Basel Banking Norms


Basel is a city in Switzerland which is also the headquarters of Bureau of International Settlement (BIS). BIS fosters co-operation among central banks with a common goal of financial stability and common standards of banking regulations.  Currently there are 27 member nations in the committee. Basel guidelines refer to broad supervisory standards formulated by this group of central banks- called the Basel Committee on Banking Supervision (BCBS). The set of agreement by the BCBS, which mainly focuses on risks to banks and the financial system are called Basel accord. The purpose of the accord is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses. India has accepted Basel accords for the banking system. 

Basel I

In 1988, BCBS introduced capital measurement system called Basel capital accord, also called as Basel 1. It focused almost entirely on credit risk. It defined capital and structure of risk weights for banks. The minimum capital requirement was fixed at 8% of risk weighted assets (RWA). 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.

The first accord Basel Iwas issued in 1988 and focused mainly on credit risk by creating a bank asset classification system. This classification system grouped a bank's assets into five risk categories:
0% - cash, central bank and government debt and any OECD government debt
0%, 10%, 20% or 50% - public sector debt
20% - development bank debt, OECD bank debt, OECD securities firm debt, non-OECD bank debt (under one year maturity) and non-OECD public sector debt, cash in collection
50% - residential mortgages
100% - private sector debt, non-OECD bank debt (maturity over a year), real estate, plant and equipment, capital instruments issued at other banks

The bank must maintain capital (Tier 1 and Tier 2) equal to at least 8% of its risk-weighted assets. For example, if a bank has risk-weighted assets of $100 million, it is required to maintain capital of at least $8 million.

Basel II

In 2004, Basel II guidelines were published by BCBS, which were considered to be the refined and reformed versions of Basel I accord. The guidelines were based on three parameters. Banks should maintain a minimum capital adequacy requirement of 8% of risk assets, banks were needed to develop and use better risk management techniques in monitoring and managing all the three types of risks that is  credit  and  increased disclosure requirements. Banks need to mandatorily disclose their risk exposure, etc to the central bank. Basel II norms in India and overseas are yet to be fully implemented.

Its goal is to better align the required regulatory capital with actual bank risk. This makes it vastly more complex than the original accord. Basel II has multiple approaches for different types of risk. It has multiple approaches for securitization and for credit risk mitigants (such as collateral). It also contains formulas that require a financial engineer.

Some countries have implemented basic versions of the new accord, but in the United States, Basel II is seeing a painful, controversial and prolonged deployment (even as large banks have been working for years to meet its terms). Many of the problems are inevitable: The agreement tries to coordinate bank capital requirements across countries and across bank sizes. International coherence is hard enough, but so is scaling the requirements - in other words, it is very hard to design a plan that does not give advantage to a banking giant over a smaller regional bank.

Basel II is Three Pillars

Basel II has three pillars: minimum capital, supervisor review and market discipline.
Minimum capital is the technical, quantitative heart of the accord. Banks must hold capital against 8% of their assets, after adjusting their assets for risk.

Supervisor review is the process whereby national regulators ensure their home country banks are following the rules. If minimum capital is the rulebook, the second pillar is the referee system.
Market discipline is based on enhanced disclosure of risk. This may be an important pillar due to the complexity of Basel. Under Basel II, banks may use their own internal models (and gain lower capital requirements) but the price of this is transparency.

Basel II Charges for Three Risks

The accord recognizes three big risk buckets: credit risk, market risk and operational risk. In other words, a bank must hold capital against all three types of risks. A charge for market risk was introduced in 1998. The charge for operational risk is new and controversial because it is hard to define, not to mention quantify, operational risk (The basic approach uses a bank's gross income as a proxy for operational risk. It is not hard to challenge this idea.)

The Basel II Transition

Not only is the implementation staggered globally, but the accord itself contains tiered approaches. For example, credit risk has three approaches: standardized, foundation internal ratings-based (IRB), and advanced IRB. Roughly, a more advanced approach relies more on a bank's internal assumptions. A more advanced approach will also generally require less capital, but most banks will need to transition to more advanced approaches over time.

Basel III

In 2010, Basel III guidelines were released. These guidelines were introduced in response to the financial crisis of 2008. 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. Also the quantity and quality of capital under Basel II were deemed insufficient to contain any further risk. 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.

Basel III and the Banks

The Basel III regulations contain several important changes for banks' capital structures. First of all, the minimum amount of equity, as a percentage of assets, will increase from 2% to 4.5%. There is also an additional 2.5% "buffer" required, bringing the total equity requirement to 7%. This buffer can be used during times of financial stress, but banks doing so will face constraints on their ability to pay dividends and otherwise deploy capital. Banks will have until 2019 to implement these changes, giving them plenty of time to do so and preventing a sudden "lending freeze" as banks scramble to improve their balance sheets.

It is possible that banks will be less profitable in the future due in part to these regulations. The 7% equity requirement is a minimum and it is likely that many banks will strive to maintain a somewhat higher figure in order to give themselves a cushion. If financial institutions are perceived as being safer, the cost of capital to banks would actually decrease. Banks that are more stable will be able to issue debt at a lower cost. At the same time, the stock market might assign a higher P/E multiple to banks that have a less risky capital structure.

Basel III and Financial Stability 

Basel III is not a panacea, and will not single-handedly restore stability to the financial system and prevent future financial crisis. However, in combination with other measures, these regulations are likely to help produce a more stable financial system. In turn, greater financial stability will help produce steady economic growth, with less risk for crisis fueled recessions such as that experienced following the global financial crisis of 2008-2009.

While banking regulations may help reduce the possibility of future financial crises, it may also restrain future economic growth. This is because bank lending and the provision of credit are among the primary drivers of economic activity in the modern economy. Therefore, any regulations designed to restrain the provision of credit are likely to hinder economic growth, at least to some degree. Nevertheless, following the events of thefinancial crisis, many regulators, financial market participants and ordinary individuals are willing to accept slightly slower economic growth for the possibility of greater stability and a decreased likelihood of a repeat of the events of 2008 and 2009. (Find out how the Tier 1 capital ratio can be used to tell if your bank is going under.

Basel III and Investors

As with any regulations, the ultimate impact of Basel III will depend upon how it is implemented in the future. Furthermore, the movements of international financial markets are dependent upon a wide variety of factors, with financial regulation being a large component. Nevertheless, it is possible to generalize about some of the possible impacts of Basel III for investors.

It is likely that increased bank regulation will ultimately be a positive for bond market investors. That is because higher capital requirements will ultimately make bonds issued by banks safer investments. At the same time, greater financial system stability will provide a safer backdrop for bond investors, even if the economy grows at a slightly weaker pace as a result. The impact on currency markets is less clear; but increased international financial stability will allow participants in these markets to focus upon other factors while perhaps eventually giving less focus to the relative stability of each country's banking system.

Finally, the effect of Basel III on stock markets is uncertain. If investors value enhanced financial stability more than the possibility of slightly higher growth fueled by credit, stock prices are likely to benefit from Basel III (all else being equal). Furthermore, greater macroeconomic stability will allow investors to focus more on individual company or industry research while having to worry less about the economic backdrop or the possibility of broad-based financial collapse.

Monday, 11th Apr 2016, 09:09:22 AM

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