Basel Norms: Pre-crisis Basel I

Formalised by G 10 in response to
Herstatt Bank liquidation
Wef 1988: Focussed on credit risk:
Banks reqd to hold 8% capital to riskweighted assets ratio
Tier 1 capital minimum of 4% of RWAs
Tier 2 debt instruments of at least 5
years; maximum of 4% of RWAs. Tier 3
short term debt of at least 2 yrs

Gaming Basel
Capital reqd for mortgage loans was higher
than for mortgaged backed securities so banks
securitized their mortgage loans through bankfinanced Special Investment Vehicles (SIV)
Securitization enhanced the credit rating
Enhanced ratings require less capital, so banks
invested in these products. Thus, there was an
incestuous relationship between banks and
SIVs .

Basel II
Attempt to refine Basel I
3 Pillar approach
Pillar I Credit Risk (Std & IRB model),
operational & market risk (VaR)
Pillar 2 Supervisory ie liquidity risk,
systemic risk, legal risk etc
Pillar 3 Disclosure ie market discipline

Basel Norms
Financial crisis: Contributory factors
The Basel requirement of common equity
was just 2% of risk-weighted assets
(RWAs).
Banks also tried to game the system
since Basel capital rules favoured lower
capital for trading book & higher capital
for banking book, banks tried to shift
assets from banking to trading book

Shadow Banking
The size of shadow banking (thro
NBFCs) system became almost thrice
the formal banking system.
Same time there was a growing
dependence on wholesale funding
Both factors made the system very
vulnerable

Basel I to II to III to ..?

When the crisis hit, the BIS was working
on Basel II to make good the
shortcomings of Basel I
However crisis showed that even Basel II
was inadequate so Basel III published in
Dec 2010
Main feature of Basel III is that it tried to
improve the shock-absorbing capacity of
banks

Basel III
Tier 1 capital : the predominant form of
Tier 1 capital must be common shares
and retained earnings
Tier 2 capital instruments will be
harmonized
Tier 3 capital will be eliminated.

Changed scenario
Under Basel III, Tier 1 capital must be
predominant form of regulatory capital
at minimum 75% of the total capital of
8%, i.e., 6%, as against 4%
Within Tier 1 capital, common equity
must be the predominant form of
capital. It will be minimum 75% of the
Tier 1 capital requirement of 6%, i.e.,
4.5%, from the existing 2%.

Additional safeguards
Additionally banks required to maintain
a Net Stable Funding Ratio (NSFR),ie
ratio of stable sources of funding relative
to liquidity profiles of assets & the
potential for contingent liquidity needs
from off-balance sheet commitments,
over a one-year horizon.
Idea is to limit over-reliance on shortterm wholesale funding.

Further,
To ensure rescue of non-viable banks
does not cause losses to tax-payers
while leaving non-common equity capital
providers unscathed, all non-common
Tier 1 & Tier 2 instruments reqd to have
a provision for write off or conversion
into common equity in case of trouble
Tier III capital completely abolished

Basel III
Seeks to address issues relating to systemic risk through
i. leverage ratio
ii. capital conservation buffer
iii. countercyclical capital buffer
iv. addressing pro-cyclicality of provisioning
requirements
v. addressing interconnectedness
vi. addressing the too-big-to-fail problem
vii.addressing reliance on external credit rating agencies

Capital Conservation Buffer

Basel III prescribes a capital
conservation buffer of 2.5% of RWAs,
comprising common equity Tier 1
capital, over & above the minimum
common equity requirement of 4.5% &
total capital requirement of 8% to be
built up outside periods of stress. This
can be drawn down as losses are
incurred during periods of stress

Counter-cyclical capital buffer

This varies between zero and 2.5% of
RWAs, depending on the extent of the
build-up of system-wide risks. Banks are
required to meet this buffer with
common equity Tier 1 capital or other
fully loss-absorbing capital

Addressing pro-cyclicality of
provisioning
The Basel Committee is working closely
with the International Accounting
Standards Board (IASB) towards an
expected loss approach to loan loss
provisioning instead of the present
practice of incurred loss

Addressing inter-connectedness
Basel prescribes higher asset value
correlation under the Internal Ratings
Based (IRB) Approach for exposures to
large financial institutions with assets of
US $ 100 billion and with unregulated
institutions.

Addressing reliance on external ratings

Banks allowed to make their own
internal assessments of externally rated
securitization exposures, the elimination
of certain cliff effects (sharp increase
in applicable risk weights) associated
with credit risk mitigation practices

Time frame of Basel III

Phased implementation staring from
January 1, 2013 to January 1, 2019.
Capital instruments that no longer
qualify as non-core Tier 1 capital or Tier
2 capital, will be phased out over a tenyear period starting from 2013

Capital Requirements in India

Elements of Tier I Capital

Paid-up capital (ordinary shares), statutory
reserves, and other disclosed free reserves, if any;
Perpetual Non-cumulative Preference Shares
(PNCPS) eligible for inclusion as Tier I capital subject to laws in force from time to time;
Innovative Perpetual Debt Instruments (IPDI)
eligible for inclusion as Tier I capital; and
Capital reserves representing surplus arising out of
sale proceeds of assets.

Elements of Tier II Capital

Undisclosed Reserves
Revaluation Reserves
General Provisions and Loss Reserves
Hybrid Debt Capital Instruments
Subordinated Debt
Investment Reserve Account