Overview of The Basel Norms – I, II & III

Arunav Nayak

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 Adequacy NormsTier I Capital

Tier II Capital

Risk Weighted Assets

Subordinated Debts

Risks InvolvedCredit Risk

Market Riska) Interest Rate Riskb) Foreign Exchange Riskc) 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 - ITier 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 Categorization According to Basel I, the total capital should

represent at 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 NormsLimited 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 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 ratings- based (IRB), and advanced IRB Operational Risk has measurement approaches like the Basic Indicator approach, Standardized approach and the Advanced Measurement approach.

Impact on Banking SectorCapital Requirement

Wider Market

Products

Customers

Advantages of Basel II over IThe 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 normsToo 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 Norms Basel – III norms aim 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 disclosures

Structure of Basel – III AccordMinimum 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 - IIIBetter Capital QualityCapital Conservation BufferCounter cyclical BufferMinimum Common Equity and Tier I Capital

requirementsLeverage RatiosLiquidity RatiosSystematically Important Financial

Institutions

Basel III and its impactOn Banks

On Financial Stability

On Investors

ReferencesBank 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

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