Basel Norms: An Overview

Why Regulate Banks?

Insurance for deposit holders

Leading to systemic risk
Should regulator bail out banks?

History of Bank Regulation

Pre-1988
1988: BIS Accord (Basel I)
1996: Amendment to BIS Accord
1999: Basel II first proposed
2010: Basel III first proposed

Pre-1988

Banks were regulated using balance sheet

measures such as the ratio of capital to assets
Definitions and required ratios varied from
country to country
Enforcement of regulations varied from
country to country
Bank leverage increased in 1980s
Off-balance sheet derivatives trading increased
LDC debt was a major problem
Basel Committee on Bank Supervision set up

1988: BIS Accord

Main Provisions:
Capital must be 8% (9% in India) of risk
weighted amount.
Framework was to be implemented by end 1992
At least 50% of capital must be Tier 1
Tier 1 Capital: common equity, non-cumulative
perpetual preferred shares
Tier 2 Capital: cumulative preferred stock,
certain
types
of
99-year
debentures,
subordinated debt with an original life of more
than 5 years

The Math

RWA

i 1

On-balance sheet
assets: principal
times risk weight

wi Li

j 1

w C
*
j

Derivatives and off-balance

sheet commitments: credit
equivalent amount times
risk weight

For a derivative Cj = max(Vj,0) + ajLj where Vj is

value, Lj is principal and aj is add-on factor

Risk Weights and Capital Allocation

Risk weight (%)

Asset Category (On-balance sheet)

10

Claims on domestic public sector entities

50

Residential mortgages

20

100

Obligation on OECD government and US treasuries.

Claims on OECD banks/securities issued by US

government agencies/Claims on municipalities, NonOECD short-term inter-bank loans
All other claims such as corporate debt/Claims on
both OECD/Non-OECD, Non-OECD long term interbank loans, Commercial real estate etc.

Add-on Factors (% of Principal)

Remaining
Maturity (yrs)

Interest
rate

Exch Rate
and Gold

Equity

<1

0.0

1.0

6.0

7.5

10.0

1 to 5
>5

0.5
1.5

5.0

8.0

Precious
Metals
except gold

Other
Commodities

7.0

10.0

6.0

15.0

7.0

12.0

Example: A $100 million interest rate swap with 3 years to maturity and with
market value of $5 million would have a credit equivalent amount of $5.5
million

Implementation of Basel I

Basel I does not have any legal force

Accepted by G-10 and Non-G10 countries
as global standard
IMF assesses members compliance with
financial sector codes and standards
Market forces and rating agencies
125 countries had adopted Basel I Accord

What has happened since Basel I

Criticism of Basel I
Liberalization and Transformation of the
financial sector
Various amendments to Basel I: the market
risk amendment 1996
The revised capital accord or Basel II

Problems with Basel I

Systematic curtailment of lending and world

recession of 1990
Change in priorities of banks, profit maximizing
investments
Led to financial bubbles, stock market and real
estate booms and then crashes
From commercial lending towards residential
mortgages and public sector securities
Commercial disadvantage of lending to highly
rated borrowers w.r.t. other NBFCs

Problems with Basel I

Does not distinguish among different credit

exposures

Both AAA and BBB assets attract the same

capital charge.

Static measure of default risk.

Does not take into account the probability of

default.

Incentive towards short term lending led to the

late 1990s financial crisis

1996 Amendment to Incorporate

Market Risk

1996 amendment treats trading positions in

bonds,
equity,
foreign
exchange
and
commodity in the market risk framework.
Provides explicit capital charges on banks open
position in each instrument
Provides scope for BIS standardized approach
and internal models approach.

Banks can either choose BIS prescribed model or

their own internal model (e.g. Value at Risk) to
assess
market
risk
subject
to
supervisory
compliance.

1996 Amendment Contd..

Capital charge is to be made on the

following

Held to maturity (HTM) category

Available for sale
Foreign exchange positions
Trading positions in derivatives
Derivatives entered into for hedging trading
book exposures.

The New Basel Capital Accord

Will replace 1988 Basel Accord.

Based on three mutually enforcing
pillars.
Specific reference to operational risk in
banking.
Implementation scheduled for 2007.

The New Basel Capital Accord

PILLAR I
Minimum capital
requirements
Credit risk
Market
Market risk
Operational risk

PILLAR II
Supervisory
Review
Review of the
institutions
capital adequacy
Review of the
internal
assessment
process

PILLAR III
Market
Discipline

Enhancing
transparency
through
rigorous
disclosure
norms.

The New Basel Capital Accord

Total Capital
Credit + Market + Operational
Risk
Risk
Risk

Revised

Unchanged

= Capital Ratio (minimum 8%)

New

The new Accord focuses on revising only the denominator (riskweighted assets), the definition and requirements for capital are
unchanged from the original Accord.

The New Basel Capital Accord

Credit Risk

Standardized approach
Internal Rating Based (IRB) approach
Foundation vs. Advanced

Operational Risk

Basic indicator approach

Standardized approach
Advanced measurement appraoch

Credit Risk and Standardized

Approach

Standardized approach(0% to 150%)

The capital required is estimated as

Exposure at Default (EAD) Risk weight (RW)

8%

The risk weights are standardized under Basel II.

Credit Risk and Standardized

Approach

Risk weights of sovereigns

Credit
Assessment

AAA to A+ to
AAA-

Risk
0
weights (%)

20

BBB+ to
BBB-

BB+ to B- Below
B-

Unrated

50

100

100

150

Credit Risk and Standardized

Approach

Risk weights of corporates

AAA to AA- A+ to
ARisk weights 20
(%)

50

BBB+
to
BB-

100

Below Unrated
BB150

Risk weights of retail exposure at 75%

Credit derivatives are considered

100

Implications of the Standardized

Approach
Emphasis on credit ratings increase difficulty in
accessing bank finance for unrated companies,
especially SMEs
Loans to SMEs may be classified under retail
exposures, 75% risk weight
Higher capital requirements during recession

Credit Risk and IRB Approach

IRB approach is based on four key

parameters

Probability of default (PD)

Loss given default (1 recovery rate)
Exposure at default (EAD)
Effective Maturity

Credit Risk and IRB Approach

Foundation approach

Only PDs are internally estimated and all

other parameters such as LGD and EAD are
standardized as per supervisory estimates

Advanced approach

All parameters are internally determined

including the LGD.

Operational Risk

Basic indicator approach

Sets the charge for operational risk as 15%

of positive annual gross income averaged
over the previous three years.
Thus links to the risk of an expected loss
due to internal or external events.

Operational Risk

Basic indicator approach

KBIA = EI*

Where
KBIA = the capital charge under the Basic Indicator
Approach
EI = the level of an exposure indicator for the whole
institution, provisionally gross income
= a fixed percentage, set by the Committee, relating
the industry-wide level of required capital to the
industry-wide level of the indicator

Operational Risk

Standardized approach

Requires that the institution partition its

operation into different lines of business.
The capital charge is estimated as an
exposure indicator for each line of business
multiplied by a coefficient.
Provisionally, the Basel committee intends to
use gross income for this purpose.

Operational Risk

Standardized approach

KTSA = (EI*)

Where:
KTSA
= the capital charge under the Standardized
Approach
EI
= the level of an exposure indicator for each of
the 8 business lines
= a fixed percentage, set by the Committee, relating
the level of required capital to the level of the gross
income for each of the 8 business lines

Operational Risk

Business Lines

Corporate finance
Trading and sales
Retail banking
Commercial banking
Payment and settlement
Agency services
Asset management
Retail brokerage

Beta Factor
18%
18%
12%
15%
18%
15%
12%
12%

Operational Risk

Advanced measurement approach (AMA)

Capital requirement is based on banks

internal
operational
risk
measurement
system.
Focuses
on
both
measurement
and
management of operational risk.
Requires supervisory approval based on
qualitative and quantitative standards.

Operational Risk

Advanced measurement approach

KIMA = (EIij*PEij*LGEij*ij)

KIMA = the capital charge under the Internal Measurement

Approach
EIij = the level of an exposure indicator for each business line and
event type combination
PEij = the probability of an event given one unit of exposure, for
each business line and event type combination
LGEij = the average size of a loss given an event for each business
line and event type combination
ij = the ratio of capital to expected loss for each business line and
event type combination

Market Risk

Risk of loss due to movements in market

prices of assets
Asset categories
Fixed income vs. others

Principal risk

Interest rate and volatility risk

Market Risk for Fixed Income

Standardized Approach

Internal Model Based Approach

VaR could be used for market risk

Market Risk for Other Assets

Standardized Approach

Classify assets based on type, origin,

maturity, and volatility
Assign weights from 2.25% to 100%
Scenario analysis is must

Internal Model Approach

VaR with a 10-day time horizon and at 99%

confidence level

Market Risk Charge

The capital requirement for market risk is
Max(VaRt-1 , mc * VaRavg ) + SRC
where mc = multiplicative factor, minimum is 3
SRC = specific risk charge

Back Testing and Capital Charge

Basel II and Total Capital

Total Capital = 0.08 * (credit risk
RWA + market risk RWA +
operational risk RWA)

Supervisory Review Process

Four basic principles

Banks should have a process for assessing

their overall capital
Supervisory review of banks internal capital
adequacy and compliance
Supervisor must expect the banks to
operate
above
the
minimum
capital
requirements.
Appropriate intervention on behalf of the
supervisor before it gets too late!

Market Discipline

Comprehensive disclosure is essential for

market participants to understand the
relationship between risk profile and
capital of an institution.
Includes the disclosure of capital
structure,
capital
adequacy,
risk
exposure such as market, credit and
operational etc.

Basel II Limitations

Capital charge for specific risk (credit risk)

in market risk framework (trading book)
was lower than capital charge for credit
risk in banking book
Lower capital charge for trading book led to
scope for capital arbitrage
Capital charge for counterparty credit risk
for derivative positions also covered only
the default risk and migration risk was
not captured

Basel II Limitations cont

The global financial crisis mostly

happened in the areas of trading book
/off balance sheet derivatives / market
risk and inadequate liquidity risk
management
Banks suffered heavy losses in their
trading book
Banks did not have adequate capital to
cover the losses

Basel III

Objectives

Improving banking sectors ability to absorb

shocks
Reducing risk spillover to the real economy

Fundamental reforms proposed in the

areas of

Micro prudential regulation at individual bank

level
Macro prudential regulation at system wide
basis

Basel III

Key characteristic of the financial crisis

was
inaccurate
and
ineffective
management of liquidity risk
Two standards/ratios proposed

Liquidity Coverage Ratio (LCR) for short

term (30 days) liquidity risk management
under stress scenario
Net Stable Funding Ratio (NSFR) for
longer term structural liquidity mismatches

Basel III

Liquidity Coverage Ratio (LCR)

Ensuring enough liquid assets to survive an

acute stress scenario lasting for 30 days
Defined as stock of high quality liquid assets
/ Net cash outflow over 30 days > 100%
Stock of high quality liquid assets: Cash +
central bank reserves + high quality sovereign
paper (also in foreign currency supporting
banks operation) + state govt., & PSE assets
and high rated corporate/covered bonds at a
discount of 15%
Level 2 liquid assets with a cap of 40%

Basel III

Net Stable Funding Ratio (NSFR)

To promote medium to long term structural

funding of assets and activities
Defined as Available amount of stable
funding / Required amount of stable
funding > 100%

Basel III: Capital Rules

Capital Conservation Buffer

Make certain that banks accumulate capital

buffers in times of low financial stress
Use the same during financial stress

Counter Cyclical Buffer

Capital
requirements
must
consider
macroeconomic environment and credit
growth in the economy

Impact on Indian banks

Most of Indian banks are not trading banks,

so not much increase in enhanced risk
coverage for counterparty credit risk
Whether our SLR securities can be part of
liquid assets?
Indian banks are generally not as highly
leveraged as their global counterparts
The leverage ratio of Indian banks would be
comfortable