Basel Framework in Layman Terms
The Basel Framework is a set of international banking regulations created to make the banking system more stable and secure. It provides guidelines for banks to manage their risks, maintain adequate capital, and ensure they have enough funds to handle unexpected losses.
The framework has evolved over time, with different versions known as Basel I, Basel II, and Basel III. Each version introduced new rules and requirements to address weaknesses in the banking sector and respond to financial crises.
In simple terms, here’s what the Basel Framework aims to achieve:
- Capital Adequacy: Banks are required to have enough capital to cover potential losses. Capital acts as a financial cushion, protecting depositors and ensuring banks can absorb losses without collapsing. The Basel Framework establishes minimum capital requirements that banks must meet.
- Risk Management: Banks must assess and manage their risks effectively. The framework encourages banks to have robust risk management processes, including identifying, measuring, and monitoring risks. This helps banks make informed decisions and prevents excessive risk-taking.
- Supervision and Regulation: The Basel Framework promotes effective supervision and regulation of banks by authorities. Regulators monitor banks’ compliance with the framework, assess their risk profiles, and take necessary actions to ensure banks are operating safely and soundly.
- Disclosure and Transparency: Banks are required to provide clear and accurate information about their financial health, risk exposures, and risk management practices. This promotes transparency, helps investors and stakeholders make informed decisions, and fosters market discipline.
- Liquidity Management: The Basel Framework introduced rules to ensure banks have enough liquid assets to meet their short-term obligations, even during periods of financial stress. This helps prevent liquidity crises and ensures banks can meet customer withdrawals and payment obligations.
The Basel Framework is an ongoing international effort to maintain a stable and resilient banking system. It continues to evolve as regulators and policymakers address new challenges and risks in the financial industry.
Overview of Basel I, II and III
Basel I (1988)
- In effect since 1988
- Very simple in application
- Easy to achieve significant capital reduction with little or no risk transfer
- Issue: Overly simple rules were subject to “regulatory arbitrage” and poor risk management
Basel II (2004)
- In effect since 2004
- More risk sensitive
- Treats both exposures and banks very unequally
- Issue: Profoundly altered bank behaviour but contained “gaps” that banks exploited
Basel III (2010-2019)
- Fully implemented only in 2022
- Addresses perceived shortcomings of Basel II
- Greatest impact on trading book, bank liquidity and bank leverage
- Issue: Will increase capital charges materially and make certain banking activities much more capital intensive
Basel I was the first regulatory framework introduced by the BCBS. It focused primarily on credit risk and established minimum capital requirements for banks. Under Basel I, banks were required to maintain a minimum capital adequacy ratio (CAR) of 8% of their risk-weighted assets. It classified assets into four risk categories (0%, 10%, 20%, or 100% weightings) based on their credit risk. While it established a standardized framework, Basel I was criticized for oversimplification and inadequate risk sensitivity.
Basel II aimed to enhance the risk sensitivity and accuracy of capital requirements. It introduced a three-pillar approach to risk management:
Pillar 1: Minimum Capital Requirements: Similar to Basel I, Pillar 1 focused on credit risk and expanded to incorporate operational risk. It introduced more sophisticated methods for calculating risk weights and capital requirements based on credit ratings, internal models, or standardized approaches.
Pillar 2: Supervisory Review Process: Basel II emphasized the importance of banks’ internal risk management and required regulators to assess and review banks’ risk management processes regularly. Banks were expected to develop their own internal models to quantify risks and align their capital levels with their individual risk profiles.
Pillar 3: Market Discipline: Pillar 3 aimed to enhance transparency and disclosure practices. Banks were required to publish information on risk exposure, capital adequacy, and risk management practices to enable market participants to assess their risk profiles.
Basel III was introduced as a response to the global financial crisis of 2008. Its primary objective was to strengthen the banking sector’s resilience and address shortcomings in risk management practices. Basel III implementation began in 2013 and continued in stages until 2019. The framework has undergone subsequent revisions, and additional updates may occur in the future to adapt to evolving risks and challenges in the banking industry.
- Higher Capital Requirements: Basel III raised the minimum CAR and introduced additional capital buffers to absorb losses during periods of financial stress. It mandated a common equity tier 1 (CET1) capital ratio of at least 4.5% and a total CAR of 8%, with additional capital buffers for systemically important banks.
- Liquidity Standards: Basel III introduced liquidity standards to ensure banks maintain sufficient liquidity buffers to withstand periods of market stress. It introduced the Liquidity Coverage Ratio (LCR), which requires banks to hold high-quality liquid assets to cover short-term liquidity needs.
- Leverage Ratio: Basel III introduced a non-risk-based leverage ratio as a supplementary measure to the risk-based CAR. It aims to constrain excessive leverage by setting a minimum level of capital to total exposure.
- Counterparty Credit Risk: Basel III introduced additional requirements for managing counterparty credit risk arising from derivatives and other transactions.
Basel III implementation began in 2013 and continued in stages until 2019. The framework has undergone subsequent revisions, and additional updates may occur in the future to adapt to evolving risks and challenges in the banking industry.
To learn more about analysing bank performance and how bank manage risks under Basel III, click the following:
- Funding and Liquidity, Asset Quality, Capitalisation and Leverage, Earnings and Profitability
- Liquidity requirements
- Regulatory capitals and the ratios
As of this writing, there is no official Basel IV framework established by the Basel Committee. Basel IV is a term that has been used informally to refer to potential future revisions and enhancements to the Basel III framework. It represents the possibility of further updates to the regulatory standards for banks. The term “Basel IV” has been used in discussions and debates to suggest the potential direction of future regulatory reforms. These discussions have included topics such as the treatment of risk-weighted assets, capital requirements, leverage ratios, and additional measures to address systemic risks.
Here are some of the key provisions of Basel IV:
- Increased capital requirements: Banks will be required to hold more capital against their risk-weighted assets. This will make them more resilient to shocks and less likely to fail.
- New risk-assessment framework: Banks will be required to use a more sophisticated risk-assessment framework when calculating their RWAs. This will take into account a wider range of factors, such as the creditworthiness of borrowers and the liquidity of assets.
- New capital requirements for derivatives: Banks will be required to hold more capital against their derivative exposures. This will reduce the risk of systemic risk in the financial system.