BASEL GUIDELINES

Ms. P. Soumya
Faculty, IIBF
September 23, 2022

INDIAN INSTITUTE OF BANKING & FINANCE

BASEL-I, II and III

 Basel I- Brief Background

 Basel II- Improvements

 Basel III- Further Improvements

HISTORY….
 8 bank failures (or bankruptcies) in the US
 Highly leveraged banks
 Lending extensively
 Resulting into low security/capital
 German Herstatt Bank failure of 1974
 Central bank governors of G-10 countries established a
committee
 First meeting took place in February 1975
 Aim of the Committee
 no bank would escape supervision
 supervision would be adequate and consistent across member
jurisdictions
BASEL I ACCORD
 1980’s faced the Latin American Debt crisis
 Capital ratios of main international banks deteriorated
 Strengthen capital to halt capital erosion
 Remove inequality arising from differences in national capital
requirements
 Arrived at the weighted approach for
both on and off banks’ balance sheets
 Capital measurement system was
published in December 1987
 Approved by G-10 governors and released to banks in July 1988
 April 1996 – introduced market risk
BASEL I – RISK WEIGHTS
Weight Asset Type
0% Cash held
Claims on OECD Central Governments
Claims on central governments in national currency
20% Cash to be received
Claims on OECD banks and regulated securities firms
Claims on non-OECD banks below 1 year
Claims on multilateral development banks
Claims on foreign OECD public sector entities
50% Residential mortgage loans
100% Claims on private sector
Claims on non-OECD banks above 1 year
Real Estate
Plant & Equipment
BASEL II

 Result of two triggers

 Banking crises of 1990s

 Limitations of Basel I
 Limited differentiation of credit risk
 No recognition of term structure of credit risk
 Simplified calculation of multi-country counterparty risk
 Non-recognition of portfolio diversification effects
 Static measure of default risk
BASEL II
Designed to

 Improve the way regulatory capital requirements reflect

the underlying risks

 Address the financial innovation occurred in recent years

 Define new calculation for credit risk & market risk

 Introduce operational risk

BASEL II: THREE PILLARS

• Credit Risk • Consistent Disclosures for

• Market Risk Review • Capital
• Operational Risk • Timely exposure
intervention • Risk Exposure
• External factors • Capital
• Risks not Adequacy
covered in Pillar
1
BASEL II - APPROACH

Foundation Advanced
Standardised Internal Internal
CREDIT RISK Approach Rating Based Rating Based
Approach Approach

Internal
Standardised
MARKET RISK Approach
Model
Approach

OPERATIONAL Basic The Advanced

Indicator Standardised Measurement
RISK Approach Approach Approach
NEED FOR BASEL III
 Fundamental need to strengthen Basel II framework

 Too much leverage

 Inadequate liquidity buffers

 Poor governance/risk management

 Inappropriate incentive structures

 Mispricing of credit and liquidity risk

NEED FOR BASEL III
 Sub prime crisis of 2007-08

 Losses unabsorbed despite high

capital adequacy ratios in books

 High leveraging in off balance sheet items/ over

the counter (OTC) (not through exchange )

 Derivatives disproportionate to their balance sheets

COMPARISON – BASEL II & III

BASEL II BASEL III

Pillar I
Pillar II
Pillar I Enhanc Pillar III
Pillar II Enhanc Liquidi
Minimu Pillar III ed Enhanc
Supervi ed ty
m Market Minimu ed
sory Supervi
Capital
Review
Discipli m
sory
Market Manag
Require ne Capital Discipli ement
Process Review
ment Require ne
Process
ment
BASEL III – KEY POINTS
 Released by BCBS (Basel Committee on Banking Supervision )
in Dec 2010
 Raise the standards of Pillar II and Pillar III
 Address & prevent systemic risk to avoid spillover effect of
the banking system to real economy
 Identify Systemically Important Banks (SIBs) for special
regulation as to capital & other regulatory measures
 Improve overall risk sensitivity of banks to various risks
 Introduce measures to address market risks
 Regulators to exercise both micro prudential and macro
prudential measures to regulate banking/ financial systems
CAPITAL REQUIREMENT
TIER 1 vs AT1 vs TIER 2

TIER 1 AT1 Tier 2

• Going • Hybrid • Gone
Concern bonds concern

• Absorb • When CET1 • Absorb

losses falls below losses at
without a certain the time of
triggering threshold liquidation
bankruptcy
Domestic Systemically Important
Banks (D-SIBs)
 Banks that are perceived as ‘Too Big To Fail (TBTF)’
 3 banks identified as D SIBs –
 SBI (Aug 2015) ICICI Bank (Aug 2016) & HDFC bank (Sep
2017)
 Place under 5 buckets from 1 to 5 depending on Systemic
Importance Scores (SIS)
 Based on the Bucket, place additional CET 1 (% of RWAs)
 Branch of a foreign bank which is considered as Global
Systemically important bank will also attract additional CET
1
DSIBs- Additional CET Requirement
Additional CET 1
Bucket Banks
From April 2019
5 1.00%

4 0.80%

3 0.60% State Bank of India

2 0.40%
ICICI Bank, HDFC
1 0.20%
Bank
COMMON EQUITY TIER 1 (CET1)
Components
 Equity Capital
 Share premium
 Statutory reserves
 Capital reserves
 Foreign Currency Translation Reserve (FCTR) @ 25% discount &
subject to conditions
 Other disclosed Free Reserves
 Revaluation reserves @ 55% discount, subject to conditions
 Credit balance in P&L of last year
 P&L of current year provided NPA provisions not more than 25% of
average of last FY 4 quarters
EXCLUSIONS – CET1
 Good will

 Intangible assets

 Deferred tax assets (DTA) associated with accumulated

losses

 Other DTA net of DTL

 Cash flow hedge reserve

ADDITIONAL TIER 1 CAPITAL (AT1)
Components

 Perpetual Non Cumulative Preference Shares (PNCPS)

 Premium on issue of such shares

 Perpetual Debt capital instruments

 Any other instruments notified by RBI

 Less Regulatory adjustments

TIER 2 CAPITAL
 Perpetual cumulative preference shares (PCPS)

 Redeemable Non cumulative preference shares (RNCPS)

 Redeemable cumulative preference shares (RCPS)

 Share premium on issue of these instruments

 Any other instrument notified by RBI as eligible for Tier II

capital
TIER 2 CAPITAL
Components
 General provisions & loss reserves
 Provisions on standard assets , floating provisions
 Incremental provisions in respect of unhedged forex exposures
 Provision for country exposure
 Excess provision on sale of NPA accounts & Countercyclical Capital
Conservation Buffer
 Investment Fluctuation Reserve account
 Debt capital instrument issued by banks
 Revaluation Reserves @ 55% discount
 Less Regulatory Adjustments
CAPITAL CONSERVATION BUFFER
 Build buffers during normal times
 Ability to withstand adverse economic conditions
 To be utilised in times of financial stress
 Built out of Common Equity Tier I
 Prescribes buffer of 2.5% above the minimum
capital (0.625% in phases)
 Last tranche effective October 1, 2021
 When drawn down,
 enforces constraints on distribution of earnings
 Have a definite plan to replenish the buffer
BASEL III
Revolves around two sets of compliance

Capital Liquidity

Liquidity Coverage Ratio

Tier 1 (CET1 + AT1)
(LCR)

Capital Conservation Buffer

Net Stable Funding Ratio (NSFR)
(CCB)

Tier 2 capital Leverage Ratio

Countercyclical Capital
Conservation Buffer (CCCB)
LIQUIDITY COVERAGE RATIO (LCR)
 Objective
 To promote resilience of short term liquidity
 To make sufficient investment in short term High Quality
Liquid Assets (HQLA)

 Quickly and easily convertible into cash

 Sustain financial stress for 30 days period
 LCR = Stock of HQLA > 100%
Total net cash outflows over the next 30 days
LIQUIDITY COVERAGE RATIO (LCR)
 It is like the current ratio of a borrower.

 Minimum LCR since January 1, 2019 – 100%

 Due to recent COVID-19 pandemic situation, RBI had relaxed

the maintenance of LCR

 From April 1, 2021 onwards reinstated 100%

LIQUIDITY COVERAGE RATIO (LCR)
 Two categories of HQLA
 Level 1 – Cash reserves above CRR; Govt. securities in
excess of SLR; Within SLR securities allowed to the
extent under MSF by RBI
 Level 2 – Not more than 40% of the overall HQLA

 Level 2 comprises of
 2A Assets – claims guaranteed by sovereigns; Corporate Bonds
& Commercial Papers not issued by Banks/PDs/FIs
 2B Assets – Not more than 15% of the total stock of HQLA;
haircut of 50% to be applied on the market value of each
Level 2B stock held; Marketable securities; Common Equity
Shares
NET STABLE FUNDING RATIO (NSFR)
 Objective to deter reliance on short term means of finance
 Finance through stable sources on an ongoing basis
 Long term assets acquired through stable and risk less
liabilities
 A time horizon of 1 year
 NSFR addresses the medium term (1year) liquidity
mismatches faced by bank.
 Implementation from October 1, 2021
 NSFR = Amount available of stable funding > 100%
Required amount of stable funding
LEVERAGE RATIO
 Banks portrayed healthy capital adequacy ratios

 Overuse of on and off balance sheet seen in the financial crisis

 Created to act as a supplement for capital requirement

 Simple, transparent, non-risk based ratio

 Leverage Ratio = Tier 1 Capital > 3.5%

Total Exposure
LEVERAGE RATIO
 For D-SIBs, a minimum of 4%

 Exposure Measure sum of the following

 On-balance sheet exposures
 Derivative exposures
 Securities Financing Transactions (SFT) exposures
 Off-Balance Sheet items

 Capital Measure, Exposure measure and Leverage Ratio to be

disclosed quarterly

 Banks to meet the minimum leverage ratio at all times.

ICAAP
 Bank’s internal process
 Assessing capital adequacy
 Relation to its risk profile
 Strategy for maintaining capital levels
 Complete Enterprise Risk Management (ERM)
framework
 Brings together risk and capital management
 Should be bank specific and bank driven
 Cannot be avoided even if large capital buffers
available
 Signals credibility
ICAAP - FEATURES
 ICAAP to be part of management & decision making culture of
the bank
 Sound and comprehensive capital assessment
 Identifying, measuring, monitoring & reporting risks
 Independent review & validation at periodical intervals
 It should be forward looking
 Should include stress tests and scenario analysis
 Use of marketing/statistical models to be used for prediction
 Every bank to put in place ICAAP (Internal Capital Adequacy
Assessment Process) as an on going process to assess, measure,
factor the risks they undertake and the capital they need to
maintain at all times. As part of SREP, RBI will evaluate the
effectiveness of ICAAP system in the bank
ICAAP REPORT

Should have the following sections

1. Executive Summary
2. Background
3. Structure and Governance
4. Statement of Risk Appetite
5. Enterprise Risk Framework
6. Capital Planning
7. Liquidity Planning
8. Stress Testing & Scenario Analysis
9. Integration, Review & Approval
RESIDUAL RISKS
Basel III also advises banks to factor in & capture other residual risks
(other than credit, Operational & market risk ) like
1. Interest rate risk in the banking book
2. Credit concentration risk
3. Liquidity risk
4. Settlement risk
5. Reputational risk
6. Strategic risk
7. Pension Risk
8. Systemic risk
9. Legal Risk
10. Risk of under-estimation of credit risk under the Standardised approach
11. Model risk i.e., the risk of under-estimation of credit risk under the IRB approaches
12. Risk of weakness in the credit-risk mitigants
13. Residual risk of securitisation, etc.
MARKET DISCIPLINE
 Purpose to complement the minimum capital
requirements and the supervisory review process
 Help assess key pieces of information on the scope of
application, capital, risk exposures, risk assessments etc.
 Required to make disclosures on half yearly basis even if
financial statements are not audited
 Following to be made on a quarterly basis
1. Capital Adequacy
2. Credit Risk: Disclosures for All Banks
3. Credit Risk: Disclosures for Portfolios subject to
Standardised Approach
MARKET DISCIPLINE
 Guiding principles for disclosures
 Principle 1 – should be clear

 Principle 2 – should be comprehensive

 Principle 3 – should be meaningful to users

 Principle 4 – should be consistent over time

 Principle 5 – should be comparable across banks

BASEL III – IMPROVEMENT OVER
BASEL II
 Augmentation in the level and quality of capital

 Introduction of liquidity standards

 Modifications in provisioning norms

 Better and more comprehensive disclosures

AT A GLANCE…..
Basel 1 Basel 2 Basel 3
Introduction 1988 & 1996 2004 2010
Risks Covered Credit Risk Credit Risk Credit Risk
Market Risk Market Risk Market Risk
Operational Risk Operational Risk
Liquidity Risk
Tools Capital to CRAR CRAR
Risk Weighted Supervisory Supervisory Review
Assets Ratio Review Market Discipline
(CRAR) Market Discipline CCB
CCCB
LCR
NSFR
Leverage Ratio
Minimum CRAR = 9% CRAR = 9% CRAR = 11.5%
Ratio (RBI) Tier 1 = 6% Tier 1 = 7%
“Not taking risks, one doesn’t
understand often the best form
of risk management”
- Dr. Raghuram Rajan, Former Governor, Reserve Bank of India