2. Introduction to BASEL.
Basel committee was established in 1974.
The central bank governors of the G10 countries established a committee on
banking regulation and supervisory practices.
Later renamed as the Basel committee on banking supervision(BCBS).
Head office of the basel committee is in Basel, Switzerland and
representative officers in Hong Kong S A R and in Mexico city.
Basel committee on banking supervision(BCBS) came into being under the
patronage of Bank for international settlement(BIS), Basel, Switzerland.
Currently there are 45 members, from 28 jurisdictions in the committee.
The Basel committee on banking supervision provides a forum for regular
corporation on banking supervisory matters.
Its mandates is to strengthen the regulations, supervision and practices of
banks worldwide with a purpose of enhancing financial stability.
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3. The prudential norms defined components of capital, assigned risk, weights to
different type of asserts and stipulated the minimum capital adequacy to
aggregate risk weighted asserts (CRAR).
The minimum standard of capital to be kept with commercial banks was fixed 8%
of RWA under basil 1& basil norms which was increased to 9% of RWA under
Basel 3.
The set of agreements by the BCBS, which mainly focuses on risk to banks and
the financial system are called Basel accords.
The purpose of accord is to ensure that the financial institutions have enough
capital on account to meet obligations and obserb unexpected losses. India has
accepted basel accords for the baning system.
4. What is CAR?
◦ Capital adequacy provides regulators with the mean
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 bank’s capital to its asserts, to assess
risk.
◦ CAR = (Bank’s capital)/ (Risk weighted asserts)
= ( Tier 1 Capital + Tier 2 Capital) / (Risk
weighted asserts)
5. Concept of Capital Adequacy
Norms.
◦ Tier I Capital: share capital and disclosed reserves and it is
banks' highest quality capital because it is fully available to
cover losses.
◦ Tier II Capital: it consists of certain reserves and certain
types of subordinate debts.
The losses absorption capacity of tier II is lower than that
of tier 1 capital.
◦ Risk weighted asserts.
◦ Subordinated debts.
6. Risk involved.
◦ Credit risk.
◦ Market risk.
a) Interest rate risk.
b) Foreign exchange risk.
c) Commodity price risk.
◦ Operational risk.
7. Basel 1 Norms.
◦ In 1988 the Basel 1 capital accord was created. The general purpose was to:
◦ Risk management (focused on credit risk, no recognition of operational risk).
◦ Capital adequacy, sound supervision and regulation.
◦ Transparency of operations.
Unquestionably accepted by developed and developing countries.
Capital requirement 8% of assets.
Tier 1 capital at 4%
Tier II capital at 4%
◦ Strengthen the stability of international banking system.
◦ Set up a fair and consistent international banking system in order to
increase the competitive inequality among international banks.
8. Basis of Capital in Basel 1.
◦ Tier 1 ( Core capital): Tier 1 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 asserts, 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.
9. Risk Categorization.
According to the Basel-1, the total capital should represent
at least 8% of the bank’s credit.
Risk can be:
• The on-balance sheet risk (lie risk associated with cash &
gold held with banks, government bonds, corporate bonds
etc.)
• Market risk includes interest rates, foreign exchange, equity
derivatives and commodities.
• Non trading off-balance sheet risk like forward purchase of
asserts or transaction related debt asserts.
10. Limitations of Basel 1 norms.
◦ Limited differentiations of credit risk.
◦ Static measure of default risk.
◦ Non recognition of term-structure of credit risk.
◦ Simplified calculation of potential future counterparty risk.
◦ Lack of recognition of portfolio diversification efforts.
12. 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 rating
based (IRB) and advanced IRB.
Operational risk has measurement approaches like
the basic Indicator approach, standardized
approach and the advanced measurement
approach.
13. Impact on Banking Sector.
◦ Capital requirement.
◦ Wider market.
◦ Products.
◦ Customers.
14. Advantages of Basel II over 1.
◦ The discrepancy between economic capital and
regulatory capital is reduced significantly, due to
that the regulatory equipments rely on bank’s
own risk methods.
◦ More risk sensitive.
◦ Wider recognition of credit risk mitigation.
15. Pitfalls of Basel II Norms.
◦ Too much regulatory appliance
◦ Over focusing on credit risk
◦ The new accord is complex and therefore demanding for
the new supervision, and unsophisticated banks.
◦ Strong risk differentiation in the new accord can adversely
affect the borrowing position of risky borrowers.
16. Basel III Norms.
Basel III norms aims to:
• Improving the banking sector’s ability to absorb
shocks arising from financial and economic stress.
• Improve risk management and governance
• Strengthen banks transparency and disclosure.
17. Structure of Basel III Accord.
◦ Minimum regulatory capital requirement based on risk
weighted assert (RWAs): maintaining capital calculated
through credit, market and operational risk areas.
◦ Supervisory review process: regulating tools and
framework for dealing with peripheral risks that banks face.
◦ Market discipline: increasing the disclosure that banks
must provide to increase the transparency of banks.
18. Major Changes in Basel III .
◦ Better capital quality.
◦ Capital conservation buffer.
◦ Counter cyclical buffer.
◦ Minimum common equity and Tier 1 capital
requirements.
◦ Leverage ratio.
◦ Liquidity ratio.
◦ Systematically important financial institutions.
19. Basel III and its impact.
◦ On banks: It accounts for more risk in the system than
earlier. As a result it increases bank’s minimum capital
requirement. This capital can be easily used to raise funds
in the time of trouble. Plus, banks also have a hold an
additional buffer of 2.5% of risk asserts.
◦ On financial stability: it resulted in a safer financial system
while restraining future economic growth to a small
degree.
◦ On investors: for investors impact is likely to be diverse,
but it should result in safer markets for bond investors and
greater stability for stock market investors.
