Basel 1, Basel 2, Basel 3: Evolution of banking regulations and preparation for Basel 4

Since the 1980s, the Basel Accords have shaped the international banking landscape in response to successive financial crises. These regulations, developed by the Basel Committee on Banking Supervision, aim to strengthen the stability of the financial system by imposing strict requirements on capital adequacy, risk management and transparency. For finance students and professionals in the sector, understanding this evolution is essential to grasping the current and future challenges of banking regulation.

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Basel I (1988): The foundations of modern banking regulation

Context and objectives : Adopted in 1988, Basel I was created in response to the banking crises of the 1970s and 1980s, which were marked by a series of bankruptcies and growing financial instability. Its main objective was to harmonise capital requirements for banks internationally in order to strengthen their resilience and create a level playing field between financial institutions in different countries.

Key measures : Basel I introduced the concept of the Cooke ratio, requiring banks to maintain a minimum level of capital equal to 8% of their risk-weighted assets. This simple but revolutionary approach marked the beginning of coordinated global banking regulation.

Limitations and criticism : Although Basel I was a major step forward, its limitations quickly became apparent. The risk weighting system was too simplistic, failing to take into account the diversity of the actual risks incurred by banks. Furthermore, it did not address market risks or operational risks, leaving significant gaps in the coverage of financial risks.

Basel II (2004): A more sophisticated and risk-sensitive approach

Context and objectives : In response to the limitations of Basel I and developments in financial markets, Basel II was introduced in 2004 to refine risk measurement and better align capital requirements with the actual risks incurred by banks. This reform also aimed to encourage more rigorous risk management within financial institutions.

Basel II introduced a three-pillar structure:

1. Minimum capital requirements: A more nuanced approach than Basel I, with advanced methods for calculating credit, market and operational risks.

2. Prudential supervision process: Strengthening the role of regulators to ensure that banks have adequate processes in place to assess and manage their risks.

3. Market discipline: Increased transparency requirements to enable markets to better assess the financial soundness of banks.

Impact and limitations : Basel II marked a significant improvement by allowing banks to use internal models to assess their risks. However, the 2008 financial crisis revealed its weaknesses, particularly in terms of systemic risk and liquidity management. Banks had underestimated certain risks, and internal models sometimes proved to be overly optimistic.

Basel III (2010-2019): Strengthening resilience after the financial crisis

Background and objectives : In response to the 2008 financial crisis, which highlighted the shortcomings of previous regulations, Basel III was introduced to significantly strengthen the resilience of banks. Its measures aimed to improve the quality and quantity of capital, introduce new liquidity requirements and reduce excessive leverage in the banking system.

Key innovations of Basel III

•    Strengthened capital requirements: Increased the quality of capital (with an emphasis on Common Equity Tier 1 capital) and introduced leverage ratios to limit excessive debt.

•    Liquidity requirements: Introduction of the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) to ensure that banks have sufficient liquidity to cope with short- and long-term crises.

•    Systemic risk management: Introduction of measures to limit excessive interconnectedness between banks and reduce the risk of contagion in the event of a crisis.

• Leverage ratio: Limitation on the level of debt banks can hold relative to their capital.

Implementation and impact : Basel III was implemented gradually between 2013 and 2019, allowing banks to adapt to the new requirements. This regulation has significantly strengthened the stability of the banking system, but it has also increased compliance costs for financial institutions. Some critics point out that these stricter requirements could limit banks' ability to lend, thereby affecting economic growth.

Basel IV (2022-2028): Completion of the reform and new challenges

Context and objectives : Basel IV, officially known as ‘Basel III finalised’, represents the final stage of the regulatory reform initiated after the 2008 financial crisis. Its objective is to finalise the work of Basel III by filling the remaining gaps and further harmonising risk calculation approaches between banks.

Key developments in Basel IV

•    Reducing the variability of internal models: Limiting the use of internal models by banks to calculate their capital requirements in order to reduce differences between institutions.

•    Revised standardised approach: Strengthening the standardised approach for calculating credit risk to make it more risk-sensitive and more comparable between banks.

•    Treatment of market risks: Reform of the market risk calculation framework to make it more robust and sensitive to actual risks.

•    Capital requirements for operational risks: Introduction of a new standardised approach for calculating capital requirements related to operational risks.

Implementation schedule : Implementation of Basel IV began in 2022 and is due to be completed by 2028. Banks must prepare for these changes, which will have a significant impact on their capital requirements and operational models.

Expected impacts : Basel IV is expected to result in an overall increase in capital requirements for many banks, particularly those that made extensive use of internal models under Basel II and III. This could have implications for banks' profitability and their ability to extend credit, although the ultimate goal remains to strengthen the stability of the financial system.

What finance students need to remember

For finance students and future banking professionals, understanding the evolution of Basel regulations is crucial for several reasons:

1. Understanding regulatory constraints: Banks and financial institutions operate within a strict regulatory framework. Knowing these rules is essential for working in compliance, risk management or corporate finance.

2. Impact on finance professions: Basel regulations directly influence banking practices, risk management and investment strategies. Professionals must adapt their skills to these changes, particularly in terms of risk analysis and capital management.

3. Preparing for future challenges: With Basel IV, banks will need to continue adjusting their models and strategies. Students who master these issues will be better prepared for careers in risk, compliance or financial regulation.

4. Opportunities in fintech and innovation: Strict regulations are pushing banks to innovate, particularly through fintech and digital solutions. Students familiar with these issues will be able to contribute to the development of compliant and effective solutions.

Conclusion

The Basel Accords have profoundly transformed the international banking landscape in response to successive financial crises. From Basel I to Basel IV, each step has strengthened the resilience of banks, while increasing the complexity of regulation. For finance students, understanding this evolution is essential to grasping the current and future challenges facing the sector.

Basel IV marks the culmination of decades of reform, but the regulatory work will not stop there. Future challenges, such as the digitalisation of banking services, cryptocurrencies and climate risks, will likely require further regulatory adjustments. Finance professionals who master these issues will be well positioned to contribute to a more stable, innovative and resilient banking system.

By learning about these regulations and their implications now, finance students can prepare for exciting careers in risk management, compliance, regulation or financial innovation. Understanding Basel means understanding the future of finance.