A Report on

“Adaption and implementation of BASEL- III in

Bangladesh”

i
Course Name: Management of Financial Institutions

Course code: F-502

Submitted To

Shoilee Sumiyaa
Lecturer,
Department of Finance & Banking
University of Barishal

Submitted By
MD. Alamin Akon
MBA
Session 2018-2019
ID No.14 FIN 073
Department of Finance and Banking
University of Barishal
Date of Submission: 25th September, 2020

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Letter of Transmittal

25th September, 2020

Shoilee Sumiyaa
Lecturer,
Department of Finance & Banking
University of Barishal

Subject: Submission of Report on “Adaption and implementation of BASEL- III in Bangladesh’’

Dear Mam,
With due respect, I would like to notify you that I have completed my Report on Adaption and
implementation of BASEL- III in Bangladesh. “This particular report enables me to get an insight of the
BASEL III and I have acquired knowledge about banking regulation on capital requirements known as Basel
III. I have added latest information of BASEL III in Bangladesh in which Ratios and requirements has
shown and implementation and challenges has depicted.
Finally, I would like to express my gratitude for your supportive thoughts and kind consideration in making
this report. At each stage, I have given my best efforts in preparing this report. Without any doubt, this
experience enriches my knowledge in a greater degree. If you have any query over any aspect of my report, I
would gladly answer them.
Yours faithfully

Alamin akon
………………………………………….
MD. Alamin Akon
MBA
Session 2018-2019
ID. No 14 FIN 073
Department of Finance and Banking
University of Barishal

iii
 Acknowledgement

In the beginning, I would express my gratitude to Almighty Allah for whose Mercy I am mentally and
physically sound in order to prepare this report. I am very grateful to Md. Shoilee Sumiyaa Mam, my
respective faculty who ordered me to complete this meaningful report. Also, I am extremely thankful for all
the websites, journals, books and literature that provided me information on this issue, as without that, the
report would go nowhere. This report titled “Adaption and implementation of BASEL- III in Bangladesh”
has given me a insight about the banking regulation called BASEL.

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 Table of contents
Contents name Page no
Chapter 1: Introduction 2-4
Origin of the study
Methodology of the study
Limitations of the Study

Chapter Two: Basel Banking Norms 5-8

History of the BASEL
Transition to Basel II

Chapter Three:Basel III: A global regulatory framework for more 10-19

resilient banks and banking systems
Basel III – an overview

Chapter Four:Basel III- implementation in and challenges for 20-31

Bangladesh
Implementation of the Basel III in Bangladesh Bank
Key Issue of Bangladesh banking sector

Chapter Five: 32-34

Conclusion

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 Executive Summary
Bangladesh Bank (BB) is the governing body of all the commercial banks in this country. To be in line with
the international standard for regulation of banking industry (Basel Accord), BB has introduced Risk Based
Capital Adequacy guideline relating to Basel II. All banks have to follow this guideline and report to BB
effective from 1st January, 2010. The guidelines are structured in three aspects or pillars: (1) banks should
have minimum capital to guard against different kinds of risks (credit, market and operation risk);
Assessing capital adequacy with risk profile of the bank and capital growth plan and (3) public disclosure of
bank‟s position on risk, capital and management. The three main risks that a commercial bank faces are:
Credit risk, Market risk and Operational risk. Credit risk is the risk that arises from the probability that the
borrowers of the bank will not pay back. Market risk is the risk that puts the bank in adverse situation when
interest rate, foreign exchange or equity price move in unfavorable direction. The Components include: Paid
up capital, general and statutory reserves, retained earnings, minority interest, non-cumulative non putable
preference shares, etc. Tier 2 Capital, also known as supplementary capital, supports Tier 1 capital.
Components include: general provision; revaluation reserves for Fixed Assets, Securities and equity
investments; other preference shares and subordinated debt. Tier 3 Capital, also known as additional
supplementary capital, whose components include: short term Sub ordinated debt to solely guard against
market risk. There are more specific guidelines for eligibility of the capital tiers. To measure adequacy;
Capital Adequacy Ratio (CAR) is calculated with Risk Weighted Asset (RWA) on the basis of credit,
market and operational risk. Capital planning is an important part to face the risks of the bank. One of the
measure or technique to assess the potential damage is stress testing. It is just a type of what-if analysis. The
financial situation of the bank is given some unfavorable “shocks” and potential worst case scenario is
observed. BB provides reporting format for the banks. Banks have to follow the regulatory rules; otherwise
BB can impose penalty and/or punishment as per Bank Company Act of 1991.

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Chapter One
Introduction

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1.1 INTRODUCTION
Basel III (or the Third Basel Accord) is a global, voluntary regulatory framework on bank capital adequacy,
stress testing, and market liquidity risk. It was agreed upon by the members of the Supervision in 2010–11,
and was scheduled to be introduced from 2013 until 2015; however, changes from 1 April 2013 extended
implementation until 31 March 2018 and again extended to 31 March 2019. The third installment of the
Basel Accords (see Basel I, Basel II) was developed in response to the deficiencies in financial regulation
revealed by the financial crisis of 2007–08. Basel III is intended to strengthen bank capital requirements by
increasing bank liquidity and decreasing bank leverage (any technique that amplifies profits or losses).

1.2 ORIGIN OF THE STUDY

The Term Paper is the partial requirements of the BBA program, which will be helpful to become familiar
with the practical business operations. After the completion of all the courses of BBA program every student
will need to go to the practical field. As a student of BBA program of University of Barisal, we have
prepared this term paper which will enrich our practical knowledge. We have worked on “BASEL III”.
Many phases are covered to collect the relevant data.

1.3 BACKGROUND OF THE STUDY

Basel III is an international regulatory accord that introduced a set of reforms designed to improve the
regulation, supervision and risk management within the banking sector. In the BBA program, term paper” is
one of the vital parts, which has to be done by every student. The program provides an opportunity for the
student to minimize the gap between theoretical and practical knowledge and will help in practical life. We
got this great opportunity to perform our term paper on “BASEL III”. We have completed this term paper
based on theoretical and practical knowledge. It was almost one-month hard industry of our group member.

1.4 OBJECTIVE OF THE STUDY

The main objectives of the study are as follows:

 To fulfill the requirement for the completion of BBA program.

 To observe & learn about BASEL III.
 To know about the implementation of BASEL III in Bangladesh.

The objective of term paper is to know how to improve the banking sector‟s ability to absorb shocks arising
from financial and economic stress. Specific objectives are as followed: To fulfill academic requirement; to
gather knowledge about the given topic.

1.5 METHODOLOGY OF THE STUDY

Methods followed to perform a job or conducting activities to complete a task is called methodology. In
conducting this term paper the following methodology was adopted in data & Information, preparation of
reports etc. Both qualitative and quantitative methods were applied for preparing this term paper. The data
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were analyzed and presented by different ways. Best effort was given to analyze the numerical findings. The
main focus is on theoretical data in preparing the term paper. Also statistical portion of the report has been
used as the demand of the report.

1.6 DATA COLLECTION

There were two types of sources of data

 Primary sources

 I have gone through the interior information of BASEL III. We study how to the BASEL III
regulations, namely the capital to asset ratio (CAR), the net stable funding ratio (NAFR) and
liquidity coverage ratio (LCR), are likely to impact the banks?

 Secondary sources

 I have collected some important documents and PDF files from internet.

 I have collected information from newspaper & magazine.

1.7 SCOPE OF THE STUDY
As I‟ve worked only on “BASEL III”. Furthermore, information was available on the internet that was a
great scope for us.

1.8 LIMITATIONS OF THE STUDY

Time limitation: It was one of the main constraints that affected covering all aspects of the study.

Lack of Secondary Information: The study also suffered from inadequacy of data provided by different
sources for the completion of this term paper. Other limitations are as follows: For the lack of our practical
knowledge, some shortcoming may be available in the paper. There also exists the limitation of practical
experience

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 Chapter Two
Basel Banking Norms

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 2.1 History of Basel:
The birth of the Basel banking norms is attributed to the incorporation of the Basel Committee on Banking
Supervision (BCBS), established by the central bank of the G-10 countries in 1974. This came into being
under the patronage of Bank for International Settlements (BIS), Basel, Switzerland. The Committee
formulates guidelines and provides recommendations on banking regulation based on capital risk, market
risk and operational risk. The Committee was formed in response to the chaotic liquidation of Herstatt Bank,
based in Cologne, Germany in 1974. The incident illustrated the presence of settlement risk in international
finance.

Historically, in 1973, the sudden failure of the Bretton Woods System resulted in the occurrence of
casualties in 1974 such as withdrawal of banking license of Bankhaus Herstatt in Germany, and shut down
of Franklin National Bank in New York. In 1975, three months after the closing of Franklin National Bank
and other similar disruptions, the central bank governors of the G-10 countries took the initiative to establish
a committee on Banking Regulations and Supervisory Practices in order to address such issues. This
committee was later renamed as Basel Committee on Banking Supervision. The Committee acts as a forum
where regular cooperation between the member countries takes place regarding banking regulations and
supervisory practices. The Committee aims at improving supervisory knowhow and the quality of banking
supervision quality worldwide. Currently there are 27 member countries in the Committee since 2009. These
member countries are being represented in the Committee by the central bank and the authority for the
prudential supervision of banking business. Apart from banking regulations and supervisory practices, the
Committee also focuses on closing the gaps in international supervisory coverage.

The first set of Basel Accords, known as Basel I, was issued in 1988 with the primary focus on credit risk. It
proposed creation of a banking asset classification system on the basis of the inherent risk of the asset. Basel
II, the second set of Basel Accords, was published in June 2004 – in order to control misuse of the Basel I
norms, most notably through regulatory arbitrage. The Basel II norms were intended to create a uniform
international standard on the amount of capital that banks need to guard themselves against financial and
operational risks. This again would be achieved through maintaining adequate capital proportional to the
risk the bank exposes itself to (through its lending and investment practices).It also laid increased focus on
disclosure requirements. The third installment of the Basel Accords (Basel III) was introduced in response to
the global financial crisis, and is scheduled to be implemented by 2018. It calls for greater strengthening of
capital requirements, bank liquidity and bank leverage. However, critics argue that these norms may further
hamper the stability of the financial system by providing higher incentive to circumvent the regulations.

Decoding the Basel Accords – with Facts and Figures

2.2 Basel I: The Capital Accord
In 1987, the Committee introduced capital measurement system which focused on the credit risk and risk-
weighting of assets. This system is commonly known as the Basel Capital Accord or the Basel I norms as
approved by the Governors of G-10 countries which were released to the banks in July 1988. The
Committee, by the end of 1992, had implemented the minimum requirement ratio of capital to be fixed at 8

5
percent of risk-weighted assets not only in the G-10 countries but also other non-member countries with
active international banks. Apart from focusing on the credit risk, the committee also issued Market Risk
Amendment to the capital accord in January 1996 which came into effect at the end of 1997. The reason for
such an amendment arose from banks‟ market risk exposures to foreign exchange, debt securities, equities,
commodities and options. An important characteristic of this amendment was banks‟ convenience of
measuring their market risk capital requirement with the help of internal value-at-risk models, which were
subject to strict quantitative and qualitative standards.

2.2.1 Evolution of Basel I Accords

The pre-Basel era was characterized by increasing globalization, leading to rapid expansion of international
financial services sector. The swift proliferation contributed to gradual deregulation, which created new
revenue opportunities for banking institutions, and intensified competition. International banks indulged in
regulation arbitrage, and relocated to less stringent geographies.

The chaotic bankruptcy of Germany based Bankhus I. D. Herstatt in 1974 added momentum to harmonize
international banking capital standards. The German bank had accepted receipts in Deutsche Marks in
exchange for payments in US Dollars. However, Herstatt ceased operations before the time of payment in
the USA due to time zone difference. The incident bought to light the significance of counter party risk, in
international transactions.

As a response to the cross-jurisdictional implications of a bankruptcy of a multi-national bank, the Basel

Committee on Banking Supervision (BCBS) was formed in 1975, under the auspices of Bank of
International Settlement (BIS), headquartered in Basel, Switzerland. The Committee had representations
from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, The Netherlands, Sweden,
Switzerland, United Kingdom and USA. The countries are represented by the respective central banks and
lead bank supervisory authority.

The goal of BCBS, as highlighted in the charter, is to “…extend regulatory coverage, promote adequate
banking supervision, and ensure that no foreign banking establishment can escape supervision”. Since
inception, the BCBS issued several best practices papers for the banking industry, having significant impact
on banking supervision and bank capital regulation. Since the recommendations of the committee were
legally non-binding, it was up to the discretion of the member states to implement and enforce these
recommendations. Inadequate capitalization of banks, varying banking structures and different risk profiles
across different countries made agreement on capital standards difficult. However, after years of
deliberation, in July 1988, the „International Convergence of Capital Measurements and Capital Standards‟
(informally known as the Basel I Capital Accord) was created. These norms set minimum level of capital
adequacy requirements for banks, and encouraged banks and countries to be more aggressive in
implementation of these norms.

2.2.2 Features of Basel I

The Basel I Accord attempted to create a cushion against credit risk. The norm comprised of four pillars,
namely Constituents of Capital, Risk Weighting, Target Standard Ratio, and Transitional and implementing
arrangements.

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Pillar I – Constituents of Capital
Constituents of Capital prescribe the nature of capital that is eligible to be treated as reserves. Capital is
classified into Tier I and Tier II capital. Tier I capital or Core Capital consists of elements that are more
permanent in nature and as a result, have high capacity to absorb losses. This comprises of equity capital and
disclosed reserves. Equity Capital includes fully paid ordinary equity/common shares and non-cumulative
perpetual preference capital, while disclosed/published reserves include post-tax retained earnings. Because
of availability of several other legitimate avenues of capital, the accord defines a separate layer of capital
(Tier II) to accommodate these elements. However, given the quality and permanent nature of Tier I capital,
the accord requires Tier I capital to constitute at least 50 percent of the total capital base of the banking
institution. Tier II capital is more ambiguously defined, as it may also arise from difference in accounting
treatment in different countries. In principal, it includes, revaluation reserves, general provisions and
provisions against non-performing assets, hybrid debt capital instruments, and subordinated term debt.

Pillar II – Risk Weighting

Risk Weighting creates a comprehensive system to provide weights to different categories of bank‟s assets
i.e. loans on the basis of relative riskiness. The capital of the bank is related to risk weighted assets, to
determine capital adequacy.

Pillar III – Target Standard Ratio

Target Standard Ratio acts as a unifying factor between the first two pillars. A universal standard, wherein
Tier I and Tier II capital should cover at least 8 percent of risk weighted assets of a bank, with at least 4
percent being covered by Tier I capital.

Pillar IV – Transitional and Implementing Arrangement

Transitional and implementing arrangement sets different stages of implementation of the norms in a phased
manner. Switzerland, Luxembourg and G-10 countries endorsed the Basel I Accord in July 1988. Due to
widespread undercapitalization of the banking community during that time, a phased manner of
implementation was agreed upon, wherein a target of 7.25 percent was to be achieved by the end of 1990
and 8 percent by the end of 1992.

2.3Transition to Basel II
Basel II was fundamentally conceived as a result of two triggers – the banking crises of the 1990s on the one
hand, and the criticisms of Basel I itself on the other. In the year 1999, the Basel Committee proposed a new,
far more thorough capital adequacy accord. Formally, the accord was known as A Revised Framework on
International Convergence of Capital Measurement and Capital Standards (hereinafter referred to as Basel
II). The new framework was designed to improve the way regulatory capital requirements reflect the
underlying risks for addressing the recent financial innovation. Also, this framework focuses on the
continuous improvements in risk measurement and control. For successful implementation of the new
capital framework across borders, the committee‟s Supervision and Implementation Group (SIG)
communicates with the supervisors outside the committee‟s membership through its contacts with regional

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associations. The new framework neatly retained the „pillar‟ framework of Basel I, yet crucially expanded
the scope and specifics of Basel I.

Pillar I – Minimum Capital Requirements

The first „pillar‟, namely Minimum Capital Requirements, shows the most expansion when compared to
Basel I. A primary mandate of this accord was to widen the scope of regulation. This is achieved by
including „on a fully consolidated basis, any holding company that is the parent entity within a banking
group to ensure that it captures the risk of the whole banking group‟. This preempts the possibility that a
bank will conceal risk-taking by transferring assets to other subsidiaries.

Pillar II – Regulator-Bank Interaction

Pillar II focuses on the aspect of regulator-bank interaction. Specifically, it empowers regulators in matters
of supervision and dissolution of banks. For instance, regulators may supervise internal risk evaluation
mechanisms outlined in Pillar I – and change them to more conservative or simpler ones, as the case
demands. Regulators are permitted to create a buffer capital requirement over and above the minimum
capital requirements as per Pillar I.

Pillar III – Banking Sector Discipline

Pillar III aims to induce discipline within the banking sector of a country. Basel II suggested that,
disclosures of the bank‟s capital and risk profiles which were shared solely with regulators till this point
should be made public. The premise was that information to shareholders could be widely disseminated.
They would be able to ensure prudence in the risk levels of banks.

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 Chapter Three
Basel III: A global regulatory framework for more resilient banks and
banking systems

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3.1 Why Basel III?
Ever since the first proposal of the existing Basel II Capital Accord was issued, its merits and its weaknesses
are discussed in the banking world. But only the recent financial crisis proved that internationally active
banks still failed to fully absorb credit losses since they fell short of capital. Note however that Basel II still
needed to be fully implemented at the onset of the financial crisis. Nevertheless politicians pressured the
Basel Committee on Banking Supervision (BCBS) to discuss the shortcomings of the Basel II Capital
Accord and come up with possible amendments. These are now described as Basel III.

In short, Basel III builds upon the existing regulatory capital framework but introduces some adjustments
that are meant to reflect the lessons learned from the financial cri-sis. The final draft of Basel III will be
proposed to world leaders on the G20 meeting in Seoul, in November 2010. The support of G20-leaders is
necessary since Basel has no regulatory role; its advice needs to be incorporated internationally, in the
European directives and in national laws.
This brochure wants to inform you about Basel III based on the information that is available until mid-
October 2010.
According to the BCBS, the Basel III proposals have two main objectives:
 To strengthen global capital and liquidity regulations with the goal of promoting a more resilient
banking sector

 To improve the banking sector‟s ability to absorb shocks arising from financial and economic stress,
which, in turn, would reduce the risk of a spillover from the financial sector to the real economy.

To achieve these objectives, the Basel III proposals are broken down into three parts on the basis of the main
areas they address:

 Capital reform (including quality and quantity of capital, complete risk coverage, leverage ratio and
the introduction of capital conservation buffers, and a counter-cyclical capital buffer)

 Liquidity reform (short-term and long-term ratios)

 Other elements relating to general improvements to the stability of the financial system.

3.2 Basel III – an overview

In December 2009 the initial Basel III proposal was issued for consultation. Since then the Basel Committee
made some amendments and published more concrete details on the implementation phase. Basel III
proposes changes in the following areas:

a) Definition Own Funds: Harmonization and tightening of capital instruments allowed for inclusion in
own funds to calculate the ratios.

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 b) Capital buffers: Increasing the explicit mini mum ratios of Tier 1 common equity, Tier 1 capital and
total capital to risk weighted as-sets.
c) Risk Coverage: Strengthening the capital requirements (hence RWA) for, market risk, securitizations
and counterparty credit risk arising from derivative transactions.
d) Leverage ratio: Introducing a constraint on leverage based on gross exposure as a non-risk weighted
„backstop‟.
e) Liquidity requirements: Implementation of a short term and a long term liquidity ratio that are
internationally consistent.

The proposed changes will be subsequently discussed in this brochure. Summarized altogether, the changes
lead to higher minimum standards of capital ratios that are increasing during the transition period from 2013
to 2019.

3.2.1 Definition of own funds

Basel I introduced the concept that banks should have enough own funds to cover their risks. Basel II did
change the view on risks but only slightly adjusted the definition of own funds. It should be noted that this
definition of own funds significantly differs from that of IFRS equity. The existing own funds definition
under Basel II has several flaws: there are large inconsistencies across jurisdictions, there is lack of loss
absorbency of some capital components and there is no harmonized list of regulatory adjustments (e.g.
deductions). As a consequence, it has been possible for some banks to display strong solvency ratios with
limited tangible common equity. In order to fight these shortcomings, the Basel Committee announced
several measures in order to raise the quality, consistency, and transparency of own funds. As a first step a
difference is made between going concern own funds (Tier 1 capital) and gone concern own funds (Tier 2
capital). Subsequently the going concern has been split in Tier 1 common equity and additional Tier 1
capital. The three own funds components are described below:

1. Tier 1 – Common equity

Common equity must consist of a combination of common shares and retained earnings. Banks are
especially faced with more stringent definitions for common shares. Hence, banks need to invest their efforts
into attracting capital in terms of shares and into raising the profitability of their business. Common equity
will probably become the primary and most restrictive form of own funds under Basel III. On top of that, all
regulatory adjustments will be at the expense of common equity.

2. Tier 1 – Additional
Additional Tier 1 capital consists of instruments that are subordinated, have fully discretionary non-
cumulative dividends or coupons and have neither a maturity date nor an incentive to redeem. This means
that current innovative hybrid capital instruments will be phased out because they typically have a fixed
distribution percentage, they have no „loss absorption capabilities‟1 and they have an incentive to redeem
through features like step-up clauses.

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3. Tier 2 Capital
Tier 2 capital contains instruments that are capable of bearing a loss, not only in case of default, but also in
the event that a bank is unable to support itself in the private market (hence gone concern capital).
Therefore, the contractual terms of capital instruments need to allow banks to write them down or convert
them into shares.

Capital category Basel II Basel III

Retained earnings Tier 1 - common equity Tier 1 - common equity.

Common shares Tier 1 - common equity Tier 1 - common equity

(includes member
certificates).

Innovative capital instrument Tier 1 - additional Excluded and grandfathered

due to incentive to redeem.

Non-innovative capital Tier 1 - additional Included, but will probably

instruments need some restructuring.

Subordinate debt Tier 2 Will be included in Tier 2

only if it is loss absorbent in
the case of stress (gone-
concern).

In the past the growth of banks has been partly supported by hybrid forms of capital. Due to the increasing
importance of Tier 1 common equity this is no longer possible. Retained earnings will be primary source to
bolster Tier 1 common equity. This is especially true for cooperative banks since they cannot issue shares
like listed banks would do. For both type of banks this requires an even greater awareness for costs and
returns which requires careful commercial choices.

Regulatory adjustments
On top of the above definitions of own funds a whole range of regulatory adjustments are specified to
harmonize the inclusions and exclusions of certain adjustments. Under Basel II these regulatory adjustments
could be split evenly over Tier 1 and Tier 2 capital. Basel III however will attribute all adjustments to Tier 1
common equity. The adjustments deal with consolidated and unconsolidated interests in financial
institutions, intangibles like software and pension assets and liabilities. The table below gives a short, but
not exhaustive overview of some of these adjustments under Basel III.

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 Regulatory Description
Adjustment
Minority Interests Acknowledgement of minority interest reduced to only
include subsidiaries that are a „bank‟.

Goodwill and Intangibles Next to goodwill also other intangibles are to be deducted
(like software).

Shortfall provisions to EL Is to be fully deducted from Tier 1 common equity instead of

50% from Tier 1 and 50% from Tier 2.

Cash flow hedge reserve Should not be included in Tier 1 common equity.

Pension fund Are to be deducted from Tier 1 common equity.

asset/liabilities

Unrealized gains and losses Are to be taken into account in Tier 1 common equity.

Deferred Tax Assets DTAs, MSRs and unconsolidated FIs are to be weighted for
(DTA) the first 10% (of Tier 1 common equity) with a max of 15%
when combined. All exposures above the 10% per category,
Unconsolidated Financial
or the 15% combined, are to be deducted from Tier 1
Institution
common equity.
Mortgage Servicing Rights
(MSR)

Other deductions All other deductions specified under Basel II which are not
specified above are to be weighted (like certain securitization
exposures).

3.2.2 Capital buffers

Next to redefining the own funds components as outlined above, the Basel Com-mittee wants to strengthen
the capital base by increasing the explicit minima for Tier 1 common equity, total Tier 1 en total capital.
After a transition period until 2015, Tier 1 common equity should equal at least 4.5% of risk weighted
assets; total Tier 1 should equal at least 6% and the minimum for total capital equals 8%. As the figure
below shows, the mix of the capital components changes significantly. On top, two additional buffers are
proposed: the „capital conservation buffer‟ and the „countercyclical buffer‟ and a third buffer is being
discussed for Systemically Important Financial Institutions (SIFI).

As of 1st January 2015 Tier 1 Tier 1 Total

common Capital capital
equity

Basel II Minimum 2% 4% 8%

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 Basel III Minimum 4.5% 6% 11.5%

Capital Conservation Buffer 2.5%

Minimum plus cons. buffer 7% 8.5% 15.5%

Countercyclical buffer 0% - 2.5%

SIFI not clear yet

Capital conservation buffer

At the onset of the financial crisis, a number of banks continued to make large distributions in the form of
dividends, share buybacks and generous compensation payments, even though their individual financial
condition was deteriorating. The capital conservation buffer is introduced to avoid this by giving regulators
the ability to control banks‟ earnings distribution. After the phase-in period, banks are required to hold 2.5%
of their Tier 1 common equity on top of regulatory minimum as of 1 January 2019. The purpose is to ensure
that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and
economic stress. However, as a bank‟s capital falls into the buffer range and approaches the minimum
requirement, the bank would be subject to increasing restrictions on earnings distribution.

Countercyclical capital buffer

This buffer is structured as an „add-on‟ to the capital conservation buffer. It is meant to counterbalance pro
cyclical bank lending behavior. This is achieved by linking the height of this buffer to the economic cycle. If
there are signs of excessive credit growth the buffer can be applied at the discretion of the national
regulatory authority. The buffer ranges from 0% to 2.5% and consists of either Tier 1 common equity or
other fully loss absorbing capital instruments.

Buffer for systemically important financial institutions

Currently there is a lot of uncertainty regarding who will be classified as a Systemically Important Financial
Institution (SIFI) and what the consequences will be. Switzerland was the first to announce more concrete
regulation. They require their SIFIs to have an extra buffer in the order of 10% which can consist of
contingent capital.

Given the long transition period, banks should be able to meet the higher minimum standards set by the
supervisor. However, the market will expect banks to comply with the higher standards long before 2019.

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3.2.3 Risk coverage
The financial crisis showed that banks underestimated the counterparty credit risk related to derivatives,
repos, and securities financing activities. Some prominent examples with large losses are Lehman Brothers,
AIG and Bear Stearns. Therefore, the Basel Committee wants to strengthen the capital requirements for
counterparty credit risk arising from these transactions.

I. Wrong way risk

Implement an explicit capital charge for specific wrong-way risk: Wrong-way risk occurs when derivative
exposure increases as the credit quality of the counterparty deteriorates. During the financial crisis
deteriorations in credit worthiness occurred precisely at the time when market volatilities and counterparty
exposures were higher than usual. In order to take the potential of increasing exposure into account, the new
regulation requires banks to calculate the exposure at de-fault by using data that includes a one year period
of market stress.

ii. Credit Valuation Adjustment

Mark-to-market losses due to „Credit Valuation Adjustments‟ 2 were not directly ca-pitalized in the past.
Hence, losses built up from tumbling market values with no capital buffers in place to absorb these losses.
Therefore, the Basel Committee imposes banks to add an additional capital charge to cover unexpected
counterparty mark-to-market losses due to credit value adjustments.

iii. Clearing
Up to now banks do not make much use of central exchanges to clear trades. This means that most
transactions are bilateral OTC contracts where two parties agree directly on terms of the transaction. The
drawback is that there is few regulatory oversight and parties depend heavily on each other. The
interconnectedness of banks through derivative markets increases the systemic risk. The Basel Commit-tee
is supporting initiatives to use central exchanges and standardized derivative contracts. This is done by
assigning a modest risk weight (1%-3%) to determine regulatory capital if these exchanges comply with
several criteria.

iv. Correlation of financial institutions

Large financial institutions are more interconnected than currently reflected in the capital framework. This
means that the correlation for transactions to financial institutions is underestimated in banks‟ calculations
for capital requirements. Therefore, the Basel Committee proposes to increase asset value correlation by
25%. This relates to all financial exposures under the IRB approach of regulated financial firms with assets
of at least $100 billion, and to all exposures to unregulated financial firms regardless of size.

v. Other
Requirements for stress testing will become more explicit, model validation standards will be revised and
there will be supervisory guidance for sound back-testing practices of counterparty credit risk. On top of that
the Basel Committee requires higher capital buffers for positions in the trading book and complex

15
securitization transactions (re-securitizations). Banks in the EU have to comply with the last two adjustment
already by the end of 2011.
The adjustments described above will primarily affect the RWA of banks‟ wholesale business.

3.2.4 Leverage ratio

One of the underlying features of the crisis was that banks were leveraged with excessive on- and off-
balance sheet leverage. During the crisis banks were forced by the market to reduce their leverage which
caused a downward spiral for asset prices and bank capital. Therefore, Basel III introduces a leverage ratio.
This ratio is intended to achieve a constraint on the leverage in the banking sector as a non-risk based
“backstop” measure based on gross exposure. This ratio also circumvents model risk inherent to risk
weighted asset calculations.

Timelines 2011 2012 2013 2014 2015 2016 2017 2018 2019

Leverage Supervisory Parallel run Migration to

ratio Monitoring Pillar 1
Disclosure starts 1 Jan 2015

The two elements of the ratio are capital (numerator) and gross exposure (denominator) measure. There will
also be a clear definition of on-balance sheet items, securitizations, derivatives and off-balance sheet items
but they will be weighted differently. In the July 2010 press release the Basel Committee revealed that
netting will be allowed for derivatives and credit conversion factors are applied to off-balance sheet items
(e.g. 10% CCF for unconditionally cancellable commitments). During the parallel run period, between 2013
and 2017, a minimum ratio of 3% will be tested. The Basel Committee will investigate whether this
percentage and the-de-sign of the ratio is appropriate over a full credit cycle and different types of business
models. The currently proposed ratio will have a more severe impact on one bank than on another. Based on
the results of the parallel run period, there might be adjustments in the first half of 2017. It is planned that
the leverage ratio becomes an explicit requirement as of 1 January 2018.

3.2.5 Liquidity
Throughout the financial crisis many banks struggled to maintain adequate liquidity levels. Unprecedented
levels of liquidity support were required from central banks in order to sustain the financial system. Even
with such extensive support a number of banks failed, were forced into mergers or required resolution.
These circumstances and events were preceded by several years of ample liquidity in the financial system,
during which liquidity risk and its management did not receive the same level of scrutiny and priority as
other risk areas. The crisis illustrated how quickly and severely liquidity risks can crystallize and certain
sources of funding can evaporate. Therefore, Basel III introduces two internationally consistent regulatory
standards for liquidity risk supervision.

Timeline 2011 2012 2013 2014 2015 2016 2017 2018 2019

Liquidity
coverage

16
 ratio Observation Period Introduction Minimum Standard

Net Introduction
Stable Minimum
Observation period
Funding Standard
Ratio

Liquidity Coverage Ratio

The Liquidity Coverage Ratio (LCR) identifies the amount of unencumbered, high quality liquid assets
(minimum market liquidity risk) an institution holds that can be used to offset the net cash outflows
(operational liquidity risk). The LCR assumes an acute short-term, thirty day stress scenario. The specified
scenario entails both bank-specific and market-wide shocks built upon actual circumstances experienced
during the financial crisis.

Net Stable Funding Ratio

The Net Stable Funding Ratio (NSFR) measures the amount of longer-term, stable sources of funding
employed by an institution relative to the liquidity profiles of the assets. These assets also include contingent
calls arising from off-balance sheet commitments. The standard requires a minimum amount of funding that
is expected to be stable over a one year time horizon. The NSFR is intended to promote longer-term
structural funding of banks‟ on- and off-balance sheet exposures and capital markets activities.

3.3 Summary of the major Basel III recommendations and implications

The proposals are structured around the following areas, which we address in the series of tables below,
highlighting the key changes and implications:
1. Increased quality of capital
2. Increased quantity of capital
3. Reduced leverage through introduction of backstop leverage ratio

Regulatory objective – (1) Increased quality of capital

Basel III contains various measures aimed at improving the quality of capital, with the ultimate
aim to improve loss-absorption capacity in both going concern and liquidation scenarios.

Description of the key changes Implications

17
  Common equity and retained earnings
should be the predominant component of
Tier 1 capital instead of debt-like
instruments, well above the current 50
percent rule.
 Harmonized and simplified requirements
for Tier 2 capital with explicit target for
Tier 2 capital.
 Full deduction for capital components with
little loss- absorption capacity such as
minority interests, holdings in other
financial institutions, Deferred Tax Assets.
 Gradual phase-out of hybrid Tier 1
components, including many of the step-
up/innovative/SPV–issued Tier 1
instruments used by banks over the past
decade.
Regulatory objective – (2) Increased quantity of capital
Basel III contains various measures aimed at increasing the level of capital held by institutions, as
well as providing counter-cyclical mechanisms.
Description of the key changes
 Minimum common equity Tier 1:
 Increased from 2.0 percent to 4.5 percent
 Plus capital conservation buffer of 2.5
percent
 Bringing total common equity
requirements to 7.0 percent
 To be phased in from 2013 to 2019
 Minimum total capital:
 Increased from 8.0 to percent to 10.5
percent (including conservation buffer )
 To be phased in from 2013 to 2019
Counter-cyclical capital buffer is being
developed, which is expected to be
implemented by increases to the capital
conservation buffer during periods of
 BCBS measures are already discounted by
markets, so banks are likely to clean up their
balance sheets as soon as possible.
 Likely to see raising of significant capital
by banks, along with retention of profits and
reduced dividends.
 National regulators will have less flexibility
to allow capital instruments to be included
in Tier 1 or Tier 2 capital.
 Systemically important banks (and,
potentially, all banks) may be allowed to
issue contingent convertibles to meet
additional capital requirements
Implications
 Banks will face a significant capital
requirement, and bulk of this shortfall will
need to be raised as common equity or
otherwise by retaining dividends.
 In principle, banks will be able to draw on
the capital conservation buffer during
periods of stress, but it seems unlikely that
they would choose to do so, given the
associated constraints on their earning
distributions.
 Consequently, banks are likely to target a
higher common equity ratio and the market
expectation for common equity tier
1appears to be moving to approximately 9
percent.
 There is likely to be further add-ons for
pillar 2 risks, systemically important firms,
18
 excessive credit growth and the counter-cyclical capital buffer, so
banks may target a total capital ratio of 13-
15 percent.

Regulatory objective – (3) Reduced leverage through introduction of backstop leverage ratio

The leverage ratio acts as a non-risk sensitive backstop measure to reduce the risk of a build-up of
excessive leverage in the institution and in the financial system as a whole. The leverage ratio
remains controversial, and there remains ambiguity about certain aspects of the exact mechanics.

Description of the key changes Implications

 The leverage limit is set as 3 percent, i.e. a
bank‟s total assets (including both on- and
off-balance-sheet assets) should not be
more than 33 times bank capital.
 In 2011, reporting templates will be
developed. In 2013,regulators will start
monitoring leverage ratio data, and the
ratio will be effective from January 2018
 The ratio is introduced to supplement the
risk-based measures of regulatory capital
 The leverage ratio is implemented on a
gross and unweighted basis, not taking into
account the risks related to the assets
 The introduction of the leverage ratio could
lead to reduced lending and is a clear
incentive to banks to strengthen their capital
position, although it remains to be seen
whether the ratio will bite for individual
firms.
 The non-risk-adjusted measure could
incentivize banks to focus on higher-
risk/higher-return lending.
 Pressure arises on banks to sell low margin
assets (e.g., mortgages), which could drive
down prices on these assets
 Banks may be required by the market and
the rating agencies to maintain a higher
leverage ratio than required by the
regulator.

19
 Chapter Four

BASEL III- IMPLEMENTATION IN AND CHALLENGES FOR BANGLADESH

20
4.1 why should Bangladesh adopt BASEL III?
The discussion may be started from original Basel III accord of the BIS, which is the base of the BB's
guideline. Basel III was introduced in 2010 with the intention of gradual implementation starting from
January 01, 2013 and full implementation starting from January 01, 2019. Basel II guideline, the previous
version of capital standard, was felt inadequate to maintain financial stability during global financial crisis
started in 2007. The financial instability took a heavy toll and led to economic crisis in various countries.
Basel III guideline has been formulated to improve shock resilience capacity of the banks to prevent
recurrence of such financial and economic crisis. In fact, Bangladesh should implement Basel III because of
several reasons. By far the most important reason is that as Bangladesh Banks go abroad and foreign banks
come on to our shores, we cannot afford to have a regulatory deviation from global standards. The
“perception” of a lower standard regulatory regime will put Bangladeshi banks at a disadvantage in global
competition, especially because the implementation of Basel III is subject to a “peer group” review whose
findings will be in the public domain. Deviation from Basel III will also hurt us in actual practice. We have
to recognize that Basel III provides for improved risk management systems in banks. It is important that
Bangladeshi banks have the cushion afforded by these risk management systems to withstand shocks from
external systems, especially as they deepen their links with the global financial system going forward.

4.2 What would be the impact of BASEL III on banks and financial system?
4.2.1 Capital
Capital requirements are also a part of Basel III. Banks are required to hold 4.5% of risk-weighted assets in
the form of their own equity. This rule is an effort to make banks have skin in the game when it comes to
making decisions to reduce the agency problem. More capital rules include 6% of risk-weighted assets being
of Tier 1 quality. Risk weighted assets are the most vulnerable during a downturn, so these rules will protect
the banks.

4.2.2 Liquidity ratios

Another element of Basel III is required liquidity ratios. The liquidity coverage ratio mandates that banks
must hold high-quality, liquid assets that would cover the bank's cash outflows for a minimum of 30 days in
the event of an emergency. The net stable funding requirement is for banks to have enough funding to last
for a whole year in an emergency.

4.2.3 Impact on business segments

No assessment of the impact of Basel III would be complete without a review of the effect on profitability of
individual businesses and the bank as a whole. As suggested in our April 2010 white paper, three types of
impact must be considered:

Balance-sheet-specific impact at the corporate level:

Balance Sheet Specific impact at the corporate level cannot be attributed to individual businesses. Examples
include those capital deductions that will affect each bank‟s balance sheet differently, depending on its
assets, but will not have a particular effect on businesses.

21
Universal impact across all banks and businesses:
The new capital and leverage ratios are the best examples of rules that affect all businesses proportionally.
The impact would be more pressing on marginally profitable businesses, but all businesses would suffer
unless the cost rise could be passed on to customers.

Business-specific impact:
This category includes rules on risk-weighted assets (RWAs), liquidity, and long-term-funding, which were
designed specifically to address the risks that were visible during the crisis, for example, in trading and
securitization

4.2.4 Shadow Banking

Excessive leverage i.e. use of non-equity fund has played major role in both initiation and deepening of the
crisis. The initiation of the crisis was in shadow banking system of the USA. The shadow banking system is
a set of institutions that carry out functions very similar to those of traditional banks but that are less
regulated. They are kept less regulated because they do not receive deposit from the public. How do they
provide bank-like services without accepting deposit? Let us explain it with a simplified example. Suppose
that an investor availed margin loan from a broker to purchase a security. The security is kept pledged to the
broker against the margin loan. The broker can use the pledged security to enter into a repo (repurchase
agreement) transaction with a pension fund which have excess fund to invest for a short period. The pension
fund can deposit the excess fund in a bank but the return of such short-term deposit is not attractive. So,
pension fund searches for alternative profitable avenues for investment with equal importance on safety of
the fund. If it enters into repo transaction with the broker, it will be able to invest its short-term fund more
profitably that is secured by repo security. In this case, the pension fund is called repo lender, the broker is
called repo borrower and the security of the repo transaction is called collateral. Thus, a banklike transaction
is made in the shadow banking system and leverage is created contracts in the period prior to the financial
crisis. The asset size of shadow banking system in the USA was even higher than the formal banking system
at that period. Mortgage Backed Securities (MBS) were popularly used as repo collateral in these
transactions. MBS are created by pooling mortgage loans and selling them as security. The sale of mortgage
loan increases the availability of fund for extending further loan. The demand of MBS as repo collateral in
pre-crisis period caused more securitization of mortgage loans and the loanable fund for house purchasers
increased markedly. The availability of loan increased the home prices excessively.

In 2007, the overpriced housing market started to decline in the US. Consequently, the price of the
mortgage-backed securities started to fall due to fear of increase of default by the home owners (borrowers).
As a result, the repo lenders started to refuse to lend money against such securities. The securities had to be
forcedly sold out to pay the repo lenders money. The sale pressure of the securities further reduced the price
of the same and the loop continued to worsen the scenario day by day.

Like the shadow banks, the formal banks also accumulated excessive leverage in their balance sheet while
maintaining necessary risk-based capital ratio. The de-leveraging process and the price slump in the shadow
banking system greatly affected these banks. They were compelled to reduce their leverage in a forced
manner that caused huge losses, reduced capital ratio and contracted the availability of the credit in the
economy. But it is apparent that the excessive leverage of the banks contributed to the crisis. Even the banks
maintained necessary risk-based capital ratio. It means that capital ratio alone is not sufficient to protect the
22
stability of financial sector. As such, Basel III introduces a simple, transparent, non-risk-based regulatory
Leverage Ratio to constrain leverage in the banking sector and supplement risk-based capital ratio as a
safeguard against model risk. The leverage ratio is calculated by dividing tier 1 capital with total exposure.

4.2.5 Substandard quality and inadequacy of capital

Another reason of failure of banks to withstand the shock of financial crisis was substandard quality and
inadequacy of capital. The capital of the banks lacked good proportion of high quality capital like common
share and retained earnings in the pre-crisis period. Short-term subordinated debt was used as tier-3 capital
which did not have the strength to provide support during the prolonged crisis. Rather these debts matured
within a short period of time and banks faced extra pressure to redeem the debts. At the onset of crisis, the
banks made large distributions of capital in the form of cash dividend, share buy-back and generous
compensation with the market signaling that they are sufficiently strong, which actually weakened the
position of the banks.

To increase the quality and quantity of the capital base of the banks, Basel III has introduced the
following measures:
i)Tier 1 capital has been divided into two parts: Common Equity Tier 1 (CET1) and Additional Tier 1
(AT1). Minimum Tier 1 capital requirement has been set at 6 per cent out of which CET1 is 4.5 per cent and
AT1 is 1.5 per cent. However, minimum capital requirement has been kept unchanged from Basel II.
ii) The definition of capital has been made stringent. Tier 3 capital has been eliminated.

iii) A buffer CET1 capital named Capital Conservation Buffer has been proposed @ 2.5 per cent in addition
to the minimum capital requirement. Restriction has been put in distribution of profit (cash dividend and
discretionary bonuses to staff) until the buffer is developed.
iv) In addition, the banks are required to deduct goodwill and other intangible assets, deferred tax asset,
shortfall in provision, defined benefit pension fund assets and liabilities, investment in shares of financial
institutions (including bank, NBFI and insurance) in excess of 10 per cent of bank's capital, investment in
own share, gain on sale related to securitization transactions etc. from their capital.

Also, insufficient liquidity buffer is the third point of our discussion regarding the reasons of financial crisis.
The banks excessively relied on short-term low-cost funding to create long-term assets. They also failed to
maintain high-quality long-term assets to stand out the stressed condition. During the crisis, they faced much
difficulty to meet the liquidity needs, which necessitated intervention from the central bank. The crisis
revealed that supervisory standard on liquidity is of equal importance as capital to maintain stability of the
financial sector. Accordingly, Basel III introduced liquidity standard as a complement to the capital
standard.

23
4.3.1 Implementation of the Basel III in Bangladesh Bank

Basel III refers to the capital and liquidity of the International Banking System to agree to the stability of the
International Banking System by the Bank for International Settlements (BIS). BIS is an international
financial institution, BIS acts as a bank of central bank. In Bangladesh, Basel-I was launched in 1996 and
2010 Basel-II was launched (Parallel Run Basel I start year 2009). In line with Basel III, the Bangladesh
Bank publishes “Guide lines on Risk Based Capital Adequacy” through BRPD circular number the 18-21th
December 2014 and Basel III is growing implementation has started from 1st January 2015. Basel III
complete implementation in Bangladesh will start from January 2019.

4.3.2 Basel III Means for Bangladesh banking system:

Basel III Capital Rule is a criticism for the banking sector in Bangladesh. Banking sector as push the
financial and economic pressure, which has reduced the risk of the fall of the source thus, has to be
overtaken by the financial sector to take advantage of these real economies to be exploited.

4.3.3 Key Issues for Bangladesh Banking Sector

Basel II is the third pillar of market discipline, which is related to further publication. The market participant
should publish a more informed decision by the bank to make a more informed decision. Basel 3
strengthened the need for publishing any further publications, where any combination of the legal capital
and legal capital of the bank. The demand for high capital also comes with the price. Trying to meet the
bank inside, they might use a combination of strategic plans which may have adverse effects on the overall
economic activity as a whole. In order to seek the new capital, the bank could introduce new simulations or
increased retained income. However, it can be achieved by reducing dividend payments, increasing
operating efficiency, reducing compensation and other costs, raising interest rates, increasing non-interest
income. In addition, reducing the size of the debt reduces the risk-weighted assets, reducing the debt
contract, reducing the term of the loan, reducing or decreasing unwanted resources, exposure to well-rated
lenders and more.

4.3.4 Capital Standard

Before discuss that Basel III has two parts: Capital Standard and Liquidity Standard. Basel III's capital is
composed of three layers, which are known as three pillars:
1. The covers of Pillar 1 the minimum capital, capital buffer and leverage
2. The covers of Pillar 2 Risk Management and Supervision
3. The covers of Pillar 3 Market Discipline
Capital Standard's Pillar 1 defines some aspect related to capital, which banks must maintain as the
minimum capital. These two main factors are risk-weighted asset ratio (CRAR) and leverage ratio from the
capital.

24
4.3.5 Capital to Risk-weighted Asset Ratio

(CRAR= Total Eligible Capital/Risk Weighted Asset)

(CET 1 Capital to RWA= CET 1/Total RWA)
(Tier 1 Capital to RWA= Total Tier 1 Capital/Total RWA)
(Tier 2 Capital to RWA= Tier 2 capital/Total RWA)

All Bangladeshi Banks should maintain minimum capital ratio of 10% or more sustainable in 400 million
which is higher 3. Along with this minimum capital, a capital conservation buffer (CCB) of 2.5% will be
developed gradually by 2019. The upper ratio has two parts: appropriate capital and risk weight resources, as
explained below.

4.3.6 Leverage Ratio

To complement CRAR, a general non-risk-based leverage ratio has been introduced. CRAR risks using
indicators as risk weighted asset/using total leverage ratio exposure. The leverage ratio is calculated as
follows:
(Leverage Ratio= Tier 1 Capital/Total Exposure)
Banks should maintain minimum leverage ratio of 3%. In Bangladesh, the calculation of the leverage ratio
will be monitored in 2016 and the need for reconsideration will be made in 2017. Banks will be forced to
maintain leverage ratio since 2018.

4.3.7 Liquidity Standard

Basel iii means the capital of liquidity standard as a supplement to the capital. It made two minimum values
for liquidity. It is Liquidity coverage ratio (LCR) and Net stable Funding Ratio (NSFR). In keeping with
Basel III, the Bangladesh Bank has circulated "Guidelines Note on Liquidity Coverage Ratio (LCR) and Net
Stable Fund Ratio (NSFR)” Given Disk Operating System Circular Number One date 1st January, 2015.

4.3.7 Liquidity Coverage Ratio

To ensure the liquidity coverage ratio, a bank is determined to meet its liquidity requirements for 30
calendar days in a difficult time, which maintains a sufficient level of easy-to-replaceable assets of high
quality cash, which is converted into cash. To calculate the LCR equation as below:
LCR=Stock of high quality liquid assets / Total net cash outflows over the next 30 days≥100%

4.3.8 Net Stable Funding Ratio

The purpose of NSFR is to increase stability in the one-year horizon, through which banks provide to the
funds through more stable sources of funding. NSFR limits the dependency on short-term funds during the
market liquidity.
The equation to calculate NSFR as below:
NSFR=Available amount of stable funding / required amount of stable funding
The minimum standard for NSFR shall be greater than 100.
25
4.3.9 Bangladesh Bank Capital Accord Basel III

With the best international practice of Bangladesh bank issued guidelines on risk-based capital equality
(Corrected Regulatory Capital Framework for Line Bank Basel III through BRPD Circular No. 18 on
December 23) 2014. BB is the main feature of this new regulatory guide the capital measurements are as
follows:
A. To ensure the quality of the capital and the level increase that bank is able to absorb well unexpected
Damage associated with banking operation. For this Finish, the capital component is divided into 2 (two)
Tiers, namely,
1. Formed Tier 1 capital

I. General Equity Level 1 (CE1) - mainly included

 Paid-up share capital

 Non-repayable share premium
 Statutory reserve
 Retained earning
 Dividend equalization account etc

II. Extra Tier 1 capital, included

 Bank paid instruments (such as bonds) Subject to the following criteria

 Maturity time - shall be the instrument be permanent, such as a certain maturity;

 Repurchase / buy-back / redemption-Principal of the device can be repurchase /
repaid by releasing Only with BB's prior approval;
 Dividend Discretion - Bank must be of course there are always complete
considerations for cancellation Distribution / Payment.

2. Formed Tier 2 Capital

 General provisions in unclassified debt and exposure to off balance sheet; And
 Loan / instrument under issued by the bank.

BB also determined the necessary deductions from Tier 1 and Tier 2 capital.

B. Increase the risk coverage of the capital structure;

C. Serve as a backstop to introduce leverage ratio Risk based capital measurement;
D. Raise standards for supervisory review Process;
E. Expand quantitative and qualitative expression the direction for the stakeholders.

26
BB also sets the minimum and maximum limit Ratio for a capital adequacy ratio starting from January 2015,
full phases Implementation of capital ratio from January 2020 under:

 Total Risk Weighted Assets (RWA) at least 4.50% Common Equity Level 1 (CET1);
 Tier 1 capital will be at least 6.0% of the total RWA;
 Minimum capital from risk-weighted asset ratio (CRAR) will be 10% of RWA;
 Minor CRAR, besides capital, Reserve buffer (CCB) @ 2.50% should be maintained in
the form of CET1;
 Tier 2 capital can be admitted up to the highest total RWA 4.0% or CET1's 88.89% to
4.0% which is higher;
 Minimum total capital plus capital reserve Buffer should be 12.50%.

4.3.10 Capital Conservation Buffer: Banks should maintain 2.5% capital saving buffer, with a minimum
of 10% controller minimum capital requirement, with the existing equity Tier 1 capital. If the capital level
falls within this limit, the banks cannot distribute the capital (i.e. dividend or bonus by any means).
However, when they fall in the familiar environment due to the unfolding of their capital, they will be able
to manage as normal business as usual. Therefore, the imposed limitations are not only related to distribution
and operations of banks. When the banks increase their range of capital levels, the restrictions that are
distributed to banks are "The levels of capital reach the lowest requirements." Basel III, the new capital
reserve market in Bangladesh is still not implemented in most banks.
The general equity Tier 1 ratio used to be used to meet 4.5% of the general equity Tier 1 capital requirement,
but to meet any additional common equity Tier 1 requirement 7% Tier 1 and 10% of the entire capital to be
pruned. For example, a bank common equity Tier 1 maintains 8% capital, 1% additional rows 1 and 1% tier
2 capitals. Therefore, all the capital's capital came to be sought, but there was a zero conservation conflict,
and therefore, the bank was 100% limited by the bonus, as per the requirement of share-buybacks and bonus
on the distribution of capital. If a bank has no less than 7% fixed income and there is a general equity Tier 1
ratio, it should not make sure net distribution.

Table Individual bank’s minimum capital conservation standards

CET1 Ratio Minimum Capital Conservation Ratio (expressed as percentage of earnings)

4.5% - 5.125% 100%

>5.125% - 5.75% 80%

>5.75% - 6.375% 60%

>6.375% - 7.0% 40%

>7.0% 0%

Transitional arrangements: The commencement of the commence changes in the new value which helps
ensure that the banking sector can meet the high capital values through imposing reasonable income and
27
withdrawing the capital, although the economy still has to support lending. In line with the Basel III
structure, the Bangladesh Bank has introduced a transitional arrangement for implementation of Basel III. In
order to implement Basel III in Bangladesh phase-in will be followed as follows:

Table Phase-in systems for Basel III Roadmap implementation in Bangladesh

Particulars 2015 2016 2017 2018 2019 2020

Minimum Common Equity Tier-1 (CET-1) Capital 6.00%
4.50% 5.50% 6.00% 6.00% 6.00%
Ratio

Plus Capital Conservation Buffer 0.625% 1.25% 1.875% 2.50% 2.50%

Minimum CET-1 plus Capital Conservation Buffer 4. 50% 6.125% 7.75% 7.875% 8.50% 8.50%

Minimum T-1 Capital Ratio 5.50% 5.50% 6.00% 6.00% 6.00% 6.00%

Minimum T-2 Capital Ratio

4.5% 4.5% 4.0% 4.0% 4.0% 4.0%

Minimum Total Capital Ratio 10.00% 10.00% 10.00% 10.00% 10.00% 10.00%

Minimum Total Capital plus Capital Conservation 12.50%

10.00% 10.625% 11.25% 11.875% 12.50%
Buffer

Phase-in of deductions from CET1

Excess Investment over 10% of a bank’s equity in

the equity of banking, financial and insurance
20% 40% 60% 80% 100% 100%
entities2

Phase-in of deductions from Tier 2 Revaluation Reserves (RR)3

RR for Fixed Assets, Securities and Equity 100%

20% 40% 60% 80% 100%
Securities

For Liquidity management, BBI Introduced different ratios under:

Particulars 2015 2016 2017 2018 2019
Leverage Ratio 3% 3% 3% Migration to Pillar 1
Readjustment
≥100%
Liquidity Coverage Ratio (LCR) ≥100% ≥100% ≥100% ≥100%
(From
Sep.)
>
Net Stable Funding Ratio (NSFR) 100% >100% >100% >100% >100%
(From
Sep.)

4.4. What are the major challenges to implement BASEL-III?

28
4.4.1 Capital
The first set of Basel III reforms agreed in later part of 2010 tackled the issue of numerator part of regulatory
capital ratio. While minimum total capital requirements were kept unchanged at 8% of the RWA, the
definition of various components of capital and its composition were thoroughly revised to ensure that
capital performs its intended role of loss absorption. The minimum common equity requirement was raised
from 2% level, before the application of regulatory adjustments, to 4.5% after the application of stricter
adjustments. This meant that common equity requirement was effectively raised from 1% to 4.5%. The Tier
1 capital, which includes common equity and other qualifying financial instruments based on stricter criteria,
was increased from 4% to 6%. It has also been agreed that there would be a capital conservation buffer of
2.5% above the regulatory minimum requirement to present 8% to 10.5%. In our case, the level of capital
increases from 9% to 11.5%, if capital conservation buffer is taken into account. In this context, it may be
pertinent to note that post crisis, major banks in advanced economies have raised their capital adequacy level
significantly. In general, globally banks have raised their CET1 ratio by almost 400 bps during last four
years. And importantly, this is mainly by way of fresh infusion of equity capital.

The second element in the capital framework is the leverage ratio. We have advised banks that they would
be monitored on a leverage ratio of 4.5%. We are watching this closely. Leverage ratio generally does not
adjust the assets for risk weights and therefore would need the required capital for a given balance sheet. We
have seen on the basis of the RW profile of banks that the leverage ratio is not acting as the binding factor
for most banks in Bangladesh. To ensure that the leverage ratio acts as a credible back-stop measure, the
Bangladesh Bank would continue to monitor the leverage ratio behavior of Bangladeshi banks and also the
developments of other related regulatory framework before finalizing the appropriate level of leverage ratio
for Bangladeshi banks.

Another element that could lead to higher capital is the changes in the Risk Weighted Assets, more
specifically, on account of proposed revisions to the standardized approaches for risk measurements. The
Banks intends to avoid reliance on credit ratings for determining risk weights for credit risk given the
lessons learnt from the crisis. Although this is work in progress, under the proposed revised framework,
banks would be required to utilize a set of risk drivers like leverage of the entity, NPAs, etc. to determine the
appropriate risk weight. Similarly, for market risk, there would be a requirement to compute sensitivities
(delta, gamma, etc.) on a deal level for computing RWAs. Besides, talks are already underway to review the
existing treatment of sovereign assets under Basel framework wherein exposure to sovereign requires zero
or very little capital charge. These proposals will alter the way banks compute RWAs. Besides, a new
explicit capital charge for interest rate risk for banking book positions is also proposed to be introduced.
Further, specific to the advanced approaches for risk measurement, the Basel Committee is undertaking a
strategic framework review with a view to enhancing simplicity, reducing complexity and at the same time
ensuring that the framework remains risk sensitive.

The fourth element impacting capital requirements is provisioning. IFRS 9 requires provisioning based on
expected loss provisions.

4.4.2 Liquidity
The second Challenge comes from Liquidity Framework. The global crisis underscored the importance of
liquidity management by banks. The apparently strong banks ran into difficulties when the interbank

29
wholesale funding market witnessed a seizure. In fact, I have mentioned elsewhere too that for me it is only
a matter of time before a liquidity risk degenerates into a solvency risk for a bank and therefore needs to be
avoided. The crisis proved that and had it not been for central bank support, the crisis toll could have gone
beyond what we saw. The LCR and the NSFR Frameworks basically address this problem
In the Bangladeshi context, any discussion on the LCR issue brings to the fore the fact that it runs parallel to
SLR requirement. We have over a period of time reduced SLR and of the current level of 21.5%, a portion
i.e.7 % is available for LCR as well. There is always the contention that the parallel need to maintain SLR
and LCR poses an additional burden on the banks in Bangladesh. We are aware of this concern and already
communicated our intention to reduce the SLR requirements in a phased manner. However, there are several
factors that would have to be addressed before we can move further to address the potential overlap.
Bangladesh Bank is looking at the comments received and will come out with the final guidelines taking
into consideration the responses to the extent we can accommodate them.

4.4.3 Technology
The Third challenge is technology. Bangladesh Bank is in the process of making significant changes in
standardized approach for computing RWAs for all three risk areas. These revised standardized approaches
themselves will be quite risk sensitive and will be dependent on a number of computational requirements.
Further, Bangladesh Bank has proposed that for those banks which are under advanced approaches, RWAs
based on standardized approaches may work as some kind of floor. BCBS is working on calibration of these
floors. Banks may need to upgrade their systems and processes to be able to compute capital requirements
based on revised standardized approach.

4.4.4 Skill development

The fourth challenge is skill development. This is a requirement both in the supervised entities and within
the Central Bank. Implementation of the new capital accord requires higher specialized skills in banks. In
fact, it requires a paradigm shift in risk management. The governance process should recognize this need
and make sure that the supervised entity gears up to it. Risk awareness has to spread bank-wide, the manner
of doing business that measures risk adjusted returns needs to permeate the system. Top management and
the Human Resource Development Policy of banks thus need to get tuned. Bangladesh Bank also need to
hone up their skills in regulating and supervising banks under the new system. This as an ongoing process
and are continuously working towards skill improvement.

4.4.5 Governance
One can have the capital, the liquid assets and the infrastructure. But corporate governance will be the
deciding factor in the ability of a bank to meet the challenges. Central bank added a separate principle on
corporate governance in its core principles for effective banking supervision which were revised in 2012. It
is interesting to note that before 2012, there was no separate principle on corporate governance. Global
community is recognizing the importance of corporate governance and is trying to fix the issues. Thus while
strong capital gives financial strength, it cannot assure good performance unless backed by good corporate
governance.

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4.4.6 Complex transactions
Excessive interconnectedness among financial institutions also made the financial crisis so severe. Financial
institutions were engaged in an array of complex transactions, which rapidly transmitted the crisis from one
institution to another. To limit the interconnectedness among financial institutions, Basel III suggested a
number of measures. These measures include: i) the bank's capital will be deducted for investment in shares
of financial institutions (including bank, NBFI and insurance) in excess of 10 per cent of bank's capital, ii)
Use of central counterparties has been encouraged in the over-the-counter derivatives, iii) Higher capital
requirement has been imposed for derivative products and iv) capital surcharge has been made applicable for
systemically important banks.

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Chapter Five
Conclusion

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5.1 Conclusion:
After reading this term paper, it is not an understatement saying that the Basel III accord is a framework of
complexity and ambiguity. We argue, that because of this, there is an imminent risk that the accord is being
misinterpreted, and that only a small number of individuals will be well-informed of it. As we mentioned in
the critique section this can lead to situations were banks and bank managers tries to surpass regulation by
interpret the accord as favorable as possible, even if this off-sets the intended purpose of Basel III.

However, we argue that the Basel III accord is in fact an important step towards a more resilient banking
system, but stresses the fact that it needs to be revised in a number of areas. As many economists argue, we
agree on the fact that the capital requirement should be even higher in the future, but accentuate the
importance of a successive implementation where the macro-economic stability is not threatened. We would
also like to see additional parts of the framework that more specifically addresses issues regarding both
systemic risk and shadow banking. Another thing that should be revisited in Basel III is if the capital ratios
are enough to actually have an impact on the banks so that they actually reduce their borrowing to conduct
their operations. In fact the capital ratios could be much higher in order to maximize the social benefit of
regulations.

The rhetoric used by banks often states that it is unreasonably high costs associated with the higher capital
ratios and will therefore impose stress on the banks finances. As we saw in the impact section there is an
exaggeration about these statements and a cost impact is fairly moderate in these cases. We argue that this
rhetorical issue both depends on banks willingness to impose increased costs on to its customers and the fact
that there is a lack of knowledge in concepts and definitions.

In order to give the regulations full and effective power, we argue that there is a need for a change in the role
of the government and its financial support toward banks. The current structure, and the concept of to-big-
to-fail, allows banks to take on more risk than desired to experience great profits on the upside whereas an
eventual downside will be paid by the government, and subsequently the taxpayers. There is a large
possibility that banks continues to act in a irresponsible way, maybe unintended, as long as this relationship
exists and despite new requirements on capital and liquidity.

Regarding the implementation of the Basel III accord in Bangladesh it can be concluded that it will decrease
the systemic risk and that the cost aligned with this will be fairly low. We want to highlight the relatively
long transition period which will help to rectify for eventual unintended side effects of the Basel III accord
implementation.

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References

1. https://www.bis.org/publ/bcbs270
2. http://phx.corporate-ir.net/External.File?item
3. https://www.investopedia.com/terms/b/basell-iii.asp

4. https://www.reuters.com/article/us-basel-banks-regulations-exclusive/exclusive-global-
regulators://www.oecd.org/finance/financial-markets
5. https://www.ibm.com/support/knowledgecenter
6. http://www.basel-iii.worldfinance.com/

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