What is Basel I Accord?
The Basel I Accord is the earliest international banking regulatory accord, established and released by the Basel Committee on Banking Supervision in 1988. The aim of the accord is to establish a set of international standards to ensure the banking sector remains healthy and stable in terms of capital adequacy and risk management.
The core requirement of the Basel I Accord is that banks must hold a certain proportion of capital to cover their risk exposure during their operational activities. Specifically, the accord requires banks to calculate their capital requirements based on the risk weights of their assets and ensure that their Tier 1 Capital Ratio is not less than 8%. Tier 1 Capital primarily includes equity and retained earnings.
The accord specifies different types of assets and businesses’ risk weights to reflect their relative risk levels. For example, cash and government bonds are considered low-risk assets with lower risk weights, while commercial loans and credit card loans, deemed high-risk assets, have higher weights. Banks are required to hold capital that matches their risk exposure, as calculated based on the asset risk weights.
Main Contents of Basel I Accord
Introduced in 1988, the main contents of the Basel I Accord include:
- Capital Adequacy Requirements: The accord specifies that banks should have a certain proportion of capital to cover their risk exposure. Banks need to maintain a Tier 1 Capital Ratio of no less than 8%, which mainly includes equity and retained earnings.
- Risk-Weighted Assets: The accord introduces the concept of risk-weighted assets, requiring banks to adjust their capital adequacy ratio according to the risk weights of different types of assets and businesses. Risk-weighted assets more accurately reflect the level of risk faced by banks.
- Capital Definition: The accord clarifies the definitions of Tier 1 and Tier 2 Capital to determine the proper categories of capital that banks can hold. Tier 2 Capital includes subordinated bonds and hybrid capital instruments.
- Minimum Capital Requirements: The accord sets forth that banks must at least maintain a certain ratio of capital corresponding to risk-weighted assets to meet minimum capital requirements. The purpose is to ensure banks have sufficient capital to face risks and protect the interests of depositors.
- Transparency and Regulatory Compliance: The accord emphasizes the importance of transparency and regulatory compliance, requiring banks to provide accurate, comprehensive information to regulatory bodies and to undergo audits and assessments.
Capital Adequacy Ratio under Basel I Accord
The Basel I Accord introduced the capital adequacy ratio as an indicator to assess the health of bank capital. The capital adequacy ratio is the ratio of a bank's core capital to its risk-weighted assets, measuring the bank's ability to endure losses in the face of risks.
According to the Basel I Accord, banks are required to maintain a Tier 1 Capital Ratio of not less than 8%. Tier 1 Capital, comprising equity and retained earnings, represents the highest level of capital that can absorb losses and support bank operations. Risk-weighted assets are the bank's total assets adjusted according to the risk weights of different types of assets and businesses.
The formula for calculating the capital adequacy ratio is as follows:
Capital Adequacy Ratio = Tier 1 Capital / Risk-Weighted Assets
For example, if a bank’s Tier 1 Capital is $1 billion, and its risk-weighted assets are $10 billion, then its capital adequacy ratio is 10% ($1 billion / $10 billion).
The purpose of the capital adequacy ratio is to ensure that banks have enough capital to maintain robust operations and protect the stability of depositors and the financial system when facing risks and pressures. A higher capital adequacy ratio means that a bank has a larger capital buffer to absorb losses and reduce the risk of bankruptcy. Under the Basel I Accord, banks are required to maintain a capital adequacy ratio that meets the minimum requirement, and based on the size and characteristics of their risk exposure, may need to maintain a higher level of capital adequacy.
Risk-Weighted Assets (RWA) in Basel I Accord
In the Basel I Accord, RWAs refer to Risk-Weighted Assets, which is the total amount of a bank's assets adjusted according to the risk weights of different types of assets and businesses to more accurately reflect the level of risk they face.
According to the Basel I Accord, different types of assets and businesses are categorized into different risk categories and assigned corresponding risk weights. Generally, high-risk assets and businesses have higher risk weights, while low-risk assets and businesses have lower risk weights.
For example, cash, central bank deposits, and government bonds are usually considered low-risk assets with lower risk weights, while commercial loans, personal loans, and credit card loans, which are higher in risk, have higher risk weights.
By weighting each asset according to its risk weight, banks can calculate the total amount of risk-weighted assets, thereby measuring the risk exposure they face. Such adjustments ensure that the capital adequacy ratio more accurately reflects the risk borne by banks and requires banks to hold capital that matches their risk exposure.
