The Basel Committee on Banking Supervision (BCBS) was formed in response to the messy liquidation of a Cologne-based bank in 1974. On 26 June 1974, a number of banks had released Deutsche Mark (German Mark) to the Bank Herstatt in exchange for dollar payments deliverable in New York. On account of differences in the time zones, there was a lag in the dollar payment to the counter-party banks, and during this gap, and before the dollar payments could be effected in New York, the Bank Herstatt was liquidated by German regulators.
This incident prompted the G-10 nations to form towards the end of 1974, the Basel Committee on Banking Supervision, under the auspices of the Bank of International Settlements (BIS) located in Basel, Switzerland. The Committee was established to facilitate information sharing and cooperation among bank regulators in major countries. The Basel Committee was constituted by the Central Bank Governors of the G-10 countries. The G-10 Committee consists of members from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, The Netherlands, Spain, Sweden, Switzerland, The UK and The US. These countries are represented by their Central Bank and also by the authority with onus for the prudent supervision of banking business where this is not the central bank.
Basel committee on banking supervision provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and quality improvement of banking supervision worldwide. This committee is best known for its international standards on capital adequacy; the core principles of banking supervision and the concordat on cross-border banking supervision.
The committee’s efforts over the last three decades have made Basel synonymous with the best practices and standards in banking regulation and supervision. Perhaps the most far-reaching of these initiatives was the laying down of minimum capital standards in 1988, known as the Basel Capital Accord, to ensure a level playing field in terms of capital required to be maintained by internationally active banks. The fact that Basel Committee’s capital standards were implemented by more than 100 countries points to their near universal acceptance. The Basel Committee does not possess any formal supranational supervisory authority and its conclusions do not have any legal or binding force. It merely formulates broad-based supervisory principles or strategies. However, it recommends statements of best practice, keeping in mind that individual authorities will undertake steps to implement them through detailed arrangements in a way that suits them best.
BASEL I
In 1988, the BASEL Committee on Banking Supervision introduced global standards for regulating the capital adequacy of banks.
Basel I, that is, the 1988 Basel Accord, primarily focused on credit risk. Assets of banks were classified and grouped in five categories according to credit risk, carrying risk weights of zero (for example home country sovereign debt), ten, twenty, fifty, and up to one hundred percent (this category has, as an example, most corporate debt). Banks with international presence are required to hold capital equal to 8 % of the risk-weighted assets.
Since 1988, this framework has been progressively introduced in member countries of G-10, currently comprising 13 countries, namely, Belgium, Canada, France, Germany, Italy, Japan, Luxemburg, Netherlands, Spain, Sweden, Switzerland, United Kingdom and the United States of America.
Most other countries, currently numbering over 100, have also adopted, at least in name, the principles prescribed under Basel I. The efficiency with which they are enforced varies, even within nations of the Group of Ten.
The original accord, was quite simple and adopted a straight-forward ‘one size fits all approach’ that does not distinguish between the differing risk profiles and risk management standards across banks.
Transition From BASEL I to BASEL II
Basel I concentrated on credit risk alone being the biggest risk a bank assumes and arising out of its lending/investment operations. It prescribed risk weights for different loan assets essentially on the basis of security available after classifying the assets as standard or non-standard on the basis of payment record. Basel I did not draw a distinction for the purpose of capital allocation between loan assets based on the intrinsic risk in lending to individual counterparties. Security in the form of tangible assets and/or guarantees from governments/banks is the sole distinguishing factor. Credit extended on secured basis to a small-scale unit and to a large corporate was put in the same category in so far as minimum capital requirement was concerned. The higher probability of default in respect of a loan to, say, a proprietorship compared to the large professionally managed corporate did not get reflected in the capital requirement.
Basel II addresses this issue by factoring in the differential risk factor in loans made to different types of businesses, entities, markets, geographies, and so on, and allowing banks to have different levels of minimum capital taking into account intrinsic riskiness of the exposure. Three methods, increasing in sophistication, for assessing credit risks have been recommended for adoption. Assets are to be risk weighted based on a rational approach cleared in advance by the regulator and then aggregated to arrive at the minimum capital requirement. Higher the risk, higher the weightage, and more the capital allocation required. In the proposed scheme of things, weak credits can carry a weightage of up to 150 per cent.
The objective of the recommendation of Basel II on credit risk is that banks should be more risk-sensitive than hitherto in their lending/investment activity and derive the benefit from lesser capital engagement for high quality credit risks. In addition to credit risk, Basel II recognizes the operational risks arising out of the day-to-day running of banks in the form of service quality shortcomings, non-adherence to policy and procedures, staff malfeasances, and so on, the capital charge for which is linked to operational income through a multiplier to be given by the regulator based on its assessment of the quality of banks operational instructions, style of functioning, control of top management and audit quality.