Analyst Profile Assignment

Topic: Basel Accords 1,2,3

Submitted By :
Amit Kumar Sindhu
PRN-18020942053
Question : 1 What is the need for Basel norms?

The economies of different countries are interdependent.

Economy of the world is getting increasingly integrated.
As a consequence economic developments in one country has immediate impact on other
economies of the world.
The impact is immediate and significant due use of technology and large volumes.
This has increased the risks for the banks manifold.
Therefore it was felt necessary that there should be a forum of central banks of different countries
for
framing norms for supervision of banks for financial stability. The Basel Committee on Bank
supervision (BCBS) was formed in 1974 as a forum for regular cooperation between its member
countries regarding supervision of banks.
The objective was financial stability through improvement in quality of banking supervision world
wide.
The committee makes banking policy guidelines for both member and non-member countries and
helps authorities to implement its suggestions.Though the committee itself does not have any
superior authority over the governments and central banks to which it makes recommendations,
its guidelines are broadly followed and well regarded in the international central banking and
finance community.

Question : 2 What are the objectives of Basel norms?

➢ Safety and Soundness of bankness.

➢ Level playing field for banking based on strengths
➢ Financial stability
Subsequently it has prescribed capital adequacy norms and guidelines for supervision of
banks which have now become risk management tools for the regulators and the banks.
So far three accords called Basel-1,Basel-2 and Basel-3 have been reached. The second
and third accords have incorporated additional risks and have prescribed more stringent
norms

Question : 3 What are the salient features of Basal 1,2 and 3

A. Basel I
 It has focused mostly on credit risk and has considered it as the major risk faced by
the banks .
2) In order to mitigate this risk it has prescribed 8% capital to risk weighted assets
ratio for internationally operating banks.
3) The assets of the of financial institutions are categorized into in to five risk
categories namely
(0%, 10%, 20%, 50% and 100%).
4) The capital of the banks was divided into two categories
Tier-I and Tier-II

Tier 1 :

• Paid-up capital
• Statutory Reserves
• Disclosed free reserves
• Capital reserves representing surplus arising out of sale proceeds of assets
Equity investments in subsidiaries, intangible assets and losses in the current period and
those brought forward from previous periods will be deducted from Tier I capital.
Tier-II Capital
➢ Undisclosed Reserves and Cumulative Perpetual Preference Shares
➢ Revaluation Reserves
➢ General Provisions and Loss Reserves
➢ Revaluation reserves,
➢ General provisions loan loss reserves ,
➢ Hybrid debt capital instruments such as bonds,
➢ Long term unsecured loans,
belongs from the category of Tier2 capital.
Total capital of the bank =(Tier-1 capital + Tier 2 capital)
As per Basel-I, banks are required to maintain capital as 8% of risk weighted assets, out of
which 4% should be tier-I and 4% should be Tier-II capital.

B. 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.
It focuses on three main areas
1) Minimum capital requirements for credit risk, market risk and operational risk.
2) Supervisory review by the Central Bank of the country (RBI) regarding bank’s capital
adequacy and internal assessment process, and
3) Market discipline to be observed by banks regarding disclosures.
Banks should maintain a minimum capital adequacy requirement of 8% of risk assets,
In India, such a practice is equivalent to maintaining a Capital Adequacy ratio (CAR).
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.
Increased disclosure requirements raise the confidence of investors and depositors in the
bank. The more transparent a bank is, the more stable it is deemed to be.
Banks need to mandatorily disclose their risk exposure, etc to the central bank.
C. Basel III

Main features of basel norms 3 are :

Improve the banking sector’s ability to absorb shocks arising from financial and economic
stress
Improve risk management and governace
Strengtehen banks’ transparency and diclosures
The objective of Basel-III accord was to strengthen banks on two aspects:
1. Capital
2. Liquidity

Capital
Minimum capital adequacy ratio has been increased to 10.5% from 8%.
Liquidity
The concept of Liquidity coverage ratio was made applicable to banks/Financial
Institutions as safeguard to prevent run on banks.
This ratio should higher than 100%
𝑡𝑜𝑡𝑎𝑙 ℎ𝑖𝑔ℎ 𝑞𝑢𝑎𝑙𝑖𝑡𝑦 & ℎ𝑖𝑔ℎ𝑙𝑦 𝑙𝑖𝑞𝑢𝑖𝑑 𝑎𝑠𝑠𝑒𝑡𝑠
Liquidity Coverage ratio =
𝑇𝑜𝑡𝑎𝑙 𝑛𝑒𝑡 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤 𝑜𝑣𝑒𝑟 𝑛𝑒𝑥𝑡 30 𝑑𝑎𝑦𝑠
Question : 4 How are the pillars of Basal 2 supportive to each other?
Unlike the Basel I where the focus is on minimum capital requirements, in the Basel II two
new pillars were added making a total of 3 pillars:
Pillar 1. - Minimum capital requirements

Minimum capital requirements:

The Basel-I accord dealt with only one risk namely , credit risk.
The Basel-II considers all three risks namely
1)Credit risk
2) Market risk and
3)Operational risk.
Other risk factors are considered as residual risk.
The minimum capital requirements are prescribed by considering all these risks.
Hence capital required is more as compared to Basel-I.
Risk weights for credit account are based on respective credit ratings of the
accounts.
Pillar 2. - Supervisory review and

The Basel-II provisions require that central bank of the country as well as banks
themselves should
Undertake supervision of all banks under its purview.
Ensure that banks have their individual risk management processes in place to
identify and assess credit risk, market risk and operational risks.
Confirm that risk management processes followed by banks are proper.
Confirm that adequate capital is provided by banks covering these risks.
It also provides a background framework for dealing with residual risks which
consists of systemic risk, concentration risk, strategic risk, reputational risk, liquidity
risk, and legal risk.

Pillar 3. - Market discipline

 The objective pillor-3 requires banks to disclose details of capital, risk exposures,
risk assessment processes and capital adequacy.
This results into sharing of information and facilitates assessment of the bank by
investors, analysts, customers, other banks, and rating agencies, which impacts
valuation of its shares.
This ultimately forces management to follow good governance practices.

Question : 5 Comparison between Basal 1,2 and 3?

Comparative Analysis Basel 1, 2 & 3 at a glance
Basel 1 Basel 2 Basel 3
Types of Credit Risk Credit Risk, Credit Risk
Risk Market Risk Market Risk & Market Risk
Covered Operational Risk Operational Risk
Liquidity Risk
Counter Cycle Risk
Main tools Capital to Risk 1. CRAR 1.CRAR
of Risk Weighted 2. Supervisory Review 2.Supervisory Review
Manageme Assets Ratio 3. Market Discipline 3.Market Discipline
nt (CRAR) 4.Liquidity Coverage
Ratio
5.Counter cycle
Buffer
6.Capital
Conservation
Buffer
7.Leverage Ratio

Ways of Simple but From Simple to Complex & flexible Same as Basel 2 but
Calculation standard Approach additional capital for
of Risk Lesser Risk Weights in Complex Capital Conservation
Weighted 4 major risk Approaches & Contra Cyclical
Assets and categories of Type of Method 1 Method 2 Method 3 Buffer
CRAR assets and Risk
 risk weights Credit Standardize Foundation Advanced
according to Risk d Approach Internal Internal
it Rating Rating
Based Based
Market Standardize Internal Model Approach
Risk d Approach
Operation Basic Standardize Advanced
al Indicator d Approach Measurem
Approach Approach ent
Approach
Major First 1. Covered Operational risk apart from credit & Liquidity Risk
Contributio International market risk Management
n Measure to 2. Recognized differentiation & brought flexibility Will help to build
cover banking 3. Better asset quality helped banks to reduce capital during good
risk Capital Requirements time, which can be
used in stressed
situation by Counter
Cycle Buffer
Introduction of
Capital
Conservation
Buffer

AIMA Journal of Management & Research, May 2013, Volume 7, Issue 2/4, ISSN 0974 – 497
Copy right© 2013 AJMR-AIMA
Limitations Too simple 1. Additional Capital requirement for Op. Risk Requirement of
to cover all 2. Higher capital requirement in stressed situation additional CRAR
risks as asset quality reduces. Capital markets also dry between 2.5% to
Banks had to at that time. 5%
raise 3. High costs for up gradation of technology, Increased
additional disclosure & information system requirement of
capital 4. Increased supervisory review required in case of common equity
advanced approaches share capital also.
5. Subprime crises exposed the inadequate credit &
liquidity risk covers of banks
Minimum CRAR= 8% CRAR= 8% CRAR= 10.5% TO
CRAR Tier 1= 4% 13%
according Tier 1= 6%
to BCBS Common Equity=
4.5%
Minimum CRAR= 9% CRAR= 9% CRAR= 11.5%
CRAR Tier 1= 6% Tier 1 = 7%
according Common Equity= 3.6% Common Equity=
to RBI GOI recommended CRAR for PSU= 12% 5.6%
Question : 6 Discus the present status of the implementation of Basel III norms?

The government of India is scaling disinvesting their holdings in PSBs to 52 per

cent.
The government will soon infuse Rs 6,990 crore in nine public sector banks
including SBI, Bank of Baroda (BoB), Punjab National Bank (PNB) for enhancing
their capital and meeting global risk norms.
This is the first tranche of capital infusion for which the government had allocated
Rs 11,200 crore in the Budget for 2014-15.
The government has infused Rs 58,600 crore between 2011 to 2014 in the state-
owned banks.
Finance Minister Arun Jaitley in the Budget speech had said that "to be in line
with Basel-III norms there is a requirement to infuse Rs 2,40,000 crore as equity
by 2018 in our banks. To meet this huge capital requirement we need to raise
additional resources to fulfil this obligation.
The RBI has postponed the implementation of these norms to 2019.

It is important to note that it is not easy to implement these norms as it requires

several changes in the present banking system.

There are several challenges in the successful implementation of Basel III norms.

1. Higher capital requirement for banks – The private banks have the
autonomy to raise capital from the markets. But the Public sector banks have to
rely on the government mostly. The government has recently decided to infuse
12000 Cr. rupees in the PSBs. In the coming years even more will be required.

2. More technology deployment – Implementing the norms would require much

more sophisticated technology and management styles that the Indian banks are
presently using. Upgrading both will impose huge cost on the banks and hurt
their profitability in the coming years.

3.Liquidity crunch – Banks would need to invest more on liquid assets. These
assets do not give handsome returns usually which would reduce the bank’s
operating profit margin. Further higher deployment of more funds in liquid assets
may crowd out good private sector investments and also affect economic growth.
 Question : 7 It is observed that the economic crises continue to occur in
spite of the implementation of Basal accords. What can be the possible
reasons?

The financial market turmoil led to severe financial crisis that spread across different
financial instruments and financial markets to disseminate worldwide. This crises
revealed that most risk management tools used by banks, including the stress tests
performed aren’t effective enough to rely upon and will fail to predict the risk hence they
use the historic data. Hence the causes of economic crisis are the bank trends which
cause market illiquidity.
The possible reasons for the same can be:
1) Capital: the concept of regulatory capital ratio. The minimum capital requirements
were kept unchanged but various components of the capital and its composition
were thoroughly revised to endure that the capital performs its intended role of
loss absorption.

2) Leverage ratio: the banks are advised to monitor leverage ratio of 4.5%. the
leverage ratio does not adjust the assets for weights and therefore would need
the required capital for a given balance sheet. Leverage ratio is not acting as the
binding factor for most banks in India.

3) Changes in the risk weighted assets: the banks will avoid credit ratings for
determining risk weights for credit risk given the lessons learnt from the scams.
For the market risk there is a requirement to compute sensitivities (like beta,
alpha)

4) Provisioning of the loans: IFRS has to be implemented based on expected loss

provisions.

5) When capital requirement increases there is an impact on the growth.

6) The banks are not supervised with utmost care.

7) Liquidity problems that banks are facing, few lot of banks have liquidity crunch
because of which banks are not able to adhere to basel norms.