The document summarizes Basel I and Basel II capital accords. Basel I, established in 1988, was the first international agreement that defined capital requirements for banks. It had several shortcomings that led to the development of Basel II in 2004, which improved risk sensitivity and introduced three pillars for regulatory capital, supervisory review, and market discipline. The purpose of Basel II was to establish a more sophisticated framework for ensuring banks have sufficient capital to cover their risks.

1. BASEL ACCORD I
From 1965 to 1981 there were about eight bank failures (or bankruptcies) in the United States. Bank
failures were particularly prominent during the '80s, a time which is usually referred to as the "savings
and loan crisis." Banks throughout the world were lending extensively, while countries' external
indebtedness was growing at an unsustainable rate. As a result, the potential for the bankruptcy of the
major international banks because grew as a result of low security. In order to prevent this risk, the
Basel Committee on Banking Supervision, comprised of central banks and supervisory authorities of
10 countries, met in 1987 in Basel, Switzerland.
The committee drafted a first document to set up an international 'minimum' amount of capital that
banks should hold. This minimum is a percentage of the total capital of a bank, which is also called
the minimum risk-based capital adequacy. In 1988, the Basel I Capital Accord (agreement) was
created. The Basel II Capital Accord follows as an extension of the former, and was implemented in
2007. In this article, we'll take a look at Basel I and how it impacted the banking industry.
The Purpose of Basel I
In 1988, the Basel I Capital Accord was created. The general purpose was to:
1. Strengthen the stability of international banking system.
2. Set up a fair and a consistent international banking system in order to decrease
competitive inequality among international banks.
The basic achievement of Basel I has been to define bank capital and the so-called bank
capital ratio. In order to set up a minimum risk-based capital adequacy applying to all banks
and governments in the world, a general definition of capital was required. Indeed, before
this international agreement, there was no single definition of bank capital. The first step of
the agreement was thus to define it.
Two-Tiered Capital
Basil I defines capital based on two tiers:
1. Tier 1 (Core Capital): Tier 1 capital includes stock issues (or share holders equity) and
declared reserves, such as loan loss reserves set aside to cushion future losses or for
smoothing out income variations.
2. Tier 2 (Supplementary Capital): Tier 2 capital includes all other capital such as gains on

2. investment assets, long-term debt with maturity greater than five years and hidden reserves
(i.e. excess allowance for losses on loans and leases). However, short-term unsecured debts
(or debts without guarantees), are not included in the definition of capital.
Credit Risk is defined as the risk weighted asset (RWA) of the bank, which are banks assets
weighted in relation to their relative credit risk levels. According to Basel I, the total capital
should represent at least 8% of the bank's credit risk (RWA). In addition, the Basel
agreement identifies three types of credit risks:
The on-balance sheet risk (see Figure 1 for example).
The trading off-balance sheet risk. These are derivatives, namely interest rates,
foreign exchange, equity derivatives and commodities.
The non-trading off-balance sheet risk. These include general guarantees, such as
forward purchase of assets or transaction-related debt assets.
Let's take a look at some calculations related to RWA and capital requirement. Figure 1
displays predefined categories of on-balance sheet exposures, such as vulnerability to loss
from an unexpected event, weighted according to four relative risk categories.
Risk Weight
0%
Asset Class
Cash & gold held in bank
Obligation OECD government and US treasuries.
20%
Claims on OECD banks
Securities issued by US government agencies.
50%
Residential Mortgages.
100%
All other claims such as corporate bonds, less developed
countries’ debt, claims on OECD banks, equities, real estate,
plant & equipment.
Figure 1: Basel's Classification of risk weights of on-balance sheet assets
As shown in Figure 2, there is an unsecured loan of Rs.1,000 to a non-bank, which requires a
risk weight of 100%. The RWA is therefore calculated as RWA=Rs.1,000 × 100%=Rs1,000. By
using Formula 2, a minimum 8% capital requirement gives 8% × RWA=8% ×Rs.1,000=Rs. 80.
In other words, the total capital holding of the firm must be Rs 80 related to the unsecured
loan of Rs.1,000. Calculation under different risk weights for different types of assets are
also presented in Table 2.
Asset Category
Risk Weight Capital
Ratio
Amount
RWA
Treasury Bond
Municipal Bond
Residential
mortgage
Unsecured
0%
20%
50%
8%
8%
8%
Rs.1000
Rs.1000
Rs.1000
Rs.0
Rs.20
Rs.500
Minimal
Capital
Requirement
Rs.0
Rs.16
Rs.40
100%
8%
Rs.1000
Rs.1000
Rs.80

3. Loaan
Figure 2: Calculation of RWA and capital requirement on-balance sheet assets
Market risk includes general market risk and specific risk. The general market risk refers to
changes in the market values due to large market movements. Specific risk refers to changes
in the value of an individual asset due to factors related to the issuer of the security. There
are four types of economic variables that generate market risk. These are interest rates,
foreign exchanges, equities and commodities. The market risk can be calculated in two
different manners: either with the standardized Basel model or with internal value at risk
(VaR) models of the banks. These internal models can only be used by the largest banks that
satisfy qualitative and quantitative standards imposed by the Basel agreement. Moreover,
the 1996 revision also adds the possibility of a third tier for the total capital, which includes
short-term unsecured debts. This is at the discretion of the central banks. (For related
reading, see Get To Know The Central Banks and What Are Central Banks?)
Pitfalls of Basel I
Basel I Capital Accord has been criticized on several grounds. The main criticisms include the
following:
Limited differentiation of credit risk
There are four broad risk weightings (0%, 20%, 50% and 100%), as shown in Figure1,
based on an 8% minimum capital ratio.
Static measure of default risk
The assumption that a minimum 8% capital ratio is sufficient to protect banks from
failure does not take into account the changing nature of default risk.
No recognition of term-structure of credit risk
The capital charges are set at the same level regardless of the maturity of a credit
exposure.
Simplified calculation of potential future counterparty risk
The current capital requirements ignore the different level of risks associated with
different currencies and macroeconomic risk. In other words, it assumes a common
market to all actors, which is not true in reality.
Lack of recognition of portfolio diversification effects
In reality, the sum of individual risk exposures is not the same as the risk reduction
through portfolio diversification. Therefore, summing all risks might provide
incorrect judgment of risk. A remedy would be to create an internal credit risk model
- for example, one similar to the model as developed by the bank to calculate market
risk. This remark is also valid for all other weaknesses.
These listed criticisms have led to the creation of a new Basel Capital Accord, known as
Basel II, which added operational risk and also defined new calculations of credit risk.
Operational risk is the risk of loss arising from human error or management failure. Basel II
Capital

4. Conclusion
The Basel I Capital Accord aimed to assess capital in relation to credit risk, or the risk that a
loss will occur if a party does not fulfill its obligations. It launched the trend toward
increasing risk modeling research; however, its over-simplified calculations, and
classifications have simultaneously called for its disappearance, paving the way for the Basel
II Capital Accord and further agreements as the symbol of the continuous refinement of risk
and capital. Nevertheless, Basel I, as the first international instrument assessing the
importance of risk in relation to capital, will remain a milestone in the finance and banking
history.
Basel Accord II
By the late 1990s, banks had become much more sophisticated in their operations and risk
management and were increasingly able to find ways to reduce a bank's risk weighted assets in ways
that did not reflect lower real risk (what has become known as regulatory capital arbitrage). It was
therefore decided that a new capital standard was required and work began on Basel II.
Basel II is the second of the Basel Accords, (now extended and effectively superseded by Basel III),
which are recommendations on banking laws and regulations issued by the Basel Committee on
Banking Supervision.
Basel II, initially published in June 2004, was intended to create an international standard for banking
regulators to control how much capital banks need to put aside to guard against the types of financial
and operational risks banks (and the whole economy) face. One focus was to maintain sufficient
consistency of regulations so that this does not become a source of competitive inequality amongst
internationally active banks. Advocates of Basel II believed that such an international standard could
help protect the international financial system from the types of problems that might arise should a
major bank or a series of banks collapse. In theory, Basel II attempted to accomplish this by setting
up risk and capital management requirements designed to ensure that a bank has adequate
capital for the risk the bank exposes itself to through its lending and investment practices. Generally
speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount
of capital the bank needs to hold to safeguard its solvency and overall economic stability.
Politically, it was difficult to implement Basel II in the regulatory environment prior to 2008, and
progress was generally slow until that year's major banking crisis caused mostly by credit default
swaps, mortgage-backed security markets and similar derivatives.

5. Objective
The Basel II Accord aims at:
1. Ensuring that capital allocation is more risk sensitive;
2. Enhance disclosure requirements which will allow market participants to assess the capital
adequacy of an institution;
3. Ensuring that credit risk, operational risk and market risk are quantified based on data and
formal techniques;
4. Attempting to align economic and regulatory capital more closely to reduce the scope
for regulatory arbitrage.
Structure of Basel II
Basel II consists of 3 'pillars' which enshrine the key principles of the new regime. Collectively, they go
well beyond the mechanistic calculation of minimum capital levels set by Basel I, allowing lenders to
use their own models to calculate regulatory capital while seeking to ensure that lenders establish a
culture with risk management at the heart of the organisation up to the highest managerial level.
Basel II uses a "three pillars" concept – (1) minimum capital requirements (addressing risk),
(2) supervisory review and (3) market discipline.
The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the first
Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an
afterthought; operational risk was not dealt with at all.
The first pillar (Minimum Capital Requirement)
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. Other risks are not considered fully
quantifiable at this stage.
Credit risk
While Basel I offered a single approach to calculating regulatory capital for credit risk, one of the
greatest innovations of Basel II is that it offers lenders a choice between:

6. 1. The standardised approach. This follows Basel I by grouping exposures into a series of risk
categories. However, while previously each risk category carried a fixed risk weighting, under Basel II
three of the categories (loans to sovereigns, corporates and banks) have risk weights determined by
the external credit ratings assigned to the borrower.
Amongst the other categories that continue to have fixed risk weights applied by Basel II, loans
secured on residential property carry a risk weight of 35% against 50% previously, as long as the
loan-to-value (LTV) ratio is up to 80%. This lower weighting is a recognition of the historically low rate
of losses typically incurred on residential mortgage loan portfolios across different countries and over
a range of economic environments.
2. Foundation internal ratings based (IRB) approach. Lenders are able to use their own models to
determine their regulatory capital requirement using the IRB approach. Under the foundation IRB
approach, lenders estimate a probability of default (PD) while the supervisor provides set values for
loss given default (LGD), exposure at default (EAD) and maturity of exposure (M). These values are
plugged into the lender's appropriate risk weight function to provide a risk weighting for each exposure
or type of exposure.
3. Advanced IRB approach. Lenders with the most advanced risk management and risk modelling
skills are able to move to the advanced IRB approach, under which the lender estimates PD, LGD,
EAD and M. In the case of retail portfolios only estimates of PD, LGD and EAD are required and the
approach is known as retail IRB.
Given that a key objective of Basel II is to improve risk management culture, it is unsurprising that the
regime encourages lenders to move towards the IRB approach and ultimately, the advanced or retail
IRB approach. To this end, most banks can expect to see a modest release of regulatory capital in
moving from the standardised to foundation IRB approach and on to the advanced or retail IRB
approach.
Operational risk
The Accord defines operational risk as 'the risk of loss resulting from inadequate or failed internal
processes, people and systems or from external events'. In keeping with the approach to credit risk, it
provides three mechanisms for computing operational risk of rising complexity to suit lenders' varying
characteristics.
Market risk
For market risk the preferred approach is VaR (value at risk).

7. As the Basel II recommendations has phased in by the banking industry it has moved from
standardised requirements to more refined and specific requirements that have been developed for
each risk category by each individual bank. The upside for banks that do develop their own bespoke
risk measurement systems is that they will be rewarded with potentially lower risk capital
requirements. In the future there will be closer links between the concepts of economic and regulatory
capital.
The Second Pillar (Supervisory Review)
Pillar 2 is meant to identify risk factors not captured in Pillar 1, giving regulators discretion to adjust
the regulatory capital requirement against that calculated under Pillar 1. For most lenders, the Pillar 2
process results in a higher regulatory capital requirement than calculated under Pillar 1 alone. Pillar 2
requires banks to think about the whole spectrum of risks they might face including those not captured
at all in Pillar 1. It provides a framework for dealing with 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. Banks can review their risk management system.
The Third Pillar (Market Discipline)
Pillar 3 is designed to increase the transparency of lenders' risk profile by requiring them to give
details of their risk management and risk distributions. This pillar aims to complement the minimum
capital requirements and supervisory review process by developing a set of disclosure requirements
which will allow the market participants to gauge the capital adequacy of an institution.
Market discipline supplements regulation as sharing of information facilitates assessment of the bank
by others, including investors, analysts, customers, other banks, and rating agencies, which leads to
good corporate governance. The aim of Pillar 3 is to allow market discipline to operate by requiring
institutions to disclose details on the scope of application, capital, risk exposures, risk assessment
processes, and the capital adequacy of the institution. It must be consistent with how the senior
management, including the board, assess and manage the risks of the institution.
When market participants have a sufficient understanding of a bank's activities and the controls it has
in place to manage its exposures, they are better able to distinguish between banking organizations
so that they can reward those that manage their risks prudently and penalize those that do not.
These disclosures are required to be made at least twice a year, except qualitative disclosures
providing a summary of the general risk management objectives and policies which can be made
annually. Institutions are also required to create a formal policy on what will be disclosed and controls
around them along with the validation and frequency of these disclosures.

8. Implementation of Basel Accord II
In India, Reserve Bank of India has implemented the Basel II standardized norms on 31 March 2009
and banks are mandated to use Standardized Approach for credit risk and Basic Indicator Approach
for operational risk.
Existing RBI norms for banks in India (on September 2010): Common equity (incl of buffer): 3.6%
(Buffer Basel 2 requirement requirements are zero.); Tier 1 requirement: 6%. Total Capital: 9% of risk
weighted assets.
According to the draft guidelines published by RBI the capital ratios are set to become: Common
Equity as 5% + 2.5% (Capital Conservation Buffer) + 0–2.5% (Counter Cyclical Buffer), 7% of Tier 1
capital and minimum capital adequacy ratio (excluding Capital Conservation Buffer) of 9% of Risk
Weighted Assets. Thus the actual capital requirement is between 11 and 13.5% (including Capital
Conservation Buffer and Counter Cyclical Buffer)
In summary, Basel II aims not only to align regulatory capital more closely with risk but to promote a
more sophisticated approach to risk management and to create a 'risk culture' inside lenders, whereby
the organisation, and senior management in particular, understand risk and remain alert to risk as a
core issue.

9. BASEL ACCORD-III
The BASEL-III guidelines were released in 2010, this was introduced in response to the economic
crisis of 2008, which stemmed from the Sub-prime crisis in the US. These latest norms were release
because it was observed that the banking systems in the developing countries, like India were undercapitalized, over-leveraged and had a greater dependence on short-term funding. Thus it was felt by
the Basel Committee on Banking Supervision (BCBS) there was an utmost need to strengthen the
banking system. The quality and quantity of the capital under BASEL-II were deemed insufficient to
contain any further risk. This was mainly based on the experiences of the 2008 Crisis, the objective of
the new set of BASEL-II norms were to make most of the banking activities like trading book activities
more capital-intensive. The guidelines aim to promote a more resilient banking system by focusing on
three vital banking parameters :
Capital Requirement:
The original Basel III rule from 2010 was supposed to require banks to hold 4.5% of common equity
(up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) of "risk-weighted assets"
(RWA). Basel III introduced "additional capital buffers", (i) a "mandatory capital conservation buffer" of
2.5% and (ii) a "discretionary counter-cyclical buffer", which would allow national regulators to require
up to another 2.5% of capital during periods of high credit growth.
Leverage Ratio:
Basel III introduced a minimum "leverage ratio". The leverage ratio was calculated by dividing Tier 1
capital by the bank's average total consolidated assets; The banks were expected to maintain a
leverage ratio in excess of 3% under Basel III. In July 2013, the US Federal Reserve Bank announced
that the minimum Basel III leverage ratio would be 6% for 8 SIFI banks and 5% for their bank holding
companies.
Liquidity:
Basel III introduced two required liquidity ratios. The "Liquidity Coverage Ratio" was supposed to
require a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30
days; the Net Stable Funding Ratio was to require the available amount of stable funding to exceed
the required amount of stable funding over a one-year period of extended stress.
Difficulties with implementing Basel-III norms:

10. There are worries among certain bankers that the implementation of Basel-III proposals will have
an adverse impact on the return on equity and financial ratios. There are concerns that public sector
banks may not be able to grow their loans since government-dependent lenders would not have
adequate capital. Critics of Basel-III norms feel that just because banks would have more capital, it
does not mean that a bank will not get into trouble. The crises may at best be postponed. Walter
Bagehot, the former editor of 'The Economist', had famously said, "No capital is required for a well-run
bank and no amount of capital can save a badly-run bank!"
A taskforce of leading bankers warned in June'2012 that the Basel III rules were too focused on
problems that occurred in Europe and the US .They argued the standards unfairly penalize
trade finance and project finance, two forms of credit that are particularly important in developing
nations. This school of thought believes that the Indian banking system has proved robust due to constant
monitoring by the RBI. As per past instance, Indian Banks had carried a huge negative net-worth for three
years without any problem. As per this argument, Public Sector banks do not need more capital.
Since Basel-III is an international norm, therefore, Indian banks, including PSB's (Public Sector
Banks) with international presence, would find it an obstacle if they are non-compliant. One of the
solution proposed by policymakers is to go slow on imposing new capital adequacy norms for PSB's as
all of them do not have a foreign presence. However, the difficulty in increasing the capital of PSB's is
not because of their inability to attract investors. If investors are given confidence, banks would be able
to raise sufficient capital. But the government would have to dilute its holding in the PSB's.
It seems difficult because the government may be unwilling to let go its majority stake in these banks. If
fresh equity is to be raised without diluting the government's share, huge budget allocations are
required. As per estimates, about Rs.60000-75000 Crore demands for capital from banks could be
there in the next six years. Again, it may not be easy for the government, considering its fiscal deficit.
Merits of Basel-III norms:
As per some of the research reports relating to Banking industry, there is enough evidence that the
most serious economic crisis are associated with banking sector adversities and high public
sector interventions. The Basel Committee's long-term impact study of crisis shows that banking
crisis generally result in losses in economic output equal to about 60% of pre-crises GDP. Moreover,
there is a significant spill-over of risk between the banking sector and governments.
The recent experience of industrialized nations shows that to save the banking sector,
governments of these nations had to increase their debts to such an extent that their debt-to-GDP
ratios have risen by 10-25% points. Therefore, people who are concerned that tighter norms under BaselIII would impose a heavy burden on Indian government in terms of infusion of capital in Public sector
banks (PSB's), should also take into consideration the fact that the costs associated with the failure
of PSB's will be much higher in dimension and their subsequent impact. Hence, the economic benefits of

11. making banks more resilient to shocks are huge.
There is a concern that a higher capital requirement under Basel-III would reduce the profitability of
PSB's and make loans more expensive. As per RBI's estimates, there could be a marginal drop in
GDP growth in the short-term. But given that the banking sector stability is a precondition of
sustainable economic growth, a short-term sacrifice of growth has to be tolerated in the interest of
long-term sustainable growth. This is a typical perplexity that an emerging economy faces.
The features of Basel-III such as higher risk coverage, thrust on loss-absorbing capital in periods of
stress, improving liquidity standards, creation of capital buffers in good times and prevention of
excess build-up of debt during boom times would help create a resilient banking system.
Conclusion
Given the current environment, the RBI has extended the final date for Basel-III to 2018. This is positive as
PSB's will get more time for
preparation. Moreover, capital deduction now starts at 20% against
40% stipulated earlier. This move is encouraging and should ensure smoother migration to the new
framework. The RBI wants to implement the recommendations of the 'Basel Committee on Banking
Supervision' to make the financial system safe. It is aimed at protecting the depositors and to
prevent a 2008-like crises . Moreover, the 'perception' of a lower standard regulatory regime will put
Indian banks at a disadvantage in global competition. RBI is currently working on operational
aspects of implementation of the Countercyclical Capital Buffer. Besides, certain other proposals
viz. 'Definition of Capital
Disclosure
Requirements', 'Capitalisation of Bank Exposures to Central
Counterparties' etc., are also engaging the attention of the Basel Committee at present. Therefore, as
per RBI, the final proposals of the Basel Committee on these aspects will be considered for
implementation, to the extent applicable, in future. Further, for the financial year ending March 31,
2013, banks will have to disclose the capital ratios computed under the existing guidelines (Basel II)
on capital adequacy as well as those computed under the Basel III capital adequacy
framework. India's struggling banking sector will face a period of lower profitability as it seeks to raise at
least Rs. 5000 billion in extra capital to meet the new Basel-III international