The Basel Accords refer to the banking supervision Accords

issued by the Basel Committee on Banking

Supervision (BCBS).

It includes the Basel I , Basel II and Basel III norms.

They are called the Basel Accords as the BCBS maintains
its secretariat at the Bank for International Settlements
in Basel, Switzerland and the committee normally meets
there.

The Basel Committee on Banking
Supervision (BCBS)is a committee of
banking supervisory authorities that was
established by the central bank governors
of the G-10 countries in 1974.

Since 2009, all of the other G-20 major economies are
represented, as well as some other major banking
locales such as Hong Kong and Singapore.
Basel Committee on banking supervision
introduced the Basel 1 also known as the
1988 Basel Accord , a set of minimum capital
requirements for banks.

Basel I is primarily focused on credit risk and
appropriate risk weighting of assets.
The 1988 Accord requires:
The bank to hold capital equal to atleast 8%
of their risk-weighted assets (RWA).

The definition of capital is set in two tiers:
Tiers 1 being of shareholders equity and
retained earnings.
Tier 2 being additional internal and external
resources available to the bank.



Risk-weighted asset is a bank's assets or off-
balance sheet exposures, weighted according
to risk.

The Committee insisted that the banks use this
approach for capital calculation because
1. it provides an easier approach to compare banks
across different geographies
2. off-balance-sheet exposures can be easily
included in capital adequacy calculations
3. banks are not deterred from carrying low risk
liquid assets in their books

Assets of banks were classified and grouped
in five categories according to credit risk:
carrying risk weights of 0% (for example cash,
bullion, home country debt like Treasuries)
20% (securitizations such as mortgage
backed securities (MBS) with the highest AAA
rating)
50% mortgaged loans
100% (for example, most corporate debt)
some assets were given no rating.



The tier 1 capital ratio = tier 1 capital / all
RWA

The total capital ratio = (tier 1 + tier 2
capital) / all RWA

Leverage ratio = total capital/average total
assets

Limited differentiation of credit risk
There are four broad risk weightings (0%, 20%, 50% and 100%), 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 risk
The current capital requirements ignore the different level of risks associated with
different currencies and macroeconomic risk.

Lack of recognition of portfolio diversification effects
In 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

Pillar 1 sets out the minimum capital requirements firms will be

required to meet to cover credit, market and operational risk.

Pillar 2 sets out a new supervisory review process. Requires
financial institutions to have their own internal processes to assess
their overall capital adequacy in relation to their risk profile.

Pillar 3 cements Pillars 1 and 2 and is designed to improve market
discipline by requiring firms to publish certain details of their risks,
capital and risk management as to how senior management and the
Board assess and will manage the institution's risks.



Three Pillars of Basel II Framework

Pillar 1 : Minimum capital requirements

Institution's total regulatory capital must be atleast
8% (ratio same as in Basel I) of its risk
weighted assets, based on measures of THREE RISKS
Measuring credit risk


Banks can assess risk using three different ways of
varying degree of sophistication

Standardized approach

Foundation IRB(Internal Rating-Based Approach)

Advanced IRB

Credit
Assessment
AAA
TO
AA-
(%)
A+ TO
A

(%)
BBB+ TO
BBB-

(%)
BB+ TO
BB-

(%)
BELOW
B-

(%)
UNRATE
D

(%)
SOVEREIGN
CREDIT
0 20 50 100 150 100
CLAIMS ON
BANKS
OPTION1 20 50 100 100 150 100
OPTION 2 20 50 50 100 150 50
OPTION 3 20 20 20 50 150 20
CORPORATES 20 50 100 150 150 100
Probability of
default(PD)
Probability that counterparty will not meet its financial
obligation
Loss given
default(LGD)
Expected amount of loss on default
Exposure at
default (EAD)
Expected amount of exposure
maturity
Average maturity of the exposure
Exposure
type
(IRBF)

Internal
data
(IRBF)

Regulatory
data
(IRBA)

Internal data

(IRBA)

Regulatory
data

CORPORATES,
SOVEREIGN ,
OTHER BANKS
PD LGD, EAD, M PD, LGD,
EAD, M
Measuring operational risk


Operational risk is risk of loss resulting from
inadequate or failed internal processes, people and
systems or from external events. It includes legal risk,
such as exposure to fines, penalties etc.

Methods to measure operational risk
Basic Indicator Approach
Standardized Approach
CAPITAL REQUIREMENT

=Average positive gross income over the last
three years* 15%

Gross income= net interest and commission
income excluding profits/losses from sale of
securities
BUSINESS LINE BETA FACTOR
Corporate finance 18%
Trading and sales 18%
Retail banking 12%
Commercial banking 15%
Payment and settlement 18%
Supervisory review process has been
introduced to ensure

o banks have adequate capital to support all
the risks

o to encourage them to develop and use better
risk management techniques in monitoring
and managing their risks.
Process for assessing overall capital adequacy
in relation to risk profile.
Review and evaluate banks internal capital
adequacy assessment
Expect banks to operate above the minimum
regulatory capital ratios
Intervene at early stage to prevent capital
from falling below minimum levels
Covers transparency and the obligation of banks to
disclose meaningful information to all stakeholders

Clients and shareholders should have sufficient
understanding of activities of banks, and the way they
manage their risks
Increased Capital requirement

Profitability- implementation of models

Rating requirement

Absence of historical database( PD,LGD, EAD,
M)

Disadvantages for smaller banks









BASEL 3
CAPI TAL REQUI REMENTS-
Banks to hold 4.5% of common equity & 6% of tier I
capital of Risk Weighted Assets (RWA).
{Tier 1 capital= common shares+ retained earnings}

ADDI TI ONAL CAPI TAL BUFFERS-
Mandatory capital conservation buffer of 2.5% of RWA.
banks must hold 7.0% CET 1 capital on an individual
and consolidated basis at all times.


CET 1 capital includes

a) A payment of cash dividends;
b) A distribution of fully or partly paid bonus
shares or other capital instruments;
c) A redemption or purchase by an
institution of its own shares or other
specified capital instruments;
d) A repayment of amounts paid up in
connection with specified capital instruments;
LEVERAGE REQUI REMENTS
Leverage Ratio = Tier 1 capital > = 3%
Total exposure


Liquidity coverage ratio(LCR)

The Liquidity Coverage Ratio requires institutions
to hold a sufficient buffer of high quality liquid
assets to cover net liquidity outflows during a 30-
day period of stress.


= High quality liquid assets > = 100%
Total net liquidity outflows

HIGH QUALITY LIQUID ASSETS-

a) Cash and deposits held with central banks to the extent that
these deposits can be withdrawn in times of stress;
b) Transferable assets that are of extremely high liquidity and
credit quality;
c) Transferable assets guaranteed by the central government
or a third country if the institution incurs a liquidity risk in that
third country that it covers by holding those liquid assets;
Listed on a recognized exchange

Net liquidity outflows =
Liquidity outflows - liquidity inflows in
the stress scenario


Net stable funding ratio
The Net Stable Funding Ratio (NSFR)
requires institutions to maintain a sound
funding structure over one year in an
extended firm-specific stress scenario.


NSFR =Available stable funding
Required stable funding

AVAILABLE STABLE FUNDING
a) Own funds;
items not included in the own funds:
i) Retail deposits as defined in the
Regulation;
ii) All funding obtained from financial
customers;
iii) Funding from secured lending as
specified in the Regulation;