What are Basel banking norms?

Around 10 public sector banks (PSBs) will get a total capital infusion of Rs 12,517 crore from the government before this financial year ends. This is to enable a step-up of lending at this time of slowing economic growth, as well as meeting the capital adequacy norms. In the light of this development here is a short primer on Basel banking norms. Basel is a city in Switzerland which is also the headquarters of Bureau of International Settlement (BIS). BIS fosters co-operation among central banks with a common goal of financial stability and common standards of banking regulations. Currently there are 27 member nations in the committee. Basel guidelines refer to broad supervisory standards formulated by this group of central banks- called the Basel Committee on Banking Supervision (BCBS). The set of agreement by the BCBS, which mainly focuses on risks to banks and the financial system are called Basel accord. The purpose of the accord is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses. India has accepted Basel accords for the banking system. Basel I In 1988, BCBS introduced capital measurement system called Basel capital accord, also called as Basel 1. It focused almost entirely on credit risk. It defined capital and structure of risk weights for banks. The minimum capital requirement was fixed at 8% of risk weighted assets (RWA). RWA means assets with different risk profiles. For example, an asset backed by collateral would carry lesser risks as compared to personal loans, which have no collateral. India adopted Basel 1 guidelines in 1999. Basel II In 2004, Basel II guidelines were published by BCBS, which were considered to be the refined and reformed versions of Basel I accord. The guidelines were based on three parameters. Banks should maintain a minimum capital adequacy requirement of 8% of risk assets, banks were needed to develop and use better risk management techniques in monitoring and managing all the three types of risks that is credit and increased disclosure requirements. Banks need to mandatorily disclose their risk exposure, etc to the central bank. Basel II norms in India and overseas are yet to be fully implemented.

The accord in operation

Basel II uses a "three pillars" concept (1) minimum capital requirements (addressing risk), (2) supervisory review and (3) market discipline. The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk was not dealt with at all.

The first pillar[edit source | editbeta]

The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk, and market risk. Other risks are not considered fully quantifiable at this stage. The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach, Foundation IRB, Advanced IRB and General IB2 Restriction. IRB stands for "Internal Rating-Based Approach".

For operational risk, there are three different approaches basic indicator approach or BIA, standardized approach or STA, and the internal measurement approach (an advanced form of which is the advanced measurement approach or AMA). For market risk the preferred approach is VaR (value at risk). As the Basel II recommendations are phased in by the banking industry it will move from standardised requirements to more refined and specific requirements that have been developed for each risk category by each individual bank. The upside for banks that do develop their own bespoke risk measurement systems is that they will be rewarded with potentially lower risk capital requirements. In the future there will be closer links between the concepts of economic and regulatory capital.

The second pillar[edit source | editbeta]

This is a regulatory response to the first pillar, giving regulators better 'tools' over those previously available. It also provides a framework for dealing with systemic risk, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk and legal risk, which the accord combines under the title of residual risk. Banks can review their risk management system. It is the Internal Capital Adequacy Assessment Process (ICAAP) that is the result of Pillar II of Basel II accords.

The third pillar[edit source | editbeta]

This pillar aims to complement the minimum capital requirements and supervisory review process by developing a set of disclosure requirements which will allow the market participants to gauge the capital adequacy of an institution. Market discipline supplements regulation as sharing of information facilitates assessment of the bank by others, including investors, analysts, customers, other banks, and rating agencies, which leads to good corporate governance. The aim of Pillar 3 is to allow market discipline to operate by requiring institutions to disclose details on the scope of application, capital, risk exposures, risk assessment processes, and the capital adequacy of the institution. It must be consistent with how the senior management, including the board, assess and manage the risks of the institution. When market participants have a sufficient understanding of a bank's activities and the controls it has in place to manage its exposures, they are better able to distinguish between banking organizations so that they can reward those that manage their risks prudently and penalize those that do not. These disclosures are required to be made at least twice a year, except qualitative disclosures providing a summary of the general risk management objectives and policies which can be made annually. Institutions are also required to create a formal policy on what will be disclosed and controls around them along with the validation and frequency of these disclosures. In general, the disclosures under Pillar 3 apply to the top consolidated level of the banking group to which the Basel II framework applies.
Basel III In 2010, Basel III guidelines were released. These guidelines were introduced in response to the financial crisis of 2008. A need was felt to further strengthen the system as banks in the developed economies were under-capitalized, over-leveraged and had a greater reliance on short-term funding. Also the quantity and quality of capital under Basel II were deemed insufficient to contain any further risk. Basel III norms aim at making most banking activities such as their trading book activities more capital-intensive. The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz. capital, leverage, funding and liquidity.

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Basel III Accord - Basel 3 Norms

What is Basel iii or What is Basel 3 Accord or Meaning and Definition of Basel III Accord:Basel III or Basel 3 released in December, 2010 is the third in the series of Basel Accords. These accords deal with risk management aspects forthe banking sector. In a nut shell we can say that Basel iii is the global regulatory standard (agreed upon by the members of the Basel Committee on Banking Supervision) on bank capital adequacy, stress testing and market liquidity risk. (Basel I and Basel II are the earlier versions of the same, and were less stringent) What does Basel III is all About ? According to Basel Committee on Banking Supervision "Basel III is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector". Thus, we can say that Basel 3 is only a continuation of effort initiated by the Basel Committee on Banking Supervision to enhance the bankingregulatory framework under Basel I and Basel II. This latest Accord now seeks to improve the banking sector's ability to deal with financial and economic stress, improve risk management and strengthen the banks' transparency.

What are the objectives / aims of the Basel III measures ? Basel 3 measures aim to:

improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source improve risk management and governance

strengthen banks' transparency and disclosures. Thus we can say that Basel III guidelines are aimed at to improve the ability of banks to withstand periods of economic and financial stress as the new guidelines are more stringent than the earlier requirements for capital and liquidity in the banking sector.

How Does Basel III Requirements Will Affect Indian Banks : The Basel III which is to be implemented by banks in India as per the guidelines issued by RBI from time to time, will be challenging task not only for the banks but also for GOI. It is estimated that Indian banks will be required to rais Rs 6,00,000 crores in external capital in next nine years or so i.e. by 2020 (The estimates vary from organisation to organisation). Expansion of capital to this extent will affect the returns on the equity of these banks specially public sector banks. However, only consolation for Indian banks is the fact that historically they have maintained their core and overall capital well in excess of the regulatory minimum.

What are Three Pillars of Basel II Norms or What are the changes in Three Pillars of Basel iii Accord ?

Basel III: Three Pillars Still Standing :

Any one who has ever heard about Basel I and II, is most likely must have heard about Three Pillars of Basel. Three Pillar of Basel still stand under Basel 3. Basel III has essentially been designed to address the weaknesses that become too obvious during the 2008 financial crisis world faced. The intent of the Basel Committee seems to prepare the banking industry for any future economic downturns.. The framework enhances bank-specific measures and includes macro-prudential regulations to help create a more stable banking sector.

The basic structure of Basel III remains unchanged with three mutually reinforcing pillars.

Pillar 1 : Minimum Regulatory Capital Requirements based on Risk Weighted Assets (RWAs) : Maintaining capital calculated through credit, market and operational risk areas. Pillar 2 : Supervisory Review Process : Regulating tools and frameworks for dealing with peripheral risks that banks face. Pillar 3: Market Discipline : Increasing the disclosures that banks must provide to increase the transparency of banks

What are the Major Changes Proposed in Basel III over earlier Accords i.e. Basel I and Basel II? What are the Major Features of Basel III ?

(a) Better Capital Quality : One of the key elements of Basel 3 is the introduction of much stricter definition of capital. Better quality capital means the higher lossabsorbing capacity. This in turn will mean that banks will be stronger, allowing them to better withstand periods of stress. (b) Capital Conservation Buffer: Another key feature of Basel iii is that now banks

will be required to hold a capital conservation buffer of 2.5%. The aim of asking to build conservation buffer is to ensure that banks maintain a cushion of capital that can be used to absorb losses during periods of financial and economic stress. (c) Countercyclical Buffer: This is also one of the key elements of Basel III. The countercyclical buffer has been introducted with the objective to increase capital requirements in good times and decrease the same in bad times. The buffer will slow banking activity when it overheats and will encourage lending when times are tough i.e. in bad times. The buffer will range from 0% to 2.5%, consisting of common equity or other fully loss-absorbing capital.

(d) Minimum Common Equity and Tier 1 Capital Requirements : The minimum requirement for common equity, the highest form of loss-absorbing capital, has been raised under Basel III from 2% to 4.5% of total risk-weighted assets. The overall Tier 1 capital requirement, consisting of not only common equity but also other qualifying financial instruments, will also increase from the current minimum of 4% to 6%. Although the minimum total capital requirement will remain at the current 8% level, yet the required total capital will increase to 10.5% when combined with the conservation buffer. (e) Leverage Ratio: A review of the financial crisis of 2008 has indicted that the value

of many assets fell quicker than assumed from historical experience. Thus, now Basel III rules include a leverage ratio to serve as a safety net. A leverage ratio is the relative amount of capital to total assets (not risk-weighted). This aims to put a cap on swelling of leverage in the banking sector on a global basis. 3% leverage ratio of Tier 1 will be tested before a mandatory leverage ratio is introduced in January 2018. (f) Liquidity Ratios: Under Basel III, a framework for liquidity risk management will be created. A new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are to be introduced in 2015 and 2018, respectively. (g) Systemically Important Financial Institutions (SIFI) : As part of the macroprudential framework, systemically important banks will be expected to have lossabsorbing capability beyond the Basel III requirements. Options for implementation include capital surcharges, contingent capital and bail-in-debt.

Comparison of Capital Requirements under Basel II and Basel III : Under Base Under l II Basel III 8% 2% 10.50% 4.50% to

Requirements Minimum Ratio of Total Capital To RWAs Minimum Ratio of

Common RWAs Tier I RWAs

Equity to capital to

7.00% 4% 2% None None None None None 6.00% 5.00% 2.50% 3.00% 0% to 2.50% TBD (2015) TBD (2018) TBD (2011)

Core Tier I capital to RWAs Capital Conservation Buffers to RWAs Leverage Ratio Countercyclical Buffer Minimum Liquidity Coverage Ratio Minimum Net Stable Funding Ratio Systemically important Financial Institutions Charge

None

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Q: What are Basel norms? Basel is a set of standards and practices developed for global banks to ensure that they maintain adequate capital to withstand periods of economic strain. It is a comprehensive set of reform measures designed to improve the regulation, disclosures and risk management within the banking sector. Q: What did Basel I and Basel II focus on? Basel I norms was introduced in 1998, focused almost entirely on credit risk. It defined capital requirement and structure of risk weights for banks. Basel II was introduced in 2004, laid down guidelines for capital adequacy, risk management and disclosure requirements.

Q: Why Basel III? It is widely felt that the shortcoming in Basel II norms is what led to the global financial crisis of 2008. That is because Basel II did not have any explicit regulation on the debt that banks could take on their books, and focused more on individual financial institutions, while ignoring systemic risk. To ensure that banks dont take on excessive debt, and that they dont rely too much on short term funds, Basel III norms were proposed in 2010. Q: What does Basel III norm stipulate? Basel III establishes tougher capital standards through more restrictive capital definitions, higher risk-weighted assets (RWA), additional capital buffers and higher requirements for minimum capital ratios. It also introduces new strict liquidity requirements. Q: What is the biggest criticism against Basel III? That the stringent capital requirements come at a time when the global economy is in the midst of a slowdown. This will leave banks with less money to lend, in turn pushing up the cost of borrowing; and thereby further aggravating the slowdown. Q: Why are many banks opposed to Basel III norms? Basel III norms will require banks to undertake significant process and system changes to make upgrades, particularly in the areas of stress testing, liquidity and capital management infrastructure. The reforms could fundamentally impact profitability and require sweeping changes in the business models of many banks Q: What is the deadline for banks to become Basel III compliant? For international banks the deadline is December 31, 2018 and March 31, 2018 for Indian banks. Q: Why the earlier deadline for Indian banks?

The RBI said that: We did this to align our date with the close of the Indian fiscal year, which is March 31. We could have gone up to March 31, 2019, but that would have overshot the Basel III prescription by three months and would have attracted adverse notice. Q: Why are Indian banks concerned about Basel III norms? Just like for international banks, Basel III norms will affect the profitability and return ratios of Indian banks as well. Something which is admitted by the RBI. Basel III requires higher and better quality capital. Admittedly, the cost of equity capital is high. The average Return on Equity (RoE) of the Indian banking system for the last three years has been approximately 15%. Implementation of Basel III is expected to result in a decline in Indian banks' RoE in the short-term. Q: How much extra capital will Indian banks need for Basel III? According to RBIs estimates, Indian banks will require a capital of Rs 5 lakh crore over the next five years, of which Rs 1.75 lakh crore will have to be equity capital. Within the Rs 1.75 lakh crore, anywhere between Rs 70,000-1,00,000 crore will have to raised through the market, depending on to what extent the government will infuse capital in state-owned banks. Q: Indian banks are much better off than global banks that caused the financial crisis. Why then should Indian banks then comply with Basel III norms? The RBI said: India should transit to Basel III because of several reasons. By far the most important reason is that as India integrates with the rest of the world, as increasingly Indian banks go abroad and foreign banks come on to our shores, we cannot afford to have a regulatory deviation from global standards. Any deviation will hurt us both by way of perception and also in actual practice. Also, it is important that Indian banks have the cushion afforded by improved risk management systems to withstand shocks from external systems, especially as they deepen their links with the global financial system going forward.
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