The Basel Accords refer to the banking supervision Accords issued by the Basel Committee on Banking Supervision (BCBS).

It includes the Basel I , Basel II and Basel III norms. They are called the Basel Accords as the BCBS maintains its secretariat at the Bank for International Settlements in Basel, Switzerland and the committee normally meets there.

The Basel Committee on Banking Supervision (BCBS)is a committee of banking supervisory authorities that was established by the central bank governors of the G-10 countries in 1974.
Since 2009, all of the other G-20 major economies are represented, as well as some other major banking locales such as Hong Kong and Singapore.

Basel Committee on banking supervision introduced the Basel 1 also known as the 1988 Basel Accord , a set of minimum capital requirements for banks. Basel I is primarily focused on credit risk and appropriate risk weighting of assets.

The 1988 Accord requires: The bank to hold capital equal to atleast 8% of their risk-weighted assets (RWA).

The definition of capital is set in two tiers: Tiers 1 being of shareholders equity and retained earnings. Tier 2 being additional internal and external resources available to the bank.

Risk-weighted asset is a bank's assets or offbalance sheet exposures, weighted according to risk. The Committee insisted that the banks use this approach for capital calculation because it provides an easier approach to compare banks across different geographies off-balance-sheet exposures can be easily included in capital adequacy calculations banks are not deterred from carrying low risk liquid assets in their books

1. 2. 3.

Assets of banks were classified and grouped in five categories according to credit risk: carrying risk weights of 0% (for example cash, bullion, home country debt like Treasuries) 20% (securitizations such as mortgage backed securities (MBS) with the highest AAA rating) 50% mortgaged loans 100% (for example, most corporate debt) some assets were given no rating.

The tier 1 capital ratio = tier 1 capital / all RWA

The total capital ratio = (tier 1 + tier 2 capital) / all RWA Leverage ratio = total capital/average total assets

Limited differentiation of credit risk There are four broad risk weightings (0%, 20%, 50% and 100%), based on an 8% minimum capital ratio. Static measure of default risk The assumption that a minimum 8% capital ratio is sufficient to protect banks from failure does not take into account the changing nature of default risk. No recognition of term-structure of credit risk The capital charges are set at the same level regardless of the maturity of a credit exposure. Simplified calculation of potential future counterparty risk The current capital requirements ignore the different level of risks associated with different currencies and macroeconomic risk.

Lack of recognition of portfolio diversification effects In reality, the sum of individual risk exposures is not the same as the risk reduction through portfolio diversification. Therefore, summing all risks might provide incorrect judgment of risk

Basel 2

Three Pillars of Basel II Framework

Pillar 1 sets out the minimum capital requirements firms will be required to meet to cover credit, market and operational risk. Pillar 2 sets out a new supervisory review process. Requires financial institutions to have their own internal processes to assess their overall capital adequacy in relation to their risk profile. Pillar 3 cements Pillars 1 and 2 and is designed to improve market discipline by requiring firms to publish certain details of their risks, capital and risk management as to how senior management and the Board assess and will manage the institution's risks.

Pillar 1 : Minimum capital requirements

Institution's total regulatory capital must be atleast 8% (ratio same as in Basel I) of its risk weighted assets, based on measures of THREE RISKS

Measuring credit risk

Banks can assess risk using three different ways of varying degree of sophistication Standardized approach

Foundation IRB(Internal Rating-Based Approach)

Advanced IRB

Credit Assessment

AAA TO AA(%) 0

A+ TO A (%) 20

BBB+ TO BBB(%) 50

BB+ TO BB(%) 100

BELOW B(%) 150

UNRATE D (%) 100

SOVEREIGN CREDIT

CLAIMS ON BANKS
OPTION1 OPTION 2 OPTION 3 20 20 20 50 50 20 50 100 50 20 100 100 100 50 150 150 150 150 150 100 50 20 100

CORPORATES 20

Probability of default(PD)

Probability that counterparty will not meet its financial obligation

Loss given default(LGD)

Expected amount of loss on default

Exposure at default (EAD)

Expected amount of exposure

maturity

Average maturity of the exposure

Exposure type

(IRBF)
Internal data

(IRBF)
Regulatory data

(IRBA)
Internal data

(IRBA)
Regulatory data

CORPORATES, PD SOVEREIGN , OTHER BANKS

LGD, EAD, M

PD, LGD, EAD, M

Measuring operational risk Operational risk is risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. It includes legal risk, such as exposure to fines, penalties etc. Methods to measure operational risk Basic Indicator Approach Standardized Approach

CAPITAL REQUIREMENT =Average positive gross income over the last three years* 15% Gross income= net interest and commission income excluding profits/losses from sale of securities

BUSINESS LINE
Corporate finance Trading and sales Retail banking Commercial banking Payment and settlement

BETA FACTOR
18% 18% 12% 15% 18%

Supervisory review process has been introduced to ensure

o

banks have adequate capital to support all the risks to encourage them to develop and use better risk management techniques in monitoring and managing their risks.

Process for assessing overall capital adequacy in relation to risk profile. Review and evaluate banks internal capital adequacy assessment Expect banks to operate above the minimum regulatory capital ratios Intervene at early stage to prevent capital from falling below minimum levels

Covers transparency and the obligation of banks to disclose meaningful information to all stakeholders Clients and shareholders should have sufficient understanding of activities of banks, and the way they manage their risks

Increased Capital requirement Profitability- implementation of models Rating requirement Absence of historical database( PD,LGD, EAD, M) Disadvantages for smaller banks

BASEL 3

CAPITAL REQUIREMENTSBanks to hold 4.5% of common equity & 6% of tier I capital of Risk Weighted Assets (RWA). {Tier 1 capital= common shares+ retained earnings} ADDITIONAL CAPITAL BUFFERSMandatory capital conservation buffer of 2.5% of RWA. banks must hold 7.0% CET 1 capital on an individual and consolidated basis at all times.

CET 1 capital includes a) A payment of cash dividends; b) A distribution of fully or partly paid bonus shares or other capital instruments; c) A redemption or purchase by an institution of its own shares or other specified capital instruments; d) A repayment of amounts paid up in connection with specified capital instruments;

LEVERAGE REQUIREMENTS

Leverage Ratio =

Tier 1 capital Total exposure

> = 3%

Liquidity coverage ratio(LCR) The Liquidity Coverage Ratio requires institutions to hold a sufficient buffer of high quality liquid assets to cover net liquidity outflows during a 30day period of stress.

= High quality liquid assets Total net liquidity outflows HIGH QUALITY LIQUID ASSETS

> = 100%

a) Cash and deposits held with central banks to the extent that these deposits can be withdrawn in times of stress; b) Transferable assets that are of extremely high liquidity and credit quality; c) Transferable assets guaranteed by the central government or a third country if the institution incurs a liquidity risk in that third country that it covers by holding those liquid assets; Listed on a recognized exchange

Net liquidity outflows = Liquidity outflows - liquidity inflows in the stress scenario

Net stable funding ratio The Net Stable Funding Ratio (NSFR) requires institutions to maintain a sound funding structure over one year in an extended firm-specific stress scenario.

NSFR =Available stable funding Required stable funding AVAILABLE STABLE FUNDING a) Own funds; items not included in the own funds: i) Retail deposits as defined in the Regulation; ii) All funding obtained from financial customers; iii) Funding from secured lending as specified in the Regulation;