The Basel Committee on Banking Supervision issued the first Basel accord in 1988. The committee consisted of regulatory authorities and central bank representatives that meet in Basel, Switzerland to discuss and present recommendations. The idea behind the Basel-I accord was to make sure that financial institutions had adequate capital to guard themselves against unforeseen financial losses. This requirement is known as capital adequacy. Bank failures of the past and their widespread economic impact instigated such a measure to be implemented.
The regulations of the Basel-I accord required banks to maintain an 8 percent minimum capital. The capital amount to be maintained by a financial institution is risk weighted, which means that it is solely dependent upon the risk faced by the institution. Higher the risk, higher the capital that banks will have to maintain. In the practical sense, banks had to prepare a list of risks that it could probably encounter. They also had to report these analyzed risks to the regulatory authorities. The regulation was primarily targeted towards credit risks as a result of bond defaulters and so on.
These recommendations were adopted in a lot of countries across the globe and provided a means for analytical comparative assessment. As a result, banks and other financial institutions were expected to operate with capital which higher than the minimum requirements, especially during expansion processes and other high-risk activities. It also accomplished the risk-based capital (RBC) ratio for organisations. This resulted in a significant increase in capital ratios of international banks. This catapulted to better competitive equity. However, the Basel-I accord did have its own flaws.
It did not address the practical risks faced by the financial organisations. The risk weighting structure was very generic and was not risk-specific. It also allowed regulatory capital arbitrage. All these serious shortcomings paved the way for the second Basel accord. The aims of the Basel-II were quite clear. It was put forth with fundamental banking safety in mind. It also aimed to strike an acceptable balance between risk sensitivity and implementation burden of banks. It proposed to relatively stabile capital charges over the economic cycle.
Improvements in risk measurement and management practices were also planned. It was decided to provide improved risk sensitivity where a bank would be allowed to frame its own internal assessment process for capital adequacy, thereby encouraging efficient risk management practices. It was also aimed to lay a fair platform for to allow emerging markets to flourish. However, the existing capital adequacy framework in the banking system would remain unchanged. The Basel-II accord was drafted in 1996 and it covered credit risk, market risk as well as operational risks.
The revised accord was based on the three pillars which are as follows: 1) Minimum Capital Requirements, 2) Supervisory Review and 3) Market Discipline. A supervisory review panel was put in place to monitor the risk assessment done by financial organisations. Great emphasis was also laid on corporate governance structure. Efforts were taken to ensure the robustness of the validation process for regulating the internal models of risk assessment used by financial companies. The Basel-II also stresses on increased market discipline by requesting baking organisations to distinctly disclose their accounts.
The accounting process also had to be performed at regular intervals to maintain transparency. Now, the bigger players have started to devise their own internal models to do the asses risks, under the supervision and approval of neutral bodies. Some banks have effectively implemented this methodology to a good extent. It is essential that other banks also follow suit to build up a strong banking foundation which is very essential for financial stability. However, small banks continue to use conventional methods to assess financial risks.