Basel norms in banking sectors

2.  Banks in the process of financial
intermediation are confronted with various
kinds of financial and non-financial risks
viz.:
 Credit Risk
 Liquidity Risk
 Market Risk
 Operational Risk


3.  Credit risk: In this case money is
being lent to the borrower, who does not
make the return payments as originally
agreed.
 Liquidity Risk : Asset or Security
cannot be traded quickly enough so that
the value drops.

4. Market Risk : In this case an
investment or trading portfolio will
decrease in value due to change in the
price of portfolio in the market.
Operational risk: It raised from the
execution of a banking business functions.
This category can also include fraud risks,
physical risks, legal risks and
environmental risks.

5.  Loans and advances given by the banks to
its customers is are an Asset to the bank.
 A loan (an asset for the bank) turns as NPA
when the EMI, principal or interest
component for the loan is not paid within 90
days from the due date.
 Thus a Bad Loan is an asset that
ceases to generate any income for the
bank

6.  The non-performing assets of the
banking sector rose sharply to 1.28 per cent
in 2011-12 from 0.97 per cent a year ago due
to high interest rate and slowdown in the
economy.
 The NPAs (non-perfomring assets) or bad
loans of the public sector banks rose to 1.53
per cent in 2011-12, up from 1.09 per cent in
the previous year, said the latest RBI report.

7. • The Basel Committee on Banking
Supervision was established in 1974, by
the Bank of International Settlements
(BIS). In order to help the banks to
recognize the different kinds of risks and
to take adequate steps
• An international organization founded in
Basel, Switzerland in 1930 to serve as a
Bank for Central banks.

8.  As per Basel Committee guidelines issued
capital adequacy was considered panacea
for risk management.
 All banks were advised to have Capital
Adequacy Ratio (CAR) at least 8%. CAR is
the ratio of capital to risk weighted assets
and it provides the cushion to the
depositors in case of bankruptcy.

9. Committee consisting of members from
each of the G10 countries. It is
represented by central bank governors of
each of the G10 countries.
Thirteen industrialized Nations that meet
on an annual basis to consult each other
on international financial matters.

10.  The member countries are: France,
Germany, Belgium, Italy, Japan, the
Netherlands, Sweden, the United
Kingdom, the United States and Canada,
with Switzerland, Luxembourg, Spain
 It meets regularly 4 times a year.

11. The basic approach of capital adequacy
framework is that a bank should have sufficient
capital to provide a stable resource to absorb
any losses arising from the risks in its business.
For supervisory purposes capital is split into
two categories:
Tier I and Tier II. These categories represent
different instruments’ quality as capital:

12.  Tier I Capital consists:
 Equity Capital (Shareholders'
Funds)
 Disclosed Reserves:
◦ Premium over shares,
◦ Retained earnings,
◦ Legal reserve
 It is a bank’s highest quality capital
because it is fully available to cover
losses.

13.  Legal reserves are the only assets that
are permitted by government regulations.
 Divided into The two asset categories:
 Required Reserve (Vault cash & Reserve
deposits )
 Excess Reserve (Reserve for loan purposes)
Legal Reserve:

14. Vault Cash (Required Reserve)
 Paper bills and metal coins kept on the bank
premises, both the vault and teller drawers.
 To satisfy currency withdrawal demands of
depositors.
 Vault cash is not part of the official M1 money
supply.
 M1 includes only the paper bills and metal coins
that is in circulation and held by the nonbank
public.

15.  Reserve deposits are the one that
regulators require.
 These are deposits that banks keep with
the Reserve Bank Of India System.
 Required reserves are specified as a
fraction of outstanding deposits--usually
about 3 percent -15 percent

16.  Any legal (or total) reserves over and
above those required by regulators are
excess reserves.
 These excess reserves are used for loans,
which makes them exceedingly important
to the banking industry.

17.  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 capital
is lower than that of Tier I capital.

18.  Undisclosed reserves are not common.
 They are accepted by some regulators
where a bank has made a profit but this
has not appeared in normal retained
profits or in general reserves of the bank.
 Many countries do not accept this as an
accounting concept or a legitimate form of
capital

19.  Revaluation reserve is created when a bank
has an asset revalued and an increase in value
is brought to account.
 Example: A bank owns the land and building of
its head-offices and bought them for $100 a
century ago.
 A current revaluation is very likely to show a
large increase in value. The increase would be
added to a revaluation reserve.

20.  Adequate care must be taken to ensure
that sufficient provisions have been made
to meet all known losses and foreseeable
potential losses before considering as part
of Tier II Capital.

21.  Have some characteristics of both DEBT and
EQUITY.
 These are close to equity in nature, in that they are
able to take losses on the face value without
triggering a liquidation of the bank, they may be
counted as capital.
Example: Preferred stock usually carries no voting
rights but may carry a dividend and may have
priority over common stock in the payment of
dividends and upon liquidation.

22.  Such debt is referred to as subordinate, because
the debt providers (the lenders) have subordinate
status in relationship to the Normal debt.
 A typical example for this would be when a
promoter of a company invests money in the form
of debt, rather than in the form of stock.
 Subordinated debt has a lower priority than other
bonds of the issuer in case of liquidation during
bankruptcy. It has minimum maturity period is 5
years.

23. • Credit risk is most simply defined as the potential
that a bank’s borrower or counterparty may fail to
meet its obligations in accordance with agreed
terms.
• For most banks, loans are the largest and the
most obvious source of credit risk; however, other
sources of credit risk exist throughout the activities
of a bank like inter-bank transactions, trade
financing, foreign exchange transactions,

24. • Market Risk is the risk to the bank’s
earnings and capital due to changes in :
• Market level of interest rates
• Prices of securities
• Foreign exchange
• Equity Prices

25.  The first accord was the Basel I. It was issued in 1988
and 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 gilts bond ), ten,
twenty, fifty, and up to one hundred percent ( Corporate
debt).
 It standardizes risk-based capital requirements for
banks across countries as per following measurement:

26.  A measure of a bank's capital. It is expressed as a
percentage of a bank's risk weighted credit
exposures.
CAR = Tier I + Tier II
Risk Weighted
Assets

27. • Risk weighted assets is a measure of the
amount of a banks assets, adjusted for risk.
• It can be arrived simply by multiplying it with
factor that reflects its risk.
• Low risk assets are multiplied by a low number,
high risk assets by 100% (i.e. 1).

28. 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 gilts (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.

29. • The main use of risk weighted assets is to
calculate Tier1 and Tier 2 capital adequacy
ratios.
• If its capital is 10% of its assets, then it can
lose 10% of its assets without becoming
Insolvent. (Insolvency is simply being
unable to pay liabilities; Liabilities >
Assets and liquidate it.

30.  Basel II came into being in 2004.
 Basel II is based on 3 pillars:
 (i) Minimum capital requirements,
(ii) Supervisory review of an institution's capital
adequacy and internal assessment process;
(iii) Market discipline through effective disclosure
to encourage safe and sound banking practices.

31.  Pillar 1 includes 3 risks now, operational risk +
credit risk + market risk to meet international
standards.
 Commercial banks in India adopt Standardized
Approach (SA) for credit risk.
 Standardized Approach, the rating assigned by
the eligible external credit rating agencies, largely
supports the measure of credit risk.

32.  Banks rely upon the ratings assigned by the
external credit rating agencies chosen by the
RBI for assigning risk weights for capital
adequacy 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.

33.  Banks must disclose the names of the
credit rating agencies that they use for the
risk weighting of their assets.
 The risk weights associated with the
particular rating grades as determined by
RBI for each eligible credit rating agency
as well as the aggregated risk weighted
assets.

34.  Pillar 2: Supervisory Review Process (SRP) —
The establishment of suitable risk management
systems in banks and their review by the
supervisory authority (RBI). As:
 In terms of the Pillar 2 requirements of the New
Capital Adequacy Framework, banks are expected
to operate at a level well above the minimum
requirement.


35.  Pillar 3: Market Discipline — seeks to achieve
increased transparency through expanded
disclosure requirements tor banks.
 For such comprehensive disclosure, IT structure
must be in place for supporting data collection
and generating MIS which is compatible with
Pillar 3 requirements.

36.  Basel II Tier I CRAR = Tier I capital / (Credit
Risk RWA + Operational Risk RWA + Market Risk
RWA)
 Basel II Total CRAR = Total capital / (Credit
Risk RWA + Operational Risk RWA + Market Risk
RWA)
 RWA - risk weighted assets

37.  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 March 31, 2009.
 The Government of India has stated that public
sector banks must have a capital cushion with a
CRAR of at least 12%, higher than the threshold
of 9% prescribed by the RBI.

38.  Failure to adhere to Basel II can attract
RBI action including restricting lending
and investment activities.
 However, private sector banks as well as
public sector banks are likely to comply
with Basel II norms since March 31, 2009

39.  In order to strengthen risk management
mechanism:
 “Indian banks should have minimum Tier-I
capital of 7 percent of risk-weighted
assets.
 Total capital must be at least 9 percent of
risk-weighted assets.

40.  Besides, it has also suggested for setting up of
the capital conservation buffer in the form of
Common Equity of 2.5 per cent of RWAs.
that takes the total capital requirement to 11.5%
higher than the BIS norm of 10.5%.
 Implementation of the minimum capital
requirements will begin from January 2013 and
should be fully implemented by March 31, 2017.
 S&P expects all banks that it rates in India to
meet the RBI's requirements within the stipulated
timeframe

41. Currently, RBI follows Basel II norms: As
 Banks are required to maintain a minimum
Capital to Risk weighted Assets Ratio (CRAR) of
9 per cent.
 Tier 1 capital should be at least 6 per cent of risk
weighted assets
 On aggregate, banks are comfortably placed in
terms of capital adequacy, but a few individual
banks may fall short due to implementation of
Basel III norms.


42.  It is proposed that the implementation period of
minimum capital requirements and deductions
from Common Equity will begin from January 1,
2013 and be fully implemented as on March 31,
2018.
 The BIS has set the deadline for full
implementation as 2019; the RBI would like Indian
banks to comply by 2018.