All About Basel Norms – Banking Awareness for Upcoming Exams

The Basel Accords refer to the banking supervision Accords (recommendations on banking regulations)—Basel I, Basel II and Basel III—issued by the Basel Committee on Banking Supervision (BCBS). They are called the Basel Accords as the BCBS maintains its secretariat at the Bank for International Settlements in Basel, Switzerland and the committee normally meets there. The Basel Accords is a set of recommendations for regulations in the banking industry.

The Basel Committee on Banking Supervision

Basel Committee consisted of representatives from central banks and regulatory authorities of the Group of Ten countries plus Luxembourg and Spain. Since 2009, all of the other G-20 major economies are represented, as well as some other major banking locales such as Hong Kong and Singapore.

The committee does not have the authority to enforce recommendations, although most member countries as well as some other countries tend to implement the Committee’s policies. This means that recommendations are enforced through national (or EU-wide) laws and regulations, rather than as a result of the committee’s recommendations – thus some time may pass between recommendations and implementation as law at the national level.

BASEL Norms I:

Basel Norms 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. A new set of rules known as Basel II was later developed with the intent to supersede the Basel I accords. However they were criticized by some for allowing banks to take on additional types of risk, which was considered part of the cause of the US subprime financial crisis that started in 2008. In fact, bank regulators in the United States took the position of requiring a bank to follow the set of rules (Basel I or Basel II) giving the more conservative approach for the bank. Because of this it was anticipated that only the few very largest US banks would operate under the Basel II rules, the others being regulated under the Basel I framework. Basel III was developed in response to the financial crisis; it does not supersede either Basel I or II [clarification needed], but focuses on different issues primarily related to the risk of a bank run.

BASEL Norms II:

Basel Norms II is the second of the Basel Accords, (now extended and partially superseded by Basel Norms III), which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision.

The Basel Norms II Accord was published initially in June 2004 and was intended to amend international banking standards that controlled how much capital banks were required to hold to guard against the financial and operational risks banks face. These regulations aimed to ensure that the more significant the risk a bank is exposed to, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability. Basel II attempted to accomplish this by establishing risk and capital management requirements to ensure that a bank has adequate capital for the risk the bank exposes itself to through its lending, investment and trading activities. One focus was to maintain sufficient consistency of regulations so to limit competitive inequality amongst internationally active banks.

Basel Norms II was implemented in the years prior to 2008, and was only to be implemented in early 2008 in most major economies; that year’s Financial crisis intervened before Basel II could become fully effective. As Basel III was negotiated, the crisis was top of mind and accordingly more stringent standards were contemplated and quickly adopted in some key countries including in Europe and the US.

Objective:

The final version aims at:

• Ensuring that capital allocation is more risk sensitive;
• Enhance disclosure requirements which would 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.

While the final accord has at large addressed the regulatory arbitrage issue, there are still areas where regulatory capital requirements will diverge from the economic capital.

The first pillar: Minimum capital requirements

The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk, and market risk. Other risks are not considered fully quantifiable at this stage.

The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach, Foundation IRB, Advanced IRB and General IB2 Restriction. IRB stands for “Internal Rating-Based Approach”.

For operational risk, there are three different approaches – basic indicator approach or BIA, standardised approach or TSA, 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).

As the Basel II recommendations are phased in by the banking industry it will move from standardised requirements to more refined and specific requirements that have been developed for each risk category by each individual bank. The upside for banks that do develop their own bespoke risk measurement systems is that they will be rewarded with potentially lower risk capital requirements. In the future there will be closer links between the concepts of economic and regulatory capital.

The second pillar: Supervisory review

This is a regulatory response to the first pillar, giving regulators better ‘tools’ over those previously available. It also provides a framework for dealing with 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. Banks can review their risk management system.

The Internal Capital Adequacy Assessment Process (ICAAP) is a result of Pillar 2 of Basel II accords.

In India, the RBI has issued the guidelines to the banks that they should have an internal supervisory process which is called ICAAP or Internal Capital Adequacy Assessment Process. With this tool the banks can assess the capital adequacy in relation to their risk profiles as well as adopt strategies for maintaining the capital levels.

Apart from that, there is another process stipulated by RBI which is actually the Independent assessment of the ICAAP of the Banks. This is called SREP or Supervisory Review and Evaluation Process.

The independent review and evaluation may suggest prudent measures and supervisory actions whatever is needed.

ICAAP is conducted by Banks themselves and SREP is conducted RBI which is along with the RBI’s Annual Financial Inspection (AFI) of the bank.

The third pillar: The Market Discipline

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.

Market discipline supplements regulation as sharing of information facilitates assessment of the bank by others, including investors, analysts, customers, other banks, and rating agencies, which leads to good corporate governance. 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. It must be consistent with how the senior management, including the board, assess and manage the risks of the institution.

When market participants have a sufficient understanding of a bank’s activities and the controls it has in place to manage its exposures, they are better able to distinguish between banking organizations so that they can reward those that manage their risks prudently and penalize those that do not.

These disclosures are required to be made at least twice a year, except qualitative disclosures providing a summary of the general risk management objectives and policies which can be made annually. Institutions are also required to create a formal policy on what will be disclosed and controls around them along with the validation and frequency of these disclosures. In general, the disclosures under Pillar 3 apply to the top consolidated level of the banking group to which the Basel II framework applies.

BASEL Norms III:

Basel Norms III (or the Third Basel Accord) is a global, voluntary regulatory framework on bank capital adequacy, stress testing, and market liquidity risk. It was agreed upon by the members of the Basel Committee on Banking Supervision in 2010–11, and was scheduled to be introduced from 2013 until 2015; however, changes from 1 April 2013 extended implementation until 31 March 2018 and again extended to 31 March 2019. The third installment of the Basel Accords was developed in response to the deficiencies in financial regulation revealed by the financial crisis of 2007–08. Basel III is intended to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage.

The Basel Norms III standard aims to strengthen the requirements from the Basel II standard on bank’s minimum capital ratios. In addition, it introduces requirements on liquid asset holdings and funding stability, thereby seeking to mitigate the risk of a run on the bank.

BREAKING DOWN ‘Basel Norms III’

Basel III is part of the continuous effort to enhance the banking regulatory framework. It builds on the Basel I and Basel II documents, and seeks to improve the banking sector’s ability to deal with financial stress, improve risk management, and strengthen the banks’ transparency. A focus of Basel III is to foster greater resilience at the individual bank level in order to reduce the risk of system-wide shocks.

Minimum Capital Requirements

Basel Norms III introduced tighter capital requirements in comparison to Basel Norms I and Basel Norms II. Banks’ regulatory capital is divided into Tier 1 and Tier 2, while Tier 1 is subdivided into Common Equity Tier 1 and additional Tier 1 capital. The distinction is important because security instruments included in Tier 1 capital have the highest level of subordination. Common Equity Tier 1 capital includes equity instruments that have discretionary dividends and no maturity, while additional Tier 1 capital comprises securities that are subordinated to most subordinated debt, have no maturity, and their dividends can be cancelled at any time. Tier 2 capital consists of unsecured subordinated debt with an original maturity of at least five years.

Basel III left the guidelines for risk-weighted assets largely unchanged from Basel II. Risk-weighted assets represent a bank’s assets weighted by coefficients of risk set forth by Basel III. The higher the credit risk of an asset, the higher its risk weight. Basel III uses credit ratings of certain assets to establish their risk coefficients.

In comparison to Basel II, Basel III strengthened regulatory capital ratios, which are computed as a percent of risk-weighted assets. In particular, Basel III increased minimum Common Equity Tier 1 capital from 4% to 4.5%, and minimum Tier 1 capital from 4% to 6%. The overall regulatory capital was left unchanged at 8%.

Counter cyclical Measures

Basel III introduced new requirements with respect to regulatory capital for large banks to cushion against cyclical changes on their balance sheets. During credit expansion, banks have to set aside additional capital, while during the credit contraction, capital requirements can be loosened. The new guidelines also introduced the bucketing method, in which banks are grouped according to their size, complexity and importance to the overall economy. Systematically important banks are subject to higher capital requirements.

Leverage and Liquidity Measures

Basel III introduced leverage and liquidity requirements to safeguard against excessive borrowings and ensure that banks have sufficient liquidity during financial stress. In particular, the leverage ratio, computed as Tier 1 capital divided by the total of on and off-balance assets less intangible assets, was capped at 3%.