Basel Accord I,II and III

Basel is a city in Switzerland which is also the headquarters of

Bureau of International Settlement (BIS).
BIS fosters co-operation among central banks with a common
goal of financial stability and common standards of banking
regulations. Currently there are 30 member nations in the
committee.
Basel guidelines refer to broad supervisory standards formulated
by this group of central banks- called the Basel Committee on
Banking Supervision (BCBS).
The set of agreement by the BCBS, which mainly focuses on
risks to banks and the financial system are called Basel accord.
The purpose of the accord is to ensure that financial institutions
have enough capital on account to meet obligations and absorb
unexpected losses. India has accepted Basel accords for the
banking system.

Basel I is the round of deliberations by central bankers from

around the world, and in 1988, the Basel Committee on Banking

Supervision (BCBS) in Basel, Switzerland, published a set of
minimum capital requirements for banks.
This is also known as the 1988 Basel Accord, and was enforced
by law in the Group of Ten (G-10) countries in 1992
Basel I is now widely viewed as outmoded/outdated.
The world has changed as financial conglomerates, financial
innovation and risk management have developed, and a more
comprehensive set of guidelines, known as Basel II, are in the
process of implementation by several countries. Basel III was
developed in response to the financial crisis.

The Committee was formed in response to the messy

liquidation of a Cologne-based bank (Herstatt Bank) in 1974.

On 26 June 1974, a number of banks had released Deutsche
Mark (German Mark) to the Herstatt Bank in exchange for dollar
payments deliverable in New York.
On account of differences in the time zones, there was a lag in
the dollar payment to the counterparty banks, and during this
gap, and before the dollar payments could be effected in New
York, the Herstatt Bank was liquidated by German regulators.
This incident prompted the G-10 nations to form the Basel
Committee on Banking Supervision, towards the end of 1974,
under the auspices of the Bureau of International Settlements
(BIS) located in Basel, Switzerland.

Since 1988, this framework has been progressively

introduced in member countries of G-10, currently
comprising 13 countries, namely, Belgium, Canada,
France, Germany, Italy, Japan, Luxembourg,
Netherlands, Spain, Sweden, Switzerland, United
Kingdom and the United States of America.
Most other countries, currently numbering over 100,
have also adopted, at least in name, the principles
prescribed under Basel I.
The efficacy with which the principles are enforced
varies, even within nations of the Group.

Committee founded in 1974.

By Central Bank Governors of G10.
Focus Banking Supervision.
Objective - Adequate supervision.
Meet 4 Times in a year.
Around 30 working groups/Task Force.
Location at Secretariat : Basel, Switzerland.

4 Sub-committees
Standard Implementation Group
Policy Development Group
Accounting Task Force
Basel Committee Group

Basel I
In 1988, BCBS introduced capital measurement system called
Basel capital accord, also called as Basel 1.
It focused almost entirely on credit risk. It defined capital and
structure of risk weights for banks.
The minimum capital requirement was fixed at 8% of risk
weighted assets (RWA).
RWA means assets with different risk profiles. For example, an
asset backed by collateral would carry lesser risks as compared
to personal loans, which have no collateral.
India adopted Basel 1 guidelines in 1999.

Basel I, that is, the 1988 Basel Accord, is primarily focused on

credit risk and appropriate Risk Weighting of Assets.
Assets of banks were classified and grouped in five categories
according to credit risk, carrying risk weights of 0% (for
example cash, bullion, home country debt like Treasuries), 20%
(securitisations rated AAA) 50%-100% (for example, most
corporate debt), and some assets given No Rating.
Banks with an international presence are required to hold capital
equal to 8% of their risk-weighted assets.
The Tier 1 Capital Ratio = Tier 1 Capital / All RWA
The Total Capital Ratio = (Tier 1 + Tier 2 + Tier 3 Capital) / All
RWA
Leverage Ratio = Total Capital/Average Total Assets

What is Tier 1 Capital ?

Core capital
Includes (Equity, Perpetual Non-Convertible Preference Shares,
Disclosed Reserves)
Maximum 15% usage
Tier 1 Capital Ratio = Equity capital/RWA
What is Tier 2 Capital?
Supplementary Capital
Includes (Undisclosed Reserves, Revaluation Reserves, GP,Hybrid
instruments, unsecured debt.)
100% Usage

Objectives of Basel Accord 1 are as follows:

To ensure an adequate level of capital in the international

banking system.
To strengthen the competitive markets, under which

banks could no longer build in adequate business volumes

without adequate capital backing.
According to Basel 1, banks are required to hold capital

equal to 8% of the risk-weighted assets.

Basel Accord 1
Capital = 8% of Risk Weighted Asset

Tier 1: Shareholders
Equity and Reserves
and Surplus
Tier 2: Undisclosed
Reserves, Hybrid
Instruments and
Revaluation Assets

Risk Weighted
Assets=Assets
classified in the
baskets of
10%, 20%, 50%,
100%
(on the basis of
quality of assets)

THE RESERVE BANK OF INDIAS GUIDELINES FOR BASEL

CAPITAL COMPLIANCE
According to Section 17 of the Banking Regulation Act (1949) every bank
incorporated in India is required to create a reserve fund and transfer a sum
equal to but not less than 20 per cent of its disclosed profits, to the reserve
fund every year.
The RBI has advised banks to transfer 25 per cent and if possible, 30 per
cent to the reserve fund.
The First Narasimham Committee Report recommended the introduction of
a capital to risk-weighted assets system for banks in India since April 1992.
This system largely conformed to international standards. It was
stipulated that foreign banks operating in India should achieve a CRAR of
8 per cent by March 1993 while Indian banks with branches abroad should
comply with the norm by March 1995. All other banks were to achieve a
capital adequacy norm of 4 per cent by March 1993 and the 8 per cent
norm by March 1996.

In its mid-term review of Monetary and Credit Policy in October

1998, the RBI raised the minimum regulatory CRAR requirement to 9
per cent, and banks were advised to attain this level by March 31,
2009.
The RBI responded to the market risk amendment of Basel I in 1996
by initially prescribing various surrogate capital charges such as
investment fluctuation reserve of 5 per cent of the banks portfolio
and a 2.5 per cent risk weight on the entire portfolio for these risks
between 2000 and 2002.
These were later replaced with VaR-based capital charges, as required
by the market risk amendments, which became effective from March
2005.
India went a step ahead of Basel I in that banks in India were required
to maintain capital charges for market risk on their available for sale
portfolios as well as on their held for trading portfolios from March
2006 while Basel I requires market risk charges for trading portfolios
only.

 Drawbacks of Basel Accord 1:

The measures were seen to be in conflict with

sophisticated internal measures of economic capital

The bucket approach with a flat 8% charge for claims

on private sector , has led the banks to move high quality

assets off their balance sheet, thus reducing the average
asset quality
Unable to recognize credit risk mitigation tech

BASEL Accord II

Basel II
In 2004, Basel II guidelines were published by BCBS, which
were considered to be the refined and reformed versions of Basel
I accord. The guidelines were based on three parameters.
Banks should maintain a minimum capital adequacy requirement
of 8% of risk assets, banks were needed to develop and use
better risk management techniques in monitoring and managing
all the three types of risks that is credit and increased disclosure
requirements.
Banks need to mandatorily disclose their risk exposure, etc to the
central bank. Basel II norms in India and overseas are yet to be
fully implemented.

The RBI announced the implementation of Basel II norms in India for

internationally active banks from March 2008 and for the domestic
commercial banks from March 2009.
IssuesIn May 2004, RBI announced that banks in India should examine the
options available under Basel II for revised capital adequacy
framework.
In February 2005, RBI issued the first draft guidelines on Basel II
implementations in which an initial target date for Basel II
compliance was set for March 2007 for all commercial banks,
excluding Local Area Banks (LABs) and Regional Rural Banks
(RRBs).
This deadline was, however, postponed to March 2008 for
internationally active banks and March 2009 for domestic commercial
banks in RBIs mid-year policy announcement of October 30,2006.

Although RBI and the commercial banks have been preparing

for the revised capital adequacy framework since RBIs first
notification on Basel II compliance, the complexity and
intense data processing requirement of Basel II have thrown
up several challenges in its implementation. Given the
limited preparation of the banking system for Basel II
implementation, this postponement was not surprising.
The final RBI guidelines on Basel II implementation were
released on April 27, 2007.
According to these guidelines, banks in India would initially
adopt Standardized Approach for credit risk and Basic
Indicator Approach for operational risk.
RBI provided the specifics of these approaches in its
guidelines. After adequate skills are developed, both by
banks and the RBI, certain banks would be allowed to
migrate towards the more sophisticated approach Internal
Ratings Based Approach (IRBA).

Under the revised regime of Basel II, Indian banks were required
to maintain a minimum CRAR of 9 per cent on an ongoing basis.
Further, banks were encouraged to achieve a tier I CRAR of at
least 6 per cent by March 2010.
In order to ensure a smooth transition to Basel II, RBI advised
banks to have a parallel run of adhering to the revised norms as
well as compliance with the currently applicable norms.

Basel II stands on three pillars:

(1) Minimum regulatory capital (Pillar 1): This is a revised and
comprehensive framework for capital adequacy standards, where
CRAR is calculated by incorporating credit, market and
operational risks.
(2) Supervisory review (Pillar 2): This lays down the key
principles for supervisory review, risk management guidance
and
supervisory transparency and accountability.
(3) Market discipline (Pillar 3): This pillar instils market
discipline through disclosure requirements for market
participants to assess key information on risk exposure, risk
assessment process and banks capital adequacy.

BASEL ACCORD II

PILLAR I- Minimum Capital Requirement

Capital for Credit Risk
Standardized approach
Risk weights assigned by borrowers credit rating agencies.
Internal Ratings based approach Foundation and
Advanced
Internal ratings by banks are used.

Capital for Operational Risk

Basic Indicator Approach
Fixed percentage of the average of gross income for 3 years
Standardized Approach
Risk measured based on division of Banks business into 8
lines and respective exposure
Advanced Measurement Approach
Risk measure generated by internal operational risk
measurement system

Capital for Market Risk

VaR measure
Value At Risk measure is calculated on the banks current
portfolio to measure the impact of the current market
factors on the portfolio.
Based on historical data for past 12 months

Capital to Risk Weighted Asset Ratio

CRAR = (TIER 1 Capital + TIER 2 Capital) /
(Credit RWA + Market RWA + Operational RWA)
*RWA- Risk Weighted Assets
As per RBI, banks in India must maintain a CRAR of 9%

Pillar 2
SUPERVISORY REVIEW PROCESS
It is a regulatory response to the first pillar.
Ensures maintenance of minimum capital by banks.
Monitors and guides banks on risk management of its

assets.

Functions
of
supervisor
Ensuring banks have a process to assess minimum capital
requirements.
Reviewing these assessments.
Ensure banks maintain capital above the minimum
requirement.
Prevent capital from falling below the minimum levels.

Pillar 3 : Market Discipline

This is meant to complement the other two

pillars.
The banks disclosures need to be consistent
with how senior management and the Board
of Directors assess and manage the risks of
the bank.

MD Framework

Basel III
In 2010, Basel III guidelines were released. These guidelines
were introduced in response to the financial crisis of 2008 (in US
and Europe).
A need was felt to further strengthen the system as banks in the
developed economies were under-capitalized, over-leveraged and
had a greater reliance on short-term funding.
Also the quantity and quality of capital under Basel II were
deemed insufficient to contain any further risk.
Basel III norms aim at making most banking activities such as
their trading book activities more capital-intensive.
The guidelines aim to promote a more resilient banking system
by focusing on four vital banking parameters viz. capital,
leverage, funding and liquidity.

Around 10 public sector banks (PSBs) will get a total capital

infusion of Rs 12,517 crore from the government before this
financial year ends. This is to enable a step-up of lending at this
time of slowing economic growth, as well as meeting the capital
adequacy norms. In the light of this development here is a short
primer on Basel banking norms.

We are aware that originally Basel Committee was

formed in 1974 by a group of central bank governors
from 10 countries. Earlier guidelines were known as
Basel I and Basel II accords.
Later on the committee was expanded to include
members from nearly 30 countries , including India.
Inspite of implementation of Basel I and II guidelines,
the financial world saw the worst crisis in early 2008
and whole financial markets tumbled.
One of the major debacles was the fall of Lehman
Brothers.
One of the interesting comments on the Balance Sheet
of Lehman Brothers read : Whatever was on the lefthand side (liabilities) was not right and whatever was
on the right-hand side (assets) was not left. Thus, it
became necessary to re-visit Basel II and plug the
loopholes and make Basel norms more stringent and
wider in scope.

BCBS, through Basel III, put forward norms aimed at

strengthening both sides of balance sheets of banks
viz.
(a) enhancing the quantum of common equity;
(b)improving the quality of capital base
(c) creation of capital buffers to absorb shocks;
(d)improving liquidity of assets
(e) optimising the leverage through Leverage Ratio
(f) creating more space for banking supervision by
regulators under Pillar II and (g) bringing further
transparency and market discipline under Pillar III.
Thus, Basel III norms were released by BCBS and
individual central banks were asked to implement
these in a phased manner.
RBI (India's central bank) too issued draft guidelines
in the initial stage and then came up with the final
guidelines

Over View of the RBI Guidelines for Implementation of Basel III

guidelines :
The final guidelines have been issued by Reserve Bank of India for
implementation of Basel 3 guidelines on 2nd May, 2012. Full detailed
guidelines can be downloaded from RBI website, by clicking on the
following
link
: Implementation of Base III Guidelines. Major
features of these guidelines are :
(a) These guidelines would become effective from January 1, 2013 in
a phased manner. This means that as at the close of business on
January 1, 2013, banks must be able to declare or disclose capital
ratios computed under the amended guidelines. The Basel III capital
ratios will be fully implemented as on March 31, 2018
(b) The capital requirements for the implementation of Basel III
guidelines may be lower during the initial periods and higher during
the later years. Banks needs to keep this in view while Capital
Planning;

(c) Guidelines on operational aspects of implementation of the

Countercyclical Capital Buffer. Guidance to banks on this will be issued
in due course as RBI is still working on these. Moreover, some other
proposals viz. Definition of Capital Disclosure Requirements,
Capitalisation of Bank Exposures to Central Counterparties etc., are
also engaging the attention of the Basel Committee at present.
Therefore, the final proposals of the Basel
Committee on these aspects will be considered for implementation, to
the extent applicable, in future.
(d) For the financial year ending March 31, 2013, banks will have to
disclose the capital ratios computed under the existing guidelines
(Basel II) on capital adequacy as well as those computed under the
Basel III capital adequacy framework.
(e) The guidelines require banks to maintain a Minimum Total Capital
(MTC) of 9% against 8% (international) prescribed by the Basel
Committee of Total Risk Weighted assets. This has been decided by
Indian regulator as a matter of prudence. Thus, it requirement in this
regard remained at the same level. However, banks will need to raise
more money than under Basel II as several items are excluded under
the new definition.
(f) of the above, Common Equity Tier 1 (CET 1) capital must be at least
5.5% of RWAs;

(g) In addition to the Minimum Common Equity Tier 1 capital of

5.5% of RWAs, (international standards require these to be only
at 4.5%) 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. 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. In case suchbuffers have
been drawn down, the banks have to rebuild them through
reduced discretionary distribution of earnings. This could
include reducing dividend payments, share buybacks and staff
bonus.
(h) Indian banks under Basel II are required to maintain Tier 1
capital of 6%, which has been raised to 7% under Basel III.
Moreover, certain instruments, including some with the
characteristics of debts, will not be now included for arriving at
Tier 1 capital;
(i) The new norms do not allow banks to use the consolidated
capital of any insurance or non financial subsidiaries for
calculating capital adequacy.

(j) Leverage Ratio : Under the new set of guidelines, RBI has
set the leverage ratio at 4.5% (3% under Basel III). Leverage
ratio has been introduced in Basel 3 to regulate banks which
have huge trading book and off balance sheet derivative
positions. However, In India, most of banks do not have large
derivative activities so as to arrange enhanced cover for
counterparty credit risk. Hence, the pressure on banks should
be minimal on this count.
(k) Liquidity norms: The Liquidity Coverage Ratio (LCR) under
Basel III requires banks to hold enough unencumbered liquid
assets to cover expected net outflows during a 30-day stress
period. In India, the burden from LCR stipulation will depend
on how much of CRR and SLR can be offset against LCR. Under
present guidelines, Indian banks already follow the norms set
by RBI for the statutory liquidity ratio (SLR) and cash reserve
ratio (CRR), which are liquidity buffers. The SLR is mainly
government securities while the CRR is mainly cash. Thus, for
this aspect also Indian banks are better placed over many of
their overseas counterparts.

(l) Countercyclical Buffer: Economic activity moves in cycles and banking

system is inherently pro-cyclic. During upswings, carried away by the
boom, banks end up in excessive lending and unchecked risk build-up,
which carry the seeds of a disastrous downturn. The regulation to create
additional capital buffers to lend further would act as a break on
unbridled bank-lending. The detailed guidelines for these are likely to be
issued by RBI only at a later stage
On the day of release of these guidelines, analysts felt that India may need
at least $30 billion (i.e. around Rs 1.6 trillion) to $40 billion as capital over
the next six years to comply with the new norms. It was also felt that this
would impose a heavy financial burden on the government, as it will need
to infuse capital in case it wanst to continue its hold on these PS Banks.
RBI Deputy Governor, Mr Anand Sinha viewed that the implementation
of Basel II may have a negative impact on India's growth story. In FY
2012-13, Government of India is expected to provide Rs 15888 crores to
recapitalize the banks. as to maintain capital adequacy of 8% under old
Basel II norms.