The Accord requires banks to develop technical competence and an expansive pool of risk data. Furthermore, it mandates them to implement rigorous models for capital adequacy.

The Accord’s emphasis on increased loan loss provisions and risk-based capital charges for certain assets will put pressure on bank profitability, with any associated increased borrowing costs or capacity limitations being passed onto borrowers as a result.

Basel I Accord

Basel I is one of a series of banking regulation agreements designed to ensure financial institutions have adequate capital reserves to absorb unexpected losses. This agreement focused heavily on credit risk, encouraging banks to make large investments in government securities and mortgage-backed debt (which at times was higher-risk than unrated corporate bonds) while creating perverse regulatory incentives that contributed to the 2008 global financial crisis.

Basel II was an improvement upon its predecessor accord, which focused solely on credit risk. It allowed banks to use internal models for capital calculations while mandating that their supervisors approve any methods used to calculate requirements.

Basel III was devised following the 2008 global financial crisis to improve bank governance and liquidity management as well as to align incentives. It includes new capital reserve requirements as well as countercyclical measures that increase reserve levels during periods of lending expansion while relaxing them during contractions.

Basel II Accord

The Basel II Accord, also referred to as the New Capital Framework, is an updated version of the 1988 Basel Accord designed to enhance bank safety and soundness through improving supervisory knowhow and quality as well as regulate capital requirements of banks globally while setting out standards that national banking regulatory bodies must enforce.

The Basel III Accord provides improved methods for measuring credit risk and market risk, and greater risk sensitivity in capital requirements calculations, by taking into account model-based approaches for market and operational risks. Furthermore, risk weights assigned based on credit ratings of obligors – an enormous improvement over Basel I – have also been introduced by this framework.

The Accord includes disclosure requirements designed to ensure banks are being open and transparent with regulators, as well as an evaluation system for internal capital adequacy that reduces opportunities for regulatory arbitrage.

Basel III Accord

This new accord not only addresses bank capital adequacy but also includes guidelines on how banks assess operational risk. This will require more in-depth analyses into how risks such as fraud and system failures impact a bank’s financial stability.

Basel III will also increase Tier 1 capital requirements to 6% of RWAs, comprising all shareholder equity (including audited profits) less deducted accounting reserves that do not meet loss-absorbing “today.” Furthermore, this framework will introduce both a mandatory leverage ratio and stable funding requirement (NSFR).

Importantly, increasing levels of provisions and reserves should not be seen as a replacement for strengthening internal limits and improving control and risk management processes. Otherwise, banks could find themselves paying an unnecessary price in increased loan losses or restrictions to their capacity to lend.

Impact of Basel Accords on Bank Risk Management

The Accords aim to meet industrialized country’s long-held desire for an internationally active bank supervision framework by creating a standard set of rules relating to capital requirements and credit risk weightings; compliance is mandatory. Furthermore, banks may opt for conducting and using their own internal rating of credit exposures when calculating capital requirements (subject to certain prescribed criteria).

The main weakness of the Accord was its narrow focus on credit risk, not taking account of market or operational risks; furthermore, regulatory capital arbitrage occurred due to assigning fixed risk weights among asset categories for regulatory capital arbitrage purposes, thus decreasing quality bank loan portfolios. Following the financial crisis this issue was rectified through Basel II reforms; then again later with Basel III.

The Accords hold great potential to improve international banking regulation. By helping ensure banks have adequate capital on hand to meet their obligations and absorb unexpected losses, the risk of global financial system collapse will be diminished, potentially protecting millions of lives worldwide from dire poverty and loss.