Study Notes

BASEL NORMS
and
Its Implementation in India
Basel Norms

Introduction

 Basel Accord is a set of global voluntary regulatory framework for banking

supervision to ensure financial stability.
 These are framed by the Basel Committee on Banking Supervision (BCBS)
headquartered at Bank for International Settlement (BIS), Basel, Switzerland.
 BCBS was established in 1974 by the governors of central banks of G-10 following the
banking and currency crisis from failure of Bankhaus Herstatt in West Germany.
 BCBS provides a forum for regular cooperation on banking supervisory matters with a
goal to ensure financial stability and common standards of banking regulation.
 Currently BCBS has 28 country members with 12 countries as permanent members.
The member countries are Argentina, Australia, Belgium, Brazil, Canada, China, France,
Germany, Hong Kong, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico,
Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden,
Switzerland, Turkey, United Kingdom, United States and European Union.

Basel Accords – a comparative

Till date, the BCBS has released three Basel Accords known as Basel 1, Basel 2 and Basel 3.
Currently the BASEL III is under implementation by various members including India:

Basel 1 Basel 2 Basel 3

Also Known Basel I, Basel II, Basel III

as Basel Capital Accord New Basel Capital Accord

Introduced July 1988 June 2004 December 2010

in

Focus Area Credit Risk Capital, market risk and Capital, leverage, funding and liquidity
operational risk risks

Key Features • Introduced capital • Introduced the 3 pillars • Improving CAR and bank’s ability to
measurement (minimum capital absorb shocks due to economic
system requirement, stress
• Gave structure of supervisory review, • Improving risk management and
risk weighted market discipline) governance
assets (RWA) • Min. CAR of 8% with • Strengthening transparency and
• Fixed min. capital core capital of at least disclosures
requirement at 8% of 4% • Introduced CCB of 2.5%
RWA • Mandatory disclosure of • Introduced Countercyclical Buffer of
risk exposures 0-2.5%
• Introduced Leverage Ratio of >3%
• Introduced LCR of > 100%
• Introduced Net Stable Funding Ratio
(NSFR) of > 100%

Compliance Adopted Basel 1 Min. CAR of 9% Being adopted in phased manner from
by India guidelines in 1999 April 2013 – Oct 01, 2021)

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Basel Norms

Box 1: Meaning of Capital

The Basel Accord focuses on the capital adequacy framework which specifies that a
bank should have sufficient capital to provide a stable resource to absorb any losses
arising from the risks in its business.

For the regulatory purpose, a bank/financial institution should have the following
regulatory capital:
1. Tier 1 Capital
a. Common Equity Tier 1 (CET 1)
b. Additional Tier 1 (AT1)
2. Tier 2 Capital

The capital is stated in relation to the risk weighted assets (RWA) of the bank.
As such, Regulatory capital of bank is given as:
Capital Adequacy Ratio (CAR) or Capital to Risk-weighted Assets Ratio (CRAR)
= (Tier 1 + Tier 2 Capital)/RWA

Tier 1 capital
 It is the capital that has the loss absorbing ability without triggering a bankruptcy
of the bank/financial institution. As such it is also referred to as the “going-
concern” capital.
 It is a bank’s highest quality capital because it is fully available to cover losses
 Tier I capital consists mainly of share capital and disclosed reserves
 Tier 1 capital has two components:

CET AT1 Bonds

It is the core equity capital
consisting of pure equity
capital and reserves
These are perpetual (i.e. no maturity)
instruments with a contingent conversion
feature (i.e. they can be converted into equity
and absorb losses/cancel payment of
coupon) in case of crisis/point of insolvency

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Basel Norms

Box 1: Meaning of Capital contd..

Tier 2 capital
 It is the capital which will absorb losses only in a situation of liquidation of the
bank and is therefore, also referred to as the “gone-concern” capital.
 The loss absorption capacity of Tier II capital is lower than that of Tier I
capital. It is therefore, also called subordinate capital or supplementary
capital.
 Tier II capital includes:
o Undisclosed reserves
o Revaluation Reserves – at a discount value of 55%
o General Provisions and loss reserves (ceiling of 1.25% of total RWA)
o Hybrid debt capital instruments such as bonds, Long term unsecured
loans, Debt Capital Instruments etc.
o Subordinated debt

Risk Weighted Assets (RWA)

The amount of assets of a bank calculated based on the weighted approach to the
measurement of risk, both on and off banks' balance sheets. The risks taken into
account are the credit risk, market risk and operational risk associated with a
particular asset.

For example, say a bank has the following assets and the risk weights are also
known as given in the table; in the following case the RWA of the bank will be:

Asset Actual Amount Risk weight factor RWA Value

(a) (b) (a*b)
Cash 10 0% 0
Advances 100 120% 120
Investments 25 100% 25
Other assets 15 100% 15
Total 150 160

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Basel Norms

Three Pillars of BASEL Accords

 The three pillars of Basel Accord were introduced under the Basel II.
 The three pillars have been further strengthened to increase the scope of risk
management and enhance the minimum capital requirements along with minimum
liquidity requirements, under Basel III (the details discussed under Basel III later).

Pillar 1 Pillar 2 Pillar 3

Min. Capital Requirement Supervisory Review Process Market Discipline

Deals with maintenance of Intended to ensure that the  complements the first
regulatory capital calculated for banks have adequate capital and second pillar by
three major risks, a bank faces: to support all the risks ensuring transparency
 Credit risk associated in their businesses
o Standardized Approach  Regulatory framework for  effective use of
o Foundation IRB Banks disclosure as a lever to
Approach o Internal Capital strengthen market
o Advanced IRB Adequacy Assessment discipline and
Approach Process (ICAAP) encourage sound
 Market risk o Risk Management banking practice
o Standardized Approach  RBI Supervision
o Internal VaR Model o Supervisory Review
 Operational risk and Evaluation
o Basic Indicator Process (SREP)
Approach o Evaluating bank’s
o Alternative internal systems
Standardized Approach o Assessing risk profile
o Advanced o Reviewing compliance
Measurement with regulations
Approach o Supervisory measures

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Basel Norms

Box 2: Approaches to Risk Measurement

Credit Risk Measurement

 BASEL-III provides two options for measurement of capital charge for credit risk -
standardized approach (SA) and Internal rating based approach (IRB).
 Under the SA, the banks use a risk-weighting schedule for measuring the credit risk of its
assets by assigning risk weights based on the rating assigned by the external credit rating
agencies.
 The IRB approach, on the other hand, allows banks to use their own internal ratings of
counterparties and exposures, which permit a finer differentiation of risk for various
exposures and hence delivers capital requirements that are better aligned to the degree of
risks. The IRB approaches are of two types: Foundation IRB and Advanced IRB.

Market Risk Measurement

 For market risk the preferred approach is VaR (value at risk) which indicates the measure
of risk of investments.
 VaR estimates how much a set of investments might lose, given normal market conditions,
in a set time period such as a day, given a certain level of confidence.
 VaR is typically used to gauge the amount of assets needed to cover possible losses.

Operational Risk Measurement

 Basel Committee gives three options for calculating operational risk capital charges.
These are, in the order of their increasing complexity, (i) the Basic Indicator Approach (ii)
the Standardised Approach and (iii) Advanced Measurement Approaches.
 Under the Basic Indicator Approach, banks have to hold capital for operational risk equal
to average of 3 years of a fixed percentage (alpha of 15%) of positive gross income (i.e.
NII + other income)
 In the Standardised Approach, banks’ activities are divided into eight business lines:
corporate finance, trading & sales, retail banking, commercial banking, payment &
settlement, agency services, asset management, and retail brokerage. The capital charge
is the sum of the capital charge for each business line which is calculated by multiplying
gross income of that business line by a factor (denoted beta) assigned to that business
line.
 Under the Advanced Measurement Approach (AMA), the regulatory capital requirement
will equal the risk measure generated by the bank’s internal operational risk measurement
system using the quantitative and qualitative criteria for the AMA, detailed by RBI. Use of
the AMA is subject to supervisory approval.

In India, banks have been advised to compute capital requirements for credit risk
adopting the Standard Approach and Basic Indicator Approach for operational risk;
however for operational risk they may move to higher level approach as they develop
more sophisticated operational risk measurement systems and practices.

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 Basel Norms

BASEL III

 Basel III was introduced in the aftermath of sub-prime crisis following which Lehman
Brothers collapsed in September 2008.
 The financial crisis highlighted the risks in the banking system due to too much leverage
and inadequate liquidity buffers.
 The excess growth witnessed before 2008 was characterized by inadequate credit
pricing, high liquidity risk, poor governance and risk management and inappropriate
incentive structures.
 In the light of the weaknesses revealed by this financial market crisis, BCBS issued the
Basel III accords to further strengthen the capital framework of banks and address
another risk – the liquidity risk, in commercial banks.

The key highlights of the BASEL III accord are:

Stricter requirements for the quality and

Minimum liquidity ratio,
LCR, intended to quantity of regulatory capital, in particular
provide enough cash to
1. Core Equity reinforcing the central role of common equity
cover funding needs
over a 30-day period of
An additional layer
stress; and a longer-
of common equity -
term ratio, the NSFR, 5. Liquidity 2. Capital that, when
intended to address Ratios (LCR & Conservation breached, restricts
maturity mismatches NSFR)* Buffer (CCB) payouts to help
over the entire balance BASEL meet the minimum
sheet
III common equity
requirement

A minimum amount of loss- 3. A buffer that places

absorbing capital relative to 4. Leverage Countercyclical restrictions on participation
all of a bank's assets and Ratio Capital Buffer by banks in system-wide
off-balance sheet exposures (CCyB) credit booms with the aim
regardless of risk weighting
of reducing their losses in
credit busts

*LCR = Liquidity Coverage ratio; NSFR = Net Stable Funding Ratio

Figure 1: Changes in the BASEL III Framework

BASEL III additionally introduced requirements like additional loss absorbency and
strengthened arrangements for cross-border supervision and resolution for systemically
important banks.

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Basel Norms

Capital Buffers

1. Capital Conservation Buffer (CCB)

 CCB is a mandatory buffer introduced under Basel III norms which has to be
maintained over and above the minimum CRAR requirement.
 It is mandated at 2.5% of the risk weighted assets of the bank, comprised of
Common Equity Tier I.
 The CCB is designed to ensure that banks build up capital buffers outside
periods of stress which can be drawn down as losses are incurred.
 The requirement is based on simple capital conservation rules designed to avoid
breaches of minimum capital requirements.
 When buffers have been drawn down, one way banks should look to rebuild
them is through reducing discretionary distributions of earnings. This could
include reducing dividend payments, share-backs and staff bonus payments.

2. Countercyclical Capital Buffer (CCyB/CCCB)

 The countercyclical capital buffer is intended to protect the banking sector

against losses that could be caused by cyclical systemic risks.
 BASEL III defined the range of this buffer as 0-2.5% of risk weighted assets as
deemed fit by the central bank.
 The exact requirement is to be set by the Central bank of the country depending
on the circumstances of the economy and its banking system and its exposure to
the global economy.
 It is discretionary buffer such that it will be deployed by central banks when
excess aggregate credit growth is judged to be associated with a build-up of
system-wide risk to ensure the banking system has a buffer of capital to protect it
against future potential losses.
 This focus on excess aggregate credit growth means that jurisdictions are likely
to only need to deploy the buffer on an infrequent basis.
 The aim of the CCCB regime is twofold:
i. Firstly, it requires banks to build up a buffer of capital in good times which
may be used to maintain flow of credit to the real sector in difficult times.
ii. Secondly, it achieves the broader macro-prudential goal of restricting the
banking sector from indiscriminate lending in the periods of excess credit
growth that have often been associated with the building up of system-
wide risk.

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Basel Norms

Capital Adequacy Framework – Basel & RBI

The RBI has mandated banks to maintain minimum CAR of 9% and CCB of 2.5% making the
overall minimum capital requirement as 11.5% including CCB.

Figure 2: CAR under BASEL accords and RBI

Box 3: RBI & CCyB

In India, the CCyB is currently 0% (as of Feb 2022).

The RBI came out with the guidelines for CCyB in 2015 as follows:

 The credit-to-GDP gap shall be the main indicator in the CCyB framework in India.
However, it shall not be the only reference point and shall be used in conjunction with
Gross Non-Performing Advances (GNPA) growth.
 Credit-to-GDP gap is difference between credit-to-GDP ratio and the long term trend
value of credit-to-GDP ratio at any point in time
 The CCyB may be maintained in the form of Common Equity Tier 1 (CET 1) capital
or other fully loss absorbing capital only
 The amount of the CCyB may vary from 0 to 2.5% of total RWA of the banks.
 The CCyB decision would normally be pre-announced with a lead time of 4
quarters. However, depending on the CCCB indicators, the banks may be advised to
build up requisite buffer in a shorter span of time.

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Basel Norms

Liquidity Ratios

1. Liquidity Coverage Ratio (LCR)

 LCR is aimed to ensure short term liquidity of a bank
 The LCR is mandated to ensure can banks respond promptly to potential liquidity
disruptions over the short term.
 Here, banks must have high quality liquid assets (HQLA) to survive an acute
stress scenario lasting for 30 days.
 HQLA are unencumbered highly liquid assets that can be converted into cash to
meet liquidity needs.

LCR = HQLA/Total net cash outflow over next 30 calendar days

 LCR should be 100% or more i.e. at a minimum, the stock of liquid assets
should enable the bank to survive until day 30 of the stress scenario, by which
time it is assumed that appropriate corrective actions can be taken.
 In India, the LCR was implemented from January 01, 2015 to be implemented in
a phased manner to reach a minimum value of 100% by January 01, 2019.
Jan 1, 2015 Jan 1, 2016 Jan 1, 2017 Jan 1, 2018 Jan 1, 2019
Min. LCR 60% 70% 80% 90% 100%

2. Net Stable Funding Ratio (NSFR)

 The NSFR measures the long-term liquidity of a bank
 It is defined as the amount of available stable funding relative to the amount of
required stable funding.
 Available stable funding (ASF) is defined as the portion of capital and liabilities
expected to be reliable over the time horizon considered by the NSFR, which
extends to one year.
 The amount of stable funding required (Required stable funding, RSF) by a
specific institution is a function of the liquidity characteristics and residual
maturities of the various assets held by that institution as well as those of its off-
balance sheet exposures.
NSFR = Available stable funding/Required stable funding

 The above ratio should be equal to at least 100% on an ongoing basis.

 However, the NSFR would be supplemented by supervisory assessment of the
stable funding and liquidity risk profile of a bank. On the basis of such
assessment, the RBI may require an individual bank to adopt more stringent
standards to reflect its funding risk profile and its compliance with the 'sound
principles'.
 In India, the NSFR would be binding on banks with effect from October 01,
2021 (implementation of NSFR was deferred by RBI to from Oct 2020 to April 01,
2020 due to COVID-19 and has further been deferred to Oct 01, 2021 now)

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Basel Norms

Implementation of BASEL III under RBI

 As per BCBS, implementation of Basel III was to be done in a phased manner (from
January 01, 2013 to January 01, 2019) in order to ensure smooth migration to Basel III
without aggravating any near term stress.
 In India, the transitional arrangements for capital ratios began as on April 1, 2013.
However, the phasing out of non-Basel III compliant regulatory capital instruments
began from January 1, 2013.
 Capital ratios and deductions from Common Equity were to be fully phased-in and
implemented by March 31, 2019. However in November 2018, RBI's board decided to
ease capital pressure on banks by allowing them one more year to meet the CCB
requirement. The transition period to implement the last tranche of 0.625 per cent under
CCB has been extended by one year — up to March 31, 2020.
 The compliance with the last tranche of 0.625% of the CCB has again been revised by
RBI on March 27, 2020 in response to the potential stress on account of COVID-19 on
banks to March 31, 2021. In February 2021, the RBI has further deferred the compliance
of the last tranche by another six months to September 30, 2021.
 The phase-in arrangements for banks operating in India are as follows (in %):
Min.
Apr 01, Mar 31, Mar 31, Mar 31, Mar 31, Mar 31, Mar 31, Mar 31, Sep 30,
Capital
2013 2014 2015 2016 2017 2018 2019 2020 2021*
Ratio
CET 1 4.50 5.00 5.50 5.50 5.50 5.50 5.50 5.50 5.50
CCB - - - 0.625 1.25 1.875 1.875 1.875 2.50
CET 1 +
4.50 5.00 5.50 6.125 6.75 7.375 7.375 7.375 8.00
CCB
Tier I 6.00 6.50 7.00 7.00 7.00 7.00 7.00 7.00 7.00
Total CAR 9.00 9.00 9.00 9.00 9.00 9.00 9.00 9.00 9.00
Total CAR
9.00 9.00 9.00 9.625 10.25 10.875 10.875 10.875 11.50
+ CCB
*the pre-specified trigger for loss absorption through conversion/write-down of Additional Tier 1
instruments (PNCPS and PDI) shall remain at 5.5% of risk-weighted assets and will rise to
6.125% of RWAs on September 30, 2021.

Extension of BASEL III norms to AIFI

 RBI has proposed to extend the CAR requirements of 11.5% (including 2.5% CCB) to
the four All India Financial Institutions (AIFI) viz. NABARD, NHB, Exim Bank and SIDBI.
 As per RBI, these institutions should have a minimum total capital at 9% from April 1,
2022 as well as a minimum capital buffer at 2.5%.
 These entities are required to adopt standardized approaches for measurement of
capital charge for market risk and credit risk.
 RBI also proposes that, the insurance and non-financial subsidiaries, joint ventures or
associates of AIFI, with 10% of common share capital, should not be consolidated for
capital adequacy.

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