BIS & Basel Norms and its effect
Basel banking was established due to the Basel Committee on Banking Supervision (BCBS) that was established by the central bank of the G-10 countries in 1974. This was under the Bank for International Settlements (BIS), Basel, Switzerland. The Committee is responsible for formulation of guidelines and to provide recommendations on banking regulation based on capital risk, operational risk and market risk. The Committee consists of 27 member countries.
Basel I Norm
- The Basel Capital Accord or the Basel I norms were incorporated by the banks in July 1988. Its primary focus was on credit risk. A Market Risk Amendment was issued to the capital accord in January 1996 due to greater market risk exposures of bank.
Basel I Norms stated that capitals should be treated as reserves. Tier I capital also known as Core Capital consists of elements which are more permanent in nature and have high capacity to absorb losses.This includes the following.-
Tier II Capital includes:
- Undisclosed Reserves and Cumulative Perpetual Preference Shares
- Revaluation Reserves
- General Provisions and Loss Reserve
- A comprehensive system is provided to weight different categories of bank assets like loans based on relative riskiness.
- Banks are supposed to maintain a fixed 8% of Risk Weighted Assets.
- Target Standard ratio acts as a binding factor between the first two pillars.
Advantages of Basel I
- A benchmark for assessment by market participants
- Steady increase in capital adequacy ratios of internationally active banks
- simple structure
- Adoption methods which are international
- Improved connectivity and competition among internationally active banks
- Proper methods of managing capital
Weaknesses of Basel I
- Though Capital adequacy depends on credit risk, but market risk and operational risk was missing 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 II Norm
Basel II came into being because of these incidents– The banking crises of the 1990s, and the criticisms of Basel I.
Hence, in the year 1999 a new improved accord was proposed by the Basel Committee.
The pillars of the Basel II Norms have been stated below.
Minimum Capital Requirements
- The primary aim of this accord was to widen the scope of regulation.
- Any parent company within the banking group which is a holding company should capture the risk of the entire banking group.
- Basel II focussed to measure the risk-weighted assets (RWAs) of a bank more carefully.
- The Standardized Approach directed banks to use ratings from external credit rating agencies to compute capital requirements that are in proportion to the level of credit risk.
- The two Internal Ratings Based Approaches were – the Foundation IRB and the Advanced IRB.
- Foundation IRB provided banks the freedom to develop their own models to ascertain risk weights for their assets.
- Advanced IRB is similar to Foundation IRB but the only difference is that the banks are free to use their own assumptions in the models they develop. Operational Risk
- The Basic Indicator Approach requires banks to hold 15 % of their gross annual incomes as capital.
- The Standardized Approach follows business lines to split banks into compartments.
- The Advanced Measurement Approach allow banks to perform their own calculations for operation risk.
Market risk can be defined as the risk of loss that can arise as a result of variations in the market price of assets. In terms of assets, fixed income products are treated differently as compared to others.
Total Capital Adequacy
In the case of Basel I, a bank must maintain equal amounts of Tier 1 and Tier 2 capital reserves. Further, the reserve requirement continued at 8 percent.
Reserves = 0.08 * Risk-Weighted Assets + Operational Risk Reserves + Market Risk Reserves
Banking Regulation and Supervision
Pillar II focuses on the aspect of regulator-bank interaction. It empowers regulators in matters of supervision and dissolution of banks.
It provides policies for dealing with systematic risk, pension risk, concentration risk, strategic risk, liquidity risk and legal risk which entirely comes under this category.
The Internal Capital Adequacy Assessment process(ICAAP) comes under this Pillar II.
Pillar III aims to incorporate discipline within the banking sector of the country. Basel II made it mandatory to share the bank’s capital and risk profiles publicly instead of sharing them only with the regulators. When participants of market have a proper knowledge of banks activities it will be easy for them to distinguish between banking organizations based on their performance and reward or penalize these banks accordingly.
Basel III Norm:
Banks in emerging economies were at a disadvantage in terms of receiving loans from global banks. The issues surrounding Basel II together contributed to the emergence of the Basel III accord. The essence of Basel III revolves around two sets of compliance:
- Capital - A good quality capital would ensure long term stability.
- Liquidity - Liquidity would ensure proper backups in times of financial crisis or instability.
Liquidity Rules- One of the objectives of Basel III accord was to strengthen the liquidity profile of the banking industry. This is because despite having adequate capital levels, banks still experienced difficulties during the times of financial crisis. Hence, two standards of liquidity were introduced.
- Liquidity Coverage Ratio (LCR) - It was ensured that by making sufficient investment in short term, high quality liquid assets could be quickly and easily converted into cash so that total net cash outflows over 30 days can be covered.LCR- (High Quality Liquid Assets/Total Net Liquidity Outflow)
- Net Stable Funding Ratio (NSFR) - The Net Stable Funding Ratio encouraged banks to obtain financing through stable sources in a regular basis. A minimum quantum of stable and risk less liabilities are utilized to acquire long term assets.
- These rules have been updated to continue to ensure that banking institutions maintain a sound and stable capital base. Enhancement of risk coverage is the objective of Basel III accords and the same is achieved by introduction of capital conservation buffer and countercyclical buffer.
- The intention behind the capital conservation buffer is to make certain that banks accumulate capital buffers in times of low financial stress. Such a buffer is handy when banks are hit by losses, and aims to prevent violations of minimum capital requirements.
- The leverage ratio was incorporated in order to have a non-risk based metric in addition to the risk based capital requirements in place. The primary intentions were to throttle the tendency of excessive leverage and strengthen risk based requirements.The banks are expected to maintain a leverage ratio greater than 3%. It is calculated as: Leverage ratio- (Tier 1 Capital) / (Total Exposure)
Amendments of Basel Norms
- The Basel Accord was amended in January 1996 for providing an additional buffer for risk due to fluctuations in prices, on account of trading activities carried out by the banks.
- The occurrence of financial crisis of 2008 highlighted the failure of Basel II norms to contain the widespread shock. This led to more stringent definition of capital and capital requirements. Besides, liquidity standards were introduced to ensure stable source of short term (30 days) and medium term funding (one year) of the bank of its assets. Thus, the liquidity coverage ratio and net stable funding ratio made its way into the refined Basel III accord.