How a bank works?

Banks operate as financial intermediary.

Banks manage the flow of money between people and businesses. Banks offer deposit
accounts that are secure places for people to keep their money. Banks use the money in
deposit accounts to make loans to other people or businesses.

Bank lend at higher rate than the interest they pay to depositors and that’s how they
make money.
 What is credit risk?
It is the possibility of a loss resulting from a borrower's failure to repay a
loan.
It refers to the risk that a lender may not receive the owed principal and
interest, which results in an interruption of cash flows and increased costs
for collection.

To avoid or reduce credit risks, a lender generally checks the credibility and
background of the borrower.
 Can a bank lend 100% of the deposits?

A bank needs to keep some of its own money so that depositors can be paid
back. This own money is called Equity/Capital of the bank.
Usually, a large bank will not get affected by some defaults.

Risk of insolvency
Bad name
Loss of reputation, flooding of withdrawal requests
 How much capital must a bank keep?

How will other institutions get to know that a particular bank ABC has kept
sufficient capital?

Risk of doing business with that bank (Globalised world)

Import – Export

Therefore, there is a need for international norms/rules

Need for mutual understanding between the countries
We need a body to strengthen the regulation, supervision and practices of
banks worldwide with the purpose of enhancing financial stability.

Someone should tell a bank

How to identify the risk?
How to protect oneself from the risk?
How to safeguard against risk of insolvency?
 What would a bank prefer, to keep more capital or less capital?

We want the bank to be accountable, because its own capital is subject to more profit and less
loss.
Highly skewed calculations in its favour.

Let’s say someone opens a bank with 1000 crore rupees.

He gets deposits of 9000 crore rupees.

Total – 10,000 crore

He lends the money @10% interest

Earnings – 1000 crore

 Earnings – 1000 crore

At 9000 crore, he promised 5% interest.

So he pays them back 450 crore.

Profit – 550 crore.

Return on equity – 550/1000 x 100 = 55%

Return on investment – 1000/10000 x 100 = 10%
 Return on equity– 550/1000 x 100 = 55%

Now, imagine that bank had put just 100 crore capital and
the remaining 9900 crore was of the depositors

Then, what is the new return on investment and return on equity?

Return on investment – 1000/10000 x 100 = 10% (SAME)

Return on Equity – profit / total investment x 100

Profit – 1000 – 495 crore = 505 crore

Return on Equity – 505 / 100 x 100 = 505%
 If a bank keeps more capital then the risk of bankruptcy
will reduce but its return on equity will reduce too.

But we need to make sure that the bank is well capitalized.

We need to safeguard the interests of the consumer.
 Basel norms are also known as Basel accords

These are the international banking regulations issued

by the Basel Committee on Banking Supervision (BCBS)

The Basel Committee (initially named the Committee on Banking Regulations

and Supervisory Practices) was established by the central bank Governors of
the Group of Ten countries (G10) at the end of 1974 in the aftermath of serious
disturbances in international currency and banking markets (notably the
failure of Bankhaus Herstatt in West Germany).
 The Committee, headquartered at the Bank for International Settlements in Basel, was
established to enhance financial stability by improving the quality of banking supervision
worldwide, and to serve as a forum for regular cooperation between its member
countries on banking supervisory matters.

The Committee's first meeting took place in February 1975, and meetings have been held
regularly three or four times a year since.
 Bank for International Settlements

The BIS was originally intended to facilitate reparations imposed on Germany by the Treaty of Versailles
after World War I, and to act as the trustee for the German Government International Loan (Young Loan)
that was floated in 1930. The need to establish a dedicated institution for this purpose was suggested in
1929 by the Young Committee.

The BIS has two regional offices: the Representative Office for Asia and the Pacific in Hong Kong SAR and
the Representative Office for the Americas in Mexico City.

The Financial Stability Institute (FSI) was jointly created in 1998 by the Bank for International Settlements
and the Basel Committee on Banking Supervision. Its mandate is to assist supervisors around the world in
improving and strengthening their financial systems.
HQ - Basel, Switzerland
 Basel 1

These were introduced in 1988

India adopted Basel-I Norms guidelines in 1999

Basel Norms focus only on credit risk.

It is the possibility of a loss resulting from a borrower's failure to repay a loan.

Risk-weighted asset (also referred to as RWA) is a bank's assets weighted according to

risk.
For example, an asset-backed by collateral would carry lesser risks as compared to
personal loans, which have no collateral.
 How to calculate Risk-weighted assets?

According to Basel 1

ONLY 1 Pillar – Minimum Capital Requirement

There are 4 classes of assets

Class Class Risk
Notification weights

Sovereign debt to OECD countries and S 0%

their central banks

Other banks and public sector B 20%

institutions in OECD countries

Any loan secured by residential R 50%

property

All other loans O 100%

 Let us say there is a bank ABC

It gives loans equal to 1000 crore

200 crore – it loans to RBI
200 crore – it loans to ONGC
200 crore – Secured loan
400 crore – personal loan

(Personal Loan is an unsecured credit provided by financial institutions based

on criteria like employment history, repayment capacity, income level,
profession and credit history).
 Risk-weighted assets will therefore be =
(0% x S) + (20% x B) + (50% x R) + (100% x O)

0 + 40 + 100 + 400 = 540 crores

It means Risk-weighted assets = 540 crore

So CAR – 8% of 540 crore = 43.2 crore

Where at least 4 % is from tier-one capital (T1) , which is core capital
and the remaining from tier-two capital (T2)

Banks are required to hold capital equal to 8% of their risk-

weighted assets (RWA).

Basel I - October 30, 1998 - The announcement by RBI in its Mid-

term Review of Monetary and Credit Policy for 1998-99 to raise
CRAR from 8 per cent to 9 per cent.
So the total capital requirement according to BASEL 1
is given by equation

(𝑇𝑇1+𝑇𝑇2) / 𝑅𝑅𝑊𝑊𝐴𝐴 > 8 %

 Tier 1 capital (Core Capital)
Tier 1 capital is the primary funding source of the bank
Tier 1 capital consists of shareholders' equity & disclosed reserves
Retained earnings also included
Most reliable & Liquid
Tier 1 capital has highest capacity to absorb losses for ongoing operations

Tier 2 capital (Supplementary capital)

It includes revaluation reserves, hybrid capital instruments and subordinated term debt,
general loan-loss reserves, and undisclosed reserves.
Tier 2 capital is considered less reliable than Tier 1 capital because it is more difficult to
accurately calculate and more difficult to liquidate.
 Pros & Cons - Basel 1 Norms

Pros – It is very simple and easy to calculate

Sound framework for determining risk
Sound framework for calculating CAR & Capital

Cons – Oversimplified
Only talks about credit risk
There are only four broad risk weightings (0%, 20%, 50% and 100%)
The current capital requirements ignore the different level of risks associated with different
currencies and macroeconomic risk
The gist seems to be against profitability, government loans given preference as it has least risk
Corporate loans can be of different types, new vs established corporates
 Cons – Example

Let’s say a bank gives home loans worth 1000 crores.

Riskiness depends on so many factors

Place where hour is going to be set up

Individual’s credit history
His income status, dependents on him and many other complex factors

Securitization - the conversion of an asset, especially a loan, into marketable securities, typically for the
purpose of raising cash by selling them to other investors.

Regulatory arbitrage - It refers to banks structuring their activities in a way that reduces the impact of
regulation without a corresponding reduction in the underlying risk.
 Basel 2 Norms

These were introduced in 2004

These were the updated versions of the Basel I accord

The guidelines were based on three pillars

The first pillar: Minimum capital requirements

The second pillar: Supervisory review
The third pillar: Market discipline & disclosure
 Minimum capital requirements – Same as Basel 1 – 8%
At least 4% of the bank's capital reserve must be in the form of Tier 1
Out of 4% of tier 1 capital, 2% should be common equity (CET1 capital)

Supervisory review
Provides a framework to deal with residual risk (like systemic risk, pension risk,
concentration risk, strategic risk, reputational risk, liquidity risk and legal risk)

Market discipline & disclosure

It will allow the market participants to gauge the capital adequacy of an institution, it
should be disclosed at least once in two years
 Basel 1 talked of only one risk – Credit Risk
Basel 2 mentions three types of risks
1. Credit risk
2. Market risk
Market risk is defined as the risk of losses arising from movements in
market prices. Some of the market risks are default risk, interest rate
risk, credit spread risk, equity risk, foreign exchange risk and
commodities risk for trading book instruments
3. Operational risk
Cybersecurity Risk, Third-party Risk, Internal Fraud and External Fraud.
Business Disruptions and Systems Failures
The main innovation of Basel II in comparison to Basel I is that it takes into
account the credit rating of assets in determining their risk weights.
The higher the credit rating, the lower the risk weight.

Credit
AAA to BBB+ to BB+ to Below
Assessmen A+ to A- Unrated
AA- BBB- B- B-
t
Risk Weight 100% 100% 100% 100% 100% 100%

Credit
AAA to BBB+ to BB+ to Below
Assessmen A+ to A- Unrated
AA- BBB- B- B-
t
Risk Weight 20% 50% 100% 100% 150% 100%
 Minimum capital requirements – 8%

At least 4% of the bank's capital reserve must be in the form of Tier 1

Out of 4% of tier 1 capital, 2% should be common equity (CET1 capital)
Tier 2 – 4%
 Shortcomings of Basel II

Basel II underestimated the risks involved in current banking practices and that the
financial system was undercapitalized.

Banks have difficulties in estimating rare but large events

Market Disclosure not getting checked, Investors are not going through the market
disclosure to evaluate the status and raise red alert

External credit rating agencies may not understand the risk associated with the firm’s
operation
 Basel 3

Financial crisis of 2008

In 2010, Basel III guidelines were released.

Minimum capital requirements – 8%

At least 6% of the bank's capital reserve must be in the form of Tier 1
Out of 6% of tier 1 capital, 4.5% should be common equity (CET1 capital)
Tier 2 – 2%

In India, RBI Says 9%

So, Tier 1 – 7%
Tier 2 – 2%
CET1 (Common equity) – 5.5%
 Basel 3

Capital conservation buffer in the form of common equity at 2.5% of RWA, in

addition to the minimum capital adequacy ratio of 9%.
The capital conservation buffer was introduced to ensure that banks have an
additional layer of usable capital that can be drawn down when losses are
incurred. It must be met with Common Equity Tier 1 (CET1) capital only.

Counter-cyclical buffer is also to be maintained at 0-2.5%

The countercyclical capital buffer (CCyB) aims to protect the banking sector
from periods of excess aggregate credit growth t
 Leverage ratio under Basel 3

it has been decided that the minimum Leverage Ratio shall be 4% for Domestic
Systemically Important Banks (DSIBs) and 3.5% for other banks

The leverage ratio, as defined under Basel-III norms, is Tier-I capital as a percentage
of the bank’s exposures. Higher leverage ratio can decrease the profitability of banks
because it means banks can do less profitable lending. However, increasing the
leverage ratio means that banks have more capital reserves and can more easily
survive a financial crisis.
 The liquidity coverage ratio (LCR) – Basel 3
Basel Committee on Banking Supervision (BCBS) had introduced Liquidity Coverage Ratio
(LCR), which requires banks to maintain High Quality Liquid Assets (HQLAs) to meet 30
days net outgo under stressed conditions.

The Net Stable Funds Rate (NSFR) requires banks to maintain a stable funding profile in
relation to their off-balance-sheet assets and activities. NSFR requires banks to fund their
activities with stable sources of finance (reliable over the one-year horizon). The
minimum NSFR requirement is 100%.

LCR measures short-term (30 days) resilience, and NSFR measures medium-term (1 year)
resilience.
Requirements Under Basel II Under Basel III
Capital Conservation Buffers to
None 2.50%
RWAs
•
Minimum Ratio of Total Capital
8% 10.50%
To RWAs

Minimum Ratio of Common

2% 4.50%
Equity to RWAs
Tier I capital to RWAs 4% 6.00%
4.00% for D-SIB banks and 3.5%
Leverage Ratio None
for other banks
Countercyclical Buffer None 0% to 2.50%
Minimum Liquidity Coverage
None 100%
Ratio
Net Stable Funding Ratio (NSFR) None 100%