RAL1 - BASEL REFORMS

The Basel Committee on Banking Supervision, under the auspices of the Bank of International
Settlements (BIS) located in Basel, Switzerland was formed in response and as a result to the messy
liquidation of a Cologne (Germany’s fourth largest city) based bank in 1974. On 26 June 1974, a
number of banks had released Deutsche Mark (German Mark) to the Bank Herstatt in exchange for
dollar payments deliverable in New York. On account of differences in the time zones, there was a
lag in the dollar payment to the counter-party banks, and during this gap and before the dollar
payments could be effected in New York, the Bank Herstatt was liquidated by German regulators.
Basel I is the round of deliberations by central bankers from around the world, and in 1988, the Basel
Committee on Bank Supervision (BCBS), in Basel, Switzerland, published a set of minimal capital
requirements for banks. This is also known as the 1988 Basel Accord. This was enforced by law initially
by 10 countries (G-10) in 1992 and was progressively introduced by many other countries. It primarily
focused on credit risk and required Banks with international presence to hold capital equal to 8 % of
the risk-weighted asset.
With the passage of time Banking industry witnessed newer methods of financing and thus new risks
were identified which necessitated more stringent capital requirement norms. Thus, Basel – II accord
came into existence. The purpose of Basel II, which was initially published in June 2004, is to create
an international standard that banking regulators can use when creating regulations about how much
capital banks need to put aside to guard against the types of financial and operational risks banks
face., Basel II attempted to accomplish this by setting up rigorous risk and capital management
requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank
exposes itself to through its lending and investment practices.
"Three pillars" concept introduced:
(1) Minimum Capital Requirements (addressing risk),
(2) Supervisory review and
(3) Market discipline – to promote greater stability in the financial system.

The global financial crises of 2008-2009 exposed the inadequacy of the BASEL – II and thus, BASEL –
III came into being in December 2010. It is only a continuation of effort initiated by the Basel
Committee on Banking Supervision to enhance the banking regulatory framework under Basel I and
Basel II. This latest Accord now seeks to improve the banking sector's ability to deal with financial
and economic stress, improve risk management and strengthen the banks' transparency. The intent
of the Basel Committee seems to prepare the banking industry for any future economic downturns.
The framework enhances bank-specific measures and includes macro-prudential regulations to help
create a more stable and resilient banking sector.

Basel III measures aim to:

• improve the banking sector's ability to absorb shocks arising from financial and economic stress,
whatever the source
• improve risk management and governance
• strengthen banks' transparency and disclosures.

Thus, Basel III guidelines are aimed at to improve the ability of banks to withstand periods of
economic and financial stress as the new guidelines are more stringent than the earlier requirements
for capital and liquidity in the banking sector.

Pillar-I - Minimum Capital Requirements

Banks have to ensure maintenance of minimum capital for credit risk weighted assets, market risk
weighted assets and operational risk weighted assets. Regulators have defined minimum CRAR
(Capital to Risk-Weighted Asset Ratio) under Basel-III

1
Pillar-II - Supervisory Review and Evaluation Process (SREP)

The Basel-III reforms have defined Pillar II as Supervisory Review and Evaluation Process (SREP) which
envisages the establishment of suitable risk management systems in banks and their review by the
supervisory authority.

Hence Banks have to address all the risk under Pillar-II, which Pillar-I fails to address.

The main objective of Pillar-II is to ensure that banks have adequate capital to support all the risks
in their business as also to encourage them to develop and use better risk management techniques
for monitoring and managing their risks.

This in turn would require a well-defined internal assessment process within banks through which
they assure the RBI that adequate capital is indeed held towards the various risks to which they are
exposed.

The process of assurance could also involve an active dialogue between the bank and the regulator
(RBI) so that, when warranted, appropriate intervention could be made to either reduce the risk
exposure of the bank or augment / restore its capital. Thus, ICAAP (Internal Capital Adequacy
Assessment Process) is an important component of the SREP.

The main aspects to be addressed under the SREP and therefore, under the ICAAP, would include:

(a) risks that are not fully captured by the minimum capital ratio prescribed under Pillar 1;
(b) risks that are not at all taken into account by the Pillar 1; and
(c) factors external to the bank.
Risks covered by the Bank under Pillar-II:
(a) Interest rate risk in the banking book;
(b) Credit concentration risk;
(c) Liquidity risk;
(d) Settlement risk;
(e) Reputational risk;
(f) Strategic risk;
(g) Risk of under-estimation of credit risk under the Standardised approach;
(h) “Model risk” i.e., the risk of under-estimation of credit risk under the IRB approaches;
(i) Risk of weakness in the credit-risk mitigants;
(j) Residual risk of securitisation, etc.

Pillar-III - Market Discipline :

The purpose of Market discipline is to complement the minimum capital requirements and the
supervisory review and evaluation process. The aim is to encourage market discipline by developing
a set of disclosure requirements which will allow market participants to assess key pieces of
information on the scope of application, capital, risk exposures, risk assessment processes and hence,
the capital adequacy of the institution.

Following is the transition table of Basel-III implementation :

Minimum capital ratios April 1, March March March March March March
2013 31, 31, 31, 31, 31, 31,
2014 2015 2016 2017 2018 2020
Minimum Common
4.5 5.0 5.5 5.5 5.5 5.5 5.5
Equity Tier 1 (CET1)
Additional Tier 1 capital,
1.5 1.5 1.5 1.5 1.5 1.5 1.5
maximum (AT 1)
Minimum Tier 1 capital
6.0 6.5 7.0 7.0 7.0 7.0 7.0
(CET + AT 1).
Capital conservation
buffer (CCB) in the form - - - 0.625 1.25 1.875 2.5
of CET
2
 Minimum capital ratios April 1, March March March March March March
2013 31, 31, 31, 31, 31, 31,
2014 2015 2016 2017 2018 2020
Tier II capital
2.0 2.0 2.0 2.0 2.0 2.0 2.0
(Maximum)
Minimum CET1+ CCB 4.5 5 5.5 6.125 6.75 7.375 8
Minimum Total Capital 9 9 9 9 9 9 9
Minimum Total Capital
9 9 9 9.625 10.25 10.875 11.5
+CCB
From the above table it may be noted that by 31st March 2019 all the Bank in India have to maintain
a minimum CRAR of 11.50%.

Though BASEL – III continued the concept of 3 Pillars (introduced in BASEL -II), the guidelines
brought about more stringency as follows :
a) Better Capital Quality: One of the key elements of Basel - III is the introduction of much stricter
definition of capital. Better quality capital means the higher loss-absorbing capacity. This in turn
will mean that banks will be stronger, allowing them to better withstand periods of stress.

b) Capital Conservation Buffer: Another key feature of Basel - III is that now banks will be required to
hold a capital conservation buffer of 2.5%. The aim of asking to build conservation buffer is to ensure
that banks maintain a cushion of capital that can be used to absorb losses during periods of financial
and economic stress.

c) Countercyclical Buffer: This has been introduced with the objective to increase capital
requirements in good times and decrease the same in bad times. The buffer will slow banking activity
when it overheats and will encourage lending when times are tough i.e. in bad times. The buffer
will range from 0% to 2.5%, consisting of common equity or other fully loss-absorbing capital.

d) Minimum Common Equity, Tier 1 and total Capital Requirements: The minimum requirement for
common equity, the highest form of loss-absorbing capital, has been raised under Basel III to 8% of
total risk-weighted assets. The overall Tier 1 capital requirement, consisting of not only common
equity but also other qualifying financial instruments, has been increased to 9.50% and total capital
requirement increased to 11.5% when combined with the conservation buffer.

e) Leverage Ratio: A review of the financial crisis of 2008 has indicated that the value of many assets
fell quicker than assumed from historical experience. Thus, now Basel III rules include a leverage
ratio to serve as a safety net. A leverage ratio is the relative amount of capital to total assets (not
risk-weighted). This aims to put a cap on swelling of leverage in the banking sector on a global basis.
Reserve Bank of India desired it to be at 4.50%.

f) Liquidity Ratios: Under Basel III, a framework for liquidity risk management is created. Liquidity
Coverage Ratio (LCR) was introduced in 2015 and Net Stable Funding Ratio (NSFR) will be introduced
from 2019.

g) Systemically Important Financial Institutions (SIFI): As part of the macro-prudential framework,

systemically important banks will be expected to have loss-absorbing capability beyond the Basel III
requirements. Options for implementation include capital surcharges, contingent capital and bail-in-
debt.

Bench marks Set up by RBI as a percentage of Total RWA:

Sl No Particular Requirement Minimum/Maximum
1 CRAR Pillar-I (Tier-I & Tier- 11.50% (w.e.f 31.03.2020) Minimum
II)
2 CET 5.50% Minimum
3 CCB (in the form of CET) 2.50% (w.e.f 31.03.2020) Minimum
4 AT-I Capital 1.50% Maximum
5 Tier-I 7.00% (w.e.f 31.03.2020) Minimum
6 Tier-II Capital 2.00% Maximum
******