Limited differentiation of credit riskThere are four broad risk weightings (0%, 20%, 50% and 100%), as shown in Figure1, based on an 8% minimum capital ratio. Static measure of default risk The assumption that a minimum 8% capital ratio is sufficient to protect banks from failure does not take into account the changing nature of default risk.No recognition of term-structure of credit risk The capital charges are set at the same level regardless of the maturity of a credit exposure. Simplified calculation of potential future counterparty riskThe current capital requirements ignore the different level of risks associated with different currencies and macroeconomic risk. In other words, it assumes a common market to all actors, which is not true in reality. Lack of recognition of portfolio diversification effectsIn reality, the sum of individual risk exposures is not the same as the risk reduction through portfolio diversification. Therefore, summing all risks might provide incorrect judgment of risk. A remedy would be to create an internal credit risk model - for example, one similar to the model as developed by the bank to calculate market risk. This remark is also valid for all other weaknesses.
Refer G.Vijayaraghavan book pp 170-171
Regulatory Compliance: Economic capital was originally devised to help banks run their businesses better. While the regulatory advocacy of economiccapital frameworks is heartening, banks shouldn’t over-focus on regulatory applications or, even, capital adequacy. Instead they should immediately useeconomic capital analysis to throw light on areas such as business line profitability, risk-based pricing and the potential use of credit derivatives to optimise portfolios - and plan the full roll-out of at least one short-term business goal such as improved economic-capital based credit limit setting.Over Focusing on Credit Risk: Credit risk is the first and sometimes the only banking risk banks consider, but other risk types can account for up to 45percent of overall economic capital at a ‘typical’ bank. These risk sources must be quantified if a bank wants to understand overall capital requirements and compare the performance of business lines – not least because the proportion of risk from each risk source often varies dramatically (eg, between lending and non-lending business lines). One typical problem is that banks forget to assign capital to important risks not fully addressed by the Basel II reforms such as financially-driven business risks, eg, the way interest rate volatility drives the revenue of mortgage origination units.
(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 loss-absorbing 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 introduced 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 macro-prudential framework, systemically important banks will be expected to have loss-absorbing capability beyond the Basel III requirements. Options for implementation include capital surcharges, contingent capital and bail-in-debt.
Basel III and the BanksWith that in mind, banks must hold more capital against their assets, thereby decreasing the size of their balance sheets and their ability to leverage themselves. While these regulations were under discussion prior to the financial crisis, their necessity is magnified as more recent events occur. The Basel III regulations contain several important changes for banks' capital structures. First of all, the minimum amount of equity, as a percentage of assets, will increase from 2% to 4.5%. There is also an additional 2.5% "buffer" required, bringing the total equity requirement to 7%. This buffer can be used during times of financial stress, but banks doing so will face constraints on their ability to pay dividends and otherwise deploy capital. Banks will have until 2019 to implement these changes, giving them plenty of time to do so and preventing a sudden "lending freeze" as banks scramble to improve their balance sheets.It is possible that banks will be less profitable in the future due in part to these regulations. The 7% equity requirement is a minimum and it is likely that many banks will strive to maintain a somewhat higher figure in order to give themselves a cushion. If financial institutions are perceived as being safer, the cost of capital to banks would actually decrease. Banks that are more stable will be able to issue debt at a lower cost. At the same time, the stock market might assign a higher P/E multiple to banks that have a less risky capital structure.Basel III and Financial Stability Basel III is not a panacea, and will not single-handedly restore stability to the financial system and prevent future financial crisis. However, in combination with other measures, these regulations are likely to help produce a more stable financial system. In turn, greater financial stability will help produce steady economic growth, with less risk for crisis fueled recessions such as that experienced following the global financial crisis of 2008-2009.While banking regulations may help reduce the possibility of future financial crises, it may also restrain future economic growth. This is because bank lending and the provision of credit are among the primary drivers of economic activity in the modern economy. Therefore, any regulations designed to restrain the provision of credit are likely to hinder economic growth, at least to some degree. Nevertheless, following the events of the financial crisis, many regulators, financial market participants and ordinary individuals are willing to accept slightly slower economic growth for the possibility of greater stability and a decreased likelihood of a repeat of the events of 2008 and 2009. Basel III and InvestorsAs with any regulations, the ultimate impact of Basel III will depend upon how it is implemented in the future. Furthermore, the movements of international financial markets are dependent upon a wide variety of factors, with financial regulation being a large component. Nevertheless, it is possible to generalize about some of the possible impacts of Basel III for investors.It is likely that increased bank regulation will ultimately be a positive for bond market investors. That is because higher capital requirements will ultimately make bonds issued by banks safer investments. At the same time, greater financial system stability will provide a safer backdrop for bond investors, even if the economy grows at a slightly weaker pace as a result. The impact on currency markets is less clear; but increased international financial stability will allow participants in these markets to focus upon other factors while perhaps eventually giving less focus to the relative stability of each country's banking system.Finally, the effect of Basel III on stock markets is uncertain. If investors value enhanced financial stability more than the possibility of slightly higher growth fueled by credit, stock prices are likely to benefit from Basel III (all else being equal). Furthermore, greater macroeconomic stability will allow investors to focus more on individual company or industry research while having to worry less about the economic backdrop or the possibility of broad-based financial collapse.
An Overview of the Basel Norms
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 AdequacyNorms Tier I Capital Tier II Capital Risk Weighted Assets Subordinated Debts
Risks Involved Credit Risk Market Risk a) Interest Rate Risk b) Foreign Exchange Risk c) Commodity Price Risk etc. Operational Risk
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 CategorizationAccording to Basel I, the total capital should representat 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 risk 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 counterparty 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
Risk CategorizationIn the Basel – II accord, Credit Risk, Market Risk andOperational Risks were recognized.Under Basel – II, Credit Risk has three approachesnamely, standardized, foundation internal ratings-based (IRB), and advanced IRBOperational Risk has measurement approaches likethe Basic Indicator approach, Standardized approachand the Advanced Measurement approach.
Impact on Banking Sector Capital Requirement Wider Market Products Customers
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 NormsBasel – III norms aim to: Improving 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
Basel III and its impact On Banks On Financial Stability On Investors
References Bank For International Settlements, “Basel Committee on Banking Supervisions”, http://www.bis.org/bcbs/index.htm Investopedia, http://www.investopedia.com/articles/economics/10/ understanding-basel-3- regulations.asp#axzz26w2DIKab Bank Credit Management by G.Vijayaraghavan, Chapter – 14, pp- 170 - 171