The deadline for the implementation of Basel-III was March 2019 in India. The Indian authorities, however, postponed it to March 2020. Now, in light of the coronavirus pandemic, the RBI has put on hold the implementation of Basel norms by further 6 months. Jump to Main Points.
Going by the dictionary, norms are accepted standard/s or a way of behaving or doing things that most people agree with. Basel norms are a standard that the global banking system accepts or aspires to accept.
Coming close to the point, Basel norms refer to broad supervisory standards formulated by the Basel Committee on Banking Supervision (BCBS). The Basel Committee is the primary global standard-setter for financial stability & Banking supervisory matters. BCBS members include organizations with direct banking supervisory authority and central banks.
So, the set of the agreements by the BCBS, which mainly focuses on risks to banks and the world financial system is called Basel accord. After the failure of Herstatt Bank in Germany, the BCBS was set up by the G-10 countries, Spain and Luxembourg in 1974 under the auspices of BIS. It is a standing committee.
Basel, the City
Now, Basel is a city in Switzerland. (Thus we see, BASEL unlike several other terms is not an acronym. It is a proper noun.) The Basel city hosts the headquarters of Bureau of International Settlement. This BIS (not to be confused with the Bureau of Indian Standards) is a global financial institution that works with the central banks of different countries with the common goal of maintaining financial stability and attaining common business standards in the countries individually and also globally. Sixty member countries/central banks have accepted Basel accords.
Every two months BIS hosts a meeting of the governors and senior officials of the central banks of member countries. Currently, there are 27 member nations in the committee. India has accepted Basel accords for the banking system. In fact, on a few parameters, the RBI has prescribed more stringent norms as compared to the norms prescribed by the BCBS.
Banks in a way play intermediaries between depositors and borrowers. Banks lend the deposits of the public as well as money raised from the market – equity and debt. The business of lending carries its own risk. Cases of big banks collapsing due to their inability to sustain the risk exposures are readily available. Therefore, banks keep aside a certain percentage of capital as security against the risk of non-recovery. Basel committee has produced norms called Basel Norms for Banking to tackle the risk.
In 1988, BCBS introduced a capital measurement system called Basel Capital Accord, also called as Basel I. It focused almost entirely on credit risk (default risk) – the risk of counter-party failure. It defined the capital requirement and structure of risk-weights for banks.
The minimum capital (Equity Capital + retained earnings) requirement was fixed at 8% of risk-weighted assets, a concept which captures the amount of risk and the uncertainty involved with the assets that it may fail to get liquidated to what it is actually worth for.
Thus, RWA means assets with different risk profiles. For example, an asset backed by collateral would carry lesser risks as compared to personal loans, which have no collateral. India adopted Basel 1 guidelines in 1999.
Capital Adequacy Ratio
Capital Adequacy Ratio (CAR) = Tier 1 Capital + Tier 2 Capital/ Risk Weighted Assets
Tier 1 capital represents the core capital of a bank and includes, inter alia, the paid-up share capital. The Tier 1 capital should form at least 50% of the bank’s total capital base. Tier 2 capital represents the supplementary capital and includes cumulative non-redeemable preference share capital.
In 1996 a new factor was introduced viz. market risk which is the risk of losses in on and off-balance sheet positions arising from movements in market prices. The calculation of CAR now incorporates Tier 3 capital which is composed of Short term subordinated bonds that would exclusively cover market risks. Market risk is composed of interest rate risk, equity position risk, foreign exchange risk and commodities risk.
CAR = Tier 1 + Tier 2 + Tier 3 Capital/ RWA
One of the major roles of Basel norms is to standardize the banking practices across all countries which however it hardly could achieve. This was because there are major problems with the definition of Capital and Differential Risk Weights to Assets across countries. They compute Basel standards on the basis of book-value accounting measures of capital and not market values. Accounting practices vary significantly across the G-10 countries and often produce results that differ markedly from market assessments.
Other problem was that the risk weights didn’t attempt to take account of risks other than credit risk, viz., market risks, liquidity risk and operational risks that might be important sources of insolvency exposure for banks.
To offset these issues, in June ’04, the BCBS published Basel II guidelines. This edition was a refined, reformed and advanced version of Basel I accord. It added risk management (Market Risk and Operational Risk) and disclosure requirements.
The norms define operational risk as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputation risk, whereby legal risk includes exposures to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements. There are complex methods to calculate this risk. The guidelines were based on three parameters, which the committee calls as pillars. These pillars are:
- Capital Adequacy Requirements: Banks should maintain a minimum capital adequacy requirement of 8% of risk assets. CAR decides the minimum amount of capital that the banks mandatorily hold to reduce the risk of insolvency. Well simply put, insolvency is the situation where a bank cannot raise enough cash to meet its obligations.
- Supervisory Review: According to this, banks need to develop and use better risk management techniques in monitoring and managing all the three types of risks that a bank faces, viz. credit, market and operational risks
- Market Discipline: This needs increased disclosure requirements. Banks need to mandatorily disclose their CAR, risk exposure, etc to the central bank.
The financial crisis happened in 2008. Needless to say, Basel II norms could not foresee or prevent the global financial crisis of 2008. Systemic shortcomings were there. Admittedly, Basel II did not have any explicit regulation on the debt that banks could take on their books, and focused more on individual financial institutions, while ignoring systemic risk.
A need was felt to further strengthen the system as banks in the developed economies were under-capitalized, over-leveraged and had a greater reliance on short-term funding. Moreover, the quantity and quality of capital under Basel II were deemed insufficient to contain any further risk.
So, in 2010, they came up with Basel III norms. The new norms strive to ensure that banks don’t take on excessive debt and that they don’t rely too much on short term funds. Basel III norms aim at making most banking activities such as their trading book activities more capital-intensive. The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz. capital, leverage, funding and liquidity.
Further modified parameters such as leverage ratio, mandatory capital conservation buffers and discretionary counter-cyclical buffers were introduced. The liquidity coverage ratio (LCR) requires banks to hold a buffer of high-quality liquid assets sufficient to deal with the cash outflows encountered in an acute short term stress scenario like “Bank Run”.
In India, Basel norms were first accepted in the year 1999 with Basel I. Later in 2005 RBI proposed guidelines for implementation of Basel II. Section 17 of the Banking Regulation Act, 1947 requires banks to transfer at least 20% of the disclosed profit to a reserve fund every year. This is in line with Basel II standards. Going overboard, we maintain CAR at 9% level, a step ahead of Basel II level.
However, India is yet to implement in toto Basel III norms. The recurring massive banking frauds demand stringent adherence to standardized banking practices lest we suddenly face a Lehman-like collapse. Just to note, before going bankrupt in 2008, Lehman was the fourth-largest investment bank in the United States. Yes, it was fourth after Goldman Sachs, Morgan Stanley, and Merrill Lynch doing business in investment banking, U.S. Treasury securities, equity, and personal banking and was in operation for 158 years since 1850.
Main Points (In 100 Words)
Basel, a city in Switzerland, hosts the headquarters of Bureau of International Settlement. Here in 1974, the G-10 countries set up BCBS for global banking supervision. Including India, sixty nations are signatory to the Basel accords. And, we have three rounds so far.
They released Basel I in 1988. The latest series Basel III is the after-thought of the 2008 financial crisis which Basel II couldn’t pre-empt. Basel norms are based on Capital Adequacy Ratio, risk management supervision and increased disclosure mandates.
Recent massive bank frauds in India warrant no less than full implementation of the Basel III norms. We cannot just attribute so frequent frauds only to the collusion of bank insiders. What are the audits for, then? This is a systemic fault. We expect Basel III norms to plug the fault lines.