Capital Standards under Basel III:

Business Challenges & Disclosure

Requirement
 The Basel Committee and the Financial Crisis
• Basel II made fundamental changes to the capital requirements for
internationally active banks.

• It was considered more risk sensitive than the earlier one i.e. Basel I.

• Main changes included the adoption of external credit ratings to

determine counterparty risk weights, the ability for banks to use their own
internal models to calculate capital charges for credit risk, Introduction of
Regulatory Retail, greater recognition of credit risk mitigation techniques,
new rules on securitization and a new capital charge for operational risk.
 The Limitations of Basel II
• The lack of emphasis on liquidity in the Basel II framework: Capital
requirements are concerned with solvency and aim to enable an institution
to continue trading in times of financial adversity. However, a bank can
equally fail as a result of insufficient liquidity

• Did not impose restrictions on leverage: This gave rise to incentives for
banks to engage in riskier trading activities in the relatively benign economic
conditions that prevailed prior to the onset of the financial crisis, which
boosted revenues and profits in that period, but at the same time increased
systemic risk and the possibility of individual bank failure.

• Overlooked Systemic Risk: The focus of Basel II on capital also resulted in

regulators overlooking the growth of systemic risk as they concentrated on
the position of individual institutions.
 The Need for Basel-III
• The global financial crisis of 2007-2008 caused by the build up of excessive
leverage both in the on- and off-balance sheet.

• One of the major contributor to the crisis was inadequate liquidity risk
management due to which Banks suffered heavy losses in trading book.

• Crisis exacerbated by a excessive leverage and the interconnectedness of

systemic institutions.

• This financial crisis highlighted the need for government and central banks
to revise banking sector regulation and to address the issues highlighted by
the latest financial crisis.
 Basel-III-Objectives
• According to Basel Committee on Banking Supervision(BCBS),
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
 Basel-III - Main Building Blocks
• To achieve these objectives, the Basel III proposals may
be viewed as three building blocks on the basis of areas
they address:

• Capital reforms (including quality and quantity of capital,

complete risk coverage, leverage ratio and the introduction of
capital conservation buffers, counter-cyclical capital buffer)

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

• Separate capital requirement for Systemic Risk and

Interconnectedness applicable to Systemically Important Banks.
Basel-III Building Blocks

Source: KPMG: Basel III issues and implications

 Basel-III Building Blocks: Capital Reforms
• Existing Rules under Basel II:
• The types of regulatory capital, as well as the 8% minimum ratio of capital to risk-
weighted assets, were set by the Basel Committee in 1988. Both were left
unchanged by Basel II.

• The Basel II rules place no restriction on the amount of Tier 1 capital that a bank can
hold and Tier 2 capital is limited to 100% of a bank’s Tier 1 capital after deductions.

• At least 50% of Tier 1 capital must comprise ordinary shares and reserves, known as
Core Tier 1 capital. Under the existing framework a bank could therefore hold Core
Tier 1 capital representing only 2% of its risk-weighted assets with the balance made
up of hybrid capital and subordinated debt.

• In practice, banks have tended to hold higher amounts of

common equity and less Tier 2 capital than permitted by the
rules, but as the financial crisis demonstrated, the levels of
capital were still inadequate.
Capital Reforms- Improving Quality, Quantity, Transparency, Consistency
• Improving the Quality and Quantity of Capital: In order to address the
problem highlighted, Basel III aims to increase both the quality as well as
quantity of the capital held by the bank.
• Increase in Minimum Capital requirements: Common equity component of
capital has been increased to 4.5% and the Total Tier 1 ratio to 6%. This
increase will be phased in as follows:
Common Equity Total Tier 1

Basel II Requirement 2.0% 4.0%

From 1st Jan’2013 (Basel III) 3.5% 4.5%

From 1st Jan’2014 (Basel III) 4.0% 5.5%

From 1st Jan’2015 (Basel III) 4.5% 6.0%

• Improving Transparency: The transparency of capital base has been

improved, with all elements of capital required to be disclosed along with
a detailed reconciliation to the published accounts.
 Capital Reforms (contd..)
Improvement in Quality of Capital:
• Basel III seeks to reinforce the position of Core Tier 1 capital as the
predominant form of capital. This is known as Common Equity Capital.
• To ensure its quality and consistency across jurisdictions Basel III sets out a
list of criteria that common equity tier 1 will be required to satisfy.
• Similarly, the criteria for Additional Tier I capital were made more stringent
by removing step up option clause and introducing loss absorption criteria.
• Criteria for Tier II capital were also made stringent.
 Capital Reforms- Deductions from Capital
• Under existing Basel-II rules the following deductions are made from Tier 1
Capital
• Investment in own shares;
• Intangible assets (including goodwill);
• Net losses on equities in the available-for-sale asset category; and
• 50% of deductions in respect of material holdings(i.e. investment in
Subsidiaries)
• Basel III will result in a radical overhaul to deductions from capital and
most of the deductions should be made from core Tier 1 capital
• The practical effect of making deductions from core Tier 1 capital is to
increase the amount of common equity and reserves that a bank must
hold.
 Capital Reforms- Deductions from Capital
• Under Basel-III following deduction shall be made from core equity capital
• Goodwill and other Intangibles
• DTAs and Liabilities
• Cash Flow Hedge Reserve
• Shortfall in Provisions
• Gain on Sale of Certain Securitization Transactions
• Gains and Losses Due to Changes in Own Credit Risk
• Pension Fund Assets and Liabilities
• Investment in Own Shares
• Reciprocal Cross-holdings
• Material Holdings and Investments in Affiliates
 Capital Reforms- Leverage Ratio
• The years leading up to the financial crisis were marked by an excessive
increase in leverage.
• Once the crisis erupted, the pressure to reduce leverage amplified
downward pressure on asset prices, magnifying mark-to-market losses
and write downs against capital, thereby leading to a significant
contraction in the availability of credit to the real economy.
• The Basel Committee therefore decided to supplement the risk-based
measurements in Basel II with a leverage ratio to curtail the build up of
leverage and risk in the financial sector.
• Leverage ratio is defined as ratio of Tier I Capital to Total exposure which
includes both on and off balance sheet exposure including derivatives.
 Capital Reforms- Leverage Ratio
• The Measure of Capital: Presently, the capital measure used for the leverage
ratio is proposed to be Tier 1 capital.
• The Measure of Exposure: It is sum total of on balance sheet items and off
balance sheet items including derivatives.
• On-balance sheet items: All assets on balance sheet must be included
within the leverage ratio. Positive mark to market value of derivative
exposures will also be added.
• Off balance Sheet Items: All Non Market related off balance sheet items
with uniform 100% credit conversion factor except for commitments that
are unconditionally cancellable at any time by the bank without prior
notice, which shall attract 10% CCF.
• The minimum Leverage ratio specified by the Basel committee is 3%.
 Capital Reforms- Capital Conservation Buffer
• Under Basel III, a capital conservation buffer range will be established over and
above the regulatory minimum.
• Banks whose capital levels fall within the buffer range will be subject to quantitative
restrictions on distributions, buy-backs and staff bonus payments, but will not be
constrained in respect of their other activities (e.g. lending).
• The table below shows the minimum capital conservation ratios a bank must meet at
various levels of the Common Equity Tier 1 (CET1) capital ratios. For example, a bank
with a CET1 capital ratio in the range of 5.125% to 5.75% 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).
 Capital Reforms- Counter Cyclical Buffer
• Under the proposals national authorities will monitor credit growth and any other
factors that may signal a build up of system-wide risk to assess whether credit growth
is excessive. If the authorities judge this to be the case, they will announce the
imposition of a counter-cyclical capital buffer.

• This buffer will be added to the capital conservation buffer, increasing the overall
buffer from 2.5% to a maximum of 5% of risk-weighted assets. The buffer must be met
with common equity or “other fully loss absorbing capital”

• The Basel Committee considered that setting a buffer is likely to be appropriate where
the ratio of credit to GDP exceeds its long-term trend.

• A bank that fails to satisfy the counter-cyclical buffer will be subject to the same
restrictions on distributions and discretionary payments to staff as apply to banks that
do not meet the capital conservation buffer
 Basel-III Building Blocks: Liquidity Standards
• The Basel Committee has formulated two new liquidity standards:
• Liquidity Coverage Ratio(LCR) It is the ratio of Stock of high quality liquid
assets to the Total net cash outflows over the next 30 calendar days. It
aims to ensure that a bank maintains an adequate level of unencumbered,
high-quality liquid assets that can be converted into cash to meet its
liquidity needs for a 30 calendar day time horizon under a significantly
severe liquidity stress scenario specified by supervisors.

• Net Stable Funding Ratio (NSFR) It is the ratio of Available Stable Funding
to Required Stable Funding. It is designed to ensure that long term assets
are funded with at least a minimum amount of stable liabilities in relation
to Bank’s liquidity risk profiles.
 Basel II Vs. Basel III – A Comparison
Basel II Basel III

Under the existing capital adequacy guidelines based on Under the Basel 3, total regulatory capital is comprised
Basel-II framework, total regulatory capital is of:
comprised of:  Tier-I capital
 Tier-I capital  Common Equity
 Additional Tier 1
 Tier-II capital
 Tier-II capital
Tier-I capital should be at least 6% of Risk weighted Common Equity Tier-I (CET1) capital must be at least
Assets (RWA). 5.5% of risk weighted assets (RWA). Additional Tier-I
capital can be admitted at 1.5% of RWAs. Tier-II capital
Total capital (Tier-I pus Tier-II capital) must be at least can be admitted maximum up to 2%. Total capital
9% of RWAs on an ongoing basis (Tier-I plus Tier-II capital) must be at least 9% of
RWAs on an ongoing basis (other than capital
conservation buffer and counter cyclical capital buffer).
 Basel II Vs. Basel III – A Comparison
Basel II
Capital conservation buffer and counter cyclical buffer
do not exist under existing guidelines
Under existing guidelines there are three type of Debt
Capital instruments - Innovative Perpetual Debt
Instruments in Tier-I capital and Upper Tier-II bonds
Subordinated Bonds Debts instruments with step-ups
may be reckoned for Tier I/II capital.
Basel III
Under Basel-III guidelines, banks are required to
maintain a capital conservation buffer of 2.5% of
RWAs in the form of common Equity Tier-I capital. A
countercyclical capital buffer within a range of 0-2.5%
of RWAs in form of common Equity or other fully loss
absorbing capital will be maintained,
Under Basel-III guidelines there will be two types of
debt capital instruments: Perpetual Debt Instruments in
additional Tier-I capital, Debt Capital instruments as
Tier-II capital. There should not be any step-ups and
must have loss absorption features in Debt instruments.
 Basel II Vs. Basel III – A Comparison
Basel II
The leverage ratio does not exist in Basel-II guidelines.
Under Basel-II guidelines, banks may include half
yearly/quarterly profits for computation of Tier-I
capital only if the quarterly/half yearly results are
audited by statutory auditors and not when the results
are subjected to limited review.
Basel III
Under Basel-III, a simple, transparent, non-risk based
leverage ratio has been introduced. During the period of
parallel run, banks should strive to maintain their
existing level of leverage ratio but, in no case leverage
ratio should fall below 4.5% (Indian perspective).
Under Basel-III, banks may reckon the profits in
current financial year for CRAR calculation on a
quarterly basis provided the incremental provisions
made for non-performing assets at the end of any of the
four quarters of the previous financial year have not
deviated more than 25%form the average of the four
quarters.
 Basel II Vs. Basel III – A Comparison
Basel II Basel III

Under Basel-II, Gains and losses due to Under Basel-III, banks are required to
changes in own Credit Risk on fair valued derecognize the gains, arising from decline in
financial Liabilities is recognized. fair value of their liabilities due to
deterioration in their own creditworthiness,
in the calculation of Common Equity Tier-I
capital.

Under the existing guidelines, there is no
explicit guidance on treatment of defined
benefit pension fund assets and liabilities in the
books of banks from the perspective of capital
adequacy.
Under Basel-III, defined benefit pension fund
liabilities, as included on the balance sheet
must be fully recognized in the calculation of
Common Equity Tier-I capital ( i.e. common
equity Tier-I capital can not be increased
through derecognizing these liabilities).For
each defined benefit pension fund that is an
asset on the balance sheet, the asset should be
deducted from Common Equity.

Under existing guidelines, the risk weight
percentage pertaining to claims on banks is
based on the capital adequacy ratio of Investee
banks.
Under Basel-III guidelines, the risk weight
percentage to claims on banks will be based on
the level of common equity Tier-I capital
including applicable capital conservation
buffer of the investee banks
 Basel II Vs. Basel III – A Comparison
Basel II Basel III

Securitization exposures are required to be Under Basel-III guidelines, the securitization

deducted at 50% from Tier-I capital and 50% exposures will be risk weighted at 1111%.
from Tier-II capital under the existing
guidelines.

All investment in the paid –up equity of non-
financial entities, which are not consolidated
for capital purposes with the bank, is assigned
risk weight of 125%.
Claims on commercial entities in the nature of
equity, will be assigned risk weight as under:
•All investment in the paid-up equity of non-
financial entities (other than subsidiaries)
which exceed 10% of the issued common share
capital of the issuing entity, will receive a risk
weight of 1111%.

•Equity investments equal to or below 10%

paid-up equity of such investee companies
shall be assigned a 125% risk weight or the risk
weight as warranted by rating or lack of it,
whichever higher.
 Basel II Vs. Basel III – A Comparison
Basel II
As per existing instructions, banks’ exposure to
capital instruments issued by non-banking
financial entities is not subject to any specific
risk weights; these are risk weighted as per the
general capital adequacy norms applicable to
bank’s claims on non-banking financial entities
i.e. 100%.
Basel III
Claims on capital instruments issues by NBFCs
will be assigned risk weight as under:
•The exposure to capital instruments issued by
NBFCs (where bank does not own more than
10% of the issued common share capital if the
entity) issued which are not deducted and are
required to be risk weighted, would be risk
weighted at 125% or as per the external
ratings, whichever is higher.
•The exposure to capital instruments issued by
NBFCs (where bank own more than 10% of
the issued common share capital if the entity)
issued which are not deducted and are
required to be risk weighted, would be risk
weighted at 250%.
RBI Guidelines on Basel III –
Salient Features
 Highlights of RBI Basel III Guidelines
• Basel III has been implemented in India w.e.f 1st April,
2013.
• RBI’s approach has been to adopt Basel III capital and
liquidity guidelines with more conservatism.
• The important provisions of the guidelines and the
impact of the same on Indian Banks are discussed in
the next slides.
 Components of Capital
Components of CET 1, AT 1 & T2 capital under Basel III
CET 1 AT 1 T2
• Paid up Equity share • Perpetual Non • General Provisions &
capital Cumulative Preference Loss Reserves
• Share premium Shares (PNCPS) • Eligible Debt Capital
resulting from the • Share Premium Instruments
issue of common resulting from the issue • PCPS / RNCPS /
shares of instruments included
in AT1 capital RCPS
• Statutory reserves • Share Premium
• Eligible Debt Capital
• Other disclosed free Instruments resulting from the
reserves • Less Regulatory issue of instruments
• Balance in Profit & Deductions included in T2 capital
Loss Account at the • Revaluation reserves
end of the previous at a discount of 55%
financial year • Less Regulatory
• Less Regulatory Adjustments
Adjustments

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 Highlights of RBI Guidelines
• Capital Conservation Buffer (CCB): The capital conservation buffer in the
form of Common Equity of 2.5% of RWAs.
• Countercyclical Capital Buffer (CCCB): The range prescribed is (0-2.5% of
CET). This would be introduced as an extension of the capital conservation
buffer. Recently, RBI has issued the final working group recommendations
on CCCB.
• Leverage Ratio: Banks are expected to strive to operate at a
minimum Tier 1 leverage ratio of 4.5%.
• Adjustments from Common Equity Capital: Most of the
adjustments under Basel III will be made from Common Equity.
However, wherever applicable, phase-in deductions are
allowed from CET 1 and rest from Tier I in phased manner.
 Highlights of RBI Guidelines
Important Provisions for Additional Tier I / Tier 2
instruments:
• Banks can not issue AT 1 capital instruments to the retail investors.

• Capital instruments which no longer qualify as non-common equity Tier1 capital or

Tier 2 capital (e.g. IPDI and Tier 2 debt instruments with step-ups) will be phased out
beginning January 1, 2013. Fixing the base at the nominal amount of such
instruments outstanding on January 1, 2013, their recognition will be capped at 90%
from January 1, 2013, with the cap reducing by 10 %age points in each subsequent
year.

• Elements of Tier 2 will largely remain the same except that there will be no separate
Tier 2 debt instruments in the form of Upper Tier 2 and subordinated debt.
 Highlights of RBI Guidelines
Important Provisions for Additional Tier I/ Tier 2 instruments:
• The Loss Absorption features have been introduced for non-equity Capital
instruments.
• In such cases, these instruments must have principal loss absorption through
either (i) Conversion to common shares at an objective pre-specified trigger
point or (ii.) A write-down mechanism which allocates losses to the
instrument at a pre-specified trigger point.
• The write-down will have the following effects:
Reduce the claim of the instrument in liquidation;
Reduce the amount re-paid when a call is exercised; and
Partially or fully reduce coupon payments on the instrument.
Guidelines on Domestic Systemically Important Banks (D-SIB)
• Banks will be selected for computation of systemic importance based on
analysis of their size (based on Basel III Leverage ratio Exposure measure) as
a percentage of GDP. Banks having size as percentage of GDP beyond 2%
will be selected in the sample.

• Four indicators viz. Size, Interconnectedness, Substitutability and Complexity

will be used for assessment of systemic importance.

• Banks having systemic importance above a threshold decided by RBI will be

designed D-SIBs.

• Further, D-SIBs will be segregated into 4 different buckets initially based on

their scores and they would be subject to capital surcharge in graded
manner depending on the buckets in which they are placed.

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Guidelines on Domestic Systemically Important Banks - DSIB
• Banks classified as D-SIBs will be subjected to additional Common Equity
Tier 1 (CET1) requirement based on the score buckets in which they fall.
The prescribed CET1 for D-SIB falling in lowest band is 0.20% of RWA and
capital requirement increases in steps of 0.2% for higher bands / buckets
up to 0.8% of RWA.

• RBI will consider imposing regulatory restrictions like Liquidity surcharge,

tighter large exposure restrictions etc. as and when BCBS arrives at a
consensus. Banks designated as D-SIBs will also be subjected to more
intensive supervision in form of higher frequency / intensity of on and off-
site monitoring.

• Higher capital requirement will be applicable to D-SIBs w.e.f 01.04.2016 in

phased manner and will be fully implemented by 01.04.2019.

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 Guidelines on Counter-cyclical Capital Buffer
• The credit-to-GDP gap may be used for empirical analysis to facilitate CCCB
decision. However, it may not be the only reference point in the CCCB
framework for banks in India and other indicators like incremental Credit-
Deposit ratio, Industry Outlook (IO) assessment index, interest coverage
ratio, House Price Index / RESIDEX and Credit Condition Survey may also be
used.

• The CCCB shall increase from 0 to 2.5 per cent of the risk weighted assets
(RWA) of the bank based on the position of credit-to-GDP gap between 3
percentage points and 15 percentage points.

• The CCCB decision shall be pre-announced by RBI with a lead time of 4

quarters.

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 Major Issues / Challenges of the Guidelines
• Capital as required by RBI in response to Basel III guideline calls for 1 %
extra capital.
• The definition of capital under Basel III has also become more
stringent with focus on improving the quality.
• Leverage Ratio prescribed is on higher side vis-à-vis Basel floor.
• Investors are wary of Loss Absorption features of capital instruments. Compensating
investors for Loss Absorption makes the instruments costlier, thus raising the cost of
capital.
• Market for Additional Tier 1 Instruments is not developed. No takers for AT1
instruments may lead to replenishing the requirement through Common Equity.
• With RBI’s approval for setting up new banks, there would be congestion in the
market with more Banks vying for capital among more or less the same investor
base.