THE "BASEL I ACCORD" FOR CREDIT RISK

The Basel 1 Accord remained in force until the end 2007 in Europe, until the "New Accord," or "Basel 2 Accord," was enforced. But Basel 2 was essentially enforced in Europe, and only for major international banks in the US. The Basel 1 regulation remained in force until Basel 2 was enforced, and still is used in regions less prepared to follow Basel 2 guidelines and rules. A quick summary of the Basel 1 Accord plus the description of the amendment to market risk are an adequate introduction to the details of the Basel 2 Accord.

The Cooke Ratio and Credit Risk

The 1988 accord requires internationally active banks in the G10 countries to hold capital for credit equal to, at least, 8% of weighted assets. This is the Cooke ratio for credit risk. Weighted assets are the product of risk weights (RW) by the value of the facility. A risk weight of 100% corresponds to a ratio of capital to asset value of 8%. Hence:

capital — risk weight x value

For example, a loan of value 1000 with a risk weight equal to 100% has a capital charge of 80.

The weight scale starts from zero, for commitments with sovereign counterparties within OECD, at the time when Basel 1 was implemented, up to 100% for private businesses. Other weights are 20% for banks and municipalities within OECD countries, and 50% for residential mortgage-backed loans. Off-balance sheet outstanding balances are weighted 50%. There is also a grid of capital charges for off-balance sheet exposures through guarantees, commitments, forward claims, etc.

The 1988 accord requires a two-step approach whereby banks convert their off-balance sheet positions into credit equivalent amounts through a scale of conversion factors, which are then weighted according to the counterparty's risk weighting. The factor is 100% for direct credit substitutes such as guarantees and decreases for less stringent commitments.

The bank has to hold at least halfofits measured capital in Tier 1 form. Tier 1 capital is subject to a minimum constraint of 3% of total assets. The calculation of the ratio uses asset weights for differentiating the capital load according to their quality in terms of credit standing.

The capital calculation under Basel 1 Accord is simple. Consider a loan to a corporation of 1000, risk weighted 100%. The capital charge for credit risk is:

100% x 8% x 1000 = 80

For a mortgage, backed by property, the same loan would have a capital charge of:

50% x 8% x 1000 = 40

 
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