GFMP Sem 3 Session 10 - Basel Norms

Global Financial Market Program
Semester 3
Banking Operations and Products III
Session 10
Basel Norms
Recapitulate
the
Last session
Key learning points
Concepts
Definitions
PS:to review by a brief summary, as at the end of a speech or dis

cussion; summarize.
GFMP Semester 3 Banking Operations and Products III
2015 BSE Institute Limited
Session Objectives:
At the end of this session, you will be able to
Understand role of Bank of International Settlement

Identify the different Basel Accords I, II & III
Summarise the guidelines for Implementation of Basel III
Explain the Impact of Basel III on the economy
Why Capital Requirement?

While banks assets (loans & investments) are risky and
prone to losses, its liability (deposits) are certain.
Assets = External Liabilities + Capital.
Liabilities (deposits) to be honored. Hence reduction in
capital. When capital is wiped out Bank fails.
Bank failures - mainly by losses in assets:

Default by borrowers (Credit Risk),
Losses of investment in different securities (Market
Risk) and
Frauds, system and process failures (Operational
Risk)
Bank
for
International Settlements
(BSI)
Functions and Objectives of (BIS):

Functions:
Regulates capital adequacy
Encourages reserve transparency
Banking supervision (provide Basel Committee on Banking
Supervision)
Provides banking services, but only to central banks
Acting as a prime counterparty for central banks in their
financial transactions
Objectives:
To promote information sharing
To increase transparency in banking and financial system
To minimize the risk in banking and financial system
To enhance financial stability
Introduction of BIS
Established on 17 May 1930
Based in Basel, Switzerland, with representative offices in Hong
Kong and Mexico City.
BIS is an international organization of central banks
Mission is to fosters international monetary and financial
cooperation and serves as a bank for central banks".
Oldest international financial organization
60 Central banks are the member BIS
Why Basel committee was

formed?
Basel Committee on Banking Supervision has its origins in the

financial market turmoil that followed the breakdown of
the Bretton Woods system of managed exchange rates in
1973. After the collapse of Bretton Woods, many banks
incurred large foreign currency losses.
Default of Herstatt Bank (German) - foreign exchange
exposures was three times then its capital- (1974)
Default of Franklin National Bank (New York) 1974
Hence, the central bank governors of the G10 countries
established in 1974 Basel Committee on Banking Supervision
The Committee's members:
Argentina, Australia, Belgium, Brazil, Canada, China, France,
Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea,
Luxembourg, Mexico, Netherlands, Russia, Saudi Arabia, Singapore,
South Africa, Spain, Sweden, Switzerland, Turkey, United Kingdom
and United States
History of Basel Committees:

Basel I: the Basel Capital Accord, introduced in 1988 and
focuses on
Capital adequacy of financial institutions.
Basel II: the New Capital Framework, issued in 2004,
focuses on following three main pillars
Minimum capital Standard [Minimum CAR or CRAR]
Supervisory review [Review by central Bank RBI, on time
to time]
Market discipline: [Review by market, stake holders,
customer, share holder, government etc]
History of Basel committees:

Basel III: Basel III released in December, 2010,
(implementation till March 31, 2018)
"Basel III" is a comprehensive set of reform measures in,
Regulation,
Supervision &
Risk management of the banking sector.
10
Basel I
Set up an international 'minimum' amount of capital that banks
should hold.
Minimum amount of capitalminimum risk-based capital
adequacy
The set of agreement- mainly focuses on
risks to banks
the financial system
To ensure that financial institutions
have enough capital on account to meet obligations
absorb unexpected losses.
Focused on credit risk.
Supervision should be adequate.
11
The Accord
Divided into 4 pillars:
1. The Constituents of Capital
2. Risk Weighting
3. A Target Standard Ratio
4. Transitional and Implementing Agreements
Pitfalls of Base I
Limited differentiation of credit risk
Static measure of default risk
No recognition of term-structure of credit risk
Simplified calculation of potential future counterparty risk
Lack of recognition of portfolio diversification effects
Falsification of balance sheets
12
Basel II - Structure
13
Pillar 1:Minimum Capital

Requirements
Pillar 1 aligns the minimum capital requirements more
closely to actual risks of bank's economic loss.
Revised risks:
Credit risk
Operational risk
Market risk
a) Interest Rate Risk
b) Foreign Exchange Risk
c) Commodity Price Risk etc.
14
Pillar 1:Minimum Capital

Requirements(cont.)
Credit risk
The standardised approach
Foundation internal ratings based (IRB) approach
Advanced IRB approach
Operational risk
Basic indicator approach
Standardized approach
Advanced measurement approach
Market risk
standardized approach
internal models approach
15
Minimum Capital Requirement

Pillar One
Standardized
Internal Ratings
Credit Risk
Credit Risk Models
Credit Mitigation
Risks
Trading Book
Market Risk
Banking Book
Operational
Other Risks
Other
16
Pillar 2:Supervisory Review

Process
Pillar 2 requires banks to think about the whole spectrum of
risks they might face including those not captured at all in Pillar
1 such as interest rate risk.
Coverage in Pillar 2:
Risks that are not fully covered by Pillar 1
Credit concentration risk
Counterparty credit risk
Risks that are not covered by Pillar 1
Interest rate risk in the banking book
Liquidity risk
Business risk
Stress testing
17
Pillar 3:Market Discipline

Pillar 3 is designed to increase the transparency in banking
system
Increased in minimum public disclosure of banks on:
Risk information
Capital structure
Risk measurement and management practices
Capital adequacy
18
Capital:
Under the Basel Accord, a bank's capital consists of tier 1
capital and tier 2 capital.
Tier 1 capital is a bank's core capital, whereas tier 2 capital is
a bank's supplementary capital.
A bank's total capital is calculated by adding its tier 1 and tier
2 capital together.
Regulators use the capital ratio to determine and rank a
bank's capital adequacy.
19
Tier I Capital:
Tier 1 capital consists of
shareholders' equity and
retained earnings.
Tier 1 capital is intended to measure a bank's financial health

and is used when a bank must absorb losses without ceasing
business operations.
Under Basel III, the minimum tier 1 capital ratio is 6%, which
is calculated by dividing the bank's tier 1 capital by its total
risk-based assets.
For example, bank ABC has $600,000 in equity and retained
earnings and has $10 million in risk-weighted assets. Its tier 1
capital ratio is 6% ($600000/$10 million), which meets the
minimum Basel III requirement.
20
Tier II Capital:
Tier 2 Capital
includes revaluation reserves,
hybrid capital instruments and
subordinated term debt,
general loan-loss reserves, and
undisclosed reserves.
Tier 2 capital is supplementary capital because it is less

reliable than tier 1 capital.
In 2015, under Basel III, the minimum total capital ratio is
8%, which indicates the minimum tier 2 capital ratio is 2%, as
opposed to 6% for the tier 1 capital ratio.
21
Risk weighted assets:

Risk weighted assets is a measure of the amount of a banks
assets, adjusted for risk.
By adjusting the amount of each loan for an estimate of how
risky it is, we can transform this percentage into a rough
measure of the financial stability of a bank.
Risk weighting adjusts the value of a asset for risk, simply by
multiplying it be a factor that reflects its risk.
Suppose a bank has the following assets: Rs 1Cr in T Bills, Rs
2 Cr secured by mortgages, and Rs 3 Cr of loans to
businesses.
The risk weightings used are 0% for T bills (a risk free asset),
50% for mortgages, and 100% for the corporate loans. The
bank's risk weighted assets are 0 Rs1 Cr + 50% Rs2 Cr +
100% Rs 3 Cr = Rs 4 Cr.
22
Capital Adequacy Ratio:

Capital Adequacy Ratio (CAR), also known as Capital to Risk
(Weighted) Assets Ratio (CRAR), is the ratio of a
bank's capital to its risk.
Helps regulators track a bank's CAR to ensure that it can
absorb a reasonable amount of loss and complies with
statutory Capital requirements
RBI currently prescribes a minimum capital of 9% of riskweighted assets, which is higher than the internationally
prescribed percentage of 8%.
Capital Adequacy Ratio =Tier 1 Capital + Tier 2 Capital Riskweighted Exposures
23
Capital Adequacy Ratio:

Capital Adequacy Ratio =Tier 1 Capital + Tier 2 Capital
/ Exposure
Item
Weight
Exposures 0 %
Government TreasuryRiskheld asweighted
asset
15,00,000
Loans to Corporates
150,00,000
10 %
Loans to Small Businesses
80,00,000
20 %
Guarantees and other non-balance

sheet exposures
60,00,000
10 %
The bank's Tier 1 Capital and Tier 2 Capital are 200,000 and
300,000 respectively.
Bank's Total capital = 200,000 + 300,000 = 500,000
Risk-weighted exposures = 1.50% + 1510% + 820% +
610% = 3.7 million
Capital Adequacy Ratio = 0.5 million /3.7 million = 14 %
24
Why Basel-III?
Because of the global financial crisis which begin 2008
because of:
Too much leverage
Inadequate liquidity buffers (liquidity issues)
Mispricing of credit
Liquidity risk
Excess credit growth.
Failures of Basel II being
Inability to strengthen financial stability
Insufficient capital reserve
Global financial crisis in spite of Basel I & Basel II
Liquidity issues in banking system
Inadequate comprehensive risk management approach
25
Why Basel-III?
Responding to these risk factors, the Basel Committee
did following major reforms in BASEL-III:
Increase the quality and quantity of capital

Introduce Leverage ratio
Improve liquidity rules
Introduce Countercyclical Buffer
Introduce Liquidity coverage Ratios
26
Objectives Of Basel-III
To improve quality of capital
To improve liquidity of assets
To bring further transparency and market discipline under
Pillar III.
To improve the banking sector's ability to deal with financial
and economic stress
To enhancing the quantum of common equity
To improve risk management
To Improving banking sectors ability to absorb shocks (by
creating capital buffer)
To optimizing the leverage through Leverage Ratio
To reduce risk spillover to the real economy
27
Basel III: Strengthening the Global

Capital Framework
A. Capital reform.
B. Liquidity standards.
C. Systemic risk and interconnectedness.
A. Capital reform.
A new definition of capital.

Capital conservation buffer
Countercyclical capital buffer
Minimum capital standards
28
A New Definition of Capital

Total regulatory capital will consist of the sum of the
following elements:
1. Tier 1 Capital (going-concern capital)
a. Common Equity Tier 1
b. Additional Tier 1
2. Tier 2 Capital (supplementary capital)
For each of the three categories above (1a, 1b and 2)
there is a single set of criteria that instruments are
required to meet before inclusion in the relevant category.
29
Capital Conservation Buffer

The capital conservation buffer is designed to ensure that
banks build up capital buffers outside periods of stress which
can be drawn down as losses are incurred.
A capital conservation buffer of 2.5%, comprised of
Common Equity Tier 1, is established above the regulatory
minimum capital requirement.
Outside of periods of stress, banks should hold buffers of
capital above the regulatory minimum.
30
Countercyclical Capital Buffer

The countercyclical buffer aims to ensure that banking
sector capital requirements take account of the macrofinancial environment in which banks operate.
It will be deployed by national jurisdictions 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.
31
B. Liquidity Standards:
1. Short-term: Liquidity Coverage Ratio (LCR)
2. Long-term: Net Stable Funding Ratio (NSFR)
1.Short-term:LCR
The LCR is a response from Basel committee to the recent
financial crisis.
The LCR proposal requires banks to hold high quality liquid
assets in order to survive in emergent stress scenario.
32
Short-term: LCR
Must be no lower than 1.
The higher the better.
High quality liquid: liquid in markets during a time of
stress and ideally be central bank eligible.
Banks are still expected to conduct their own stress tests

to assess the level of liquidity they should hold beyond
this minimum, and construct scenarios that could cause
difficulties for their specific business activities.
33
2. Long-term: NSFR
Objectives:
To promote more medium and long-term funding activities
of banking organizations.
Ensure that the investment activities are funded by stable
liabilities.
To limit the over-reliance on wholesale short-term funding
(money market)
34
Long-term: NSFR
Available stable funding (ASF) is defined as the total amount of
an institutions:
Capital.
Preferred stock with maturity of equal to or greater than one

year.
Liabilities with effective maturities of one year or greater.
Deposits and/or term deposits with maturities of less than one
year that would be expected to stay with the institution for an
extended period a stress event.
35
Required Stable Funding:

The required amount of stable funding is calculated as:
Sum of the value of the assets held and funded by the institution
Multiplied by a RSF factor,

Added to the amount of OBS activity (or potential liquidity
exposure)
Multiplied by its associated RSF factor.
36
Required Stable Funding

These components of required stable funding are not equally
weighted.
100% of loans longer than one year.
85% of loans to retail clients with a remaining life shorter than

one year.
50% of loans to corporate clients with a remaining life shorter
than one year.
20% of government and corporate bonds.
Off-balance sheet categories are also weighted.
37
C. Systemic risk & Inter

connectedness (Counterparty risk)
Capital incentives for using CCPs for OTC.
Higher capital for systemic derivatives.
Higher capital for inter-financial exposures.
Contingent capital.
Capital surcharge for systemic banks.
38
Regulatory Capital Requirement

in India
Overall capital as % to risk weighted assets:
39
Timeline For Implementation

(International)
40
Impact on Indian banking system
Profitability
Capital acquisition
Liquidity Needs
Limits on lending
Bank consolidation
Pressure on Yield on Assets
Pressure on Return on Equity
Stability in the Banking system
41
The Impact of Basel III

Impact on economy:
IIF study:
(IIF) calculated that the economies of G3 (US, Euro Area and
Japan) would be 3% smaller after implementation of Basel-III till
2015.
Basel Committee study:
0.2% Impact on GDP each year for 4 years
Global banks could have a gap of liquid assets of 1,730

billion in four years
Global big banks could have a capital shortfall of 577
billion to meet 7% common equity norm
However, long term gains
will be immense
42
Impact on Public Sector Banks

Public sector banks- needs around Rs 1400 1500 billions over
next 5 years
Some public sector banks are likely to fall short of the revised
core capital adequacy requirement.
Government to recapitalize an estimated Rs 900 billion or be
ready to reduce their equity stake in banks below 50%.
Increase in the requirement of capital will affect the ROE of the
Public banks.
43
Check Your Understanding:

1. What are Basel Accords?
2. Explain briefly the Basel II?
3. What is Tier I and Tier II Capital
4. What was the of Basel III?

5. What is the impact of Basel III on Banking system?
44
Questions
Thank You

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Global Financial Market Program

PS:to review by a brief summary, as at the end of a speech or dis

2015 BSE Institute Limited

Understand role of Bank of International Settlement

GFMP Semester 3 Banking Operations and Products III

2015 BSE Institute Limited

Why Capital Requirement?

Bank failures - mainly by losses in assets:

2015 BSE Institute Limited

GFMP Semester 3 Banking Operations and Products III

2015 BSE Institute Limited

Functions and Objectives of (BIS):

2015 BSE Institute Limited

2015 BSE Institute Limited

Why Basel committee was

Basel Committee on Banking Supervision has its origins in the

History of Basel Committees:

2015 BSE Institute Limited

History of Basel committees:

GFMP Semester 3 Banking Operations and Products III

2015 BSE Institute Limited

GFMP Semester 3 Banking Operations and Products III

2015 BSE Institute Limited

2015 BSE Institute Limited

GFMP Semester 3 Banking Operations and Products III

2015 BSE Institute Limited

Pillar 1:Minimum Capital

2015 BSE Institute Limited

Pillar 1:Minimum Capital

2015 BSE Institute Limited

Minimum Capital Requirement

GFMP Semester 3 Banking Operations and Products III

2015 BSE Institute Limited

Pillar 2:Supervisory Review

2015 BSE Institute Limited

Pillar 3:Market Discipline

GFMP Semester 3 Banking Operations and Products III

2015 BSE Institute Limited

GFMP Semester 3 Banking Operations and Products III

2015 BSE Institute Limited

Tier 1 capital is intended to measure a bank's financial health

2015 BSE Institute Limited

Tier 2 capital is supplementary capital because it is less

GFMP Semester 3 Banking Operations and Products III

2015 BSE Institute Limited

Risk weighted assets:

2015 BSE Institute Limited

Capital Adequacy Ratio:

GFMP Semester 3 Banking Operations and Products III

2015 BSE Institute Limited

Capital Adequacy Ratio:

Loans to Small Businesses

Guarantees and other non-balance

2015 BSE Institute Limited

2015 BSE Institute Limited

Increase the quality and quantity of capital

GFMP Semester 3 Banking Operations and Products III

2015 BSE Institute Limited

GFMP Semester 3 Banking Operations and Products III

2015 BSE Institute Limited

Basel III: Strengthening the Global

A new definition of capital.

GFMP Semester 3 Banking Operations and Products III

2015 BSE Institute Limited