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Subject ECONOMICS

Paper No and Title 11- Money & Banking

Module No and Title 28- Basel Norms for Capital Adequacy

Module Tag ECO_P11_M28

ECONOMICS PAPER No. : 11, Money & Banking

MODULE No. : 28, Basel Norms for Capital Adequacy
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TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Basel I Accord
3.1 Foundation of Basel I Accord
3.2 Criticism
4. Basel II Accord
4.1 Three Pillars
4.2 Criticism
5. Basel III
6. India and Basel Compliance
7. Summary

ECONOMICS PAPER No. : 11, Money & Banking

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1. Learning Outcomes
After studying this module, you shall be able to

 Learn the risk management practices of commercial banks.

 Understand the prudential norms.

2. Introduction

Banks as financial intermediaries are exposed to several types of risks like credit risk,
interest rate risk, foreign exchange risk, liquidity risk, legal risk, regulatory and
reputational risk, operational risk and market risk to list a few. These risks operate
alongside the progression of banking system and have interconnected implications that
are long term. Hence one should not view these risks as independent event. It thus calls
for risk management systems, which can address to such hidden perils, monitor and
mitigate them on time.

A risk management structure or system (RMS) should be measurable, should be

consistent with operating strategy of the organization, should set guidelines and
parameters for future references, should constantly monitor and control, segregate the
responsibilities of the departments and functionaries and should be subjected to regular
reviews and evaluation.

Loan as a credit requires constant evaluation along with provisions for losses. A loan
review mechanism (LRM) should include quick identification of sour or weak loan
positions with immediate corrective actions, isolate the problematic area from the main
portfolio, provide information for adequate loss provisions, comply with laws and
regulations and provide information to the concerned parties.

The Basel Committee on Banking Supervision (BCBS) is a supervisory authority

established by the central bank governors of 10 countries in 1985. With its permanent
secretariat at Basel, the committee came out with Capital Accord for banks in 1988,
incorporating the balance sheet and off balance sheet items. Under this new system,
balance sheet assets and non-balance sheet exposures have been assigned risk based
weights and banks have to allocate unimpaired minimum capital funds in prescribed ratio
on these risk weighted assets.

ECONOMICS PAPER No. : 11, Money & Banking

MODULE No. : 28, Basel Norms for Capital Adequacy
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3. Basel I Accord
Basel I was introduced with the aim of standardizing regulatory capital norms across
member nations. The morns and guidelines were specific to the founding economics and
were not meant for the emerging ones. The initial guidelines focused on loan-based risks
and left the mandate over other risks with countries themselves. With a conservative
approach, the accord imposes minimum capital requirements, which should not be treated
as panacea for banking system.

The main objectives of this system were to strengthen the soundness and stability of the
international banking system and to diminish existing sources of competitive inequality
among international banks.

3.1 Foundation of Basel I Accord:

The accord rests upon four basic prerequisites, which provide sufficient insight into
understanding the regulatory framework:

3.1.1Capital composition defined the type and nature of capital reserves to be

accounted for the risk based minimum capital requirement. Capital Reserves were
divided in to Tier 1 (which included disclosed cash reserves and other capital paid for by
the sale of equity in the form of stock and preferred shares) and Tier 2 capital (which
included reserves to cover potential loss on loans, holdings of subordinated debt, hybrid
debt/equity instrument and potential gains from the sale of assets purchased through the
sale of bank stock).

3.1.2 Weighted Risk assessment provided categories of risk levels to assets

ranging from riskless to most risky. Cash and sovereign debt were considered to be
riskless and most liquid. Private sector claims were considered highly risky.

3.1.3only credit risk element was taken into consideration and a minimum capital
requirement was fixed at 8% of total risk based assets i.e. minimum 8% of banks risk
based assets should be covered by Tier 1 & Tier 2 capital reserves. In India, this
minimum Capital-to- Risk Weighted Asset Ratio (CRAR) was kept at 9 % on ongoing
basis.

3.1.4 Each central bank should set aside and meet the timeline prescribed to
achieve these requirements and to constantly monitor the progress.

All Basel Committee members achieved the prescribed targets by 1992 except for Japan.
India also accomplished the task by 1999.

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3.2 Criticism

Basel I was viewed with skepticism because of its narrow outlook and participation. The
reason for criticism lied with the limited approach of risk assessment i.e. only credit risk
and concentration of proposals to suit G-10 member nations. Hasty implementation and
complex terminology was another issue. Methods like securitization and splicing led to
diversion from incentivized risk coverage and further added to risk exposure of banks.

The overall experience with Basel I accord led the Committee to revamp the structure and
they came out with an amended report called the ‘International Convergence of Capital
Measurement and Capital Standards: A Revised Framework’ (or commonly called Basel
Report II) in June 2004. The revised framework was learning from the previous accord
and gave a more comprehensive and risk sensitive approach to capital requirements. The
spectrum of risk assessment was also widened. The basic objective here was to further
strengthen the International Banking Structure in a sound and stable manner along with
creation of greater risk sensitive capital requirements.

4. Basel II Accord

The new set of rules under Basel II report brought in significant innovation in terms of
using internal information by banks for capital assessment across banking community. It
also gave a flexible option to the banks in risky economies to extend the minimum capital
requirement limits to suit their risk appetite.

4.1 Three Pillars:

Three mutually binding pillars namely, Minimum Capital Requirements, Supervisory

Review of Capital Adequacy and Market Discipline supported Basel II framework.

4.1.1 Minimum Capital Requirement:

Under this pillar, three types of capital constituents are offered for Credit Risk and
Operational Risk. The choices under credit risk were Standardized Approach, Foundation
Internal Rating Based Approach and Advance Internal Rating Based Approach and for
operational risk included Basic Indicator Approach, Standardized Approach and
Advanced Measurement Approach.

To maintain harmony, Reserve Bank of India suggested all banks to use Standardized
Approach for Credit Risk and Basic Indicator Approach for Operational Risk. The new
capital adequacy norms were applicable to both single and consolidated banks.
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A minimum of 9% of CRAR to be maintained by the banks on ongoing basis along with

higher levels of these ratios to be decided by the central authority based on risk profile of
the individual bank. Tier 2 capital elements to be limited to maximum 100% of Tier 1
Capital. Subordinated term debt to be up to 50% of Tier 1 capital. Tier 3 capital to be
restricted to 250% of tier 1 capital and to serve the market risk exposure. General
provisions or loan reserves to be 1.25% maximum and asset revaluation reserves to be
subject to 55% discount.

It is important here to define the components of Tier 1, 2 & 3 capitals.

Tier 1 capital includes paid up equity capital like fully paid ordinary shares or preference
shares, statutory reserves and disclosed free reserves out of share premium, legal
reserves etc., other instruments notified by RBI and innovative perpetual debt
instruments.

Tier 2 capital includes undisclosed reserves created out of after tax surplus profits and
excluding values of securities held in balance sheet which are valued below market price,
revaluation reserves arising out of revaluation of fixed assets like bank premises or from
equity securities held a lower historic cost in balance sheet, general provisions and loss
reserves for potential unexpected losses, hybrid debt capital instruments which
characterize the attributes of debt and equity instruments, subordinated debt and
innovative perpetual debt instruments.

Tier 3 capital is employed specifically to meet the capital requirements for market risk
and in the form of subordinated debt instruments.

4.1.2 Supervisory Review of Capital Adequacy

This pillar focuses on supervisory review and risk management guidance, transparency
and accountability. Attention is paid to treatment for interest rate risk, credit risk,
operational risk and securitization of assets. The aim of such supervisory system is to
cover and provide support for broader risk categories and to encourage banks to develop
monitoring techniques. The process enforces internal capital assessment along with
accomplishment of individual capital requirement targets subject to risk profiles.
Relevant and timely intervention enhances the supervisor roles within an organization
and removes operational deficiencies. Adding up of capital stock should not be viewed as
compliance with Basel committee norms, rather supervisory review considered:

 Creation of streamlined system for assessing overall capital adequacy matching

the individual risk profile along with supported capital levels.
 Supervisors to judge the internal capacity and comply with regulatory framework
and take corrective steps accordingly.

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 Operative capacity to be above the minimum required and hold capital in excess
calls for better quality of capital reserves alongside provisions and internal
controls.

Focus areas here include risks left unaddressed under Pillar 1 like credit concentration,
factors excluded under Pillar 1 like interest rate, business and strategic risks, and factors
external to banking system like business cycles.

The committee highlights four important principles to be Rapid remedial action to avoid
reduction in regulatory capital.

Using the standardized approach, RBI has notified external credit rating agencies to
provide rating for credit risk to assist in creating capital charge for such risk. Claims
include claims on Domestic sovereigns, foreign sovereigns, Public sector entities,
Multilateral Development Banks, IMF and Bank for International Settlements, Primary
Dealers, corporates, claims secured by commercial real estate, claims secured by
residential property, Non Performing Assets (NPA’s) and Securitization Exposures.

Techniques for credit risk mitigation include Collateralized Transactions, Off Balance
sheet Nettings and use of Guarantees.

Market Risk is defined as the loss in balance sheet and off balance sheet items due to
adverse movements in market price. Risks covered here include instruments and equities
in trading books of the banks. Trading books includes securities held for trading,
securities under available for sale, Open gold and foreign exchange positions, trading
positions in derivatives and hedging exposures.

Operational Risk pertains to shortcomings due to internal process person or systems. It

includes legal risk and excludes strategic and reputational risk.

On implementation front, Basel II accord underwent two amendments till 2005.India

completed its implementation by 2013.

4.1.3 Market Discipline

Along with the supervisory role, accountability is also a key responsibility of the
supervisor for which the committee recommended the third pillar of disclosures. This
aspect warrants the provisioning of timely information to all the participants of banking
system. It will assist the market participants to access key information related to capital,
risk, assessment process and steps take. Lack of achievement of such disclosure attracts
penalty. Sufficient efforts have been made to comply with international accounting
standards to make the information homogeneous to all backgrounds. The disclosure to be
both qualitative and quantitative and should be made available in several formats
including printed and online media. Since this is an important piece of information, the
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reports need to be audited by external auditors to guarantee authenticity and compliance

with best practices. Disclosures pertain to all the above prerequisites of the Basel
framework in detail.

4.2 Criticism

The foremost criticism for Basel II comes from the segmentation of banking principles
for emerging market economies where a separate set of rules were set for these nations
without addressing to their immediate economic needs. These norms also ignored the
country specific socio-economic environment concerning strict regulators, lack of skilled
work force and laxity in regulating private banks. Banks in emerging markets also
ignored the rating aspect of lending due to cost reduction and unfavorable after effects of
such downgraded ratings.

Erstwhile governor of RBI has highlighted another line of criticism. He blamed the pro-
cyclical nature of Basel II norms whereby extra stringency is observed during stressed
market behavior and calls for greater capital requirements. Deleveraging and conversion
of assets from banking book into trading book led to linkage with crisis of 2008. Failure
to address interconnectedness of institutions or the Systematic Risk was another bell-
weather, which was ignored.

5. Basel III Accord

Basel III is seen as an up gradation of Basel II, keeping the essence of Basel II framework
intact. There have been additions to the structure and guidelines, which can be classified
into augmentation in the level and quality of capital, introduction to liquidity standards,
modifications in provisioning norms and better comprehensive disclosures.

The newer framework lays greater focus on common equity with the minimum
requirement raised to 4.5% of risk- weighted assets, after deductions. It also introduces
Capital Conservation Buffer comprising common equity of 2.5% of risk-weighted assets,
bringing the total common equity standard to 7% and Minimum total capital requirement
to 10.5%. The buffer is to ensure smooth functioning of banks without deleveraging. It
also constraint a bank’s discretionary distributions like dividends and bonus when banks
fall into the buffer range.

Another addition to the capital adequacy adjustments is the Countercyclical Capital

Buffer ranging between 0 to 2.5% of Risk Weighted Assets. This buffer comes into play
during phases of excess credit growth. Leverage ratio is a non-risk-based leverage ratio
that includes off-balance sheet exposures and serves as a backstop to the risk-based
capital requirement. Also helps contain system wide buildup of leverage. Inclusions have
also been made for Counterparty Credit Risk, which includes higher capital for inter-
financial sector exposures.

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Table1: Comparison Table for Capital Requirements

Addressing the liquidity concerns, 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. It should be at least 100% of total net cash
outflow over the next 30 calendar days. Apart from LCR, 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 over one year time period.
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 colleges are some of the
additions to Pillar 2 basis.
Basel committee is of the view that provisioning measures should be based upon
‘Expected loss’ criteria making the reporting more useful for stakeholders.

Disclosures have been made a mandate by individual regulators specially related to

regulatory adjustments and composition of regulatory capital. The requirements
introduced relate to securitization exposures and sponsorship of off-balance sheet items.
Enhanced disclosures also pertain to details of the components of regulatory capital and

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their reconciliation to the reported accounts, including a comprehensive explanation of

how a bank calculates its regulatory capital ratios.

Table 2. Consolidated Capital Requirements and Deadlines

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6. India and Basel Compliance

Indian economy is undergoing a structural adjustment whereby manufacturing will pick
up pace and would call for greater financial assistance from the financial sector. Credit to
GDP ratio will also rise and would force banks to raise additional capital to meet the
regulatory capital requirement. RBI estimates Rs. 5 Trillion of capital requirement of
which Rs. 1.75 will be of equity nature. Indian government will find it difficult to meet
these levels and the only possibility is capitalization of Public Sector Banks. Reliance on
private sector for such large funding is also difficult, as market will grapple for funds to
fuel the growth process. The higher capital requirement will be matched with higher
credit demand and it will put a dent in the capacity building process. Economy will also
witness the shift towards industrial activity along with financial inclusion at pace. The
argument can be cut short into short term vs. long term urgency.

The role of banking system is crucial as the major burden will be borne by banks in the
form of reduced earnings, interest margins and profitability ratios in short run, but with
greater space for stable and environment to operate in long term. Another dimension t
this debate is that Indian banks cannot ignore foreign competitions and advancements nor
can they allow external shocks.

As far as deadlines are concerned, India has been proactive in achieving the set dates and
will implement the Basel III norms by 31 December 2018, 9 months in advance of
globally set date, since it is through with the consultative process.

In light of the argument of too-big to fail, to curtail the risk appetite of large banks, Basel
III identifies Globally Systematically Important Banks (G-SIBs). Although no Indian
Bank qualifies in this list, proposals have been forwarded to identify Domestically
Systematically Important Banks (D-SIBs).

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7. Summary

 Risk Management Systems are need of the hour given the size and quantity of
operations of Banks.
 Several types of risks need to be taken into consideration in order to provide
protection against them. These include credit risk, interest rate risk, market risk
and operational risk to name a few.
 Basel Committee for banking Supervision (BCBS) has put forth a regulatory
framework for international banking community in order to provide a protection
against such risks.
 The basis of this framework is to provide Minimum Capital to Risk weighted
Assets with varied capital requirements.
 Basel accords have been implemented across the globe and India is a front runner
in achieving the set standards
 The norms call for flexible adjustments to suit the risk profile of individual banks
and focuses on constant monitoring in wake of unwarranted movements in
Balance sheet and off balance sheet items due to internal or external actions.

ECONOMICS PAPER No. : 11, Money & Banking

MODULE No. : 28, Basel Norms for Capital Adequacy