BASEL NORMS

BASEL
Committee formed in response to the messy liquidation of a Cologne based bank in 1974 Established by the central-bank Governors of the Group of Ten countries, located at the Bank for International Settlements in Basel, Switzerland Provides a forum for regular cooperation on banking supervisory matters

To enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide

G-10-Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom and the United States.

BASEL 1
In 1988,BCBS published a set of minimal capital requirements for banks, also known as the Basel Accord, and was enforced by law in the G-10 countries in 1992 The standards are almost entirely addressed to credit risk. Assets of banks grouped in five categories - carrying risk weights of 0%,10%,20%,50%,100%. Required to hold capital equal to 8 % of the risk-weighted assets. Required banks to identify their Tier-I and Tier-II capital and assign risk weights to the assets.

BASEL1
Off-balance-sheet positions into a credit equivalent amount. In 1996,trading positions in bonds, equities were removed from the credit risk framework and given explicit capital charges related to the bank's open position in each instrument.

OBJECTIVE
To ensure an adequate level of capital in the international banking system. To create a "more level playing field" in competitive terms .

LOOPHOLES
One-size-fits-all approach It does not take into consideration the operational risks of banks Banks have an incentive to move high quality assets off the balance sheet through securitization It does not sufficiently recognize credit risk mitigation techniques, such as collateral and guarantees

Why Basel II ?
Basel I is less Risk Sensitive (More broad brush approach) Basel II is more Risk Sensitive (Granular capturing of Risk Profile) Covers Operational risks Times had changed from 1988 and there was a need to change with time The measures envisaged in Basel II are intended to help Bank initiate appropriate Risk Mitigation Measures

From Trust Me to Prove & Evidence Me World

High TRUST ME TELL ME TRUST SHOW ME

PROVE ME Low Low TRANSPARENCY High

The higher the pressure put on trust The more important transparency and accountability become

What is Basel II ?
New accord signed in 2004 Basically concerned with financial health of the banks Focus
Risk determination Quantification of credit risk, market risk and operational risk faced by banks

Based on three pillars: Capital Adequacy, Supervisory Review and Market Discipline

Objectives of Basel II

To design a capital adequacy framework that: Responds to changes in credit quality Alerts bank management, supervisors Better suited to the complex activities of large, internationally active banking organizations Adapt to market and product evolution Invest more in risk management activities

Three Pillars of Basel II

Minimum Capital requirement

Supervisory Review Process

Market Discipline

First Pillar - Capital Adequacy

CRAR Ratio = Tier I Capital + Tier II Capital
Credit Risk + Operational Risk + Market Risk

> 8%

Capital Adequacy Ratio

Indicates a bank's risk-taking ability To check availability of enough capital to absorb unexpected losses or risks involved Higher the risk, more the capital back up required Basel I: CAR based only on credit risk Basel II: CAR based on market, credit and operational risk

Core Capital Definition of Capital Supplementary Capital

IRB Approach
Standardized Approach

Minimum Capital Requirement

Credit Risk

Basic Indicator Approach

Standardized Approach

Risk Weighted Assets

Operational Risk

Advance Measurement Approach Standardized Approach

Market Risk

Models Approach

Tier-I Capital Tier-II Capital Paid-up capital Undisclosed Reserves and Cumulative Statutory Reserves Disclosed free reserves Perpetual Preference Shares Capital reserves Revaluation Reserves Less Equity investments in General Provisions and subsidiaries, intangible Loss Reserves assets & losses

First Pillar - Capital Adequacy

CRAR Ratio =
Tier I Capital + Tier II Capital
Credit Risk + Operational Risk + Market Risk

The Standardized approach

Allocate risk-weight to each of the assets and off balance- sheet positions Under Basel 1 individual risk weights depend on the broad category of borrower (i.e. sovereigns, banks or corporates) Under Basel 2 the risk weights are to be refined by reference to a rating provided by an external credit assessment institution (such as a rating agency) that meets strict standards.

 Option 1 = Country Option 2a = Individual Banks Option 2b = Individual Banks with claims of maturity <6 months

IRB Approach
Own internal estimates of risk components of banks used to assess credit risk Covers a range of portfolios with different exposures
Corporate, Bank and Sovereign Exposure. Retail Exposure Specialised Lending Equity Exposure

Minimum Requirement of CAR

8% is prescribed Capital Adequacy Norm 9% - Scheduled Commercial Banks 10% - New Private Sector Banks 10% - Banks undertaking Insurance Business 15% - Local Area Banks

First Pillar - Capital Adequacy

CRAR Ratio =
Tier I Capital + Tier II Capital
Credit Risk + Operational Risk + Market Risk

OPERATIONAL RISK
This risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.

Business Lines
Corporate Finance (1) Trading and Sales (2) Retail banking (3)

Beta Factors
18% 18% 12%

Commercial Banking (4)

Payment and settlement (5) Agency Services (6) Asset Management (7) Retail Brokerage (8)

15%
18% 15% 12% 12%

Advanced Measurement Approach

Under advanced measurement approach, the regulatory capital will be equal to the risk measures generated by the banks internal risk measurement system using the prescribed quantitative and qualitative criteria.

First Pillar - Capital Adequacy

CRAR Ratio =
Tier I Capital + Tier II Capital
Credit Risk + Operational Risk + Market Risk

MARKET RISK

The risk of adverse price movements such as: Value of securities Exchange rates Interest rates As per the guidelines, minimum capital requirement is expressed in terms of two separately calculated charges: (a) Specific Risk (b) General Market Risk

(a) Specific Risk: Capital charge for specific risk is designed to protect against an adverse movement in price of an individual security due to factors related to individual issuer. The specific risk charges are divided into various categories: Investments in Govt. securities Claims on Banks Investments in mortgage backed securities Securitized papers

(b) General Market Risk: Charge for general market risk is designed to capture the risk of loss arising from changes in market interest rates. The Basel Committee suggested two broad methodologies for computation of capital charge for market risk: Standardized Method Internal Risk Management Model Method

 Principle 1
Banks should have a process for assessing their overall capital in relation to their risk profile and a strategy for maintaining their capital levels

Principle 2
Supervisors should review and evaluate banks internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios

 Principle 3
Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum

Principle 4
Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank

Objective: To improve market discipline through effective public disclosure accountability through transparency Pillar 3 disclosures can be broadly divided into the following categories: - Capital structure (debt/equity) - Capital adequacy (capital/risk weighted assets) - Risk

IMPACT OF BASEL II ON BANKS

Banks will have to develop:
Credit and Operational Risk Models Business Models and Surrounding Processes Skill levels of Operating Personnel Valid and Integrated Data Backup

Managing bad debts Lower risk weights Growing pressure to compete with the international banks

ADVANTAGES OF BASEL 2
Better business decisions Better risk management Market discipline Opportunity for IT and consulting companies

 Additional capital requirement

CHALLENGES & ISSUES OF BASEL II

Impact on Loan Pricing, Portfolio Composition, Bank Performance and the Lending Process as a Whole Corporate rating penetration (Ratings to issuers) Incentive to remain unrated Lead to Possible Consolidations in the Banking Industry (large NPAs) Cost Impact on Borrowers

Impact on Profitability

The banks which have migrated to Basel II

Allahabad Bank Andhra Bank Axis Bank Bank of Baroda Bank of India Canara Bank HDFC Bank ICICI Bank Indian Bank Indian Overseas Bank Induslnd Bank Punjab National Bank State Bank of India Syndicate Bank UCO Bank Union Bank of India

BASEL 3
Formed in response to the recent financial crisis Basel Committee on Banking Supervision gave it due recognition in September 2010

Objectives:
Strengthening the resilience of the banking sector. International framework for liquidity risk management, standards and monitoring.

CHANGES PROPOSED IN BASEL 3

Tighter definitions of Tier I Capital Build up of Capital Conservation buffer and Countercyclical Capital buffer

CHANGES PROPOSED IN BASEL 3

Measures to limit counterparty credit risk Introduction of leverage ratio as a supplementary measure to Basel 2 Stronger provisioning practices Minimum Liquidity Standard