The Basel Accords are some of the most influential—and misunderstood—agreements in modern international finance. Drafted in 1988 and 2004, Basel I and II have ushered in a new era of international banking cooperation. Through quantitative and technical benchmarks, both accords have helped harmonize banking supervision, regulation, and capital adequacy standards across the eleven countries of the Basel Group and many other emerging market economies. On the other hand, the very strength of both accords—their quantitative and technical focus—limits the understanding of these agreements within policy circles, causing them to be ...view middle of the document...
Six years of deliberations followed; in July of 1988, the G-10 (plus Spain) came to a final agreement: The International Convergence of Capital Measurements and Capital Standards, known informally as “Basel I.”
It should first be noted that Basel I was created to promote the harmonization of regulatory and capital adequacy standards only within the member states of the Basel Committee. All the states of the G-10 are considered developed markets by most (if not all) international organizations, and therefore, the standards set forth in Basel I are tailored to banks operating within such markets. The agreement expressly states that it is not intended for emerging market economies, and due to the unique risks and regulatory concerns in these economies, should not be seen as the “optimal” emerging market banking reform. In sum, because Basel I gives considerable regulatory leeway to state central banks, views domestic currency and debt as the most reliable and favourable financial instruments, sees FDIC-style depositor insurance as risk-abating, and uses a “maximum” level of risk to calculate its capital requirements that is only appropriate for developed economies, its implementation could create a false sense of security within an emerging economy’s financial sector while creating new, less obvious risks for its banks.
Secondly, it should also be noted that Basel I was written only to provide adequate capital to guard against risk in the creditworthiness of a bank’s loan book. It does not mandate capital to guard against risks such as fluctuations in a nation’s currency, changes in interest rates, and general macroeconomic downturns. Due to the great variability of these risks across countries, the Basel Committee decided not to draft general rules on these risks—it left these to be evaluated on a case-by-case basis within the G10 member states.
Thirdly, Basel I overtly states that it only proposes minimum capital requirements for internationally active banks, and invites sovereign authorities and central banks alike to be more conservative in their banking regulations. Moreover, it warns its readers that capital adequacy ratios cannot be viewed in isolation and as the ultimate arbiters of a bank’s solvency.
Pillars of Basel I
The Basel I Accord divides itself into four “pillars.” These have been discussed as follows. As would be analysed later, these norms were not void of limitations.
Pillar I - The Constituents of Capital
The first, known as The Constituents of Capital, defines both what types of on-hand capital are counted as a bank’s reserves and how much of each type of reserve capital a bank can hold. The accord divides capital reserves into two tiers. Capital in the first tier, known as “Tier 1 Capital,” consists of only two types of funds—disclosed cash reserves and other capital paid for by the sale of bank equity, i.e....