What are the Basel Accords, and how do Basel I, II, and III differ in their approach to bank capital requirements?

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AcadiFi · Accepted Answer

The Basel Accords are international banking regulations developed by the Basel Committee on Banking Supervision (BCBS). Each iteration addressed shortcomings revealed by financial crises. For FRM Part I, you need to understand the evolution and key features of each.

**Basel I (1988) — The Foundation**

**Problem it solved:** Before Basel I, banks in different countries had wildly different capital standards, creating competitive distortions.

**Key features:**
- Introduced the **minimum capital ratio of 8%** (capital / risk-weighted assets)
- Simple risk-weight categories:
  - 0%: Government bonds (OECD)
  - 20%: Bank claims
  - 50%: Residential mortgages
  - 100%: Corporate loans

**Example:** Pemberton National Bank holds:
- $500M in US Treasuries (0% weight) → RWA = $0
- $200M in bank loans (20% weight) → RWA = $40M
- $300M in mortgages (50% weight) → RWA = $150M
- $400M in corporate loans (100% weight) → RWA = $400M
- Total RWA = $590M
- Required capital = 8% × $590M = **$47.2M**

**Shortcoming:** Too simplistic — a AAA corporate loan had the same 100% weight as a CCC loan. This created perverse incentives: banks held riskier assets within each bucket to maximize return on capital.

**Basel II (2004) — Three Pillars**

Basel II introduced a much more sophisticated framework:

**Pillar 1 — Minimum Capital Requirements**
- **Credit risk:** Banks could use standardized ratings-based weights OR internal ratings-based (IRB) models
- **Market risk:** Value at Risk (VaR) with a 10-day horizon and 99% confidence
- **Operational risk:** New category — losses from failed processes, systems, fraud. Three approaches: Basic Indicator, Standardized, Advanced Measurement

**Pillar 2 — Supervisory Review**
- Regulators evaluate whether banks' internal risk assessments are adequate
- Can require additional capital beyond Pillar 1 minimums

**Pillar 3 — Market Discipline**
- Banks must publicly disclose risk exposures, capital adequacy, and risk management practices
- Transparency allows the market to impose discipline

**Shortcoming:** Basel II was finalized just before the 2008 financial crisis. It failed because:
- VaR models dramatically underestimated tail risk
- Pro-cyclicality: capital requirements shrank during booms (lower measured risk) and surged during crises
- No regulation of liquidity risk
- Insufficient quality of capital (too much Tier 2 and hybrid instruments)

**Basel III (2010-2019, phased in through 2028) — Post-Crisis Reform**

Basel III dramatically tightened capital and added new requirements:

**Higher Capital Quality:**
- Common Equity Tier 1 (CET1) minimum: **4.5%** (up from ~2% effective)
- Tier 1 capital minimum: **6%**
- Total capital minimum: **8%**

**New Capital Buffers:**
- **Capital Conservation Buffer (CCB):** 2.5% CET1 above the minimum
- **Countercyclical Buffer:** 0-2.5% CET1, set by national regulators during credit booms
- **G-SIB surcharge:** 1-3.5% additional CET1 for globally systemically important banks

Effective minimum for a large bank: 4.5% + 2.5% + up to 2.5% + up to 3.5% = potentially **13%+ CET1**

**New Liquidity Requirements:**
- **LCR (Liquidity Coverage Ratio):** High-quality liquid assets must cover 30 days of net cash outflows
- **NSFR (Net Stable Funding Ratio):** Stable funding must exceed required stable funding over 1 year

**Leverage Ratio:**
- Minimum 3% Tier 1 capital / total exposure (non-risk-weighted backstop)

**Summary Table:**

| Feature | Basel I | Basel II | Basel III |
|---|---|---|---|
| Risk sensitivity | Low | High | High |
| Operational risk | No | Yes | Yes |
| Liquidity rules | No | No | Yes (LCR, NSFR) |
| Leverage ratio | No | No | Yes (3%) |
| Capital quality focus | Low | Moderate | High (CET1) |
| Countercyclical tools | No | No | Yes |

**Exam Tip:** FRM Part I focuses on the conceptual framework and key ratios rather than granular calculation details. Know the three pillars of Basel II, the major additions in Basel III (buffers, LCR, NSFR, leverage ratio), and why each iteration was needed.

Dive deeper into regulatory capital with our FRM Part I course materials.

What are the Basel Accords, and how do Basel I, II, and III differ in their approach to bank capital requirements?

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