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http://www.insightsonindia.com/2014/06/30/understanding-banking-system-basel-norms-banking-stability/
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Introduction
Banking system is the backbone of any nations economy. For an economy to remain healthy and going, it is
important that the banking system grows fast and yet be stable.
This catches the biggest dilemma of policymakers. How to achieve both the objectives simultaneously?
Over a period of time, several indicators have been developed which gauge the depth and stability of the banking
system. Examples can be Non-performing assets, Capital adequacy ratio (CAR) etc.
Similarly, mechanisms to ensure their stability have also been developed. Some of the examples can be CRR;
SLR; Basel conventions; regular directions of the RBI; Financial Stability and Development Council etc.
In this section, we will talk about some of these indicators and mechanisms. They have also been in news for
quite some time Basel III norms and Non-Performing assets (NPAs).
We will try to first clarify the related concepts; then understand the seriousness of the issue; gauge their impact on
the Indian economy and then offer some possible solutions as well as look into some of the committees reports
which have examined the matter.
In this article (Part-1 of a two part series), we will only deal with Basel norms. NPAs will be dealt with
comprehensively in the next article.
The purpose of the accord is to ensure that financial institutions have enough capital on account to meet
obligations and absorb unexpected losses. India has accepted Basel accords for the banking system.
So, if the Basel norms are banking standards, then who has the authority to make them? Are they mandatory for
every country?
As said earlier, the Basel Committee makes these norms. The Committees decisions have no legal force. Rather,
the Committee formulates supervisory standards and guidelines and recommends statements of best practice in
the expectation that individual national authorities will implement them. In this way, the Committee encourages
convergence towards common standards and monitors their implementation, but without attempting detailed
harmonisation of member countries supervisory approaches.
So, India can either accept them or reject them depending on the kind of financial system it wants. So far, we have
implemented or wished to implement all Basel norms.
Basel I
In 1988, BCBS introduced capital measurement system called Basel capital accord, also called as Basel 1. It
focused almost entirely on credit risk. It defined capital and structure of risk weights for banks. Naturally if the
capital with the banks is adequate to cover the risks ( e.g. a power plant) they have invested in, then the bank is
safe.
The minimum capital requirement was fixed at 8% of risk weighted assets (RWA). RWA means assets with
different risk profiles. For example, an asset backed by collateral would carry lesser risks as compared to
personal loans, which have no collateral. India adopted Basel 1 guidelines in 1999. The Basel norms are set up
by the Basel committee on Banking supervision.
It is important to understand that the Basel accords have been the result of cooperation by the countries over the
years.
But why cooperate between member countries when banks operate within national
boundaries?
It is because these banks lend not only to its country men but also other nations. Also, private investors and
sovereign nations take loans from banks across other nations. Further, the financial system of the world is so
interconnected that one incident of a banking collapse has its repercussions all over the world. There can be no
better example that the 2008 Global recession.
Therefore, global cooperation on banking matters is a absolute necessity in todays world. And, not only
cooperation but also adoption of some uniform standards is also important.
The Basel norms try to achieve exactly the same. Till date three different Basel accords ( or norms) have come
each with a better safeguard than the next one.
Basel II
In 2004, Basel II guidelines were published by BCBS, which were considered to be the refined and
reformed versions of Basel I accord. The guidelines were based on three parameters.
Basel III
In 2010, Basel III guidelines were released. These guidelines were introduced in response to the financial crisis of
2008.
A need was felt to further strengthen the system as banks in the developed economies were under-capitalized,
over-leveraged and had a greater reliance on short-term funding. Too much short-term funding makes the banks
prone to risks. Banks generally rely on short-term funding because it is profitable.
Also the quantity and quality of capital under Basel II were deemed insufficient to contain any further risk. This was
because the banking system was growing. The world economy was growing too. Hence, what is sufficient earlier
was not sufficient now.
Basel III norms aim at making most banking activities such as their trading book activities more capital-intensive.
The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz.
capital, leverage, funding and liquidity.
Again we need not go in technicalities, just the broad picture.
This is how it was broadly done.
Capital
The capital requirement (as weighed for risky assets) for Banks was more than doubled. ( e.g. 4.5% from 2% in
Leverage
Leverage basically means buying assets with borrowed money to multiply the gain. The underlying belief is that
the asset will return the investor more than the interest he has to pay on the loan.
Obviously doing so is risky business. Thus the Basel III puts a limit on the banks for doing this. The numbers are
not important here. Getting the concept is important.
cost deposit base. For this, banks need to focus more on having business correspondents/facilitators to reach
customers as adding branches will increase costs and have an impact on the profit margin.
The RBI is thinking of introducing UID based mobile wallets to increase the reach of the financial system. Perhaps
the banks can tie up with wallet operators based on some innovative business model. There are many
opportunities.
3. Improvement in systems and procedures Refining the systems and procedures may help banks
economise their risk-weighted assets, which will help reduce capital requirements to some extent. It is possible
that they would impose cost in the short-run, but they would yield great returns in the future.
Conclusion
It is clear that the banking system in the coming times will have to go through a lot of rough weather. Increasing
operational complexities, global interconnectedness and high economic growth worldwide will present several
challenges for the banks. While strategies like Basel III will of course address these challenges, what is even
more important is their proper implementation. More than this, the banks will need to have a wider outlook. They
must anticipate changes in the Indian economic system and react accordingly. Indian banking regulations are one
of the most stringent and consequently one of the safest in the world. Let us evolve each time better and stronger.
Model questions
Prelims
1. Consider the following statements:
1. Basel norms are mandatory for every member nation.
2. India has not implemented Basel III norms till date.
Which of these is/are correct?
a) Only 1
b) Only 2
c) Both
d) None
Solution: b)
2. Consider the following statements key focus areas in the banking system:
1. Merger of banks
2. Regular disclosure of information to the Central bank
3. Investment in risky assets
Which of these areas are dealt with by the Basel III norms?
a) 1 and 2
b) 2 and 3
c) 1 and 3
d) All of the above
Solution: b)
Mains
1. The Indian banking system has been exposed to a lot of vulnerabilities in past few years due to the global
economic climate. Critically examine some of the important mechanisms available to address these
vulnerabilities in India. (300 words)
2. The Basel III norms present a much safer regulation of the banking system than Basel II, yet it has not been
implemented in India. Examine the key issues and challenges in their implementation and offer some solutions to
address the same. (300 words)
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