The Basel Accord: A Primer

What is Basel?

According to BIS, “Basel III is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector. These measures aim to:

  • improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source
  • improve risk management and governance
  • strengthen banks’ transparency and disclosures.

The reforms target:

  • bank-level, or microprudential, regulation, which will help raise the resilience of individual banking institutions to periods of stress.
  • macroprudential, system wide risks that can build up across the banking sector as well as the procyclical amplification of these risks over time.”

 

A Brief Timeline:

1973: The Bretton Woods System collapses, causing chaos in BFSI sector.

1974: Herstatt debacle: In exchange of dollars to be delivered to New York, a number of banks released Deutsche Marks to Bankhaus Herstatt in Germany. In between the timing of this payment, owing to timezone differences, Herstatt ceased operations as German regulators forced it into liquidation. The NY banks never received their dollar payment. It exposed default/counter party risk in the sector.

1974-75: Central bankers of G-10 countries forms (Basel Committee on Banking Supervision- Basel Committee) under the patronage of the Bank for International Settlements (BIS), in Basel, Switzerland.

G-10 Countries: Belgium, Canada, France, Germany, Italy, Japan, The Netherlands, Sweden, Switzerland, United Kingdom and USA

The goal of BCBS,  is to “…extend regulatory coverage, promote adequate banking supervision, and ensure that no foreign banking establishment can escape supervision”. Currently there are 27 member countries in the Committee, represented by the central bank and the authority for the prudential supervision of banking business.

1988: Basel-1 Accord issued

1990s: Banking Crisis

2004: Basel-2 Accord set up to prevent misuse of Basel-1

2008: Post 2008 crisis, Basel-3 is introduced, to be implemented in 2019

2013: RBI started implementation of Basel -3. Period allotted is 6 years.

 

Basel – 1  Accord:

Basel-1 Primarily dealt with credit risk (default risk). Capital requirement and structure of risk weights for banks were defined. the idea is to ensure that banks  “hold capital and reserves sufficient to support the risks that arise in their business”.

Capital Requirement:

Bank Assets (Loans)= External liabilities (Deposits)+ Capital

Since a banks deposits are certain, Capital requirement should be stipulated to control default risk.

The Pillars of Basel-1 Accord:

A. Tier-1 and Tier-2 Capital:

Tier-1: Equity capital+ retained earnings

Tier-2: Debts (bonds), hybrid instruments such as “optionally fully convertible debentures”. This capital is further classified into Upper T2 and lower T2.

B. Risk Weighting:

Assets are categorized into 5 with different risk weights assigned to them, namely: Cash and Government bonds of OECD member countries (0%), Claims on domestic public sector entities (10%), Inter-bank loans to bank headquartered in OECD member countries (20%), Home mortgages (50%) Other loans (100%)

C. Target Standard Ratio

Basel Capital adequacy requirement (CAR)= 8% of RWA (Risk weighted assets); of which at least 4% is in tier-1 capital. 

D. Transitional and Implementing Arrangement

A phased manner of implementation to be completed by 1992

Basel-2 Accord

Revised framework , changes to pillars:

A. Pillar I – Minimum Capital Requirements:

Credit Risk:To prevent bank transferring risk to subsidiaries, scope of regulation was widened.

Three methodologies for risk rating: Standardised (external credit rating agencies ratings), Foundation Internal Ratings Based Approach, Advanced internal ratings based approach (IRB approaches).

Operational Risk: Basic Indicator Approach, Standardized Approach and Advanced Measurement Approach

Market Risk: Categorised into asset based and principal income based

Total Capital Adequacy: 

Reserves = 0.08 * Risk-Weighted Assets + Operational Risk Reserves + Market Risk Reserves

B. Pillar 2 – Regulator-Bank Interaction

Regulators may supervise internal risk evaluation mechanisms outlined in Pillar I. Regulator  can create buffer capital requirements over and above minimum capital requirements.

C. Pillar 3– Banking Sector Discipline

Disclosures of the bank’s capital and risk profiles which were shared solely with regulators were made public.

The Shortcomings of Basel II

The financial crisis highlighted a series of shortcomings in the Basel II accords:

• The capital requirement ratio of 4% was inadequate to withstand the huge losses that were incurred.

• Responsibility for the assessment of counterparty risk (essential to the risk weighting of banks’ assets and therefore in assessing the capital requirement) is assigned to the ratings agencies, which proved to be vulnerable to potential conflicts of interest.

• The capital requirement is ‘pro-cyclical:’ if the global economy expands and asset prices rise, the country and counterparty risks associated with a borrower tend to decrease and thus the capital requirement is lower; however, in the event of a recession, the reverse is also true, thus raising the capital requirement for banks and further restraining lending.

• Basel II incentivizes the process of ‘securitization’, as financial institutions that repackage their loans into asset-backed securities are then able to move them off their balance sheets and thus reduce the assets’ risk-weighting. As a result, this process enabled many banks to reduce their capital requirement, take on growing risks and increase their leverage.

 

Basel-3 Accord

Basel II did not have any regulation on the debt that banks could take on their books. The focus was on individual financial institutions. Two sets of compliance were introduced:

1. Capital                       2. Liquidity

Liquidity Standards:

Liquidity Coverage Ratio (LCR): Sustain financial stress  upto 30 days

𝐿𝐶𝑅 = 𝑆𝑡𝑜𝑐𝑘 𝑜𝑓 ℎ𝑖𝑔ℎ 𝑞𝑢𝑎𝑙𝑖𝑡𝑦 𝑙𝑖𝑞𝑢𝑖𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 𝑇𝑜𝑡𝑎𝑙 𝑛𝑒𝑡 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠 𝑜𝑣𝑒𝑟 𝑡ℎ𝑒 𝑛𝑒𝑥𝑡 30 𝑐𝑎𝑙𝑒𝑛𝑑𝑎𝑟 𝑑𝑎𝑦𝑠 ≥ 100𝑝𝑒𝑟𝑐𝑒𝑛𝑡

Net Stable Funding Ratio (NSFR): obtain finances through stable sources; discourage shrt term funding during favorable times.

𝑁𝑆𝐹𝑅 = 𝐴𝑚𝑜𝑢𝑛𝑡 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑜𝑓 𝑠𝑡𝑎𝑏𝑙𝑒 𝑓𝑢𝑛𝑑𝑖𝑛𝑔 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑠𝑡𝑎𝑏𝑙𝑒 𝑓𝑢𝑛𝑑𝑖𝑛𝑔 > 100𝑝𝑒𝑟𝑐𝑒𝑛�

Capital:

Enhanced risk coverage through  introduction of capital conservation buffer and countercyclical buffer.

Leverage Ratio introduced to have a non-risk based metric in addition to the risk based capital requirements in place. (deter excessive leverage)

Countercyclical Capital Buffer (CCCB): build up a buffer of capital for achieving the broader macro prudential goal by restricting the banking sector’s wide range of lending in the excess credit growth period.

Impact on India

framework for revitalizing distressed assets:

Why Basel-3 for India?

Regulatory deviation from global market perspective can be detrimental for India. Hence conforming to global standards makes the country competent enough.

RBI prescribes a minimum Capital to Risk Weighted Asset Ratio (CRAR) at 9 percent, higher than 8 percent prescription of Basel III accord.

According to the CARE’s estimate, the total equity capital requirement for Indian banks till March 2019 (when Basel III would be fully implemented) is likely to be in the range of Rs.1.5-1.8 trillion assuming that the average GDP growth will be 6 percent and the average credit growth will be in the range of 15 percent to 16 percent over the next five years .

At the outset, estimates of capital infusion requirements are to the tune of USD 50 billion (Fitch) and USD 80 billion (ICRA).

The Reserve Bank of India’s (RBI) increased capital requirements under Basel III are likely to put nearly half of Indian banks in danger of breaching capital triggers, international rating agency Fitch Ratings said in a report: “Our analysis of 27 Indian banks with outstanding hybrid capital instruments indicates that at end-June 2016 the total capital adequacy ratio (CAR) for 11 banks was at or lower than the minimum of 11.5% required by end-March 2019 (FYE19),” Fitch said in its report.

RBI has eased rules to increase banks’ core capital base. Real estate assets, foreign currency assets and deferred tax assets to be counted while calculating Tier-1 capital; but only the discounted value can be taken into account. This would unlock capital of up to Rs 35,000 crore for PSBs and Rs 5,000 crore for private banks, according to RBI sources. The recent demonetization drive is estimated to provide a gain worth 2.5 lakh Cr. INR to the Indian government, which can be infused to the economy.

Challenges to implementing basel-3:

1. Capital requirement – 12000 Cr. Rs to be infused in PSBs, and private banks to raise capital from the markets. PNB and few other private players have raised capital through bonds.

2.Liquidity crunch – Liquid assets do not  have handsome returns, reducing operating profit margin. Growth may be affected as private funding will face backlash.

 

Sources:

http://www.asmgroup.edu.in/incon/publication/incon13-fin-010.pdf

https://www.iimb.ernet.in/research/sites/default/files/WP%20No.%20470_0.pdf

http://www.bloombergquint.com/global-economics/2016/07/12/reserve-bank-of-india-braces-for-basel-battle-on-sovereign-bonds

http://www.livemint.com/Industry/kTlQtgbGJ5gJt4rU52jSxI/Increased-capital-requirements-under-Basel-III-to-add-to-ris.html

https://www.linkedin.com/pulse/can-basel-norms-solve-npa-problem-indian-psbs-vivek-yadav

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