Basel 1: In 1988, the Basel Committee on Banking Supervision (BCBS) published a set of rules regarding minimum capital requirements. Known, by the Basel accord was enforced as a low by group of 10 countries.
The Primary focus of Basel -1 norms was Credit Risk within Banking System. Banks that operate internationally are required to maintain a minimum amount (8%) of capital based on a percent of risk-weighted assets. Basel -1 is the first of three sets of regulations known individually as Basel 1, 2 and 3. These set of rules together known as the Basel Accords.
- In 1988 Basel Committee on Banking supervision (BCBS) introduced first set of norms for Banking system also known as Basel
- Basel -1 norms were primarily focused on Credit Risk and Risk Weighted Assets with assets been classified into 5 categories
- Cash and Treasuries with high liquidity had Risk Weight of 0%
- Mortgage Backed Securities (Rating of AAA) been given weights of 20%
- Municipal Bonds and Residential Mortgages were given 50% weight
- Most of the Corporate Debt were given 100% weight
- Few types of assets were not given any rating
- Banks with an international presence are required to hold capital (Tier 1 and Tier 2 Capital) equal to 8% of their risk-weighted assets (RWA). The minimum capital ratio reserve requirement for a bank is set at 8%, 4% of which must be provided by Tier 1 capital.
Tier 1 Capital: Tier 1 capital, used to describe the capital adequacy of a bank. It is core capital that includes equity capital and disclosed reserves. Equity capital is inclusive of instruments that cannot be redeemed at the option of the holder. Core capital is composed, primarily, of disclosed reserves (also known as retained earnings) and common stock. It can also include noncumulative, nonredeemable preferred stocks.
Tier 2 Capital: Tier 2 capital is the secondary component of bank capital, in addition to Tier 1 capital, that makes up a bank’s required reserves. Tier 2 capital is designated as supplementary capital, and is composed of items such as revaluation reserves, undisclosed reserves, hybrid instruments and subordinated term debt.
Key Indicators for Basel-1:
- The tier 1 capital ratio = tier 1 capital / all RWA
- The total capital ratio = (tier 1 + tier 2 + tier 3 capital) / all RWA
- Leverage ratio = total capital/average total assets
The Basel 1 Accord attempted to create a cushion against credit risk. The norm comprised of four pillars, namely Constituents of Capital, Risk Weighting, Target Standard Ratio, and Transitional and implementing arrangements.
Pillar 1 – Constituents of Capital: Constituents of Capital prescribe the nature of capital that is eligible to be treated as reserves. Capital is classified into Tier I and Tier II capital. Tier I capital or Core Capital consists of elements that are more permanent in nature and as a result, have high capacity to absorb losses.
Pillar 2 – Risk Weighting: Risk Weighting creates a comprehensive system to provide weights to different categories of bank’s assets i.e. loans on the basis of relative riskiness. The capital of the bank is related to risk weighted assets, to determine capital adequacy. The details of Risk weights assigned to different categories already been given point no 2 of Basel Accords.
Pillar 3 – Target Standard Ratio: Target Standard Ratio acts as a unifying factor between the first two pillars. A universal standard, wherein Tier I and Tier II capital should cover at least 8 percent of risk weighted assets of a bank, with at least 4 percent being covered by Tier I capital.
Pillar 4 – Transitional and Implementing Arrangement: Transitional and implementing arrangement sets different stages of implementation of the norms in a phased manner. Due to widespread undercapitalization of the banking community during that time, a phased manner of implementation was agreed upon, wherein a target of 7.25 percent was to be achieved by the end of 1990 and 8 percent by the end of 1992.