Or, how the world’s regulators learned to say: “Not all loans are created equal.”
📏 Basel’s Big Idea: Not Just Capital, but Risk-Weighted Capital
Imagine you’re packing a lifeboat. Do you treat a gold bar and a rubber duck the same? Hopefully not.
Before Basel I, regulators were basically doing just that — evaluating bank safety using total assets, without asking how risky those assets were.
Basel I changed the game by introducing a revolutionary concept:
“Let’s weigh assets by risk.”
So, a $1 million government bond doesn’t count the same as a $1 million corporate loan.
But what exactly were the requirements?
🧮 Three Key Capital Requirements under Basel I
- Total Assets-to-Capital must be < 20
(i.e., capital > 5$\%$ of total assets — a legacy holdover from older frameworks) - Tier 1 Capital ≥ 4$\%$ of Risk-Weighted Assets (RWA)
— Core capital like equity and perpetual preferred shares. - Total Capital (Tier 1 + Tier 2) ≥ 8$\%$ of RWA
— Includes supplementary capital like subordinated debt, but Tier 2 can’t be more than 50$\%$ of total.
Wait — what exactly are Tier 1 and Tier 2 capital?
🧱 What Counts as Capital? $($Hint: Not All Capital Wears a Cape$)$
Tier 1 (Core Capital):
- Common Equity (minus goodwill)
- Noncumulative perpetual preferred stock
💡 This is your “first line of defense.” It absorbs losses while the bank is still alive.
Tier 2 (Supplementary Capital):
- Cumulative preferred stock
- Subordinated long-term debt
- Certain hybrid instruments
🛠️ Think of Tier 2 as the emergency repair kit — not the first choice, but useful in a crash.
Now we know how much capital is needed. But how do we measure risk-weighted assets?
🧾 Step 1: Risk-Weight the On-Balance Sheet Items
This is where Basel I got spicy. It assigned risk weights to different types of assets:
| Risk Weight | Example Asset Category |
|---|---|
| 0$\%$ | Cash, U.S. Treasuries, OECD sovereigns |
| 20$\%$ | Claims on OECD banks, agency bonds (e.g., Fannie Mae) |
| 50$\%$ | Uninsured residential mortgages |
| 100$\%$ | Corporate loans, non-OECD banks, consumer loans |
📌 Example:
Blue Star Bank holds:
- \$20M in Treasuries (0%)
- \$20M in insured mortgages (0%)
- \$50M in uninsured mortgages (50%)
- \$150M in corporate loans (100%)
RWA =(0 × 20) + (0 × 20) + (0.5 × 50) + (1.0 × 150) = $175 million
That’s the on-balance sheet side. But what about the hidden stuff banks keep off the books?
🧾 Step 2: Convert Off-Balance Sheet Items to Credit Equivalents
Some risks don’t show up on the balance sheet — like letters of credit or loan guarantees. Basel I assigns conversion factors to convert these into credit equivalent amounts:
| Conversion Factor | Off-Balance Sheet Item Example |
|---|---|
| 100$\%$ | Loan guarantees, banker’s acceptances |
| 50$\%$ | Standby letters of credit |
| 20$\%$ | Loan commitments > 1 year |
| 0$\%$ | Commitments < 1 year |
📌 Example:
A $200M standby letter of credit to a government agency:
- Convert: $200M × 50$\%$ = \$100M
- Apply risk weight: $100M × 20$\%$ = $20M RWA
And what about the complex stuff like derivatives?
🔄 Step 3: Measuring Risk in Derivatives $($Enter: The Add-On$)$
Basel I introduced a simple yet clever formula for OTC derivatives: $Credit\ Equivalent=max(V,0)+D×L$
Where:
- V = Current value of derivative
- D = Add-on factor ($\%$)
- L = Principal amount
Add-on factors vary based on asset type & maturity:
| Maturity | Interest Rate Swaps | FX/Gold | Equity | Commodities |
|---|---|---|---|---|
| <1 yr | 0.0$\%$ | 1.0$\%$ | 6.0$\%$ | 10.0$\%$ |
| 1-5 yrs | 0.5$\%$ | 5.0$\%$ | 8.0$\%$ | 12.0$\%$ |
| >5 yrs | 1.5$\%$ | 7.5$\%$ | 10.0$\%$ | 15.0$\%$ |
📌 Example:
A $175M interest rate swap, 3 years remaining, current value = \$2.5M
- Add-on = 0.5$\%$ of $175M = \$0.875M
- Credit Equivalent = $2.5M + \$0.875M = $3.375M
But how risky is the counterparty?
🎭 Step 4: Apply Counterparty Risk Weight
The final step: assign risk weight based on who the other party is:
| Counterparty | Risk Weight |
|---|---|
| OECD Bank | 20$\%$ |
| Corporation/Non-OECD | 100$\%$ |
📌 Example:
Assume our swap is with a corporation
RWA = $3.375M × 100$\%$ = $3.375M
If it were an OECD bank: $3.375M × 20$\%$ = $675K
Now… let’s bring it all together.
🧮 Final Calculation: Total RWA and Capital Requirement
From our examples:
- On-balance RWA = $175M
- Off-balance RWA (swap w/ corporation) = $3.375M
Total RWA = $178.375M
Required Capital (8$\%$ of RWA) =
0.08 × 178.375 = $14.27M
That’s the capital cushion Blue Star Bank needs to pass Basel I’s risk-based requirement.
🧠 Final Thought: Why Basel I Was Just the Beginning
Basel I laid the groundwork for smarter banking regulation by:
- Recognizing not all assets carry the same risk
- Bringing off-balance sheet risk into the light
- Forcing banks to hold real capital for real risk
But it was also simple — maybe too simple. It didn’t account for operational risk, liquidity, or more complex exposures.
So naturally…
What do you do when the world gets riskier, and banks get trickier?
🎓 You evolve the rules — and that’s where Basel II and Basel III step in.