Basel Norms in Banking Sectors

8/2/2019 Basel Norms in Banking Sectors

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The Basel Committee on Banking

Supervision was established in 1974, bythe Bank of International Settlements(BIS).

An international organization founded inBasel, Switzerland in 1930 to serve as aBank for Central banks.


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Committee consisting of members fromeach of the G10 countries. It isrepresented by central bank governors ofeach of the G10 (developed)countries.(NOW 13)

Thirteen industrialized Nations that meeton an annual basis to consult each otheron international financial matters.


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The member countries are: France,Germany, Belgium, Italy, Japan, theNetherlands, Sweden, the United

Kingdom, the United States and Canada,with Switzerland, Luxembourg, Spain

It meets regularly 4 times a year.


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Basel Committee on BankingSupervision (BCBS) framework onCapital Adequacy takes into accountthe elements of credit risk to

strengthen the capital base of banks.

RBI decided in April 1992 to introducea risk asset ratio system for banks inIndia as a capital adequacy measure.


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The basic approach of capital adequacyframework is that a bank should have sufficientcapital to provide a stable resource to absorbany losses arising from the risks in its business.

For supervisory purposes capital is split intotwo categories:

Tier I and Tier II. These categories representdifferent instruments quality as capital:


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Tier I Capital consists:

Equity Capital (Shareholders' Funds) Disclosed Reserves:

Premium over shares, Retained earnings, Legal reserve

It is a banks highest quality capitalbecause it is fully available to cover

losses.


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Legal reserves are the only assets that arepermitted by government regulations.

Divided into The two asset categories:

Required Reserve (Vault cash & Reserve

deposits ) Excess Reserve (Reserve for loan purposes)

Legal Reserve:


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Vault Cash (Required Reserve)

Paper bills and metal coins kept on the bankpremises, both the vault and teller drawers.

To satisfy currency withdrawal demands of

depositors.

Vault cash is not part of the official M1 moneysupply.

M1 includes only the paper bills and metal coinsthat is in circulation and held by the nonbankpublic.


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Reserve deposits are the one thatregulators require.

These are deposits that banks keep withthe Reserve Bank Of India System.

Required reserves are specified as afraction of outstanding deposits--usuallyabout 3 percent -15 percent


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Any legal (or total) reserves over andabove those required by regulators areexcess reserves.

These excess reserves are used for loans,which makes them exceedingly importantto the banking industry.

Holding excess reserves means loss ofinterest revenue.


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Tier II capital Consists:

Undisclosed reserves Revaluation reserves General provisions Subordinated debt Hybrid Instruments.

This capital is less permanent in nature.

The loss absorption capacity of Tier II capitalis lower than that of Tier I capital.


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Undisclosed reservesare not common.

They are accepted by some regulators

where a bank has made a profit but thishas not appeared in normal retainedprofits or in general reserves of the bank.

Many countries do not accept this as anaccounting concept or a legitimate form ofcapital


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Revaluation reserve is created when a bankhas an asset revalued and an increase in valueis brought to account.

Example: A bank owns the land and building ofits head-offices and bought them for $100 acentury ago.

A current revaluation is very likely to show alarge increase in value. The increase would beadded to a revaluation reserve.


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Adequate care must be taken to ensurethat sufficient provisions have been madeto meet all known losses and foreseeablepotential losses before considering as partof Tier II Capital.


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Have some characteristics of both DEBT andEQUITY.

These are close to equity in nature, in that they are

able to take losses on the face value withouttriggering a liquidation of the bank, they may becounted as capital.

Example: Preferred stock usually carries no votingrights but may carry a dividend and may havepriority over common stock in the payment ofdividends and upon liquidation.
http://en.wikipedia.org/wiki/Liquidationhttp://en.wikipedia.org/wiki/Dividendhttp://en.wikipedia.org/wiki/Common_stockhttp://en.wikipedia.org/wiki/Liquidationhttp://en.wikipedia.org/wiki/Liquidationhttp://en.wikipedia.org/wiki/Common_stockhttp://en.wikipedia.org/wiki/Common_stockhttp://en.wikipedia.org/wiki/Common_stockhttp://en.wikipedia.org/wiki/Dividendhttp://en.wikipedia.org/wiki/Liquidation


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Such debt is referred to as subordinate,

because the debt providers (the lenders) havesubordinate status in relationship to theNormal debt.

A typical example for this would be when apromoter of a company invests money in theform of debt, rather than in the form ofstock.

Subordinated debt has a lower priority thanother bonds of the issuer in case ofliquidation during bankruptcy. It hasminimum maturity period is 5 years.
http://en.wikipedia.org/wiki/Liquidationhttp://en.wikipedia.org/wiki/Bankruptcyhttp://en.wikipedia.org/wiki/Liquidationhttp://en.wikipedia.org/wiki/Bankruptcyhttp://en.wikipedia.org/wiki/Bankruptcyhttp://en.wikipedia.org/wiki/Liquidation


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Credit risk is most simply defined as thepotential that a banks borrower orcounterparty may fail to meet its obligationsin accordance with agreed terms.

For most banks, loans are the largest and themost obvious source of credit risk; however,other sources of credit risk exist throughout

the activities of a bank like inter-banktransactions, trade financing, foreignexchange transactions,


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Market Risk is the risk to the banksearnings and capital due to changes in :

Market level of interest rates

Prices of securities

Foreign exchange

Equity Prices


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The first accord was the Basel I. It was issued in 1988and focused mainly on credit risk.

Banks with international presence are required to hold

capital equal to 8 % of the risk-weighted assets.

Carrying risk weights of zero (for glits bond ), ten, twenty,fifty, and up to one hundred percent ( Corporate debt).

It standardizes risk-based capital requirements forbanks across countries as per following measurement:


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A measure of a bank's capital. It is expressed

as a percentage of a bank's risk weightedcredit exposures.

CAR = Tier I + Tier IIRisk Weighted Assets


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Risk weighted assets is a measure of theamount of a banks assets, adjusted for risk.

It can be arrived simply by multiplying it withfactor that reflects its risk.

Low risk assets are multiplied by a low number,high risk assets by 100% (i.e. 1).


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Suppose a bank has the following assets:

Rs. 1bn in gilts

Rs. 2 bn secured by mortgages

Rs. 3bn of loans to businesses. The risk weights used are: 0% for glits (a risk free

assets)

50% for mortgages

100% for the corporate loans. The bank's risk weighted assets are 0 1bn +

50% 2bn + 100% 3bn = 4bn.


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The main use of risk weighted assets

is to calculate Tier1and Tier 2capitaladequacy ratios.

If its capital is 10% of its assets, thenit can lose 10% of its assets withoutbecoming Insolvent. (Insolvency is

simply being unable to pay liabilities;Liabilities > Assets and liquidate it.
http://moneyterms.co.uk/tier-1/http://moneyterms.co.uk/tier-2/http://moneyterms.co.uk/capital-adequacy/http://moneyterms.co.uk/capital-adequacy/http://moneyterms.co.uk/insolvency/http://moneyterms.co.uk/insolvency/http://moneyterms.co.uk/capital-adequacy/http://moneyterms.co.uk/capital-adequacy/http://moneyterms.co.uk/capital-adequacy/http://moneyterms.co.uk/tier-2/http://moneyterms.co.uk/tier-2/http://moneyterms.co.uk/tier-2/http://moneyterms.co.uk/tier-1/http://moneyterms.co.uk/tier-1/


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Basel II came into being in 2004. Basel II is based on 3 pillars:

(i) Minimum capital requirements,(ii) Supervisory review of an institution'scapital adequacy and internal assessment

process;

(iii) Market discipline through effectivedisclosure to encourage safe and soundbanking practices.


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Pillar 1 includes 3 risks now, operational

risk + credit risk + market risk to meetinternational standards.

Commercial banks in India adopt

Standardized Approach (SA) for credit risk. Standardized Approach, the rating

assigned by the eligible external creditrating agencies, largely supports themeasure of credit risk.


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Banks rely upon the ratings assigned by theexternal credit rating agencies chosen bythe RBI for assigning risk weights for capitaladequacy purposes. As:

a) Credit Analysis and Research Ltd. b) CRISIL Ltd. c) FITCH Ltd. and d) ICRA Ltd.

International credit rating agencies :

a) Fitch; b) Moody's; and c) Standard &Poor's.


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Banks must disclose the names of thecredit rating agencies that they use for therisk weighting of their assets.

The risk weights associated with theparticular rating grades as determined byRBI for each eligible credit rating agency aswell as the aggregated risk weightedassets.


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Pillar 2: Supervisory Review Process (SRP)

The establishment of suitable riskmanagement systems in banks and theirreview by the supervisory authority (RBI). As:

In terms of the Pillar 2 requirements of theNew Capital Adequacy Framework, banks are

expected to operate at a level well above the

minimum requirement.


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Pillar 3: Market Discipline

seeks to achieveincreased transparency through expandeddisclosure requirements tor banks.

For such comprehensive disclosure, ITstructure must be in place for supporting datacollection and generating MIS which is

compatible with Pillar 3 requirements.


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Basel II Tier I CRAR = Tier I capital / (CreditRisk RWA + Operational Risk RWA + MarketRisk RWA)

Basel II Total CRAR = Total capital / (CreditRisk RWA + Operational Risk RWA + MarketRisk RWA)

RWA - risk weighted assets


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Capital to Risk Weighted Assets Ratio (CRAR)of 8% and Tier I capital of 6%.

The RBI has stated that Indian banks must

have a CRAR of minimum 9%, effective March31, 2009.

The Government of India has stated that

public sector banks must have a capitalcushion with a CRAR of at least 12%, higherthan the threshold of 9% prescribed by theRBI.


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Failure to adhere to Basel II can attractRBI action including restricting lending andinvestment activities.

However, private sector banks as well aspublic sector banks are likely to complywith Basel II norms by March 31, 2009


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In order to strengthen risk managementmechanism:

Indian banks should have minimum Tier-Icapital of 7 percent of risk-weightedassets.

Total capital must be at least 9 percent ofrisk-weighted assets.


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Besides, it has also suggested for setting up

of the capital conservation buffer in the formofCommon Equity of 2.5 per cent of RWAs.

Implementation of the minimum capitalrequirements will begin from January 2013 andshould be fully implemented by March 31, 2017.

S&P expects all banks that it rates in India tomeet the RBI's requirements within thestipulated timeframe


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Currently, RBI follows Basel II norms: As Banks are required to maintain a minimum

Capital to Risk weighted Assets Ratio (CRAR) of9 per cent.

Tier 1 capital should be at least 6 per cent of riskweighted assets

On aggregate, banks are comfortably placed interms of capital adequacy, but a few individualbanks may fall short due to implementation ofBasel III norms.

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Basel Norms in Banking Sectors

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