Basel Norms: Pre-crisis Basel IFormalised by G 10 in response to Herstatt Bank liquidationWef 1988: Focussed on credit risk: Banks reqd to hold 8% capital to risk-weighted assets ratio Tier 1 capital minimum of 4% of RWAs Tier 2 debt instruments of at least 5 years; maximum of 4% of RWAs. Tier 3 short term debt of at least 2 yrs

Gaming Basel Capital reqd for mortgage loans was higher than for mortgaged backed securities so banks securitized their mortgage loans through bank-financed Special Investment Vehicles (SIV)Securitization enhanced the credit rating Enhanced ratings require less capital, so banks invested in these products. Thus, there was an incestuous relationship between banks and SIVs .

Basel IIAttempt to refine Basel I3 Pillar approach Pillar I Credit Risk (Std & IRB model), operational & market risk (VaR) Pillar 2 Supervisory ie liquidity risk, systemic risk, legal risk etc Pillar 3 Disclosure ie market discipline

Basel Norms Financial crisis: Contributory factorsThe Basel requirement of common equity was just 2% of risk-weighted assets (RWAs). Banks also tried to game the system since Basel capital rules favoured lower capital for trading book & higher capital for banking book, banks tried to shift assets from banking to trading book

Shadow Banking The size of shadow banking (thro NBFCs) system became almost thrice the formal banking system. Same time there was a growing dependence on wholesale funding Both factors made the system very vulnerable

Basel I to II to III to ..?When the crisis hit, the BIS was working on Basel II to make good the shortcomings of Basel I However crisis showed that even Basel II was inadequate so Basel III published in Dec 2010Main feature of Basel III is that it tried to improve the shock-absorbing capacity of banks

Basel IIITier 1 capital : the predominant form of Tier 1 capital must be common shares and retained earningsTier 2 capital instruments will be harmonizedTier 3 capital will be eliminated.

Changed scenarioUnder Basel III, Tier 1 capital must be predominant form of regulatory capital at minimum 75% of the total capital of 8%, i.e., 6%, as against 4%Within Tier 1 capital, common equity must be the predominant form of capital. It will be minimum 75% of the Tier 1 capital requirement of 6%, i.e., 4.5%, from the existing 2%.

Additional safeguards Additionally banks required to maintain a Net Stable Funding Ratio (NSFR),ie ratio of stable sources of funding relative to liquidity profiles of assets & the potential for contingent liquidity needs from off-balance sheet commitments, over a one-year horizon.Idea is to limit over-reliance on short-term wholesale funding.

Further,To ensure rescue of non-viable banks does not cause losses to tax-payers while leaving non-common equity capital providers unscathed, all non-common Tier 1 & Tier 2 instruments reqd to have a provision for write off or conversion into common equity in case of troubleTier III capital completely abolished

Basel IIISeeks to address issues relating to systemic risk throughleverage ratiocapital conservation buffercountercyclical capital bufferaddressing pro-cyclicality of provisioning requirementsaddressing interconnectednessaddressing the too-big-to-fail problemaddressing reliance on external credit rating agencies

Capital Conservation BufferBasel III prescribes a capital conservation buffer of 2.5% of RWAs, comprising common equity Tier 1 capital, over & above the minimum common equity requirement of 4.5% & total capital requirement of 8% to be built up outside periods of stress. This can be drawn down as losses are incurred during periods of stress

Counter-cyclical capital buffer

This varies between zero and 2.5% of RWAs, depending on the extent of the build-up of system-wide risks. Banks are required to meet this buffer with common equity Tier 1 capital or other fully loss-absorbing capital

Addressing pro-cyclicality of provisioning The Basel Committee is working closely with the International Accounting Standards Board (IASB) towards an expected loss approach to loan loss provisioning instead of the present practice of incurred loss

Addressing inter-connectedness

Basel prescribes higher asset value correlation under the Internal Ratings Based (IRB) Approach for exposures to large financial institutions with assets of US $ 100 billion and with unregulated institutions.

Addressing reliance on external ratings

Banks allowed to make their own internal assessments of externally rated securitization exposures, the elimination of certain cliff effects (sharp increase in applicable risk weights) associated with credit risk mitigation practices

Time frame of Basel IIIPhased implementation staring from January 1, 2013 to January 1, 2019.Capital instruments that no longer qualify as non-core Tier 1 capital or Tier 2 capital, will be phased out over a ten-year period starting from 2013

Capital Requirements in India

Elements of Tier I CapitalPaid-up capital (ordinary shares), statutory reserves, and other disclosed free reserves, if any;Perpetual Non-cumulative Preference Shares (PNCPS) eligible for inclusion as Tier I capital - subject to laws in force from time to time;Innovative Perpetual Debt Instruments (IPDI) eligible for inclusion as Tier I capital; andCapital reserves representing surplus arising out of sale proceeds of assets.

Elements of Tier II CapitalUndisclosed ReservesRevaluation ReservesGeneral Provisions and Loss ReservesHybrid Debt Capital InstrumentsSubordinated DebtInvestment Reserve Account