Definition of the Basel accords
The Basel accord is a set of regulatory agreements that were set by the Basel committee with the intention of regulating the banks. This happened after it was noticed that banks and other financial institutions were facing unforeseeable risks hence strategies to absorb the impact of such risks were prudent. These regulations revolved around risks like capital risks, market risks and operational risks (Corrigan 2009). The first Basel accord was referred to as Basel 1 and was issued in the late 1980s. This accord laid its emphasis on banks’ and other financial institutions’ capital adequacy. A risk like Capital adequacy is defined as the risk that a bank or any other financial institution may incur due to unpredicted losses. Based on the categories of percentage risks set for banks, international banks are required to maintain 8% or less risk weight.
The second accord which was meant to be fully realized by the year 2015 is a bit broader because it encompasses a wide range of regulations. This accord is concerned with regulating the minimum capital requirements, supervision as well as checking and regulating market discipline. The minimum capital requirements, the supervisory reviews and the market discipline are regulatory procedures that are commonly referred to as the three pillars. This accord is motivated by the need to strengthen international banking requirements.
Reasons for the Basel accords
The first Basel accord was introduced in 1988 and it had to be fully realized by the year 1992. Although the composition of this accord was primarily centered on banks running on the global platform, the ideologies on which it was built on are suitable even for banks in other stages of functioning. The accord was to be upheld and adhered to in a given period of time by all internationally influential financial institutions and banks. This accord was all about measuring and standardizing the appropriate capital for setting up an international bank. This would help in distinguishing a local bank from an international one.
The Basel committee was formed after the disastrous and controversial liquidation of the Herstatt bank in the year 1974. This happened after the bank received deutsche marks from a number of other banks in exchange for the American dollars (Anjum 2012). Due to time differences, the Herstatt bank was liquidated by German regulators even before the dollar transactions were affected and before the money was transferred to the beneficiary banks. This scenario prompted the G10 countries to form a committee to regulate and avoid such like incidents in the future.
Basel 1 accord
The Basel 1 accord was motivated by the need to regulate banking players to ensure that they have adequate and sufficient capital to keep them away from financial problems and difficulties. As much as this strategy may protect the bank, the benefit is much greater than just protecting financial institutions. This accord offers protection indirectly to depositors and at the same time to the entire economy. As discussed above, these accords focus on international players in the banking industry and financial market. A failure in such banks can be of great harm to the entire economy.
The Basel 1 accord was formulated for the purpose of strengthening the international banking system. This had to be achieved through setting up a fair and a consistent banking system with an attempt to reduce the level of inequality in competitiveness within the banking industry. The effects of the Basel accord were felt when the committee separated Capital in two tiers, the 1st and 2nd tier. The first tier was the core capital while the second tier was the supplementary capital. The core capital included the shareholders equity and other reserves such as loan loss reserves (Hasan 2002).
Basil 1 accord had some defects that would lead to some financial inconsistencies for banks and other financial institutions as well. The percentage ratio required is limiting in regards to credit risk differentiation. Risks keep on changing hence the assumption that the 8% minimum capital ratio can be held as an ideal and sufficient ratio to avert financial failure might not work. This is what led to the improvement of the Basel1 accord as compared to the second Basel accord which was more detailed in banks’ risk management.
Basel accord 2
Due to the changes in today’s financial systems, the Basel 1 accord has proven to be inadequate to offer financial support in regards to the prevailing possible risks in the money market. This prompted the Basel committee to go back to the drawing board and come up with more specific and broader solutions for the looming banking risks. Bank level management, market discipline and supervision were the upcoming approaches that the committee felt would be effective in the risk management strategic plan. And it was these three pillars that the Basel 2 accord was built on. The Basel 2 accord has really improved the reliability and safety in the financial industry (Zaher 2007).
Unlike the first Basel accord, the second accord laid its emphasis on bank’s individual management with regards to internal control (Peek & Rosengren 1995). Built on three mutual support pillars, this accord has helped banks to mount effective surveillance of possible risks hence averting the possibility of failing the depositors. The revised accord has by far improved the measurement of risks bringing into account the measure of operational risks. This accord is more sensitive to risks. As discussed in this research, prudent measures to keep financial institutions on the check are vital. The failure in a major bank is not only a loss to the shareholders and the bank but also such a situation poses a great risk to the economy in a global scale which means it can lead to an international economic collapse.
The Basel committee has taken the recommended measure by keeping this in regular check and coming up with possible ways to mitigate these risks. As the Basel committee agrees, a standardized approach in dealing with financial institutions is of the great importance to avoid financial shock with unpredicted losses. In this research I have discussed briefly the historic background of the Basel committee explaining the intentions behind it and the effects of its actions on banks and financial institutions. The research has extensively looked into the two accords and their implications. The well elaborated effect of the accords gives an insight of the possibility to have a review of the currently existing accords. This is especially true and supported by the existing changes in financial risks, hence reviews are inevitable now and in the future.
Anjum, N, 2012, The Three Pillars of the Basel II Accord, Web.
Corrigan, M, 2009, Background to and Impact of the New Basel Capital Accord – Basel II, Web.
Hasan, M, 2002, The Significance of Basel 1 and Basel 2 for the Future of the Banking Industry with Special Emphasis on Credit Information, Web.
Peek, J & Rosengren, E 1995. ‘Bank regulation and the credit crunch’, Journal of Banking & Finance, Elsevier, vol. 19 no.1, pp. 679-692.
Zaher, F 2007, How Basel 1 Affected Banks, Web.