Trying to Understand Basel I, Basel II, Basel III, and Basel IV? We Can Help!
Basel regulations may not be something you have ever heard of. Basel 1, Basel 2, Basel 3, or Basel 4 may feel irrelevant to you unless you own a bank. After all, is knowing what the Basel III Leverage Ratio important when you have bills to pay?
Actually, it just may be!
Sometimes, understanding complex financial concepts and regulations can be difficult for those outside of the financial world. Since these concepts affect everyone’s money, however, they affect everyone’s lives. It is important to learn them.
Our goal here is to help you do just that when it comes to Basel regulations.
Here is your guide to Basel I, Basel II, Basel III, and the talks of a future Basel IV.
Throughout this guide, we will take the time to:
- Define and go through all terms and concepts that have to do with these regulations
- Offer a Basel I summary, Basel II summary, and Basel III summary
- Explain why people are now talking about Basel 4
At the end, you should be able to better understand these financial regulations. You will also be able to see how Basel capital requirements affect you and your money.
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The Basel Committee on Banking Supervision (BCBS)
To understand Basel I, Basel II, Basel III, and Basel IV, we first need to talk about the organization creating these regulations.
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The Basel Committee on Banking Supervision (BCBS) was established in 1974. They create Basel regulations to help countries better supervise their banking practices.
According to the Bank for International Settlements, the role of the BCBS is as follows:
- Exchanging information on developments in the banking sector and financial markets
- Sharing supervisory issues, approaches, and techniques
- Establishing and promoting global standards
- Addressing regulatory and supervisory gaps
- Monitoring the implementation of the BCBS standards
- Consulting with central banks and bank supervisory authorities that are not members of the BCBS
- Coordinating and cooperating with other financial sector standard setters and international bodies
The Basel regulations created by the BCBS are for the “Group of Ten” and include:
- Belgium
- Canada
- France
- Germany
- Italy
- Japan
- Netherlands
- Sweden
- Switzerland
- United Kingdom
- United States
In 2017, the BCBS will meet on:
- March 1-2
- June 14-15
- September 13-14
- December 6-7
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What Are The Basel Accords?
The Basel accords are sets of agreed-upon banking rules. These rules are put forth by the Basel Committee on Bank Supervision.
Each has multiple layers of Basel regulations to make sure:
- There is not too much risk
- There is always enough capital to pay for any obligation or loss that could potentially occur
This also allows international banks to have a more unified set of guidelines. Now there can be uniform ways to manage the finances and economic issues of the world’s banking systems.
We will go into more details about the rules each of the three accords brought about with each summary below. Then we will talk about the possible rules that can come from Basal 4 in the future.
You will see that the rules become stricter and more specific as the banking industry changes and evolves over the years.
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Important Definitions to Understand Basel Regulations:
The best way to make harder financial concepts easier is through simple definitions. Feel free to jump up to this definition key anytime throughout reading our guide to Basel 1 – Basel 4.
- Asset: Something owned that has value and can be used to pay a debt or commitment
- Capital: Capital is simply wealth; this could be money or other assets
- Risk-weighted assets: This term refers to how many assets banks must have to prevent or reduce the chance of not being able to meet financial obligations
- Liquidity: How much cash assets are available right now
What Are Basel Capital Requirements?
We have one more important definition. When we look through Basel 1 – Basel 4, we will frequently mention Basel capital requirements. To make everything easier, let’s define them.
Capital Requirements Definition: The amount of financial assets (money) a financial institution (like a bank) is required by a regulator to hold.
In the case of Basel capital requirements, that regulator is the BCBS. The purpose of a capital requirement is:
- To make sure these financial institutions are not at an overwhelming risk of defaulting on investments.
- To make sure they have enough money to operate even if they give withdrawals to their customers.
These Basal regulations have been changed/altered at different times, which have brought us:
- Basel I
- Basel II
- Basel 2.5
- Basel III
And now there are talks about a future Basel 4. We will dive into this topic at the end.
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Basel 1: What You Need to Know
In 1988, the BCBS brought forth their first set of Basal regulations, after a debt crisis in Latin America raised concerns of capital ratios among international banks. Basel I was all about credit risk and a classification system for bank assets.
Basel I Summary
This first Basal accord did the following:
- Created bank asset classification (5 separate risk categories)
- Created regulation for capital ratio, that is, how assets needed to be balanced properly with risks
- Defined capital with two tiers: core capital (like stock) and supplementary capital (like investment gains)
The bank’s Basel capital requirements had to be at least 8% of whatever it had in risk-weighted assets. In simple calculations, if a bank had $100 of risky assets, it would need to keep $8 in capital for protection.
Problems with this model were believed to be from its “over-simplified calculations and classifications.”
But this accord was created for evolution. It was necessary, then, to adjust and move into Basel II.
Basel II: Everything You Need to Know
Basel 2 came about to help correct some over-simplification of Basel 1. Not to mention that new methods of finance were continuously growing. Basel II was all about creating more complex models for capital regulations/requirements to meet that growth.
Basel II Summary
Basel 2 did the following main things. These three points are often called the “pillars” of Basel 2.
- Pillar 1: Minimum capital requirements. More risk; more capital requirements. While the banks had to keep their 8% minimum capital requirement with Basel 2, that capital was further divided into Tier 1, Tier 2, and Tier 3 to bring up Basel capital requirements when necessary.
- Pillar 2: Supervision. Adding extra supervision over the regulations was also included in Basel 2.
- Pillar 3: Market discipline. Market discipline was introduced in Basel 2 with disclosure requirements – mandating disclosure of particular bank activities be made twice each year.
While Basel 2 started out in 2004, it was still slowly being implemented in 2008 – right at the time of financial hardship in the Group of Ten countries. The time the United States was entering their recession.
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Is There a Basel 2.5?
Before we move on to Basel 3, let’s take a quick look at the mid-way point – Basel 2.5. While Basel 1, 2, and 3 are technically the only true accords that exist, some small changes happened in between Basel 2 and Basel 3.
These changes are often referred to as Basel 2.5.
Basel 2.5 was a revision of some of the aspects of Basel 2. As Market Realist points out, they believed “the existing norms often failed to correctly address the market risks that banks took on their trading books.”
What Basel 2.5 did, then, was update Basel 2’s regulatory Basel capital requirements when it came to market trading risks.
Ultimately, however, the largest and most important changes actually came through Basel 3. Let’s look at the main difference between Basel 2 and Basel 3.
Basel III: Everything You Need to Know
What is the difference between Basel 2 and Basel 3?
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Let’s take a look at Basel III. This accord came right after the financial crisis around 2008. In response, the BCBS created new Basel regulations to help manage the financial stress at the individual bank level.
Basel III Summary
Here is a Basel III summary of the changes and Basel III capital requirements bringing a closer look at the difference between Basel 2 and Basel 3 – namely, higher standards overall for commercial banks.
- Basel III capital requirements were stricter than Basel II.
- Basel III ratios for risk-weighted assets were strengthened.
- The Basel III Leverage Ratio was introduced. The equation is actually simple: divide capital (money) by total consolidated assets. The minimum percentage allowed to come from this calculation is the Basel III Leverage Ratio; today the ratio is at 6% or 5% depending on the type of institution.
- New ways to guard against issues that arise from the cyclical nature of banks were included in Basel III. For example, during certain cycles, banks had to have more capital set aside.
- A Liquidity ratio was also implemented. This would provide enough money in case of any 30-day time of financial stress.
Basel III is still being implemented currently. The actual start date is not until 2019.
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Basel IV: The Future of Basel Regulations
Since Basel III and the Basel III capital requirements are still not even fully implemented, what is Basel 4? As the banking world grows and changes quickly, some realize that even tighter regulations than those in Basel III may be needed.
Basel 4 would be the response to those needs.
Basel 4 Summary
At this point, any ideas associated with Basel 4 are just that – ideas. That being said, some of the possible requirements in Basel 4 could be:
- A stricter leverage ratio (stricter than the Basel III leverage ratio)
- Simple models for calculations
- Even more disclosure for transparency among international banks
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Basel Regulations and You
Now that you have some basic knowledge about what Basel 1, Basel 2, Basel 3, and the potential Basel 4 are, it is time to see exactly what this means for our world today.
Of course, if you are in any banking or financial line of work, or want to be in those fields, understanding these concepts is vitally important.
But for the average consumer, they play a role, too.
Your money is in these banks. Your investments are through these banks. When they make choices to help lessen risk or increase transparency through disclosure, your money becomes safer.
Many people even suggest that Basel II had a lot to do with the financial crisis that came in the late 2000s.
Conclusion: Understanding Basel 1 – Basel 4
Now we have a clearer understanding on what the Basel capital requirements are over the three variations, and what Basel 4 may add to the picture.
If you are interested in getting a more detailed look at each of these accords, you can find the documents laying out Basel II, Basel 2.5, and Basel III for each of the countries under their jurisdiction on the Bank for International Settlements website.
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