CAPITAL ADEQUACY NORMS:

BASEL II
 Table of Contents

1.BASEL II & THREE PILLARS

2.FIRST PILLAR, CREDIT RISK,

MARKET RISK AND OPERATIONAL
RISK
BASEL II
3.CAPITAL ADEQUACY RATIO,
TIER 1,2 & 3

4.ISSUES, RBI APPROACH, IMPLICATIONS

AND CONCLUSIONS

2
 OVERVIEW
 Basel I, published in 1988 is framework for measuring capital
adequacy and a minimum ratio to be achieved by the banks

 Implemented in India in 1992

 On 26 JUNE 2004, BCBS released a revised framework,

known as “Basel II Framework”
 Capitalizes on the modern risk management techniques
 Why BASEL 2
FOCUS AREA BASEL I BASEL II
Risk measure Single risk measure Counterparty and transaction
specific risk
measures
Risk sensitivity Broad brush approach Granularity and risk sensitivity
Credit risk mitigation Broad brush approach Comprehensive recognition
Operational risk Excluded Included
Counterparty credit risk Broad brush approach Menu of approaches
Range of risks Narrow Far more extensive
Flexibility One size fits all Menu of approaches
Supervisory review Implicit and opaque Explicit and more transparent
Market discipline None Market given explicit
information and role
Incentives None Explicit and well defined
Economic capital Divergence Convergence
BASEL II
 Table of Contents

1.BASEL II & THREE PILLARS

2.FIRST PILLAR, CREDIT RISK,

MARKET RISK AND OPERATIONAL
RISK
BASEL II
3.CAPITAL ADEQUACY RATIO,
TIER 1,2 & 3

4.ISSUES, RBI APPROACH, IMPLICATIONS

AND CONCLUSIONS

6
 Types of risk

Capital components

Credit Risk Market Risk Operational Risk

 Credit risk
It is the risk that borrowers may fail to make timely
repayment of loan, interest and other terms of contract.

Factors affecting credit risk

 Exposure at default

 Loss given default

 Probability of default
CREDIT RISK-Measurement
Methodologies
 Standardized Approach
 The bank allocates a risk weight to the assets
depending on rating given by credit rating agencies.

 The bank allocates a risk weight to each of its assets

and off-balance sheet positions and produces a sum of
risk weighted asset values
 Internal Rating Based (IRB) Approach
Bank uses internal estimates of risk portfolios to assess credit
risk. The bank estimates the credit worthiness and future
estimated loss ascertained.

Risk components:-
 Probability of default

 Loss given default

 Exposure at default

 Effective maturity
 Securitization Framework

 It is used for determining regulatory

requirement on exposure arising from
securitization.
 Market risk
• Reduction in Investment due to moves in market
forces.
 Equity risk

 Interest rate risk

 Currency risk

 Commodity risk
 Operational Risk
Defined as risk of loss from inadequate or failed internal processes,
people and systems, or from external events .

Examples of risks covered

 Internal and external fraud
 Legal risks
 Damages to customers
 Losses arising out of labour, health and safety, diversity, personal injury, etc.
 Damage to physical assets
 Business interruption
Examples of risks not covered
 Reputational risk
 Strategic errors
 Operational Risk
Basic approach Standardized Advanced approach
approach

Gross income for Gross income by Own empirical

the bank-15 % business line,12-18 model to quantify
% capital
Simple, for minimal Specific criteria Specific criteria
operation risk

Minimum standards Effective Quantitative/qualita

operational risk tive factors
management
 Table of Contents

1.BASEL II & THREE PILLARS

2.FIRST PILLAR, CREDIT RISK,

MARKET RISK AND OPERATIONAL
RISK
BASEL 2
3.CAPITAL ADEQUACY RATIO,
TIER 1,2 & 3

4.ISSUES, RBI APPROACH, IMPLICATIONS

AND CONCLUSIONS

16
CAPITAL ADEQUACY RATIO??
A measure of a bank's capital. It is expressed as a
percentage of a bank's risk weighted credit exposures
and calculated as given below

CAR= (TIER I + TIER II + TIER III)CAPITAL

Credit risk + Operational Risk + Market risk
 TIER I CAPITAL
• A term used to describe the capital adequacy of a bank. Tier I
capital is core capital, this includes equity capital and disclosed
reserves

Components of Tier I Capital:

 Paid up capital

 Statutory reserves

 Disclosed free reserves

 Capital reserves representing surplus arising out of sale proceeds

of assets.
 Tier II
• Tier II capital is secondary bank capital that includes :

 Undisclosed reserves and cumulative

perpetual preference shares
 Revaluation reserves
 General loss reserves
 Subordinated term debt
 Hybrid debt capital instrument
 TIER III
 Tier 3 capital debts may include a greater number of subordinated
issues,undisclosed reserves and general loss reserves compared to tier 2
capital.

 Tier 3 capital is used to support market risk, commodities risk and foreign

currency risk.

 To qualify as tier 3 capital, assets must be limited to 250% of a banks tier 1

capital, be unsecured, subordinated and have a minimum maturity of two
years
 Table of Contents

1.BASEL II & THREE PILLARS

2.FIRST PILLAR, CREDIT RISK,

MARKET RISK AND OPERATIONAL
RISK
BASEL 2
3.CAPITAL ADEQUACY RATIO,
TIER 1,2 & 3

4.ISSUES, RBI APPROACH,

IMPLICATIONS
AND CONCLUSIONS

21
 ISSUES AND CHALLENGES
 Capital requirement

 Profitability

 Risk management planning

 Rating requirement
ISSUES AND CHALLENGES (cont.)
 Choice of alternative approaches

 Absence of historical database

 Incentive to remain unrated

 Corporate governance issues

 Disadvantage of smaller banks

 RBI APPROACH
 Steering committee for consultation

 Deadline extended from 31 March,2008 to 31 March,2009

 Adopt Standardised Approach for credit risk

 Adopt Basic Indicator Approach for operational risk

 indicative set of weights by RBI

 RBI APPROACH (cont.)
 In case of retail exposures, the RBI has gone with the lower 75
percent risk weight prescribed under Basel II norms, (currently
its 100 %and 125 %)

 Significant reduction in credit risk weights and required

regulatory capital
 IMPLICATIONS
 Indian banks would need additional capital to the extent of Rs.120 billion
to meet the capital charge requirement for operational risk

 Emphasis on the foreign ownership of banking assets in India

 Foreign investment limits in private banking hiked to 74 percent

“ One track is consolidation of the domestic banking system in both public

and private sectors. The second track is gradual enhancement of the
presence of foreign banks in a synchronised manner ” - RBI
 CONCLUSIONS
 It provides significant incentives to banks to sharpen their risk
management expertise to enable more efficient risk-return
trade offs.

 Presents a valuable opportunity to gear up their internal

processes to the international best standards.

 It requires substantial capacity building and commitment of

resources through close involvement of the banks’ Top
Management in guiding this arduous undertaking
BASEL II IS RE-REGULATION
 REFRENCES
 www.rbi.org.in

 www.bis.org

 ICRA Rating Feature, March 2006

 Basel Norms- Challenges in India, SWAPAN BAKSHI, The Chartered

Accountant, October 2004

 Basel II and India's Banking Structure Mar 3rd 2007, C.P. Chandrasekhar

and JAYANTI GHOSH
THANK YOU