BASEL GUIDELINES

P. Soumya
Faculty, IIBF

INDIAN INSTITUTE OF BANKING & FINANCE

BASEL-I, II and III

 Basel I- Brief Background,

 Basel II- Brief Background

 Basel III- Further Improvements

History….
 8 bank failures (or bankruptcies) in the US
 Highly leveraged banks
 Lending extensively
 Resulting into low security/capital
 German Herstatt Bank failure of 1974
 Central bank governors of G-10 countries established a committee
 First meeting took place in February 1975
 Aim of the Committee
 no bank would escape supervision
 supervision would be adequate and consistent across member jurisdictions


Basel I Accord
 1980’s faced the Latin American Debt crisis
 Capital ratios of main international banks deteriorated
 Strengthen capital to halt capital erosion
 Remove inequality arising from differences in national capital requirements
 Arrived at the weighted approach for both on and off banks’ balance sheets
 Capital measurement system was published in December 1987
 Approved by G-10 governors and released to banks in July 1988
 April 1996 – introduced market risk


Basel I – Risk Weights


Basel II

 Result of two triggers

 Banking crises of 1990s

 Limitations of Basel I
 Limited differentiation of credit risk
 No recognition of term structure of credit risk
 Simplified calculation of multi-country counterparty risk
 Non-recognition of portfolio diversification effects
 Static measure of default risk
Basel II
 Designed to

 Improve the way regulatory capital requirements reflect the underlying risks

 Address the financial innovation occurred in recent years

 Define new calculation for credit risk & market risk

 Introduce operational risk

Basel II
Comprises of three pillars



Basel II - approach


Need for Basel III
 Fundamental need to strengthen Basel II framework

 Too much leverage

 Inadequate liquidity buffers

 Poor governance & risk management

 Inappropriate incentive structures

 Mispricing of credit and liquidity risk

Need for Basel III
 Sub prime crisis of 2007-08

 Losses unabsorbed despite high capital adequacy ratios in books

 High leveraging in off balance sheet items/ over the counter (OTC) (not
through exchange )

 Derivatives disproportionate to their balance sheets

COMPARISON
Basel III – key points
 Released by BCBS (Basel Committee on Banking Supervision ) in Dec 2010
 Raise the standard of supervisory review process (Pillar II)
 Raise standards for disclosures (Pillar III)
 Address & prevent systemic risk due to spillover effect from the banking
system to real economy
 Identify Systemically Important Banks (SIBs) for special regulation as to
capital & other regulatory measures
 Improve overall risk sensitivity of banks to various risks
 Introduce measures to address market risks
 Regulators to exercise both micro prudential and macro prudential measures
to regulate banking/ financial systems
Domestic Systemically Important Banks
(D-SIBs)
 Banks perceived as ‘Too Big To Fail (TBTF)’

 RBI identified 3 banks as D SIBs

 SBI (Aug 2015), ICICI Bank (Aug 2016) & HDFC bank (Sep 2017)

 Place under 5 buckets from 1 to 5 depending on Systemic Importance Scores

(SIS)

 Based on the Bucket, place additional CET 1 (% of RWAs)

 Branch of a foreign bank which is considered as Global Systemically important

bank will also attract additional CET 1
Additional CET 1 requirement- DSIB

Bucket Additional CET 1 from April 2018 From April 2019

5 0.75% 1.00%
4 0.60% 0.80%
3 0.45% 0.60%
2 0.30% 0.40%
1 0.15% 0.20%
Basel III
 Banks to maintain capital for credit risk, operational risk & market risk
 Minimum total capital under Pillar I is 9% of Risk weighted assets
 Of which minimum Common Equity Tier I capital is 5.50% of RWA
 Additional Tier I to be 1.50% of RWA
 Tier II capital shall be 2.0% of RWA
 Tier I including Additional Tier I shall be 7% minimum
 Capital conservation buffer to be maximum of 2.5% of RWA. CCB to consist of
Common equity .
Capital Requirement
Basel III – improvement over Basel II
 Augmentation in the level and quality of capital

 Introduction of liquidity standards

 Modifications in provisioning norms

 Better and more comprehensive disclosures

Basel III
 Revolves around two sets of compliance

Capital Liquidity
Liquidity Coverage
Tier 1 (CET1 + AT1)
Ratio (LCR)

Capital Conservation Buffer

Net Stable Funding Ratio (NSFR)
(CCB)

Tier 2 capital Leverage Ratio

Countercyclical Capital
Conservation Buffer (CCCB)
Tier 1 vs Tier 2

Tier 1 Capital Tier 2 Capital

• Going concern • Gone concern

• Absorb losses • Absorb losses at

without triggering the time of
bankruptcy liquidation
Common Equity Tier 1 (CET1)
 COMPONENTS
 Equity Capital
 Share premium
 Free General Reserves
 Statutory reserves
 Capital reserves
 Revaluation reserves @ 55%
 Credit balance in P&L of last year
 P&L of current year provided NPA provisions in 4 quarters of last FY is not
more than 25% of average of such 4 quarter

Exclusions Common Equity Tier I
 Good will

 Intangible assets

 Deferred tax assets (DTA) associated with accumulated losses

 Other DTA net of DTL

 Cash flow hedge reserve

Additional Tier 1 Capital (AT1)
 Has a loss absorbing capacity
 Hybrid in nature i.e. both equity & bonds

 COMPONENTS
 Perpetual Non Cumulative Preference Shares (PNCPS)

 Premium on issue of such shares

 Perpetual Debt capital instruments

 Any other instruments notified by RBI

Tier 2 Capital

 COMPONENTS
 General provisions & loss reserves
 Provisions on standard assets , floating provisions
 Incremental provisions in respect of unhedged forex exposures
 Provision for country exposure
 Investment reserve account
 Excess provision on sale of NPA accounts
 Debt capital instrument issued by banks
 Countercylical Capital Conservation Buffer
Tier 2 Capital
 Perpetual cumulative preference shares (PCPS)

 Redeemable Non cumulative preference shares (RNCPS)

 Redeemable cumulative preference shares (RCPS)

 Share premium on issue of these instruments

 Any other instrument notified by RBI as eligible for Tier II capital

Capital Conservation Buffer
 Build buffers during normal times

 Strengthen ability to withstand adverse economic conditions

 To be utilised in times of financial stress

 Built out of Common Equity Tier I

 Prescribes buffer of 2.5% above the minimum capital (0.625% in phases)

 When drawn down,

 enforces constraints on distribution of earnings
 Have a definite plan to replenish the buffer
Countercylical Capital Conservation Buffer
 Addresses the systemic risk

 Macro-economic environment in which the banks operate

 Enacted by national authorities

 Two fold effect

 Build capital in good times
 Restrict lending in times of excess credit growth

 Subject to capital of 0 to 2.5% of total risk weighted assets

 Two thresholds with respect to credit-to-GDP gap

Countercyclical Capital Conservation Buffer
 Based on following
 Credit to GDP Gap 3-15 % variation
 GNPA Growth
 Incremental CD Growth – moving for 3 years
 Industry outlook assessment index
 Interest Coverage Ratio

 Credit to GDP Ratio - Ratio of Public debt to GDP

 Credit to GDP Gap – difference between Credit to GDP ratio and its long
term trends.

 Credit growth implies potential financial distress

Liquidity Coverage Ratio
 Objective to promote resilience of short term liquidity

 To make sufficient investment in short term High Quality Liquid Assets

(HQLA)

 Quickly and easily convertible into cash

 Sustain financial stress for 30 days period

 LCR = Stock of HQLA > 100%

 Total net cash outflows over the next 30 days

 Minimum LCR by January 1, 2019 – 100%

Liquidity Coverage Ratio
 It is like the current ratio of a borrower.

 Two categories of HQLA

 Level 1 – Cash reserves above CRR; Govt. securities in excess of SLR; Within
SLR securities allowed to the extent under MSF by RBI

 Level 2 – Not more than 40% of the overall HQLA

 Level 2 comprises of
 2A Assets – claims guaranteed by sovereigns; Corporate Bonds & Commercial
Papers not issued by Banks/PDs/Fis

 2B Assets – Not more than 15% of the total stock of HQLA; haircut of 50% to
be applied on the market value of each Level 2B stock held; Marketable
securities; Common Equity Shares

Net Stable Funding Ratio
 Objective to deter reliance on short term means of finance

 Finance through stable sources on an ongoing basis

 Long term assets acquired through stable and risk less liabilities

 A time horizon of 1 year

 NSFR address the medium term (1year) liquidity mismatches faced by

bank.

 NSFR = Amount available of stable funding > 100%

 Required amount of stable funding
Leverage Ratio
 Banks portrayed healthy capital adequacy ratios

 Overuse of on and off balance sheet seen in the financial crisis

 Created to act as a supplement for capital requirement

 Non-risk based ratio as figures are from the balance sheet itself
(banking book)

 Leverage Ratio = Tier 1 Capital > 3%

 Total Exposure
Leverage Ratio
 Presently RBI has stipulated the ratio at 4.5%

 To be maintained on quarterly basis

 To be implemented in phase wise manner until 2019

ICAAP
 Bank’s internal process
 Assessing capital adequacy
 Relation to its risk profile
 Strategy for maintaining capital levels
 Complete Enterprise Risk Management (ERM) framework
 Brings together risk and capital management
 Should be bank specific and bank driven
 Cannot be avoided even if large capital buffers available
 Signals credibility
ICAAP - features
 ICAAP to be part of management & decision making culture of the bank
 Sound and comprehensive capital assessment
 Identifying, measuring, monitoring & reporting risks
 Independent review & validation at periodical intervals
 It should be forward looking
 Should include stress tests and scenario analysis
 Use of marketing/statistical models to be used for prediction
 As part of risk management apparatus every bank should put in place ICAAP
(Internal Capital Adequacy Assessment Process) as an on going process to
assess, measure, factor the risks they undertake and the capital they need
to maintain at all times. As part of SREP, RBI will evaluate the effectiveness
of ICAAP system in the bank
ICAAP Report
 Should have the following sections
 Executive Summary
 Background
 Structure and Governance
 Statement of Risk Appetite
 Enterprise Risk Framework
 Capital Planning
 Liquidity Planning
 Stress Testing & Scenario Analysis
 Integration, Review & Approval
RESIDUAL RISKS
 Basel III also advises banks to factor in & capture other residual risks (other than credit,
Operational & market risk ) like
 Interest rate risk in the banking book;
 Credit concentration risk
 Liquidity risk
 Settlement risk
 Reputational risk
 Strategic risk
 Pension Risk
 Systemic risk
 Legal Risk
 Risk of under-estimation of credit risk under the Standardised approach
 Model risk i.e., the risk of under-estimation of credit risk under the IRB approaches
 Risk of weakness in the credit-risk mitigants
 Residual risk of securitisation, etc.
Market Discipline
 Purpose to complement the minimum capital requirements and the
supervisory review process

 Help assess key pieces of information on the scope of application, capital,

risk exposures, risk assessments etc.

 Required to make disclosures on half yearly basis even if financial

statements are not audited

 Following to be made on a quarterly basis

 Capital Adequacy
 Credit Risk: Disclosures for All Banks
 Credit Risk: Disclosures for Portfolios subject to Standardised Approach
Market Discipline
 Guiding principles for disclosures

 Principle 1 – should be clear

 Principle 2 – should be comprehensive

 Principle 3 – should be meaningful to users

 Principle 4 – should be consistent over time

 Principle 5 – should be comparable across banks

At a glance…..
Basel 1 Basel 2 Basel 3
Introduction 1988 & 1996 2004 2010
Risks Covered Credit Risk Credit Risk Credit Risk
Market Risk Market Risk Market Risk
Operational Risk Operational Risk
Liquidity Risk
Tools Capital to Risk CRAR CRAR
Weighted Supervisory Review Supervisory Review
Assets Ratio Market Discipline Market Discipline
(CRAR) CCB
CCCB
LCR
NSFR
Leverage Ratio
Minimum CRAR = 9% CRAR = 9% CRAR = 11.5%
Ratio (RBI) Tier 1 = 6% Tier 1 = 7%