1530266570ECO P11 M28 E-Text
1530266570ECO P11 M28 E-Text
1530266570ECO P11 M28 E-Text
Subject ECONOMICS
TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Basel I Accord
3.1 Foundation of Basel I Accord
3.2 Criticism
4. Basel II Accord
4.1 Three Pillars
4.2 Criticism
5. Basel III
6. India and Basel Compliance
7. Summary
1. Learning Outcomes
After studying this module, you shall be able to
2. Introduction
Banks as financial intermediaries are exposed to several types of risks like credit risk,
interest rate risk, foreign exchange risk, liquidity risk, legal risk, regulatory and
reputational risk, operational risk and market risk to list a few. These risks operate
alongside the progression of banking system and have interconnected implications that
are long term. Hence one should not view these risks as independent event. It thus calls
for risk management systems, which can address to such hidden perils, monitor and
mitigate them on time.
Loan as a credit requires constant evaluation along with provisions for losses. A loan
review mechanism (LRM) should include quick identification of sour or weak loan
positions with immediate corrective actions, isolate the problematic area from the main
portfolio, provide information for adequate loss provisions, comply with laws and
regulations and provide information to the concerned parties.
3. Basel I Accord
Basel I was introduced with the aim of standardizing regulatory capital norms across
member nations. The morns and guidelines were specific to the founding economics and
were not meant for the emerging ones. The initial guidelines focused on loan-based risks
and left the mandate over other risks with countries themselves. With a conservative
approach, the accord imposes minimum capital requirements, which should not be treated
as panacea for banking system.
The main objectives of this system were to strengthen the soundness and stability of the
international banking system and to diminish existing sources of competitive inequality
among international banks.
The accord rests upon four basic prerequisites, which provide sufficient insight into
understanding the regulatory framework:
3.1.3only credit risk element was taken into consideration and a minimum capital
requirement was fixed at 8% of total risk based assets i.e. minimum 8% of banks risk
based assets should be covered by Tier 1 & Tier 2 capital reserves. In India, this
minimum Capital-to- Risk Weighted Asset Ratio (CRAR) was kept at 9 % on ongoing
basis.
3.1.4 Each central bank should set aside and meet the timeline prescribed to
achieve these requirements and to constantly monitor the progress.
All Basel Committee members achieved the prescribed targets by 1992 except for Japan.
India also accomplished the task by 1999.
3.2 Criticism
Basel I was viewed with skepticism because of its narrow outlook and participation. The
reason for criticism lied with the limited approach of risk assessment i.e. only credit risk
and concentration of proposals to suit G-10 member nations. Hasty implementation and
complex terminology was another issue. Methods like securitization and splicing led to
diversion from incentivized risk coverage and further added to risk exposure of banks.
The overall experience with Basel I accord led the Committee to revamp the structure and
they came out with an amended report called the ‘International Convergence of Capital
Measurement and Capital Standards: A Revised Framework’ (or commonly called Basel
Report II) in June 2004. The revised framework was learning from the previous accord
and gave a more comprehensive and risk sensitive approach to capital requirements. The
spectrum of risk assessment was also widened. The basic objective here was to further
strengthen the International Banking Structure in a sound and stable manner along with
creation of greater risk sensitive capital requirements.
4. Basel II Accord
The new set of rules under Basel II report brought in significant innovation in terms of
using internal information by banks for capital assessment across banking community. It
also gave a flexible option to the banks in risky economies to extend the minimum capital
requirement limits to suit their risk appetite.
Under this pillar, three types of capital constituents are offered for Credit Risk and
Operational Risk. The choices under credit risk were Standardized Approach, Foundation
Internal Rating Based Approach and Advance Internal Rating Based Approach and for
operational risk included Basic Indicator Approach, Standardized Approach and
Advanced Measurement Approach.
To maintain harmony, Reserve Bank of India suggested all banks to use Standardized
Approach for Credit Risk and Basic Indicator Approach for Operational Risk. The new
capital adequacy norms were applicable to both single and consolidated banks.
ECONOMICS PAPER No. : 11, Money & Banking
MODULE No. : 28, Basel Norms for Capital Adequacy
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Tier 1 capital includes paid up equity capital like fully paid ordinary shares or preference
shares, statutory reserves and disclosed free reserves out of share premium, legal
reserves etc., other instruments notified by RBI and innovative perpetual debt
instruments.
Tier 2 capital includes undisclosed reserves created out of after tax surplus profits and
excluding values of securities held in balance sheet which are valued below market price,
revaluation reserves arising out of revaluation of fixed assets like bank premises or from
equity securities held a lower historic cost in balance sheet, general provisions and loss
reserves for potential unexpected losses, hybrid debt capital instruments which
characterize the attributes of debt and equity instruments, subordinated debt and
innovative perpetual debt instruments.
Tier 3 capital is employed specifically to meet the capital requirements for market risk
and in the form of subordinated debt instruments.
This pillar focuses on supervisory review and risk management guidance, transparency
and accountability. Attention is paid to treatment for interest rate risk, credit risk,
operational risk and securitization of assets. The aim of such supervisory system is to
cover and provide support for broader risk categories and to encourage banks to develop
monitoring techniques. The process enforces internal capital assessment along with
accomplishment of individual capital requirement targets subject to risk profiles.
Relevant and timely intervention enhances the supervisor roles within an organization
and removes operational deficiencies. Adding up of capital stock should not be viewed as
compliance with Basel committee norms, rather supervisory review considered:
Operative capacity to be above the minimum required and hold capital in excess
calls for better quality of capital reserves alongside provisions and internal
controls.
Focus areas here include risks left unaddressed under Pillar 1 like credit concentration,
factors excluded under Pillar 1 like interest rate, business and strategic risks, and factors
external to banking system like business cycles.
The committee highlights four important principles to be Rapid remedial action to avoid
reduction in regulatory capital.
Using the standardized approach, RBI has notified external credit rating agencies to
provide rating for credit risk to assist in creating capital charge for such risk. Claims
include claims on Domestic sovereigns, foreign sovereigns, Public sector entities,
Multilateral Development Banks, IMF and Bank for International Settlements, Primary
Dealers, corporates, claims secured by commercial real estate, claims secured by
residential property, Non Performing Assets (NPA’s) and Securitization Exposures.
Techniques for credit risk mitigation include Collateralized Transactions, Off Balance
sheet Nettings and use of Guarantees.
Market Risk is defined as the loss in balance sheet and off balance sheet items due to
adverse movements in market price. Risks covered here include instruments and equities
in trading books of the banks. Trading books includes securities held for trading,
securities under available for sale, Open gold and foreign exchange positions, trading
positions in derivatives and hedging exposures.
Along with the supervisory role, accountability is also a key responsibility of the
supervisor for which the committee recommended the third pillar of disclosures. This
aspect warrants the provisioning of timely information to all the participants of banking
system. It will assist the market participants to access key information related to capital,
risk, assessment process and steps take. Lack of achievement of such disclosure attracts
penalty. Sufficient efforts have been made to comply with international accounting
standards to make the information homogeneous to all backgrounds. The disclosure to be
both qualitative and quantitative and should be made available in several formats
including printed and online media. Since this is an important piece of information, the
ECONOMICS PAPER No. : 11, Money & Banking
MODULE No. : 28, Basel Norms for Capital Adequacy
____________________________________________________________________________________________________
4.2 Criticism
The foremost criticism for Basel II comes from the segmentation of banking principles
for emerging market economies where a separate set of rules were set for these nations
without addressing to their immediate economic needs. These norms also ignored the
country specific socio-economic environment concerning strict regulators, lack of skilled
work force and laxity in regulating private banks. Banks in emerging markets also
ignored the rating aspect of lending due to cost reduction and unfavorable after effects of
such downgraded ratings.
Erstwhile governor of RBI has highlighted another line of criticism. He blamed the pro-
cyclical nature of Basel II norms whereby extra stringency is observed during stressed
market behavior and calls for greater capital requirements. Deleveraging and conversion
of assets from banking book into trading book led to linkage with crisis of 2008. Failure
to address interconnectedness of institutions or the Systematic Risk was another bell-
weather, which was ignored.
The newer framework lays greater focus on common equity with the minimum
requirement raised to 4.5% of risk- weighted assets, after deductions. It also introduces
Capital Conservation Buffer comprising common equity of 2.5% of risk-weighted assets,
bringing the total common equity standard to 7% and Minimum total capital requirement
to 10.5%. The buffer is to ensure smooth functioning of banks without deleveraging. It
also constraint a bank’s discretionary distributions like dividends and bonus when banks
fall into the buffer range.
Addressing the liquidity concerns, the liquidity coverage ratio (LCR) will require banks
to have sufficient high- quality liquid assets to withstand a 30-day stressed funding
scenario that is specified by supervisors. It should be at least 100% of total net cash
outflow over the next 30 calendar days. Apart from LCR, net stable funding ratio
(NSFR) is a longer-term structural ratio designed to address liquidity mismatches. It
covers the entire balance sheet and provides incentives for banks to use stable sources of
funding over one year time period.
Address firm-wide governance and risk management; capturing the risk of off-balance
sheet exposures and securitization activities; managing risk concentrations; providing
incentives for banks to better manage risk and returns over the long term; sound
compensation practices; valuation practices; stress testing; accounting standards for
financial instruments; corporate governance; and supervisory colleges are some of the
additions to Pillar 2 basis.
Basel committee is of the view that provisioning measures should be based upon
‘Expected loss’ criteria making the reporting more useful for stakeholders.
The role of banking system is crucial as the major burden will be borne by banks in the
form of reduced earnings, interest margins and profitability ratios in short run, but with
greater space for stable and environment to operate in long term. Another dimension t
this debate is that Indian banks cannot ignore foreign competitions and advancements nor
can they allow external shocks.
As far as deadlines are concerned, India has been proactive in achieving the set dates and
will implement the Basel III norms by 31 December 2018, 9 months in advance of
globally set date, since it is through with the consultative process.
In light of the argument of too-big to fail, to curtail the risk appetite of large banks, Basel
III identifies Globally Systematically Important Banks (G-SIBs). Although no Indian
Bank qualifies in this list, proposals have been forwarded to identify Domestically
Systematically Important Banks (D-SIBs).
7. Summary
Risk Management Systems are need of the hour given the size and quantity of
operations of Banks.
Several types of risks need to be taken into consideration in order to provide
protection against them. These include credit risk, interest rate risk, market risk
and operational risk to name a few.
Basel Committee for banking Supervision (BCBS) has put forth a regulatory
framework for international banking community in order to provide a protection
against such risks.
The basis of this framework is to provide Minimum Capital to Risk weighted
Assets with varied capital requirements.
Basel accords have been implemented across the globe and India is a front runner
in achieving the set standards
The norms call for flexible adjustments to suit the risk profile of individual banks
and focuses on constant monitoring in wake of unwarranted movements in
Balance sheet and off balance sheet items due to internal or external actions.