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Basel Accord Definition
The Basel Accords refer to a set of banking regulations that gives recommendations with respect to market risk, capital risk, and operational risk. The Basel Accords are set by the Basel Committee on Bank Supervision (BCBS) to guide financial institutions on capital risk, market risk, and operational risk. BCBS acts as a supervisory authority for banks, this authority ensures that banks have enough liquidity to meet their financial obligations and liabilities.
A Little More on What is the Basel Accord
The Basel Accords comprises a series of banking regulations names Basel I, Basel II and Basel III. These sets of regulations are internationally agreed upon as a response to the Financial Crisis in the banking industry. These banking regulations were created by the ten largest economies. The Basel Committee on Bank Supervision (BCBS) was established in 1974 to act as the supervisory authority over banking matters.
When it was established, the objective of BCBS was to enhance the financial stability of banks and improve the quality of banks through adequate banking supervision. BCBS also ensures that banks have enough capital to absorb risks and perform their obligations.
Basel I is the first Basel Accord, which was issued in 1988 to ensure the capital adequacy of banks and financial institutions. This Basel Accord was a response to the capital risk that financial institutions were exposed to. Given that banks are expected to face unexpected losses, they must possess enough capital to withstand the risk. The Basel I accord stipulates that banks have a capital adequacy risk weight of 8% or less before they operate.
Assets owned by financial institutions are grouped into five risk categories which are; 0%, 10%, 20%, 50%, and 100%.
Basel II is otherwise known as the Revised Capital Framework given that it is an updated version of the original Basel Accord. This second Base Accord has three key focus areas which are capital requirements, capital adequacy and the use of disclosure. Basel II sets the minimum capital requirements for banks and financial institutions, it also oversees the assessment process of capital adequacy and ensures that sound market practices exist in the banking sector.
Basel III was third the Basel Accord that was created as a response to the 2008 financial crisis. After the 2008 crisis. The supervisory authority, BCBS set up Basel II as a way of strengthening the existing accords. This accord proffers solution to inadequate management, bad governance, and poor structures that wretched the financial industry. The three focus areas of Basel II were maintained and continued by Basel III, this accord also introduced additional regulations and requirements for financial institutions.
The implementation of Basel III commenced in January 2013 and this implementation is expected to be fully achieved in January 2019.
Reference for “Basel Accord”
Academics research on “Basel Accord”
Procyclicality and the new Basel Accord-banks’ choice of loan rating system, Catarineu-Rabell, E., Jackson, P., & Tsomocos, D. P. (2005). Procyclicality and the new Basel Accord-banks’ choice of loan rating system. Economic Theory, 26(3), 537-557. The Basel Committee on Banking Supervision is proposing to introduce, in 2006, new risk-based requirements for internationally active (and other significant) banks. These will replace the relatively risk-invariant requirements in the current Accord. The new requirements for the largest bank will be based on bank ratings of the probability of default of the borrowers. There is evidence that the choice of loan ratings which are conditional on the point in the economic cycle could lead to sharp increases in capital requirements in recessions. This makes the question of which rating schemes banks will use very important. The paper uses a general equilibrium model of the financial system to explore whether banks would choose to use a countercyclical, procyclical or neutral rating scheme. The results indicate that banks would not choose a stable rating approach, which has important policy implications for the design of the Accord. It makes it important that banks are given incentives to adopt more stable rating schemes. This consideration has been reflected in the Committee’s latest proposals, in October 2002.
The effect of the Basel Accord on bank portfolios in Japan, Montgomery, H. (2005). The effect of the Basel Accord on bank portfolios in Japan. Journal of the Japanese and international economies, 19(1), 24-36. This study investigates the hypothesis that stricter capital adequacy requirements introduced under the Basel Accord caused Japanese banks to alter their portfolios away from heavily weighted risk assets such as loans and corporate bonds and into unweighted assets such as government bonds. Using a panel of Japanese bank balance sheets for fiscal years 1982–1999, this study finds that neither international nor domestic bank asset portfolios are strongly affected by the total regulatory capital ratio. However, there is clear evidence that international bank asset portfolios are highly sensitive to the core tier I capital requirement. International banks with relatively low core capital ratios tend to reduce heavily risk weighted assets such as loans and substitute into unweighted low-risk assets such as government bonds. International banks with relatively low core capital ratios also tend to issue more subordinated debt, which counts toward tier II capital. This sensitivity of international bank portfolios to capitalization is only observed in the post-Basel period since 1988, indicating that the regulatory changes implemented under the Accord significantly affected the behavior of international banks. There is no evidence that the portfolios of domestic banks were affected by the Accord. J. Japanese Int. Economies19 (1) (2005) 24–36.
The macroeconomic implications of the new Basel Accord, Tanaka, M. (2003). The macroeconomic implications of the new Basel Accord. CESifo Economic Studies, 49(2), 217-232. This paper assesses the macroeconomic implications of Basel II in light of recent development in the literature. It argues that although Basel II is likely to strengthen banks’ incentives to control their risk-taking, it may reduce credit supply to certain borrowers, such as small- and medium-sized enterprises (SMEs) and firms based in developing countries. Furthermore, Basel II may increase procyclical fluctuation of bank loans while weakening the monetary transmission mechanism during recessions. A widespread adoption of the “through-the-cycle” risk models may mitigate these problems, but not completely eliminate them. This paper also considers whether monetary policy can be used to counter effectively the procyclicality problem inherent in Basel II. (JEL E 52, G 21, G 28)
The impact of the 1988 Basel Accord on banks’ capital ratios and credit risk-taking: an international study, Van Roy, P. (2005, July). The impact of the 1988 Basel Accord on banks’ capital ratios and credit risk-taking: an international study. In EFMA 2004 Basel Meetings, Forthcoming. The purpose of this paper is to see whether and how G-10 banks have complied with the 1988 Basel Accord. The interest of this study lies in the fact that the standardized approach to credit risk in the New Basel Accord is conceptually similar to the 1988 agreement. However, very little is known about the reaction of non-US banks to the imposition of minimum capital requirements that make use of risk-weight categories. Building on previous studies, this paper uses a simultaneous equations model to analyze adjustments in capital and credit risk at banks from G-10 countries over the 1988-95 period. The results show that regulatory pressure was successful in raising the capital to assets ratios of undercapitalized banks in Canada, Japan, the UK and the US but not in France and Italy. In addition, there is no evidence that undercapitalized G-10 banks increased or decreased their credit risk over the period studied. Interestingly, these findings are robust to the inclusion of a variable measuring the role of market discipline in influencing bank capital and risk choices. All in all, the results suggest that the 1988 Basel standards were effective in that, subsequent to their adoption, undercapitalized G-10 banks generally increased their capital but not their credit risk.
Capital shocks, bank asset allocation, and the revised Basel Accord, Jacques, K. T. (2008). Capital shocks, bank asset allocation, and the revised Basel Accord. Review of Financial Economics, 17(2), 79-91. In contrast to the 1988 Basel Accord (Basel I), the revised risk-based capital standards (Basel II) propose regulatory capital requirements based on credit ratings. This paper develops a theoretical model to analyze how banks will adjust their low and high credit risk commercial loans under the proposed newer standard. Capital-constrained banks respond to an adverse capital shock by reducing high credit risk loans, while under certain circumstances, low credit risk loans may actually increase. When compared to Basel I, it is shown that high-risk loans are reduced more under Basel II, but whether a bank reduces total lending more under Basel I or under the revised standards depends on a complex interaction of factors.