Neha Gundherva

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Formation of BASEL Committee
The Committee was formed in response to the messy liquidation of a Cologne-based bank
(Herstatt) in 1974. On 26 June 1974, a number of banks had released Deutsche Mark (German
Mark) to the Bank Herstatt in exchange for dollar payments deliverable in New York. On
account of differences in the time zones, there was a lag in the dollar payment to the counter-
party banks, and during this gap, and before the dollar payments could be effected in New York,
the Bank Herstatt was liquidated by German regulators.

This incident prompted the G-10 nations to form towards the end of 1974, the Basel Committee
on Banking Supervision, under the auspices of the Bank of International Settlements (BIS)
located in Basel, Switzerland.

BASEL I
Basel I is the round of deliberations by central bankers from around the world, and in 1988, the
Basel Committee (BCBS) in Basel, Switzerland, published a set of minimal capital
requirements for banks. This is also known as the 1988 Basel Accord, and was enforced by law
in the Group of Ten (G-10) countries in 1992. Basel I is now widely viewed as outmoded.
Indeed, the world has changed as financial conglomerates, financial innovation and risk
management have developed. Therefore, a more comprehensive set of guidelines, known as
Basel II are in the process of implementation by several countries and new updates in response to
the financial crisis commonly described as Basel III.

Basel I, that is, the 1988 Basel Accord, primarily focused on credit risk. Assets of banks were
classified and grouped in five categories according to credit risk, carrying risk weights of zero
(for example home country sovereign debt), ten, twenty, fifty, and up to one hundred percent
(this category has, as an example, most corporate debt). Banks with international presence are
required to hold capital equal to 8 % of the risk-weighted assets. However, large banks like
JPMorgan Chase found Basel I's 8% requirement to be unreasonable and implemented credit
default swaps so that in reality they would have to hold capital equivalent to only 1.6% of
assets.

Since 1988, this framework has been progressively introduced in member countries of G-10,
currently comprising 13 countries, namely, Belgium, Canada, France, Germany, Italy, Japan,
Luxembourg, Netherlands, Spain, Sweden, Switzerland, United Kingdom and the United States
of America.

Most other countries, currently numbering over 100, have also adopted, at least in name, the
principles prescribed under Basel I. The efficiency with which they are enforced varies, even
within nations of the Group of Ten.
BASEL II
Basel II is the second of the Basel Accords, which are recommendations on banking laws and
regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II,
which was initially published in June 2004, is to create an international standard that banking
regulators can use when creating regulations about how much capital banks need to put aside to
guard against the types of financial and operational risks banks face. Advocates of Basel II
believe that such an international standard can help protect the international financial system
from the types of problems that might arise should a major bank or a series of banks collapse. In
theory, Basel II attempted to accomplish this by setting up risk and capital management
requirements designed to ensure that a bank holds capital reserves appropriate to the risk the
bank exposes itself to through its lending and investment practices. Generally speaking, these
rules mean that the greater risk to which the bank is exposed, the greater the amount of capital
the bank needs to hold to safeguard its solvency and overall economic stability.

The final version aims at:

1. Ensuring that capital allocation is more risk sensitive;

2. Separating operational risk from credit risk, and quantifying both;
3. Attempting to align economic and regulatory capital more closely to reduce the scope for
regulatory arbitrage.

While the final accord has largely addressed the regulatory arbitrage issue, there are still areas
where regulatory capital requirements will diverge from the economic.

Basel II has largely left unchanged the question of how to actually define bank capital, which
diverges from accounting equity in important respects.

THREE PILLARS OF BASEL II

Basel II uses a "three pillars" concept –

(1) Minimum capital requirements (addressing risk),

(2) Supervisory review and

(3) Market discipline.

The First Pillar: Minimum Capital Requirements

The first pillar deals with maintenance of regulatory capital calculated for three major
components of risk that a bank faces: credit risk, operational risk, and market risk. Other
risks are not considered fully quantifiable at this stage.

The credit risk component can be calculated in three different ways of varying degree of
sophistication, namely standardized approach, Foundation IRB and Advanced IRB. IRB stands
for "Internal Rating-Based Approach".

For operational risk, there are three different approaches - basic indicator approach or BIA,
standardized approach or TSA, and the internal measurement approach (an advanced form of
which is the advanced measurement approach or AMA).

For market risk the preferred approach is VaR (value at risk).

As the Basel 2 recommendations are phased in by the banking industry it will move from
standardized requirements to more refined and specific requirements that have been developed
for each risk category by each individual bank. The upside for banks that do develop their own
bespoke risk measurement systems is that they will be rewarded with potentially lower risk
capital requirements. In future there will be closer links between the concepts of economic profit
and regulatory capital.

Credit Risk can be calculated by using one of three approaches:

1. Standardized Approach

2. Foundation IRB (Internal Ratings Based) Approach

3. Advanced IRB Approach

The standardized approach sets out specific risk weights for certain types of credit risk. The
standard risk weight categories are used under Basel 1 and are 0% for short term government
bonds, 20% for exposures to OECD Banks, 50% for residential mortgages and 100% weighting
on unsecured commercial loans. A new 150% rating comes in for borrowers with poor credit
ratings. The minimum capital requirement (the percentage of risk weighted assets to be held as
capital) remains at 8%.

For those Banks that decide to adopt the standardized ratings approach they will be forced to rely
on the ratings generated by external agencies. Certain Banks are developing the IRB approach as
a result.
The Second Pillar: Supervisory Review

The second pillar deals with the regulatory response to the first pillar, giving regulators much
improved 'tools' over those available to them under Basel I. It also provides a framework for
dealing with all the other risks a bank may face, such as systemic risk, pension risk,
concentration risk, strategic risk, reputational risk, liquidity risk and legal risk, which the accord
combines under the title of residual risk. It gives banks a power to review their risk management
system.

Pillar II defines the process for supervisory review of an institution’s risk management
framework and, ultimately, its capital adequacy. It sets out specific oversight responsibilities for
the board and senior management, thus reinforcing principles of internal control and other
corporate governance practices established by regulatory bodies in various countries worldwide
(see page 6). According to the Basel Committee, “The [New Accord] stresses the importance of
bank management developing an internal capital assessment process and setting targets for
capital that are commensurate with the bank’s particular risk profile and control environment.
Supervisors would be responsible for evaluating how well banks are assessing their capital
adequacy needs relative to their risks.
This internal process would then be subject to supervisory review and intervention, where
appropriate.”6 As a consequence, the supervisor may require, for example, restrictions on
dividend payments or the immediate raising of additional capital.

The Third Pillar: Market Discipline

This pillar aims to promote greater stability in the financial system

Market discipline supplements regulation as sharing of information facilitates assessment of the

bank by others including investors, analysts, customers, other banks and rating agencies. It leads
to good corporate governance. The aim of pillar 3 is to allow market discipline to operate by
requiring lenders to publicly provide details of their risk management activities, risk rating
processes and risk distributions. It sets out the public disclosures that banks must make that lend
greater insight into the adequacy of their capitalization. When marketplace participants have a
sufficient understanding of a bank’s activities and the controls it has in place to manage its
exposures, they are better able to distinguish between banking organizations so that they can
reward those that manage their risks prudently and penalize those that do not.

Pillar III aims to bolster market discipline through enhanced disclosure by banks. It “sets out
disclosure requirements and recommendations in several areas, including the way a bank
calculates its capital adequacy and its risk assessment methods.”
Enhanced comparability and transparency are the intended results. At the same time, the Basel
Committee has sought to ensure that the Basel II disclosure framework aligns with national
accounting standards—and, in fact, does not conflict with broader accounting disclosure
standards with which banks must comply.
 PILLAR I PILLAR II PILLAR III
Minimum Capital Supervisory Review Market Discipline
Requirements
Market risk Banks should have a process Market discipline reinforces
 No changes from Basel I for assessing their overall efforts to promote safety and
Credit risk capital adequacy and strategy soundness in banks
 Significant change from for maintaining capital levels
Basel I  Core disclosures (basic
 Three different approaches  Supervisors should review information) and
to the calculation of and evaluate banks’ internal supplementary disclosures
minimum capital capital adequacy assessment to make market discipline
requirements and strategies more effective.
 Capital incentives for banks  Supervisors should expect
to move to more banks to operate above the
sophisticated credit risk minimum capital ratios and
management should have the ability to
 approaches based on require banks to hold capital
internal ratings in excess of the minimum
 Sophisticated approaches (i.e., trigger/target ratios in
have systems/controls and the United Kingdom;
data collection requirements prompt corrective action in
as well as qualitative the United States)
requirements for risk  Supervisors should seek to
management intervene at an early stage to
Operational risk prevent capital from falling
 Not explicitly covered in below minimum levels
Basel I
 Three different approaches
to the calculation of
minimum capital
requirements
 Adoption of each approach
subject to compliance with
defined ‘qualifying criteria’
Implications of Basel II Norms for Indian Banks and NBFCs

• With the feature of additional capital requirements, the overall capital level of the banks will
see an increase. But, the banks that will not be able to make it as per the norms may be left out of
the global system.
• Another biggest challenge is re-structuring the assets of some of the banks would be a tedious
process, since most of the banks have poor asset quality leading to significant proportion of
NPA. This also may lead to Mergers & Acquisitions, which itself would be loss of capital to
entire system.
• The new norms seem to favor the large banks that have better risk management and
measurement expertise, who also have better capital adequacy ratios and geographically
diversified portfolios. The smaller banks are also likely to be hurt by the rise in weight age of
inter-bank loans that will effectively price them out of the market. Thus, banks will have to re-
structure and adopt if they are to survive in the new environment.
• Since improved risk management and measurement is needed, it aims to give impetus to the use
of internal rating system by the international banks. More and more banks may have to use
internal model developed in house and their impact is uncertain. Most of these models require
minimum historical bank data that is a tedious and high cost process, as most Indian banks do not
have such a database.
• The technology infrastructure in terms of computerization is still in a nascent stage in most
Indian banks. Computerization of branches, especially for those banks, which have their network
spread out in far-flung areas, will be a daunting task. Penetration of information technology in
banking has been successful in the urban areas, unlike in the rural areas where it is insignificant.
• Experts say that dearth of risk management expertise in the Asia Pacific region will serve as a
hindrance in laying down guidelines for a basic framework for the new capital accord.
• An integrated risk management concept, which is the need of the hour to align market, credit
and operational risk, will be difficult due to significant disconnect between business, risk
managers and IT across the organizations in their existing set-up.
• Implementation of the Basel II will require huge investments in technology. According to
estimates, Indian banks, especially those with a sizeable branch network, will need to spend well
over $ 50-70 Million on this.

Conclusion
The Basel Committee on Banking Supervision is a Guideline for Computing Capital for
Incremental Risk. It is a new way of managing risk and asset-liability mis-matches, like asset
securitization, which unlocks resources and spreads risk, are likely to be increasingly used. This
was designed for the big banks in the BCBS member countries, not for smaller or less developed
economies.
The major challenge the country's financial system faces today is to bring informal loans into the
formal financial system. By implementing Basel II norms, our formal banking system can learn
many lessons from money-lenders. Its implementation may involve significant changes in
business model in which potential economic impacts must be carefully monitored.
In a nut-shell, we would like to conclude that keeping in view the cost of compliance for both
banks and supervisors, the regulatory challenge would be to migrate to Basel II in a non-
disruptive manner. We would like to continue the process of interaction with other countries to
learn from their experiences through various international fora. India is one of the early countries
which subjected itself voluntarily to the FSAP of the IMF, and our system was assessed to be in
high compliance with the relevant principles. With the gradual and purposeful implementation of
the banking sector reforms over the past decade, the Indian banking system has shown
significant improvement on various parameters, has become robust and displayed ample
resilience to shocks in the economy. There is, therefore, ample evidence of the capacity of the
Indian banking system to migrate smoothly to Basel II.

BASEL III
The new norms have also introduced a countercyclical buffer within a range of 0% - 2.5% of
common equity or other fully loss absorbing capital that has to be implemented as per the
national circumstances. It is primarily supposed to serve the macro-prudential goal of protecting
the banking sector from periods of excess aggregate credit growth. For any given country, this
buffer will only be in effect when there is excess credit growth that is resulting in a system wide
build up of risk. The countercyclical buffer, when in effect, would be introduced as an extension
of the conservation buffer range.

The BCBS wishes that these capital requirements are supplemented by a non-risk-based leverage
ratio that will serve as a backstop to the risk-based measures described above. In July 2010,
Governors and Heads of Supervision agreed to test a minimum Tier 1 leverage ratio of 3%
during the parallel run period. Based on the results of the parallel run period, any final
adjustments would be carried out in the first half of 2017 with a view to migrating to a Pillar 1
treatment on
1 January 2018 based on appropriate review and calibration. Moreover, the BCBS recommends
implementation of Basel
III by 1 January 2015. The transition period would be from 2013 to 2015.

The new norms have also introduced a countercyclical buffer within a range of 0% - 2.5% of
common equity or other fully loss absorbing capital that has to be implemented as per the
national circumstances. It is primarily supposed to serve the macro-prudential goal of protecting
the banking sector from periods of excess aggregate credit growth. For any given country, this
buffer will only be in effect when there is excess credit growth that is resulting in a system wide
build up of risk. The countercyclical buffer, when in effect, would be introduced as an extension
of the conservation buffer range.

The BCBS wishes that these capital requirements are supplemented by a non-risk-based leverage
ratio that will serve as a backstop to the risk-based measures described above. In July 2010,
Governors and Heads of Supervision agreed to test a minimum Tier 1 leverage ratio of 3%
during the parallel run period. Based on the results of the parallel run period, any final
adjustments would be carried out in the first half of 2017 with a view to migrating to a Pillar 1
treatment on
1 January 2018 based on appropriate review and calibration. Moreover, the BCBS recommends
implementation of Basel III by 1 January 2015. The transition period would be from 2013 to
2015.

Implications of Basel III Norms for Indian Banks and NBFCs

The Basel III Framework does not pose any formidable challenge for Indian banks. Under the
current Capital Adequacy rules, Indian banks have already been deducting deferred tax assets,
intangibles (like goodwill) and investments in subsidiaries. Given that our banks have limited
usage of non common equity Tier 1 instruments, we believe that most of our banks will be able
to meet the minimum capital requirements ahead of the scheduled time table. In the long run,
however, a vast majority of bank capital will be raised through equity and only small amount
through debt. The banks are likely to use debt more for funding rather than for capital purpose.
However, some problem could be there, especially for public sector banks (PSBs) on account of
the use of preference share capital and perpetual debt instruments. As Indian PSBs have a larger
component of perpetual debt (which means higher leverage) and also lower Tier 1 ratios as
compared to their private peers, a compliance with Basel III Framework would pose relatively
grater capital requirements on them, which, in turn, may adversely affect their loan-book
expansion in the coming years.

The PSBs which have more than 70% of the total assets of the Indian banking industry and
which have been the primary lenders to productive sectors even during the tough times marked
by the global financial crisis are likely to face some constraints on lending as a result of the Basel
III implementation. This does not augur well with the Indian dream of achieving and sustaining a
9.0%-plus growth in the coming years. The option of raising capital freely from the market is
also not available to most of the PSBs as the government has a policy of maintaining at least
51% stake in them. Currently, there are only seven PSBs in which government equity is more
than 65%. So, the government has to come out with a clear roadmap about its capital infusion
plan for the PSBs in order to protect their credit growth momentum and ratings. The other option
for the government is to reduce its stake in the ownership of the PSBs in a phased manner. The
quicker the policy response, the better it is for the capital planning effort of the PSBs. So far as
the new liquidity regime is concerned, Indian banks do not seen to have any serious issues. Most
of our banks follow a retail business model and also have a substantial amount of liquid assets,
which should enable them to meet the new standards with comfort. However, there may be some
challenge due to the fact that our banks have a limited capacity to collect the relevant data
accurately and granularly, and to formulate and predict the liquidity stress scenarios. But the
phase in period for the compliance with these ratios is fairly long (up to 2019) and this challenge
could be easily overcome by then.

Additionally, there is some ambiguity about the treatment of Statutory Liquidity Ratio (SLR)
under the new banking regulations. The RBI has been negotiating for taking at least the part of
the SLR in the liquidity ratios as these are government bonds against which the RBI provides
liquidity to banks. To conclude, there is no doubt that the proposed new global banking
regulation (Basel III) seeks to improve the ability of banks to withstand periods of economic and
financial stress by prescribing more stringent capital and liquidity requirements for them. So far
as the Indian banking industry is concerned, the transition to new framework is relatively easy as
the regulatory norms on capital adequacy in India are already more stringent and historically
Indian banks have maintained both the core and overall capital well in excess of the minimum
requirement. However, Indian PSBs, which control more than 70% of the total assets of Indian
banking sector and which are the primary source of credit to the productive sectors may not be
able to support rapid loan-book expansion in the coming years, unless the government supports
these banks with the infusion of core tier 1 capital or comes out with a concrete roadmap to
lower its stake in the PSBs in a phased manner. The prompter the policy response, the better it is
for the capital planning effort and the international standing of this crucial segment of the Indian
banking industry.