THE BASEL COMMITTEE RECOMMENDATIONS

Prof.Mishu Tripathi Assistant Professor-Finance

Introduction
On June 26, 1974, German regulators forced the troubled Bank Herstatt into liquidation. That day a number of banks had released payment to Herstatt in Frankfurt in exchange for US$ that was to be delivered in New York. Because of the time- zone differences, Herstatt ceased operation between the times of the respective payments. The counter party banks did not receive their US$ payments. Responding to the cross-jurisdictional implications of Herstatt debacle, the G-10 countries formed a standing committee under the auspices of Bank of International Settlements (BIS) Called the Basel Committee or (Basle Committee

G-10 Countries
Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, Switzerland, the United Kingdom and the United States

Objectives of the Committee

Ensure that international banks or bank holding companies do not escape comprehensive supervision by a home regulatory authority. Promote uniform capital requirements so that banks from different countries may compete with another on a level playing field

Core principles for effective Banking supervisions

Principle 1 Objectives, independence, powers, transparency and cooperation 1. Effective supervision will have clear responsibilities and objectives. They should possess operational independence. 2. A suitable legal framework to support is also required. 3. Arrangement for sharing information between supervisors and protecting the confidentiality of such information should be in place.

Principle 2 Permissible activities

The permissible activities of institutions that are licensed and subject to supervision as banks must be clearly defined and the use of the word bank in names should be controlled as far as possible.

Licensing and structure

3. Banking supervisors must have the authority to review and reject any proposal to transfer significant ownership or controlling interest in existing banks to other parties. 4. Banking supervisors must have the authority to establish criteria for reviewing major acquisitions or investment by banks with special reference to risk associated with it.

Principle 3 Licensing criteria

The licensing process, at a minimum, should consist of an assessment of the ownership structure and governance of the bank and its wider group, including the fitness and propriety of Board members and senior management, its strategic and operating plan, internal controls and risk management, and its projected financial condition, including its capital base.

Principle 3 Licensing criteria

Where the proposed owner or parent organization is a foreign bank, the prior consent of its home country supervisor should be obtained. The licensing authority must have the power to set criteria and reject applications for establishments that do not meet the standards set.

Principle 4 Transfer of significant ownership

The supervisor has the power to review and reject any proposals to transfer significant ownership or controlling interests held directly or indirectly in existing banks to other parties.

Principle 5 Major acquisitions

The supervisor has the power to review major acquisitions or investments by a bank, against prescribed criteria, including the establishment of cross-border operations, and confirming that corporate affiliations or structures do not expose the bank to undue risks or hinder effective supervision.

Principle 6 Capital adequacy

Supervisors must set prudent and appropriate minimum capital adequacy requirements for banks that reflect the risks that the bank undertakes, and must define the components of capital, bearing in mind its ability to absorb losses. At least for internationally active banks, these requirements must not be less than those established in the applicable Basel requirement.

Principle 7 Risk management process:

Supervisors must be satisfied that banks and banking groups have in place a comprehensive risk management process (including Board and senior management oversight) to identify, evaluate, monitor and control or mitigate all material risks and to assess their overall capital adequacy in relation to their risk profile. These processes should be commensurate with the size and complexity of the institution.

Principle 8 Credit risk

Supervisors must be satisfied that banks have a credit risk management process that takes into account the risk profile of the institution, with prudent policies and processes to identify, measure, monitor and control credit risk (including counterparty risk). This would include the granting of loans and making of investments, the evaluation of the quality of such loans and investments, and the ongoing management of the loan and investment portfolios.

Principle 9 Problem assets, provisions and reserves

Supervisors must be satisfied that banks establish and adhere to adequate policies and processes for managing problem assets and evaluating the adequacy of provisions and reserves.

Principle 10 Large exposure limits

Supervisors must be satisfied that banks have policies and processes that enable management to identify and manage concentrations within the portfolio, and supervisors must set prudential limits to restrict bank exposures to single counterparties or groups of connected counterparties.

Principle 11 Exposures to related parties

In order to prevent abuses arising from exposures (both on balance sheet and off balance sheet) to related parties and to address conflict of interest, supervisors must have in place requirements that banks extend exposures to related companies and individuals on an arms length basis; these exposures are effectively monitored; appropriate steps are taken to control or mitigate the risks; and write-offs of such exposures are made according to standard policies and processes.

Principle 12 Country and transfer risks

Supervisors must be satisfied that banks have adequate policies and processes for identifying, measuring, monitoring and controlling country risk and transfer risk in their international lending and investment activities, and for maintaining adequate provisions and reserves against such risks.

Principle 13 Market risks

Supervisors must be satisfied that banks have in place policies and processes that accurately identify, measure, monitor and control market risks; supervisors should have powers to impose specific limits and/or a specific capital charge on market risk exposures, if warranted.

Principle 14 Liquidity risk

Supervisors must be satisfied that banks have a liquidity management strategy that takes into account the risk profile of the institution, with prudent policies and processes to identify, measure, monitor and control liquidity risk, and to manage liquidity on a day-to-day basis. Supervisors require banks to have contingency plans for handling liquidity problems.

Principle 15 Operational risk

Supervisors must be satisfied that banks have in place risk management policies and processes to identify, assess, monitor and control/mitigate operational risk. These policies and processes should be commensurate with the size and complexity of the bank.

Principle 16 Interest rate risk in the banking book

Supervisors must be satisfied that banks have effective systems in place to identify, measure, monitor and control interest rate risk in the banking book, including a well defined strategy that has been approved by the Board and implemented by senior management; these should be appropriate to the size and complexity of such risk.

Principle 17 Internal control and audit

Supervisors must be satisfied that banks have in place internal controls that are adequate for the size and complexity of their business. These should include clear arrangements for delegating authority and responsibility; separation of the functions that involve committing the bank, paying away its funds, and accounting for its assets and liabilities; reconciliation of these processes; safeguarding the banks assets; and appropriate independent internal audit and compliance functions to test adherence to these controls as well as applicable laws and regulations.

Principle 18 Abuse of financial services

Supervisors must be satisfied that banks have adequate policies and processes in place, including strict know-your-customer rules, that promote high ethical and professional standards in the financial sector and prevent the bank from being used, intentionally or unintentionally, for criminal activities.

Principle 19 Supervisory approach

An effective banking supervisory system requires that supervisors develop and maintain a thorough understanding of the operations of individual banks and banking groups, and also of the banking system as a whole, focusing on safety and soundness, and the stability of the banking system.

Principle 20 Supervisory techniques

An effective banking supervisory system should consist of on-site and off-site supervision and regular contacts with bank management.

Principle 21 Supervisory reporting

Supervisors must have a means of collecting, reviewing and analyzing prudential reports and statistical returns from banks on both a solo and a consolidated basis, and a means of independent verification of these reports, through either on-site examinations or use of external experts.

Principle 22 Accounting and disclosure

Supervisors must be satisfied that each bank maintains adequate records drawn up in accordance with accounting policies and practices that are widely accepted internationally, and publishes, on a regular basis, information that fairly reflects its financial condition and profitability.

Principle 23 Corrective and remedial powers of supervisors:

Supervisors must have at their disposal an adequate range of supervisory tools to bring about timely corrective actions. This includes the ability, where appropriate, to revoke the banking license or to recommend its revocation.

Principle 24 Consolidated supervision

An essential element of banking supervision is that supervisors supervise the banking group on a consolidated basis, adequately monitoring and, as appropriate, applying prudential norms to all aspects of the business conducted by the group worldwide.

Principle 25 Home-host relationships

Cross-border consolidated supervision requires cooperation and information exchange between home supervisors and the various other supervisors involved, primarily host banking supervisors. Banking supervisors must require the local operations of foreign banks to be conducted to the same standards as those required of domestic institutions.

THE BASEL CAPITAL ACCORD

The Basel capital Accord, the current international framework on capital adequacy was adopted in 1988 by many banks worldwide and it was adopted in 1992 in India. The 1988 Basel Accord primarily addressed banking in the sense of deposit taking and lending therefore its focus was on credit risk. Banks were subject to 8% capital requirement.

THE BASEL CAPITAL ACCORD

Tier 1(core) capital included the book value of common stock, non-cumulative perpetual preferred stock and published reserves from post tax retained earnings. Tier 2 (supplementary) capital was deemed of lower quality. It included cumulative and/ or redeemable preferred stock, assets revaluation reserves, general loan reserves, subordinated term debt. A maximum of 50% of a banks capital could comprise of tier-2 capital. Credit risk was calculated as the sum of risk weighted asset values.

BASEL II
In June 1999 the Basel committee on banking supervision issued a new consultative paper on New Capital Adequacy framework. After conducting three quantitative impact studies to assess those proposals, the finalized Basel Accord called International Convergence of Capital Measures and Capital Standards: a Revised Framework, was adopted on June2004

BASEL II
Basel II is based on three pillars 1. Minimum capital requirement for banks 2. Supervision to review banks capital adequacy and internal assessment processes 3. Use of Market Discipline for greater transparency and disclosure encouraging best international practices

BASEL II
Basel II reflects more risk sensitive requirements of banks with greater attention to supervision and market discipline. The revised accord has retained the minimum requirement of 8% of capital to risk weighted assets. Capital --------------------------------------------------- 8% Credit risk + market risk + operational risk The operational risk has been added to take note of increasing globalization, enhanced use of technology, product innovations and growing complexity in operations.

Operational Risk
Operational risk has been defined as the risk of loss resulting from inadequate or failed internal processes, people and system or from external events.

Varying Risk weight

The biggest change is proposed in the system of risk weighting so that the rate of interest that is charged to a borrower reflects the riskiness of the underlying asset. Therefore, instead of a onesize-fitsall approach (100%), the committee has proposed reduction in risk weight for certain high quality assets and increase in risk weight for lower quality assets e.g. venture capital and private placements (100%, 150%).

Credit Rating
Another major change is that under the new accord, risk weights are to be determined on the basis of ratings assigned by independent external credit rating agencies. At present, credit rating is required for debt instruments only but under the new framework, credit rating will be extended to bank loans also.

Banks Internal Models

1. Risk control unit must be independent from trading units and report directly to senior management. 2. Risk management model must be integrated into the daily management process. 3. There must be appropriate stress test and back testing 4. Independent review of risk measurement and risk management system must be conducted annually.

Market Discipline
To strengthen the safety and soundness of the system, the requirement of disclosure by banks has been strengthened. For instance, banks will have to disclose additional details of the way in which they calculate their capital adequacy, their risk management strategies and practices, and also credit assessment institutions that they use for the risk weighting of their assets The disclosure relating to comprehensive risk exposures would include credit risk, market risk, liquidity risk, operational risk, legal and other risks as well as accounting policies and information on corporate governance.

CAPITAL ADEQUACY IN THE INDIAN BANKING CONTEXT

Capital adequacy and other prudential norms, first introduced as a part of banking sector reforms in 1992 are being fine tuned continuously by RBI aligning them more closely with international best practices. The minimum capital to risk asset ratio was raised from 8% to 9% effective March 31, 2000. Capital charge to cover market risk has already been incorporated in certain items: Banks have to assign additional risk weight of 2.5% on entire investment portfolio. FOREX/gold open position limits of banks carry 100% risk weight (from 31.3.99)

CAPITAL ADEQUACY IN THE INDIAN BANKING CONTEXT

An investment fluctuation reserve has been put in place from March 31, 2003 with minimum 5% of the investment portfolio in the Available for Sale (AFS) and Held for Trading (HFT) categories, as a cushion for market risk and it will gradually be raised to 10%. All investments in bonds /debentures of FIs assigned a uniform risk weight of 20%. Risk weight for State Government guaranteed advances in default: 20% as on 31.3.2000 and 100% where default continues even after 31.3.2001.

CAPITAL ADEQUACY IN THE INDIAN BANKING CONTEXT

Bank loans are to be classified as substandard when payments remain outstanding for one quarter from the year ending March 31, 2004. General provision on standard assets was allowed to be included in tier 2 capital upto a maximum of 1.25% of total risk weighted assets in October 2000 in line with international best practices. In May 2004 RBI announced that banks will be required to provide capital to cover interest rate risk on their trading book exposures (including derivatives) by 31 March 2005 and on investments under Available for Sale category by 31 March 2006.

IMPACT ON INDIAN BANKS

The consolidation in banking to overcome capital constraint, streamlining of risk management, maximizing return on capital, greater use of technology for efficiency gains, more robust risk based pricing and closer alignment with international best practices will strengthen the foundation of Indian banking system. The new standards are mandatory for internationally active banks, even small banks would be willing to adopt the new system to be more competitive.

Consolidation
The immediate impact of Basel II will be that the banks will need additional capital to cover market risk and operational risk besides credit risk. Also, banks will need more capital to support expansion. The stronger banks will be able to meet their need for additional capital by tapping the market- both domestic and international or by ploughing back profits. However the weaker banks may need to merge with banks having surplus capital or those with ability to raise capital from the market.

Impact on profitability
Competition among banks for prime customers will intensify, pushing down spread even further. Additional cost on account of rating as also cost of putting in place risk management system, technology infrastructure, MIS for building adequate database will impact profitability.

Better Risk Management

The core of the new accord is how to measure and monitor risk. Banks need to identify key risks, map them with the processes and ensure sufficient controls against those risks by putting integrated risk management in place. Banks need to improve management practices, compliance and sound corporate governance.

Use of Internal Models

The new accord allows banks to use their internal ratings to assess risk and allocate capital provided they satisfy certain basic minimum eligibility criteria including methodology to make meaningful credit differentiation, well developed rating system, well functioning data collection and IT system, estimation of past defaults etc.

Impact on Borrowers
While there will be reduction in borrowing cost for prime borrowers, the cost of borrowing for non-prime / unrated borrowers will go up.

Treatment of small banks

The new accord addresses only the large banks and does help measure risk in smaller banks.

Push to retail
With almost 70% of Indias population under 30 years of age, less than 5% of GDP in personal and housing finance and a booming services sector, there is no doubt the demographic dynamics will drive retail banking in India in the years ahead.

Greater Use of Technology

Minimizing risk and maximizing return on capital to provide risk sensitive products and pricing and the enormous data requirement for business and compliance will require greater use of technology by banks.

HR Issues
IT, risk management and increasing sophistication in other areas will push up the demand for skilled and specialized staff. At the same time, the need to redeploy, retrain and reskill existing staff remain the major challenge before the Indian banking industry.

Greater disclosure and transparency

Markets will demand more information in banks balance sheet and analysts will look for more frequent and transparent data on risk profile. This will increase the demand on banks systems and therefore, banks must have computer systems backed by knowledge and skill in place to provide the needed information.

BASEL-III
December 17, 2009 Basel Committee issued two consultative documents:
Strengthening the resilience of the banking sector International framework for liquidity risk measurement, standards and monitoring

BASEL-III
The proposals were finalized and published on December 16, 2010:
Basel III: A global regulatory framework for more resilient banks and banking systems Basel III: International framework for liquidity risk measurement, standards and monitoring

BASEL-III
Objectives
Improving banking sectors ability to absorb shocks Reducing risk spillover to the real economy

Fundamental reforms proposed in the areas of

Micro prudential regulation at individual bank level Macro prudential regulation at system wide basis

Building Blocks of Basel III

1. Raising quality and transparency of capital base 2. Improving/enhancing risk coverage on account of counterparty credit risk 3. Supplementing risk based capital requirement with leverage ratio 4. Addressing systematic risk and interconnectedness 5. Reducing pro-cyclicality and introducing countercyclical capital buffers (0-2.5%) 6. Minimum liquidity standards