The Basel norms are a set of comprehensive agreements and recommendations put forth by the

Basel Committee on Banking Supervision (BCBS) that put their focus on the banking sector. The main
aspects covered by the BCBS are risk management, liquidity, capital requirements and more
recently, stress-testing assets.

Please note In this summary report, the word bank will be used to represent any financial
institution that has regulated capital.

The Basel III Accord is a global, voluntary framework to establish and promote a more resilient
banking sector. Basel III is a continuation of the Basel I & II which aims to bridge the gaps and
inconsistencies left out by the previous accords. This was evident during the global financial crisis of
2008 that the earlier norms need strengthening up, hence paving way for a more resilient banking
sector.

The case for Basel III

Excessive on-balance sheet and off-balance sheet leverage of banks.
Steady and gradual capital erosion of banks.
Deteriorating quality of capital.
Lack of liquidity at banks resulting in decreased ability to absorb shocks.
Interconnected and correlated investment and commercial banking systems.

All the above reasons magnified during the global financial crisis of 2008. The governments and
central banks of many countries had to bail out banks, orchestrate mergers, spin offs and inject
liquidity into the economy by putting taxpayers money into the system.

These problems magnified and spread like wildfire, causing panic and contraction of liquidity across
the globe. The Basel Committee, thereby decided to implement a new set of stricter rules and
systems to protect the world economy from similar future shocks and crises.

The changes from Basel I & II into Basel III are as follows -
Raising capital requirements.
Strengthening risk coverage of banks.
Pre-determined leverage ratio to assist risky capital requirements.
Promoting countercyclical buffers to absorb shocks.
Implementing policies to keep the interconnectedness of banks in check.
Implementing a global liquidity standard which will include liquidity coverage ratios, net
stable funding ratios and use of monitoring metrics.

Regulatory Framework

Capital Requirements
The primary function of bank capital is to provide a cushion against loss. Banks having become
increasingly leveraged these days and can only sustain a small amount of loss before turning
insolvent. There are two categories of capital- Tier 1 & Tier 2.

Common Equity Tier 1 Capital includes the following-

Common stock issued by the bank.
Stock surplus from issuance of Tier 1 Capital.
Retained Earnings.
Minority interest in banks.
Accumulated, other comprehensive income and reserves.
Tier 2 Capital includes the following-
Instruments that meet the criteria if Tier 2 Capital but not Tier 1 Capital.
Stock surplus from issuance of Tier 2 Capital.
Minority interest not included in Tier 1 Capital.
Loan loss provisions.

Minimum Capital Requirement Standards

Capital % of risk weighted

assets
Common Equity Tier 1 4.5
Common Equity Tier 1 + Additional Tier 1 6.0
Tier 1 + Tier 2 8.0

Stress Testing & Wrong Way Risk

Wrong-way risk is a risk that arises when a banks exposure to a counterparty is adversely correlated
with the creditworthiness of that counterparty. To know more about the wrong way risk, banks use
stress testing and scenario analysis like Monte Carlo, which helps them in identifying positively
correlated counterparty risk factors.

Stress testing includes possibility of severe shocks and worst case scenarios. Banks identify, monitor
and control the wrong way risk. Banks must document and rate each counterparty in a separate
exposure with respect of wrong way risk.