BASEL NORMS

SUBMITTED BY: SANYA SHARMA BFIA-III 16053

The Basel Accords refer to the banking supervision Accords (recommendations on banking regulations) Basel I, Basel II and Basel IIIissued by the Basel Committee on Banking Supervision (BCBS). The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten countries in 1975. eight International Monetary Fund (IMF) members, Belgium, Canada, France, Italy, Japan, the Netherlands, the United Kingdom, and the United Statesand the central banks of two others, Germany and Sweden.

BASEL ACCORDS

The Committee was formed in response liquidation of Herstatt Bank in 1974. On 26 June 1974, a number of banks had released Deutsche Mark (German Mark) to the Bank Herstatt 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 counter-party banks, and during this gap, and before the dollar payments could be effected in New York, the Bank Herstatt was liquidated by German regulators. This triggered serious disturbances in international currency and banking markets and prompted the G-10 nations to form the BCBS towards the end of 1974. The first meeting took place in February 1975 and meetings have been held regularly three or four times a year since.

THE NEED FOR BASIL ACCORDS

A capital measurement system commonly referred to as the Basel Capital Accord (or the 1988 Accord), now commonly called the BASEL I was approved by the G10 Governors and released to banks in July 1988. OBJECTIVES: 1. Strengthen the stability of international banking system. 2. Set up a fair and a consistent international banking system in order to decrease competitive inequality among international banks. The basic achievement of Basel I has been to define the bank capital.

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BASELBASEL-1

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Tier 1 (Core Capital): Includes common stock, preferred stock that is irredeemable and non-cumulative, retained earnings and declared reserves, such as loan loss reserves set aside to cushion future losses or for smoothing out income variations. Tier 2 (Supplementary Capital): Tier 2 capital includes undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt. Capital components such as gains on investment assets, longterm debt with maturity greater than five years and hidden reserves (i.e. excess allowance for losses on loans and leases). However, short-term unsecured debts (or debts without guarantees), are not included in the definition of capital.

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TWOTWO-TIERED CAPITAL

Basel I, that is, the 1988 Basel Accord, primarily focused on credit risk. The Basel agreement identifies three types of credit risks:
The on-balance sheet risk. The trading off-balance sheet risk. These are derivatives, namely interest rates, foreign exchange, equity derivatives and commodities. The non-trading off-balance sheet risk. These include general guarantees, such as forward purchase of assets or transactionrelated debt assets.

Implementation of the framework with a minimum capital ratio of capital to risk-weighted assets of 8 percent by end-1992.

BASELBASEL-1 PROVISIONS

Assets of banks were classified and grouped in five categories according to credit risk, carrying risk weights of zero (for example home country sovereign debt), ten, twenty, fifty, and up to one hundred percent (this category has, as an example, most corporate debt). 0% - cash, central bank and government debt and any OECD government debt 0%, 10%, 20% or 50% - public sector debt 20% - development bank debt, OECD bank debt, OECD securities firm debt, non-OECD bank debt (under one year maturity) and non-OECD public sector debt, cash in collection 50% - residential mortgages 100% - private sector debt, non-OECD bank debt (maturity over a year), real estate, plant and equipment, capital instruments issued at other banks

RISK CATEGORIES

In June 1999, the Committee issued a proposal for a new capital adequacy framework to replace the 1988 Accord, culminating in the release of the New Capital Framework on 26 June 2004. Need for Replacing BASEL I: Ensuring that capital allocation is more risk sensitive. Enhance disclosure requirements which will allow market participants to assess the capital adequacy of an institution; Ensuring that credit risk, operational risk and market risk are quantified based on data and formal techniques. Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.

BASELBASEL-2

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THE FIRST PILLAR: Maintenance of regulatory capital calculated for three components of risk that a bank faces: credit risk, operational risk, and market risk. The credit risk component can be calculated in 2 ways, namely standardized approach and Foundation IRB or Advanced IRB. IRB stands for "Internal Rating-Based Approach. Standardized Approach: capital requirements are equal 8% of the outstanding amount of money. Under this approach the banks are required to use ratings from External Credit Rating Agencies to quantify required capital for credit risk. IRB: in general, banks are ought to calculate borrowers probability of default using internal measures (Foundation IRB). In particular, banks can also estimate the loss given default and the exposure at default using their own methods (Advanced IRB).

THE THREE PILLARS

For operational risk, there are three different approaches - basic indicator approach or BIA, standardized approach or STA, and the internal measurement approach (an advanced form of which is the advanced measurement approach or AMA).

For market risk the preferred approach is VaR (value at risk). y VaR is defined as a threshold value such that the probability that the mark-to-market loss on the portfolio over the given time horizon exceeds this value (assuming normal markets and no trading in the portfolio) is the given probability level.
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THE SECOND PILLAR: much improved 'tools to regulators over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk and legal risk, which the accord combines under the title of residual risk. It gives banks a power to review their risk management system.

THE THIRD PILLAR: This pillar aims to complement the minimum capital requirements and supervisory review process by developing a set of disclosure requirements which will allow the market participants to gauge the capital adequacy of an institution. y The aim of pillar 3 is to allow market discipline to operate by requiring institutions to disclose details on the scope of application, capital, risk exposures, risk assessment processes and the capital adequacy of the institution
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Capital Requirement: The new norms will almost invariably increase capital requirement in all banks across the board. Profitability: Competition among banks for highly rated corporates needing lower amount of capital may exert pressure on interest spread. Risk Management Architecture: The new standards call for introduction of advanced risk management system with wider application throughout the organization which in itself is a daunting task.

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Choice of Alternative Approaches: The new framework provides for alternative approaches for computation of capital requirement of various risks. However, competitive advantage of IRB approach may lead to domination of this approach among big banks. y . Hence, the system as a whole may maintain lower capital than warranted and become more vulnerable.
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Disclosure Regime: While the disclosure may be useful for supervisory authorities and rating agencies the expertise and ability of the general public to comprehend and interpret disclosed information is open to question

ISSUES WITH BASEL-2 BASEL-

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Definition of CAPITAL: Going by the new rules, the predominant component of capital is common equity and retained earnings. The new rules restrict inclusion of items such as deferred tax assets, mortgageservicing rights and investments in financial institutions to no more than 15% of the common equity component. PROVISIONS: key capital ratio changed to 7% of risky assets, according to the new norms, Tier-I capital that includes common equity and perpetual preferred stock will be raised from 2-4.5% starting in phases from January 2013 to be completed by January 2015. In addition, banks will have to set aside another 2.5% as a contingency for future stress. Banks that fail to meet the buffer would be unable to pay dividends, though they will not be forced to raise cash.

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CHANGES..

A McKinsey Quarterly Report on BASEL III estimates that banks in Europe and the United States will have to raise about 1.65 trillion of new capital, about 1.9 trillion of short-term liquidity, and about 4.5 trillion of long-term funding. The capital shortfall is equivalent to about 60 percent of all outstanding Tier 1 capital, and the short-term liquidity gap is about 50 percent of all the liquidity that banks currently hold. Their analysis shows that these rules could reduce return on equity (ROE) for the average European bank by between 3.7 and 4.3 percentage points by 2019, from the pre-crisis ROE average of 15 percent This highlights the daunting prospect that the implementation of BASEL III is, particularly in light of the incumbent financial turmoil in Europe.

THE BIG ISSUE

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