Why Basel I (1988 Accord) Needed to be Replaced?

The rules of the original 1988 Accord are generally acknowledged to be flawed for various reasons, discussed below:

• Credit risk assessment under Basel I is not risk-sensitive enough. Capital need assessment under Basel I accord was not being able to differentiate between banks with lower risks and banks with higher risks. For example, exposure on a company with AAA rating and a company with B rating are treated identically for the purpose of capital adequacy. Both will be placed in 100% risk weight category, although risks associated with them would be quite different.

• It promotes financial decision-making on the basis of regulatory constraints rather than on the basis of economic opportunities. Capital requirement for all corporate accounts being the same, it encouraged financing of assets with more risk for higher returns. Whereas a sound decision should take into account risk and return characteristics of an asset, it was discouraged, as capital requirements were not differentiated based on risk characteristics of assets.

• It did not recognize the role of credit risk mitigants, such as credit derivatives, securitizations, collaterals and guarantees, in reducing credit risk.

• The accord does not appropriately take maturity factors into effect. For example, revolving credit arrangements with a term of less than one year do not require any regulatory capital while a short-term, facility with 366 days to maturity bears the same capital charge as any long-term facility.

• Lastly, the Accord does not address complex issues such as portfolio effects, even though credit risk in any large portfolio is bound to be partially offset by diversification.

These shortcomings would lead to a distorted assessment of risk and capital, and therefore, in 1996, the Basel Committee declared its intentions to build a new capital adequacy framework, known as Basel II.

The fundamental objectives to revise the 1988 Accord have been:

• To develop a framework that would strengthen the soundness and stability of the international banking system

• To ensure that it does not become a source of competitive inequality among internationally active banks and yet have a capital adequacy regulation that is sufficiently consistent

• To help promote the adoption of stronger risk management practices by the banking industry.

Basel II was released on June 26, 2004.