FIN 6002 – Session 7

Pradeepta Sethi
TAPMI
 Capital regulations

¢ Bank capital regulations were introduced in order to redress the

natural tendency of banks to maintain insufficient capital.

¢ The Basel capital adequacy regime dates back to the Basel Accord of
1988, which led to the introduction of what we now know as Basel I.

¢ Has its origins in the financial market turmoil that followed the
breakdown of the Bretton Woods system of managed exchange rates
in 1973.

¢ After the collapse of Bretton Woods, many banks incurred large

foreign currency losses.
 Origins of Capital regulations

¢ On 26th June 1974, West Germany’s Federal Banking Supervisory

Office withdrew Bankhaus Herstatt’s banking license after finding that
the bank’s foreign exchange exposures amounted to three times its
capital.

¢ Banks outside Germany took heavy losses on their unsettled trades

with Herstatt, adding an international dimension to the turmoil. In
October the Franklin National Bank of New York also closed its doors
after incurring large foreign exchange losses.

¢ The central bank governors of the G10 countries established a

Committee on Banking Regulations and Supervisory Practices at the
end of 1974. Later renamed it as Basel Committee on Banking
Supervision (BCBS).
 Basel Committee

¢ Committee was designed as a forum for regular cooperation between

its member countries on banking supervisory matters.

¢ It’s aim was and is to enhance financial stability by improving

supervisory know how and the quality of banking supervision
worldwide.

¢ Currently there are 28 member countries.

¢ Countries are represented on the Committee by their central bank and

also by the authority for the prudential supervision of banking
business.
 Basel I

¢ Capital adequacy became the main focus of the Committee’s

activities.

¢ Capital measurement system – ‘International Convergence of Capital

Measurements and Capital Standards’ commonly referred to as the
Basel Capital Accord (1988 Accord) was approved by the G10
Governors and released to banks in July 1988.

¢ The 1988 Accord called for a minimum capital ratio of capital to risk-
weighted assets of 8% to be implemented by the end of 1992.

¢ Focused mainly on the assessment of the quantity of credit risk -

created a cushion against credit risk.
 Basel – I: Four Pillars

¢ Constituents of Capital

¢ Risk weighting

¢ Target standard ratio

¢ Transitional & implementing arrangements

 ¢ Capital as per Basel accord, better known
as regulatory capital, is sum of Tier I and
Tier II capital.

¢ Tier I capital or core capital consists of

BASEL - I
elements that are more permanent in nature
and as a result, have high capacity to
absorb losses.

Pillar I: l This comprises of equity capital and

disclosed reserves.
Constituents of
Capital l Equity capital includes fully paid ordinary
equity/common shares and non-cumulative
perpetual preference capital.

l Disclosed/published reserves include post-

tax retained earnings.

l The accord requires Tier I capital to

constitute at least 50 percent of the total
capital base of the banking institution.
 ¢ Tier II capital is ambiguously defined as it
may also arise from difference in
accounting treatment in different countries.

¢ Tier II capital (supplementary capital) is

made up of a broad mix of near equity
BASEL - I
components and hybrid (capital/debt)
instruments.

l Upper Tier II comprises of items closer to

Pillar I: common equity, like perpetual subordinated
debt;
Constituents of
Capital l Lower Tier II comprises of items closer to
debt than of equity.

¢ The total of Tier II capital is limited to 100

per cent of Tier I capital.

¢ Tier III capital (additional supplementary

capital) was added in 1996 and can only be
used to meet capital requirements for
market risk.
 ¢ Some assets (i.e. loans) are riskier than others.
Each asset class can be assigned a risk weight
according to how risky it is judged to be.

¢ These weights are then applied to the bank’s

BASEL - I assets, resulting in risk-weighted assets (RWAs).

¢ Capital Adequacy Ratio (CAR) = Capital-to-risk

weighted assets ratio (CRAR) — measure of a
bank’s capital — It is the ratio of a bank's capital
in relation to its risk weighted assets.
Pillar II: Risk
e.g. Assuming a home mortgage has 50% of risk
Weighting ¢
weights. So if a bank has a portfolio of ₹100
crores home mortgage, then RWA for home
mortgage is ₹50 crores and if CAR IS 8%, then
the bank has to keep 50×.08= ₹4 crores as
capital for the home mortgage portfolio.

¢ The framework of weights was kept simple with

five weights used for on-balance sheet assets.
The risk weights include 0, 10, 20, 50 & 100% as
weights.
 Categories of assets Risk Weights

Cash and Government bonds of

BASEL - I 0%
OECD member

Claims on domestic public

10%
sector entities
Pillar II: Risk
Weighting Inter-bank loans to bank
headquartered in OECD 20%
member countries

Home mortgages 50%

Other loans 100%

Source : Basel I document

 ¢ Off-balance sheet elements - contingent
BASEL - I liabilities such as letters of credit,
guarantees and commitments, and Over-
The-Counter (OTC) derivative
instruments, were to be first converted to
a credit equivalent by multiplying the
Pillar II: Risk nominal principal amounts by a credit
Weighting conversion factor (CCF).

¢ The resulting amounts then being

weighted according to the nature of the
counterparty.
Instruments Credit Conversion
Factors (%)

Commitments with an original maturity of up to one year, or which can

0
be unconditionally cancelled at any time
Short-term self-liquidating trade-related contingencies (such as
shipments documentary credits collateralized by the underlying 20
shipments)
• Certain transaction-related contingent items (for example,
performance bonds, bid bonds, warranties and standby letters of
credit related to particular transactions)
50
• Note issuance facilities and revolving underwriting facilities
• Other commitments (for example, formal standby facilities and
credit lines) with an original maturity of over one year
• Direct credit substitutes, for example, general guarantees of
indebtedness (including standby letters of credit serving as
financial guarantees for loans and securities) and acceptances
(including endorsements with the character of acceptances)
• Sale and repurchase agreements and asset sales with recourse, 100
where the credit risk remains with the bank
• Forward asset purchases, forward deposits and partly-paid
shares and securities, which represent commitments with certain
drawdown
 ¢ The risk weighted method is favored over
a simple gearing ratio method due to the
following benefits:
BASEL - I
¢ Provides for a fair basis of comparison
between international banks with different
capital structures;

Pillar II: Risk ¢ Enables accountability of off-balance

Weighting sheet elements;

¢ Avoids discouraging banking institutions

to hold liquid and low risk assets to
manage capital adequacy.
 ¢ Banks to meet two minimum capital
BASEL - I ratios, both computed as a percentage of
the risk-weighted (both on- and off-
balance sheet) assets.

The minimum Tier I ratio was 4 per cent

Pillar III: Target ¢
of risk-weighted assets.
Standard Ratio
¢ Total capital (Tiers I & II) had to exceed 8
per cent of risk-weighted assets.
 BASEL - I ¢ Sets different stages of implementation of
the norms in a phased manner.

¢ Due to widespread undercapitalization of

Pillar IV: the banking community during that time, a
Transitional & phased manner of implementation was
Implementing agreed upon, wherein a target of 7.25
Arrangement percent was to be achieved by the end of
1990 and 8 percent by the end of 1992.
 Major principles of Basel Accord

¢ A bank must hold equity capital to at least 8 per cent of its risk-
weighted credit exposures as well as capital to cover market risks in the
bank’s trading account.

¢ When capital falls below this minimum requirement shareholders may be

permitted to retain control, provided that they recapitalize the bank to
meet the minimum capital ratio.

¢ If the shareholders fail to do so, the bank’s regulatory agency is

empowered to sell or liquidate the bank.
 Amendment in 1996

¢ Amended in January 1996 for providing an additional buffer for risk due to
fluctuations in prices, on account of trading activities carried out by the banks.

¢ Banks were permitted to use internal models to determine the additional quantum
of capital to be provided.

¢ Banks had to estimate value-at-risk (VAR) on account of its trading activities that
is the maximum quantum of loss the portfolio could suffer over the holding tenure
at a certain probability.

¢ The capital requirement is then set on the basis of higher of the following
estimate.

l Previous day’s Value-at-risk; and,

l Three times the average of the daily value-at-risk of the preceding sixty
business days
 Criticism of Basel I

¢ Basel I standards stems from the fact that they attempt to define and measure
bank portfolio risk categorically by placing different types of bank exposures into
separate ‘buckets’.
¢ Banks are then required to maintain minimum capital proportional to a weighted
sum of the amounts of assets in the various risk buckets.
¢ That approach incorrectly assumes that risks are identical within each bucket and
that the overall risk of a bank’s portfolio is equal to the sum of the risks across the
various buckets.
¢ Standards have not been able to meet one of the central objectives, viz., to make
the competitive playing field more even for international banks.
¢ ’One-size-fits-all’ – imposing same rules on all banks even within a country.
¢ Basel I encouraged transactions using securitization and off balance sheet
exposures.