This presentation is the one stop point to learn about Basel Norms in the Banking
This is the most comprehensive presentation on Risk Management in Banks and Basel Norms. It presents in details the evolution of Basel Norms right form Pre Basel area till implementation of Basel III in 2019 along with factors and reason for shifting of Basel I to II and finally to III.
Links to Video's in the presentation
Risk Management in Banks
https://www.youtube.com/watch?v=fZ5_V4RW5pE
Tier 1 Capital
http://www.investopedia.com/terms/t/tier1capital.asp
Tier 2 Capital
http://www.investopedia.com/terms/t/tier2capital.asp
Basel I
http://www.investopedia.com/terms/b/basel_i.asp
Capital Adequacy Ratio
http://www.investopedia.com/terms/c/capitaladequacyratio.asp
Basel II
http://www.investopedia.com/video/play/what-basel-ii/?header_alt=c
Basel III
http://www.investopedia.com/terms/b/basell-iii.asp
RBI Governor - Raghuram G Rajan on the importance if Basel III regulations
https://youtu.be/EN27ZRe_28A
3. HistoryâŠ...
ï” Historically, in 1970, the sudden failure of the Bretton Woods System resulted in the
occurrence of casualties in 1974 such as withdrawal of banking license of many banks.
ï” âOn 26 June 1974, German regulators forced the troubled Bank Herstatt into liquidation. That day, a
number of International banks had released payment of Deutsche Marks (DEM) to Herstatt in Frankfurt
in exchange for US Dollars (USD) that were to be delivered in New York. Because of time zone
differences, Herstatt ceased operations between the times of the respective payments.
The counterparty banks did not receive their USD payments.â
ï” In 1975, three months after the closing of Franklin National Bank and other similar
disruptions, the central bank governors of the G-10 countries took the initiative to establish
a committee on Banking Regulations and Supervisory Practices in order to address such
issues.
ï” This committee was later renamed as Basel Committee on Banking Supervision (BCBS)
ï” The Committee acts as a forum where regular cooperation between the member countries
takes place regarding banking regulations and supervisory practices.
4. History
ï” The Committee aims at improving supervisory knowhow and the quality of banking
supervision quality worldwide. Purpose of supervision is
ï” to ensure that bank operates in a safe and sound manner.
ï” to ensure that Bank âhold capital and reserves sufficient to support the risks that arise
in their business
ï” Sound practices for bankâs risk management
ï” The Committee formulates guidelines and provides recommendations on banking
regulation based on capital risk, market risk and operational risk.
ï” Though the BCBS committee itself does not have any superior authority over the
governments and central banks to which it makes recommendations, but its guidelines are
broadly followed and well regarded in the international central banking and finance
community.
ï” In a Nutshell :- âAn International Framework for Internationally Active Banksâ
5. Pre Basel I Period (1975 â 1988)
ï” From 1965 to 1981 there were about eight bank failures (or bankruptcies) in the United
States.
ï” âSavings and Loan (S&L) crisis was one of the largest financial scandals in U.S. history, the Savings and
Loan Crisis emerged in the late 1970s and came to a head in the 1980s, finally ending in the early
1990s. S&L deposits were insured by the Federal Savings and Loan Insurance Corporation (FSLIC),
depositors continued to put money into these risky institutions. But S&L engaged in increasingly risky
corrupt activities, including commercial real estate lending and investments in junk bonds resulting
collapse of them. This led to the insolvency of the FSLIC, the government bailout of the thrifts to the
tune of $124 billion in taxpayer dollars and the liquidation of 747 insolvent S&Ls by the U.S.
governmentâ
ï” Highly leveraged Banks throughout the world were lending extensively, so much that the
potential for the bankruptcy of the these major international banks grew as a result of low
security / capital.
ï” to prevent this risk, the Basel Committee on Banking Supervision, comprised of central banks
and supervisory authorities of 10 countries, met in 1987 in Basel, Switzerland.
ï” The committee drafted a first document to set up an international 'minimum' amount of
capital that banks should hold. This minimum is a percentage of the total capital of a bank,
which is also called the minimum risk-based capital adequacy.
6. Basel â I / Basel Capital Accord-1988 - 1999
ï” The General purpose of the Accord was
ï” To strengthen the stability of International Banking System
ï” To set up a fair and consistent international banking system in order to decrease competitive
inequality amongst international banks
ï” In 1988, the Committeeâs introduced capital measurement system / accord which mainly
focused on
ï” the credit risk and
ï” Minimum amount of Capital that bank should hold
ï” The Committee, by the end of 1992, had implemented the minimum requirement ratio of
capital to be fixed at 8 percent of Risk-Weighted Assets.
ï” The committee also issued Market Risk Amendment to the capital accord in January 1996
which came into effect at the end of 1997. A concept of Value At Risk (VaR) was introduced.
The capital requirement was set on the basis of higher of Previous dayâs Value-at-risk or
Three times the average of the daily value-at-risk of the preceding sixty business days.
7. Basel Accord / Basel I â Four Pillars
The Basel I Accord attempted to create a cushion against credit risk. The norm comprised of
four pillars.
ï” Pillar I â Constituents of Capital :- It prescribe the nature of capital that is eligible to be
treated as reserves. Capital is classified into Tier I and Tier II capital. The accord requires Tier
I capital to constitute at least 50 percent of the total capital base of the banking institution.
ï” Pillar II â Risk Weighting :- Risk Weighting creates a comprehensive system to provide
weights to different categories of bankâs assets & liabilities
ï” Pillar III â Target Standard Ratio :- Target Standard Ratio acts as a unifying factor between
the first two pillars. A universal standard, wherein Tier I and Tier II capital should cover at
least 8 percent of risk weighted assets of a bank, with at least 4 percent being covered by
Tier I capital.
ï” Pillar IV â Transitional and Implementing Arrangement :- Transitional and implementing
arrangement sets different stages of implementation of the norms in a phased manner.
8. Key Concepts
ï” Tier I Capital (Core Capital) :- It includes stock issues (or
share holder equity) and declared reserves such as Loan
Loss reserves set aside to cushion future losses or for
smoothing out income variation.
ï” Tier II Capital (Supplementary Capital) :- It includes all
other capital such as revaluation reserves, undisclosed
reserves, hybrid instruments and subordinated term
debt. It also includes gain on investment assets , long
term debt with maturity greater than 5 years and hidden
reserves. However, short-term are not included.
10. CAR â Capital Adequacy Ratio
CRAR - Capital to Risk weighted Assets Ratio
11. Transition to Basel II from Basel I
Basel II was fundamentally conceived as a result of two triggers â
ï” the banking crises of the 1990s on the one hand, and
ï” the criticisms/limitations of Basel I itself on
ï” Limited differentiation of credit risk : There were just four broad risk weightings (0%,
20%, 50% and 100%), based on an 8% minimum capital ratio.
ï” No recognition of term-structure of credit risk : The capital charges are set at the same
level regardless of the maturity of a credit exposure.
ï” Simplified calculation of future multi-country counterparty risk : The current capital
requirements ignore the different level of risks associated with different currencies
and their macroeconomic risk.
ï” Lack of recognition of portfolio diversification effects: In reality, the sum of individual
risk exposures is not the same as the risk reduction through portfolio diversification.
ï” Static measure of default risk: The assumption that a minimum 8% capital ratio is
sufficient to protect banks from failure does not take into account the changing nature
of default risk / banking scenarioâs.
12. BASEL II
ï” In the year 1999, a new, far more thorough capital adequacy accord was introduced which
was initially known as âA Revised Framework on International Convergence of Capital
Measurement and Capital Standardsâ (hereinafter referred to as Basel II)
ï” For successful implementation of the new capital framework across borders, the
committeeâs Supervision and Implementation Group (SIG) was formed.
ï” The new framework was designed to
ï” improve the way regulatory capital requirements reflect the underlying risks for
addressing the recent financial innovation.
ï” focuses on the continuous improvements in risk measurement and control so as to
maintain consistency of regulations and to create uniform international standards for
Banking
ï” It introduced âOperational Riskâ; define new calculation for Credit Risk and for Market Risk, it
ensured that the capital allocation is more risk sensitive.
ï” Also, a primary mandate of this accord was to widen the scope of regulation. This is
achieved by including âon a fully consolidated basis, any holding company that is the parent
entity within a banking group to ensure that it captures the risk of the whole banking
groupâ.
16. Pillar I â Min Capital Charge - Credit Risk
ï” Standardized Approach: It directed banks to use ratings from external credit rating agencies
to compute capital requirements commensurate with the level of credit risk. There are 13
categories of individual assets specifically named in the Basel II accord with risk-weighting
norms.
ï” Foundation - Internal Rating Based (FIRB) Model: gives banks the freedom to develop their
own models to ascertain risk weights for their assets. These are, however, subject to the
approval of the banking regulator. Further, the regulators provide the model assumptions â
loss given default2 (LGD), exposure at default (EAD), and effective maturity4 (M). Banks are,
however, allowed to use their own estimates of the probability of default5 (PD).
ï” Advanced IRB (AIRB): It is fundamentally the same as Foundation IRB, except that banks are
free to use their own assumptions (of LGD, EAD and M) in the models they develop.
Understandably, this approach can be used only by a select set of banks.
By design, the IRB approaches are âself-regulating mechanismsâ& from a regulatory standpoint,
this translates into lower legal and regulatory costs.
17. Pillar I â Min Capital Charge - Operational Risk
ï” The Basic Indicator Approach: It suggests that banks hold 15 percent of their average
annual gross income (over the past three years) as capital. On the basis of risk assessments
of individual banks, regulators may adjust the 15 percent threshold
ï” The Standardized Approach: It basically splits a bank into compartments based on its
business lines. The idea is that business lines with lower operational risk (asset
management, for instance) would translate into lower reserve requirements.
ï” The Advanced Measurement Approach: It gives banks the freedom to perform their own
computations for operational risk. Once again, these are subject to regulatory approval.
They share similarity with Credit Risk â IRB Model in terms of their âSelf Regulationâ nature.
18. Pillar I â Min Capital Charge - Market Risk
Market Risk (Fixed Income Assets)
ï” Market risk is simply the risk of loss as a result of movements in the market prices of assets.
ï” Basel II makes two clear distinctions â one in respect of asset categories, and the other
regarding types of principal risks (interest rate risk and volatility risk)
ï” Value at Risk (VaR) measure is put forth for Fixed Income Assets. Banks can use their own
computations (subject to regulatory approval)
ï” Basel II proposes two distinct risk protection methods for banks, who couldnât follow VaR
method:
ï” In respect of interest rate risk, the reserve requirements are mapped to the maturity of the
asset
ï” In terms of volatility risk, the correspondence is established through credit risk ratings of the
assets
19. VaR
ï” Value at Risk (VaR) is the most probable loss that we may incur in normal market
conditions over a given period due to the volatility of a factor, exchange rates, interest
rates or commodity prices.
ï” The probability of loss is expressed as a percentage â VaR at 95% confidence level,
implies a 5% probability of incurring the loss;
ï” at 99% confidence level the VaR implies 1% probability of the stated loss.
ï” The loss is generally stated in absolute amounts for a given transaction value (or value of
a investment portfolio).
ï” The VaR is an estimate of potential loss, always for a given period, at a given confidence
level. For e.g. A VaR of 5p in USD / INR rate for a 30- day period at 95% confidence level
means that Rupee is likely to lose 5p in exchange value with 5% probability, or in other
words, Rupee is likely to depreciate by maximum 5p on 1.5 days of the period (30*5% ) .
ï” A VaR of Rs. 100,000 at 99% confidence level for one week for a investment portfolio of
Rs. 10,000,000 similarly means that the market value of the portfolio is most likely to
drop by maximum Rs. 100,000 with 1% probability over one week, or , 99% of the time
the portfolio will stand at or above its current value.
20. Market Risk (Non Fixed Income Assets)
ï” The Standard / Simplified Approach: It puts assets into compartments based on certain
parameters: type, origin, maturity, and volatility. It then gives risk weights â from 2.25
percent for the least risky assets to 100 percent for the most risky assets.
ï” The Standard / Scenario Analysis: the risk weights are assigned by taking into
consideration the scenarios that could exist in each countryâs markets. This method is
clearly less conservative, and thus allows banks to be more experimental. Yet, it comes
with its complexity.
ï” The Internal Model Approach: It gives banks the choice to design their own market risk
models.
Total Capital Adequacy Reserves =
[0.08 * Risk-Weighted Assets + Operational Risk Reserves + Market Risk Reserves]
Pillar I â Min Capital Charge - Market Risk
21. Basel II - Pillar II & III
ï” Pillar II â Supervisory Review Process: It focuses on the aspect of regulator-bank interaction.
Specifically, it empowers regulators in matters of supervision and dissolution of banks. For
instance, regulators may supervise internal risk evaluation mechanisms outlined in Pillar I â
and change them to more conservative or simpler ones, as the case demands. Regulators
are permitted to create a buffer capital requirement over and above the minimum capital
requirements as per Pillar I.
ï” Pillar III â Market Discipline: It aims to induce discipline within the banking sector of a
country. Basel II suggested that, disclosures of the bankâs capital and risk profiles which
were shared solely with regulators till this point should be made public. The premise was
that information to shareholders could be widely disseminated. They would be able to
ensure prudence in the risk levels of banks.
22. Transition to Basel III from Basel II
ï” Basel Committee declared that the committeeâs recommendations were for G-10 member
states. This leaves out emerging economies, and actually implied potential unfavorable
impact on these economies.
ï” The scope of responsibilities for regulators (in emerging economies) may be too much for
them to handle.
ï” Central banks might not be stringent enough in regulating private banks, thus letting them
raise their risk exposure â defeating the entire purpose.
ï” Banks in emerging economies were at a disadvantage in terms of receiving loans from
global banks. The consequence here was that global banks would need to maintain more
capital for a loan to an emerging market bank on recommendation of external credit rating
agencies.
ï” Basic assumption was pre-cyclical process and thus it failed to consider capital requirements
during Inflation/Deflation of the Economy.
ï” Depends on good underlying data; complex to implement for emerging Banking system
and hence required skilled supervision and high depend on external credit rating agencies.
23. Basel 2.5 (2009 â 2010)
The financial crisis of 2007 and 2008 exposed the limitations of Basel II, wherein certain risks
were not under the purview of this regulation.
ï” Augmenting the Value-at-Risk based trading book framework with an additional charge for risk
capital, including mitigation risk and default risk.
ï” Addition of stressed value-at-risk condition. This condition takes into account probability of
significant losses over a period of one year
But above two conditions were incorporated into Basel III in 2010.
24. Basel III 2010⊠- 2019
The essence of Basel III revolves around two sets of compliance:
i. Capital
ii. Liquidity
While good quality of capital will ensure stable long term sustenance, compliance with
liquidity covers will increase ability to withstand short term economic and financial stress.
Liquidity Rules: One of the objectives of Basel III accord is to strengthen the liquidity
profile of the banking industry. This is because despite having adequate capital levels,
banks still experienced difficulties in the recent financial crisis. Hence, two standards of
liquidity were introduced
26. Capital â CCB & CCCB
ï” Capital Conservation Buffer : The intention behind it is to make certain that banks
accumulate capital buffers in times of low financial stress. When the buffer is utilized, banks
need to recreate it by pruning their discretionary distribution of earnings. Banks facing
reduced capital buffers must certainly not signal their financial strength by way of
distributing earnings. Thus, the accord enforces constraints on distribution of earnings.
Basel III prescribes Buffer of 2.5 percent above the minimum capital requirement. This
buffer is built out of Common Equity Tier 1 (CETI)11, only after the 6 percent Tier 1 and 8
percent total capital requirements have been fulfilled.
ï” Counter-Cyclical Buffer : The underlying premise of the countercyclical buffer is that capital
requirements in the banking sector must take into consideration the macroeconomic
environment in which banks operate. Banks must arm themselves with capital buffers in
times of rapidly-growing financial stress. It will be enacted by national authorities, when
they believe that the excess credit growth potentially implies a threat of financial distress.
The buffer for internationally-active banks is computed as a weighted average of the
buffers for all jurisdictions where the bank bears a credit exposure. Banks would be subject
to a countercyclical buffer between zero and 2.5 percent of their total risk-weighted assets
27. Liquidity - LCR & NSFR
ï” Liquidity Coverage Ratio (LCR) : LCR was introduced with the objective of promoting efficacy
of short term liquidity risk profile of the banks. This is ensured by making sufficient
investment in short term high quality liquid assets, which can be quickly and easily
converted into cash, such that it financial institution to withstand sustained financial stress
for 30 days period.
ï” Net Stable Funding Ratio (NSFR) : It incentivizes banks to obtain financing through stable
sources on an ongoing basis. the standard requires that a minimum quantum of stable and
risk less liabilities are utilized to acquire long term assets. The objective is to deter reliance
on short term means of finance, especially during favorable market periods. The NSFR has a
time horizon of one year
28. Liquidity â Leverage Ratio
ï” A critical characteristic of the 2007-08 financial crisis was the overuse of on- and off-
balance sheet leverage in the banking sector.
ï” banks portrayed healthy risk based capital ratios. However, when banks had no choice but
to reduce leverage in the worst part of the crisis, a vicious circle was created
ï” The leverage ratio was incorporated in order to have a non-risk based metric in addition to
the risk based capital requirements in place.
ï” the primary intentions were thus to control the tendency of excessive leverage and
strengthen risk based requirements.
ï” Since the implementation of Basel III involves significant changes in capital structure, the
same shall be implemented in a phase wise manner till 2019
30. Key points related to Indian scenario
ï” The implementation of Basel III norms commenced in India from April 1, 2013 in a phased
manner, with full compliance initially targeted to be achieved by March 31, 2018 but
extended to March 31, 2019.
ï” The Reserve Bank of India specified minimum Tier 1 Leverage Ratio of 4.5 percent during
the parallel run period as against the Basel Committeeâs minimum Tier 1 leverage ratio of 3
percent.
ï” the biggest concern for the financial sector is the growing volume of the Restructured
Assets and Non-Performing Assets (NPA), a framework for revitalizing distressed assets has
been implemented in the economy which has come into effect from April 2014.
ï” The RBI prescribes a minimum Capital to Risk Weighted Asset Ratio (CRAR) at 9 percent,
higher than 8 percent prescription of Basel III accord.
ï” According to the CAREâs estimate, the total equity capital requirement for Indian banks till
March 2019 is likely to be in the range of Rs. 70,000 crores assuming that the average GDP
growth will be 6 percent and the average credit growth will be in the range of 15 percent
to 16 percent over the next five years.