?BASEL ACCORDS: AN OVERVIEW
BY ADITI GUPTA AND PRACHI MATHUR
MADRAS SCHOOL OF ECONOMICS
The Basel Committee on Banking Supervision (BCBS) is the primary global standard setter for financial stability & Banking supervisory matter. It was established in 1974 by central bank governors of G10 countries. It provides a forum for regular cooperation on banking supervisory matters. Basel I, II, and III are the round of deliberations by central bankers. The Committee frames guidelines and standards in different areas – some of the better known among them are the international standards on capital adequacy, the Core Principles for Effective Banking Supervision and the Concordat on cross-border banking supervision.
It is known that risks and returns are integral parts of the banking industry. With that being said, the activities of lending and borrowing by banks give rise to ‘credit risk’.This committee was formed due to Herstatt bank crisis which occurred in Germany in 1974. Herstatt bank had to liquidate due to pressure from its creditors and shareholders, but due to a difference in time zones, the payments released by New York banks to Herstatt bank was not received due to the ceasing of operations of Herstatt. As a result of disturbances seen in the international currency and banking markets, the central bank Governors of the G10 countries established the Basel Committee at the end of 1974. This was done to strengthen financial stability by improving quality of banking supervision, promote safer banking practices and to serve as a forum for regular cooperation between its member countries on banking supervisory matters.
The Basel Committee on Banking Supervision (BCBS) introduced the Basel Capital Accord (1988), to manage banking risk by implementing minimum capital adequacy ratio. To address the challenges faced in Basel accord 1, risks such as market and operational risks than only credit risk, the Basel accord 2 (2004) was introduced. Support was expressed towards an improvement of capital regulation by incorporating changes in the banking and risk management practices and maintaining a framework that could be applied uniformly at the national level. RBI took a conservative approach and maintained standards tougher than the norms. The global financial crisis of 2007-09 and the need for strengthening Basel-II paved the way for Basel-III norms (2010). The main features of which intended to increase the level and quality of capital, include credit valuation adjustment risk, constrain bank leverage, improve bank liquidity and limit procyclicality.
Some of the keywords used are defined as follows:
Capital- Refers to the shareholder’s money on the balance sheet of a bank. It is kept to absorb losses.
Liquidation-the process of bringing a business to an end in case of insolvency, assets of the bank are sold off to pay the creditors and shareholders.
Bank insolvency- Insolvency is defined as an inability to pay one’s debts. This can occur due to two reasons, First, bank may have ended up owing more than it owns i.e. its assets are worth lesser than its liabilities, Second, bank is not able to liquidate as quickly even when assets and liabilities are worth the same i.e. some fixed assets of banks are not able to sell quickly, lack of liquidity.
Volatility- it is the rate at which the prices change in the economy, i.e. degree of variation in prices.
Risk-weighted assets (RWA)bank’s assets or off-balance-sheet exposures, weighted according to risk.
Credit Risk- a risk of default on a debt that may arise from a borrower failing to make the required payments
Operational Risk- risk remaining after determining financing and systematic risk, and includes risks resulting from breakdowns in internal procedures, people and systems.
Market Risk- a possibility of an investor experiencing losses due to factors that affect the overall performance of the financial markets
Liquidity Risk- risk that a company or bank may be unable to meet short-term financial demands
BASEL ACCORDS CHRONOLOGY:
Basel 1: The Basel Capital Accord (1988)
Basel 2: The Capital framework (2004)
Basel 3: Responding to the 2007-09 financial crisis (2010)
Basel 1 refers to a set of international banking rules enacted in 1988 by the Basel Committee on Banking Supervision (BCBS). Basel 1’s objective was to improve banking stability through strong rules and supervision during a time of increase in bank failures and bankruptcy risks. It weighed the capital the banked owed to the credit risk it faced. Basel -1 defined the bank capital ratio which requires banks to maintain a minimum ratio of total capital to risk-weighted assets of 8%.
Basel I outlined two tiers of bank capital:
TIER 1 i.e. Bank’s Core Capital includes issued stock and declared reserves.
TIER 2 i.e. Bank’s Supplementary Capital including gains on investment, long-term debt and hidden reserves.
Basel 1 also created a bank asset classification system that grouped a bank’s assets into 5 risk categories. It was also the first combined international effort to assess risk relative to bank capital. Assets were classified and grouped into five categories according to credit risk,
I.e. 0%, 10%, 20%, 50% and 100%. With 0 % risk weight to cash, bullion, home country debt like treasuries etc.
Two major problems with Basel I were,
First, the definition of capital and differential weights to assets across countries because Basel standards are computed on basis of Book value accounting measures and not market values,
Second, Risk weights do not attempt to take into account any other risk other than credit risk. To counteract these issues, revised version Basel II norms were introduced in 2004.
These were introduced in 2004 and intended to amend international standards that controlled how much capital banks were required to hold to guard against the financial and operational risks that banks faced. Basel I took care of only one type of risk which was the credit risk.
Basel II was intended to address most of the shortcomings of Basel I,
Besides imposing minimum capital requirements in line with technological advancements, it was expected to incorporate a more enhanced supervisory review and public disclosure was a part of market discipline. Basel II intended to provide more risk-sensitive approaches while maintaining an overall level of regulatory capital. Its implementation was envisioned so as to allow banks to adequately emphasize its own internal risk management methodologies.
Shortcomings of Basel I and objectives for Basel II:
“Broad brush” and lacks in risk differentiation in Basel I
A divergence between Basel I risk weights and actual economic risks
Inadequate recognition of advanced credit risk mitigation techniques(securitization and CDS)
Provide banks with incentives to enhance risk measurement and management capabilities.
According to Basel II, there are three tiers of banking capital:
Tier 1 (Core Capital): It is deemed to have the highest capacity to absorb losses in order to allow banks to continue to operate on an ongoing basis. It mainly consists of Common shareholders equity and Disclosed reserves.
Tier 2(Supplementary Capital): This consists of a)Undisclosed reserves- which though unpublished, have gone through profit and loss account and have been accepted by a bank’s supervisory; b)Revaluation reserves-assets which are revalued to reflect their certain current value and are included in the capital base.
Tier 3(Short-term Subordinated debt): This consists of Shareholder’s equity, retained earnings and supplementary capital which can be used to meet a proportion of capital requirement of market risk.
Basel II was working on 3 pillars,
1. Minimum capital requirements: Pillar 1 improves the computation of regulatory capital in 3 ways, First, it uses a granular approach to credit risk weights, Second, it provides banks with a choice of methodology for calculating risk weights for certain types of risk, Third, it incorporates operating risk into the capital requirement.
This pillar evaluates the regulatory capital requirement for 3 major components of risk that a bank faces i.e. a)Credit risk b)Operational risk c)Market risk.
Credit Risk: requires the banks to hold a minimum amount of capital for each loan, largely independent of the risk of this loan. Banks should, therefore, hold more capital for more risky credit exposures and vice versa. Approaches used to calculate this risk are Standard Approach(SA) and Internal Rating based approach(IRB)
Operational Risk: Basel II has defined the operational risk of loss from inadequate or failed internal processes, systems, due to external events. This is the risk arising from the execution of a company’s business functions.
Market Risk: Risk of losses of on and off-balance sheet positions arising from movements in the market price i.e. due to interest rate, equity portfolio, foreign exchange etc. Market risk has been put as 2 types; General Market risk and Specific risk.
Principle 1: Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.
Principle 2: Supervisors should review and evaluate a bank’s internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios.
Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.
Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored
The focus of the second pillar in Basel II has been to recommend the supervisor to evaluate the bank’s capital levels according to their risk profiles and ensure regulatory intervention when in need. It obligates the regulators to evaluate the quality of individual banks’ risk modeling and also it promotes closer cooperation between supervisor and bank.
3. Market Discipline: The focus of this pillar has been to encourage greater transparency of banks holding in the interest of all the stakeholders and to bring in accountability and better corporate governance among the bank’s management. It is designed to allow the market to have a better picture of the overall risk positions of the bank to allow counterparties to price properly.
After the financial crisis of 2008, factors such as mispricing of credit and liquidity risks, and excess credit growth were demonstrated. Basel committee’s reforms to strengthen global capital and liquidity rules while promoting a more resilient banking system are presented in Basel-III. The improved norms aimed at improving the banking sector’s ability to absorb shocks arising from financial stress and reducing the risk of spill-over from the financial sector to the real economy. Basel 3 aims to build a robust capital base for banks to ensure sound liquidity and leverage ratios to avoid a banking crisis in the future.
Shortcomings of Basel-II that paved way for Basel-III:
The Basel-II framework was seen to be pro-cyclical.
It did not require banks to have additional capital requirements, the failure of which evolved into a cycle of deleveraging.
The absence of corporate governance and clearly stated regulations for leverages.
Did not take into account the liquidity risk.
Ignorance of systematic risk that resulted from integrated markets worldwide leading to a deeper impact and spread of the global crisis witnessed.
The reform targets both at the macro-micro level with a cautious basis, that will :
Make individual banking system to be more resilient in the period of stress.
System-wide risks over the banking system as well as the procyclical amplification of these risks over time.
Mentioned below are the 3 pillars of Basel-III that are a revised and strengthened version of Basel-II pillars:
Enhanced minimum capital and liquidity requirements: Capital (Quality and level of capital, Capital loss absorption at the point of non-viability), Risk coverage (Securitisations, Counterparty Credit Risk), Containing leverage, Liquidity (Liquidity Coverage Ratio, Net Stable Funding Ratio, Principles for Sound Liquidity Risk Management and Supervision)
Enhanced Supervisory Review Process for Firm-wide risk management and Capital planning: Supplemental Pillar 2 requirements from Basel-II, Interest rate risk in the banking book (IRRBB)
Enhanced Risk Disclosure and Market discipline: Revised Pillar 3 requirements from Basel-II
Features of the Basel-III accord:
Increase the level and quality of capital- This objective aims at ensuring quality, consistency, and transparency across jurisdictions. Banks are required to maintain more capital of higher quality to cover unexpected losses. Minimum Tier 1 capital holdings rise from 4% to 6%. Highest quality assets such as common stock and retained earnings should be 4.5% and the remainder of tier 1 holdings can comprise of subordinate instruments. In Basel III, the aim to increase the augmented level of Tier 1 capital and to have more exposure of better quality capital, thus, it is reflected by introducing a minimum limit to the Common Equity Tier 1 Capital to 4.5%. However, the minimum total capital requirement remains unaltered at 8%. Maintenance of countercyclical capital buffers during periods of high economic growth was proposed so that banks can sustain themselves during periods of stress.
Enhancing risk capture- This objective aims at the strengthening of the risk coverage of the capital framework that leads to a significant rise in capital requirements for market risk. Capital requirements are calculated based on 12 months of crucial financial stress. There is an inclusion of Credit risk, Market risk, Credit Valuation Adjustment risk and Operational risk in the framework.
Constrain Bank leverage- The Leverage ratio is introduced to achieve reinforcement of risk-based requirements that serve as a backstop to the risk-based measures. It also aims to constraint the system-wide build-up of leverage in the banking sector and avoids deleveraging and destabilizing processes.
Improve Bank Liquidity- This Liquidity Coverage Ratio (LCR) requires banks to have sufficient unencumbered, high-quality assets which are adequately liquid to weather 30-day stress scenario that is specified by the supervisors. Net Stable Funding Ratio (NSFR) mandates a minimum amount of stable sources of funding relative to the liquidity profile of the assets. It targeted to encourage banks to exploit stable sources of funding. The Committee’s 2008 guidance Principles for Sound Liquidity Risk Management and Supervision takes into account the lessons learned during the crisis. It is based on a fundamental review of sound practices for managing liquidity risk in banking organizations.
Supplemental Pillar 2 requirements from Basel II- This objective includes the address of firm-wide governance and risk management, management of risk concentrations, provision of incentives to banks for better risk management and returns over the long term, sound compensation and valuation practices, stress testing, corporate governance and accounting standards for financial instruments.
Interest rate risk in the banking book (IRRBB)- IRRBB refers to the current or prospective risk to the bank’s capital and earnings arising from adverse movements in interest rates that affect the bank’s banking book positions. This objective aims at:
Providing extensive guidance to commercial banks for IRRBB management (shock and stress scenarios, modeling and behavioral assumptions)
Enhanced disclosure requirements targeted to provide greater consistency, transparency, and comparability in the measurement of IRRBB
A tightened threshold for identification of ‘outlier banks’
Basel-III requires banks to disclose sufficient, transparent and all relevant details on their risky investments and capital. It stresses on the need for disclosure of correct information to the investors for better and informed decision making.
BENEFITS OF EFFECTIVE BASEL-III IMPLEMENTATION:
Use of a more standardized approach globally.
Reducing systematic risk
Lowering credit extension by making banks more self-sustainable
Removal of weak individual banks
COMPARISON OF BASEL ACCORDS:
Basel I Basel II Basel III
Introduced 1988 2004 2010
Types of risks covered 1. Credit Risk
2. Market Risk 1. Credit Risk
2. Market Risk
3. Operational Risk 1. Credit Risk
2. Market Risk
3. Operational Risk
4. Liquidity Risk
5. Credit Valuation Adjustment Risk
Tools of Risk Management 1. Capital to Risk Weighted Assets Ratio (CRAR) 1. CRAR
2. Supervisory Review
3. Market Discipline 1. Revised CRAR
2. Enhanced Supervisory Review
3. Enhanced Risk Disclosure and market discipline
6. Leverage Ratio
7. Countercyclical buffers
Major Contribution 1. Providing an international definition of bank capital ; bank capital ratio 1. Explicit information and role were given to the market
2. The inclusion of the component of Operational Risk
1. Liquidity Risk Management
2. Maintenance of countercyclical capital buffers
according to BCBS CRAR= 8%
Tier 1= 4%
CRAR= 10.5% TO
Tier 1= 6%
Focus Single measure Capital Adequacy, Supervisory Review, Market discipline (3 pillars) Increase in quantity and quality of capital, the inclusion of specific market risk
Approach Broad brush approach Risk-sensitive approach
Revision to standardized approaches for Credit, Market and Operational risks for greater risk-sensitivity and comparability
Dr. G. Raju, Dr. Vijila V (year), Basel Accord and Indian Banking Industry
BCBS, An Explanatory Note on the Basel II IRB Risk Weight Functions
Swamy, V. (year), Basel III: Implications for Indian Banking