Basel Critical Evaluation

7/31/2019 Basel Critical Evaluation

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Basel Norms : Critical

Evaluation

Mayuri Gabani 11228

Karan Mehta 11229

Rayees Mohammad 11240

Amitkumar Sarvade 11244


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Contents

BIS

Basel committee

Basel I

Basel II

Basel III


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Bank for International

Settlements (BIS) Established on 17 May 1930

The head office is in Basel,

Switzerland

Its mission is to serve central banks in

their pursuit of monetary and financial

stability, to foster international

cooperation in banking areas and toact as a bank for central banks.

One of the world's oldest international

financial organization.


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THE BASEL COMMITTEE ON

BANKING SUPERVISION

(BCBS) The Basel Committee on BankingSupervision provides a forum for regularcooperation on banking supervisory matters.

Objective: 1.Enhance understanding of keysupervisory issues.

2.improve the quality of bankingsupervision worldwide.

Develop guidelines and supervisorystandards

Committee is best known for its internationalstandards on capital adequacy; the Core

Principles for Effective Banking Supervision;and on cross-border banking supervision.


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Objectives

The G10 countries recognized the need tostrengthen the solvency of the internationalbanking system and to remove thecompetitive inequality that arose fromdifferences in national capital

requirements. In response, the BaselCommittee introduced in 1988 a new capitaladequacy framework the Basel Capital

Accord

The Accord should continue to promotesafety and soundness in the financial system

The Accord should contain approaches tocapital adequacy that are appropriatelysensitive to the degree of risk involved in a

banks positions and activities.


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Basel norms

Basel I 1988 Accord

Basel II 2004 Accord

Basel III 2010-2011

Accord


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Basel I

Requires the banks to hold capitalequal to at least 8% of its RiskWeighted Assets CAR

Capital is broadly into two tiersTier 1and Tier 2

Weights are assigned to each assetdepending on its riskiness.

Assets are classified into four buckets(0%, 20%, 50%, 100%) according totheir debtor category.


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Tier I Capital

Consists of :

Paid up capital Statutory reserves Disclosed free reserves Capital reserves representing surplus

arising out of sale proceeds of asset

Excludes : Equity investments in subsidiaries Intangible assets and losses


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Tier II Capital

Consists of : Undisclosed reserves and Cumulative

perpetual preference shares

Revaluation reserves General provisions and loss reserves

Hybrid debt capital instruments

Subordinated debt

Tier II capital cannot exceeds tier1 capital.


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Capital Adequacy Ratio

Capital adequacy ratio (CAR), also called Capital to Risk (Weighted)Assets Ratio (CRAR), is a ratio of a bank's capital toits risk. National regulators track a bank's CARto ensure that it canabsorb a reasonable amount of loss and complies withstatutory Capital requirements.

Three aspects are relevant:

Composition of Capital

Composition of Risk Weighted Assets

Assigning Risk Weights

Capital Adequacy Ratio

= Tier I Capital +Tier II Capital

Risk Weighted Assets


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Basel I Criticisms

Following are the criticisms of the FirstBasel Accord (Basel I):-

It took too simplistic an approach tosetting credit risk weights

Ignoring other types of risk. Risks weights were based on what the

parties to the Accord negotiated ratherthan on the actual risk of each asset.

Risk weights did not flow from anyparticular insolvency probabilitystandard, and were for the most part,arbitrary.


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Basel II

The minimum capital requirementremains set at 8% of RWA

However, the calculation procedures

used in establishing the risk weightshave been modified to incorporate

Credit risk

Market risk

Operational risks.

Three methods to calculate credit risk


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3 methods

Basel II includes three options forcalculating credit risk and three methodsfor measuring operational risk. Thecredit risk estimation options are

Standardized approach

IRB approaches (Foundation andAdvanced) Determined through a combination ofthe quantitative inputs provided by banks and theformulae specified by the Committee.

Credit assessmentAAA to

AA-A+ to A-

BBB+ to

BB-Below BB Unrated

Risk-weight 20% 50% 100% 150% 100%


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3 pillars

In essence, Basel II rests on threemutually reinforcing pillars:

Pillar I - Minimum Capital Requirement(Addressing Credit Risk, Operational Risk &Market Risk)

Pillar II - Supervisory Review (ProvidesFramework for Systematic Risk, LiquidityRisk & Legal Risk)

Pillar III - Market Discipline & Disclosure (Topromote greater stability in the financialsystem)


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Capital adequacy ratio

Capital Adequacy Ratio= Total Capital (Tier I Capital + Tier II Capital+

Tier III Capital)

Market Risk(RWA) + Credit Risk(RWA)

+ Operation Risk(RWA)

Tier III Capital includes subordinate debt witha maturity of at least 2 years. This is additionor substitution to the Tier II Capital to covermarket risk alone. Tier III Capital should notcover more than 250% of Tier I capitalallocated to market risk.


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Basel II merits

The revised framework keeps the key elementsof the 1988 framework

Contains further risk-sensitive capitalrequirements

Paying due regard to particular features of thepresent supervisory and accounting systems inindividual member countries.

Introduces significant innovations, including agreater reliance on the use of participating banksown internal risk assessments as inputs to

capital requirement calculations It is designed to establish minimum levels of

capital reserves for internationally active banksand will allow national authorities the discretion toadopt arrangements that set higher levels of

minimum capital


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Continue

Range of options for determining capitalrequirements for credit, market andoperational risk,

Allowing greater latitude for banks andregulators to select the methods best suitedto their operations and their financial marketinfrastructure

Greater attention to the supervisory reviewand market discipline

Aggression towards development of theexisting standards by banks.

Strong regulatory impact by central bank toall the banks for implementation


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Basel II criticism

For some developing countries, the new capitaladequacy rules may unduly restrict access tocredit.

Unfairly favors the larger financial institutions

Implementation of the capital accord may be

delayed as financial institutions struggle toupgrade their systems, practices andprocedures.

The recruitment of qualified staff with adequateknowledge and experience to implement the new

capital adequacy regime Some financial institutions may sidestep by

shifting riskier assets off their balance sheet tosubsidiaries, or may employ similar strategies totransfer risk to third parties.


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Continue

The implementation of Basel II raises a numberof challenges that need to be addressed in theareas of risk identification, measurement andmonitoring, it concerns the management ofoperational risk

Pillar 3 purports to enforce market disciplinethrough stricter disclosure requirement. Whileadmitting that such disclosure may be useful forsupervisory authorities and rating agencies

The expertise and ability of the general public to

comprehend and interpret disclosed informationis open to question.

Too much disclosure may cause informationoverload and may even damage financialposition of bank.


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Basel III

RBI's version Basel III

Migrate fully by March 31, 2018 January 1, 2019

Risk capital 11.5% 10.5%

Tier I capital 5.5% 4.5%

Particulars % of its risky assets

Tier I 5.5%

Tier II 2%

Additional equity 1.5%

Capital conservation buffer 2.5%

Counter cyclical buffer 2.5%

Total capital that banks need to

set aside

14%


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Continue

The risk capital to be set aside by Indianbanks is 11.5 per cent of all its risky loans inthe form of common equity whereas theglobal requirement is 10.5 per cent.

Indian banks are required to set asideminimum common equity of 5.5 per cent(TierI) capital for its risky assets (loans).

Banks also have to set aside two per centTier-2 capital.

Banks also have to bring in additional equityat a minimum of 1.5 per cent of its riskyassets (loans).

To counter liquidity crunch, banks have to setaside a capital conservation buffer of 2.5 percent in the form of common equity.


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Banks have to build this buffer when they makebumper profits. This buffer would be drawn downwhen banks face losses due to a downturn inbusiness.

Finally, banks are also expected to counter the

cyclical nature of their business by setting aside2.5 per cent common equity as counter cyclicalbuffer.

So, the total capital that banks need to set asideis 14 per cent.

Rs 2.5 lakh crore of additional equity under theBasel III capital regulations announced by theRBI

75 per cent needed to be added between 2015-16 and 2017-18


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Basel II v/s Basel III

The quality, consistency, andtransparency of the capital base

Tier 3 capital will be eliminated

capital conservation buffer of 2.5 percent in the form of common equity.

2.5 per cent common equity as countercyclical buffer.

Basel III introduces a minimum 3%leverage ratio and two required liquidityratios

Liquidity requirement


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References

BIS website

rbi-guidelines-on-basel-iii

financialexpress.com thehindubusinessline

parl.gc.ca-

ResearchPublications

Basel Critical Evaluation

Documents

Transcript of Basel Critical Evaluation