Basel Committee

 BASEL Committee on Banking Supervision was established by Central-Banks

of G-10 countries in 1974.
 Committee today consists of central bankers and supervisory regulators
from 13 countries.
 The Committee was established to facilitate information sharing and
cooperation among bank regulators in major countries.
 The Basel Committee on Banking Supervision provides a forum for regular
cooperation on banking supervisory matters.
 Its objective is to enhance understanding of key supervisory issues and
improve the quality of banking supervision worldwide.
 At times, the Committee uses this common understanding to develop
guidelines and supervisory standards in areas where they are considered
desirable.
 The Committee's work is organised under four main sub-committees:
1. Standards Implementation Group (SIG)
2. Policy Development Group (PDG)
3. Accounting Task Force (ATF)
4. International Liaison Group (ILG)

1. Standards Implementation Group (SIG) : The Standards Implementation

Group (SIG) was originally established to share information and promote
consistency in implementation of the Basel II Framework. In January 2009,
its mandate was broadened to concentrate on implementation of Basel
Committee guidance and standards more generally.
2. Policy Development Group (PDG): The primary objective of the Policy
Development Group (PDG) is to support the Committee by identifying and
reviewing emerging supervisory issues.
3. Accounting Task Force (ATF): The Accounting Task Force (ATF)  works to
help ensure that international accounting and auditing standards and
practices promote sound risk management at financial institutions, support
market discipline through transparency.
4. International Liaison Group (ILG): The International Liaison Group (ILG) 
provides a forum for deepening the Committee's engagement with
supervisors around the world on a broader range of issues.

Basel I

 In 1988, the BASEL Committee on Banking Supervision introduced global

standards for regulating the capital adequacy of banks.
 Basel I, that is, the 1988 Basel Accord, primarily focused on credit risk.
 The main objective of Basel I was to set minimum capital standards for
Bank, adequate supervision and no internationally active bank should
escape supervision.
 The Reason for the Accord was to create a level playing field for
internationally active banks that is Banks from different countries
competing for the same loans would have to set aside roughly the same
amount of capital on the loans.
 Capital was set at 8% and was adjusted by a loan’s credit risk weight
 Credit risk was divided into 5 categories: 0%, 10%, 20%, 50%, and 100%
 To calculate required capital, a bank would multiply the assets in each risk
category by the category’s risk weight and then multiply the result by 8%
 For example, for a $100 commercial loan, a bank would have to first
multiply it by 100% and then by 8%, resulting in a capital requirement of $8
 The original accord, was quite simple and adopted a straight-forward
approach that does not distinguish between the differing risk profiles and
risk management standards across banks.
BASEL II

Basel II is the second of the Basel Accords, which are recommendations on

banking laws and regulations issued by the Basel Committee on Banking
Supervision. Basel II was signed in June 2004 at Bank for International settlement
located at Basel, Switzerland.

It is an improvement over Basel I which had certain deficiencies which have now
been removed. Basel II is based on three pillars:
Capital Adequacy, Supervisory review and Market discipline.

The purpose of Basel II, which was initially published in June 2004, is to create an
international standard that banking regulators can use when creating regulations
about how much capital banks need to put aside to guard against the types of
financial and operational risks banks face. These rules mean that the greater risk
to which the bank is exposed, the greater the amount of capital the bank needs to
hold to safeguard its solvency and overall economic stability. In November 2005,
the Committee issued an updated version of the revised Framework incorporating
the additional guidance set forth in the Committee's paper The Application of
Basel II to Trading Activities and the Treatment of Double Default Effects.

On 4 July 2006, the Committee issued a comprehensive version of the Basel II

Framework. On 16th January, 2009, the Basel Committee announced a series of
proposals to enhance the Basel II framework.
The final version aims at:
 Ensuring that capital allocation is more risk sensitive;
 Separating operational risk from credit risk, and quantifying both;
 Guidelines for computing capital for incremental risk;
 Attempting to align economic and regulatory capital more closely to reduce
 The scope for regulatory arbitrage.
BASEL II - THE THREE PILLARS

 While Basel I framework was confined to the prescription of only

minimum capital requirements for banks, the Basel II framework
expands this approach not only to capture certain additional risks in the
minimum capital ratio but also includes two additional areas, viz.
Supervisory Review Process and Market Discipline through increased
disclosure requirements for banks. Thus, Basel II framework rests on the
following three mutually- reinforcing pillars:

Pillar 1: Minimum Capital Requirements — prescribes a risk-sensitive

calculation of capital requirements that, for the first time, explicitly
includes operational risk along with market and credit risk.

Pillar 2: Supervisory Review Process — envisages the establishment of

suitable risk management systems in banks and their review by the
supervisory authority.

Pillar 3: Market Discipline and Disclosures — seeks to achieve increased

transparency through expanded disclosure requirements for banks .

PILLAR 1: MINIMUM CAPITAL REQUIREMENTS

 Pillar 1 offers distinct options for computing capital requirements for

"Credit Risk", "Operational Risk" and "Market Risk".

Credit Risk:

 Pillar 1 stipulates the following options for assigning capital to meet

credit risk:

 1. Standardised Approach

 2. Internal Rating Based (IRB) Approach

 3. Advanced IRB Approach.

 1. Standardised Approach:

 Banks may use external credit ratings by institutions recognized for the
purpose by the central bank for determining the risk weight. Exposure
on sovereigns and their central banks could vary from zero percent to
150 percent depending on credit assessment from ‘AAA’ to below B- .
Similarly, exposure on public sector entities, multilateral development
banks, other banks, securities firms and corporates also may have risk
weights from 20 percent to 150 percent. Exposure on retail portfolio
may carry risk weight of 75 percent.

 While Basel II stipulates minimum capital requirement of 8 percent on

risk weighted assets, India has prescribed 9 percent. Under Basel II
exposure on a corporate with ‘AAA’ rating will have a risk weight of only
20 percent. This implies that for Rs. 100 crore exposure on a ‘AAA’ rated
corporate the capital adequacy will be only Rs.1.8 crore (100 x 20% x
9%) compared to the earlier requirement of Rs. 9 crore. However, claims
on a corporate with below BB- rating will carry a risk weight of 150
percent and the capital requirement will be Rs.13.50 crore (100 x 150% x
9%). Thus, a bank with a credit portfolio with superior rating may be
able to save capital while banks having lower rated credit exposure will
have to mobilize more capital. Risk weights can go beyond 150 percent
in respect of exposures with low rating. For example, securitisation
tranches with rating between BB+ and BB- may carry risk weight of 350
percent. In order to adopt standardized approach, banks will have to
encourage their corporate customers to go in for ‘obligor (borrower)
rating’ and get themselves rated. The central bank has to accredit
External Credit Assessment Institutions (ECAI) who satisfies defined
 criteria of objectivity, independence, international access, transparency,
disclosure, resources and credibility.

 2. Internal Ratings Based (IRB) Approach:

 It is also called Foundation Internal ratings Based Approach. Banks,

which have developed reliable Management Information System (MIS)
and have received the approval of the central bank, can use the IRB
approach to measure credit risk on their own. The bank should have
reliable data on Probability of Default (PD), Loss Given Default (LGD),
Exposure at Default (EAD) and effective Maturity (M) to make use of IRB
approach. Minimum requirements to adopt the IRB approach are:

 1. Bank’s overall Credit Risk management practices must be consistent

with the sound practice guidelines issued by the Basel committee and
the National Supervisor.

 2. Rating dimensions to include both Borrower Rating and Facility Rating

and has to be applied to all asset classes.

 3. The Rating Structure adopted need to have minimum 7 grades of

performing borrowers and a minimum 1 Grade of non-performing
borrowers and Enough grades to avoid undue concentrations of
borrowers in particular grades.

 4. Criteria of Rating Systems to be documented and have the ability to

differentiate risk, predictive and discriminatory power.

 5. Assessment Horizon for PD estimation to be 1 year.

  6. Use of models to be coupled with the use of human judgement and
oversight.

 7. Rating Assignment and Rating Confirmation to be independent.

 8. The PD to be a long run average over an entire economic cycle (at

least 5 years)

 9. Banks should have confidence in the robustness of PD estimates and

the underlying statistical analysis.

 10. Data collection and IT systems to improve the predictive power of

rating systems and PD estimates.

 11. Validation of internal Rating systems/ Models by the Supervisor.

 12. Streamlining use of credit risk mitigants and ensuring legal certainty
of executed documents.

 3. Advanced Internal Rating Based (IRB) Approach:

 Under foundation approach banks provide more of their own estimates

of Probability of Default (PD) and rely on supervisory estimates for other
risk components. In the case of advanced approach banks provide more
of their own estimate of Loss Given Default (LGD), Exposure at Default
(EAD) and effective Maturity (M), subject to meeting minimum
stipulated standards.

PILLAR 2: SUPERVISORY REVIEW PROCESS

  Compliance of requirements under Pillar 1 and providing adequate
capital alone may not be enough to prevent bank failures and to protect
the interests of depositors. Therefore, under Pillar 2 which deals with
key principles of supervisory review, risk management guidance and
supervisory transparency and accountability with respect to banking
risks, including guidance relating to the treatment of interest rate risk in
the banking book, credit risk (stress testing, definition of default,
residual risk and credit concentration risk), operational risk, enhanced
cross border communication and co-operation and securitisation,
supervisors are expected to evaluate how well banks are assessing their
capital needs relative to their risks and to intervene where appropriate.
This interaction is intended to foster an active dialogue between banks
and supervisors so that when deficiencies are identified, prompt and
decisive action can be taken to reduce risk or restore capital. Supervisors
may focus more intensely on banks with risk profiles or operational
experience, which warrants such attention.

There are the following four main areas to be treated under Pillar 2:

1. Risks considered under Pillar 1 that are not fully captured by Pillar 1
process (e.g credit concentration risk);
2. Those factors not taken into account by Pillar 1 process (e.g. interest
rate risk in the banking book, business and strategic risk).
3. Factors external to the bank (e.g. business cycle effects).
4. Assessment of compliance with minimum standards and disclosure
requirements of the more advanced methods under Pillar 1.

 Supervisors have to ensure that these requirements are being met both
as qualifying criteria and on a continuing basis.

 The four key principles of supervisory review are:

Principle 1:
  Banks should have a process for assessing their overall capital adequacy
in relation to their risk profile and a strategy for maintaining their capital
levels.

The five main features of a rigorous process are as follows:

1. Board and senior management oversight;

2. Sound capital assessment;
3. Comprehensive assessment of risks;
4. Monitoring and reporting; and
5. Internal control review.

Principle 2:

 Supervisors should review and evaluate banks’ internal capital adequacy

assessments and strategies, as well as their ability to monitor and
ensure their compliance with regulatory capital ratios. Supervisors
should take appropriate supervisory action if they are not satisfied with
the result of this process.

Principle 3:

 Supervisors should expect banks to operate above the minimum

regulatory capital ratios and should have the ability to require banks to
hold capital in excess of the minimum.

Principle 4:

 Supervisors should seek to intervene at an early stage to prevent capital

from falling below the minimum levels required to support the risk
characteristics of a particular bank and should require rapid remedial
action if capital is not maintained or restored.
  Reserve Bank of India has implemented the risk-based supervision and
has made a good beginning in implementation of the guidelines under
Pillar 2. Internal inspections of banks in India are also tuned more
towards risk-based audit.

PILLAR 3: MARKET DISCIPLINE AND DISCLOSURES

 Disclosure requirements are stipulated for banks to encourage market

discipline. This will help the market participants to assess the
information on capital, risk exposures, risk assessment processes and
capital adequacy of the bank. Such disclosures are more important in
the case of banks, which are permitted to rely on internal
methodologies giving them more discretion in assessing capital
requirements. Market discipline supplements regulation as sharing of
information facilitates assessment of the bank by others including
investors, analysts, customers, other banks and rating agencies. It also
leads to good corporate governance.

 Supervisors can stipulate the minimum disclosures to be made by banks.

Banks can also have Board approved policies on disclosure. A
transparent organization may create more confidence in the investors,
customers and counter parties with whom the bank has dealings. It
would also be easier for such banks to attract more capital.

TRANSITION FROM BASEL I TO BASEL II

 Basel I concentrated on credit risk alone being the biggest risk a bank
assumes and arising out of its lending/investment operations. It
prescribed risk weights for different loan assets essentially on the basis
of security available after classifying the assets as standard or non-
standard on the basis of payment record. Basel I did not draw a
distinction for the purpose of capital allocation between loan assets
 based on the intrinsic risk in lending to individual counterparties.
Security in the form of tangible assets and/or guarantees from
governments/banks is the sole distinguishing factor. Credit extended on
secured basis to a small-scale unit and to a large corporate was put in
the same category in so far as minimum capital requirement was
concerned. The higher probability of default in respect of a loan to, say,
a proprietorship compared to the large professionally managed
corporate did not get reflected in the capital requirement.

 Basel II addresses this issue by factoring in the differential risk factor in

loans made to different types of businesses, entities, markets,
geographies, and so on, and allowing banks to have different levels of
minimum capital taking into account intrinsic riskiness of the exposure.
Three methods, increasing in sophistication, for assessing credit risks
have been recommended for adoption. Assets are to be risk weighted
based on a rational approach cleared in advance by the regulator and
then aggregated to arrive at the minimum capital requirement. Higher
the risk, higher the weightage, and more the capital allocation required.
In the proposed scheme of things, weak credits can carry a weightage of
up to 150 per cent.

 The objective of the recommendation of Basel II on credit risk is that

banks should be more risk-sensitive than hitherto in their
lending/investment activity and derive the benefit from lesser capital
engagement for high quality credit risks. In addition to credit risk, Basel
II recognizes the operational risks arising out of the day-to-day running
of banks in the form of service quality shortcomings, non-adherence to
policy and procedures, staff malfeasances, and so on, the capital charge
for which is linked to operational income through a multiplier to be
given by the regulator based on its assessment of the quality of banks
operational instructions, style of functioning, control of top
management and audit quality.
Capital Adequacy Ratio
The Committee on Banking Regulations and Supervisory Practices (Basel
Committee) had released the guidelines on capital measures and capital
standards in July 1988 which were been accepted by Central Banks in
various countries including RBI. In India it has been implemented by RBI
w.e.f. 1.4.92

Objectives of CAR : The fundamental objective behind the norms is to

strengthen the soundness and stability of the banking system.

Capital Adequacy Ratio or CAR or CRAR : It is ratio of capital fund to

risk weighted assets expressed in percentage terms i.e.

Minimum requirements of capital fund in India:

* Existing Banks 09 %
* New Private Sector Banks 10 %
* Banks undertaking Insurance business 10 %
* Local Area Banks 15%

Tier I Capital should at no point of time be less than 50% of the total
capital. This implies that Tier II cannot be more than 50% of the total
capital.

Capital fund

Capital Fund has two tiers –

Tier I capital include

*paid-up capital
*statutory reserves
*other disclosed free reserves
*capital reserves representing surplus arising out of sale proceeds of assets.
Minus
*equity investments in subsidiaries,
*intangible assets, and
*losses in the current period and those brought forward from previous periods
to work out the Tier I capital.

Tier II capital consists of:

*Un-disclosed reserves and cumulative perpetual preference shares:
*Revaluation Reserves (at a discount of 55 percent while determining their value
for inclusion in Tier II capital)
*General Provisions and Loss Reserves upto a maximum of 1.25% of weighted risk
assets:
*Investment fluctuation reserve not subject to 1.25% restriction
*Hybrid debt capital Instruments (say bonds):
*Subordinated debt (long term unsecured loans:

Risk weighted assets - Fund Based : Risk weighted assets mean fund based
assets such as cash, loans, investments and other assets. Degrees of credit risk
expressed as percentage weights have been assigned by RBI to each such assets.

Non-funded (Off-Balance sheet) Items : The credit risk exposure attached

to off-balance sheet items has to be first calculated by multiplying the face
amount of each of the off-balance sheet items by the credit conversion factor.
This will then have to be again multiplied by the relevant weightage.

Reporting requirements :
Banks are also required to disclose in their balance sheet the quantum of Tier I
and Tier II capital fund, under disclosure norms.
An annual return has to be submitted by each bank indicating capital funds,
conversion of off-balance sheet/non-funded exposures, calculation of risk
-weighted assets, and calculations of capital to risk assets ratio

BASEL II TO INDIA

The Basel I recommendations on minimum capital requirement were

accepted by most countries for adoption by the banks operating within their
boundaries. In India, too, a Minimum Required Capital (MRC) was accepted and a
timetable prescribed for banks to exceed the minimum capital requirement
prescribed by the Basel Committee. Today, banks in India take pride in indicating
in their balance sheets the extent to which they exceed the minimum Capital
Adequacy Requirement (CAR). Banks in India also adopted the asset classification
and provisioning norms prescribed by the Basel Committee and as directed by the
Reserve Bank of India. The general belief now is that the commercial banks'
balance sheets are comparable with most of the banks in the developing world
and many in the developed world too.

Though not mandatory for non Basel II countries including India, majority of
them are also going to implement Basel II. Some great opportunities for India are
coming out of Basel II implementation. These opportunities can be classified in
two categories - Banking and Non - Banking. With second highest growth rate in
the world and huge scientific and general work force, India is now well recognized
as one of the fast emerging nations in the world. Goldman Sachs and many other
research reports have predicted a robust growth of Indian economy in the coming
decades. A sound and evolved banking system would be a prime requirement to
support the hectic and enhanced levels of domestic and international economic
activities in the country.

Though India is credited with a very strong banking system, in comparison

to many peer group countries, still some better risk practices by Indian banks are
required. The majority of Indian banks are either nascent or at a very low level of
competence in all, Credit, Market and Operational risk measurement and
management system. They are lagging behind in the use of modern risk
methodologies and tools in comparison to their western counterparts. Economic
reforms, higher market dynamics and large-scale globalization demand a robust
Risk Management System in the Indian banks. The current level of Risk Based
Supervision and Market disclosures are also not very satisfactory in the Indian
Banking system. This is more evident from the recent problems in one well-known
private sector bank and in some co-operative banks. Basel II gives an opportunity
and a framework for improvement to the Indian banks. A Basel II compliant
banking system will further enhance the image of India in the League of Nations.
The country rating of India will surely improve, and consequently facilitate a
higher capital inflow in the country. This will tremendously help India to move on
the higher growth trajectory in the coming decades.

The explanation why countries such as India are eager to adopt the new
framework perhaps lies in the Basel II authors' contention that "by motivating
banks to upgrade and improve their risk management systems, business models,
capital strategies and disclosure standards, the Basel II framework should improve
their overall efficiency and resilience." Even Basel I was originally meant for
internationally active banks in the G-10 countries but it was soon accepted
universally as a benchmark measure of a bank's solvency and was, subsequently,
adopted in some form by more than 100 countries.
 Introduction of Basel I coincided with the initiation of financial reforms in
India in the early 1990s. The prudential norms set out by Basel I came as a timely
solution to the ills affecting the Indian banks, particularly the public sector banks
(PSBs) after two decades of nationalization. That these banks despite the
differences in their strengths and weaknesses could switch over to the
international standards without much hiccups has surprised many a critic.

There was so much talk of weak banks, merger of banks, and closure of
overseas branches and so on when the reforms began. But the same banks in
question are now posting impressive profits year after year, opening new
overseas branches and are even looking for banks to take over. Evidently, it is this
successful switchover that has made the country eager to adopt the Basel II
framework as well.

SCOPE OF BASEL II IN BANKS

 To the greatest extent possible, all banking and other relevant

financial activities (Both regulated and unregulated) conducted
within a group containing an internationally active bank will be
captured through consolidation. Thus, majority-owned or –controlled
banking entities, securities entities (where subject to broadly similar
regulation or where securities activities are deemed banking
activities) and other financial entities should generally be fully
consolidated.

 Supervisors will assess the appropriateness of recognising in

consolidated capital the minority interests that arise from the
consolidation of less than wholly owned banking, securities or other
financial entities. Supervisors will adjust the amount of such minority
interests that may be included in capital in the event the capital from
such minority interests is not readily available to other group entities.
 There may be instances where it is not feasible or desirable to
consolidate certain securities or other regulated financial entities.
This would be only in cases where such holdings are acquired
through debt previously contracted and held on a temporary basis,
are subject to different regulation, or where non-consolidation for
regulatory capital purposes is otherwise required by law. In such
cases, it is imperative for the bank supervisor to obtain sufficient
information from supervisors responsible for such entities.

 If any majority-owned securities and other financial subsidiaries are

not consolidated for capital purposes, all equity and other regulatory
capital investments in those entities attributable to the group will be
deducted, and the assets and liabilities, as well as third-party capital
investments in the subsidiary will be removed from the bank’s
balance sheet.

 Supervisors will ensure that the entity that is not consolidated and
for which the capital investment is deducted meets regulatory capital
requirements. Supervisors will monitor actions taken by the
subsidiary to correct any capital shortfall and, if it is not corrected in
a timely manner, the shortfall will also be deducted from the parent
bank’s capital.

 Significant minority investments in banking, securities and other

financial entities, where control does not exist, will be excluded from
the banking group’s capital by deduction of the equity and other
regulatory investments. Alternatively, such investments might be,
under certain conditions, consolidated on a pro rata basis. For
example, pro rata consolidation may be appropriate for joint
ventures or where the supervisor is satisfied that the parent is legally
or de facto expected to support the entity on a proportionate basis
only and the other significant shareholders have the means and the
willingness to proportionately support it. The threshold above which
 minority investments will be deemed significant and be thus either
deducted or consolidated on a pro-rata basis is to be determined by
national accounting and/or regulatory practices.

 The Committee reaffirms the view set out in the 1988 Accord that
reciprocal crossholdings of bank capital artificially designed to inflate
the capital position of banks will be deducted for capital adequacy
purposes.

Conclusion

Undoubtedly, Basel II introduces a vastly more sophisticated and risk sensitive

framework.  There is even a school of thought that, had Basel II been fully
implemented a few years ago, at the height of the credit "boom", the current
"crunch" may have been less severe.  Nevertheless, we can expect to see
increased regulation (possibly in the form of refinements to Basel II) as
governments and regulators respond to current market turmoil.

Basel II is an international Accord which is implemented India by all the

internationally active banks this will change the entire banking scenario. The norm
is very complex and it is recently implemented due to which entire data could not
be collected.

 Basel II will improve risk management exercise in Banks.

 State Bank of India will get international standard for adopting Basel II.

 All the areas of risks have been taken care.

 Some additional Capital is required.