Basel Norms and its implications for banks treasurers

Prof. MishuTripathi Assistant ProfessorFinance

Importance of Capital in Banks

Capital provides the funds necessary to commence banking operation much before mobilization of deposits. It acts as a buffer or cushion against failure and absorbs temporary unexpected losses. Permanent source of revenue for the shareholders and funding for a bank. It provides ready access to capital market. It supports growth of business of bank Capital provides confidence to depositors and reassures other stakeholders in a bank. Capital regulates the growth in assets of a bank.

Capital Accord 1988

Basel Committee on Banking Supervision (BCBS) under the aegis of Bank for International Settlement (BIS), Basel, Switzerland. A committee of central bank governors of Group of 10(G-10) countries had addressed issue of capital adequacy. Back drop: bank failures in the 80s

Capital Accord 1988

In July 1988, the committee headed by Mr. Peter Cooke released a document titled The agreed framework on international convergence of capital measures and standards. the accord was meant for G-10 countries. Over 140 countries including India have adopted the accord and applied it uniformly across banks.

Objectives of Capital Accord

a.

b. c.

Strengthen the soundness of banks by boosting capital position. Promote stability of global banking system Create a level playing field for banks by removing competitive inequality in the form of differing national capital adequacy standard. The accord prescribed capital adequacy norms and sought to make regulatory capital more sensitive to differences in risk profiles among banks Take into account off balance sheet exposure explicitly in determining capital adequacy Lower disincentives to hold liquid and low risk assets.

a.

b.
c.

Need for Basel II

The regulatory measures were seen to be in conflict with increasingly sophisticated internal measures of economic capital Since each banks had separate risk measurement approach and appetite, the one size-fits-all approach was disruptive The approach did not sufficiently recognize credit risk mitigation technique

Three pillars of the Basel II framework

Minimum Capital Requirements

Supervisory Review Process Banks own capital strategy Supervisors review

Market Discipline

Credit risk Operational risk

Enhanced disclosure

Market risk

Pillar I Minimum Capital Requirements

Total capital Credit risk + Market risk + Operational risk

= Banks capital ratio (minimum 9%)

Total Capital

Credit Risk

Total capital = Tier 1 + Tier 2 Tier 1: Shareholders equity + disclosed reserves Tier 2: Supplementary capital (e.g. undisclosed reserves, provisions) The risk of loss arising from default by a creditor or counterparty The risk of losses in trading positions when prices move adversely The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events

Market Risk Operational Risk

PILLAR II - SUPERVISORY REVIEW PROCESS

To ensure robust internal processes for risk management for adequacy of capital. Evaluation of risk assessment.

Prescribe necessary.

differential

capital

wherever

Intervention by the respective Countrys Central Bank

PILLAR III - MARKET DISCIPLINE

Disclosure norms about risk management practices and allocation of regulatory capital. To enhance disclosuresCore and

discretionary. Timely disclosures.

Differences between the Accords I & II

o

Talks of Credit Risk only

Capital Charge for Credit Risk 8% Does not mention separate Capital charge for Market and Operational Risk No mention about market Discipline No effort to quantify Market and Operational Risk

Talks of Credit, Market and Operational Risks Capital Charge dependant on Risk rating of assets Capital Charge to include risks arising out of Credit, Market and Operational risks. Not a broad brush approach Quantitative approach for calculation of Market and Operational risks as for Credit Risk.

The 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

The 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

The 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

The Building Blocks of Basel III

1. Raising quality (Tier 1 6%, of which TCE - 4.5%), level (8+2.5% CCB), consistency (deductions mostly from TCE) 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 (discretion of supervisory authority)

The Building Blocks of Basel III

4. Addressing systemic interconnectedness risk and

5. Reducing pro-cyclicality and introducing countercyclical capital buffers (0-2.5%) 6. Minimum liquidity standards

Characteristics of Basel III

Key characteristic of the financial crisis was inaccurate and ineffective management of liquidity risk Two standards/ratios proposed
Liquidity Coverage Ratio (LCR) for short term (30 days) liquidity risk management under stress scenario Net Stable Funding Ratio (NSFR) for longer term structural liquidity mismatches

Characteristics of Basel III

Liquidity Coverage Ratio (LCR) Ensuring enough liquid assets to survive an acute stress scenario lasting for 30 days Defined as stock of high quality liquid assets / Net cash outflow over 30 days > 100% Stock of high quality liquid assets cash + central bank reserves + high quality sovereign paper (also in foreign currency supporting banks operation) + state govt., & PSE assets and high rated corporate/covered bonds at a discount of 15% - (A) Level 2 liquid assets with a cap of 40%

Implications of Basel III

Impact on economy
IIF study loss of output of 3% in G3 (US, Euro Area and Japan) on full implementation during 2011-15 Basel Committee study likely to have modest impact of 0.2% on GDP for each year for 4 years for 1% increase in TCE Similarly, for 25% increase in liquid assets, half the impact of 1% increase in TCE However, long term gains will be immense

Impact on Indian banks

Most of deductions are already mandated by RBI, so little impact Most of our banks are not trading banks, so not much increase in enhanced risk coverage for counterparty credit risk Indian banks are generally not as highly leveraged as their global counterparts The leverage ratio of Indian banks would be comfortable