The 1988 Basel Accord, also known as Basel I, established minimum capital standards for the banking industry by linking the banks’ capital requirements to their capital exposures. Basel I primarily focused on credit risk.
The credit exposures were divided into five categories that represented similar types of borrowers. Each category is tied to a specific risk weight, which is used to calculate the total capital requirements
Five risk categories encompass all assets on a bank’s balance sheet. These categories and their risk weights are described below:
|Risk weight||Asset Category|
|0%||Cash and gold bullion, claims on OECD governments such as Treasury bonds, or insured residential mortgages|
|20%||Claims on OECD banks and OECD public sector entities such as securities issued by U.S. government agencies or claims on municipalities.|
|50%||Uninsured residential mortgages|
|100%||All other claims, such as corporate bonds and less-developed country debt, claims on non-OECD banks, equity, real estate, premises, plant and equipment.|
|Variable||Claims on domestic public sector entities, which can be valued at 0, 10, 20, or 50% depending on the central bank’s discretion.|
As an example, an uninsured residential mortgage of $10,000 will carry a risk weight of 50%. So, the risk weighted assets will be $10,000*50%, i.e., $5,000.
As per Basel I, banks with international presence are required to hold capital equal to 8% of the risk-weighted assets. This is also known as the Target Standard Ratio. It sets a universal standard whereby 8% of a bank’s risk-weighted assets must be covered by Tier 1 and Tier 2 capital reserves. Moreover, Tier 1 capital must cover 4% of a bank’s risk-weighted assets. This ratio is seen as “minimally adequate” to protect against credit risk in deposit insurance-backed international banks in all Basel Committee member states.
The capital requirements could be calculated using the following formula:
Capital ratio (min 8%) = Total Capital/Risk-weighted assets
In our example above, the minimum required capital will be 8% of $5,000, i.e. $400.