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An Overview of the Basel Norms


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Published in: Economy & Finance

An Overview of the Basel Norms

  1. 1. Arunav Nayak
  2. 2. 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)
  3. 3. Concepts of Capital AdequacyNorms Tier I Capital Tier II Capital Risk Weighted Assets Subordinated Debts
  4. 4. Risks Involved Credit Risk Market Risk a) Interest Rate Risk b) Foreign Exchange Risk c) Commodity Price Risk etc. Operational Risk
  5. 5. 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.
  6. 6. 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.
  7. 7. 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
  8. 8. 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
  9. 9. 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
  10. 10. 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.
  11. 11. Impact on Banking Sector Capital Requirement Wider Market Products Customers
  12. 12. 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.
  13. 13. 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
  14. 14. 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
  15. 15. 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
  16. 16. 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
  17. 17. Basel III and its impact On Banks On Financial Stability On Investors
  18. 18. References Bank For International Settlements, “Basel Committee on Banking Supervisions”, Investopedia, understanding-basel-3- regulations.asp#axzz26w2DIKab Bank Credit Management by G.Vijayaraghavan, Chapter – 14, pp- 170 - 171
  19. 19. Thank You