Govind Gurnani, Former AGM, Reserve Bank Of India

Insights : A Journey From Basel II To Basel IV : Norms For

Strengthening Capital Requirements & Resilience Of Banking
Sector

Basel II Accord : Norms To Strengthen Capital Adequacy In

Banks

Basel II accord is an extension of the regulations for minimum

capital requirements as de ned under Basel I.

Three Pillars:
1. Capital Adequacy Requirements
2. Supervisory Review Process
3. Market Discipline

1. Capital Adequacy Requirements

Pillar 1 improves on the policies of Basel I by taking into

consideration operational risks in addition to credit risks associated
with risk-weighted assets (RWA). It requires banks to maintain a
minimum capital adequacy requirement of 8% of its RWA. Basel II
also provides banks with more informed approaches to calculate
capital requirements based on credit risk, while taking into account
each type of asset’s risk pro le and speci c characteristics.

1⃣ Standardised Approach (SA)

The SA is suitable for banks with a smaller volume of operations

and a simpler control structure. It involves the use of credit ratings
from external credit assessment institutions for the evaluation of
the creditworthiness of a bank’s debtor.

2⃣ Internal Ratings-based (IRB) Approach

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The IRB approach is suitable for banks engaged in more complex
operations, with more developed risk management systems. There
are 2 IRB approaches for calculating capital requirements for credit
risk based on internal ratings:

▪ Foundation Internal Ratings-based Approach (FIRB)

In FIRB, banks use their own assessments of parameters such as

the PD, while the assessment methods of other parameters, mainly
risk components such as LGD & EAD, are determined by the
supervisor.

▪ Advanced Internal Ratings-based Approach (AIRB)

Under the AIRB approach, banks use their own assessments for all
risk components & other parameters.

2. Supervisory Review Process

Pillar 2 was added owing to the necessity of e cient supervision

and lack thereof in Basel I, pertaining to the assessment of a
bank’s internal capital adequacy. Under Pillar 2, banks are
obligated to assess the internal capital adequacy for covering all
risks they can potentially face in the course of their operations. The
supervisor is responsible for ascertaining whether the bank uses
appropriate assessment approaches & covers all risks associated.

▪ Internal Capital Adequacy Assessment Process

A bank must conduct periodic internal capital adequacy

assessments in accordance with their risk pro le & determine a
strategy for maintaining the necessary capital level.

▪ Supervisory Review & Evaluation Process

Supervisors are obligated to review & evaluate the internal capital

adequacy assessments & strategies of banks, as well as their
ability to monitor their compliance with the regulatory capital ratios.
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3. Market Discipline

Pillar 3 aims to ensure market discipline by making it mandatory to

disclose relevant market information. This is done to make sure
that the users of nancial information receive the relevant
information to make informed trading decisions & ensure market
discipline.

Basel III Norms : A Foundation For Resilient Banking System

The Basel III framework is a central element of the Basel Committee's

response to the global nancial crisis. It addresses shortcomings of the pre-
crisis regulatory framework and provides a regulatory foundation for a
resilient banking system that supports the real economy.

Basel III is composed of three pillars :

Pillar 1 focuses capital & liquidity adequacy and provides minimum

requirements.

Pillar 2 outlines supervisory monitoring and review standards.

Pillar 3 promotes market discipline through prescribed public disclosures.

Pillar 1 : Minimum Capital Requirements

The Basel III accord increased the minimum Basel III capital requirements for
banks from 2% in Basel II to 4.5% of common equity, as a percentage of the
bank's risk-weighted assets. There is also an extra 2.5% bu er capital
requirement that brings the total minimum requirement to 7% in order to be
Basel compliant.

Banks can use the bu er when they face nancial stress, but using the bu er
can lead to even more nancial constraints when paying dividends.

While Basel Committee has prescribed for maintaining minimum 8% CAR,

the RBI has prescribed for maintaining CAR at 9% for its regulated entities.

Leverage Ratio
Basel III introduced a non-risk-based leverage ratio (LR) as a backstop to the
risk-based capital requirements. Banks are required to hold a leverage ratio
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 in excess of 3%, and the non-risk-based leverage ratio is calculated by
dividing Tier 1 capital by the average total consolidated assets of a bank.
RBI’s prescription for LR is at 4% for D-SIBs and 3.5% for other banks.

Liquidity Requirements

Basel III introduced the use of two liquidity ratios, including the Liquidity
Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). In India, the
banks have been prescribed to maintain these both ratios at minimum
100%.

LCR mandates that banks hold su cient highly liquid assets that can
withstand a 30-day stressed funding scenario, as speci ed by the
supervisors.

NSFR mandates that banks maintain stable funding above the required
amount of stable funding for a period of one year of extended stress.

Changes to Counterparty Credit Risk

Basel III introduced capital requirements to cover credit valuation adjustment

risk and higher capital requirements for securitisation products.

Pillar 2 : Supervisory Monitoring And Review Standards

Supervisory review is intended to ensure that banks not only have adequate
capital to support all the risks in their business, but also develop and use
better risk management techniques in monitoring and managing these risks.
A bank’s management bears responsibility for ensuring that the bank has
adequate capital to support its risks beyond the minimum requirements.

In addition, supervisors evaluate how well banks assess their capital needs
relative to their risks and take measures, where appropriate. The supervisory
evaluation is, therefore, intended to generate an active dialogue between
banks and supervisors so that when excessive risks, insu cient capital or
de ciencies are identi ed, prompt and decisive action can be taken to
reduce risk, address de ciencies or restore capital.
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Pillar 3 : Market Discipline
In pillar 3, the Basel Committee warrants the banks to make six disclosures
in three broad areas : capital, risk exposures and capital adequacy.

Disclosure : Capital

➡ A bank should, at least annually and more frequently where possible &
appropriate, publicly disclose summary information about: (a) its capital
structure & components of capital & (b) the terms & conditions of the main
features of capital instruments.
➡ A bank should disclose information on its accounting policies for the
valuation of assets and liabilities, provisioning and income recognition.

Disclosure : Risk Exposures

A bank should publicly disclose qualitative and quantitative information

about its risk exposures, including its strategies for managing risk.

Disclosure : Capital Adequacy

➡ (i) A bank should, at least annually, publicly disclose its capital ratio other
relevant information on its capital adequacy on a consolidated basis.
(ii) A bank should disclose measures of risk exposures calculated in
accordance with the methodology set out in the Basel Capital Accord.
➡ A bank should provide an analysis of factors impacting on its capital
adequacy position.
➡ A bank should disclose its structure and process of allocating economic
capital to its business activities.

Basel IV Framework : Strengthening Capital Requirements In

The Banks

Basel IV is a package of banking reforms developed in response to the

2008-09 financial crisis. It is a comprehensive set of measures that
makes significant changes to the way banks calculate risk-weighted
assets for capital adequacy ratio. Basel IV included new standards for
credit risk, operational risk and a credit valuation adjustment. It
introduced an output floor, revisions to the definition of the leverage ratio
and the application of the leverage ratio to global systemically important
banks.

1. New Standards For Credit Risk

An analysis of Internal Rating Based approaches for credit risk by the

Basel Committee on Banking Supervision highlighted a high degree of
variability in bank’s calculation of their risk weighted assets. It was
found that advanced internal risk models give banks the most freedom
to estimate their credit risk, often yielding a much lower risk than the
regulator’s standard model. Basel IV reforms for credit risk aims to
restore credibility in those calculations by constraining banks’ use of
internal risk models.

Revised Standardised Approach For Credit Risk

The new Standardised Approach framework for credit risk explicitly

requires banks to assess the risk of their exposures at origination and
on an annual basis. Banks are also required to assess whether risk
weights applied are appropriate and prudent.

Exposure To Banks And Corporates

Risk weights have been modeled based on underlying external ratings

and due diligence to ensure that the rating properly re ects underlying
risk of the exposure. It is to be assumed that 5 per cent of total
exposures fail the due diligence requirement and need to be backed by
a higher risk weight. Corporate SME exposure receives a risk weight of
85 percent.

Exposure To Sovereign

Risk weight for exposure to sovereign is to be applied according to

external rating of the country.

Regulatory Retail And Other Retail Exposures

i) Regulatory Retail : Qualifying revolving retail exposure and other non-

SME exposures receive a risk weight of 75 percent.
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 ii) Other Retail : All other retail exposures are to be risk weighted at 100
per cent.

Exposures Related To Equity And Subordinated Debt

Risk weights for equity and subordinated debt exposure are to be

applied in the range of 150-250 per cent. It is assumed that average
risk of approximately 200 per cent is applied to these exposures.

Exposure To Real Estate

There is increased sensitivity for exposures secured by commercial and

retail real estate, with greater emphasis placed on the loan to value ratio
as the driver of the risk weight. Under this, it is to be assumed that 20
per cent of the exposures is highly dependent on the cash ow of the
underlying property.

2. New Standards For Operational Risk

As de ned by the BCBS, operational risk refers to the risk of loss

resulting from inadequate or failed internal processes, people and
systems or from external events. This de nition includes legal risk, but
excludes strategic and reputational risk.

Prior to Basel IV, there were 3 approaches for assessment of

operational risk capital under Basel Accord viz. Basic Indicator
Approach, The Standardised Approach, and Advanced Measurement
Approach.

Under Basel IV, Standardised Measurement Approach replaces above

mentioned three approaches for assessment of operational risk capital.

Standardised Measurement Approach

Under the new standardised measurement approach (SMA), operational

risk capital is calculated as follows:

Operational Risk Capital = Business Indicator Component x Internal

Loss Multiplier
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 Business Indicator Component

Business Indicator Component (BIC) corresponds to a progressive

measure of income that increases with a bank’s size. It serves as the
baseline capital requirement and is calculated by multiplying the
Business Indicator (BI) by marginal coe cients.

The BI is a nancial statement-based proxy for operational risk

consisting of sum of three following elements, each calculated as the
average over three years:
1. the interest, leases and dividend component;
2. the services component; and
3. the nancial component.

Marginal coe cients are regulatory determined constants based on the

size of the BI.

Internal Loss Multiplier

The internal loss multiplier (ILM) is a risk-sensitive component capturing

a bank’s internal operational losses. It serves as a scaling factor that
adjusts the baseline capital requirement depending on the operational
loss experience of the bank. It is proportional to the ratio of the loss
component (LC) and the BIC, whereby the LC corresponds to 15 times
the average annual operational risk losses incurred over the previous 10
years. In calculating the LC, banks need to meet the requirements on
loss data identi cation, collection and treatment.

3. Standards For Credit Valuation Adjustment

Credit valuation adjustment (CVA) risk of derivative instruments was a

major source of loss for banks during the Global Financial Crisis and
was revised in 2020 following the release of the Basel III reforms.

Meaning Of CVA Risk

CVA risk refers to the risk of losses arising from changing CVA values in
response to movements in counterparty credit spreads and market risk
factors that drive prices of derivative transactions and securities
nancing transactions (SFTs).
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 What Are SFTs?

Securities nancing transactions (SFTs) allow investors and rms to use

assets, such as the shares or bonds they own, to secure funding for
their activities.

A securities nancing transaction can be

1⃣ a repurchase transaction - selling a security and agreeing to

repurchase it in the future for the original sum of money plus a return for
the use of that money

2⃣ lending a security for a fee in return for a guarantee in the form of

nancial instruments or cash given by the borrower

3⃣ a buy-sell back transaction or sell-buy back transaction

4⃣ a margin lending transaction

The CVA risk capital requirements are calculated for a bank’s “CVA
portfolio” on a standalone basis. The CVA portfolio includes CVA for a
bank’s entire portfolio of covered transactions and eligible CVA hedges.

Approaches For CVA Capital Requirements

There are two approaches for calculating CVA capital requirements: the
standardised approach (SA-CVA) and the basic approach (BA-CVA).
Banks must use the BA-CVA unless they receive approval from their
relevant supervisory authority to use the SA-CVA.

Basic Approach -CVA

The BA-CVA has been revised into a reduced and full version. This
approach has more granular counterparty type risk weights while the
rating buckets have been simpli ed into two categories. Banks have to
adjust parameters in their regulatory calculation engine and evaluate
how they record their CVA weight mappings.
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 Furthermore, banks employing CVA hedges will have to manage bigger
impacts on their calculations, due to the intricacies involved in its
consideration of hedges, as well as it being a two-part calculation
(reduced and full) that must be combined for the nal CVA result.

Standardised Approach - CVA

The new standardised approach (SA-CVA) is more granular and risk

sensitive, requiring pre-modelled inputs not previously needed for CVA.
In the past, CVA could have been done within the credit risk process
with only credit risk inputs; however, banks now need to consider
market volatilities, correlations, and credit spreads given that CVA
aligns with the revised market risk framework.

4. Introduction Of Output Floor

Since the publication of Basel II, the banks generally use two methods
to determine minimum capital requirements viz. Standardised Approach
(SA) and Internal Ratings Based Approach (IRBA).

Standardised Approach prescribes risk weights for all categories of

risk assets.

Internal ratings based approach considers the actual risk situation of

a bank by modelling credit risk based on internal and external
customer-speci c data. The use of IRBA requires constant investment
in model development and validation but allows a great deal of leeway
to determine and possibly reduce a bank’s minimum capital
requirements. As a result of these advantageous e ects, major banks
have implemented IRBA years ago with the introduction of Basel II
requirements.

However, the targeted review of internal rating models used in the

banks by BCBS in 2019 concluded that the risk-weighted assets (RWA)
calculated using internal models are in some cases highly inconsistent
and therefore unreliable, unlike RWA calculated using SA. At di erent
banks, the risk quanti cation of the same loan portfolio led to varying
RWA results due to critical de ciencies in the development of
probability of default (PD) and loss given default (LGD) models and in
the assessment of data quality. The numerous shortcomings of internal
models are now to be corrected by introducing the output oor from the
nalised Basel III reform.
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The introduction of output oors means that the RWAs calculated using
internal models cannot fall below a given percentage of the RWAs
calculated using the standardised approach.

From 2023 onwards, an RWA result calculated according to the IRBA

should be at least 50% of the RWA calculated with SA. Subsequently,
the output oor will increase by ve percentage points annually until it
reaches its nal value of 72.5 % in 2028 viz.
2023 : 50%
2024 : 55%
2025 : 60%
2026 : 65%
2027 : 70%
2028 : 72.5%

Despite the gradual introduction of the output oor, it is essential that

the banks and nancial institutions should start looking into the
acquisition of additional capital, as the cost of capital is likely to
increase due to rising demand.

5. Revised De nition Of Leverage Ratio

The leverage ratio is de ned as the capital measure, being Tier 1 capital
divided by exposure measure, with this ratio expressed in percentage.

The exposure measure is the sum of following exposures : i) on balance

sheet exposures (excluding on balance sheet derivative and SFT

exposures ii) derivative exposures iii) SFT exposures and iv) o balance
sheet (OBS) exposures.

In the light of impact over leverage ratio, the BCBS has proposed
amendments to the exposure measure of leverage ratio.

The Basel IV standard includes :

i) more detail and examples in response to speci c challenges raised by
the industry ( the treatment of regular way purchases and cash pooling
in the exposure measure)

ii) an alignment of elements of the LR framework with the other

elements of Basel IV package (e.g. SA-CR and securitisations
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framework for OBS exposures and SA-CCR for derivative potential
future exposure calculations); and

iii) adjustments to various other elements of the calculation of the

exposure measure.

Banks globally have been prescribed to hold a leverage ratio at 3% of.

the tier 1 capital (common equity tier 1 plus Additional tier 1 capital)
against total exposures. RBI’s prescription for LR is at 4% for D-SIBs
and 3.5% for other banks.

6. Additional Requirement Of Leverage Ratio For Global- Systemic

Important Banks (G-SIBs)

In order to maintain the relative roles of the risk-based capital and

leverage ratio requirements, the banks identi ed as G-SIBs are require
to meet a leverage ratio buffer requirement.The leverage ratio buffer will
be set at 50% of a G-SIB’s higher loss-absorbency risk-based
requirements. For example, a G-SIB subject to a 2% higher loss-
absorbency requirement would be subject to a 1% leverage ratio buffer
requirement.

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