What it means
Before 1988 there was no common standard for how much capital an internationally active bank should hold. Basel I set one: each asset was assigned a risk weight, the weighted amounts were added together, and capital had to be at least 8% of that total.
Cash and most developed-country government debt carried 0%, residential mortgages 50%, and ordinary corporate lending 100%. The agreement also split capital into two tiers.
Tier 1 was the highest quality, mainly ordinary shares and retained profits, and had to make up at least half the total, while Tier 2 included items such as subordinated debt and certain revaluation reserves. Basel I mattered because it levelled the international playing field.
Banks in countries with lax rules had been able to lend more cheaply simply by holding less capital, and a common floor removed much of that advantage. Off-balance-sheet items were handled through credit conversion factors, which turned commitments and guarantees into a notional loan amount before the risk weight was applied.
An undrawn facility, for instance, might be converted at 50% and then weighted, so it consumed capital even though no money had left the bank. Its weakness was the coarseness of the buckets.
A loan to a blue-chip manufacturer and a loan to a struggling start-up both attracted a 100% weight, so banks had every incentive to keep the riskiest assets in each bucket and move the safest ones off the balance sheet. That behaviour, usually called regulatory capital arbitrage, drove the shift to risk-sensitive rules.
Basel I still matters as background, and its headline 8% figure survived into every later accord.
In practice
Real-world examples.
Example
A treasury team at a bank shifts $80,000,000 from corporate loans into government bonds ahead of a reporting date. Risk-weighted assets fall by the full $80,000,000 because the bonds carry a 0% weight, and the reported capital ratio improves without a dollar of new equity.
Example
A building society finds that its residential mortgage book, weighted at 50%, consumes half the capital of an equivalent commercial loan book. Management uses this to justify concentrating growth in home lending rather than business lending.
Example
An international bank compares two subsidiaries writing similar business in different countries and finds their capital ratios almost identical. That comparability was exactly what Basel I was designed to produce.
Formula
Calculation
Risk-weighted assets = Sum of (Asset amount x Risk weight); Minimum total capital = Risk-weighted assets x 8%.
Take a bank with four holdings: $50,000,000 of cash weighted at 0%, $100,000,000 of domestic government bonds at 0%, $200,000,000 of residential mortgages at 50%, and $400,000,000 of corporate loans at 100%. The weighted amounts are $0, $0, 200,000,000 x 0.50 = $100,000,000, and 400,000,000 x 1.00 = $400,000,000. Risk-weighted assets therefore total $500,000,000, so minimum total capital is 500,000,000 x 0.08 = $40,000,000, of which at least half, $20,000,000, must be Tier 1. The bank holds $750,000,000 of assets in total but carries capital against only two-thirds of that amount, which shows how much the weighting scheme changes the answer.Case study
Seen in the real world.
Halberd Commercial Bank is an invented, illustrative example rather than a real institution. Under Basel I it held a large book of loans to mid-sized companies, every one weighted at 100% regardless of whether the borrower was rated highly or barely creditworthy at all.
Its treasurer noticed the obvious consequence. Since the capital cost was identical either way, the bank earned far more spread on the weaker borrowers for exactly the same regulatory charge, so the loan book quietly drifted towards riskier names while the reported capital ratio stayed unchanged.
This fictional case captures the central criticism of Basel I. The ratio looked stable at 9% throughout, but the underlying risk had risen sharply, and only a risk-sensitive framework such as Basel II would have shown it.
Watch out
Common mistakes.
- Believing Basel I required 8% capital against total assets, when the 8% applies to risk-weighted assets, which are usually far smaller.
- Treating a 0% risk weight as meaning zero risk, when it simply reflected a political and practical decision to treat sovereign debt as safe.
- Assuming Basel I has been fully retired, when many smaller jurisdictions and simplified regimes still use its basic bucket approach.
Questions
People also ask.
When was Basel I introduced?
It was published by the Basel Committee in 1988 and phased in across member countries by the end of 1992.
What risks did Basel I cover?
Credit risk initially, with a market risk amendment added in 1996; operational risk was not covered until Basel II.
Why was Basel I replaced?
Because its fixed buckets ignored differences in borrower quality, which encouraged banks to hold the riskiest assets in each category.
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