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Bis and Basel
Bis and Basel
the International Monetary Fund, have historically led to losses in the billions as banks try to
maintain a policy using open market methods that have proven to be based on unrealistic
assumptions.
Central banks do not unilaterally "set" rates, rather they set goals and intervene using their
massive financial resources and regulatory powers to achieve monetary targets they set. One
reason to coordinate policy closely is to ensure that this does not become too expensive and
that opportunities for private arbitrage exploiting shifts in policy or difference in policy, are
rare and quickly removed.
Two aspects of monetary policy have proven to be particularly sensitive, and the BIS therefore
have two specific goals: to regulate capital adequacy and make reserve
requirements transparent.
About BIS:
The mission of the Bank for International Settlements (BIS) is to serve central banks in their
pursuit of monetary and financial stability, to foster international cooperation in those areas
and to act as a bank for central banks.
In broad outline, the BIS pursue its mission by:
supporting dialogue with other authorities that are responsible for promoting financial
stability;
acting as a prime counterparty for central banks in their financial transactions; and
All members of staff are required to behave in accordance with general principles laid
down in the staff code of conduct. The BIS Compliance Charter describes the guiding
principles for managing compliance at the Bank.
Governance structures
The governance of the Bank is determined by its Statutes, which were last revised
in June 2005 following a review of the governance of the Bank by three leading
independent legal experts.
The three most important decision-making bodies within the Bank are:
Decisions taken at each of these levels concern the running of the Bank and as such are
mainly of an administrative and financial nature, related to its banking operations, the
policies governing internal management of the BIS and the allocation of budgetary resources
to the different business areas.
The Bank's administrative and budgetary rules apply to the committees hosted by the BIS.
Other aspects of the committees' governance are the responsibility of the body to which each
report.
Since 1930, central bank cooperation at the BIS has taken place through the regular
meetings in Basel of central bank Governors and experts from central banks and other
agencies. In support of this cooperation, the Bank has developed its own research in
financial and monetary economics and makes an important contribution to the
collection, compilation and dissemination of economic and financial statistics.
Apart from fostering monetary policy cooperation, the BIS has always performed
"traditional" banking functions for the central bank community (e.g. gold and foreign
exchange transactions), as well as trustee and agency functions. The BIS was the
agent for the European Payments Union (EPU, 1950-58), helping the European
currencies restore convertibility after the Second World War. Similarly, the BIS have
acted as the agent for various European exchange rate arrangements, including the
European Monetary System (EMS, 1979-94) which preceded the move to a single
currency.
Central banks do not unilaterally "set" rates, rather they set goals and intervene using
their massive financial resources and regulatory powers to achieve monetary targets
they set. One reason to coordinate policy closely is to ensure that this does not become
too expensive and that opportunities for private arbitrage exploiting shifts in policy or
difference in policy are rare and quickly removed.
Two aspects of monetary policy have proven to be particularly sensitive, and the BIS
therefore have two specific goals: to regulate capital adequacy and make reserve
requirements transparent.
Regulates capital adequacy
Capital adequacy policy applies to equity and capital assets. These can be overvalued
in many circumstances because they do not always reflect current market conditions or
adequately assess the risk of every trading position. Accordingly the BIS requires the
growth of offshore financial centres (OFCs), highly leveraged institutions (HLIs), large
and complex financial institutions (LCFIs), deposit insurance, and especially the
spread of money laundering and accounting scandals.
The BIS provides the Basel Committee on Banking Supervision with its 17-member
secretariat, and with it has played a central role in establishing the Basel Capital
Accords of 1988 and 2004. There remain significant differences between United
States, European Union, and United Nations officials regarding the degree of capital
adequacy and reserve controls that global banking now requires. Put extremely
simply, the United States, as of 2006, favored strong strict central controls in the
spirit of the original 1988 accords, while the EU was more inclined to a distributed
system managed collectively with a committee able to approve some exceptions.
The UN agencies, especially ICLEI, are firmly committed to fundamental risk
measures: the so-called triple bottom line and were becoming critical of central
banking as an institutional structure for ignoring fundamental risks in favour of
technical risk management.
expectation that individual national authorities will implement them. In this way, the
Committee encourages convergence towards common standards and monitors their
implementation, but without attempting detailed harmonization of member countries
supervisory approaches. At the outset, one important aim of the Committees work was to
close gaps in international supervisory coverage so that
No foreign banking establishment would escape supervision; and
That supervision would be adequate and consistent across member jurisdictions. A first
step in this direction was the paper issued in 1975 that came to be known as the
Concordat, which set out principles by which supervisory responsibility should be
shared for banks foreign branches, subsidiaries and joint ventures between host and
parent (or home) supervisory authorities. In May 1983, the Concordat was revised and reissued as Principles for the supervision of banks foreign establishments.
In April 1990, a supplement to the 1983 Concordat was issued with the aim of
improving the cross-border flow of prudential information between banking supervisors.
In June 1992, certain principles of the Concordat were reformulated as minimum
standards. These standards were communicated to other banking supervisory
authorities, who were invited to endorse them and published in July 1992.In October
1996, the Committee released a report on The supervision of cross-border banking, drawn
up by a joint working group that included supervisors from non-G10 jurisdictions and
offshore centers. The document presented proposals for overcoming the impediments to
effective consolidated supervision of the cross-border operations of international banks.
Subsequently endorsed by supervisors from 140 countries, the report helped to forge
relationships between supervisors in home and host countries. The involvement of nonG10 supervisors also played a vital part in the formulation of the Committees Core
principles for effective banking supervision in the following year. The impetus for this
document came from a 1996 report by the G7 finance ministers that had called for
effective supervision in all important financial marketplaces, including those of emerging
economies.
OBJECTIVES OF THE BASEL CAPITAL ACCORD
In its June 1999 Consultative Paper, the Committee outlined its objectives in developing a
comprehensive approach to capital adequacy. As the Committee continues to refine the
new framework, it maintains the belief that:
The Accord should continue to promote safety and soundness in the financial System
and, as such, the new framework should at least maintain the current overall level of
capital in the system;
The Accord should continue to enhance competitive equality;
The Accord should constitute a more comprehensive approach to addressing risks;
The Accord should contain approaches to capital adequacy that are appropriately
sensitive to the degree of risk involved in a banks positions and activities;
The Accord should focus on internationally active banks, although its underlying
principles should be suitable for application to banks of varying levels of complexity
and sophistication.
BASEL ACCORD I
From 1965 to 1981 there were about eight bank failures (or bankruptcies) in the
United States. Bank failures were particularly prominent during the '80s, a time which is
usually referred to as the "savings and loan crisis." Banks throughout the world were
lending extensively, while countries' external indebtedness was growing at an
unsustainable rate. As a result, the potential for the bankruptcy of the major international
banks because grew as a result of low security. In order to prevent this risk, the Basel
Committee on Banking Supervision, comprised of central banks and supervisory
authorities of 10 countries, met in 1987 in Basel, Switzerland.
The committee drafted a first document to set up an international 'minimum'
amount of capital that banks should hold. This minimum is a percentage of the total
capital of a bank, which is also called the minimum risk-based capital adequacy. In 1988,
the Basel I Capital Accord (agreement) was created. The Basel II Capital Accord follows
as an extension of the former, and was implemented in 2007. In this article, we'll take a
look at Basel I and how it impacted the banking industry.
Tier 1 capital includes stock issues (or shareholders equity) and declared reserves,
such as loan loss reserves set aside to cushion future losses or for smoothing out income
variations.
BASEL ACCORD II
By the late 1990s, banks had become much more sophisticated in their operations
and risk management and were increasingly able to find ways to reduce a bank's risk
weighted assets in ways that did not reflect lower real risk (what has become known as
regulatory capital arbitrage). It was therefore decided that a new capital standard was
required and work began on Basel II.
Basel II is the second of the Basel Accords, (now extended and effectively
superseded by Basel III), which are recommendations on banking laws and regulations
issued by the Basel Committee on Banking Supervision. Basel II, initially published in
June 2004, was intended to create an international standard for banking regulators to
control how much capital banks need to put aside to guard against the types of financial
and operational risks banks (and the whole economy) face. One focus was to maintain
sufficient consistency of regulations so that this does not become a source of competitive
inequality amongst internationally active banks. Advocates of Basel II believed that such
an international standard could help protect the international financial system from the
types of problems that might arise should a major bank or a series of banks collapse. In
theory, Basel II attempted to accomplish this by setting up risk and capital management
requirements designed to ensure that a bank has adequate capital for the risk the bank
exposes itself to through its lending and investment practices. Generally speaking, these
rules mean that the greater risk to which the bank is exposed, the greater the amount of
capital the bank needs to hold to safeguard its solvency and overall economic stability.
Politically, it was difficult to implement Basel II in the regulatory environment
prior to 2008, and progress was generally slow until that year's major banking crisis
caused mostly by credit default swaps, mortgage-backed security markets and
similar derivatives.
Basel II consists of 3 'pillars' which enshrine the key principles of the new regime.
Collectively, they go well beyond the mechanistic calculation of minimum capital levels
set by Basel I, allowing lenders to use their own models to calculate regulatory capital
while seeking to ensure that lenders establish a culture with risk management at the heart
of the organization up to the highest managerial level. Basel II uses a "three pillars"
concept (1) minimum capital requirements (addressing risk), (2) supervisory review and
(3) market discipline.
The Basel I accord dealt with only parts of each of these pillars. For example: with
respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple
manner while market risk was an afterthought; operational risk was not dealt with at all.
The first pillar deals with maintenance of regulatory capital calculated for three
major components of risk that a bank faces: credit, operational risk, and market risk. Other
risks are not considered fully quantifiable at this stage.
Pillar 2 is meant to identify risk factors not captured in Pillar 1, giving regulators
discretion to adjust the regulatory capital requirement against that calculated under Pillar
1. For most lenders, the Pillar 2 process results in a higher regulatory capital requirement
than calculated under Pillar 1 alone. Pillar 2 requires banks to think about the whole
spectrum of risks they might face including those not captured at all in Pillar 1. It
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.
Pillar 3 is designed to increase the transparency of lenders' risk profile by requiring them
to give details of their risk management and risk distributions. 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.
Capital
Liquidity
Basel III
Leverage
To strengthen global capital and liquidity regulations with goal of promoting more
resilient banking sector
ii.
Based on the above mentioned objectives the Basel IIIs recommendations are divided
into three parts:
i.
ii.
iii.
Capital Includes quality and quantity of capital, risk weightage to assets, leverage
ratio, capital conservation buffer, counter-cyclical buffer
Liquidity Short term & long term ratios
Other elements pertaining to overall stability of financial system.
As per RBI
9%
5.50%
1.5%
7.00%
2%
2.50%
8.00%
11.5%
come as the non-equity portion. This capital can be raised through markets and through
Government (in PSBs)
Also under Basel III, the trading book exposures, especially those having credit risk
and Resecuritizations exposures in both banking and trading book attract enhanced capital
charges. The CVA for OTC derivatives will also attract additional capital. Since the trading
book and OTC derivative portfolios of Indian banks are very small and they do not have any
exposures to re-securitized instruments, impact of these changes in capital regulation on their
balance sheets is insignificant.
Leverage Ratios
RBI already had Statuary Liquidity Ratio (SLR), as a regulatory mandate. The statutory
liquidity portfolio of Indian banks is constituted only for moderate risk i.e. Market Risk and it
is excluded from leverage ratio. The tier I capital of many Indian banks is comfortable (more
than 8% as per Basel II regulation of Tier I capital) and their derivatives activities are not
very large. So leverage ratio will not be a binding constraint for Indian Banks.
Liquidity Ratio
The major challenge for banks in implementing the liquidity standards is to develop
the capability to collect the relevant data accurately and to formulate them for identifying the
stress scenario with accuracy. However positive side for Indian banks, they have a substantial
amount of liquid assets which will enable them to meet requirements of Basel III.
In India, banks are statutorily required to hold minimum reserves of high-quality liquid
assets. Currently, such reserves (statutory liquidity ratio SLR) are required to be maintained
at a minimum of 24 per cent of net demand and time liabilities. Since these reserves are part
of the minimum statutory requirement, the Reserve Bank faces a dilemma whether and how
much of these reserves can be allowed to be reckoned towards the LCR. If these reserves are
not reckoned towards the LCR and banks are to meet the entire LCR with additional liquid
assets, the proportion of liquid assets in total assets of banks will increase substantially,
thereby lowering their income significantly. Thus the Reserve Bank is examining to what
extent the SLR requirements could be reckoned towards the liquidity requirement under
Basel III.
CONCLUSION
The Basel I Capital Accord aimed to assess capital in relation to credit risk, or the risk
that a loss will occur if a party does not fulfil its obligations. It launched the trend toward
increasing risk modelling research; however, its over-simplified calculations, and
classifications have simultaneously called for its disappearance, paving the way for the
Basel II Capital Accord and further agreements as the symbol of the continuous refinement
of risk and capital. Nevertheless, Basel I, as the first international instrument assessing the
importance of risk in relation to capital, will remain a milestone in the finance and banking
history.
Given the current environment, the RBI has extended the final date for Basel-III to 2018.
This is positive as PSB's will get more time for
preparation. Moreover, capital
deduction now starts at 20% against 40% stipulated earlier. This move is encouraging and
should ensure smoother migration to the new framework. The RBI wants to implement
the recommendations of the 'Basel Committee on Banking Supervision to make the
financial system safe. It is aimed at protecting the depositors and to prevent a 2008-like
crises. Moreover, the 'perception' of a lower standard regulatory regime will put Indian
banks at a disadvantage in global competition. RBI is currently working on operational
aspects of implementation of the Countercyclical Capital Buffer. Besides, certain other
proposals viz. 'Definition of Capital Disclosure Requirements', 'Capitalization of
Bank Exposures to Central Counterparties' etc., are also engaging the attention of the Basel
Committee at present. Therefore, as per RBI, the final proposals of the Basel Committee on
these aspects will be considered for implementation, to the extent applicable, in future.
Further, for the financial year ending March 31, 2013, banks will have to disclose the
capital ratios computed under the existing guidelines (Basel II) on capital adequacy as
well as those computed under the Basel III capital adequacy framework. India's
struggling banking sector will face a period of lower profitability as it seeks to raise at least
Rs. 5000 billion in extra capital to meet the new Basel-III.
Both internationally and in India bankers have expressed their concerns over the
additional capital requirements under Basel III. It is feared that these additional capital
requirements, leverage ratios would hurt profitability of the bank. But studies have shown
that though the Basel III guidelines would impose short term costs on the banks in the long
term it would strengthen the financial system and make the banks more resilient against
stress. Also investors would appreciate the fact that though the returns have lowered the
risk has also reduced.
In India Basel III would make our banks compliant with global regulations, this would
help the Indian banks who wish to expand overseas. Also through Basel III would
strengthen the financial system. Capital requirements under Basel III may cause some
smaller banks to merge with the larger banks leading to consolidation of banks. In the
initial stages Basel III will require banks to incur expenditure on both capital as well as IT
infrastructure for accurate risk measurement. But adoption of a more risk sensitive
approach will increase the profitability of the banks in the long run. Also as the banks will
be perceived to be more stable and thus less risky the cost of capital will also decrease in
future.
Now apart from raising capital the other challenges ahead of the banks are improving
their operational efficiency to decrease their NIM margins. Also reducing their NPA levels
in the current macroeconomic scenario will be a major challenge for the banks.