Basel III

Strong international compensation standards aimed at lending practices that led to excessive risk-taking,
to improve the over-the-counter derivatives market and to create more powerful tools to hold large
global firms to count for the risks they take. For all these reforms, the leaders set for themselves strict
and precise timetables. Consequently, the Basel Committee on Baking Supervision (BCBS) released
comprehensive reform package entitled “Basel III: A global regulatory framework for more resilient
banks and Banking System” (Known as Basel III capital regulations) in December 2010.

Basel III is only a continuation of effort initiated by the Basel Committee on Banking Supervision to
enhance the baking regulatory framework under Basel I and Basel II. This latest Accord now seeks to
improve the banking sector’s ability to deal with financial and economic stress, improve risk
management and strengthen the banks’ transparency. The reserve Bank issued Guidelines based on the
Basel III reforms on capital regulation on May 2, 2012, to the extent applicable to banks operating in
India. The Basel III capital regulation has been implemented as on March 31, 2019. Basel III represents
an effort to fix the gaps and lacunae in Basel II that came to light during the crisis as also to reflect other
lessons of the crisis. Basel III does not jettison Basel II; on the contrary, it builds on the essence of Basel
II- the link between the risk profiles and capital requirements of individuals banks. In that sense, Basel III
is not a negation, but an enhancement of Basel II. The enhancements of Basel III over Basel II come
primarily in four areas i) augmentation in the level and quality of capital; (ii) introduction of liquidity
standards; (iii) modifications in provisioning norms; and (iv) better and more comprehensive disclosures.

Objectives/aims of the Basel III

(a) Improve the banking sector’s ability to absorb shocks arising from financial and economic stress,
whatever the source.
(b) Improve risk management and governance.
(c) Strengthen banks’ transparency and disclosures.

Major Changes Proposed in Basel III over earlier Accords i.e. Basel I and Basel II

(a) Better Capital Quality: One of the key elements of Basel III is the introduction of much stricter
definition of capital. Better quality capital means the higher loss-absorbing capacity. This is turn
will mean that banks will be stronger, allowing them to better withstand periods of stress.
(b) Capital Conservation Buffer: Another key feature of Basel III is that now banks will be required to
hold a capital conservation buffer of 2.5%. the aim of asking to build conservation buffer is to
ensure that banks maintain a cushion of capital that can be used to absorb losses during periods
of financial and economic stress.
(c) Countercyclical Buffer: This is also one of the key elements of Basel III. The countercyclical buffer
has been introduced with the objectives to increase capital requirements in good times and
decrease the same in bad times. The buffer will range from 0% to 2.5%, consisting of common
equity or other fully loss-absorbing capital.
(d) Minimum Common Equity and Tier I Capital Requirements: The minimum requirement for
common equity, the highest form of loss-absorbing capital, has been raised under Basel III from
 2% to 4.5% of total risk-weighted assets. The overall Tier I capital requirement, consisting of not
only common equity but also other qualifying financial instruments, will also increase from the
current minimum of 4% to 6%.although the minimum total capital requirement will remain at
the current 8% level, yet the required total capital will increase to 10.5% when combined with
the conservation buffer.
(e) Leverage Ratio: A review of the financial crisis of 2008 has indicated that the value of many
assets fell quicker than assumed from historical experience. Thus, now Basel III rules include a
leverage ratio to serve as a safety net. A leverage ratio is the relative amount of capital tp total
assets (not risk-weighted). This aims to put a cap on swelling of leverage in the banking sector
on a global basis. 3% leverage ratio of Tier 1 will be tested before a mandatory leverage ratio is
introduced in January 2018.
(f) Liquidity Ratios: Under Basel III, a framework for liquidity risk management will be crated. A new
Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are to be introduced in 2015
and 2018, respectively.
(g) Systemically important Financial Institution (SIFI): as part of the macro-prudential framework,
systematically important banks will be expected to have loss-absorbing capability beyond the
Basel III requirement. Options for implementation include capital surcharges, contingent capital
and bail-in-debt.

As a percentage of risk weighted assets

Basel II Basel III
(as on January 1,2019)
A=(B+D) Minimum Total Capital 8.0 8.0
B Minimum Tier 1 capital 4.0 6.0
C Of which: Minimum Common Equity Tier 1 2.0 4.5
Capital
D Minimum Tier 2 Capital( within Total 4.0 2.0
Capital)
E Capital Conservation Buffer(CCB) - 2.5
F=C+E Minimum Common Equity Tier 1 Capital + 2.0 7.0
CCB
G=A+E Minimum Total Capital + CCB 8.0 10.5

As per Basel guidelines the Central banks of individual countries, which decide to implement Basel III
norms, will issue their own norms and time frames for implementation of the above broad goals to be
achieved. In India the same are issued by Reserve Bank of India. Originally, RBI has issued draft
guidelines. However, final guidelines have been issued in May 2012, and banks have been asked to
implement the same as per revised schedule given by RBI.

Major Features of the Guidelines Issued by RBI and its impact

(a) Basel III Capital Regulations have been implanted in India with effect from April 1, 2013 in a
phased manner and will be fully implemented as on Mach 31, 2019
(b) The capital requirements for the implementation of Basel III guidelines may be lower during the
initial periods and higher during the later years. Banks need to keep this in view while Capital
Planning;
(c) Guidelines on operational aspects of implementation of the Countercyclical Capital Buffer.
Guidance to banks on this will be issued in due course as RBI is still working on these. Moreover,
some other proposals viz. ‘Definition of Capital Disclosure Requirements”, ‘Capitalization of
Bank Exposures to Central Counterparties’ etc., are also engaging the attention of the Basel
Committee at present. Therefore, the final proposals of the Basel Committee on these aspects
will be considered for implementation, to the extent applicable, in future.
(d) With effect from the financial year ended March 31, 2013, banks have to disclose the capital
ratios computed under the existing guidelines (Basel II) on capital adequacy as well as those
computed under the Basel III capital adequacy framework.
(e) The guidelines require banks o maintain a Minimum Total Capital(MTC) of 9% against 8%
(international) prescribed by the Basel Committee of total Risk weighted assets. This has been
decided by Indian regulator as a matter of prudence. Thus, its requirement in this regard
remained at the same level. However, banks will need to raise more money that under Basel II
as several items are excluded under the new definition.
(f) Of the above, Common Equity Tier 1(CET 1) capital must be at least 5.5% of RWAs.
(g) In addition to the Minimum Common Equity Tier 1 capital of 5.5% of RWAs, (international
standards require these to be only at 4.5%) banks are also required to maintain a capital
Conservation Buffer (CCB) of 2.5% of RWAs in the form of Common Equity Tier 1 capital. CCB is
designed to ensure that banks build up capital buffers during normal times (i.e. outside periods
of stress) which can be drawn down as losses are incurred during a stressed period. In case such
buffers have been drawn down, the banks have to rebuild them through reduced discretionary
distribution of earnings. This could include reducing dividend payments, share buybacks and
staff bonus.
(h) Indian banks under Basel II are required to maintain Tier 1 capital of 6%, which has been raised
to 7% under Basel III. Moreover, certain instruments, including some with the characteristics of
debts, will not be now included for arriving at Tier 1 capital.
(i) The new norms do not allow banks to use the consolidated capital of any insurance or non-
financial subsidiaries for calculating capital adequacy.
(j) Leverage Ratio: Under the new set of guidelines, RBI has set the leverage ratio at 4.5% (3%
under Basel III). Leverage ratio has been introduced in Basel III to regulate banks which have
huge trading book and off balance sheet derivative positions. (However, in India, most of banks
do not have large derivative activities so as to arrange enhanced cover for counterparty credit
risk. Hence the pressure on banks should be minimal on this count.)
(k) Liquidity norms: The Liquidity Coverage Ratio (LCR) under Basel III requires banks to hold
enough unencumbered liquid assets to cover expected net outflows during a 30-days stress
period. (In India, the burden from LCR stipulation will depend on how much of CRR and SLR can
be offset against LCR. Under present guidelines, Indian banks already follow the norms set by
RBI for the statutory liquidity ratio (SLR) –and cash reserve ratio (CRR), which re liquidity buffers.
The SLR is mainly investment in government securities while the CRR is mainly deposit in cash.
 Thus, for this aspect also Indian banks are better placed over many of their overseas
counterparts.
(l) Countercyclical Buffer: Economic activity moves in cycles and banking system is inherently pro-
cyclic. During upswings, carried away by the boom, banks end up in excessive lending and
unchecked risk build-up, which carry the seeds of a disastrous downturn. The regulation to
create additional capital buffers to lend further would act as a break on unbridled bank-lending.

Countercyclical Capital Buffer

In addition to the capital conservation buffer, Basel III introduces another capital buffer- the
countercyclical capital buffer- in the range of 0-2.5 % of RWA which could be imposed on banks during
periods of

Excess credit growth. Also, there is a provision for a higher capital surcharge on systematically important
banks. To mitigate the risk of banks building up excess leverage as happened under Basel II, Basel III
institutes a leverage ratio as a backstop to the risk based capital requirement. The basel Committee is
contemplating a minimum Tier 1 leverage ratio of 3 percent(33.3 times) which will eventually become a
Pillar 1 requirement as of January 1, 2018.

Credit Valuation Adjustment Risk Capital

Basel II failed to demand adequate loss absorbing capital to cover market risk. To remedy this, Basel III
strengthens the counterparty credit risk framework in market risk instruments. This includes the use of
stressed input parameters to determine the capital requirement for counterparty credit default risk.
Besides, there is new capital requirement known as CVA (credit valuation adjustment) risk capital charge
for OTC derivatives to protect banks against the risk of decline in the credit quality of the counterparty.

Reserve Bank Prescription on Capital and Leverage Norms

Reserve Bank has prescribed higher capital and leverage norms for Indian banks than the Basel III
minimum. Table summarizes the Basel III (international) prescription alongside the current requirements
in India under Basel II and as required under Basel III when fully implemented.

Minimum Regulatory Capital Prescription

(as percentage of risk weighted assets)

Basel III Reserve Banks’s

(as on January 1, Prescription
2019)
Current (Basel II) Basel III (as on
March 31, 2018)
A=(B+D) Minimum Total Capital 8.0 9.0 9.0
B Minimum Tier 1 capital 6.0 6.0 7.0
C of which: Minimum Common 4.5 3.6 5.5
Equity tier 1 Capital
D Maximum Tier 2 2.0 3.0 2.0
Capital(within Total Capital)
E Capital Conservation 2.5 - 2.5
Buffer(CCB)
F=C+E Minimum Common Equity 7.0 3.6 8.0
Tier 1 capital +CCB
G=A+E Minimum Total Capital+ CCB 10.5 - 11.5
H Levarage Ratio (ratio to total 3.0 - 4.5
assets)

Several other jurisdictions, particularly Asian countries, have proposed higher capital adequacy ratos
under Basel III as may be seen from Table 8.2

Table 8.2 Sample of Countries with Higher Capital Adequacy Norms than India

Country Minimum Common Equity Minimum Total Capital Ratio

Ratio(including capital conservation (Percentage)
buffer) (percentage)
Basel III 7.0 10.5
India 8.0 11.5
Philippines 8.5 12.5
Singapore 9.0 12.5
China 7.5 10.5
South Africa 9.0 12.5

Revised Basel III Transitional Arrangements

In terms of Basel III capital Regulations issued by the Reserve Bank of India, the Capital Conservation
Buffer(CCB) is scheduled to be implemented from March 31, 2015 in phases and would be fully
implanted as on March 31, 2019. However Rbi vide circular dated 27-3-2014 has advised that the
implantation of CCB will begin as on March 31, 2016. Consequently, Basel III Capital Regulations will be
fully implemented as on March 31,2019. The Transitional Arrangement is, revised as under:

Transitional Arrangements-Scheduled Commercial Banks(excluding LABs and RPBs)

(% of RWAs)
Minimum capital ratios April 1 March 31, March 31, March 31, March 1, March 31, March 31,
2013 2014 2015 2016 2017 2018 2019
Minimum Common 4.5 5 5.5 5.5 5.5 5.5 5.5
Equity Tier 1 (CET 1)
Capital conservation - - - 0.625 1.5 1.875 2.5
buffer (CCB)
Minimum CET1+CCB 4.5 5 5.5 6.125 6.75 7.375 8
Minimum tier 1 capital 6 6.5 7 7 7 7 7
Minimum Total Capital* 9 9 9 9 9 9 9
Minimum Total 9 9 9 9.625 10.25 10.475 11.5
Capital+CCB
Phase-in of all deductions 20 40 60 80 100 100 100
from CeT1(in %)#

The difference between the minimum total capital requirement of 9% and the Tier 1 requirement can be
met with Tier 2 and higher forms of capital;

# The same transition approach will apply to deductions from Additional Tier 1 and Tier 2 capital