord (1988)

Focused entirely on Credit Risk

Classification of Basel 1 Accord - The definition of capital; The structure of risk weights

It's important to understand KEY TERMINOLOGIES:

Capital; RWA; Capital Adequacy Ratio

Benefits and Limitations of Basel 1

Benefits:

• Substantial increase in capital adequacy ratio of internationally active banks
• Simplicity
• Worldwide adoption
• Increased competitive equality among internationally active banks
• Greater discipline in managing capital
• It set a benchmark for assessment by market participants

Limitations

• Capital Adequacy in Basel 1 was dependent only on Credit Risk
• Emphasis on the book values of assets rather than the market values
• In credit risk assessment there was no difference between debtors of different credit quality
• The risk buckets were homogenous
• Use of off-balance sheet items to mitigate risk exposures not recognized under Basel 1

To be cont...