Basel I

Basel I (also known as the '1988 Basel Accord') was the first international agreement setting minimum capital requirements for banks. It was a landmark effort by the Basel Committee on Banking Supervision (BCBS), a group of central bankers from around the world who meet at the Bank for International Settlements in Basel, Switzerland. Its primary goal was to strengthen the stability of the international banking system and to remove a key source of competitive inequality arising from differences in national capital requirements. The core of the agreement was simple yet powerful: it mandated that internationally active banks must maintain a minimum Capital Adequacy Ratio (CAR) of 8%. This meant a bank’s own capital (its safety buffer) had to be at least 8% of its Risk-Weighted Assets (RWA). By tying capital requirements to risk, Basel I ensured that banks taking on riskier loans had to have more skin in the game, making the global financial system a safer place for everyone, including investors.

Imagine a world where every country sets its own speed limit for cars. Some might be very strict, while others might have no limits at all. In the 1970s and 80s, international banking was a bit like that. As banks expanded across borders, regulators grew anxious. A bank in a country with lax rules could operate with very little capital, allowing it to offer cheaper loans and grow faster, putting more prudent banks at a disadvantage. More frighteningly, the spectacular 1974 collapse of Germany's Bankhaus Herstatt showed how the failure of one bank could send shockwaves through the entire global system. Regulators realized they needed a common set of rules to prevent this “race to the bottom” and protect the interconnected financial world. Basel I was the answer—the first globally agreed-upon speed limit for bank risk-taking.

The genius of Basel I was its simplicity. The 8% rule was built on two key components: what counts as capital, and how to measure risk.

For a bank, capital is the ultimate safety net. It's the money that belongs to its owners and can be used to absorb unexpected losses without the bank going under and depositors losing their money. Basel I defined two types of capital:

• Tier 1 Capital: The highest-quality, core capital. Think of this as the bank's bedrock, consisting of common stock (shareholder equity) and disclosed reserves (like retained earnings). It's the first line of defense.
• Tier 2 Capital: Supplementary capital. This is a bit less secure and includes things like undisclosed reserves, general provisions for losses, and certain types of subordinated debt.

Basel I mandated that at least half of the required 8% capital (i.e., 4%) had to be the super-reliable Tier 1 Capital.

Basel I recognized that a bank's assets carry different levels of risk. A loan to a stable government is far safer than a commercial real estate loan. To account for this, it assigned “risk weights” to different asset classes, primarily focusing on Credit Risk (the risk of a borrower defaulting). Here’s a simplified look at the risk weights:

• 0% Weight: Cash and loans to central governments of developed countries (considered risk-free).
• 20% Weight: Loans to reputable development banks or to banks in developed countries.
• 50% Weight: Residential mortgages.
• 100% Weight: Most other loans, like commercial and consumer loans, and corporate bonds.

Let's do the math: Imagine a bank has two assets:

1. $200 million in government bonds (0% risk weight)
2. $100 million in corporate loans (100% risk weight)

Its total assets are $300 million, but its Risk-Weighted Assets (RWA) are calculated like this:

1. ($200 million x 0) + ($100 million x 1.0) = $100 million

To comply with Basel I, the bank would need to hold capital of at least 8% of its RWA:

1. $100 million x 0.08 = $8 million in total capital (with at least $4 million being Tier 1).

For a value investor, analyzing a bank's health is paramount. A well-capitalized bank is like any other business with a strong Balance Sheet—it's durable, resilient, and better equipped to survive economic storms. Basel I provided the first standardized yardstick to measure this resilience across the globe. An investor could look at a bank's Capital Adequacy Ratio and get a quick sense of its safety buffer. However, a savvy investor, much like Warren Buffett, would also recognize the accord's limitations. The risk-weighting system was very broad. Under Basel I, a loan to a blue-chip giant like Coca-Cola was treated exactly the same as a loan to a speculative tech startup—both received a 100% risk weight. This crude “one-size-fits-all” approach was a major flaw, as it didn't accurately reflect the true risk of a bank's portfolio. This weakness, along with its narrow focus on just credit risk, led to its evolution. Regulators soon realized they needed a more sophisticated system, which gave rise to Basel II and, later, Basel III, which incorporated rules for Market Risk and Operational Risk.

Though now superseded, Basel I was a monumental achievement. It successfully established a common language for bank capital and created the first global regulatory framework. It forced banks worldwide to bolster their capital cushions and laid the essential groundwork for all modern banking regulation. While the rules have become more complex, the core principle of Basel I—that banks must hold sufficient capital against the risks they take—remains the unshakeable foundation of global financial stability.