This document presents the results of the Committee's work on the international convergence of regulations governing the capital adequacy of banks. It establishes a framework for measuring capital adequacy and defines the minimum standard ratio to be achieved by national authorities. The aim is to strengthen the stability of the international banking system while reducing competitive inequalities among…
This document entitled "International Convergence of Capital Measurement and Capital Standards" (Basel Accord I) was published in July 1988 by the Basel Committee on Banking Supervision, composed of central and banking supervisory authorities from G-10 countries. It presents a harmonized international framework for measuring the adequacy of capital of international banks. The scope covers international banks from G-10 member countries, focusing on credit risk management and defining minimum capital standards to be reached by the end of 1992. The document comprises 30 pages and details the components of capital, risk weightings, the target ratio, and transitional application modalities (p. 1-30).
The document addresses the establishment of a common international framework to measure the adequacy of capital of international banks, aiming to strengthen the stability of the global banking system and ensure fair competition among banks from different countries (p. 3). This framework is based on a two-tier definition of capital: Tier 1 (core capital, mainly common equity and disclosed reserves) which must represent at least 50% of total capital, and Tier 2 (supplementary capital, including undisclosed reserves, general provisions, subordinated debt, etc.) limited to 100% of Tier 1 (p. 6-9, 17-22). A system of asset weighting according to credit risk is introduced, with five possible weights (0%, 10%, 20%, 50%, 100%) to reflect counterparty quality and asset nature (p. 10-14, 23-25). The target ratio is set at 8% risk-weighted capital, including at least 4% in Tier 1, to be reached by the end of 1992, with an intermediate step at 7.25% by the end of 1990 (p. 14-16). Transitional provisions allow progressive inclusion of certain capital elements and limitations on the use of general provisions and subordinated debt (p. 15-17, 28). The framework also incorporates off-balance sheet exposures by converting them into credit risk equivalents via specific conversion factors (p. 13-14, 25-27). The document recommends harmonized application by national authorities while allowing some limited national adaptations. It emphasizes that this standard is a minimum and that other risks (interest rate, investment) must be considered by supervisors (p. 3-5).
This document is the result of several years of work by the Basel Committee aimed at harmonizing banking supervision rules related to the adequacy of capital of international banks. The main objective is to strengthen the soundness and stability of the international banking system and reduce competitive inequalities among banks from different countries by applying a common and coherent framework (p. 3). The framework is primarily addressed to banks active internationally in G-10 countries, with openness to broader adoption. It focuses on credit risk while recognizing that other risks must be considered by supervisory authorities. The document provides for a transitional period until the end of 1992 to allow banks to adapt to the new standards (p. 3-5, 15-17). National limits are accepted in some cases, notably for risk weightings and the precise definition of capital elements, but convergence and coherence remain key objectives. The framework is designed to be applicable on a consolidated basis, including banking and financial subsidiaries (p. 4-5, 10).
Capital Definition:
- Capital is divided into two tiers: Tier 1 (core capital) including common shares and disclosed reserves, which must represent at least 50% of total capital; Tier 2 (supplementary capital) including undisclosed reserves, general provisions, revaluation reserves, hybrid debt/equity instruments, and subordinated debt (p. 6-9, 17-22).
- Certain deductions are applied, notably goodwill and investments in unconsolidated subsidiaries, to avoid double counting of capital (p. 9-10, 18).
Risk Weighting:
- Assets are weighted according to their credit risk in five categories: 0%, 10%, 20%, 50%, and 100% (p. 10-14, 23-25).
- Weightings consider counterparty type (governments, banks, private sector), location (OECD members or not), nature of collateral and guarantees, and maturity of exposures (p. 11-13).
- Loans secured by residential mortgages benefit from a reduced weight of 50% under strict conditions (p. 13).
- Off-balance sheet exposures are converted into risk equivalents using specific conversion factors according to the nature of the exposure, then weighted according to counterparty type (p. 13-14, 25-27).
- For interest rate and foreign exchange instruments, two methods are proposed to estimate credit risk exposure: a method based on current replacement cost plus a potential exposure factor, and an alternative method based on flat conversion factors (p. 14, 26-28).
Target Ratio and Transitional Period:
- The minimum risk-weighted capital ratio is set at 8%, including at least 4% in Tier 1, to be reached by the end of 1992 (p. 14-16).
- An intermediate step at 7.25% (including at least 3.6% in Tier 1) is planned for the end of 1990 (p. 15-16).
- Transitional measures allow progressive inclusion of supplementary capital elements and temporary exemptions on limits for general provisions and subordinated debt (p. 15-17, 28).
- National authorities may adapt implementation according to their legal and accounting frameworks, while aiming for as uniform application as possible (p. 17).
Supervision and Future Developments:
- The Committee plans to monitor the framework’s application and consider developments, notably to integrate other risks (interest rate, investment) and improve consolidated supervision of financial groups (p. 4-5).
- The issue of double capital holdings between banks (double gearing) is recognized as a systemic risk, but no mandatory deduction is imposed, leaving the decision to national authorities (p. 9-10).
- The framework aims to promote convergence of provisioning policies and comparability of capital across countries despite fiscal and accounting differences (p. 4-5).
Findings:
- Adoption of a harmonized international framework to measure the adequacy of capital of international banks, with a minimum ratio of 8% of risk-weighted assets (p. 14).
- Precise definition of eligible capital elements in two tiers, with quantitative limits and specific deductions (p. 6-10, 17-22).
- Implementation of a simple risk weighting system with five categories, considering counterparty type, geographic location, and nature of collateral (p. 10-14, 23-25).
- Inclusion of off-balance sheet exposures via conversion factors into risk equivalents (p. 13-14, 25-28).
Assumptions and Interpretations:
- The framework assumes credit risk is the main risk to measure, with other risks left to national authorities’ discretion (p. 4, 11).
- Differentiated asset weighting according to counterparty quality and location aims to reflect the economic reality of risk, notably distinguishing OECD member countries (p. 11-13).
- Limiting Tier 2 elements and general provisions aims to ensure capital quality and transparency (p. 7-9, 17-18).
Uncertainties:
- Variations in accounting, fiscal, and provisioning practices between countries may affect ratio comparability (p. 4-5, 7-8).
- Recognition of latent reserves and hybrid instruments depends on national authorities’ acceptance and may vary (p. 6-9, 17-22).
- Treatment of risks other than credit (interest rate, investment) is not standardized and is subject to further study (p. 4, 11).
- The effectiveness of off-balance sheet exposure calculation methods, notably for derivatives, remains to be confirmed and may differ by country (p. 14, 26-28).
The Basel Committee recommends the rapid and harmonized adoption of the presented framework to measure the adequacy of capital of international banks, with a minimum risk-weighted asset ratio of 8% to be reached by the end of 1992, including at least 4% core capital (Tier 1) (p. 14-16).
A transitional period until the end of 1992 is planned, with an intermediate step at the end of 1990, allowing banks to gradually adjust their capital and national authorities to adapt their rules (p. 15-17, 28).
National authorities are invited to define implementation modalities according to their legal and accounting frameworks, while aiming for as uniform an application as possible to reduce competitive inequalities (p. 17).
The Committee emphasizes the need to continue work on integrating other risks (notably interest rate and investment) and on consolidated supervision of financial groups (p. 4-5).
It also recommends ongoing monitoring of provisioning practices, double capital holdings between banks, and the application of weightings, to improve the framework’s coherence and robustness (p. 4, 9-10).
Finally, the framework is designed as a minimum, allowing national authorities to require higher capital levels if necessary (p. 3, 6).
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