The foundation of the Basel banking norms is attributed to the incorporation of the Basel Committee on Banking Supervision (BCBS), established by the central bank of theG-10 countries in 1974. This was under the sponsorship of Bank for International Settlements (BIS), Basel, Switzerland.
The Committee forms guidelines and provides recommendations on banking regulation on the basis of capital risk, market risk and operational risk. The Committee was established in response to the chaotic liquidation of Herstatt Bank, based in Cologne, Germany in 1974. The incident demonstrated the existence of settlement risk in international finance.
Later, this committee was renamed as Basel Committee on Banking Supervision. The Committee acts as a forum where regular collaboration concerning banking regulations and supervisory practices between the member countries takes place. The Committee targets at developing supervisory knowhow and the quality of banking supervision quality worldwide.
Presently, there are 27 member countries in the Committee since 2009. These member countries are being represented in the Committee by the central bank and the authority for the prudential supervision of banking business. Apart from banking regulations and supervisory practices, the Committee also stresses on closing the differences in international supervisory coverage.
In 1988, the Basel Committee on Banking Supervision (BCBS) in Basel, Switzerland, announced the first set of minimum capital requirements for banks — Basel I. It completely aimed on credit risk or the default risk. That is the risk of counter party failure. It stated capital need and structure of risk weights for banks.
Under these norms assets of banks were categorized and grouped into five categories according to credit risk, carrying risk weights of 0% like Cash, Bullion, Home Country Debt Like Treasuries, 10, 20, 50 and100% and no rating. Banks with an international presence were expected to hold capital equal to 8% of their risk-weighted assets (RWA). These banks must have at least 4% in Tier I Capital that is Equity Capital + retained earnings and more than 8% in Tier I and Tier II Capital. The target was set to be achieved by 1992.
One of the major functions of Basel norms is to standardize the banking practice across all countries. Anyhow, there are major problems with definition of Capital and Differential Risk Weights to Assets across countries, like Basel standards are computed on the basis of book-value accounting measures of capital, not market values. Accounting practices vary extremely across the G-10 countries and mostly yield outcomes that differ markedly from market assessments.
Another major issue was that the risk weights do not attempt to take account of risks other than credit risks, like market risks, liquidity risks and operational risks that may be critical sources of insolvency exposure for banks.
Basel II was introduced in 2004. It speculated guidelines for capital adequacy that is with more refined definitions, risk management like Market Risk and Operational Risk and exposure needs. It also expressed the use of external ratings agencies to fix the risk weights for corporate, bank and sovereign claims.
Operational risk is defined as “the risk of direct and indirect losses resulting from inadequate or failed internal processes, people and systems or from external events”. This comprises of legal risk, but prohibits strategic and reputation risk. Thereby, legal risk involves exposures to fines, penalties, or punitive damages as a result of supervisory actions in addition to private agreements. There are complex methods to appraise this risk.
The exposure needs permit participants of market to evaluate the capital adequacy of the foundation on the basis of information on the scope of application, capital, risk exposures, risk assessment processes, etc.
It is believed that the shortcomings of the Basel II norms resulted in the global financial crisis of 2008. That is due to the fact that Basel II norms did not have any explicit regulation on the debt that banks could take on their books, and stressed more on individual financial institutions, while neglecting systemic risks.
To assure that banks don’t take on excessive debt, and that they don’t depend too much on short term funds, Basel III norms were introduced in 2010.The main objective behind these guidelines were to promote a more resilient banking system by stressing on four vital banking parameters — capital, leverage, funding and liquidity.
Needs for mutual equity and Tier 1 capital will be 4.5% and 6%, respectively. The liquidity coverage ratio (LCR) requires the banks to acquire a buffer of high quality liquid assets enough to cope with the cash outflows encountered in an acute short term stress scenario as specified by the supervisors. The minimum LCR need will be to meet 100% on 1 January 2019. This is to secure situations like Bank Run. The term leverage Ratio > 3% denotes that the leverage ratio was calculated by dividing Tier 1 capital by the bank's average total combined assets.