Basel 1 and the beginning of international financial regulation
The bankruptcy of Herstatt bank in Germany in 1974 prompted the G-10 nations to form the Basel Committee on Banking Supervision under the auspices of the Bank of International Settlements (BIS) located in Basel, Switzerland. The purpose of this committee was to publish a set of rules and regulations that the banks had to follow in order to avoid a new banking bankruptcy.
One of the main points of focus was to set up a system that could be used internationally to assess the on- and off-balance sheet risks taken by banks in the course of their business. The total value of a balance sheet (and/or of the off-balance sheet items) is indeed not a clear indicator of the risks really taken by an institution: a USD 500m senior secured loan to the Government of Canada is indeed less risky than a USD 100m junior unsecured loan to a start-up, even though the total value of the financial commitment is far greater.
In its conclusion in 1988 (a set of documents known as Basel I), the Basel Committee came up with the idea that in order to properly assess the risks taken by a bank, the value of each asset should be adjusted to the risks that it carried. The value of each asset was therefore multiplied by a factor that reflects its risk. Each class of asset was assigned a fixed risk weight. Assets of banks were classified and grouped in five categories according to credit risk, carrying risk weights of zero (for example sovereign debt), 10, 20, 50, and up to 100% (this category had most corporate debt).
Calculation of RWAs under Basel I
Suppose bank ABC has the following assets:
– EUR 1bn in French OATs,
– EUR 2bn secured by mortgages, and
– EUR 4bn of unsecured loans to businesses.
The total balance sheet of bank ABC is equal to EUR 7bn.
The risk weightings used are:
– 0% for OATs (a risk free asset),
– 50% for mortgages, and
– 100% for the corporate loans.
ABC bank’s risk weighted assets are therefore 0 × EUR 1bn + 50% × EUR 2bn + 100% × EUR 4bn = EUR 5bn.
Calculation of minimum equity requirements
Once a system had been set up to properly assess the value of the on- and off- balance sheet commitments of a bank based on their risk weightings, the main purpose of Basel I was to make sure that the banks could not take an unlimited amount of risk. Basel I’s main recommendation was therefore that each bank should hold enough capital to equal at least 8% of its risk-weighted assets.
ABC bank’s risk weighted assets are EUR 5bn. As a consequence, the minimum total value of capital to be held by ABC bank is 8% × EUR 5bn = EUR 400m. Under Basel 1, capital was defined as the sum of Equity Tier 1 and Tier 2, i.e as the sum of ordinary shares, preferred shares, share premium and retained earnings (Tier 1) and hyrbid and subordinated debt (Tier 2).
The rest of ABC bank’s balance sheet (EUR 6.6bn) can be financed by loans from other banks, by clients’ deposits or even by capital, the 8% threshold being only a minimum.
Basel 1 provided an efficient tool to compare banks across different geographies and to assess their on- and off-balance-sheet risks (two banks with the same balance sheet size could indeed have a very different risk profile depending whom they were lending to). The main limits of the system however was that risks were only assessed on a credit risk basis (there was no reference to operational or market risks) and that it was not compulsory for banks to follow theses rules. Basel 1 was indeed only a set of recommendations and each government was totally free to implement them or not.