Unit 2

International Risk Regulation

The Bank for International Settlements, role of the Bank for International
Settlements, Basel Regulatory Capital, international guidelines and
supervisory standards established by the Basel Committee, Capital Adequacy
Assessment Process (ICAAP), principles of home-host state regulation,
Regulatory Risk, differences between statutory and principles-based
approaches to financial regulation.
 Risk related Regulation and Policy

◼ Individual countries, or groups of countries, impose a legal and regulatory regime

on the firms operating within their jurisdiction; over recent years there have been
increasing efforts to harmonise these regimes.

◼ The Bank for International Settlements (BIS), based in Basel, Switzerland, is the
main force behind this harmonisation, and to start by considering the
international role it plays in financial regulation
• Established in 1930, world’s oldest International Financial Institution, for the purpose
of Central bank cooperation

• Role: The BIS promotes monetary and financial stability globally. It acts as a hub for
central banks to foster international cooperation, conduct research, and provide a
platform for sharing information and best practices.

• Membership: The BIS has 63 member central banks from around the world,
representing countries that account for approximately 95% of global GDP. The
membership includes both advanced and emerging market economies.

• Functions: The BIS performs various functions, including providing a platform for
central banks to hold international reserves, facilitating transactions among central
banks, and acting as a bank for central banks. It also conducts research on monetary and
financial stability, publishes reports, and provides policy recommendations.
Financial Services: The BIS offers a range of financial services to central banks and
international organizations. These services include the custody and management of
international reserves, providing short-term financing to central banks, and acting as a
trustee or agent for international financial operations.

Basel Committee on Banking Supervision: The BIS hosts the Basel Committee on
Banking Supervision (BCBS), which is responsible for developing and promoting
international standards for banking regulation and supervision. The BCBS has issued the
Basel Accords, a set of regulatory frameworks commonly known as Basel I, Basel II, and
Basel III.

The Bank for International Settlements plays a crucial role in promoting international
monetary and financial stability by facilitating cooperation among central banks and
providing a platform for discussion and collaboration on global economic issues.
Basel Committee
◼ Basel Committee on Banking Supervision (BCBS), which exists in order to enhance
understanding of supervisory issues and improve the quality of banking supervision
worldwide – a sort of ‘regulators’ regulator’.

◼ The Committee establishes standards on capital adequacy to ensure that banks have
sufficient reserves to withstand specific levels of risk.

◼ A global standard helps to ensure a level playing field and prevents regulatory arbitrage
at a national level – the amount of capital that a bank is required to hold has a major
impact on the amount of credit which it can extend to customers and thus its level of
profitability.
 The Bank for International Settlements

❖ The world's oldest international financial institution and the principal centre for
international central bank cooperation.

❖ The BIS was established in 1930 by an intergovernmental agreement between

Germany, Belgium, France, the United Kingdom, Italy, Japan, the United States, and
Switzerland.
payment for harm, loss, or damage that
❖ In Basel, Switzerland, on 17 May 1930. has been caused to a person or an
organization

❖ Under the Young Plan, which dealt with the issue of the reparation payments imposed
on Germany by the Treaty of Versailles following the First World War.
 Cont…

◼ To take over the functions previously performed by the Agent General for Reparations in
Berlin:
◼ collection, administration and distribution of the annuities payable as reparations.

◼ The BIS was also created to act as a trustee for the Dawes and Young Loans (international
loans issued to finance reparations) and to promote central bank cooperation in general.

◼ The reparations issue quickly faded, focusing the Bank's activities entirely on
◼ cooperation among central banks and, increasingly, other agencies in pursuit of monetary and
financial stability.
◼ Central bank is considered as the lender of the last resort.

◼ Banks need to consider 2 types of capital when running their businesses:

Economic and Regulatory

◼ Economic capital: bank’s best estimate of the capital it needs to manage its
own risk profile.

◼ Regulatory capital: a mandatory level of capital which a regulator requires

a bank to hold.
 BASEL Committee

◼ Originally named “Committee on Banking Regulations and

Supervisory Practices”

◼ Established by the central bank Governors of the Group of Ten

countries at the end of 1974 in the aftermath of serious disturbances in
international currency and banking markets (notably the failure of
Bankhaus Herstatt in West Germany).
 International Standards on Capital Adequacy
◼ The Basel Committee on Banking Supervision(BCBS) - primary goal standard
setter for prudential regulation.

◼ Strengthen the mandate for regulation, supervision and practices of banks

worldwide with the purpose of enhancing financial stability

◼ Basel Accord stipulates the Minimum capital ratio - maintained by banks in

member countries.

◼ The minimum set of risks for which the capital ratios are to be maintained are
credit, market and operational risk - Firm specific
 Cont…

◼ 1st meeting in Feb 1975,

◼ 3 or 4 meetings are held a year

◼ Membership:

◼ its membership increased from the G10 to 45 institutions from 28 jurisdictions.

◼ Landmark publications: Accord on capital adequacy- Basel I, II, and III
 Cont…

Basically aimed to close gap in international supervisory coverage so that:

(i) no banking establishment would escape supervision; and
(ii) supervision would be adequate and consistent across member jurisdictions.
a
A first step in this direction was the paper issued in 1975 that came to be
known as the "Concordat"
 Cont…

◼ In May 1983, the Concordat was revised and re-issued as Principles for the
supervision of banks' foreign establishments.

◼ In April 1990, a supplement to the 1983 Concordat was issued.

◼ This supplement, Exchanges of information between supervisors of participants in the
financial markets, aimed to improve the cross-border flow of prudential information
between banking supervisors.

◼ In July 1992, certain principles of the Concordat were reformulated and published as
the Minimum standards for the supervision of international banking groups and
their cross-border establishments.
 Cont…

◼ In October 1996, the Committee released a report on The supervision of cross-border

banking

◼ After revision and supplements to the concordat

◼ 1st published in 1997: 25 principles

◼ By Sept 2012, the document of Core Principles for Effective Banking Supervision
consists of 29 principles.
Preconditions for the Effectiveness of Banking Supervision Framework
 29 Core Principles of Effective Banking Supervision

◼ Principles 1-13: Supervisory powers, responsibilities and functions,

◼ Principles 14-29: Supervisory expectations of bank, good corporate governance,
risk management, and compliance with supervisory standards.
 Principle 1: Responsibilities, objective and powers

◼ An effective system of banking supervision has clear responsibilities and

objectives for each authority involved in the supervision of banks and banking
groups.

◼ A suitable legal framework for banking supervision is in place to provide each

responsible authority with the necessary legal powers to authorise banks,
conduct ongoing supervision, address compliance with laws and undertake
timely corrective actions to address safety and soundness concerns.
 Cont…

◼ Essential Criteria
◼ Supervisors responsibilities and objectives are clearly defined
◼ Primarily to promote safety and soundness of banking system
◼ When boarder responsibility assigned, these become subordinate and shall not contradict with
primary responsibilities
◼ Enable supervisor to set and enforce minimum prudential standards - relevant to industry
and regulatory practices
◼ Supervisor has power to increase the prudential requirements for individual banks and
banking groups based on their risk profile and systemic importance
◼ Dual Control: Credible and publicly available framework to avoid regulatory and supervisory
gap
 Cont…

◼ Update prudential standard

◼ To remain effect and relevant to industry and regulatory practices
◼ Subject to public consultation
◼ Supervisor has power to:
◼ Access banks’ and bank groups’ Boards, Management and staffs records
◼ Review banking domestic and cross-boarder activities
◼ Supervise banks’ foreign activities
◼ To review parent and parents’ affiliated companies to determine their activities’
impact on bank and banking system
 Cont…

◼ When supervisor
◼ judges
◼ Bank not complying with laws and regulations or
◼ Likely to be engaging unsafe or unsound practices and
◼ That have potential to jeopardise the bank and the banking system
◼ Has power to
◼ Take or require bank to take corrective action
◼ Impose sanctions
◼ Revoke bank’s license
◼ Cooperate and coordinate for resolution or trigger resolution if appropriate
 Principle 2: Independence, accountability, resourcing, and legal
protection for supervisors
◼ Supervisor should have operational independence, transparent process, sound governance &
accountability
◼ No government or industry interference that compromises the operational independence of the
supervisor.
◼ Appointment or removal of supervisory authorities is transparent
◼ Governing body structured to avoid conflict of interest
◼ Credibility of supervisor and staffs though their professionalism and integrity
◼ Availability of adequate resources
◼ Human resource, training, remuneration, regular skill training
◼ Protection against lawsuit for their action/ omission during the conduct of duties with good
faith and cost for defence
 Principle 3 – Cooperation and Collaboration

◼ Arrangement for Co-operation & Collaboration:

◼ For analysis and sharing of information
◼ Collaborative work, with all domestic authorities with responsibility for the safety and soundness
of banks and banking system
◼ Evidence that the arrangements work in practice where necessary
◼ May provide confidential information to another domestic authority or foreign supervisor
◼ Reasonable steps taken to
◼ ensure confidential information is used only for bank-specific purpose or for system wide
supervisory purpose
◼ And treated confidential by the receiving party
 Cont…

◼ Supervisor receiving information:

◼ Uses information for bank-specific or system-wide supervisory purposes only

◼ Doe not disclose confidential information received to third parties without the permission of the supervisor providing
the information

◼ is able to deny any demand (other than a court order or mandate from a legislative body) for confidential information in
its possession.

◼ If legally compelled to disclose confidential information:

◼ promptly notifies the originating supervisor,

◼ Indicating information and circumstances necessitating such disclosure

 Cont…

◼ If consent for passing information is not given:

◼ uses all reasonable means to resist such a demand or protect the confidentiality of the
information.

◼ Processes are in place for the supervisor to support resolution

authorities (eg central banks and finance ministries as appropriate)
◼ to undertake recovery and resolution planning and actions.
 Principle 4 – Permissible activities

◼ Activities of licensed and supervised banks are clearly defined

◼ The use of the word “bank” in names is controlled.
Essential Criteria
◼ The term “bank” is clearly defined in laws or regulations.
◼ The permissible activities banks clearly defined
◼ The use of the word “bank” and any derivations such as “banking” limited to licensed and
supervised institutions only
◼ Only institutions that are licensed and subject to supervision as banks can take public deposit
◼ Current list of licensed banks, including branches of foreign banks, operating within its
jurisdiction in a way that is easily accessible to the public.
 Principle 5 – Licensing criteria

◼ The licensing authority has the power

◼ to set criteria for licensing

◼ to reject applications for establishments that do not meet the criteria.

◼ At a minimum, the licensing process consists of an assessment of the ownership

structure and governance including the capital base where the proposed owner or
parent organization is a foreign bank, the prior consent of its home supervisor is
obtained.
 Cont…

Essential Criteria

◼ The law identifies the authority responsible for granting and withdrawing a banking licence.

◼ The licensing authority could be the banking supervisor or another competent authority.

◼ If the licensing authority and the supervisor are not the same,

◼ the supervisor has the right to have its views on each application considered, and its concerns addressed.
 Cont…

◼ The licensing authority to provide information to the supervisor any material information for supervision

◼ The supervisor imposes prudential conditions or limitations on the newly licensed bank, where appropriate

◼ Licensing authority has the power

◼ to set criteria for licensing banks.

◼ To reject application when criteria not met

◼ Supervisor and licensing authority have right to revoke license if license obtained on false information
 Cont…
◼ Licensing authority to determine:
◼ The proposed legal, managerial, operational and ownership structures of the bank and its wider group will

◼ not hinder effective supervision on both a solo and a consolidated basis.

◼ not hinder effective implementation of corrective measures in the future.

◼ Identifies and determines the suitability of the

◼ bank’s major shareholders

◼ ultimate beneficial owners and others that may exert significant influence

◼ transparency of the ownership structure

◼ the sources of initial capital and

◼ the ability of shareholders to provide additional financial support,

 Cont…

◼ Minimum initial capital amount is stipulated for all banks

◼ The licensing authority, at authorisation, evaluates the bank’s proposed Board members and senior
management as
◼ to expertise and integrity (fit and proper test), and any potential for conflicts of interest.

◼ The fit and proper criteria include:

◼ (i) skills and experience in relevant financial operations commensurate with the intended activities of the bank;
and

◼ (ii) no record of criminal activities or adverse regulatory judgments that make a person unfit to uphold important
positions in a bank
 Cont…

◼ LA (Licensing authority)reviews proposed strategic and operating plans of the bank

◼ System of corporate governance,

◼ Risk management and internal controls

◼ Those related to the detection and prevention of criminal activities

◼ LR reviews pro forma financial statements and projections of the proposed bank
 Cont…

◼ In case of foreign banks establishing a branch or subsidiary,

◼ No objection from home supervisor

◼ before issuing a licence, the host supervisor establishes that no objection (or a statement of no objection) from the home supervisor
has been received.

◼ Determine if home supervisor practices global consolidated supervision

◼ For cross-border banking operations in its country, the host supervisor determines whether the home supervisor practices
global consolidated supervision.
 Principle 6 – Transfer of Significant Ownership

◼ Supervisor has power to reject or accept the proposal for transfer of significant ownership
◼ Criteria:
◼ Regulations contain clear definitions of “significant” ownership and “controlling interest

◼ The supervisor has the power to reject any proposal for a change in significant ownership,
including beneficial ownership, or controlling interest
◼ The supervisor obtains from banks, through periodic reporting or on-site examinations, the
names and holdings of all significant shareholders or those that exert controlling influence,
including the identities of beneficial owners of shares
 Principle 7: Major acquisitions

◼ The supervisor has the power to approve or reject and impose prudential conditions on,
major acquisitions or investments by a bank, against prescribed criteria.

◼ Criteria:
◼ What types and amounts of acquisitions and investments need prior supervisory approval

◼ Consistent with the licensing requirements, among the objective criteria that the supervisor
uses is that any new acquisitions and investments do not expose the bank to undue risks
◼ The supervisor determines that the bank has, from the outset, adequate financial, managerial
and organizational resources to handle the acquisition/investment.
 Principle 8 – Supervisory approach:

◼ An effective system of banking supervision requires the supervisor to:

◼ Develop and maintain a forward-looking assessment of the risk profile of individual
banks and banking groups, proportionate to their systemic importance

◼ Identify, assess and address risks starting point from banks and the banking system as a
whole

◼ Have a framework in place for early intervention, and

◼ have plans in place, in partnership with other relevant authorities, to take action to resolve
banks in an orderly manner if they become non-viable.
Criteria:

◼ which banks or banking groups present to the safety and soundness of the banking system.
◼ The supervisor has processes to understand the risk profile of banks and banking groups
and employs a well defined methodology
◼ The supervisor assesses banks’ and banking groups’ compliance with prudential regulations
and other legal requirements
◼ The supervisor takes the macroeconomic environment into account in its risk assessment of
banks and banking groups.
◼ The supervisor has a clear framework or process for handling banks in times of stress.
 Principle 9: Supervisory techniques and tools

◼ The supervisor uses an appropriate range of techniques and tools to implement the
supervisory approach
◼ Criteria:
◼ The supervisor employs an appropriate mix of on-site and off-site supervision to
evaluate the condition of banks
◼ The supervisor uses a variety of tools to regularly review and assess the safety and
◼ The supervisor has a framework for periodic independent review, for example by
an internal audit function or third party assessor
Principle 10: Supervisory reporting

◼ The supervisor collects, reviews and analyses prudential reports and statistical returns from banks on
both a solo and a consolidated basis, and independently verifies these reports, through either on-site
examinations or use of external experts

◼ The supervisor has the power to require banks to submit information, on both a solo and a consolidated
basis, on their financial condition, performance, and risks

◼ The supervisor provides reporting instructions that clearly describe the accounting standards to be used
in preparing supervisory reports

◼ The supervisor utilizes policies and procedures to determine the validity and integrity of supervisory
information.
Principle 11: Corrective and sanctioning powers of supervisors

◼ The supervisor acts at an early stage to address unsafe and unsound practices or
activities

◼ Criteria:
◼ The bank to submit regular written progress reports and checks that
corrective actions are completed satisfactorily.

◼ The supervisor cooperates and collaborates with relevant authorities in

deciding when and how to effect the orderly resolution of a problem bank
situation (merger, restructuring)
 Cont…

◼ As supervisor should have tools, if bank not follow the law or doing unsafe activities.

◼ If a bank falls below standards like ratios, as supervisor should have tools to correct & face such scenario

◼ The supervisor has the power to take corrective actions, including ring-fencing of the bank
 Principle 12: Consolidated supervision

◼ An essential element of banking supervision is that the supervisor supervises the

banking group on a consolidated basis, adequately monitoring and, as appropriate,
applying prudential standards to all aspects of the business

◼ The supervisor imposes prudential standards and collects and analyses financial
and other information on a consolidated basis for the banking group.
Principle 13: Home-host relationships

◼ Home and host supervisors of cross-border banking groups share information and
cooperate for effective supervision of the group and group entities and effective handling
of crisis situations.

◼ Supervisors require the local operations of foreign banks to be conducted to the same
standards as those required of domestic banks.
Prudential regulations and requirements - Principle 14- 29
 Principle 14: Corporate governance

◼ Supervisor determines that banks & banking groups have robust corporate governance
◼ Organizational structure
◼ Responsibility of Board

◼ Criteria
◼ The supervisor regularly assesses a bank’s corporate governance policies and
practices, and their implementation
◼ Board members are suitably qualified, effective and exercise their “duty of care” and
“duty of loyalty
 Principle 15: Risk management process

◼ The supervisor should determines that all the banks have a comprehensive risk
management process to identify, measure, evaluate, monitor, report and control
or mitigate all material risks regularly

◼ To assess the adequacy of their capital and liquidity in relation to their risk
profile and market and macroeconomic conditions.

◼ Issues standards related to, in particularly, credit risk, market risk, liquidity
risk, interest rate risk in the banking book and operational risk
Principle 16: Capital adequacy

◼ The supervisor sets prudent and appropriate capital adequacy requirements for banks that
reflect the risks undertaken by, and presented by, a bank in the context of the markets and
macroeconomic conditions.

◼ The supervisor defines the components of capital, bearing in mind their ability to absorb
losses.

◼ Atleast for internationally active banks, capital requirements are not less than the
applicable BASEL standards
Principle 17: Credit risk

◼ The supervisor regulate that banks have an adequate credit risk management process
that takes into account of the banks
◼ Risk appetite,

◼ Risk profile and

◼ Market & macroeconomic conditions.

◼ This includes prudent policies and processes to identify, measure, evaluate, monitor,
report and control or mitigate credit risk on a timely basis.
Criteria – supervisor determines

◼ Bank’s Board approves, and regularly reviews, the credit risk management strategy and
significant policies and processes
◼ Well documented and effectively implemented strategy and sound policies and processes
for assuming credit risk
◼ Effective information systems for accurate and timely identification, aggregation and
reporting of credit risk exposure to management
Principle 18: Problem assets, provisions and reserves

◼ Determines that banks have adequate policies and processes for early
identification & management of problem assets, and maintenance of adequate
provisions and reserves
◼ The supervisor require banks to formulate policies and processes for
identifying & managing problem assets.
◼ Regular review of problem assets & assets classification, provisioning and
write-offs
◼ Supervisor determines that the bank’s system for classification and
provisioning takes into account off-balance sheet exposures
Principle 19: Concentration risk and large exposure limits

◼ The supervisor determines that banks have adequate policies and processes
to identify, measure, evaluate, monitor, report and control or mitigate
concentrations of risk on a timely basis.

◼ Supervisors set prudential limits to restrict bank exposures to single

counterparties or groups of connected counterparties
Criteria

◼ The supervisor regularly obtains information that enables concentrations

within a bank’s portfolio, including sectoral, geographical and currency
exposures, to be reviewed.

◼ laws or regulations explicitly define in respect of credit exposure to single

counterparties or groups of connected counterparties,,

◼ The supervisor has the power to define, a “group of connected counterparties”

to reflect actual risk exposure
Principle 20:Transactions with related parties

◼ In order to prevent manipulations arising in transactions with related

parties and to address the risk of conflict of interest, the supervisor
requires banks
◼ To enter into any transactions with related parties on an arm’s length basis;
◼ To monitor these transactions;
◼ To take appropriate steps to control or mitigate the risks; and
◼ To write off exposures to related parties in accordance with standard policies and
processes.
Criteria

◼ Supervisor has the power to prescribe, a comprehensive definition of “related parties”.

◼ The supervisor obtains and reviews information on aggregate exposures to related

parties.

◼ The supervisor determines that banks have policies and processes to prevent persons
benefiting from the transaction or persons related to such a person from being part of
the process of granting and managing the transaction.
 Principle 21: Country and transfer risks

◼ The supervisor determines that banks have adequate policies and processes to identify,
measure, evaluate, monitor, report and control or mitigate country risk and transfer risk in
their international lending and investment activities on a timely basis

◼ Country Risk: Country risk is the risk of exposure to loss caused by events in a foreign
country.

◼ Transfer Risk: It is the risk that a borrower will not be able to convert local currency into
foreign exchange and so will be unable to make debt service payments in foreign
currency. The risk normally arises from exchange restrictions imposed by the government
in the borrower’s country.
 Principle 22 – Market risks

◼ The supervisor determines that banks have an adequate market risk management process that
takes into account their
◼ Risk appetite,
◼ Risk profile, and
◼ Market and macroeconomic conditions and
◼ The risk of a significant drop in market liquidity.

◼ This includes prudent policies and processes to identify, measure, evaluate, monitor,
report and control or mitigate market risks on a timely basis.
Principle 23 – Interest rate risk in the banking book

◼ The supervisor determines that banks have adequate systems to identify, measure,
evaluate, monitor, report and control or mitigate the
◼ Interest rate risk in the banking book on a timely basis.
◼ These systems take into account the bank’s risk appetite, risk profile and market
and macroeconomic conditions.
 Home and Host State Regulation - key principles

Basel Accord on Cross-Border Banking Supervision

◼ provides a framework for multi-jurisdiction supervision.

◼ It focuses on potential issues with international banks’ solvency, liquidity, and foreign exchange positions, and

◼ Requires the ‘home or parent regulators to communicate closely with the host regulators in countries where the bank has
branches, subsidiaries or joint ventures’.
 Principle 24 – Liquidity risk

The supervisor determines that banks have a strategy that enables prudent management
of liquidity risk and compliance with liquidity requirements.
◼ The strategy takes into account the bank’s risk profile
◼ Market and macroeconomic conditions and
◼ Prudent policies and processes,
◼ Consistent with the bank’s risk over an appropriate set of time horizons.
 Principle 25 – Operational risk

The supervisor determines that banks have an adequate operational risk management
framework that takes into account their risk appetite, risk profile and market and
macroeconomic conditions.
Principle 26 – Internal control and audit

The supervisor determines that banks have adequate internal controls to establish
and maintain a properly controlled operating environment for the conduct of their
business taking into account their risk profile.
Principle 27: Financial reporting and external audit

◼ Banks and banking groups maintain adequate and reliable records,

prepare financial statements in accordance with accounting policies
and practices
Principle 28 – Disclosure and transparency

◼ The supervisor determines that banks and banking groups regularly

publish information on a consolidated and, where appropriate, solo basis
that is easily accessible and fairly reflects their
◼ Financial position & Performance
◼ Risk exposure
◼ Risk mgt strategy
◼ Corporate governance policy & procedure
 Principle 29 – Abuse of financial services:

◼ Banks have adequate policies and processes, including strict

customer due diligence rules to promote
◼ High ethical and professional standards in the financial sector
and
◼ Prevent the bank from being used, intentionally or
unintentionally, for criminal activities.
 BCBS Core Principles on Capital Adequacy (Principle 16)

◼ Supervisors must set prudent and appropriate minimum capital adequacy requirements for
banks that reflect the risks that the bank undertakes, and
◼ Must define the components of capital, bearing in mind its ability to absorb losses. At least
for internationally active banks, these requirements must not be less than those established
in the applicable Basel requirement.
◼ Supervisors must be satisfied that banks and banking groups have in place a comprehensive
risk management process (including Board and senior management oversight)
◼ to identify, evaluate, monitor and control or mitigate all material risks and
◼ to assess their overall capital adequacy in relation to their risk profile.
◼ These processes should be commensurate with the size and complexity of the institution.
 Capital Regulation: Pre-Basel

In the US, between 1864 and 1950s

(i) static minimum capital requirements based on the population of each bank’s
service area, ratios of capital-to-total deposits and capital-to-total assets;

(ii) adjusted assets for risk; and

(iii) capital-to-risk-assets ratios,

 Cont…

◼ 1981: leverage ratio of primary capital (which consisted mainly of equity and loan
loss reserves) to average total assets
Hindrance to Uniform Capital Standard

◼ Differed view on definition of capital

◼ The inadequate capitalization of Japanese banks and
◼ Differing banking structures (universal banks of Germany vis-à-vis narrow banks of
US) and varying risk profile of individual banks made agreement on capital standards
difficult.
 Cont…

◼ The Congress in the US passed legislations in 1983, directing the federal

banking agencies to issue regulations addressing capital adequacy.
◼ 1987: The US joined the UK in announcing a bilateral agreement on capital
adequacy, soon to be joined by Japan
◼ December 1987 ‘international convergence of capital measures and capital
standards’ was achieved. In July 1988, the Basel I Capital Accord was created.
 Why adequate capital for banks

◼ To support banks’ operations by absorbing losses and changes in asset values

◼ For maintaining solvency.
◼ A comfortable bank capital level boosts depositors’ confidence, encourages
shareholders’ interest in governance of bank and

◼ Provides protection to creditors in the event of liquidation.

◼ Bank capital acts as an insurance against uncertainty.
 Basel norms of capital measurement and capital standards

◼ 1988- Regulatory capital requirements (Basel I)

◼ Market risk amendment of January 1996

◼ 2004- International Convergence of Capital Measurement and Capital

Requirements (Basel II)
◼ 2010- Basel III
 BASEL-I

◼ The Basel Accord was endorsed by 12 countries (all G-10 countries

plus Luxembourg and Switzerland) in July 1988 under the
chairmanship of W P Cooke (Bardos, 1988).
◼ A set of minimal capital requirements for banks
◼ Focus on Credit risk:
◼ Primarily addressed banking in the sense of deposit taking and lending
(commercial banking under US law)
◼ Covers: Capital, Risk Weighting System and Target Ratio
 Cont…

◼ Capital
◼ Tier I
• Paid-up capital (ordinary shares), statutory reserves, and other disclosed free
reserves, if any;
• Perpetual Non-cumulative Preference Shares (PNCPS) eligible for inclusion
as Tier I capital - subject to laws in force from time to time;
• Innovative Perpetual Debt Instruments (IPDI) eligible for inclusion as Tier I
capital; and
• Capital reserves representing surplus arising out of sale proceeds of assets.
 Cont…

Tier 2:
• Undisclosed reserves
• Revaluation reserves
• General provisions and loss reserves
• Hybrid capital instruments,
• Subordinated debt and
• Investment reserve account
 Weighting Schemes

◼ 0%: Cash, Govt. Securities

◼ 0% to 50%: (At national discretion) Public-sector entities
◼ 20%: Non-domestic development banks (OECD countries)
◼ 50%: Mortgage backed loans
◼ 100%: Loan to private sector, etc
 Target Ratio

◼
 The 1996 Amendment to the Basel Accord (Basel 1)

◼ To provide an explicit capital cushion for

◼ the price risks to which banks are exposed, particularly those arising from their
trading activities.

◼ Covers market risks arising from banks’ open positions in

◼ foreign exchange, traded debt securities, traded equities, commodities and options

◼ Market risk, interest risk, foreign exchange risk and commodities risk
 Cont…

◼ Methods to determine Capital Charge for Market Risk:

◼ Specific Risk Method (as per original framework)
◼ Internal models approach (VaR)

◼ Tier 3 Capital: Subordinate debts with maturity period of less than two years
debt which ranks after other debts if a company
falls into liquidation or bankruptcy.
 Criticisms of Basel 1

◼ Did not meet the objective “to make the competitive playing field more
even for international banks.”
◼ Taxes, accounting requirements, disclosure laws, implicit and explicit
deposit guarantees, social overhead expenditures, employment
restrictions, and insolvency laws, also affect the competitiveness of an
institution.
◼ No impact on competitiveness
◼ Lack of international financial integration on many aspects except capital
adequacy
 Cont…

◼ Encouraged capital arbitrage

◼ Encouraged transactions using securitization and off-balance sheet
exposures, whose principal aim was to arbitrage bank capital
◼ Encouraged some banks to move high quality assets off their balance
sheet, thereby reducing the average quality of bank loan portfolios
◼ Increased exposure to least creditworthy borrowers in risk-weighted class
◼ Banks took large credit risks in the least creditworthy borrowers who
had the highest expected returns in a risk-weighted class
 Cont…

◼ Uniform treatment to risk

◼ Risks are identical within each bucket and that the overall risk of a bank’s
portfolio is equal to the sum of the risks across the various buckets.

◼ The risk-weight classes did not match realized losses.

◼ Risk weights did not accurately track the credit experience in the US
◼ Collateralized loans had the least risk.
◼ Commercial loans appear to be under-burdened by the Basel I weights and
mortgages were overburdened.
 Cont…

◼ Did not take into account the benefits of portfolio diversification

◼ The aggregate risk of a bank is not equal to the sum of its individual risks
◼ Risk weighted are not based on market assessments but instead favor claims
◼ on banks headquartered in OECD countries and OECD Governments, and
on residential mortgages.
◼ Basel standards are computed on the basis of book-value accounting measures
of capital, not market values
◼ Accounting practices vary across countries
 BASEL-II
Published in 2004
Aimed at: To revise the 1988 Accord has been to develop a more
comprehensive approach as
◼ To align regulatory capital requirements more closely to the underlying
risks that banks face
◼ To promote a more forward-looking approach to capital supervision
◼ one that encourages banks to identify the risks they may face, today and
in the future, and
◼ To develop or improve their ability to manage those risks.
 Cont…

◼ In June 1999, the BCBS released for comments on its proposal to introduce a new
capital adequacy framework
◼ International Convergence of Capital Measurement and Capital Standards (BASEL II)

◼ New Basel Norms was released by the BIS on June 26, 2004, which would replace the
1988 Capital Accord by year-end 2007.
◼ In March 2005,
◼ re-discussed the schedules for national rule-making processes within member countries
and
◼ decided to review the calibration of the Basel II framework
 Cont…

◼ In November 2005-Issue of Updated Version

◼ In July 2006: BASEL II Framework - the Committee issued a comprehensive version of
the Basel II framework, which is a compilation of the
◼ The elements of the 1988 Accord that were not revised during the Basel II
process,
◼ The 1996 Amendment to the Capital Accord to Incorporate Market Risks,
◼ ‘The Application of Basel II to Trading Activities and the Treatment of Double
Default Effects’ (July 2005).

the risk of both the borrower and the guarantor or provider of credit protection
defaulting for the same receivable is smaller than the risk of just one party defaulting.
 Major Changes/Retention

◼ Retentions:
◼ CAR to be at least 8%

◼ The definition of eligible capital.

◼ Proposed Changes
◼ Consideration of interest rate risk and operational risk along with credit and market risk

◼ Consideration of capital charges for risk (Interest rate risk in capital and operational risk)

◼ Empirical based measurement of credit and operational risk (By the banks and regulators)
IRB Approach
Internal Rating Based
Approach
VaR Model - Value at Risk
Three Pillars of BASEL II
 Pillar 1: Minimum Capital Requirement
Measurement of Credit Risk

◼ Banks in India currently follow the standardized approach and

◼ They report risk weighted assets for various credit exposures depending
upon their external rating positions and hence compute capital requirement
for credit risk.
 Cont…

◼ For retail loans (e.g. residential housing loans, personal loans etc.)
◼ Risk weights are different for different sizes of exposures
◼ depending on the availability of collateral margins
◼ Risk weights are less for higher margin, better collateral and smaller loan size

◼ Banks also use various credit conversion factors (CCFs)

◼ To convert their off balance sheet exposures (e.g. CCF=50% for credit guarantees; CCF=20% for
cash credit etc.) into on balance sheet to estimate risk capital.
◼ Standard supervisory haircuts are used
◼ To take into account the benefit of eligible collaterals (like gold, bonds, NSC, KVP etc.) that
reduces their credit risk exposures.
 Cont…

◼ Foundation Internal Rating Based Approach (FIRB)

◼ Banks are allowed to develop their own empirical model to estimate the PD (Probability of
Default) for individual clients or groups of clients.
◼ The other important risk parameters like EAD and LGD will be supplied by the regulator. Banks
can use this approach only subject to approval from their local regulators.
EAD - Exposure at default
LGD - Loss given Default
◼ Advanced IRB (AIRB) approach
◼ Banks are supposed to use their own quantitative models to estimate PD (Probability of Default),
EAD (Exposure at Default), LGD (Loss Given Default) and other parameters required for
calculating the RWA (Risk-Weighted Asset).
 Measuring Market Risk

◼ Banks have to report capital requirement for interest rate risk, equity position risk and
foreign exchange risk (including Gold) to the regulator.

◼ Banks in India generally follows

◼ the standardized method that has been prescribed by the regulator.

◼ For advanced approaches, Banks can use

◼ Internal VaR models coupled with stress testing (ex. sensitivity analysis) exercises to estimate
market risk capital charge.
 Operational Risk

◼ Basic Indicator Approach (BIA)

◼ The capital charge is derived as a fixed multiple (alpha=15%) of three years average gross income of Banks.

◼ The Standardized Approach (TSA)

◼ Different business lines are assigned individual gross activity measures
◼ The regulators determine the appropriate fixed multiple (beta) to calculate the regulatory capital requirement.
◼ The exposure indicator is gross income of various business lines of the Bank.
◼ The beta values range from 12% to 18%.
◼ Many Banks of India have already adopted BIA as well as TSA.

◼ Advanced Measurement Approach (AMA).

 Cont…

◼ The advanced measurement (AMA)

◼ Banks have to use their internally defined risk parameters based on their historical internal
loss data on Frauds, Business disruption & system failures, Execution, Delivery and Process,
Transaction processing risk, Employment practices, Business Practices etc.
◼ Loss history represents the inherent operational risks and the state of the controls at a point in
time.
◼ Loss data to be categorized according to an event-driven taxonomy that enables banks to have a
risk profile for each event.
◼ Finally Banks can use Value at Risk (VaR) models to estimate figure for unexpected loss and
operational risk capital subject to the regulatory review and approval.
◼ Some banks in India have applied for AMA.
◼ Involvement of Board of directors and senior management is a must for adopting AMA in a Bank.
 CAR

As per existing Basel II rules

◼ Banks need to maintain minimum regulatory capital at 9% of the risk- weighted assets
(internationally 8%)

◼ Out of this, not less than 50% should be Tier 1 Capital

 Pillar 2: Internal Capital Adequacy Assessment Process (ICAAP).

Credit institutions must have effective systems and processes in place to determine the
amount, composition and distribution of internal capital on an ongoing basis and to hold
capital commensurate with the required level.

◼ Assess risk and their mitigants

◼ Subject the result to rigorous stress testing
◼ Determine an appropriate level of capital for those risk
 Key Elements of ICAAP Framework

◼ The firm’s risk exposure

◼ Identify risk appetite
◼ Quantification of risk not included in pillar 1 (concentration risk, etc)
◼ The firm’s view on the adequacy of its risk management process
◼ Justify capital holding for its risk exposure
◼ The firm’s financial and capital plans (Stress Testing and Scenario Analysis)
◼ Summary of current and projected financials
◼ Strategic position, balance sheet strength, future profitability
◼ Stress Testing, Scenario Analysis
 Cont…

◼ The firm’s capital adequacy

◼ Capital and Dividend Plan
◼ Diversification (correlation)
◼ The “Use Test”- the extent to which the ICAAP is embedded within the firm
◼ Senior management to challenge and review ICAAP
◼ Setting the regulatory capital level
◼ ICAAP- designed to incentivize firms to increase the quality of risk management
◼ Align regulatory capital to economic capital- reduce pillar 1 capital though effective risk
management.
 Benefits of ICAAP

◼ Business Strategy:
◼ Required regulatory capital for strategic decision

◼ Risk Assessment
◼ Increased focus on risk

◼ Senior management risk responsibility

 Supervisory Review and Evaluation Process (SREP).

The supervisors would conduct a detailed examination of the ICAAP of the banks, and if
warranted, could prescribe a higher capital requirement, over and above the minimum
capital envisaged in Pillar 1.

◼ To evaluate banks’ risk profile

◼ To assess qualitative aspects (management, strategy, internal processes), and
◼ To impose supervisory measures if necessary
 Pillar 3: Market Discipline

◼ Apart from regulators, banks are also monitored by markets

◼ Markets would be quite responsive to disclosures
◼ the banks would be duly rewarded or penalized, in tune with the nature of
disclosures, by the market forces
Disclosure requirements by Banks to complement the minimum capital
requirements (Pillar I) and the supervisory review process (Pillar II).
 Cont…

Objectives

◼ To ensure greater transparency in terms of banks’ activities and risk strategies

◼ To enhance comparability across credit institutions-which are all in the interests of
market participants.

◼ To mandate the publication of key data, the disclosure of which neither weakens banks’
competitive positions nor violates banking secrecy.
 Criticism of BASEL II

◼ Need of highly sophisticated MIS/data processing capabilities

◼ However, unavoidable mainly because the banking system and related instruments that
have evolved in recent times are inherently complex in nature.

◼ Unfairly advantage the larger banks

◼ developing countries generally also do not have these banks and that Basel II will
disadvantage the economically marginalized by restricting their access to credit or by
making it more expensive.
 Cont…

◼ Questionable ability of rating by rating agencies to predict default

◼ Changes in ratings, lag changes in actual credit quality
◼ IL&FS How credit rating agencies missed the IL&FS crisis | Mint (livemint.com)
◼ Subprime crisis: Credit rating agencies and the subprime crisis - Wikipedia
◼ (104) Ratings agencies' role in the crisis – YouTube
◼ (104) Lawsuit accuses rating agencies of fraud in company evaluations – YouTube

◼ ‘Investor-Pays Model’, “Issuer-Pays Model’

Read more
at https://marketfeed.news/how-credit-rating-agencies-in-india-earn-money/ | marketfeed.news
 Cont…

◼ “The pools of debt the agencies gave their highest ratings to included over three trillion dollars of loans to
homebuyers with bad credit and undocumented incomes through 2007. Hundreds of billions of dollars' worth
of these triple-A securities were downgraded to "junk" status by 2010, and the write-downs and losses came
to over half a trillion dollars”
-Credit rating agencies and the subprime crisis - Wikipedia
 Cont…

◼ Rating agencies have limited penetration in many emerging countries.

◼ most credit risks will tend to end up in the unrated 100 per cent category, capital requirements being no
different form basel 1

◼ Unrated borrowers will have a lower risk weight (100 per cent) as compared to the lowest graded
borrower (150 per cent)
◼ Business Cycle:
◼ Credit models used for Pillar 1 compliance typically use a one year time horizon.
◼ During a downturn in the business cycle, banks would need to reduce lending as their models forecast
increased losses, increasing the magnitude of the downturn.
◼ More capital is required in recessions because credit risk in banks’ portfolios increases in cyclical downturns
Cont…
Cont…
Cont…
 Basel III
◼ The Basel III framework is a central element of the Basel Committee's response to the global
financial crisis.
◼ to reduce excessive variability of risk-weighted assets (RWA).
Improve RWA calculation by

◼ enhancing the robustness and risk sensitivity of the standardized approaches for credit risk and
operational risk, which will facilitate the comparability of banks' capital ratios

◼ constraining the use of internally modelled approaches

◼ complementing the risk-weighted capital ratio with a finalized leverage ratio and a revised and
robust capital floor
 Cont…

◼ In 2010, Basel III guidelines were released.

◼ Reserve Bank of India in May 02, 2012 has released its final guidelines on
implementation of Basel III capital regulation in India.
◼ These guidelines became effective from January 1, 2013 in a phased manner.
 Cont…

◼ The Basel III framework sets out the following:

◼ Higher and better equity capital
◼ Better risk coverage
◼ Introduction of a leverage ratio

◼ Measures to promote the build-up of capital for periods of stress

◼ Introduction of new liquidity standards

 Capital Requirement

◼ Capital Conservation Buffer:

◼ Must be met exclusively with common equity

◼ The minimum Tier 1 capital increases from 4% in Basel II to 7%, applicable in 2015, over RWAs.

◼ This 7% is composed of 4.5% of CET1, plus an extra 2.5% of Additional Tier 1 (AT1).

◼ Capital conservation buffer of 2.5% to withstand future periods of stress

◼ Restrictions on payouts of dividends, share buybacks, and bonuses if capital conversation buffer
not maintained
 Cont..

◼ Countercyclical Capital Buffer

◼ 0% and 2.5% of common equity or other fully loss absorbing capital is implemented
according to national circumstances.

◼ Higher Common Equity Tier 1 (CET1) constitutes an increase from 2% to 4.5%. The ratio
is set at:
◼ 3.5% from 1 January 2013

◼ 4% from 1 January 2014

◼ 4.5% from 1 January 2015

 Cont…

◼ Minimum Total Capital Ratio remains at 8%.

◼ The addition of the capital conservation buffer increases the total amount of capital a
financial institution must hold to 10.5% of risk-weighted assets,
◼ Of which 8.5% must be tier 1 capital.

◼ Tier 2 capital instruments are harmonized and tier 3 capital is abolished.

 Cont…

CET1 capital comprises

◼ Shareholders equity (including audited profits),

◼ Less
◼ deductions of accounting reserve that are not believed to be loss absorbing "today",
including goodwill and other intangible assets.
◼ To prevent the potential of double-counting of capital across the economy, bank's
holdings of other bank shares are also deducted.
 Cont…

◼ Liquidity Risk:
◼ Liquidity Coverage Ratio: The ratio of Liquid assets to net cash outflow for short term (30
days) liquidity management and
◼ Net stable funding ratio (NSFR) for long term structural liquidity mismatches.
Bangko Sentral on Twitter: "The Net Stable Funding Ratio frequently asked questions (FAQs) have been updated to further deepen understanding on the
standard. You may access the updated FAQs on: https://t.co/ifHuyALre8 #BSP #BangkoSentral #NSFR https://t.co/sz9W6KQ0Qz" / Twitter
 Cont..

Finalising Basel III - In brief (bis.org)

 Cont…

◼ Constraints on using internal models

◼ To reduce unwarranted variability in banks’ calculations of risk-weighted assets
◼ Securitisations
◼ Reducing reliance on external ratings,
◼ Simplifying and limiting the number of approaches for calculating capital charges and
◼ Increasing requirements for riskier exposures.`
◼ Counterparty credit risk
◼ Capital incentives to use central counterparties for derivatives
◼ Ex:. National Securities Clearing Corporation Limited (NSCCL), Indian Clearing Corporation Limited (ICCL)
and MCX-SX Clearing Corporation Limited (MCX-SXCCL)
◼ Higher capital for inter-financial sector exposures.
 Impact

◼ Less profitability (Due to high capital requirement)

◼ Increase in cost of capital
◼ Banks will be forced to increase their lending spreads as they pass the extra cost on to their customers.

◼ Banks will also minimize business operations that are more subject to liquidity risks.
◼ Increased use of central clearing counterparty (CCP) as high capital charge for that trade.
◼ Dealers based system becomes unattractive and hence increased market participation and higher systematic
risk

Beyond the Horizon of Banking Regulation: What to Expect from Basel IV (harvardilj.org)
 Home and Host State Regulation

◼ BASEL Concordat on Cross-Boarder Banking Supervision

◼ Provides framework for multi-jurisdiction supervision
◼ Focuses on:
◼ Potential issues with international Banks’ solvency, liquidity, and foreign exchange
◼ Requires home or parent regulators to communicate closely with the host regulators in countries
where bank has branches, sub-subsidiaries, and joint-ventures.
◼ Home supervisory authority should monitor the risk
◼ of banks or banking groups wherever their business is conducted.
 Principles

1. Home country should be capable to supervise and supervise all international banks’
activities on a consolidated basis.

2. Prior permission from home and host country for all cross-broader transaction

3. Home country authority possess right to information from their cross-boarder banking
establishment

4. Impose restrictive measure or prohibit the establishment of banking offices if above

three are not complied with.
Host authority should inform home authority of any serious problems in parent bank’s
foreign establishment.
 Principles-Based Regulation

◼ Regulatory Risk
◼ Statutory Approach
◼ Principles-Based Approach
◼ National Regulatory Responsibilities to address country specific risk
◼ Monitor the compliance along with framing regulation and principles
◼ Individual firm’s risk vs Regulator’s Statutory Objectives
◼ Avoid all firms showing similar risk appetites: Having similar view on the market
conditions
◼ Incentivize ignored or avoided activities to bring balance.
 Cont…

Risk Management and Control

◼ Consumer Protection
◼ Indirect Factors: Firms’ integrity, due diligence, financial resources, market conduct
◼ Direct Factors: Intertest of customer, faire treatment, information, protection for client’s asset

◼ Business Standards
◼ Manner of marketing, distribution, sales and management of products
◼ Separation of Client Fund from Companies Fund
◼ Ex: Karvya Case: (151) The Karvy Stock Broking Scandal | Explained - YouTube
 Cont…

◼ The senior management regime

◼ The regime applies to the most senior executive management and directors who are subject to regulatory approval.

◼ Deposit-taking firms (excluding credit unions) and insurers requires relevant firms to assess the fitness and propriety
of certain employees who could pose a risk of significant harm to the firm or any of its customers.

◼ Firms must allocate prescribed responsibilities across their senior managers, setting out their duties.

◼ Preparation of statement of responsibilities for such individuals

 Cont….

◼ Regulatory Standards
◼ Provisions for information submission and disclosure
◼ Regulators’ right to access information
◼ Frequency of regulatory review and assessment
◼ Disciplinary activities of regulators
◼ Levying fine

◼ Customer compensation

◼ Appointment of experts for assessing issues

◼ Cancelling license