BASEL is a city in Switzerland that is host to the Bank for International Settlements, an organisation which fosters international monetary and financial cooperation and serves as a bank for central banks. One of its standing committees is the Basel Committee on Banking Supervision, the Basel Committee, the role of which is to improve the quality of banking supervision worldwide.

It has long been acknowledged that banks need to have sufficient capital to serve as a cushion to absorb unexpected losses.

With this in mind, in 1988 the committee issued a report entitled International Convergence of Capital Measurement and Capital Standards, which described how regulators should determine whether banks had enough capital.

This report was endorsed by regulators worldwide and has become known in recent years as Basel I.

Very simply, it allocated a risk weight to banks’ assets, as in its investments and loans.

These were set by the committee – for example, a mortgage from your bank would attract a risk weight of 50% whereas a loan to a commercial company would attract a 100% risk weight.

More recently banks and regulators decided that Basel I was too blunt an instrument to measure accurately banks’ capital requirements.

It did not assess all of banks’ risks and those it did try to assess were measured in a very rudimentary way.

After long and painful negotiation between banks and regulators, a new framework was published in November 2005 and this has become known as Basel II.

That provides a series of increasingly complex methodologies for calculating bank capital requirements but, even in its simplest form, risk weightings applied by Basel II to banks’ assets are more risk-sensitive than those under Basel I.

For example, weightings of loans to companies depend on the ratings applied to them by international credit rating agencies, such as Standard & Poor’s Ratings Services and Moody’s Investors Service, and the weighting of a mortgage would depend on its size compared with the value of the house.

More complex options under Basel II utilise banks’ own internal risk models to decide how much capital is needed.

Basel II captures more risks than Basel I.

It allocates capital requirements to market risk – the risk of a bank losing money due to a move in market prices – and to operational risk – the risk of loss resulting from poor internal processes, people and systems.

Basel II also requires banks to identify all their other risks and either allocate capital against those risks or explain to the regulator how those risks are controlled and mitigated.

As under Basel I, banks and regulators add all the risk weighted assets together and express them as a percentage of a bank’s capital.

Internationally, it is agreed that regulators will not allow this percentage, known as the risk-asset ratio, to fall below 8%.

In future articles we will examine the three pillars of Basel II and explain more how it requires banks to calculate their capital requirements under the simpler approaches available.