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FRM Exam Part II · Capital Regulation Before the Global Financial Crisis

Basel I Accord, Risk Weights and Credit Risk Capital

Updated 11 October 2026 · Fact-checked

Basel I (1988) required internationally active banks to hold capital of at least 8% of risk-weighted assets, with at least half as Tier 1. You multiply each exposure by a risk weight of 0%, 20%, 50% or 100%, add the results to get RWA, then multiply by 8% to get required capital.

Understand Basel I Accord and Credit Risk Capital

Before 1988, banks in different countries held very different amounts of capital against their loans. Banks from countries with weak rules could lend more cheaply and compete unfairly. The Basel Accord of 1988, set by the Basel Committee on Banking Supervision, created a common minimum standard for internationally active banks. It focused on credit risk.

The idea is simple. Not all assets are equally risky, so a loan to a government should need less capital than a loan to a company. Basel I sorted assets into a few risk-weight buckets. Typical examples: 0% for cash and claims on OECD governments; 20% for claims on OECD banks and some public sector entities; 50% for residential mortgages; 100% for corporate loans and most other claims. Exposure times risk weight gives risk-weighted assets (RWA).

Banks then had to hold capital of at least 8% of RWA. Capital had two tiers. Tier 1 is the core: equity capital (common shares) and disclosed reserves. Tier 2 is supplementary: items such as undisclosed reserves, revaluation reserves, general loan-loss provisions (limited) and hybrid and subordinated term debt (limited). Tier 2 could not exceed Tier 1, and Tier 1 had to be at least 4% of RWA.

Off-balance-sheet items such as guarantees and commitments were included by using credit conversion factors to turn them into on-balance-sheet equivalents (credit equivalent amounts), which were then risk weighted. For derivatives, the credit equivalent amount was current exposure plus an add-on based on notional.

Basel I was simple and transparent, but crude. Every corporate loan got 100% whatever the borrower's quality, which encouraged regulatory arbitrage, such as securitising the best loans. These weaknesses led to the 1996 Market Risk Amendment and then Basel II.

Key formulas to remember

Risk-weighted assets
RWA = Σ (exposure × risk weight)
For off-balance-sheet items, first convert to a credit equivalent amount using the conversion factor, then apply the counterparty risk weight.
Minimum total capital ratio
(Tier 1 + Tier 2) ÷ RWA ≥ 8%
Minimum required capital = 8% × RWA.
Minimum Tier 1 ratio
Tier 1 ÷ RWA ≥ 4%
Tier 1 must be at least half of required total capital.
Tier 2 limit
Tier 2 (eligible) ≤ Tier 1
Excess Tier 2 does not count toward the 8%.
Credit equivalent for derivatives
Credit equivalent = current exposure + add-on (notional × add-on factor)
Current exposure is the replacement cost, floored at zero. The result is then multiplied by the counterparty risk weight.
Typical risk weights
0% / 20% / 50% / 100%
0%: cash, OECD government claims. 20%: OECD banks. 50%: residential mortgages. 100%: corporate and most other claims.

How to solve Basel I Accord and Credit Risk Capital questions

Use this order for any Basel I calculation or conceptual question.

  1. 1Identify each exposure and whether it is on or off balance sheet.
  2. 2For off-balance-sheet items, apply the credit conversion factor (or current exposure plus add-on for derivatives) to get the credit equivalent amount.
  3. 3Assign the Basel I risk weight by counterparty or asset type: 0%, 20%, 50% or 100%.
  4. 4Multiply each amount by its risk weight and add to get total RWA.
  5. 5Multiply RWA by 8% for the minimum total capital; by 4% for the minimum Tier 1.
  6. 6Check the capital stack: apply the rule that eligible Tier 2 cannot exceed Tier 1, then compute the ratio actually held.
  7. 7Compare with the minimum and state the result: surplus, shortfall or ratio.
  8. 8For conceptual questions, link the answer to the key limitation: coarse buckets, no credit-quality differentiation, no diversification, credit risk focus.

Quickest way: Weight, add, multiply by 8%

When to use it: Use when the question gives a list of exposures and asks for RWA, required capital or the capital ratio.

  1. Write each exposure with its weight as a short product, such as 200 × 0.5.
  2. Add the products to get RWA.
  3. Required capital = RWA × 0.08; Tier 1 floor = RWA × 0.04.
  4. Cap Tier 2 at the Tier 1 amount before computing the ratio.
  5. Match the number to the options; wrong options often come from forgetting the 8% or using the wrong weight.

Common mistakes in Basel I Accord and Credit Risk Capital

  • Treating required capital as 8% of total assets rather than of RWA.

    The 8% looks like a simple leverage-type ratio.

    Fix: Always compute RWA first. Capital ratio = capital ÷ RWA.

  • Applying a 100% weight to every loan, including mortgages and OECD bank claims.

    Students remember corporates at 100% and forget the other buckets.

    Fix: Memorise the four buckets and the example assets in each.

  • Counting all Tier 2 capital toward the 8%.

    Forgetting the limit that Tier 2 cannot exceed Tier 1.

    Fix: Take the lower of Tier 2 and Tier 1 as eligible Tier 2.

  • Ignoring off-balance-sheet items such as guarantees and loan commitments.

    RWA feels like a balance sheet exercise.

    Fix: Convert them with the credit conversion factor first, then apply the counterparty risk weight.

  • Saying Basel I covers market and operational risk.

    Confusing it with later frameworks.

    Fix: Basel I (1988) covered credit risk only. Market risk came with the 1996 Amendment; operational risk with Basel II.

  • Thinking Basel I risk weights depend on the borrower's credit rating.

    Mixing it up with Basel II's standardised approach.

    Fix: Basel I used broad borrower-type categories, not ratings. A weak and a strong corporate both got 100%.

Worked examples

Example 1

A bank has: cash of $50 million, claims on an OECD government of $200 million, claims on OECD banks of $100 million, residential mortgages of $400 million and corporate loans of $300 million. Under Basel I, what is the minimum total capital?

Show the solution
  1. Cash: 50 × 0% = 0.
  2. OECD government: 200 × 0% = 0.
  3. OECD banks: 100 × 20% = 20.
  4. Mortgages: 400 × 50% = 200.
  5. Corporate loans: 300 × 100% = 300.
  6. RWA = 0 + 0 + 20 + 200 + 300 = $520 million.
  7. Minimum capital = 8% × 520 = $41.6 million.

Answer: Minimum total capital is $41.6 million (RWA $520 million). At least half, $20.8 million, must be Tier 1.

Example 2

A bank has RWA of $2,000 million, Tier 1 capital of $90 million and Tier 2 capital of $130 million. Does it meet Basel I minimums?

Show the solution
  1. Required total capital = 8% × 2,000 = $160 million.
  2. Required Tier 1 = 4% × 2,000 = $80 million. Tier 1 of $90 million meets this.
  3. Eligible Tier 2 is capped at Tier 1: min(130, 90) = $90 million.
  4. Eligible total capital = 90 + 90 = $180 million.
  5. Total capital ratio = 180 ÷ 2,000 = 9.0%, above 8%.
  6. Tier 1 ratio = 90 ÷ 2,000 = 4.5%, above 4%.

Answer: Yes. Total capital ratio is 9.0% and Tier 1 ratio is 4.5%, both above the minimums. Only $90 million of the $130 million Tier 2 counts.

Exam tips

  • Expect questions asking which asset gets which risk weight; know the four buckets cold.
  • Questions often hide the trap in Tier 2 eligibility or an off-balance-sheet item; read the exposure list twice.
  • For conceptual items, name the weakness precisely: no differentiation of credit quality within the 100% bucket, no recognition of diversification or hedging, and regulatory arbitrage.
  • Link Basel I to what came next: the 1996 Market Risk Amendment added market risk capital, and Basel II introduced ratings-based and internal-model approaches.
  • State ratios as a percentage of RWA, never of total assets.

Practice questions from Capital Regulation Before the Global Financial Crisis

Basel I Accord and Credit Risk Capital in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Basel I Accord and Credit Risk Capital: frequently asked questions

What are the Basel I risk weights?

Basel I used four main weights: 0% for cash and OECD government claims, 20% for claims on OECD banks, 50% for residential mortgages and 100% for corporate and most other claims. Exposure times weight gives RWA.

What is the difference between Tier 1 and Tier 2 capital under Basel I?

Tier 1 is core capital: common equity and disclosed reserves. Tier 2 is supplementary: items like revaluation reserves, limited general provisions and subordinated or hybrid debt. Tier 2 cannot exceed Tier 1, and Tier 1 must be at least 4% of RWA.

What is the difference between Basel I and Basel II?

Basel I covered credit risk with fixed risk-weight buckets. Basel II added three pillars: minimum capital with ratings-based and internal approaches for credit risk plus an operational risk charge, supervisory review, and market discipline. It made capital more risk sensitive.

What were the main limitations of Basel I?

Its buckets were coarse, so a safe and a risky corporate loan carried the same weight. It ignored diversification and hedging, and it encouraged regulatory arbitrage such as securitising low-risk loans. Originally it also covered only credit risk.