Basel Norms : Critical Evaluation

Mayuri Gabani 11228 Karan Mehta 11229 Rayees Mohammad 11240 Amitkumar Sarvade 11244

Contents
BIS Basel committee Basel I Basel II Basel III

Bank for International Settlements (BIS)

Established on 17 May 1930 The head office is in Basel, Switzerland Its mission is to serve central banks in their pursuit of monetary and financial stability, to foster international cooperation in banking areas and to act as a bank for central banks. One of the world's oldest international financial organization.

THE BASEL COMMITTEE ON BANKING SUPERVISION (BCBS)

The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. Objective: 1.Enhance understanding of key supervisory issues. 2.improve the quality of banking supervision worldwide. Develop guidelines and supervisory standards Committee is best known for its international standards on capital adequacy; the Core Principles for Effective Banking Supervision; and on cross-border banking supervision.

Objectives
The G10 countries recognized the need to strengthen the solvency of the international banking system and to remove the competitive inequality that arose from differences in national capital requirements. In response, the Basel Committee introduced in 1988 a new capital adequacy framework the Basel Capital Accord The Accord should continue to promote safety and soundness in the financial system The Accord should contain approaches to capital adequacy that are appropriately sensitive to the degree of risk involved in a banks positions and activities.

Basel norms
Basel I 1988 Accord Basel II 2004 Accord Basel III 2010-2011 Accord

Basel I
Requires the banks to hold capital equal to at least 8% of its Risk Weighted Assets CAR Capital is broadly into two tiers Tier 1 and Tier 2 Weights are assigned to each asset depending on its riskiness. Assets are classified into four buckets (0%, 20%, 50%, 100%) according to their debtor category.

Tier I Capital
Consists of :

Paid up capital Statutory reserves Disclosed free reserves Capital reserves representing surplus arising out of sale proceeds of asset

Excludes : Equity investments in subsidiaries Intangible assets and losses

Tier II Capital
Consists of : Undisclosed reserves and Cumulative perpetual preference shares

Revaluation reserves

General provisions and loss reserves

Hybrid debt capital instruments

Subordinated debt

Tier II capital cannot exceeds tier1 capital.

Capital Adequacy Ratio

Capital adequacy ratio (CAR), also called Capital to Risk (Weighted) Assets Ratio (CRAR), is a ratio of a bank's capital to its risk. National regulators track a bank's CAR to ensure that it can absorb a reasonable amount of loss and complies with statutory Capital requirements. Three aspects are relevant:

Composition of Capital
Composition of Risk Weighted Assets Assigning Risk Weights

Capital Adequacy Ratio =

Tier I Capital +Tier II Capital Risk Weighted Assets

Basel I Criticisms
Following are the criticisms of the First Basel Accord (Basel I): It took too simplistic an approach to setting credit risk weights Ignoring other types of risk. Risks weights were based on what the parties to the Accord negotiated rather than on the actual risk of each asset. Risk weights did not flow from any particular insolvency probability standard, and were for the most part, arbitrary.

Basel II
The minimum capital requirement remains set at 8% of RWA However, the calculation procedures used in establishing the risk weights have been modified to incorporate Credit risk Market risk Operational risks. Three methods to calculate credit risk

3 methods
Basel II includes three options for calculating credit risk and three methods for measuring operational risk. The credit risk estimation options are Standardized approach
Credit assessment Risk-weight AAA to AA20% A+ to A50% BBB+ to Below BB- Unrated BB100% 150% 100%

IRB approaches (Foundation and Advanced) Determined through a combination of

the quantitative inputs provided by banks and the formulae specified by the Committee.

3 pillars

In essence, Basel II rests on three mutually reinforcing pillars:

Pillar I - Minimum Capital Requirement (Addressing Credit Risk, Operational Risk & Market Risk) Pillar II - Supervisory Review (Provides Framework for Systematic Risk, Liquidity Risk & Legal Risk) Pillar III - Market Discipline & Disclosure (To promote greater stability in the financial system)

Capital adequacy ratio

Capital Adequacy Ratio = Total Capital (Tier I Capital + Tier II Capital+ Tier III Capital) Market Risk(RWA) + Credit Risk(RWA) + Operation Risk(RWA)

Tier III Capital includes subordinate debt with a maturity of at least 2 years. This is addition or substitution to the Tier II Capital to cover market risk alone. Tier III Capital should not cover more than 250% of Tier I capital allocated to market risk.

Basel II merits

The revised framework keeps the key elements of the 1988 framework Contains further risk-sensitive capital requirements Paying due regard to particular features of the present supervisory and accounting systems in individual member countries. Introduces significant innovations, including a greater reliance on the use of participating banks own internal risk assessments as inputs to capital requirement calculations It is designed to establish minimum levels of capital reserves for internationally active banks and will allow national authorities the discretion to adopt arrangements that set higher levels of minimum capital

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Range of options for determining capital requirements for credit, market and operational risk, Allowing greater latitude for banks and regulators to select the methods best suited to their operations and their financial market infrastructure Greater attention to the supervisory review and market discipline Aggression towards development of the existing standards by banks. Strong regulatory impact by central bank to all the banks for implementation

Basel II criticism

For some developing countries, the new capital adequacy rules may unduly restrict access to credit. Unfairly favors the larger financial institutions Implementation of the capital accord may be delayed as financial institutions struggle to upgrade their systems, practices and procedures. The recruitment of qualified staff with adequate knowledge and experience to implement the new capital adequacy regime Some financial institutions may sidestep by shifting riskier assets off their balance sheet to subsidiaries, or may employ similar strategies to transfer risk to third parties.

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The implementation of Basel II raises a number of challenges that need to be addressed in the areas of risk identification, measurement and monitoring, it concerns the management of operational risk Pillar 3 purports to enforce market discipline through stricter disclosure requirement. While admitting that such disclosure may be useful for supervisory authorities and rating agencies The expertise and ability of the general public to comprehend and interpret disclosed information is open to question. Too much disclosure may cause information overload and may even damage financial position of bank.

Basel III
RBI's version Migrate fully by Risk capital Tier I capital Particulars March 31, 2018 11.5% 5.5% Basel III January 1, 2019 10.5% 4.5% % of its risky assets

Tier I
Tier II Additional equity Capital conservation buffer Counter cyclical buffer Total capital that banks need to set aside

5.5%
2% 1.5% 2.5% 2.5% 14%

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The risk capital to be set aside by Indian banks is 11.5 per cent of all its risky loans in the form of common equity whereas the global requirement is 10.5 per cent. Indian banks are required to set aside minimum common equity of 5.5 per cent (TierI) capital for its risky assets (loans). Banks also have to set aside two per cent Tier-2 capital. Banks also have to bring in additional equity at a minimum of 1.5 per cent of its risky assets (loans). To counter liquidity crunch, banks have to set aside a capital conservation buffer of 2.5 per cent in the form of common equity.

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Banks have to build this buffer when they make bumper profits. This buffer would be drawn down when banks face losses due to a downturn in business. Finally, banks are also expected to counter the cyclical nature of their business by setting aside 2.5 per cent common equity as counter cyclical buffer. So, the total capital that banks need to set aside is 14 per cent. Rs 2.5 lakh crore of additional equity under the Basel III capital regulations announced by the RBI 75 per cent needed to be added between 201516 and 2017-18

Basel II v/s Basel III

The quality, consistency, and transparency of the capital base Tier 3 capital will be eliminated capital conservation buffer of 2.5 per cent in the form of common equity. 2.5 per cent common equity as counter cyclical buffer. Basel III introduces a minimum 3% leverage ratio and two required liquidity ratios Liquidity requirement

References
BIS website rbi-guidelines-on-basel-iii financialexpress.com thehindubusinessline parl.gc.caResearchPublications