Basel-I, Basel-II and Basel-III:
These were a set of international banking regulations put forth by the Basel Committee on Bank Supervision,(BCBS) which set out the minimum capital requirements of financial institutions with the goal of minimizing credit risk. Banks that operate internationally are required to maintain a minimum amount (8%) of capital based on a percent of risk-weighted assets. The first accord on capital standards was Basel I. It was issued in 1988 and focused mainly on credit risk by creating a bank asset classification system. One size fits all-Risk weight same for all types of assets:
The banks were to maintain capital (Tier 1 and Tier 2) equal to at least 8% of its risk-weighted assets. For example, if a bank has risk-weighted assets of $100 million, it is required to maintain capital of at least $8 million.
Initially, there was only credit risk and later on market risk was included.
Basel II: Capital standard to further strengthen soundness and stability of international banking system. More emphasis was on operational risk. The definition of regulatory capital remains same but the measurement of risk has been modified for credit risk. Operational risk is given due importance.
Three Pillars under Basel-II:-
i) Minimum Capital Requirement
Capital requirement (called capital charge) is calculated for credit, market and operational risk.
a) Credit Risk – standardized approach based on type of borrower and credit rating.
b) Operational Risk – Basic indicator approach – 15% of average positive annual gross income for 3 years.
c) Market risk – Standard Duration Method.
To migrate to;
i) Credit risk – Internal Risk Based – 31.03.2014
ii) Operational Risk – Standardized approach - 30.09.2010
Advanced measurement - 31.03.2014
iii) Market risk – Internal Model approach – 31.03.2011.
ii) Supervisory Review - To ensure that banks have adequate capital to support all the risk in their business and encourage them to develop and use better risk management techniques in monitoring and managing their risk. The banks to develop internal risk capital assessment and set capital targets commensurate with bank‘s risk profile/ control environment.
iii) Market Discipline: To complement minimum capital requirement and supervisory review through disclosure and transparency – 8% international requirement and 9% as per RBI.
Basel-III is a global regulatory standard on bank capital adequacy, stress testing and liquidity risk agreed upon by the members of the BCBS in 2010-11. Basel III was developed in response to the deficiencies in financial regulation revealed by the late-2000s financial crisis. Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage. For instance, the change in the calculation of loan risk in Basel II which some consider a causal factor in the credit bubble prior to the 2007-08 collapse:
In Basel II one of the principal factors of financial risk management was outsourced to companies that were not subject to supervision: credit rating agencies. Ratings of creditworthiness and of bonds, and various other financial instruments were conducted without supervision by official agencies, leading to AAA ratings on mortgage-backed securities, credit default swaps and other instruments that proved in practice to be extremely bad credit risks.
Moreover, bankruptcy in the financial sector in the West due to
i) loose lending standards, ii) poor underwriting of mortgages, iii) unbridled speculation, iv) gross asset liability mismatches and v) inadequate liquidity led to the collapse of even institutions considered ‗too big to fail‘.
The OECD estimates that the implementation of Basel III will decrease annual GDP growth by 0.05 to 0.15 percentage point.
Outside the banking industry itself, criticism was muted. Bank directors would be required to know market liquidity conditions for major asset holdings, to strengthen accountability for any major losses.
Basel III will require banks to hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) of risk-weighted assets (RWA). Basel III also introduces additional capital buffers, (i) a mandatory capital conservation buffer of 2.5% and (ii) a discretionary countercyclical buffer, which allows national regulators to require up to another 2.5% of capital during periods of high credit growth. In addition, Basel III introduces a minimum 3% leverage ratio and two required liquidity ratios-Liquidity Coverage Ratio requires a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days; the Net Stable Funding Ratio requires the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.
With the single most agenda of never to repeat a crisis of 2008, the BCBS put forward norms aimed at strengthening the balance sheet of banks as under:
Enhancing the quantum of common equity
Improving the quality of capital base
Creation of capital buffers to absorb shocks-2.5% during high growth
Improving liquidity of assets-LCR and NSFR
Optimising leverage through leverage ratio
Creating more space for regulatory supervision under Pillar-II of Basel-II
Bringing further transparency and market discipline under Pillar-III of Basel-II
• Minimum 4.5% in common equity (as against the current 3.6%) by March 31, 2015.
• create a capital conservation buffer (consisting of common equity) of 2.5% by March 31, 2018.
• maintain countercyclical buffer of 2.5% of RWA
• minimum overall capital adequacy of 11.5% (against the current 9%) by March 31, 2018
• a leverage ratio of 4.5%.
• Banks allowed to add interim profits (subject to conditions) for computation of core capital adequacy
Impact of Basel-III on banks in India
1. Capital Adequacy: The transition to Basel-III would be easier for Indian banks due to our strict regulatory standards.
According to Crisil, the average equity capital ratio and overall capital adequacy ratio of Indian banks are between 9% to 14%, well above the regulatory norm.
2. Cost of lending: Stricter capital requirements lead to lower Return on Equity. Moreover, as capital costs increase, loans tend to be more expensive. In order to offset this, banks would have to reduce deposit rates or augment non-interest income. Still, Basel-III norms give out the message that Indian banks will have to explore ways to conserve capital.
3. Leverage: RBI has set the leverage ratio at 4.5%, higher than the Basel-III norm of 3%.This is to regulate banks having higher trading book and off balance sheet derivative positions. However, for Indian banks, the derivative transactions are not very large and the pressure on maintaining the required leverage ratio would be lower.
4. Liquidity norms: The Basel-IIII guidelines require banks to hold enough unencumbered liquid assets to cover expected net outflows during a 30 day stress period. Since we already maintain 21.50% of NDTL under SLR and another 4.00% under CRR, the burden from LCR stipulation will depend on how much of CRR and SLR can be set off against SLR. Here also Indian banks are better placed.
