Basel I To Basel III: A Journey in Risk Management in Banks: Presented by Prof. Debajyoti Ghosh Roy

Basel I to Basel III: A Journey in Risk Management in Banks
Presented by Prof. Debajyoti Ghosh Roy

MSc. (Physics), CAIIB, DBM, CAIB (U.K.)
Adjunct Professor, Symbiosis School of Banking Management, Pune.
1/4/2014
What is the Basel Committee?

Established at the end of 1974 by Central Bank Governors of G10 to address crossborder banking issues Reports to G10 Governors/Heads of Supervision

Members are senior bank supervisors from G10, Luxembourg and Spain Work undertaken through several working groups
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Outreach to other countries

Committee started as a closed shop Over time, has developed close ties with nonmembers
Committee tries to address issues relevant for all jurisdictions worldwide

Core Principles Liaison Group (16 non-Committee jurisdictionsincluding Indiaplus IMF, World Bank) Working Group on Capital Regional groups
International Conference of Banking Supervisors (ICBS)

Participation in work of the Secretariat
Training, speeches, consultation

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The three Cs
Concordat (and subsequent papers
dealing with cross-border supervision)

Core Principles for Effective Banking
Supervision
Capital Adequacy Framework
Many other topics: risk management, corporate governance, accounting, money laundering, etc, on the Committees website (www.bis.org/bcbs)
1/4/2014 Basel I to Basel III: A Journey in Risk Management in Banks 4
Basel I Accord: International Convergence of Capital Measurements and Capital Standards

Purpose and content of Basel I standards Events and circumstances in the 1970s and 1980s (increased volatility on financial markets, deregulation, globalization, innovative instruments, debt crises) which resulted in the erosion of the capital base of large banks around the world, motivated the BCBS to create and publish in 1988 the first international agreement on capital requirements for the banks (Basel Capital Accord), known as Basel I. The purpose of Basel I standards was to introduce a uniform way of calculating capital adequacy in order to strengthen Basel I tofinancial Basel III: A Journey in Risk 1/4/2014 Management in Banks 5 stability.
Basel I Accord
Purpose and content of Basel I standards (Contd.) Basel I defines elements of bank capital, weighting factors for calculating credit risk for balance sheet items (weighted average risk factors: 0%, 20%, 50% and 100%) and credit conversion factors for off-balance items (after which appropriate risk weighting factors are applied), as well as ratio between the capital and total exposure of the bank (balance and off-balance) risk weighted in order to calculate the capital adequacy indicators. The capital adequacy indicator of a bank, calculated in this way, should be at least 8%. Basel I to Basel III: A Journey in Risk
1/4/2014 Management in Banks 6
Basel I Accord
1988 Capital Accord established minimum capital requirements for banks Minimum ratio:
Capital 8% Risk weighted assets
In 1998, Committee started revising the 1988 Accord: More risk sensitive More consistent with current best practice in banks risk management Numerator (definition of capital) remains unchanged Basel I to Basel III: A Journey in Risk
Basel I Accord: 3 Pillars
Pillar I: The Constituents of Capital (Tier I and Tier 2 Capital) Pillar 2: Risk Weighting, creates a comprehensive system to risk weight a banks assets, or in other words, its loan book. Five risk categories encompass all assets on a banks balance sheet. Pillar 3: A Target Standard Ratio, unites the first and second pillars of the Basel I Accord. It sets a universal standard whereby 8% of a banks risk-weighted assets must be covered by Tier 1 and Tier 2 capital reserves. Transitional and Implementing Agreements, sets the stage for the implementation of the Basel Accords.
Basel I Accord
Advantages and positive effects of implementation of Basel I standards: Substantial increases in capital adequacy ratios of internationally active banks; Relatively simple structure; Worldwide adoption;
Increased competitive equality among internationally active banks;

Greater discipline in managing capital;
A benchmark for assessment by market participants.

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Basel I Accord

Weaknesses of Basel I standards In spite of advantages and positive effects, weaknesses of Basel I standards eventually became evident:
Capital adequacy depends on credit risk, while other risks (e.g. market and operational) are excluded from the analysis; In credit risk assessment there is no difference between debtors of different credit quality and rating; Emphasis is on book values and not market values; Inadequate assessment of risks and effects of the use of new financial instruments, as well as risk mitigation techniques. Basel I to Basel III: A Journey in Risk
Basel I Accord
The most important amendments to Basel I standards Some of the weaknesses of Basel I, especially those related to market risk, were over bridged by the amendment to recommendations from 1993 and 1996, by means of introducing capital requirements for market risk and a new instrument for the assessment of banks market risk VaR (Value at Risk). Capital 8 % Risk weighted exposures (credit and market risks)
Basel II Accord
In 1998, Committee started revising the 1988 Accord: International Convergence of Capital Measurement and Capital Standards: More risk sensitive More consistent with current best practice in banks risk management Numerator (definition of capital) remains unchanged. Basel II provides Banks incentives to Banks invest and increase sophistication of their internal risk management capabilities to gain reduction in capital. Greater Disclosure by Banks. Follow certain standards of market discipline. Basel I to Basel III: A Journey in Risk
What are the basic aims of Basel II? of capital in relation To deliver a prudent amount
to risk To provide the right incentives for sound risk management To maintain a reasonable level playing field
Basel II is not intended to be neutral between different banks/different exposures However, there is a desire not to change the overall amount of capital in the system
Three pillars of the Basel II framework
Minimum Capital Requirements

Credit risk Operational risk Market risk
Supervisory Review Process
Market Discipline
Enhanced disclosure
Evaluate Risk Assessment.

Banks own capital strategy. Supervisors review. Ensure soundness and integrity of banks internal processes to assess the adequacy of capital. Ensure maintenance of minimum capital Prescribe differential capital where internal 1/4/2014 controls are slack.
Core disclosures and supplementary disclosures.
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The Three Pillars

All three pillars together are intended to achieve a level of capital commensurate with a banks overall risk profile.
Tier I capital and Tier II capital.
Core and supplementary capital. Limits on components of capital.
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Banks Typically face Three Kinds of Major Risks

Type of Risk Example
Market
Risk of loss due to unexpected re-pricing of assets owned by the bank, caused by either Exchange rate fluctuation Interest rate fluctuations Market price of investment fluctuations

Daily price change (%)
Stocks
Unexpected price volatility

Time Default rate (%)
Loans with credit rating 3

Unexpected default Avg. default
Credit
Risk of loss due to unexpected borrower default

Monthly change of revenue to cost (%)
Time
Business unit A
Operational
Risk of loss due to a sudden reduction in operational margins, caused by either internal or external factors
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Unexpected low cost utilization

Time
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Pillar I Credit Risk

Pillar 1 Credit Risk stipulates three levels of increasing sophistication. The more sophisticated approaches allow a bank to use its internal models to calculate its regulatory capital. Banks who move up the ladder are rewarded by a reduced capital charge .
Advanced Internal Ratings Based Approach Foundation Internal Ratings Based Approach
Banks use internal estimations of PD, loss given default (LGD) and exposure at default (EAD) to calculate risk weights for exposure classes
Standardized Approach
Banks use internal estimations of probability of default (PD) to calculate risk weights for exposure classes. Other risk components are standardized.
Risk weights are based on assessment by external credit assessment institutions
Reduce Capital requirements

Pillar I Operational Risk
Advanced Measurement Approach. Standardized approach
Basic Indicator Approach

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Pillar I Market Risk
Internal Models Method (VaR based approaches)
Standardized Duration Method.

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Advantages of Capital
Provides safety and soundness Depositor protection Limits leveraging Cushion against unexpected losses Brings in discipline in risk taking
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Framework
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RBI Time-Frame
Serial No. Approach The earliest date of making application by banks to the RBI Likely date of approval by the RBI
a.
Internal Models Approach (IMA) For Market Risk The Standardised Approach (TSA) for Operational Risk Advanced Measurement Approach (AMA) for Operational Risk Internal Ratings-Based (IRB) Approaches for Credit Risk (Foundation- as well as Advanced IRB)
April 1, 2010
March 31, 2011
b.
April 1, 2010 April 1, 2012
September 30, 2010 March 31, 2014
c.
d.
April 1, 2012
March 31, 2014
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Capital Funds of Banks
Banks are required to maintain a minimum Capital to Risk-weighted Assets Ratio (CRAR) of 9 percent on an ongoing basis.
Banks are encouraged to maintain, at both solo and consolidated level, a Tier I CRAR of at least 6 per cent. Banks which are below this level must achieve this ratio on or before March 31, 2010. A bank should compute its Tier I CRAR and Total CRAR in the following manner:
Tier I CRAR = [Eligible Tier I capital funds]/ .
[Credit Risk RWA* + Market Risk RWA + Operational Risk RWA]

* RWA = Risk weighted Assets Total CRAR = [Eligible total capital funds]/ [Credit Risk RWA + Market Risk RWA + Operational Risk RWA]
Elements of Tier I Capital
For Indian banks, Tier I capital would include the following elements:
i) Paid-up equity capital, statutory reserves, and other disclosed free reserves, if any;
ii) Capital reserves representing surplus arising out of sale proceeds of assets;
iii) Innovative perpetual debt instruments eligible for inclusion in Tier I capital, which comply with the regulatory requirements as specified in ; iv) Perpetual Non-Cumulative Preference Shares (PNCPS), which comply with the regulatory requirements, and
v) Any other type of instrument generally notified by the Reserve Bank from time to time for inclusion in Tier I capital.
Elements of Tier II Capital
1. Revaluation Reserves: These reserves often serve as a cushion against unexpected losses, but they are less permanent in nature and cannot be considered as Core Capital.
2. General Provisions and Loss Reserves: Such reserves, if they are not attributable to the actual diminution in value or identifiable potential loss in any specific asset and are available to meet unexpected losses, can be included in Tier II capital.
3. Hybrid Debt Capital Instruments: In this category, fall a number of debt capital instruments, which combine certain characteristics of equity and certain characteristics of debt.
4. Subordinated Debt: To be eligible for inclusion in Tier II capital, the instrument should be fully paid-up, unsecured, subordinated to the claims of other creditors, free of restrictive clauses, and should not be redeemable at the initiative of the holder or without the consent of the Reserve Bank of India.
Basel I to Basel III: A Journey in Risk 5. Innovative Perpetual Debt Instruments (IPDI) and Perpetual Non-Cumulative 1/4/2014 Management in Banks
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Comparison between Basel I n Basel II

S No Basel I Basel II
1.
2. 3.
Capital Adequacy based on RWA

Not risk sensitive. Prescriptive. All credit exposures carried RW of 100%-except for some sovereign exposures n mortgages. Risk capital = Credit exposure*RW*8% Implications were: Every bank had to maintain same 8% capital. Thus banks with good quality assets had no incentives. As a result credit quality had to be lowered to increase returns. Low rated exposures were subsidized by high rated exposures. No provision for economic pricing by banks.
Capital Adequacy based on RWA

Risk sensitive. Credit exposures carry RW based on credit quality Risk capital similar to Basel II but efficient banks can have less capital Implications are: Banks with good quality assets require lesser capital. Better quality assets require lesser capital. Risk pricing can be done by banks based on credit risk perception. Provision exists for economic pricing by banks.
4.
Basel III Norms: RBI Guidelines for Capital Requirement
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Summary of Basel III Capital Requirements

Improving the Quality, Consistency and Transparency of the Capital Base:
Presently, a banks capital comprises Tier 1 and Tier 2 capital with a restriction that Tier 2 capital cannot be more than 100% of Tier 1 capital.
Within Tier 1 capital, innovative instruments are limited to 15% of Tier 1 capital. Further, Perpetual Non-Cumulative Preference Shares along with Innovative Tier 1 instruments should not exceed 40% of total Tier 1 capital at any point of time. Within Tier 2 capital, subordinated debt is limited to a maximum of 50% of Tier 1 capital. However, under Basel III, with a view to improving the quality of capital, the Tier 1 capital will predominantly consist of Common Equity.
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The qualifying criteria for instruments to be included in Additional Tier 1 Basel I to Basel III: A Journey in Risk Management in capital outside the Common Equity element as well as Tier 2 capital Banks
Enhancing Risk Coverage
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At present, the counterparty credit risk in the trading book covers only the risk of default of the counterparty. The reform package includes an additional capital charge for Credit Value Adjustment (CVA) risk which captures risk of mark-tomarket losses due to deterioration in the credit worthiness of a counterparty. The risk of interconnectedness among larger financial firms (defined as having total assets greater than or equal to $100 billion) will be better captured through a prescription of 25% adjustment to the asset value correlation (AVC) under IRB approaches to credit risk. In addition, the guidelines on counterparty credit risk management with regard to collateral, margin period of risk and central counterparties and counterparty credit risk management requirements have Basel I to Basel III: A Journey in Risk Management in been strengthened. Banks
Enhancing the Total Capital Requirement and Phase-in Period

The minimum Common Equity, Tier 1 and Total Capital requirements will be phased-in between January 1, 2013 and January 1, 2015, as indicated below:
January 1, 2013 3.5% January 1, 2014 4.0% January 1, 2015 4.5%
As a %age to Risk Weighted Assets (RWAs) Minimum Common Equity Tier 1 capital Minimum Tier 1 capital Minimum Total capital
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4.5% 8.0%
5.5% 8.0%
6.0% 8.0%
Summary of Basel III Capital Requirements Capital Conservation Buffer
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The capital conservation buffer (CCB) is designed to ensure that banks build up capital buffers during normal times (i.e. outside periods of stress) which can be drawn down as losses are incurred during a stressed period. The requirement is based on simple capital conservation rules designed to avoid breaches of minimum capital requirements. Therefore, in addition to the minimum total of 8% as indicated above, banks will be required to hold a capital conservation buffer of 2.5% of RWAs in the form of Common Equity to withstand future periods of stress bringing the total Common Equity requirement of 7% of RWAs and total capital to RWAs to 10.5%. The capital conservation buffer in the form of Common Equity will be phased-in over a period of four years in a uniform manner of 0.625% per year, commencing from January 1, 2016.
Countercyclical Capital Buffer
Further, a countercyclical capital buffer within a range of 0 2.5% of Common Equity or other fully loss absorbing capital will be implemented according to national circumstances. The purpose of countercyclical capital buffer is to achieve the broader macro-prudential goal of protecting the banking sector from periods of excess aggregate credit growth. For any given country, this buffer will only be in effect when there is excess credit growth that results in a system-wide build up of risk. The countercyclical capital buffer, when in effect, would be introduced as an extension of the capital conservation buffer range.
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Summary of Basel III Capital Requirements Supplementing the Risk-based Capital Requirement with a
Leverage Ratio
One of the underlying features of the crisis was the build-up of excessive on and offbalance sheet leverage in the banking system. In many cases, banks built up excessive leverage while still showing strong risk based capital ratios.
Subsequently, the banking sector was forced to reduce its leverage in a manner that amplified downward pressure on asset prices, resulting in decline in bank capital and contraction in credit availability.
Therefore, under Basel III, a simple, transparent, non-risk based regulatory leverage
ratio has been introduced. Thus, the capital requirements will be supplemented by a non-risk based leverage ratio which is proposed to be calibrated with a Tier 1 leverage ratio of 3% (the Basel Committee will further explore to track a leverage ratio using
total capital and tangible common equity).
The ratio will be captured with all assets and off balance sheet (OBS) items at their credit conversion factors and derivatives with Basel II netting rules and a simple measure of potential future exposure (using Current Exposure Method under Basel II
framework) ensuring that all derivatives are converted in a consistent manner to a loan
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I to Basel III: A Journey in Risk Management in equivalent amount. The ratio will be calculated as an averageBasel over the quarter. Banks
Definition of Regulatory Capital
Banks are required to maintain a minimum Pillar 1 Capital to Risk weighted Assets Ratio (CRAR) of 9 % on an on-going basis (other than capital conservation buffer and countercyclical capital buffer). With a view to improving the quality and quantity of regulatory capital, it has been decided that the predominant form of Tier 1 capital must be Common Equity; since it is critical that banks risk exposures are backed by high quality capital base. Non-equity Tier 1 and Tier 2 capital would continue to form part of regulatory capital subject to eligibility criteria as laid down in Basel III. Accordingly, under revised guidelines (Basel III), total regulatory capital will consist of the sum of the following categories: (i) Tier 1 Capital (going-concern capital) (a) Common Equity Tier 1 (b) Additional Tier 1
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(ii) Tier 2 Capital (gone-concern capital)


Limits
and Minima
If
a bank has complied with the minimum Common Equity Tier 1 and Tier 1 capital ratios, then the excess Additional Tier 1 capital can be admitted for compliance with the minimum CRAR of 9% of RWAs.
addition to the minimum Common Equity Tier 1 capital of 5.5% of RWAs, banks are also required to maintain a capital conservation buffer (CCB) of 2.5% of RWAs in the form of Common Equity Tier 1 capital. with full implementation of capital ratios and CCB the capital requirements are summarised as follows: (next slide)
In
Thus,
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Regulatory Capital
(i) (ii) (iii) Minimum Common Equity Tier 1 ratio Capital conservation buffer (comprised of Common Equity) Minimum Common Equity Tier 1 ratio plus capital conservation buffer [(i)+(ii)]
As % to RWAs
5.5 2.5 8.0
(iv)
(v) (vi) (vii) (viii)
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Additional Tier 1 Capital

Minimum Tier 1 capital ratio [(i) +(iv)] Tier 2 capital Minimum Total Capital Ratio (MTC) [(v)+(vi)] Minimum Total Capital Ratio plus capital conservation buffer [(vii)+(ii)]
1.5
7.0 2.0 9.0 11.5
For the purpose of reporting Tier 1 capital and CRAR, any excess Additional Tier 1 capital and Tier 2 capital will be recognised in the same proportion as that applicable towards minimum capital requirements. This would mean that to admit any excess AT1 and T2 capital, the bank should have excess CET1 over and above 8% (5.5%+2.5%).
Accordingly, excess Additional Tier 1 capital above the 1.5% of RWAs can be reckoned by the bank further to the extent of 27.27% (1.5/5.5) of Common Equity Tier 1 capital in excess of 8% RWAs. Similarly, excess Tier 2 capital above 2% of RWAs can be reckoned by the bank further to the extent of 36.36% (2/5.5) of Common Equity Tier 1 capital in excess of 8% RWAs.
In cases where the a bank does not have minimum Common Equity Tier 1 + capital conservation buffer of 2.5% of RWAs as required but, has excess Additional Tier 1 and / or Tier 2 capital, no such excess capital can be reckoned towards computation and reporting of Tier 1 capital and Total Capital. Basel I to Basel III: A Journey in Risk Management in
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Banks
Calculation of Admissible Excess Additional Tier 1 (AT1) n Tier 2 Capital for the Purpose of Reporting n Disclosing Minimum Total Capital Ratios
Capital Ratios in the year 2018 Common Equity Tier 1 CCB Total CET1 PNCPS / PDI PNCPS / PDI eligible for Tier 1 capital PNCPS / PDI ineligible for Tier 1 capital 7.5% of RWAs 2.5% of RWAs 10% of RWAs 3.0% of RWAs 2.05 % of RWAs {(1.5/5.5)*7.5% of CET1} 0.95% of RWAs (3-2.05)
Eligible Total Tier 1 capital

Tier 2 issued by the bank Tier 2 capital eligible for CRAR PNCPS / PDI eligible for Tier 2 capital PNCPS / PDI not eligible Tier 2 capital
9.55% of RWAs
2.5% of RWAs 2.73% of RWAs {(2/5.5)*7.5% of CET1} 0.23% of RWAs (2.73-2.5) 0.72% of RWAs (0.95-.23)
Basel I to Basel III: A Journey in Risk Management in
Elements of Common Equity Tier 1 Capital Indian Banks
Elements of Common Equity Tier 1 capital will remain the same under Basel III. Accordingly, the Common Equity component of Tier 1 capital will comprise the following: (i) Common shares (paid-up equity capital) issued by the bank which meet the criteria for classification as common shares for regulatory purposes; (ii) Stock surplus (share premium) resulting from the issue of common shares; (iii) Statutory reserves; (iv) Capital reserves representing surplus arising out of sale proceeds of assets; (v) Other disclosed free reserves, if any;
(vi) Balance in Profit & Loss Account at the end of the previous financial year;
(vii) While calculating capital adequacy at the consolidated level, common shares issued by consolidated subsidiaries of the bank and held by third parties (i.e. minority interest) which meet the criteria for inclusion in Common Equity Tier 1 capital ; and (viii) Less: Regulatory adjustments / deductions applied in the calculation of
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Elements of Additional Tier 1 Capital Indian Banks
Elements of Additional Tier 1 capital will remain the same. Additional Tier 1 capital consists of the sum of the following elements: (i) Perpetual Non-Cumulative Preference Shares (PNCPS), which comply with the regulatory requirements; (ii) Stock surplus (share premium) resulting from the issue of instruments included in Additional Tier 1 capital; (iii) Debt capital instruments eligible for inclusion in Additional Tier 1 capital, which comply with the regulatory requirements; (iv) Any other type of instrument generally notified by the Reserve Bank from time to time for inclusion in Additional Tier 1 capital; (v) While calculating capital adequacy at the consolidated level, Additional Tier 1 instruments issued by consolidated subsidiaries of the bank and held by third parties which meet the criteria for inclusion in Additional Tier 1 capital; and (vi) Less: Regulatory adjustments / deductions applied in the calculation of Basel I to Basel III: A Journey in Risk Management in
Banks
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Elements of Tier 2 Capital - Indian Banks
(i) General Provisions and Loss Reserves

a. Provisions or loan-loss reserves held against future, presently unidentified losses, which are freely available to meet losses which subsequently materialize, will qualify for inclusion within Tier 2 capital. Accordingly, General Provisions on Standard Assets, Floating Provisions, Provisions held for Country Exposures, Investment Reserve Account, excess provisions which arise on account of sale of NPAs and countercyclical provisioning buffer will qualify for inclusion in Tier 2 capital. However, these items together will be admitted as Tier 2 capital up to a maximum of 1.25 % of the total credit risk-weighted assets under the standardized approach. Under Internal Ratings Based (IRB) approach, where the total expected loss amount is less than total eligible provisions, banks may recognise the difference as Tier 2 capital up to a maximum of 0.6 % of credit-risk weighted assets calculated under the IRB approach.
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b. Provisions ascribed to identified deterioration of particular assets or loan liabilities, whether individual or grouped should be excluded. Accordingly, for instance, specific provisions on NPAs, both at individual account or at portfolio level, provisions in lieu of diminution in the fair value of assets in the case of Basel I to Basel III: A Journey in Risk Management in restructured advances, provisions against depreciation in the value of investments Banks
Elements of Tier 2 Capital - Indian Banks (ii) Debt Capital Instruments issued by the banks;

(iii) Preference Share Capital Instruments [Perpetual Cumulative Preference Shares (PCPS) / Redeemable Non-Cumulative Preference Shares (RNCPS) / Redeemable Cumulative Preference Shares (RCPS)] issued by the banks; (iv) Stock surplus (share premium) resulting from the issue of instruments included in Tier 2 capital; (v) While calculating capital adequacy at the consolidated level, Tier 2 capital instruments issued by consolidated subsidiaries of the bank and held by third parties which meet the criteria for inclusion in Tier 2 capital ; (vi) Revaluation reserves at a discount of 55%; (vii) Any other type of instrument generally notified by the Reserve Bank from time to time for inclusion in Tier 2 capital; and
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(viii) Less: Regulatory adjustments / deductions applied in the I to Basel III: A Journey in Risk Management calculation of Tier 2 capital [i.e. to be deducted fromBasel the sum of items (i) in
Banks
Minimum capital ratios
Transitional Arrangements (% of RWAs)

Jan 1, 2013 Mar 31, 2014 Mar 31, 2015 Mar 31, 2016
Mar 31, 2017
Minimum Common Equity 4.5 Tier 1 (CET1)

Capital conservation buffer (CCB)
5
0.625
5.5
1.25
5.5
1.875
5.5
2.5
Minimum CET1+ CCB

Minimum Tier 1 capital Minimum Total Capital* Minimum Total Capital +CCB
4.5
6
9 9
5.625
6.5
9 9.625
6.75
7
9 10.25
7.375
7
9 10.825
8
7
9 11.5
Phase-in of all deductions 40 from CET1 (in %)
60
80
100
100
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*The difference between the minimum total capital requirement of 9% and the Tier 1 Basel I to Basel III: A Journey in Risk Management in requirement can be met with Tier 2 and higher forms of capital.
Banks
Capital Conservation Buffer
The capital conservation buffer (CCB) is designed to ensure that banks build up capital buffers during normal times (i.e. outside periods of stress) which can be drawn down as losses are incurred during a stressed period. The requirement is based on simple capital conservation rules designed to avoid breaches of minimum capital requirements. Outside the period of stress, banks should hold buffers of capital above the regulatory minimum. When buffers have been drawn down, one way banks should look to rebuild them is through reducing discretionary distributions of earnings. This could include reducing dividend payments, share buybacks and staff bonus payments. Banks may also choose to raise new capital from the market as an alternative to conserving internally generated capital. However, if a bank decides to make payments in excess of the constraints imposed as explained above, the bank, with the prior approval of RBI, would have to use the option of raising capital from the market equal to the amount above the constraint which it wishes to distribute. Basel I to Basel III: A Journey in Risk Management in
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Banks
Banks are required to maintain a capital conservation buffer of 2.5%, comprised of Common Equity Tier 1 capital, above the regulatory minimum capital requirement of 9%. Banks should not distribute capital (i.e. pay dividends or bonuses in any form) in case capital level falls within this range. However, they will be able to conduct business as normal when their capital levels fall into the conservation range as they experience losses. Therefore, the constraints imposed are related to the distributions only and are not related to the operations of banks. The distribution constraints imposed on banks when their capital levels fall into the range increase as the banks capital levels approach the minimum requirements. The Table (next slide) shows the minimum capital conservation ratios a bank must meet at various levels of the Common Equity Tier 1 capital ratios.

Minimum capital conservation standards for individual bank Common Equity Tier 1 Ratio Minimum Capital Conservation Ratios (expressed as a %age of earnings) 100%
5.5% - 6.125%
>6.125% - 6.75% >6.75% - 7.375%

>7.375% - 8.0% >8.0%
80% 60%
40% 0%
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For example, a bank with a Common Equity Tier 1 capital ratio in the range of 6.125% to 6.75% is required to conserve 80% of its earnings in the subsequent financial year (i.e. payout no more than 20% in terms of dividends, share buybacks and discretionary bonus payments is allowed). Basel I to Basel III: A Journey in Risk Management in
Banks

The
Common Equity Tier 1 ratio includes amounts used to meet the minimum Common Equity Tier 1 capital requirement of 5.5%, but excludes any additional Common Equity Tier 1 needed to meet the 7% Tier 1 and 9% Total Capital requirements. For example, a bank maintains Common Equity Tier 1 capital of 9% and has no Additional Tier 1 or Tier 2 capital. Therefore, the bank would meet all minimum capital requirements, but would have a zero conservation buffer and therefore, the bank would be subjected to 100% constraint on distributions of capital by way of dividends, sharebuybacks and discretionary bonuses.
Leverage Ratio
One of the underlying features of the crisis was the build-up of excessive on and off-balance sheet leverage in the banking system. In many cases, banks built up excessive leverage while still showing strong risk based capital ratios. During the most severe part of the crisis, the banking sector was forced by the market to reduce its leverage in a manner that amplified downward pressure on asset prices, further exacerbating the positive feedback loop between losses, declines in bank capital, and contraction in credit availability. Therefore, under Basel III, a simple, transparent, non-risk based leverage ratio has been introduced. The leverage ratio is calibrated to act as a credible supplementary measure to the risk based capital requirements. The leverage ratio is intended to achieve the following objectives: (a) constrain the build-up of leverage in the banking sector, helping avoid destabilising deleveraging processes which can damage the broader financial system and the economy; and (b) reinforce the risk based requirements with a simple, non-risk based backstop measure.
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Definition n Calculation of Leverage Ratio
The provisions relating to leverage ratio contained in the Basel III document are intended to serve as the basis for testing the leverage ratio during the parallel run period. The Basel Committee will test a minimum Tier 1 leverage ratio of 3% during the parallel run period from 1 January 2013 to 1 January 2017. During the period of parallel run, banks should strive to maintain their existing level of leverage ratio but, in no case the leverage ratio should fall below 4.5%. A bank whose leverage ratio is below 4.5% may endeavor to bring it above 4.5% as early as possible. Final leverage ratio requirement would be prescribed by RBI after the parallel run taking into account the prescriptions given by the Basel Committee. The leverage ratio shall be maintained on a quarterly basis. The basis of calculation at the end of each quarter is the average of the month-end leverage ratio over the quarter based on the definitions of capital (the capital measure) and total exposure (the exposure measure) specified in the following paragraphs.
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Definition n Calculation of Leverage Ratio

Capital Measure: (a) The capital measure for the leverage ratio should be based on the new definition of Tier 1 capital as set out in this presentation. (b) Items that are deducted completely from capital do not contribute to leverage, and should therefore also be deducted from the measure of exposure. That is, the capital and exposure should be measured consistently and should avoid double counting. This means that deductions from Tier 1 capital should also be made from the exposure measure. Exposure Measure The exposure measure for the leverage ratio should generally follow the accounting measure of exposure. In order to measure the exposure consistently with financial accounts, the following should be applied by banks: (a) on-balance sheet, non-derivative exposures will be net of specific provisions and valuation adjustments (e.g. prudent valuation adjustments for AFS and HFT positions, credit valuation adjustments); (b) physical or financial collateral, guarantees or credit risk mitigation purchased is not allowed to reduce on-balance sheet exposures; and (c) netting of loans and deposits is not allowed.
Liquidity Coverage Ratio (LCR)
The ratio aims to ensure that a bank maintains an adequate level of unencumbered, high quality assets that can be converted into cash to meet its liquidity needs for a 30-day time horizon under an acute liquidity stress scenario specified by supervisors. At a minimum, the stock of liquid assets should enable the bank to survive until day 30 of the proposed stress scenario, by which time (it is assumed) appropriate actions can be taken by the management /supervisors. The ratio can be calculated as: LCR = [Stock of high quality liquid assets / Net cash outflow over a 30 day period ] * 100 100% The Liquidity Coverage Ratio (LCR) should be more than or equal to 100% at all times. Banks are expected to meet this requirement continuously and hold a stock of unencumbered, high-quality liquid assets as a defence against the potential onset of severe liquidity stress. Basel I to Basel III: A Journey in Risk Management in
The stress scenario specified by the BCBS for LCR incorporates many of the shocks experienced during the crisis that started in 2007 into one significant stress scenario for which a bank would need sufficient liquidity on hand to survive for up to 30 calendar days. The scenario, thus, entails a combined idiosyncratic and market-wide shock that would result in: a) the run-off of a proportion of retail deposits; b) a partial loss of unsecured wholesale funding capacity; c) a partial loss of secured, short-term financing with certain collateral and counterparties; d) additional contractual outflows that would arise from a downgrade in the banks public credit rating by up to three notches, including collateral posting requirements; e) increases in market volatilities that impact the quality of collateral or potential future exposure of derivative positions and thus require larger collateral haircuts or additional collateral, or lead to other liquidity needs; f) unscheduled draws on committed but unused credit and liquidity facilities that the bank has provided to its clients; and g) the potential need for the bank to buy back debt or honour non-contractual obligations in the interest of mitigating reputational risk.
Characteristics of High Quality Liquid Assets: Liquid assets comprise of high quality assets that can be readily sold or used as collateral to obtain funds in a range of stress scenarios. They should be unencumbered i.e. without legal, regulatory or operational impediments. Assets are considered to be high quality liquid assets if they can be easily and immediately converted into cash at little or no loss of value. While the fundamental characteristics of these assets include low credit and market risk; ease and certainty of valuation; low correlation with risky assets and listed on a developed and recognized exchange market, the market related characteristics include active and sizeable market; presence of committed market makers, low market concentration and flight to quality (tendencies to move into these types of assets in a systemic crisis).

Definition of High Quality Liquid Assets There are two categories of assets that can be included in the stock of high quality liquid assets viz. Level 1 and Level 2 assets. Assets to be included in each category are those that the bank is holding on the first day of the stress period. Level 1 Assets Level 1 assets of banks would comprise of the following and these assets can be included in the stock of liquid assets without any limit as also without applying any haircut: Cash including cash reserves in excess of required CRR. Government securities in excess of the SLR requirement. SLR securities within the mandatory requirement to the extent allowed by RBI. Marketable securities issued or guaranteed by foreign sovereigns satisfying all the following conditions:
assigned a 0% risk weight under the Basel II standardized approach; traded in large, deep and active repo or cash markets characterized by a low level of concentration; proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions; and not issued by a bank/financial institution/NBFC or any of its affiliated entities.

Definition of High Quality Liquid Assets Level 2 Assets Level 2 assets can be included in the stock of liquid assets, subject to the requirement that they comprise no more than 40% of the overall stock after haircuts have been applied. The portfolio of Level 2 assets held by the bank should be well diversified in terms of type of assets, type of issuer and specific counterparty or issuer. A minimum 15% haircut should be applied to the current market value of each Level 2 asset held in the stock. Level 2 assets are limited to the following: i. Marketable securities representing claims on or claims guaranteed by sovereigns, Public Sector Entities (PSEs) or multilateral development banks that are assigned a 20% risk weight under the Basel II Standardised Approach for credit risk and provided that they are not issued by a bank/financial institution/NBFC or any of its affiliated entities. ii. Corporate bonds (not issued by a bank/financial institution/NBFC or any of its affiliated entities) which have been rated AA- or above by an Eligible Credit
Net Stable Funding Ratio (NSFR)
The NSFR is designed to ensure that long term assets are funded with at least a minimum amount of stable liabilities in relation to their liquidity risk profiles. The NSFR aims to limit over-reliance on short-term wholesale funding during times of buoyant market liquidity and encourage better assessment of liquidity risk across all on- and off-balance sheet items. In addition, the NSFR approach offsets incentives for banks to fund their stock of liquid assets with short-term funds that mature just outside the 30-day horizon for meeting LCR. .
The ratio can be calculated as: NSFR = [Available Stable Funding (ASF) / Required amount of Stable Funding (RSF)] * 100 > 100%
Stable funding is defined as the portion of those types and amounts of equity and liability financing expected to be reliable sources of funds over a one-year time horizon under conditions of extended stress.
ASF is defined as the total amount of an institutions: (i) capital; (ii) preferred stock with maturity of equal to or greater than one year; (iii) liabilities with effective maturities of one year or greater; and (iv) that portion of stable non-maturity deposits and/or term deposits with maturities of less than one year that would be expected to stay with the institution for an extended period in an idiosyncratic stress event.
RSF is calculated as the sum of the value of the assets held and funded by the institution, multiplied by a specific required stable funding (RSF) factor assigned to each particular asset type, added to the amount of OBS (off balanceBasel sheet) activity I to Basel III: A Journey (or in Risk Management in
Transition Phase for the Liquidity Standards under Basel III
Both the LCR and NSFR are currently subject to an observation period by the BCBS, with a view to addressing any unintended consequences that the standards may have for financial markets, credit extension and economic growth. At the latest, any revisions would be made to the LCR by mid-2013 and to the NSFR by mid-2016. Accordingly, the LCR, including any revisions, will be introduced as on 1 January 2015 and the NSFR, including any revisions, will move to a minimum standard by 1 January 2018. The LCR and NSFR will thus become binding for the banks from 1 January 2015 and 2018, respectively i.e. banks will have to ensure that they maintain the required LCR and NSFR at all times starting from January 2015 and January 2018, respectively. While the LCR and NSFR standards would become binding only from January 2015 and 2018, respectively, the supervisory reporting under the Basel III framework is expected from 2012. Accordingly, banks are required to furnish statements on LCR and NSFR and statements based on monitoring metrics/tools prescribed under Basel III framework to Chief General Manager-in-Charge, Department of Banking Operations and Development (DBOD), Central Office, Reserve Bank of India, Mumbai on best efforts basis from the month ending /quarter ending June 2012.
Summary: Issues with Basel II

1.
Basel II is procyclical. In good times, when banks are doing well, and the market is willing to invest capital in them, Basel II does not impose significant additional capital requirement on banks. On the other hand, in stressed times, when banks require additional capital and markets are wary of supplying that capital, Basel II requires banks to bring in more of it. The second issue with Basel II was that even as it made capital regulation more risk sensitive, it did not bring in corresponding changes in the definition and composition of regulatory capital to reflect the changing market dynamics.
2.
Summary: Issues with Basel II
3. The third issue with Basel II concerns leverage. Basel II did not have any explicit regulation governing leverage. It assumed that its risk based capital requirement would automatically mitigate the risk of excessive leverage. This assumption, as it turned out, was flawed as excessive leverage of banks was one of the prime causes of the crisis. Similarly, Basel II did not explicitly cover liquidity risk. 4. The fourth and final issue with Basel II was focusing exclusively on individual financial institutions, ignoring the systemic risk arising from the interconnectedness across institutions which, as we now know with the benefit of hindsight, was the culprit for ferociously spreading the crisis across financial markets.
How is Basel III an improvement over Basel II?
The enhancements of Basel III over Basel II come primarily in four areas: (i) augmentation in the level and quality of capital; (ii) introduction of liquidity standards; (iii) modifications in provisioning norms; and (iv) better and more comprehensive disclosures. (i) Higher Capital Requirement
As can be seen from the comparative data in the Table , Basel III requires higher and better quality capital. The minimum total capital remains unchanged at 8 per cent of risk weighted assets (RWA). However, Basel III introduces a capital conservation buffer of 2.5 per cent of RWA over and above the minimum capital requirement, raising the total capital requirement to 10.5 per cent against 8.0 per cent under Basel II. This buffer is intended to ensure that banks are able to absorb losses without breaching the minimum capital requirement, and are able to carry on business even in a downturn without deleveraging. This buffer is not part of the regulatory minimum; however, the level of the buffer will determine the dividend distributed to shareholders and the bonus paid to staff. Basel I to Basel III: A Journey in Risk Management in
Table 1: Capital Requirements Under Basel II and Basel III

As a percentage of risk weighted assets Basel II A = (B+D) Minimum Total Capital B Minimum Tier 1 Capital C of which: Minimum Common Equity Tier 1 Capital D Maximum Tier 2 Capital (within Total Capital) E Capital Conservation Buffer F=C+E (CCB) Minimum Common Equity G=A+E Tier 1 Capital + CCB Minimum Total Capital + CCB 8.0 4.0 Basel III (as on January 1, 2019) 8.0 6.0
2.0
4.0 ---2.0 8.0
4.5
2.0 2.5 7.0 10.5
How is Basel III an improvement over Basel II?:

Higher Capital Requirement (Contd.)
In addition to the capital conservation buffer, Basel III introduces another capital buffer the countercyclical capital buffer in the range of 0 2.5 per cent of RWA which could be imposed on banks during periods of excess credit growth. Also, there is a provision for a higher capital surcharge on systemically important banks. To mitigate the risk of banks building up excess leverage as happened under Basel II, Basel III institutes a leverage ratio as a backstop to the risk based capital requirement. The Basel Committee is contemplating a minimum Tier 1 leverage ratio of 3 per cent (33.3 times) which will eventually become a Pillar 1 requirement as of January 1, 2018.
To cover market risk, Basel III strengthens the counterparty credit risk framework in market risk instruments. This includes the use of stressed input parameters to determine the capital requirement for counterparty credit default risk. Besides, there is a new capital requirement known as CVA (credit valuation adjustment) risk capital charge for OTC derivatives to protect banks against the risk of decline in the credit quality of the counterparty.
How is Basel III an improvement over Basel II?: Liquidity Standards
To mitigate liquidity risk, Basel III addresses both potential short-term liquidity stress and longer-term structural liquidity mismatches in banks balance sheets (Table: Next Slide). To cover short-term liquidity stress, banks will be required to maintain sufficient high-quality unencumbered liquid assets to withstand any stressed funding scenario over a 30-day horizon as measured by the liquidity coverage ratio (LCR). To mitigate liquidity mismatches in the longer term, banks will be mandated to maintain a net stable funding ratio (NSFR). The NSFR mandates a minimum amount of stable sources of funding relative to the liquidity profile of the assets, as well as the potential for contingent liquidity needs arising from off-balance sheet commitments over a one-year horizon. In essence, the NSFR is aimed at
How is Basel III an improvement over Basel II?: Liquidity Standards

Ratio Liquidity Coverage Ratio (LCR) (to be introduced as on January 1, 2015) Basel II Basel III --Stock of high-quality liquid assets 100 per cent Total net cash outflows over the next 30 calendar days Available amount of stable funding > 100 per cent Required amount of stable
Net Stable Funding Ratio (NSFR) (to be introduced as on January 1, 2018)
---

Provisioning Norms
The
Basel Committee is supporting the proposal for adoption of an expected loss based measure of provisioning which captures actual losses more transparently and is also less procyclical than the current incurred loss approach. The expected loss approach for provisioning will make financial reporting more useful for all stakeholders, including regulators and supervisors.

Disclosure Requirement
The disclosures made by banks are important for market participants to make informed decisions. One of the lessons of the crisis is that the disclosures made by banks on their risky exposures and on regulatory capital were neither appropriate nor sufficiently transparent to afford any comparative analysis.
To remedy this, Basel III requires banks to disclose all relevant details, including any regulatory adjustments, as regards the composition of the regulatory capital of the bank.
Additional (On top of internal accruals)Common Equity requirements of Indian Banks under Basel III:
Rs in billions (RBI Bulletin October 2012)
Public Sector Banks Private Sector Banks Total
A. Additional Equity Capital Requirements 1400200-250 1600under Basel III 1500 1750 B. Additional Equity Capital Requirements 20-25 under Basel II 650-700 670-725 C. Net Equity Capital Requirements under 180-225 Basel III (A-B) 750-800 930-1025 D. Of Additional Equity Capital Requirements under Basel III for Public Sector Banks (A) Government Share (if present share --holding pattern is maintained) 880-910 --Government Share (if shareholding --is brought down to 51 per cent) 660-690 --Market Share (if the Governments --shareholding pattern is maintained at present 520-590 --level) The Reserve Bank has made some estimates based on the following two conservative assumptions
covering the period to March 31, 2018: (i) risk weighted assets of individual banks will increase by 20 per cent per annum; and (ii) internal accruals will be of the order of 1 per cent of risk weighted assets.
Will Basel III hurt growth?
The main concern is that the higher capital requirements under Basel III will kick in at a time when credit demand in the economy will be on the rise. Will this raise the cost of credit and hence militate against growth? At its core, this boils down to the tension between short-term compulsions and long term growth prospects.
Comfortingly, empirical research by BIS economists shows that even if Basel III may impose some costs in the short-term, it will secure medium to long term growth prospects.
How will Basel III affect the profitability of banks?
Basel III requires higher and better quality capital. Admittedly, the cost of equity capital is high. It is also likely that the loss absorbency requirements on the non-equity regulatory capital will increase its cost. The average Return on Equity (RoE) of the Indian banking system for the last three years has been approximately 15 per cent. Implementation of Basel III is expected to result in a decline in Indian banks RoE in the short-term. However, the expected benefits arising out of a more stable and stronger banking system will largely offset the negative impact of a lower RoE in the medium to long term. The relatively higher level of net interest margins (NIMs) of Indian banks, of approximately 3 per cent, suggests that there is scope for banks to improve their efficiency, bring down the cost of intermediation and ensure that returns are not overly compromised even as the cost of capital may increase. The competitive dimensions of Indian banking sector should ensure that banks are able to deliver efficient financial intermediation without compromising the interests of depositors and borrowers. Basel I to Basel III: A Journey in Risk Management in
Minimum Regulatory Capital Prescriptions (as percentage of risk weighted assets)

Basel III (as on Jan 1, 2019) RBI Prescriptions
Current (Basel II)
Basel III (as on March 31, 2018) 9.0 7.0

5.5 2.0 2.5 8.0 11.5 4.5
A = B+D) B C
D E F = C+E G = A+E H
Minimum Total Capital Minimum Tier 1 capital of which: Minimum Common Equity Tier 1 capital Maximum Tier 2 capital (within Total Capital) Capital Conservation Buffer (CCB) Minimum Common Equity Tier 1 capital + CCB Minimum Total Capital + CCB Leverage Ratio (ratio to total assets)
8.0 6.0
4.5 2.0 2.5 7.0 10.5 3.0
9.0 6.0
3.6 3.0 --3.6 -----
What are D-SIBs? Will any Indian bank be classified as a D-SIB?
The moral hazard relating to too-big-to-fail institutions which encourages risky behaviour by larger banks has been a huge issue on the post-crisis reform agenda. Basel III seeks to mitigate this externality by identifying global systemically important banks (G-SIBs) and mandating them to maintain a higher level of capital dependent on their level of systemic importance. The list of G-SIBs is to be reviewed annually. Currently, no Indian bank appears in the list of GSIBs. Separately, the Basel Committee is working on establishing a minimum set of principles for domestic systemically important banks (D-SIBs), and also on the norms for prescribing higher loss absorbency (HLA) capital standards for them. Besides, it is also necessary to evolve a sound resolution mechanism for D-SIBs.
What sort of capacity building is required in the implementation of Basel III?
Banks in India are currently operating on the Standardised Approaches of Basel II. The larger banks need to migrate to the Advanced Approaches, especially as they expand their overseas presence. The adoption of advanced approaches to risk management will enable banks to manage their capital more efficiently and improve their profitability. This graduation to Advanced Approaches requires three things. First and most importantly, a change in perception from looking upon the capital framework as a compliance function to seeing it as a necessary pre-requisite for keeping the bank sound, stable, and therefore profitable; second, deeper and more broad based capacity in risk management; and finally adequate and good quality data.
[Slides No. 59-72 are based on a write up by Dr. Duvvuri Subbarao, Governor, Reserve Bank of India, published in RBI Bulletin, October 2012]
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Basel I To Basel III: A Journey in Risk Management in Banks: Presented by Prof. Debajyoti Ghosh Roy

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Basel I To Basel III: A Journey in Risk Management in Banks: Presented by Prof. Debajyoti Ghosh Roy

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Basel I to Basel III: A Journey in Risk Management in Banks

Presented by Prof. Debajyoti Ghosh Roy

Adjunct Professor, Symbiosis School of Banking Management, Pune.