BASEL II

FI 9
 BASEL II
• A framework of banking laws and regulations
issued by the Basel Committee on Bank
Supervision.
• The purpose of Basel II is to create an inter-
national standard that banking regulators can
use when creating regulations about how
much capital banks need to put aside to
guard against the types of financial and
operational risks banks face.
 BASEL II
• Generally these rules mean that greater the risk to
which a bank is exposed, the greater the amount
of capital the bank needs to hold to safeguard
its solvency and overall economic stability.
• In practice, Basel II attempts to accomplish this by
setting up rigorous risk and capital management
requirements designed to ensure that a bank
holds capital reserves appropriate to the risk the
bank exposes itself to through its lending and
investment practices. 
 BASEL II - Objectives
• Ensuring that capital allocation is more risk
sensitive
• Operational risk recognized as a new
element of risk to be included in computing
the required level of regulatory capital
• Supervisory review & Market Discipline
brought in as separate Pillars, to bring out
their importance in risk management
 Basel II- Three Pillars
• Basel II uses a "three pillars" concept –
(1) minimum capital requirements
(2) supervisory review and
(3) market discipline – to promote greater
stability in the financial system

• The Basel I accord dealt with only parts of

each of these pillars
 First Pillar- Regulatory Capital
• Regulatory capital calculated for 3 major
risks that a bank faces:
1. Credit Risk
2. Operational Risk
3. Market Risk
 Credit Risk
• Credit risk is the most important risk that a
bank faces. It is the risk associated with
default or delay in repayment of credit
facility granted by a bank.
• Credit Risk is mitigated through various
measures that the bank takes such as
collateral, guarantee, constant supervision
and monitoring & follow up.
 Other Risks

• Liquidity risk
• Reputation risk
• Legal risk
• Strategic risk

• Other risks not considered quantifiable

at this stage
 Regulatory Capital
• Capital Adequacy Ratio in New BASELII
Accord :

Capital Adequacy Ratio =

Total Capital(Tier I Capital+Tier II Capital)/
Market Risk+ Credit Risk + Operation Risk
 Total Capital
• Total Capital: Tier I Capital and Tier II Capital
less shareholding in other banks.
Tier I Capital = Ordinary Capital + Retained
Earnings & Share Premium - Intangible assets.
Tier II Capital = Undisclosed Reserves +
General Bad Debt Provision+ Revaluation
Reserve + Subordinate debt+ Redeemable
Preference shares
 Credit Risk

If the counter party fails to settle the dues within

the stipulated time or thereafter, this type of risk
arises. It includes risks on derivatives. For
measuring the risk the following approach are
used:

a) Standardized Approach
b) Internal Rating Based Foundation Approach
c) Internal Rating Based Advanced Approach
 Market Risk
This is the risk or loss arising on or off
Balance Sheet due to the movement of
prices in foreign currencies, commodities,
equities and bonds. With regard to market
risk. There are two method for computation.

a) Standardised Approach
b) Internal Model Approach
 Operation Risk

This type of risk or loss results from inadequate

or failure in the corporate governance or internal
processes, people or system. RBI adopts the
following measurement techniques for
calculation 

a) Basic Indicator Approach

b) Standardised Approach
c) Advanced Measurement Approach
Minimum Requirement of CAR
Under Basel II norms, 8% is the
prescribed Capital Adequacy Norm
*Scheduled Commercial Banks CAR= 9%
* New Private Sector Banks CAR =
10%
* Banks undertaking Insurance Business
CAR = 10%
*For Local Area Banks CAR =15% 
 CAR - Current Status
• At the end of March 2008, there were 2
Scheduled Commercial Banks(1 Private Sector
Bank & 1 Foreign bank) having 0-9% of Capital
Adequacy Ratio,55 Scheduled Commercial
Banks( 28 Public Sector Banks,17 Private
Sector Banks & 10 Foreign Banks ) were having
CAR between 10%-15% and 22 Scheduled
Commercial Banks (19 Foreign Banks & 3
Private Sector Banks) having CAR of 15% and
above according to RBI Publications
 Pillar II – Supervisory Review
• Banks and investment firms not only have to comply with
minimum solvency requirements and disclosure duties,
they also must have a process by which they can assess
their capital adequacy themselves. This process, and its
assessment by the supervisory authority, is central to the
second pillar of the Basel II Accord.
• Objective and basic principles
• The objective of the second pillar is to ensure that banks
and investment firms make arrangements to ensure that
they hold enough capital to cover all their risks. The
basic principles for the application of the second pillar
are proportionality and the institutions' own responsibility.
 Supervisory Review
• In brief, Pillar 2 contains the following elements:
• The process by which institutions assess the adequacy
of their capital. This process is sometimes referred to as
the Internal Capital Adequacy Assessment Process
(ICAAP). The ICAAP is based on a solid risk
management and control framework.
• The assessment of this process by the supervisor. This
assessment is generally referred to as the Supervisory
Review and Evaluation Process (SREP). The SREP also
includes checking compliance with minimum solvency
requirements and requirements on internal control.
• Dialogue between the institution and the supervisor on
capital adequacy
 Basel II- Market Discipline
• The Basel Committee on Banking Supervision (Basel) has
sought to harness market discipline through the disclosure
requirements introduced by Pillar 3 are substantial and for
most institutions will represent a significant increase in the
amount of information they make publicly available. This will
be particularly true for banks seeking to avail of the use of the
more advanced approaches to credit, market and operational
risk under Pillar 1, where extensive disclosure is an integral
part of the qualifying criteria for these approaches.
• While setting out high-level requirements, Pillar 3 provides
banks with significant latitude in terms of how these
requirements are met. Banks therefore need to be thinking
both strategically and operationally in terms of how they are
going to meet the challenges of Pillar 3 – what is involved,
what choices do they have and what challenges are they likey
to face?
 Market Discipline
• The concept of market discipline can be summed up in the phrase ‘accountability
through transparency’.
• Accountability is the expectation that a bank’s management acts in the best
interests of outside stakeholders, principally the current and prospective holders
of its equity and debt (collectively represented by equity analysts and rating
agencies, among others).
• Transparency is the expectation that a bank discloses sufficient information so as
to allow these stakeholders to make informed judgments as to whether the bank
is acting in their best interests. If the bank is not acting in their best interests – for
example by taking excessive risk relative to an expected return – these
stakeholders can respond accordingly. When they do, and the cost of the bank’s
capital or debt increases, pressure will be brought to bear on the bank’s
management to adjust their risk-taking behavior. In this way, the market provides
a discipline on banks’ risk-taking activities which acts as a form of self-regulation.
• For the market discipline mechanism to operate effectively, it is imperative that
stakeholders receive frequent, relevant and meaningful information regarding the
risk profile and management of banks, and for the disclosure of such information
to be both mandatory and reasonably consistent across banks and jurisdictions.