Professional Documents
Culture Documents
com
BASEL I to BASEL II to BASEL III
We give below the following definitions of the above risks, for understanding in the discussions which
follows:
1) Credit Risk: Risk that the counterparty will fail to perform or meet the obligation on the agreed
terms. The common types of credit risks are
i. Transaction Risk: Risk relating to specific trade transactions, sectors or groups.
ii. Portfolio Risk: Risk arising from concentrated credits to a particular sector / lending to a few
big borrowers/lending to a large group
2) Market Risk: Market risk is the risk to a bank's financial condition that could result from adverse
movements in market price. The types of market risks are:
i. Interest Rate Risk: Risk felt, when changes in the interest rate structure put pressure on the
net interest margin of the Bank. The various types of interest rate risks are detailed below:
a) Gap/Mismatch risk: It arises from holding assets and liabilities and off balance sheet
items with different principal amounts, maturity dates and re-pricing dates thereby
creating exposure to unexpected changes in the level of market interest rates.
b) Basis risk: It is the risk that the Interest rate of different Assetslliabilities and off balance
items may change in different magnitude. The degree of basis risk is fairly high in respect
of banks that create composite assets out of composite liabilities.
c) Embedded option risk: Option of pre-payment of loan and fore- closure of deposits
before their stated maturities constitute embedded option risk
d) Yield curve risk: Movement in yield curve and the impact of that on portfolio values and
income.
e) Re price risk: When assets are sold before maturities.
f) Reinvestment risk: Uncertainty with regard to interest rate at which the future cash flows
could be reinvested.
g) Net interest position risk: When banks have more earning assets than paying liabilities,
net interest position risk arises in case market interest rates adjust downwards.
ii. Foreign Exchange or Forex Risk: This risk can be classified into three types.
a) Transaction Risk is observed when movements in price of a currency upwards or
downwards, result in a loss on a particular transaction.
b) Translation Risk arises due to adverse exchange rate movements and change in the level
of investments and borrowings in foreign currency.
c) Country Risk. The buyers are unable to meet the commitment due to restrictions imposed
on transfer of funds by the foreign govt. or regulators. When the transactions are with
the foreign govt. the risk is called as Sovereign Risk.
3) Liquidity Risk: Risk arising due to the potential for liabilities to drain from the Bank at a faster
rate than assets. Liquidity risk for banks mainly manifests on account of the following:
a) Funding Liquidity Risk - the risk that a bank will not be able to meet efficiently the
expected and unexpected current and future cash flows and collateral needs without
affecting either its daily operations or its financial condition.
b) Market Liquidity Risk - the risk that a bank cannot easily offset or eliminate a position at
the prevailing market price because of inadequate market depth or market disruption.
4) Operational Risk arises as a result of failure of operating system in the bank due to certain
reasons like fraudulent activities, natural disaster, human error, omission or sabotage etc.
5) Systemic Risk is seen when the failure of one financial institution spreads as chain reaction to
threaten the financial stability of the financial system as a whole.
6) Business Risk: These are the risks that the bank willingly assumes to create a competitive
advantage n add value to its shareholders. It pertains to the product market in which the bank
operates, n includes technological innovations, marketing n product design. A bank with a pulse on
the market and driven b technology as well as a high degree of customer focus, could be relatively
protected against this risk.
7) Strategic Risk: This risk results from a fundamental shift in the economy or political environment.
Strategic risks usually affect the entire industry and are much more difficult to protect themselves.
A few examples are: the fall of Berlin Wall, Disintegration of Soviet Empire; South East Asian
Institution of Banking & Finance VIJAYAWADA-9291539629
2 www.ccevijayawada.com
Banking Crisis in1997, 2008 Subprime lending crisis, the recent European Economic Crisis; to
name a few.
8) Reputation Risk: Reputation risk is the potential loss that negative publicity regarding an
institution's business practices, whether true or not, will cause a decline in the customer base,
costly litigation, or revenue reductions (financial loss).
PRIOR TO BASEL I SCENARIO:
Basel I norms were introduced only in 1992, and that to in a phased manner over a period of four
years, however, RBI had introduced measures for managing liquidity risk, forex risk and credit
risk (through the Health Code Systems 1985-86) in the Indian banking system.
The Health Code system, inter alia, provided information regarding the health of individual
advances, the quality of the credit portfolio and the extent of advances causing concern in
relation to total advances.
It was considered that such information would be of immense use to banks for control purposes. The
RBI advised all commercial banks (excluding foreign banks, most of which had similar coding
system) on November 7, 1985, to introduce the Health Code System indicating the quality (or
health) of individual advances under the following eight categories, with a health code assigned
to each borrower's account
1. Satisfactory - conduct is satisfactory; all terms and conditions are complied with; all accounts are
in order and safety of the advance is not in doubt.
2. Irregular- the safety of the advance is not suspected, though there may be occasional
irregularities, which may be considered as a short term phenomenon.
3. Sick, viable - advances to units that are sick but viable - under nursing and units for which nursing
revival programmes are taken up.
4. Sick: nonviable/sticky - the irregularities continue to persist and there are no immediate prospects
of regularization and the accounts could throw up some of the usual signs of incipient sickness
5. Advances recalled - accounts where the repayment is highly doubtful and nursing is not
considered worthwhile and where decision has been taken to recall the advance
6. Suit filed accounts - accounts where legal action or recovery proceedings have been initiated
7. Decreed debts - where decrees (verdict) have been obtained
8. Bad and Doubtful debts - where the recoverability of the bank's dues has become doubtful on
account of short-fall in value of security, difficulty in enforcing and realizing the debts.
Under the above Health Code System, the RBI classified problem loans of each bank into three
categories:
Advances classified as bad and doubtful by the bank (Health Code No.8)
Advances where suits were filed/decrees obtained (Health Codes No.6 and 7) and
Those advances with major undesirable features (Health Codes No.4 and 5
Basel I - Accord
The standards are almost entirely addressed to credit risk, the main risk incurred by banks. The
document consists of two main sections, which cover
a) The definition of capital and
b) The structure of risk weights.
Based on the Basle norms, the RBI also issued similar capital adequacy norms for the Indian
banks. According to these guidelines, the banks will have to identify their Tier I and Tier-II
capital and assign risk weights to the assets.
Having done this they will have to assess the Capital to Risk Weighted Assets Ratio (CRAR).
Tier-I Capital Comprises
a) Paid-up capital
b) Statutory Reserves
c) Disclosed free reserves
d) Capital reserves representing surplus arising out of sale proceeds of assets
*Equity investments in subsidiaries, intangible assets and losses in the current period and those
Institution of Banking & Finance VIJAYAWADA-9291539629
3 www.ccevijayawada.com
brought forward from previous periods will be deducted from Tier I capital comprises
Tier-II Capital
a) Undisclosed Reserves and Cumulative Perpetual Preference Shares
b) Revaluation Reserves
c) General Provisions and Loss Reserves
Basel I, that is, the Basel Accord 1988, is primarily focused on credit risk and appropriate risk-weighting of
assets (RWAs).
The notional amount of the asset is multiplied by the risk weight assigned to the asset to arrive at the risk
weighted asset number.
Under this system Assets of banks were classified and grouped in five categories according to credit risk.
This classification system grouped a bank's assets into five risk categories:
1) 0% - cash, central bank and government debt and any OECD government debt
2) 0%, 10%, 20% or 50% - public sector debt
3) 20% - development bank debt, OECD bank debt, OECD securities firm debt, non-OECD bank
debt (under one year maturity) and non-OECD public sector debt, cash in collection
4) 50% - residential mortgages
5) 100% - private sector debt, non-OECD bank debt (maturity over a year), real estate, plant and
equipment, capital instruments issued at other banks
According to Basel -1 norms Banks are required to hold capital equal to 8% of their risk-
weighted assets (RWA).
RWA means assets with different risk profiles. For example, an asset backed by collateral would
carry lesser risks as compared to personal loans, which have no collateral. For example, if a bank
has risk-weighted assets of 100 million, it is required to maintain capital of at least 8 million.
India adopted Basel 1 guidelines in 1999. Banks are also required to report off-balance-sheet
items such as letters of credit, Bills of Exchange, and derivatives etc
The 1988 Accord has been supplemented a number of times, with most changes dealing with
the treatment of off-balance-sheet activities.
A significant amendment was enacted to Basel-I in 1996, when the Committee introduced a
measure whereby trading positions in bonds, equities, foreign exchange and commodities were
removed from the credit risk framework
Weaknesses of Basel I
In spite of advantages and positive effects, weaknesses of Basel I standards eventually became evident:
Capital adequacy depends on credit risk, while other risks (e.g. market and operational) are excluded
from the analysis;
In credit risk assessment there is no difference between debtors of different credit quality and rating;
Emphasis is on book values and not market values;
Inadequate assessment of risks and effects of the use of new financial instruments, as well as risk
mitigation techniques.
*Some of the weaknesses of Basel I, especially those related to market risk, were over bridged by the
amendment to recommendations from 1993 and 1996, by means of introducing capital requirements
for market risk.
BaselII Accords
Basel II
On June 26, 2004, The Basel Committee on Banking Supervision (BCBS) released "International
Convergence of Capital Measurement and Capital Standards: A revised Framework", which is
commonly known as Basel II Accord.
Basel 1 initially had Credit Risk and afterwards included Market Risk.
In Basel 2, apart from Credit & Market Risk; Operational Risk was considered in Capital
Adequacy Ratio calculation. The Basel 2 Accord focuses on three aspects and based on 3 pillars
1) Minimum Capital Requirement
2) Supervisory Review by Central Bank to monitor bank's capital adequacy and internal
assessment process.
3) Market Discipline by effective disclosure to encourage safe and sound banking practices
A bank should calculate its regulatory operational risk capital requirement as the sum of
expected loss (EL) and unexpected loss (UL).
Expected Loss is covered by provisions & pricing and Unexpected loss through additional
capital.
Limitations Too simple 1. Additional Capital requirement for Op. Risk Requirement of
to cover all 2. Higher capital requirement in stressed situation additional CRAR
risks as asset quality reduces. Capital markets also dry between 2.5% to
Banks had to at that time. 5%
raise 3. High costs for up gradation of technology, Increased
additional disclosure & information system requirement of
capital 4. Increased supervisory review required in case of common equity
advanced approaches share capital also.
5. Subprime crises exposed the inadequate credit &
liquidity risk covers of banks
Minimum CRAR= 8% CRAR= 8% CRAR= 10.5% TO
CRAR Tier 1= 4% 13%
according Tier 1= 6%
to BCBS Common Equity=
4.5%
Minimum CRAR= 9% CRAR= 9% CRAR= 11.5%
CRAR Tier 1= 6% Tier 1 = 7%
according Common Equity= 3.6% Common Equity=
to RBI GOI recommended CRAR for PSU= 12% 5.6%
Introductio 1988: Credit 2004 2010
n Risk
1996: Market
Risk
Implement 1994 First Phase: 2008: Foreign Banks in India, Indian 2013 to 2018 in
ation in Banks with presence outside India: Basic phased manner
India: Time Approaches
line Second Phase:2009: Other Scheduled Commercial
Banks
Till 2014: Complete Implementation
Leverage Ratio:
Besides the above, BCBS has also introduced one more ratio called ‘Leverage Ratio’.
An underlying cause of the global financial crisis was the build-up of excessive on-
and off-balance sheet leverage in the banking system. In many cases, banks built up
excessive leverage while apparently maintaining strong risk-based capital ratios.
During most severe part of the crisis, the banking sector was forced by the market to
reduce its leverage in a manner that amplified downward pressure on asset prices.
This deleveraging process exacerbated the feedback loop between losses, falling
bank capital and contraction in credit availability. Therefore, under Basel III, a
simple, transparent, non-risk based leverage ratio has been introduced. The leverage
ratio is calibrated to act as a credible supplementary measure to the risk based
capital requirements and is intended to achieve the following objectives:
Act as a Check on the build-up of leverage in the banking sector to avoid
destabilising and deleveraging processes which can damage the broader financial
system and the economy;
Reinforce the risk-based requirements with a simple, non-risk based “backstop”
measure.
The Basel III leverage ratio is defined as the capital measure (the numerator) divided
by the exposure measure (the denominator), with this ratio expressed as a
percentage.
Capital Measure
Leverage Ratio =--------------------------
Exposure Measure
The BCBS will use the revised framework for testing a minimum Tier 1 leverage ratio
of 3% during the parallel run period up to January 1, 2017. The BCBS will continue to
track the impact of using either Common Equity Tier 1 (CET1) or total regulatory
capital as the capital measure for the leverage ratio. The final calibration, and any
further adjustments to the definition, will be completed by 2017, with a view to
migrating to a Pillar 1 treatment on January 1, 2018. Currently, Indian banking
system is operating at a leverage ratio of more than 4.5%. The final minimum
leverage ratio will be stipulated by RBI taking into consideration the final rules
prescribed by the BCBS by end-2017. In the meantime, these guidelines will serve as
the basis for parallel run by banks and also for the purpose of disclosures as outlined
by RBI. During this period, Reserve Bank will monitor individual banks against an
indicative leverage ratio of 4.5% to curb the build-up of excessive on and off-balance
sheet leverage in the banking system. (Source: RBI).
Liquidity Risk: BCBS had observed that one of the factors for the recent financial
crises were due to inaccurate and ineffective management of liquidity risk. To
overcome this, BCBS had come out with two ratios – Liquidity Coverage Ratio and
Net Stable Funding Ratio (NSFR).
o The Liquidity Coverage Ratio (LCR): This ratio ensures enough liquid assets to
survive an acute stress scenario lasting for 30 days.
o The objective of the LCR is to promote the short-term resilience of the liquidity
risk profile of the banks. This is done by ensuring that banks have an adequate
stock of unencumbered high-quality assets (HQLA) that can be converted easily
and immediately in private markets into cash to meet their liquidity needs for a
30 calendar day liquidity stress scenario. (Source BIS).
o This ratio is introduced from 1st January 2015, after an observation period
beginning in 2011.
o The LCR would be binding on banks from January 1, 2015; with a view to provide
a transition time for banks, the LCR requirement would be minimum 60% for the
calendar year 2015, i.e. with effect from January 1, 2015 and rise in equal steps
to reach 100% on January 1, 2019, as per the time-line given below by RBI.
www.ccevijayawada.com
o The Net Stable Funding Ratio (NSFR): This ratio aims at promoting medium to
long term structure funding of assets and activities of the Banks. BCBS aims to
trial this ratio from 2012 and makes it mandatory in January 2018.
o RBI released its Draft guidelines on NSFR on May 28, 2015. The objective of
NSFR is to ensure that banks maintain a stable funding profile in relation to the
composition of their assets and off-balance sheet activities. A sustainable
funding structure is intended to reduce the probability of erosion of a bank’s
liquidity position due to disruptions in its regular sources of funding that would
increase the risk of its failure and potentially lead to broader systemic stress. The
NFSR limits overreliance on short-term wholesale funding, encourages better
assessment of funding risk across all on- and off-balance sheet items, and
promotes funding stability. The Reserve Bank proposes to make NFSR applicable
to banks in India from January 1, 2018. (Source RBI).
Table below shows the minimum capital conservation ratios a bank must meet at
various levels of the Common Equity Tier 1 capital ratios.
For example, a bank with a Common Equity Tier 1 capital ratio in the range of
6.125% to 6.75% is required to conserve 80% of its earnings in the subsequent
financial year (i.e. payout no more than 20% in terms of dividends, share buybacks
and discretionary bonus payments is allowed).
The Tier 1 Capital should be in the nature of Going-Concern Capital, i.e., Capital
which can absorb losses without triggering bankruptcy of the Bank.
The Tier 2 Capital should be in the nature of Gone-Concern Capital, i.e., capital
which would absorb losses only in a situation of liquidation of the Bank.