The Basel Committee and Basel I · RiskAtoms Academy

By the end you will be able to

1Explain why the Basel Committee was set up and why it agreed a common capital standard in 1988.
2Calculate a bank's risk-weighted assets and its Basel I capital ratio against the 8% minimum.
3Tell Tier 1 from Tier 2 capital under Basel I, and apply the limit on Tier 2.
4Explain the weaknesses of Basel I that led to the 1996 market risk amendment and to Basel II.

Why it matters

In 1988 a committee of central bankers agreed one number: 8%. Within a few years, banks in almost every country with an international banking sector were measuring themselves against it. Where did it come from, and what does it measure?

Core explanation

One ratio for the world's banks

You met the Basel Committee on Banking Supervision (BCBS) in L1.2.09: Regulators and supervisors: a standard setter with no legal power, whose members write its rules into national law. Here is how it got its first big rule.

The committee. The central bank governors of the Group of Ten (G10) countries set it up at the end of 1974, after the disorderly failure of Bankhaus Herstatt in Germany. Its first job was cooperation: the 1975 Concordat agreed how home and host supervisors share the work of watching a bank with branches abroad. Membership widened over time, notably in 2009. Today it includes Asia-Pacific members such as Australia, China, Hong Kong SAR, India, Indonesia, Japan, Korea and Singapore, alongside the Americas, Europe, Saudi Arabia, South Africa and Turkey.

Why a capital standard? In the early 1980s the Latin American debt crisis hit the world's large banks, and the committee was worried that their capital had been falling. There was a second worry: banks from different countries competed for the same business under different rules, and a bank allowed thinner capital could lend more cheaply. The answer was the Basel Capital Accord of July 1988, now called Basel I. It aimed both to make banks safer and to give them a level playing field. Member countries were to apply it by the end of 1992.

The idea. Capital should match risk, so a bank needs more capital for a loan to a company than for a holding of government bonds. The Accord gave each kind of exposure a risk weight, from 0% to 100%. Multiply each exposure by its weight and add up: the total is risk-weighted assets (RWA), the same denominator you used in L1.8.06: Capital, equity and leverage. Capital had to be at least 8% of RWA.

Weight	Main exposures (Basel I, 1988)
0%	Cash; claims on central governments and central banks of OECD countries
20%	Claims on banks in OECD countries; claims on multilateral development banks
50%	Loans fully secured by a mortgage on a home that the borrower lives in or rents out
100%	Claims on companies and households; premises; most claims on non-OECD governments and banks

Some exposures are not on the balance sheet at all, such as a promise to lend if the customer asks. Basel I first turned these into a loan equivalent with a credit conversion factor (50% for an undrawn commitment of more than a year, for example), then applied the borrower's weight.

What counts as capital. Basel I split capital into two tiers. Tier 1 (core capital: shares and retained profits) had to be at least 4% of RWA. Tier 2 (supplementary capital, such as some reserves and subordinated debt) could make up the rest of the 8%, but counted only up to the amount of Tier 1. Basel III later tightened these definitions, giving the CET1 you met in L1.8.06: Capital, equity and leverage.

Sort itWhich Basel I weight?

Give each exposure its 1988 risk weight.

US Treasury bills held by a bank in Chicago.
A loan to a large bank in Germany.
A mortgage on a family home in Toronto, lived in by the borrower.
A loan to a top-rated global carmaker.
A bond issued by the World Bank.
The bank's own head office building.

The formal version

This is the ratio from L1.8.06: Capital, equity and leverage, with Basel I's own weights. Risk-weighted assets add up each exposure $A_i$ times its weight $w_i$ ; an off-balance sheet item is first multiplied by its conversion factor $\text{CCF}_j$ :

\text{RWA} = \sum_i w_i A_i \;+\; \sum_j w_j \,\text{CCF}_j\, B_j

Then the two tests:

\frac{\text{Tier 1} + \min(\text{Tier 2},\ \text{Tier 1})}{\text{RWA}} \ge 8\%, \qquad \frac{\text{Tier 1}}{\text{RWA}} \ge 4\%

Derived in a few lines rather than animated: the sum over weighted assets was built step by step in L1.8.06: Capital, equity and leverage. The percentages are explained in M-A01: Percentages.

Try it

This is Lakeside Bank, the bank in the worked example. Move US$10bn from mortgages into company loans and watch RWA. Then push Tier 2 above Tier 1 and see what stops counting.

Try itA Basel I calculator

Exposure and weightAmountUS$bnRWA

Cash0%0.05

Bonds of OECD central governments0%0.020

Loans to banks in OECD countries20%2.010

Residential mortgages50%15.030

Loans to companies100%30.030

Premises and other fixed assets100%5.05

Undrawn commitments to companies, over 1 year50% × 100%5.010

On a phone the figure on the right of each row is its RWA. The undrawn commitment is off the balance sheet: it is first converted at 50%, then weighted.

Tier 1 capitalUS$3.5bn

Tier 2 capitalUS$2.0bn

Balance sheet assetsUS$100bn

Risk-weighted assetsUS$57.0bn

Capital needed (8%)US$4.56bn

Total capital ratio9.65%

Tier 1 ratio (min 4%)6.14%

Meets Basel I

Worked example

Lakeside Bank under Basel I

Lakeside Bank, a made-up US lender, has US$100bn of assets, an undrawn US$10bn commitment to lend to companies over more than a year, US$3.5bn of Tier 1 capital and US$2.0bn of Tier 2.

From balance sheet to capital ratio

Step 1 of 5

1

Weight each exposure

Exposure	US$bn	Weight	RWA
Cash	5	0%	0.0
Bonds of OECD central governments	20	0%	0.0
Loans to banks in OECD countries	10	20%	2.0
Residential mortgages	30	50%	15.0
Loans to companies	30	100%	30.0
Premises and other fixed assets	5	100%	5.0
Undrawn commitments to companies, over 1 year	10	50% × 100%	5.0
Total			57.0

Regulatory lens

Basel I was simple, and that was its strength and its weakness. Open each card to see what went wrong.

Sparks

SparkThe Cooke ratio

In its early years the 8% ratio was often called the Cooke ratio, after Peter Cooke of the Bank of England, who chaired the Basel Committee from 1977 to 1988 and steered the Accord through. Bankers still use the name now and then for the basic capital-to-RWA test.

SparkA rule that spread beyond its members

Basel I was written for internationally active banks in the G10. The BIS history notes that it was introduced not only in member countries but in virtually all countries with active international banks. A rule with no legal force became a global norm because markets and supervisors used it as a yardstick.

Key takeaways

The BCBS was set up by G10 central bank governors at the end of 1974; it now includes members from every continent, among them major Asia-Pacific economies.
Basel I (July 1988) required capital of at least 8% of risk-weighted assets, with Tier 1 of at least 4%, by the end of 1992.
Risk weights ran from 0% (cash, OECD governments) through 20% (OECD banks) and 50% (home mortgages) to 100% (companies).
Tier 2 capital counted only up to the amount of Tier 1.
Flat weights invited regulatory arbitrage, and the Accord covered only credit risk until the 1996 market risk amendment.

Reaction

Check what stuck

Question 1 · objective 2

A bank holds US$40bn of OECD government bonds, US$25bn of loans to OECD banks, US$20bn of residential mortgages and US$15bn of company loans. What are its risk-weighted assets under Basel I, in US$ billions?

US$bn

Question 2 · objective 2

For that bank, what is the minimum total capital under Basel I, in US$ billions?

US$bn

Question 3 · objective 3

A bank has US$2bn of Tier 1 capital, US$3bn of Tier 2 and US$50bn of RWA. What is its Basel I total capital ratio, in %?

%

Question 4 · objective 4

Under Basel I, a loan to a top-rated multinational and a loan to a struggling small firm:

ABoth carry a 100% risk weight, so they need the same capitalBCarry 20% and 100% weightsCCarry 0% and 100% weightsDAre both excluded from risk-weighted assets

Question 5 · objective 1

Why did the Basel Committee write a common capital standard in the 1980s?

ATo set interest rates across member countriesBBecause capital at major international banks had fallen, and banks in different countries competed under different rulesCBecause the IMF required itDTo replace national supervisors

Glossary

Basel I: The Basel Capital Accord of July 1988, now called Basel I: the first international standard for bank capital.
Risk weight: A percentage that scales an exposure by how risky the rule treats it: 0% for the safest, 100% for ordinary loans.
Risk-weighted assets: Risk-weighted assets: each exposure multiplied by its risk weight, added up.
Credit conversion factor: Credit conversion factor: the share of an off-balance-sheet item, such as an undrawn loan promise, treated as if it were a loan.
Tier 1 (Basel I): Under Basel I, core capital: mainly paid-up shares and disclosed reserves (retained profits).
Tier 2 (Basel I): Under Basel I, supplementary capital such as some reserves and subordinated debt. It counted only up to the amount of Tier 1.
Level playing field: A level playing field: banks in different countries competing under the same basic rules.
Regulatory arbitrage: Changing what a bank holds, or how it is booked, to cut its capital requirement without cutting its true risk.

Deep Dives & Origins

Deep Dives

Goodhart, The Basel Committee on Banking Supervision: A History of the Early Years, 1974–1997, Cambridge University Press, 2011. Intermediate.
Hull, Risk Management and Financial Institutions, Wiley, the chapter on the Basel regulations. Intermediate.

Origins

Basel Committee on Banking Supervision, International convergence of capital measurement and capital standards, BIS, July 1988.
Basel Committee on Banking Supervision, Amendment to the capital accord to incorporate market risks, BIS, January 1996.
Basel Committee on Banking Supervision, “History of the Basel Committee”, BIS website.
Basel Committee on Banking Supervision, Report to the governors on the supervision of banks' foreign establishments (the Concordat), September 1975; revised as Principles for the supervision of banks' foreign establishments, May 1983.

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