Although Basel I brought a worldwide standard in regulations, introduced the risk-weighted assets concept, and segregated capital, it had a few deficiencies.
Basel I’s deficiencies
- The lack of risk sensitivity: For instance, a corporate loan to a small company with high leverage consumes the same regulatory capital as a loan to an AAA-rated large corporate company—8% because they are both risk weighted at 100%.
- The limited collateral recognition: The list of eligible collateral and guarantors is rather limited, compared to those effectively used by the banks to mitigate their risks.
- The incomplete coverage of risk sources: Basel I focused only on credit risk. An amendment made to Basel I in 1996—Market Risk Amendment—filled an important gap. But there are still other risk types—like operational risk, reputation risk, and strategic risk—not covered by the regulatory requirements.
- The “one-size-fits-all” approach: The requirements are virtually the same, no matter the bank’s risk level, sophistication, and activity type.
- The arbitrary measure: The 8% ratio for capital is arbitrary and not based on explicit solvency targets.
- The lack of diversified recognition: The credit-risk requirements are all additive, and diversification through granting loans to various sectors and regions is not recognized.
Basel I was more relevant for banks that had retail and commercial banking units, like JPMorgan (JPM), Wells Fargo (WFC), and other banks in an ETF like the Financial Select Sector SPDR Fund (XLF). For investment banks like Morgan Stanley (MS) and Goldman Sachs (GS), there was no separate market risk discussion in Basel I.
Although Basel I was beneficial to bank supervision, the time had come to move to a more sophisticated regulatory framework. The Basel II proposal was the answer to those shortcomings as we shall see in the next article of the series.