International Banking Regulation:Basel Norms
Historical Perspective
The Basel Committee, originally known as the Committee on Banking Regulations
and Supervisory Practices, was established at the end of 1974 by the central bank
Governors of the Group of Ten countries in the aftermath of serious disruptions in
international currency and banking markets (notably the failure of Bankhaus
Herstatt in West Germany).
The Committee, headquartered at the Bank for International Settlements in Basel,
was formed to improve financial stability by improving the quality of banking
supervision around the world, as well as to serve as a forum for regular
cooperation among its member countries on banking supervisory matters.
The first meeting of the Committee was held in February 1975, and meetings have
been held three or four times a year since then.
The Basel Committee's membership has grown from the G10 to 45
institutions from 28 jurisdictions since its inception.
Beginning with the Basel Concordat, which was first issued in 1975 and has been
revised several times since.
The Committee has established a series of international standards for bank
regulation, most notably its landmark publications of the capital adequacy
accords known as Basel I, Basel II, and, most recently, Basel III.
Why Basel Norms are Essential?
Lending to borrowers that bear their risks exposes banks to
various risks and defaults. Banks lend money obtained
from the market and people’s deposits, as a result of which
they occasionally experience losses. As a result, banks
must set aside a specific amount of capital as protection
against the risk of non-recovery to handle such situations.
BASEL- I
BCBS introduced the capital measurement
system called Basel capital accord in 1988. It was also
known as Basel 1.
It was almost entirely concerned with credit risk.
It established the capital and risk-weighting structure for
banks.
The required minimum capital was set at 8% of risk-
weighted assets (RWA).
RWA refers to assets with varying risk profiles. For
example, an asset backed by collateral would be less risky
than a personal loan with no collateral.
Capital is divided into two categories: Tier 1 capital and Tier 2 capital.
o Tier 1 capital is the bank's core capital because it is the primary
measure of the bank's financial strength.
The majority of core capital is made up of disclosed reserves (also
known as retained earnings) and paid-up capital.
It also includes non-cumulative and non-redeemable preferred
stock.
o Tier 2 capital – It is used as supplemental funding since it is less
reliable than the first tier.
It consists of undisclosed reserves, preference shares, and
subordinate debt.
In 1999, India adopted the Basel 1 guidelines
Fundamentals of Basel
Tier 1 capital and Tier 2 capital are the two kinds of capital. Because it
is the primary indicator of the bank’s financial soundness, Tier 1
capital is its core capital. Paid-up capital and stated reserves, referred
to as retained earnings, make up most of the core capital.
Non-cumulative and non-redeemable preferred stock is also included.
Since Tier 2 capital is less dependable than Tier 1, it is used as
supplemental finance.
It comprises subordinate debt, preferred shares, and secret reserves.
India embraced the Basel 1 principles in 1999.
Tier 1 and Tier 2 Capital
Tier 1: This category includes a bank’s equity, reported reserves, and
core capital, as shown on its financial statements.
A bank’s Tier 1 capital acts as a safety net in the event of substantial
losses, enabling it to withstand pressure and continue running its
business.
Tier 2: This category describes the additional capital that a bank
maintains, such as secret reserves and unsecured subordinated debt
instruments with a minimum original duration of five years.
Since it is more difficult to calculate precisely and more difficult to
liquidate, Tier 2 capital is regarded as being less dependable than Tier
1 capital.
BASEL-II
BCBS published Basel II guidelines in June 2004, which were considered to
be refined and reformed versions of the Basel I accord.
The guidelines were founded on three pillars, as the committee refers to
them:
o Capital Adequacy Requirements: Banks should keep a minimum capital
adequacy requirement of 8% of risk assets.
o Supervisory Review: According to this, banks were required to develop
and implement better risk management techniques for monitoring and
managing all three types of risks that a bank faces: credit, market, and
operational risks.
o Market Discipline: This necessitates stricter disclosure requirements.
Banks must report their CAR, risk exposure, and other information to
the central bank on a regular basis.
Fundamentals of Basel-II
The committee refers to the guidelines’ three pillars as follows,
Requirements for Capital Adequacy: A minimum capital adequacy
requirement of 8% of risk assets should be maintained by banks.
Review by a supervisor: As a result, banks were compelled to
create and put into practice improved risk management strategies for
keeping an eye on and managing the three different categories of
risks that a bank faces: operational, market, and credit risks.
Market Restrictions: This calls for stricter disclosure regulations.
Banks are required to regularly submit reports to the central bank
about their CAR, risk exposure, and other data.
Although India complies with these standards, Basel II has not yet
been fully applied outside.
Basel III
The Basel III guidelines were published in 2010.
These guidelines were put in place in response to the 2008 financial
crisis.
There was a need to further strengthen the system because banks in
developed economies were undercapitalized, over-leveraged, and
relied more on short-term funding.
Furthermore, the quantity and quality of capital required under Basel
II were deemed insufficient to contain any additional risk.
The Basel III norms aim to make most banking activities, such as
trading books, more capital-intensive.
The guidelines are intended to promote a more resilient banking
system by focusing on four critical banking parameters: capital,
leverage, funding, and liquidity.
CAPITAL
The capital adequacy ratio should be kept at 12.9 percent.
The minimum Tier 1 and Tier 2 capital ratios must be
maintained at 10.5 percent and 2 percent of risk-weighted
assets, respectively.
Furthermore, banks must maintain a capital conservation
buffer of 2.5 percent.
The counter-cyclical buffer should also be kept at 0-2.5 percent.
Leverage
The leverage rate must be at least 3%.
The leverage rate is the ratio of a bank's tier-1 capital to
average oftotal consolidated assets.
Funding and Liquidity
Basel-III established two liquidity ratios: LCR and NSFR.
Liquidity coverage ratio (LCR) will require banks to maintain a buffer of high-
quality liquid assets sufficient to deal with cash outflows encountered in an acute
short-term stress scenario as specified by regulators.
o This is done to avoid situations like the "Bank Run." The goal is to ensure that
banks have enough liquidity to weather a 30-day stress scenario if it occurs.
Net Stable Funds Rate (NSFR) mandates that banks maintain a consistent
funding profile in relation to their off-balance-sheet assets and activities.
o The NSFR requires banks to fund their operations with stable sources of
funding (reliable over the one-year horizon).
o The NSFR must be at least 100 percent.
As a result, LCR assesses short-term (30-day) resilience while NSFR assesses
medium-term (1-year) resilience.
Basel III Affects Banks: Due to the cost of strengthening capital
ratios, which would decrease lending, banks may increase lending
rates. This will have a negative impact on the economy because
investment, exports, and consumption will all decline.
