Basel I is the recommendation set published by central bank heads from G10 (Group of 10) countries in the world in 1988 which provides the norms of minimal capital requirements for Banks. Before publishing Basel II with better risk management, it was the widely used banking regulation guidelines in the world.
Basel I was prepared mainly to handle the credit risk. To reduce the credit risk, it has suggested the banks to hold some capital with them equal to some predefined percentage of all the risk weighted assets.
To do the same, assets of banks were classified into five categories based on the probable credit risk which starts from zero to 100% with 10%, 20% and 50% credit risk in the list. The example of asset with zero credit risk would be the government bond issued by the domestic country’s government and the example of asset with 50% or 100% credit risk would be the corporate debts based on the business risk. After classifying the assets based on credit risk, the total risk weighted asset is calculated after multiplying the asset weight with the credit risk percentage.
After that based on the total risk weighted asset and the minimum capital requirement percentage (mainly 8%) the minimum capital requirement is calculated which the banks are required to hold with them.
Let us see one example to understand this properly. Suppose one bank has total assets of 1000 USD in which 200 USD is invested in each type of categories with credit risk 0%, 10%, 20%, 50% and 100%.
The total risk weighted asset would be = 200*0.00 + 200* 0.10 + 200* 0.20 + 200*0.50 + 200* 1.00 = 0+ 20 + 40 + 100 + 200 = 360 USD
Now if the minimum capital requirement percentage is 8%, then the minimum capital requirement will be 360* 0.08 = 28.8 USD. So 28.8 USD has to be held with the bank for the total asset of 1000 USD.
Disadvantage of Basel I
Banks have used the minimum held capital to implement credit default swaps to pass on the credit risk to other insurance companies. By doing this they can reduce the actual capital holding requirement significantly and expose the insurance companies in the credit risk. The credit default swap was the main reason behind US insurance giant AIG filing bankruptcy during the subprime crisis in 2008.
Basel I, that is, the 1988 Basel Accord, primarily focused on credit risk. Assets of banks were classified and grouped in five categories according to credit risk, carrying risk weights of zero (for example home country sovereign debt), ten, twenty, fifty, and up to one hundred percent (this category has, as an example, most corporate debt). Banks with international presence are required to hold capital equal to 8 % of the risk-weighted assets. However, large banks like JPMorgan Chase found Basel I’s 8% requirement to be unreasonable and implemented credit default swaps so that in reality they would have to hold capital equivalent to only 1.6% of assets.