The Basel Accord was created in 1988, at an event organized in the city of Basel (Switzerland). Due to the location, the name given to the established agreements is due.
The main objective of the conference held was, on occasion, to create rules and regulations between banking institutions from all over the planet, something extremely necessary due to the effects brought about by globalization.
In this year of 1988, therefore, over 100 countries participated, willing to share measures that would regulate banks, minimize the credit risks of financial institutions and help protect the world banking system.
What are the main definitions of the Basel Accord?
Within the Basel Accord, the points discussed brought some norms and rules that started to be followed by banks from the most diverse countries involved.
Since the first meeting, called the 1st Basel Accord, there have been two revisions. From now on, you will understand what each change has brought to the global financial system.
Basel I is the name attributed to the 1st Basel Accord. These rules, unlike the others, were defined at the beginning of the meeting, and were validated in 1988.
The main determination was the creation of a minimum capital index (popularly known as Basel Index ). This index, which we will see in more detail below, obliges banks to hold at least 8% of all capital assigned to third parties (loans and investments) in cash.
In addition, it was defined that banks should carry out evaluations on borrowers of capital, better mapping the risks of an operation.
The 1st Basel Accord made an enormous contribution to the global financial system, but it presented a problem with risk assessment. How to standardize this issue with such different realities around the planet?
For this adjustment, the 2nd Basel Accord (Basel II) was created. In it, it was accepted that each bank would have autonomy to define risk as long as the country’s Central Bank validated the criteria.
In this way, institutions gained freedom from their risks while maintaining market transparency. The final objective followed the same: to guarantee the financial strength of banks and the global market.
More recently, in 2008, the great crisis that haunted the financial market demanded further adjustments to the Basel Accord. There was clearly something wrong, after all the problem was international.
To increase global financial strength, it was decided to tighten up the cash reserve. If before it was 8%, now that value should have the addition of a “conservation mattress” of 2.5% more. In other words, in other words, the reserve needed to be equivalent to 10.5% of the capital at risk.
The Basel Index
As you have already seen, one of the consequences of the Basel Accord was the creation of the Basel Index, a mathematical tool created to measure the risk of a banking institution and to understand its financial strength.
Anyone knows, even though they are absolutely lay about finance, that banks work with money. What these companies do is take advantage of their clients’ deposits to reapply that capital in loans and investments that allow an even greater return than those paid to depositors.
The problem is that these investments have risks. A loan may not be repaid, an application may face liquidity problems, and so on. In this way, the bank could not have money for all of its obligations and would end up breaking.
That is why the Basel Ratio is essential for investor decision making. It allows the risk analysis of a company in the financial segment.
How is the Basel Index calculated?
The Basel Index formula is simple, but its understanding is somewhat complex. To find this value, the Reference Equity (sum of the institution’s tier I and II capital) must be divided by the Weighted Risk Assets (which involve market, operational and credit risks).
The formula is as follows:
Basel Index = PR / RWA, where:
- PR = Reference Equity
- RWA = Risk-Weighted Assets
As we mentioned, finding these two indicators is not a practical task, especially for those who do not master financial analysis. However, the Central Bank itself is responsible for distributing the results periodically. Therefore, the most important thing is to understand what the Basel Index informs the investor.
How to interpret the result of the Basel Index?
To summarize, the formula weighs up the capital composition of a bank and the risks involved. The higher the Basel Index, the greater the bank’s financial strength and, therefore, the more secure it is.
The minimum recommended by the Basel Accord, as we have seen, is 8%. In other words, a banking institution with a lower index than this represents a high risk for investors.
If you choose to use a higher risk bank, it is recommended that you also require better offers of profitability from that institution in relation to competitors. This is because if the return promise is similar, it is not worth taking such high risks.
Therefore, the Basel Index is a tool that helps investors to measure risk situations and choose which banking institutions to place capital in.