Banking & Insurance

Basel Norms
 Herstatt Bank

• Herstatt Bank was a privately owned

bank in Germany.

• On June 26, 1974, German regulators

forced the troubled Bank, Herstatt
into liquidation.

• At the core of the problem was the

huge foreign exchange exposure of
the bank.
• That day, a number of banks had released payment
of Deutsche Marks (DM) to Herstatt in Frankfurt in exchange
for US Dollars (USD) that was to be delivered in New York.
• Because of time-zone differences, Herstatt ceased operations
between the times of the respective payments.
The counterparty banks did not receive their USD payments.
• That failure caused a string of cascading defaults in a
rapid sequence, totaling a loss of $620 million to the
international banking sector.

Herstatt risk
• Cross-currency settlement risk that arises due to time
zone differences.
 Settlement Risk

The risk that a settlement in a transfer system does not take place as
expected. Generally, this happens because one party defaults on its
clearing obligations to one or more counterparties.

Settlement Risk

Credit Risk Liquidity Risk

 Settlement Risk

Credit Risk

Credit risk arises when a counterparty cannot meet an obligation for full
value on due date and thereafter because it is insolvent.

Liquidity Risk

Liquidity risk refers to the risk that a counterparty will not settle for full
value at due date but could do so at some unspecified time thereafter;
causing the party which did not receive its expected payment to finance
the shortfall at short notice.
 BASEL

• In 1974, Basel Committee (BCBS) published a set of minimum

capital requirements for banks.

• A group of central banks around the world formed a

committee in Basel, to regulate and monitor the banks in
their respective countries.
Bank for International Settlement (BIS)

• Basel is a city in Switzerland. It is the

headquarters of Bank for International
Settlement (BIS).

• Goal - financial stability and common

standards of banking regulations.

• Established on 17 May 1930.

 Basel Guidelines

• Broad supervisory standards formulated by a group of central

banks - called the Basel Committee on Banking Supervision
(BCBS).

• The set of agreement by the BCBS, which focuses on risks to

banks and the financial system are called Basel Accord.

• The purpose is to ensure that financial institutions have

enough capital to meet obligations and absorb unexpected
losses.
BASEL I 1988
BASEL II 2004
BASEL III 2010
 Basel I

• 1988 – It focused almost entirely on credit risk.

• It defined capital and structure of risk weights for assets. The

minimum capital requirement was fixed at 8% of risk
weighted assets (RWA).

• RWA means assets with different risk profiles.

• India adopted Basel 1 guidelines in 1999.

Basel I Capital

Tier I Capital Tier II Capital

Core Capital Supplementary Capital

• Tier 1, or core capital consists of shareholders equity, retained

earnings, capital surplus and capital reserves.

• Tier 2 or supplementary Capital (loan loss allowances, preferred

stock with maturity greater than 20 years, unclosed capital reserves
and hybrid capital instruments).
 Basel I
RWA (Asset Classification):

• A portfolio approach is taken to the measure of risk, with

assets classified into four buckets (0%, 20%, 50% and 100%)
according to the debtor category.

• This means that some assets (essentially bank holdings of

government assets such as Treasury Bills and bonds) have no
capital requirement.
 Analysis

It means there are two things to

be taken care of:

1. Capital (numerator)
2. Assets (denominator)

Capital: Tier I and Tier II

Assets: Risk Weighted Assets
 CAR

• Capital Adequacy Ratio (CAR), also called Capital to

Risk (Weighted) Assets Ratio (CRAR), is a ratio of
a bank's capital to its risk.
 CAR Calculation

•Cash: 10 units Cash

Government
•Government bonds: 15 units
securities
•Mortgage loans: 20 units Mortgage loans
•Other loans: 50 units Other loans

•Other assets: 5 units

Other assets
Total risk
•Equity: 5 units
Weighted assets 65
Equity 5
CAR (Equity/RWA) 7.69%
Basel II - 2004

• Basel II is the revised capital

accord of Basel I.
 Pillars of Basel II
• Capital Adequacy: Banks should maintain a
minimum capital adequacy
requirement of 8% of risk
assets

• Supervisory Review: Use better risk management

techniques in managing all
the three types of risks that
a bank faces, viz. credit,
market and operational risks

• Market Discipline: Increased disclosure

requirements. Banks need to
mandatorily disclose their
CAR, risk exposure, etc to
the central bank.
 Basel III - 2010
• Sub – Prime Crisis: Easy Money

• The Basel Committee on Banking Supervision (BCBS)-met on

December 2010 and agreed to tougher bank capital and
liquidity standards.

• Basel III reform to apply lessons from the financial crisis

2007 - 2008, so that states are less likely to have to rescue
banks again in the next crisis.
Components of Basel III Framework

1. Constituents of capital

2. Capital Conservation Buffer

3. Counter Cyclical Buffer

4. Leverage Ratio

5. Liquidity
 1. Constituents of capital

• The common equity component of Tier 1 will be

comprised of ordinary share capital and retained
profits. Common Equity Requirement raised to 4.5%
from earlier 2% by January 2015.
• Tier I capital raised to 6% from 4% by 2015.

• All Tier 2 instruments will be required to be either

convertible into common equity or written down in the
event of the institution becoming non-viable without a
bail-out.

• Tier 3 capital will be abolished. Tier 3 capital was

unsecured subordinated debt that is fully paid up.
2. Capital Conservation Buffer: Additional Buffer

The Capital Conservation Buffer is an additional reserve buffer of

2.5% to "withstand future periods of stress", bringing the total Tier
1 Capital reserves required to 7%.
 3. Counter Cyclical Buffer:

Local regulators to be responsible also for regulating

credit volume in their national economies

If credit is expanding faster than GDP, bank regulators can

increase their capital requirements with the help of the
Countercyclical Buffer. Varying between 0% - 2.5% it can thus,
preserve national economies from excess credit growth.
 5. Liquidity: Liquidity Coverage Ratio – (LCR)

Basel III introduces a new instrument for liquidity risk

measurement – Liquidity Coverage Ratio (LCR).

It is designed to ensure that a bank maintains an

adequate level of unencumbered, high-quality assets that
can be converted into cash to meet its liquidity needs for
a 30-day time horizon.
 BASEL III NORMS: IMPACT ON INDIAN BANKS

• Basel III guidelines would necessitate Indian banks1

raising Rs. 600000 crore in external capital over next 9
years.
• At the end of June 30, 2010, the aggregate capital to risk-
weighted assets ratio of the Indian banking system stood
at 13.4%, of which Tier-I capital constituted 9.3%.
• Indian banking system is moderately leveraged and PSU
banks may not face problem in building buffer capital.
• Most Indian banks follow a retail business model - limited
dependence on short-term or overnight funding.
• Indian banks possess a large amount of liquid assets that
will enable them to meet new standards.
 RBI and BASEL
• India has accepted Basel accords for the banking
system. On a few parameters the RBI has prescribed
stringent norms.

• RBI issued final guidelines for implementation of Basel

III and directed that the banks will have to reach the
11.5% capital level in phases over a period of six years.

• Minimum total capital to be maintained by banks will

remain 9% for 2012-13 and 2013-2014. But will be
finally increased to 11.50% as on March 31 of 2018.
• In the final phase, of the minimum capital of 11.5%,
2.5% will be in the form of counter-cyclical buffer
capital.

• This counter-cyclical buffer capital must also be in

the form of common equity.