“Basel III is more about improving the risk management systems in the Banks than just Improved Quality and enhanced Quantity of capital”. Please discuss the challenges to the Indian Banks by March,2017

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Name: Kalpesh Arvind Shah| Company Name: Antony Lara Enviro Solutions Pvt Ltd
Designation: Dy. General Manager Finance & Commercials (Corporate)
Batch: AMP 2017-18|Roll No: 1 (One)
Subject: Integrated Risk Management in Banks
Topic: “Basel III is more about improving the risk management systems in the Banks than just Improved
Quality and enhanced Quantity of capital”. Please discuss the challenges to the Indian Banks by
March,2017

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Introduction:
Basel III is the regulatory response to the causes and consequences of the global financial crisis.
The Basel III framework is a central element of the Basel Committee’s response to the global financial
crisis. It addresses many shortcomings in the pre-crisis regulatory framework and provides a foundation
for a resilient banking system that will help avoid the build-up of systemic vulnerabilities.
The framework will allow the banking system to support the real economy through the economic cycle.
Basel III ‘s main features are “Increase the level and quality of capital”, “Enhance Risk Assessment &
Projection and Mitigate”, “Constrain Bank Leverage”, “Improve Bank liquidity” and finally “Limit
positive correlation between the value of a good, a service or an economic indicator”. While the first
phase of Basel III focused largely on the capital side of the capital ratio calculation the numerator, the
2017 reforms concentrate on the calculation of Risk Weighted Assets RWA-the denominator.
Banks required to maintain more capital of higher quality to cover unexpected losses. Minimum Tier 1
capital rises from 4% to 6%, of which at least three quarters must be the highest quality (common shares
and retained earnings). Global systemically important banks (G-SIBs) are subject to additional capital
requirements. Capital requirements for market risk rise significantly. Requirements are calculated based
on 12 months of market stress. Credit Valuation Adjustment risk is now included in the framework.
Revisions to the standardized approaches for calculating credit risk, market risk, Credit Valuation
Adjustment and operational risk mean greater risk sensitivity and comparability. Constraints on using
internal models aim to reduce unwarranted variability in banks' calculations of RWAs. An output floor
limits the benefits banks can derive from using internal models to calculate minimum capital
requirements.
A leverage ratio constrains the build-up of debt to fund banks' investment and activities (bank leverage),
reducing the risk of a deleveraging spiral during downturns. Global systemically important banks (G-SIBs)
are subject to higher leverage ratio requirements.
The Liquidity Coverage Ratio requires banks to hold sufficient liquid assets to sustain them for 30 days
during times of stress. The Net Stable Funding Ratio encourages banks to better match the duration of
their assets and liabilities. Banks retain earnings to build up capital buffers during periods of high
economic growth so that they can draw them down during periods of economic stress.
Pillar I, Enhancing Minimum Capital and Liquidity Requirements:
Strengthens macroprudential regulation and supervision and adds a macroprudential overlay that
includes capital buffers.
The existing rules require a capital adequacy ratio of 8% to the RWAs. Rules allow Tier 1 capital at a
minimum of 4% of RWAs and Tier 2 capital comprising of debt instruments of medium term maturity of
at least 5 years at a maximum of 4% of RWAs. Tier 3 capital with short maturity of at least 2 years can
also support Tier 2 capital to some extent. Common equity in Tier 1 capital can be as low as 2% of RWAs.
Innovative features such as step-up option is allowed in capital instruments. The regulatory adjustments
to capital are affected both at Tier 1 and Tier 2 capital in equal measure.

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The existing definition of capital is, thus, flawed. Capital is not only deficient in quality equity capital, but
also contains elements of debt which do not support the bank as a going concern. As I have stated
earlier, big banks entered the crisis with insufficient level and quality of capital. Under Basel III, Tier 1
capital will be the predominant form of regulatory capital. It will be minimum 75% of the total capital of
8%, i.e., 6%, as against 4% now, i.e., 50% of total capital. Within Tier 1 capital, common equity will be
the predominant form of capital. It will be minimum 75% of the Tier 1 capital requirement of 6%, i.e.,
4.5%, from the existing level of 2%. You may observe that the meaning of “predominant” portion of
common equity in Tier 1 capital and Tier 1 capital portion in total capital (Tier 1 plus Tier 2) as 50%
under Basel I and II has under gone a change to 75% under Basel III, improving the overall level of high
quality capital in the banks.
To my mind the most revolutionary feature of Basel III in this regard is to ensure that public sector
rescue of non-viable, but still functioning banks, does not entail absorption of losses by the tax-payers
while leaving the non-common equity capital providers unscathed. Therefore, under Basel III, the terms
and conditions of all non-common Tier 1 and Tier 2 instruments issued by banks will have a provision
that requires such instruments, at the option of the relevant authority, to be either written off or
converted into common equity upon the bank being adjudged by the supervisory authority as having
approached or approaching the point of non-viability. Additionally, innovative features in non-equity
capital instruments are no longer acceptable.
Tier 3 capital has also been completely abolished. The regulatory adjustments or deductions from capital
presently applied at 50% to Tier 1 capital and 50% to Tier 2 capital will now be 100% from the common
equity Tier 1 capital. To improve market discipline, all elements of capital are required to be disclosed
along with a detailed reconciliation to the reported accounts. These requirements will be implemented
uniformly across all jurisdictions and the consistency in application will be ensured by the Basel
Committee through a peer review process.
Thus, the definition of capital in terms of its quality, quantity, consistency and transparency will
improve under Basel III.
To reduce the reliance on external ratings of the Basel II framework, measures have been proposed that
include requirements for banks to perform their own internal assessments of externally rated
securitization exposures, the elimination of certain “cliff effects” (sharp increase in applicable risk
weights) associated with credit risk mitigation practices, and the incorporation of key elements of the
IOSCO Code of Conduct Fundamentals for Credit Rating Agencies into the Committee’s eligibility criteria
for the use of external ratings in the capital framework.
Basel III framework will have enhanced risk coverage. This is necessitated due to the excessive
exposures of banks to derivative products whose risks were not captured comprehensively under Basel I
or Basel II framework.
Quality and level of capital Greater focus on common equity. The minimum will be raised to 4.5% of risk
weighted assets, after deductions. Securitizations Strengthens the capital treatment for certain complex
securitizations. Requires banks to conduct more rigorous credit analyses of externally rated
securitization exposures.
Capital loss absorption at the point of non-viability Contractual terms of capital instruments will include
a clause that allows – at the discretion of the relevant authority – write-off or conversion to common

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shares if the bank is judged to be non-viable. This principle increases the contribution of the private
sector to resolving future banking crises and thereby reduces moral hazard. Trading book Significantly
higher capital for trading and derivatives activities, as well as complex securitizations held in the trading
book. Introduction of a stressed value-at-risk framework to help mitigate procyclicality. A capital charge
for incremental risk that estimates the default and migration risks of unsecuritised credit products and
takes liquidity into account.
Capital conservation buffer Comprising common equity of 2.5% of risk-weighted assets, bringing the
total common equity standard to 7%. Constraint on a bank’s discretionary distributions will be imposed
when banks fall into the buffer rang. Counterparty credit risk Substantial strengthening of the
counterparty credit risk framework. Includes: more stringent requirements for measuring exposure;
capital incentives for banks to use central counterparties for derivatives; and higher capital for inter-
financial sector exposures.
Countercyclical buffer Imposed within a range of 0-2.5% comprising common equity, when authorities
judge credit growth is resulting in an unacceptable buildup of systematic risk. Bank exposures to central
counterparties (CCPs) The Committee has proposed that trade exposures to a qualifying CCP will receive
a 2% risk weight and default fund exposures to a qualifying CCP will be capitalized according to a risk-
based method that consistently and simply estimates risk arising from such default fund.
Leverage ratio A non-risk-based leverage ratio that includes off-balance sheet exposures will serve as a
backstop to the risk-based capital requirement. Also helps contain system wide buildup of leverage.
In addition to meeting the Basel III requirements, global systemically important financial institutions
(SIFIs) must have higher loss absorbency capacity to reflect the greater risks that they pose to the
financial system. The Committee has developed a methodology that includes both quantitative
indicators and qualitative elements to identify global systemically important banks (SIBs). The additional
loss absorbency requirements are to be met with a progressive Common Equity Tier 1 (CET1) capital
requirement ranging from 1% to 2.5%, depending on a bank’s systemic importance. For banks facing the
highest SIB surcharge, an additional loss absorbency of 1% could be applied as a disincentive to increase
materially their global systemic importance in the future. A consultative document was published in
cooperation with the Financial Stability Board, which is coordinating the overall set of measures to
reduce the moral hazard posed by global SIFIs.
Pillar II: Risk management and supervision
Supplemental Pillar 2 requirements. Address firm-wide governance and risk management; capturing the
risk of off-balance sheet exposures and securitization activities; managing risk concentrations; providing
incentives for banks to better manage risk and returns over the long term; sound compensation
practices; valuation practices; stress testing; accounting standards for financial instruments; corporate
governance; and supervisory college
Pillar 3 Market discipline
Revised Pillar 3 disclosures requirements. The requirements introduced relate to securitization
exposures and sponsorship of off-balance sheet vehicles. Enhanced disclosures on the detail of the
components of regulatory capital and their reconciliation to the reported accounts will be required,
including a comprehensive explanation of how a bank calculates its regulatory capital ratios
Global liquidity standard and supervisory monitoring Liquidity coverage ratio.

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The liquidity coverage ratio (LCR) will require banks to have sufficient high-quality liquid assets to
withstand a 30-day stressed funding scenario that is specified by supervisors. Net stable funding ratio
the net stable funding ratio (NSFR) is a longer-term structural ratio designed to address liquidity
mismatches. It covers the entire balance sheet and provides incentives for banks to use stable sources of
funding. Principles for Sound Liquidity Risk Management and Supervision the Committee’s 2008
guidance Principles for Sound Liquidity Risk Management and Supervision takes account of lessons
learned during the crisis and is based on a fundamental review of sound practices for managing liquidity
risk in banking organizations. Supervisory monitoring. The liquidity framework includes a common set of
monitoring metrics to assist supervisors in identifying and analyzing liquidity risk trends at both the bank
and system-wide level.
In addition to meeting the Basel III requirements, global systemically important financial institutions
(SIFIs) must have higher loss absorbency capacity to reflect the greater risks that they pose to the
financial system. The Committee has developed a methodology that includes both quantitative
indicators and qualitative elements to identify global systemically important banks (SIBs). The additional
loss absorbency requirements are to be met with a progressive Common Equity Tier 1 (CET1) capital
requirement ranging from 1% to 2.5%, depending on a bank’s systemic importance. For banks facing the
highest SIB surcharge, an additional loss absorbency of 1% could be applied as a disincentive to increase
materially their global systemic importance in the future. A consultative document was published in
cooperation with the Financial Stability Board, which is coordinating the overall set of measures to
reduce the moral hazard posed by global SIFIs.
Conclusion:
Basel III is an extension of the existing Basel II Framework, and introduces new capital and liquidity
standards to strengthen the regulation, supervision, and risk management of the whole of the banking
and finance sector.
It was agreed upon by the members of the Basel Committee on Banking Supervision in 2010–2011 and
was scheduled to be introduced from 2013 until 2015. However, changes made from April 2013
extended implementation until March 31, 2018. The Basel III requirements were in response to the
deficiencies in financial regulation that is revealed by the 2000’s financial crisis. Basel III was intended to
strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage.
The global capital framework and new capital buffers require financial institutions to hold more capital
and higher quality of capital than under current Basel II rules. The new leverage ratio introduces a no
risk-based measure to supplement the risk-based minimum capital requirements. The new liquidity
ratios ensure that adequate funding is maintained in case there are other severe banking crises.
The figure below shows how Basel III strengthens the three Basel II pillars, especially Pillar 1 with
enhanced minimum capital and liquidity requirements.
Below are the Challenges for Indian Banks
Capital requirements
The Basel III rule introduced the following measures to strengthen the capital requirement and
introduced more capital buffers:

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Capital Conservation Buffer is designed to absorb losses during periods of financial and economic stress.
Financial institutions will be required to hold a capital conservation buffer of 2.5% to withstand future
periods of stress, bringing the total common equity requirement to 7% (4.5% common equity
requirement and the 2.5% capital conservation buffer). The capital conservation buffer must be met
exclusively with common equity. Financial institutions that do not maintain the capital conservation
buffer faces restrictions on payouts of dividends, share buybacks, and bonuses.
Countercyclical Capital Buffer is a countercyclical buffer within a range of 0% and 2.5% of common
equity or other fully loss absorbing capital is implemented according to national circumstances. This
buffer serves as an extension to the capital conservation buffer.
Higher Common Equity Tier 1 (CET1) constitutes an increase from 2% to 4.5%. The ratio is set at:
3.5% from 1 January 2013
4% from 1 January 2014
4.5% from 1 January 2015
Minimum Total Capital Ratio remains at 8%. The addition of the capital conservation buffer increases
the total amount of capital a financial institution must hold to 10.5% of risk-weighted assets, of which
8.5% must be tier 1 capital. Tier 2 capital instruments are harmonized and tier 3 capital is abolished.
Leverage ratio
Basel III introduced a minimum "leverage ratio". The leverage ratio was calculated by dividing Tier 1
capital by the bank's average total consolidated assets; the banks were expected to maintain a leverage
ratio in excess of 3% under Basel III. In July 2013, the US Federal Reserve Bank announced that the
minimum Basel III leverage ratio would be 6% for 8 SIFI banks and 5% for their bank holding companies.
Liquidity requirements
Basel III introduced two required liquidity ratios:
Liquidity Coverage Ratio (LCR) ensures that sufficient levels of high-quality liquid assets are available for
one-month survival in a severe stress scenario.
Net Stable Funding Ratio (NSFR) promotes resilience over long-term time horizons by creating more
incentives for financial institutions to fund their activities with more stable sources of funding on an
ongoing structural basis.
Changes to Counterparty Credit Risk (CCR)
Basel III introduced capital requirements to cover Credit Value Adjustment (CVA) risk and higher capital
requirements for securitization products.
Source and Reference:
RISK MANAGEMENT IN BANKS: NEW APPROACHES TO RISK ASSESSMENT AND INFORMATION SUPPORT-
Taras Shevchenko National University of Kyiv, Ukraine, Galyna Chornous*, Ganna Ursulenko
www.bis.org - Finalizing Basel III In brief, www.ibm.com/support/knowledgecenter