Basel I, Basel II and Basel III Comparative Framework - Article

Short Description

Introduction

The Basel framework evolved because banking itself became more complex.

Banks moved beyond traditional deposit-taking and lending into:

• securities trading;

• derivatives;

• securitisation;

• complex cross-border transactions;

• off-balance-sheet exposures; and

• technology-driven financial services.

A simple capital rule was therefore no longer sufficient.

The current IIBF CAIIB BFM Module B specifically covers:

• Basel I: The Basel Capital Accord;

• 1996 Amendment to include Market Risk;

• Basel II – need, goals and framework;

• movement towards Basel III;

• capital charges for credit, market and operational risks;

• Pillar 2 – Supervisory Review;

• Pillar 3 – Market Discipline;

• Capital Conservation Buffer;

• Leverage Ratio;

• Countercyclical Capital Buffer; and

• Systemically Important Financial Institutions.

The evolution can be understood simply as:

Basel I → Basic risk-weighted capital Basel II → Greater risk sensitivity + Three Pillars Basel III → Stronger capital + buffers + leverage + liquidity + systemic resilience

Learning Objectives

After studying this topic, you should be able to:

• distinguish Basel I, Basel II and Basel III;

• explain how risk coverage expanded over time;

• understand the Three-Pillar structure introduced under Basel II;

• explain why Basel III was needed after the global financial crisis;

• identify Basel III capital, leverage and liquidity improvements; and

• avoid common CAIIB traps involving the three Basel frameworks.

Why Did Basel Frameworks Evolve?

The basic regulatory question is:

How much capital should a bank maintain against the risks it takes?

The answer became more sophisticated over time.

Basel I

Focused mainly on creating a common minimum capital standard linked primarily to credit risk.

Basel II

Made capital requirements more risk-sensitive and introduced:

• operational-risk capital;

• supervisory review; and

• market discipline.

Basel III

Responded to weaknesses exposed by the global financial crisis by strengthening:

• capital quality;

• capital buffers;

• leverage controls;

• liquidity standards;

• counterparty-risk treatment; and

• systemic resilience.

Basel I

Background

The Basel Committee issued the original Basel Capital Accord in 1988.

Basel I established an international framework for measuring capital adequacy of internationally active banks.

The framework introduced a major regulatory principle:

Different assets should attract different capital requirements according to their risk.

Basel I prescribed a minimum total regulatory capital ratio of 8% of risk-weighted assets for internationally active banks under the Basel standard.

Main Focus of Basel I

Basel I focused principally on credit risk.

Assets were assigned to broad risk categories, and capital requirements were based on the resulting risk-weighted assets.

This was more meaningful than treating every asset identically.

For example, a relatively safe sovereign exposure and a commercial loan did not necessarily receive the same prudential treatment.

Strength of Basel I

Its greatest strengths were:

• simplicity;

• international comparability;

• common minimum capital standards; and

• introduction of risk-weighted capital.

For the first time, a widely accepted international framework clearly linked:

Risk Exposure → Risk Weight → Regulatory Capital

Limitations of Basel I

The simplicity of Basel I also became its weakness.

Its broad risk categories could not fully distinguish between borrowers having very different actual credit quality.

It also did not originally provide a comprehensive capital framework for risks such as:

• market risk;

• operational risk;

• complex securitisation;

• sophisticated derivatives; and

• other emerging banking risks.

This encouraged development of a more risk-sensitive framework.

1996 Market Risk Amendment

A very important CAIIB point is that Basel I did not remain purely a credit-risk framework.

In January 1996, the Basel Committee amended the Accord to introduce capital requirements for market risk.

The amendment recognised market risks arising from areas such as:

• traded debt securities;

• equities;

• foreign exchange;

• commodities; and

• options.

It allowed a standardised approach and, subject to supervisory conditions, an internal-model approach for market-risk capital.

Exam Significance

The historical progression was:

Basel I, 1988 → Credit Risk Focus

1996 Amendment → Market Risk Added

Basel II

Why Was Basel II Needed?

Financial markets became more sophisticated.

Banks were increasingly using:

• internal credit ratings;

• derivatives;

• advanced risk models;

• securitisation;

• complex trading strategies; and

• technology-intensive operations.

The broad risk weights of Basel I were no longer sufficiently sensitive to differences in actual risk.

Basel II was therefore designed to bring regulatory capital closer to the bank’s underlying risk profile and encourage stronger risk-management systems.

Basel II Publication

The revised Basel framework was released in June 2004, with a comprehensive version subsequently published incorporating related amendments.

The major conceptual development was its Three-Pillar Framework.

Basel II – Pillar 1

Minimum Capital Requirements

Pillar 1 covers minimum regulatory capital for:

• Credit Risk

• Market Risk

• Operational Risk

Basel II therefore expressly added operational-risk capital to the framework.

This was important because banks can suffer serious losses even when:

• borrowers do not default; and

• market prices do not move adversely.

Examples include losses caused by:

• fraud;

• failed systems;

• human errors;

• process failures; and

• external events.

Greater Credit-Risk Sensitivity

Basel II introduced more sophisticated methods for credit risk.

Depending on regulatory permission and the framework used, approaches included:

• Standardised Approach; and

• Internal Ratings-Based approaches.

This allowed capital requirements to reflect differences in credit risk more closely than the broad Basel I structure.

Basel II – Pillar 2

Supervisory Review Process

Pillar 1 cannot capture every material risk perfectly.

Pillar 2 therefore requires banks to assess whether their capital is adequate in relation to their overall risk profile.

It also gives supervisors a role in:

• reviewing the bank’s assessment;

• evaluating risk management;

• examining governance; and

• requiring corrective measures where necessary.

A key concept associated with Pillar 2 is the Internal Capital Adequacy Assessment Process (ICAAP).

The underlying principle is:

Regulatory minimum capital alone may not be sufficient for every bank.

Basel II – Pillar 3

Market Discipline

Pillar 3 uses public disclosure to strengthen discipline.

Banks disclose relevant information regarding areas such as:

• capital;

• risk exposures;

• risk-management practices; and

• capital adequacy.

The expectation is that better transparency allows:

• investors;

• counterparties; and

• market participants

to assess the bank more effectively.

Basel II therefore created three mutually reinforcing pillars:

Pillar 1 → Minimum Capital

Pillar 2 → Supervisory Review

Pillar 3 → Market Discipline

The Basel Committee described these three pillars as central to Basel II’s more risk-sensitive framework.

Limitations Revealed by the Global Financial Crisis

Basel II improved risk sensitivity, but the global financial crisis of 2007–09 exposed important weaknesses in the broader regulatory system.

These included:

• insufficient high-quality capital;

• excessive leverage;

• weak liquidity positions;

• reliance on short-term wholesale funding;

• inadequate capture of certain trading and counterparty risks;

• procyclicality; and

• excessive reliance on risk models in some areas.

A bank could therefore appear adequately capitalised under risk-weighted measures while still being dangerously leveraged or vulnerable to liquidity stress.

This led to Basel III.

Basel III

Main Objective

Basel III was the Basel Committee’s post-crisis response to strengthen the resilience of banks and the banking system.

Its initial framework was published in December 2010 and revised in June 2011. Later post-crisis reforms were finalised in December 2017.

Basel III focused not merely on the amount of capital but also on:

• quality of capital;

• leverage;

• liquidity;

• capital buffers;

• systemic risk; and

• credibility of risk-weighted assets.

Stronger Quality of Capital

Basel III places greater emphasis on Common Equity Tier 1 (CET1) because common equity has strong loss-absorbing capacity.

Under the Basel global minimum framework:

• CET1 minimum = 4.5% of RWA

• Tier 1 capital minimum = 6% of RWA

• Total capital minimum = 8% of RWA

In addition, a 2.5% CET1 Capital Conservation Buffer is established above the regulatory minimum.

Important Comparison

Basel III did not simply increase the Basel international minimum total capital ratio from 8% to some completely new basic number.

Its major change was to strengthen:

• the quality and composition of capital; and

• the buffers maintained above minimum requirements.

Capital Conservation Buffer

The Capital Conservation Buffer (CCB) is intended to ensure that banks build additional capital outside periods of stress.

Banks can then absorb losses during difficult periods without immediately breaching minimum capital requirements.

The Basel framework establishes the CCB at 2.5% of RWA in CET1.

Countercyclical Capital Buffer

The Countercyclical Capital Buffer (CCyB) adds a macroprudential dimension.

Its broad purpose is to increase loss-absorbing capacity when excessive credit growth is contributing to systemic risk and allow the buffer to be released when appropriate.

The idea is:

Build additional resilience during periods of excessive credit expansion so that the banking system is better prepared for stress.

Leverage Ratio

Risk-weighted capital depends on the measurement of risk.

If risk is underestimated, a bank may accumulate excessive total exposure while appearing adequately capitalised on a risk-weighted basis.

Basel III therefore introduced a leverage ratio as a simple, non-risk-based backstop to the risk-based capital framework.

Key Difference

Risk-Based Capital Ratio → Depends on risk weights

Leverage Ratio → Provides a non-risk-based backstop

The two measures complement each other.

Liquidity Coverage Ratio

The global financial crisis showed that adequate capital alone does not guarantee survival.

A bank may be solvent but unable to obtain enough cash during severe stress.

Basel III therefore introduced the Liquidity Coverage Ratio (LCR) to strengthen short-term liquidity resilience.

It focuses on maintaining sufficient high-quality liquid assets to withstand a prescribed short-term stress scenario.

Net Stable Funding Ratio

The Net Stable Funding Ratio (NSFR) addresses longer-term funding resilience.

Its objective is to encourage banks to maintain a more stable funding profile relative to their assets and off-balance-sheet activities.

The Basel Committee identifies both LCR and NSFR as major Basel III liquidity standards.

Systemically Important Banks

Some banks are so large, interconnected or important that their distress may cause wider financial-system disruption.

Basel III therefore includes additional measures relating to systemically important banks, including higher loss-absorbency requirements where applicable.

This reflects the principle that:

The potential systemic impact of a bank can justify additional prudential safeguards.

Basel III Final Reforms

In December 2017, the Basel Committee finalised an important package of post-crisis reforms.

These included:

• stronger standardised approaches;

• greater constraints on certain internal-model approaches;

• revised operational-risk capital treatment;

• finalisation of leverage-ratio requirements; and

• an output floor limiting how far model-based risk-weighted assets can fall below amounts produced using revised standardised approaches.

Basel I vs Basel II vs Basel III

What Basel III Retained from Basel II

A common mistake is to think Basel III completely replaced Basel II.

Instead, Basel III builds on it.

Important Basel II ideas continue in the broader Basel framework:

• risk-weighted assets;

• credit-risk capital;

• market-risk capital;

• operational-risk capital;

• Pillar 1;

• Pillar 2 supervisory review; and

• Pillar 3 disclosure.

Basel III strengthened these arrangements and added major safeguards in areas that the financial crisis showed were insufficient.

Current Position for Indian Banks

Basel standards are issued internationally by the Basel Committee on Banking Supervision.

They do not automatically become Indian regulatory requirements merely because BCBS publishes them.

RBI determines and implements the applicable prudential framework in India.

RBI introduced Basel III capital regulations in India from 1 April 2013 in a phased manner. Its currently published Master Circular dated 1 April 2025 consolidates Basel III capital regulations applicable to the scheduled commercial banks covered by that circular, together with subsequent applicable amendments.

Therefore, for CAIIB:

Use Basel standards to understand the international framework, but use RBI instructions for the applicable Indian regulatory position.

Practical Banking Application

Consider a bank with rapidly expanding assets.

Basel I-Type View

The main question would primarily be:

• What are the risk-weighted credit exposures?

• Is minimum capital adequate?

Basel II-Type View

The analysis becomes wider:

• What is the credit risk?

• What is the market risk?

• What is the operational risk?

• Does the bank’s own capital assessment capture other material risks?

• Are disclosures sufficient?

Basel III-Type View

All the above remain relevant, but additional questions become important:

• Is the capital mainly high-quality loss-absorbing capital?

• Does the bank have an adequate conservation buffer?

• Is overall leverage excessive?

• Can it survive short-term liquidity stress?

• Is its funding sufficiently stable?

• Does its systemic importance require additional loss absorption?

This shows the progressive development:

Capital Adequacy → Risk-Sensitive Capital → Capital + Liquidity + Leverage + Systemic Resilience

CAIIB Exam Focus

Remember these high-value concepts:

• Basel I was issued in 1988.

• Basel I introduced risk-weighted capital and focused mainly on Credit Risk.

• Basel I’s international minimum total capital standard was 8% of RWA.

• The 1996 amendment incorporated Market Risk into the capital framework.

• Basel II was issued in 2004.

• Basel II increased risk sensitivity.

• Basel II introduced the Three-Pillar framework.

• Pillar 1 covers minimum capital requirements.

• Credit, Market and Operational Risk are central Pillar 1 risk categories.

• Pillar 2 is Supervisory Review.

• ICAAP is an important Pillar 2 concept.

• Pillar 3 is Market Discipline through disclosure.

• Basel III arose from lessons of the global financial crisis.

• Basel III strengthened both the quantity and quality of capital.

• CET1 became particularly important.

• Basel III introduced the Capital Conservation Buffer.

• Basel III added a Countercyclical Capital Buffer framework.

• Basel III introduced a non-risk-based leverage-ratio backstop.

• Basel III introduced international liquidity standards including LCR and NSFR.

• Basel III strengthened treatment of systemic and counterparty risks.

• The 2017 reforms are officially the finalisation of Basel III.

• RBI implements the applicable Basel prudential framework for Indian banks.

Common Exam Traps

Trap 1: “Basel I Covered Operational Risk Capital”

Incorrect.

Operational-risk capital became an explicit Pillar 1 feature under Basel II.

Trap 2: “Market Risk Was Introduced for the First Time by Basel II”

Incorrect.

The Basel I framework was amended in 1996 to incorporate Market Risk.

Trap 3: “Basel II Has Only Two Pillars”

Incorrect.

It has three:

1. Minimum Capital Requirements

2. Supervisory Review

3. Market Discipline

Trap 4: “Basel III Abolished the Basel II Three-Pillar Framework”

Incorrect.

Basel III builds on and strengthens the earlier framework.

Trap 5: “Basel III Is Only about Increasing the Minimum Capital Ratio”

Incorrect.

Its reforms also cover capital quality, buffers, leverage, liquidity and systemic resilience.

Trap 6: “LCR and NSFR Were Features of Basel II”

Incorrect.

They are Basel III liquidity standards.

Trap 7: “Leverage Ratio and Risk-Weighted Capital Ratio Are the Same”

Incorrect.

The leverage ratio is a non-risk-based backstop, while the risk-based capital ratio uses RWA.

Trap 8: “The 2017 Reforms Are Officially Basel IV”

Incorrect.

BCBS officially treats them as the finalisation of Basel III.

Memory Technique

Remember 1–2–3:

• Basel I = One main starting focus: Credit-risk-based capital

• Basel II = Three Pillars: Capital, Supervision, Disclosure

• Basel III = Three major strengthening themes: Capital, Leverage and Liquidity

And remember the progression:

Basel I made capital risk-based. Basel II made the framework more risk-sensitive. Basel III made the banking system more resilient.