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Basel Norms

Dhruv Agarwal

16036/09

BFIA 3

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The Basel Accords

The Basel Accords (see alternative spellings below) refer to the banking supervision

Accords (recommendations on banking regulations)Basel I, Basel II and Basel III

issued by the Basel Committee on Banking Supervision (BCBS).

The Basel Committee on Banking Supervision (BCBS) is a committee of banking

supervisory authorities that was established by the central bank governors of the

Group of Ten countries in 1975. eight International Monetary Fund (IMF) members,

Belgium, Canada, France, Italy, Japan, the Netherlands, the United Kingdom, and

the United Statesand the central banks of two others, Germany and Sweden.

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The Committee was formed in response liquidation of Herstatt Bank 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-partybanks, and during this gap, and before the dollar payments could be effected in New

York, the Bank Herstatt was liquidated by German regulators.

This triggered serious disturbances in international currency and banking markets

and prompted the G-10 nations to form the BCBS towards the end of 1974.

The first meeting took place in February 1975 and meetings have been held regularly

three or four times a year since.

Basel Committee on Banking Supervisionand the need for Basel Accords

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BASEL I

A capital measurement system commonly referred to as the Basel Capital Accord (or

the 1988 Accord), now commonly called the BASEL I was approved by the G10

Governors and released to banks in July 1988.

OBJECTIVES:

1. Strengthen the stability of international banking system.

2. Set up a fair and a consistent international banking system in order to decrease

competitive inequality among international banks.

The basic achievement of Basel I has been to define the bank capital.

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Two-Tiered Capital

Tier 1 (Core Capital):

Includes common stock, preferred stock that is irredeemable and non-cumulative,

retained earnings and declared reserves, such as loan loss reserves set aside to cushion

future losses or for smoothing out income variations.

Tier 2 (Supplementary Capital):

Tier 2 capital includes undisclosed reserves, revaluation reserves, general provisions,

hybrid instruments and subordinated term debt.

Capital components such as gains on investment assets, long-term debt with maturitygreater than five years and hidden reserves (i.e. excess allowance for losses on loans

and leases). However, short-term unsecured debts (or debts without guarantees), are

not included in the definition of capital.

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BASEL I provisions

Basel I, that is, the 1988 Basel Accord, primarily focused on credit risk.

The Basel agreement identifies three types of credit risks:

The on-balance sheet risk. The trading off-balance sheet risk. These are derivatives, namely interest rates,

foreign exchange, equity derivatives and commodities.

The non-trading off-balance sheet risk. These include general guarantees, such

as forward purchase of assets or transaction-related debt assets.

Implementation of the framework with a minimum capital ratio of capital to risk-

weighted assets of 8 percent by end-1992.

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Risk Categories

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).

0% - cash, central bank and government debt and any OECD government debt

0%, 10%, 20% or 50% - public sector debt

20% - development bank debt, OECD bank debt, OECD securities firm debt, non-

OECD bank debt (under one year maturity) and non-OECD public sector debt, cash in

collection

50% - residential mortgages

100% - private sector debt, non-OECD bank debt (maturity over a year), real estate,

plant and equipment, capital instruments issued at other banks

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BASEL II

In June 1999, the Committee issued a proposal for a new capital adequacy framework

to replace the 1988 Accord, culminating in the release of the New Capital Framework on

26 June 2004.

Need for Replacing BASEL I:

Ensuring that capital allocation is more risk sensitive.

Enhance disclosure requirements which will allow market participants to assess the

capital adequacy of an institution;

Ensuring that credit risk, operational risk and market risk are quantified based on

data and formal techniques. Attempting to align economic and regulatory capital more closely to reduce the

scope for regulatory arbitrage.

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The Three Pillars

THE FIRST PILLAR:

Maintenance of regulatory capital calculated for three components of risk that a bank

faces: credit risk, operational risk, and market risk.

The credit riskcomponent can be calculated in 2 ways, namely standardized approachand Foundation IRB or Advanced IRB. IRB stands for "Internal Rating-Based Approach.

Standardized Approach: capital requirements are equal 8% of the outstanding amount

of money. Under this approach the banks are required to use ratings from External

Credit Rating Agencies to quantify required capital for credit risk.

IRB: in general, banks are ought to calculate borrowers probability of default using

internal measures (Foundation IRB). In particular, banks can also estimate the loss given

default and the exposure at default using their own methods (Advanced IRB).

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For operational risk, there are three different approaches - basic indicator approach or

BIA, standardized approach or STA, and the internal measurement approach (an

advanced form of which is the advanced measurement approach or AMA).

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

VaR is defined as a threshold value such that the probability that the mark-to-market

loss on the portfolio over the given time horizon exceeds this value (assuming normal

markets and no trading in the portfolio) is the given probability level.

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THE SECOND PILLAR:

Much improved 'tools to regulators 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 assystemic 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.

THE THIRD PILLAR:This pillar aims to complement the minimum capital requirements and supervisory

review process by developing a set of disclosure requirements which will allow the

market participants to gauge the capital adequacy of an institution.

The aim of pillar 3 is to allow market discipline to operate by requiring institutions to

disclose details on the scope of application, capital, risk exposures, risk assessment

processes and the capital adequacy of the institution

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Issues and Challenges, BASEL IICapital Requirement: The new norms will almost invariably increase capital requirement in

all banks across the board.

Profitability: Competition among banks for highly rated corporates needing lower amount of

capital may exert pressure on interest spread.

Risk Management Architecture: The new standards call for introduction of advanced risk

management system with wider application throughout the organization which in itself is adaunting task.

Choice of Alternative Approaches: The new framework provides for alternative approaches

for computation of capital requirement of various risks. However, competitive advantage of

IRB approach may lead to domination of this approach among big banks.

. Hence, the system as a whole may maintain lower capital than warranted and become morevulnerable.

Disclosure Regime: While the disclosure may be useful for supervisory authorities and rating

agencies the expertise and ability of the general public to comprehend and interpret

disclosed information is open to question

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BASEL III

The role of Basel II, both before and after the global financial crisis, has been discussed

widely. While some argue that the crisis demonstrated weaknesses in the framework

others have criticized it for actually increasing the effect of the crisis.

In response to the financial crisis, the Basel Committee on Banking Supervisionpublished revised global standards, popularly known as Basel III.

OBJECTIVE:

(a) better quality of regulatory capital,

(b) better liquidity management and supervision,(c) better risk management and supervision including enhanced Pillar 2 guidelines,

(d) enhanced Pillar 3 disclosures related to securitization, off-balance sheet exposures

and trading activities which would promote transparency, and

(e) cross-border supervisory cooperation.

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Change in Approach

Definition of CAPITAL:

Going by the new rules, the predominant component of capital is common equity and

retained earnings. The new rules restrict inclusion of items such as deferred tax assets,

mortgage-servicing rights and investments in financial institutions to no more than 15%

of the common equity component.

PROVISIONS:

Key capital ratio changed to 7% of risky assets, according to the new norms, Tier-I

capital that includes common equity and perpetual preferred stock will be raised from

2-4.5% starting in phases from January 2013 to be completed by January 2015. In

addition, banks will have to set aside another 2.5% as a contingency for future stress.Banks that fail to meet the buffer would be unable to pay dividends, though they will

not be forced to raise cash.

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A McKinsey Quarterly Report on BASEL III estimates that banks in Europe and the United

States will have to raise about 1.65 trillion of new capital, about 1.9 trillion of short-

term liquidity, and about 4.5 trillion of long-term funding. The capital shortfall is

equivalent to about 60 percent of all outstanding Tier 1 capital, and the short-term

liquidity gap is about 50 percent of all the liquidity that banks currently hold.Their analysis shows that these rules could reduce return on equity (ROE) for the

average European bank by between 3.7 and 4.3 percentage points by 2019, from the

pre-crisis ROE average of 15 percent

This highlights the daunting prospect that the implementation of BASEL III is,particularly in light of the incumbent financial turmoil in Europe.

The Big Issue

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