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A to Z of BASEL Norms

Basel Committee on Banking Supervision:
i. The Basel Committee on Banking Supervision is an institution of Governors of the Central Banks of “G-10” nations and was formed in 1974.
ii. The Committee is a forum for discussion on the handling of specific supervisory problems.
iii. It coordinates the sharing of supervisory responsibilities among national authorities in respect of banks' foreign establishments with the aim of ensuring effective supervision of banks' activities worldwide.
iv. The committee operates from Basel in Switzerland.

 What is CAR?
Capital adequacy provides regulators with a means of establishing whether banks and other financial institutions have sufficient capital to keep them out of difficulty. Regulators use a Capital Adequacy Ratio (CAR), a ratio of a bank’s capital to its assets, to assess risk.

CAR = (Bank’s Capital)/(Risk Weighted Assets) = 
(Tier I Capital + Tier II Capital) / (Risk Weighted Assets)

Concepts of Capital Adequacy Norms
  • Tier I Capital
  • Tier II Capital
  • Risk Weighted Assets
  • Subordinated Debts

Basel – I Norms
In 1988, the Basel I Capital Accord was created. The general purpose was to:
1. Strengthen the stability of international banking system.
2. Set up a fair and a consistent international banking system in order to decrease competitive inequality among international banks.

Basis of Capital in Basel – I

Tier I (Core Capital): Tier I capital includes stock issues (or share holders equity) and declared reserves, such as loan loss reserves set aside to cushion future losses or for smoothing out income variations.
Tier II (Supplementary Capital): Tier II capital includes all other capital such as gains on investment assets, long-term debt with maturity greater than five years and hidden reserves (i.e. excess allowance for losses on loans and leases). However, short-term unsecured debts (or debts without guarantees), are not included in the definition of capital.

Risk Categorization
According to Basel I, the total capital should represent at least 8% of the bank’s credit risk. Risks can be:
The on-balance sheet risk (like risks associated with cash & gold held with bank, government bonds, corporate bonds etc.)
Market risks including interest rates, foreign exchange, equity derivatives & commodities.
Non Trading off-balance sheet risks like forward purchase of assets or transaction related debt assets

Limitations of Basel – I Norms
  • Limited differentiation of credit risk
  • Static measure of default risk
  • No recognition of term-structure of credit risk
  • Simplified calculation of potential future counter party risk
  • Lack of recognition of portfolio diversification effects
Basel – II Norms
Basel – II norms are based on 3 pillars:
Minimum Capital – Banks must hold capital against 8% of their assets, after adjusting their assets for risk
Supervisory Review – It is the process whereby national regulators ensure their home country banks are following the rules.
Market Discipline – It is based on enhanced disclosure of risk

Pillars of Basel Norms II
 Risk Categorization 
  • In the Basel – II accord, Credit Risk, Market Risk and Operational Risks were recognized.
  • Under Basel – II, Credit Risk has three approaches namely, standardized, foundation internal ratings-based (IRB), and advanced IRB
  • Operational Risk has measurement approaches like the Basic Indicator approach, Standardized approach and the Advanced Measurement approach.

Advantages of Basel II over I
  • The discrepancy between economic capital and regulatory capital is reduced significantly, due to that the regulatory requirements will rely on banks’ own risk methods.
  • More Risk sensitive
  • Wider recognition of credit risk mitigation.
Pitfalls of Basel – II norms
  • Too much regulatory compliance
  • Over Focusing on Credit Risk
  • The new Accord is complex and therefore demanding for supervisors, and unsophisticated banks
  • Strong risk differentiation in the new Accord can adversely affect the borrowing position of risky borrowers
Basel – III Norms
Basel – III norms aim to:
  • Improve the banking sectors ability to absorb shocks arising from financial and economic stress
  • Improve risk management and governance
  • Strengthen banks transparency and disclosures

Structure of Basel – III Accord
  • Minimum Regulatory Capital Requirements based on Risk Weighted Assets (RWAs): Maintaining capital calculated through credit, market and operational risk areas.
  • Supervisory Review Process: Regulating tools and frameworks for dealing with peripheral risks that banks face
  • Market Discipline: Increasing the disclosures that banks must provide to increase the transparency of banks
Major changes in Basel – III
  • Better Capital Quality
  • Capital Conservation Buffer
  • Counter cyclical Buffer
  • Minimum Common Equity and Tier I Capital requirements
  • Leverage Ratios
  • Liquidity Ratios
  • Systematically Important Financial Institutions
Important Points:
  • In accordance with Basel III norms, Indian banks will have to maintain their capital adequacy ratio at 9 per cent as against the minimum recommended requirement of 8 per cent.  
  • Under Basel III accord, banks have to maintain Tier-one capital (equity and reserves) at 7 per cent of risk weighted assets (RWA) and a capital conservation bugger of 2.5 per cent of RWA. 
  • According to the recent RBI financial stability report, Indian banks will require an additional capital of Rs.5 trillion (5lakh crore) to comply with Basel III norms, including Rs 3.25 trillion (Rs 3.25 lakh crore) as non-equity capital and Rs 1.75 trillion(Rs 1.75 lakh crore) in the form of equity capital over the next five years. 
  • To ensure that PSU Banks meet the Basel III regulations regarding capital adequacy, the government will infuse Rs 14,000 crore in public sector banks in next fiscal (2013-14). The Basel III capital ratios will be fully phased in as on March 31, 2018.

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