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BASEL NORMS, DIFFERENCE BETWEEN BASEL II AND BASEL III NORMS BASEL NORMS

GROUP 4

Basel, a city in Switzerland is the headquarters of Bureau of International Settlement (BIS), which fosters co-operation among central banks with a common goal of financial stability and common standards of banking regulations. Every two months BIS hosts a meeting of the governor and senior officials of central banks of member countries. Currently there are 27 member nations in the committee. Basel guidelines refer to broad supervisory standards formulated by this group of central banks - called the Basel Committee on Banking Supervision (BCBS). The set of agreement by the BCBS, which mainly focuses on risks to banks and the financial system are called Basel accord. The purpose of the accord is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses. India has accepted Basel accords for the banking system. In fact, on a few parameters the RBI has prescribed stringent norms as compared to the norms prescribed by BCBS. Basel I Norms In 1988, BCBS introduced capital measurement system called Basel capital accord, also called as Basel 1. It focused almost entirely on credit risk. It defined capital and structure of risk weights for banks. The minimum capital requirement was fixed at 8% of risk weighted assets (RWA). RWA means assets with different risk profiles. For example, an asset backed by collateral would carry lesser risks as compared to personal loans, which have no collateral. India adopted Basel 1 guidelines in 1999. Basel II Norms In June 2004, Basel II guidelines were published by BCBS, which were considered to be the refined and reformed versions of Basel I accord. The guidelines were based on three parameters, which the committee calls it as pillars. - Capital Adequacy Requirements: Banks should maintain a minimum capital adequacy requirement of 8% of risk assets(assets weighted by risk) - Supervisory Review: According to this, banks were needed to develop and use better risk management techniques in monitoring and managing all the three types of risks that a bank faces, viz. credit, market and operational risks - Market Discipline: This need increased disclosure requirements. Banks need to mandatorily disclose their CAR, risk exposure, etc to the central bank. Basel II norms in India and overseas are yet to be fully implemented. Basel III Norms In 2010, Basel III guidelines were released. These guidelines were introduced in response to the financial crisis of 2008. A need was felt to further strengthen the system as banks in the developed economies were under-capitalized, over-leveraged and had a greater reliance on short-term funding. Also the quantity and quality of capital under Basel II were deemed insufficient to contain any further risk. Basel III norms aim at making most banking activities such as their trading book activities more capitalintensive. The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz. capital, leverage, funding and liquidity. Source: - http://www.moneycontrol.com/

BASEL NORMS, DIFFERENCE BETWEEN BASEL II AND BASEL III NORMS

GROUP 4

Capital Adequacy Ratio CAR

Tier 1 Capital: - Tier I capital is equal to sum of equity capital and disclosed reserves. Tier 2 Capital: - Tier 2 capital is secondary bank capital that includes items such as undisclosed reserves, loss reserves, term debts etc. Significance of Tier 1 and Tier 2 Capital:Tier one capital absorbs losses without a bank being required to cease trading and tier two capital absorbs losses if the bank winds-up its business. I.e., Capital adequacy ratio acts as a cushion in the event of loss, defaults and protects the depositors. Difference between BASEL 2 and BASEL 3 NORMS Requirements Minimum Ratio of Total Capital To RWAs Minimum Ratio of Common Equity to RWAs Tier I capital to RWAs Core Tier I capital to RWAs Capital Conservation Buffers to RWAs Leverage Ratio Countercyclical Buffer Under Basel II 8% 2% 4% 2% None None None Under Basel III 10.50% 4.50% to 7.00% 6.00% 5.00% 2.50% 3.00% 0% to 2.50%

Changes proposed in BASEL III over BASEL II norms: (a) Better Capital Quality: One of the key elements of Basel 3 is the introduction of much stricter definition of capital. Better quality capital means the higher loss-absorbing capacity. This in turn will mean that banks will be stronger, allowing them to better withstand periods of stress. (b) Capital Conservation Buffer: Another key feature of Basel iii is that now banks will be required to hold a capital conservation buffer of 2.5%. The aim of asking to build conservation buffer is to ensure that banks maintain a cushion of capital that can be used to absorb losses during periods of financial and economic stress. (c) Countercyclical Buffer: This is also one of the key elements of Basel III. The countercyclical buffer has been introduced with the objective to increase capital requirements in good times and decrease the same in bad times. The buffer will slow banking activity when it overheats and will encourage lending when times are tough i.e. in bad times. The buffer will range from 0% to 2.5%, consisting of common equity or other fully loss-absorbing capital.

BASEL NORMS, DIFFERENCE BETWEEN BASEL II AND BASEL III NORMS

GROUP 4

(d) Minimum Common Equity and Tier 1 Capital Requirements: The minimum requirement for common equity, the highest form of loss-absorbing capital, has been raised under Basel III from 2% to 4.5% of total risk-weighted assets. The overall Tier 1 capital requirement, consisting of not only common equity but also other qualifying financial instruments, will also increase from the current minimum of 4% to 6%. Although the minimum total capital requirement will remain at the current 8% level, yet the required total capital will increase to 10.5% when combined with the conservation buffer. (e) Leverage Ratio: A review of the financial crisis of 2008 has indicted that the value of many assets fell quicker than assumed from historical experience. Thus, now Basel III rules include a leverage ratio to serve as a safety net. A leverage ratio is the relative amount of capital to total assets (not riskweighted). This aims to put a cap on swelling of leverage in the banking sector on a global basis. 3% leverage ratio of Tier 1 will be tested before a mandatory leverage ratio is introduced in January 2018. (f) Liquidity Ratios: Under Basel III, a framework for liquidity risk management will be created. A new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are to be introduced in 2015 and 2018, respectively. Source: - http://www.allbankingsolutions.com/Banking-Tutor/Basel-iii-Accord-Basel-3-Norms.shtml

http://moneyterms.co.uk/risk-weighted-assets/ http://moneyterms.co.uk/capital-adequacy/

Capitalisation is the addition to the balance sheet as an asset of an amount that could otherwise have been treated as an expense. For example, if a part of R & D expenditure is capitalised it will be added to the balance sheet as an intangible asset, and then amortised. If it is not capitalised, then it will simply be shown as a cost on the P & L.
http://moneyterms.co.uk/tier-1/ http://moneyterms.co.uk/tier-2/