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BASEL I to BASEL II to BASEL III


We give below the following definitions of the above risks, for understanding in the discussions which
follows:
1) Credit Risk: Risk that the counterparty will fail to perform or meet the obligation on the agreed
terms. The common types of credit risks are
i.
Transaction Risk: Risk relating to specific trade transactions, sectors or groups.
ii.
Portfolio Risk: Risk arising from concentrated credits to a particular sector / lending to a few
big borrowers/lending to a large group
2) Market Risk: Market risk is the risk to a bank's financial condition that could result from adverse
movements in market price. The types of market risks are:
i.
Interest Rate Risk: Risk felt, when changes in the interest rate structure put pressure on the
net interest margin of the Bank. The various types of interest rate risks are detailed below:
a) Gap/Mismatch risk: It arises from holding assets and liabilities and off balance sheet
items with different principal amounts, maturity dates and re-pricing dates thereby
creating exposure to unexpected changes in the level of market interest rates.
b) Basis risk: It is the risk that the Interest rate of different Assetslliabilities and off balance
items may change in different magnitude. The degree of basis risk is fairly high in respect
of banks that create composite assets out of composite liabilities.
c) Embedded option risk: Option of pre-payment of loan and fore- closure of deposits
before their stated maturities constitute embedded option risk
d) Yield curve risk: Movement in yield curve and the impact of that on portfolio values and
income.
e) Re price risk: When assets are sold before maturities.
f) Reinvestment risk: Uncertainty with regard to interest rate at which the future cash flows
could be reinvested.
g) Net interest position risk: When banks have more earning assets than paying liabilities,
net interest position risk arises in case market interest rates adjust downwards.
ii.
Foreign Exchange or Forex Risk: This risk can be classified into three types.
a) Transaction Risk is observed when movements in price of a currency upwards or
downwards, result in a loss on a particular transaction.
b) Translation Risk arises due to adverse exchange rate movements and change in the level
of investments and borrowings in foreign currency.
c) Country Risk. The buyers are unable to meet the commitment due to restrictions imposed
on transfer of funds by the foreign govt. or regulators. When the transactions are with
the foreign govt. the risk is called as Sovereign Risk.
3) Liquidity Risk: Risk arising due to the potential for liabilities to drain from the Bank at a faster
rate than assets. Liquidity risk for banks mainly manifests on account of the following:
a) Funding Liquidity Risk - the risk that a bank will not be able to meet efficiently the
expected and unexpected current and future cash flows and collateral needs without
affecting either its daily operations or its financial condition.
b) Market Liquidity Risk - the risk that a bank cannot easily offset or eliminate a position at
the prevailing market price because of inadequate market depth or market disruption.
4) Operational Risk arises as a result of failure of operating system in the bank due to certain
reasons like fraudulent activities, natural disaster, human error, omission or sabotage etc.
5) Systemic Risk is seen when the failure of one financial institution spreads as chain reaction to
threaten the financial stability of the financial system as a whole.
6) Business Risk: These are the risks that the bank willingly assumes to create a competitive
advantage n add value to its shareholders. It pertains to the product market in which the bank
operates, n includes technological innovations, marketing n product design. A bank with a pulse on
the market and driven b technology as well as a high degree of customer focus, could be relatively
protected against this risk.
7) Strategic Risk: This risk results from a fundamental shift in the economy or political environment.
Strategic risks usually affect the entire industry and are much more difficult to protect themselves.
A few examples are: the fall of Berlin Wall, Disintegration of Soviet Empire; South East Asian

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Banking Crisis in1997, 2008 Subprime lending crisis, the recent European Economic Crisis; to
name a few.
8) Reputation Risk: Reputation risk is the potential loss that negative publicity regarding an
institution's business practices, whether true or not, will cause a decline in the customer base,
costly litigation, or revenue reductions (financial loss).
PRIOR TO BASEL I SCENARIO:
Basel I norms were introduced only in 1992, and that to in a phased manner over a period of four
years, however, RBI had introduced measures for managing liquidity risk, forex risk and credit
risk (through the Health Code Systems 1985-86) in the Indian banking system.
The Health Code system, inter alia, provided information regarding the health of individual
advances, the quality of the credit portfolio and the extent of advances causing concern in
relation to total advances.
It was considered that such information would be of immense use to banks for control purposes. The
RBI advised all commercial banks (excluding foreign banks, most of which had similar coding
system) on November 7, 1985, to introduce the Health Code System indicating the quality (or
health) of individual advances under the following eight categories, with a health code assigned
to each borrower's account
1. Satisfactory - conduct is satisfactory; all terms and conditions are complied with; all accounts are
in order and safety of the advance is not in doubt.
2. Irregular- the safety of the advance is not suspected, though there may be occasional
irregularities, which may be considered as a short term phenomenon.
3. Sick, viable - advances to units that are sick but viable - under nursing and units for which nursing
revival programmes are taken up.
4. Sick: nonviable/sticky - the irregularities continue to persist and there are no immediate prospects
of regularization and the accounts could throw up some of the usual signs of incipient sickness
5. Advances recalled - accounts where the repayment is highly doubtful and nursing is not
considered worthwhile and where decision has been taken to recall the advance
6. Suit filed accounts - accounts where legal action or recovery proceedings have been initiated
7. Decreed debts - where decrees (verdict) have been obtained
8. Bad and Doubtful debts - where the recoverability of the bank's dues has become doubtful on
account of short-fall in value of security, difficulty in enforcing and realizing the debts.
Under the above Health Code System, the RBI classified problem loans of each bank into three
categories:
Advances classified as bad and doubtful by the bank (Health Code No.8)
Advances where suits were filed/decrees obtained (Health Codes No.6 and 7) and
Those advances with major undesirable features (Health Codes No.4 and 5

Basel I - Accord
The standards are almost entirely addressed to credit risk, the main risk incurred by banks. The
document consists of two main sections, which cover
a) The definition of capital and
b) The structure of risk weights.

Based on the Basle norms, the RBI also issued similar capital adequacy norms for the Indian
banks. According to these guidelines, the banks will have to identify their Tier I and Tier-II
capital and assign risk weights to the assets.
Having done this they will have to assess the Capital to Risk Weighted Assets Ratio (CRAR).
Tier-I Capital Comprises
a) Paid-up capital
b) Statutory Reserves
c) Disclosed free reserves
d) Capital reserves representing surplus arising out of sale proceeds of assets
*Equity investments in subsidiaries, intangible assets and losses in the current period and those
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brought forward from previous periods will be deducted from Tier I capital comprises
Tier-II Capital
a) Undisclosed Reserves and Cumulative Perpetual Preference Shares
b) Revaluation Reserves
c) General Provisions and Loss Reserves
Basel I, that is, the Basel Accord 1988, is primarily focused on credit risk and appropriate risk-weighting of
assets (RWAs).
The notional amount of the asset is multiplied by the risk weight assigned to the asset to arrive at the risk
weighted asset number.
Under this system Assets of banks were classified and grouped in five categories according to credit risk.

This classification system grouped a bank's assets into five risk categories:
1) 0% - cash, central bank and government debt and any OECD government debt
2) 0%, 10%, 20% or 50% - public sector debt
3) 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
4) 50% - residential mortgages
5) 100% - private sector debt, non-OECD bank debt (maturity over a year), real estate, plant and
equipment, capital instruments issued at other banks

According to Basel -1 norms Banks are required to hold capital equal to 8% of their riskweighted 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. For example, if a bank
has risk-weighted assets of 100 million, it is required to maintain capital of at least 8 million.
India adopted Basel 1 guidelines in 1999. Banks are also required to report off-balance-sheet
items such as letters of credit, Bills of Exchange, and derivatives etc
The 1988 Accord has been supplemented a number of times, with most changes dealing with
the treatment of off-balance-sheet activities.
A significant amendment was enacted to Basel-I in 1996, when the Committee introduced a
measure whereby trading positions in bonds, equities, foreign exchange and commodities were
removed from the credit risk framework

Basel-I Indian Experience:

According to Section 17 of the Banking Regulation Act (1949) every bank incorporated in India is
required to create a reserve fund and transfer a sum equal to but not less than 20 per cent of its
disclosed profits, to the reserve fund every year(Currently it is 25 %)
The RBI has advised banks to transfer 25 percent and if possible, 30 per cent to the reserve fund.
The First Narasimham Committee Report recommended the introduction of a Capital to RiskWeighted Assets Ratio (CRAR) system for banks in India since April 1992.
It was stipulated that foreign banks operating in India should achieve a CRAR of 8 per cent by
March 1993 while Indian banks with branches abroad should comply with the norm by March 1995.
All other banks were to achieve a capital adequacy norm of 4 per cent by March 1993 and the 8 per
cent norm by March 1996.
In its mid-term review of Monetary and Credit Policy in October 1998, the RBI raised the
minimum regulatory CRAR requirement to 9 per cent, and banks were advised to attain this level
by March 31, 2009.
The RBI responded to the market risk amendment of Basel I in 1996 by initially prescribing
various surrogate capital charges such as investment fluctuation reserve of 5 per cent of the
bank's portfolio and a 2.5 per cent risk weight on the entire portfolio for these risks between
2000 and 2002.

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Advantages of Basel I
Substantial increases in capital adequacy ratios of internationally active banks;
Relatively simple structure;
Worldwide adoption;
Increased competitive equality among internationally active banks;
Greater discipline in managing capital;
A benchmark for assessment by market participants.
Weaknesses of Basel I
In spite of advantages and positive effects, weaknesses of Basel I standards eventually became evident:
Capital adequacy depends on credit risk, while other risks (e.g. market and operational) are excluded
from the analysis;
In credit risk assessment there is no difference between debtors of different credit quality and rating;
Emphasis is on book values and not market values;
Inadequate assessment of risks and effects of the use of new financial instruments, as well as risk
mitigation techniques.
*Some of the weaknesses of Basel I, especially those related to market risk, were over bridged by the
amendment to recommendations from 1993 and 1996, by means of introducing capital requirements
for market risk.

BaselII Accords

Basel II
On June 26, 2004, The Basel Committee on Banking Supervision (BCBS) released "International
Convergence of Capital Measurement and Capital Standards: A revised Framework", which is
commonly known as Basel II Accord.
Basel 1 initially had Credit Risk and afterwards included Market Risk.
In Basel 2, apart from Credit & Market Risk; Operational Risk was considered in Capital
Adequacy Ratio calculation. The Basel 2 Accord focuses on three aspects and based on 3 pillars
1) Minimum Capital Requirement
2) Supervisory Review by Central Bank to monitor bank's capital adequacy and internal
assessment process.
3) Market Discipline by effective disclosure to encourage safe and sound banking practices

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Pillar 1: Minimum Regulatory Capital


The calculation of Minimum Regulatory Capital is extension of 1988 Basel Accord.
Basel II also considers Operational Risk apart from Credit & Market Risk.
Another major difference between Basel 1 and Basel II is inclusion of flexibility in approaches
for Risk Weighted Assets Calculation.
For calculation of Capital to Risk weighted Asset Ratio (CRAR), the formulae are similar to
BASEL 1 accord.
Total CRAR = [Eligible total capital funds]/ [Credit RWA + Market RWA + Operational
RWA]
Tier I CRAR = [Eligible Tier I capital funds]/ [Credit RWA* + Market RWA + Operational
RWA]
RWA*Means Risk Weighted Assets
*Basel 2 has recommended at least 8% CRAR and 4% Tier 1 CRAR, whereas RBI has given
guidelines for at least 9% CRAR and 6% Tier 1 CRAR.
So calculation of CRAR is dependent on two major factors
1) Eligible Total Capital Funds
2) Risk Weighted Assets
Eligible Capital: The eligible capital includes Tier 1 (core) capital and Tier 2 (additional or
supporting) capital. Tier 1 capital is more stable and risk absorbing than Tier 2 capital.
Main components of Tier 1 & Tier 2 capital are:
Tier 1 Capital
1. Paid up Capital, Statutory

Tier 2 Capital

1. Revaluation Reserve (at a discount


of 55%)
2. General Provision & Loss Reserves

Reserves, disclosed free reserves


2. Capital Reserve (E.g. Surplus from
sales of assets)
3. Hybrid Debt Capital Instruments:
3. Eligible Innovative Perpetual Debt
Instruments(IPDI)- upto 15% of Tier Eg. Perpetual Cumulative Preference
1 Capital
Shares, Redeemable Non-Cumulative
Preference Share, Redeemable
Cumulative Preference Share
4. Subordinate Debt: fully paid up,
4. Perpetual Non-Cumulative
unsecured, subordinated to other
Preference Shares (PNPS) - 3 & 4
can be max 40% of Tier1
creditors, free of restrictive clauses
5. Remaining IPDI & PNPS from Tier1
Capital

Risk Weighted Assets: Another Important aspect in calculation of CRAR is calculation of


Risk weighted assets.
Basel II gives advantage to the banks with better asset quality and advanced system. The
capital requirement reduces with better asset quality as lesser risk weights can be assigned to
good assets.
The various approaches for calculation of Risk Weighted Assets calculation are:

Type of Risk/
Approach
Credit Risk

Market Risk
Operational Risk

Simple to Most Sophisticated & Advanced Approach


Standardized
Approach
Standardized
Approach
Basic Indicator
Approach

Foundation Internal
Rating Based
Approach
Internal Model
Approach
Standardized
Approach

Advanced Internal
Rating Based
Approach

Advanced
Measurement
Approach

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Credit Risk Assessment


Unlike Basel 1, BCBS have devised three approaches for calculation of credit risk weighted assets:

a) Standardized Approach to Credit Risk:

The standardized approach has fixed risk weights corresponding to various risk category
based on ratings given by approved external credit rating agencies.
The risk weights vary from 0% to 150% based on the risk category.
Unrated loans have 100% risk weights.
Standardized approach has increased risk sensitivity by considering expanded range of
collateral, guarantees and credit derivatives.
The risk weights for residential mortgage exposure were reduced in comparison to Basel 1
Accord.

b) Foundation Internal Rating Based Approach:

In Internal Rating Based Approach, credit risk is measured on basis of internal ratings given
by the banks rather than external credit rating agencies.
The ratings are based on the risk characteristics of both the borrower and the specific
transaction.
Expected loss is calculated based on probability of default (PD) of borrower, loss given
default (LGD), bank's exposure at default (EAD) and remaining Maturity (M) of exposure
Probability of default (PD) measures the likelihood that the borrower will default over a given
time horizon.
Loss Given Default (LGD) measures the proportion of the exposure that will be lost if Default
occurs.
Exposure at Default (EAD) is estimated amount outstanding in a loan commitment if default
occurs.
Maturity (M) measures the remaining economic maturity of the exposure.
There are two types of losses- Expected and Unexpected. Expected Loss, which is normal
business risk of a bank, is a multiplication of PD, LGD, EAD and M.
Expected Loss= PD x LGD x EAD x M
Unexpected Loss is that part of credit risk that cannot be priced in the product and hence the
banks have to provide capital for it by risk weighing their assets.
Unexpected Loss is the upward variation in expected loss over a definite time horizon.
Unexpected Loss (UL) may be expressed as under:
UL = Ex LGD x Standard Deviation of PD.
In Foundation IRB, PD is calculated by the bank and the remaining are based on
supervisory values set by Basel Committee or RBI (in India)

c) Advanced Internal Rating Based Approach:

Advanced IRB is advanced version of foundation IRB. The only difference is that Loss Given
Default, Exposure at Default and Maturity are also estimated by the bank based on the
historical data.
Data Input/
Approach
1. Probability at
Default
2. Loss Given
Default
3. Exposure at
Default
4.Maturity

Credit Risk Assessment Approaches


Standardized
Foundation IRB
Approach
Provided by bank based on own
estimates
Supervisory values set by Basel
Committee
Supervisory values set by Basel
Predicted by
Committee
External Credit Supervisory values set by the
Rating Agency Committee or at National
discretion provided by bank
based on own estimates.

Advanced IRB
Estimated by Bank based on
historical records
Provided by bank based on
own estimates
Provided by bank based on
own estimates
Provided by bank based on
own estimates

5. Data
Historical Data for past 7
Data
of 5 years
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Operational Risk Assessment:

"Risk of direct or indirect loss resulting from inadequate or failed internal control processes,
people, and systems or from external events"
Such breakdowns can lead to financial losses through Error, Fraud, Failure to perform in a
timely manner, may cause the interest of the bank to be compromised like exceeding authority,
conducting business in an unethical or risky manner.
It is the risk of loss arising from the potential that inadequate information system; technology
failures, breaches in internal controls, fraud, unforeseen catastrophes, or other operational
problems may result in unexpected losses or reputation problems
The Basel II Accord has 3 methods of calculating risk weighted assets with increase in
sophistication and risk sensitivity
(a) The Basic Indicator Approach (BIA); (b) the Standardized Approach (TSA); and
(c) Advanced Measurement Approaches (AMA).

a) Basic Indicator Approach:

Under this approach banks must hold capital for operational risk equal to the average over
the previous three years of a fixed percentage (denoted as alpha) of positive annual gross
income.
Figures for any year in which annual gross income is negative or zero, should be excluded
from both the numerator and denominator when calculating the average.

b) The Standardized Approach:

In this approach, banks' activities are divided into eight business lines: corporate finance,
trading & sales, retail banking, commercial banking, payment & settlement, agency
services, asset management, and retail brokerage.
The capital charge for each business line is calculated by multiplying gross income by a
factor (denoted beta-B as 12, 15 and 18) assigned to that business line. The sum of gross
income of all business line should be equal to gross income of the bank
Alternative Standardized Approach: ASA is a special variant of TSA. The approach of
calculation of capital charge is same as TSA except for two business lines- retail &
commercial banking.
For these business lines, loans and advances multiplied by a fixed factor 'm' - replaces gross
income as the exposure indicator.
The betas for retail and commercial banking are unchanged from the Standardised
Approach.

c) Advanced Measurement Approach:

Under the AMA, the regulatory capital requirement will equal the risk measure generated by
the bank's internal operational risk measurement system (ORMS).
After these criteria have been satisfied, the operational risk capital charge is computed from the
unexpected loss of VaR (Value at Risk) at the 99.9 percent confidence level over one year
horizon provided the expected loss is accounted for through provisions.

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A bank should calculate its regulatory operational risk capital requirement as the sum of
expected loss (EL) and unexpected loss (UL).
Expected Loss is covered by provisions & pricing and Unexpected loss through additional
capital.

Market Risk Assessment:


Market risk is potential for loss resulting from adverse movement in market risk factors
such as interest rates, forex rates, currency valuations, equity prices and commodity prices.
In Basel 2, market risks are divided into two major risks: interest rate risk and volatility
risk. Therefore there is a clear distinction between fixed income and other products such as
equity, commodity and foreign exchange vehicles. The approaches to calculate market risk
in capital charge are:

a) Standardized Approach:

Under the standardized method there are two principal methods of measuring market risk, a
"maturity" method and a "duration" method.
As "duration" method is a more accurate method of measuring interest rate risk, RBI has
adopted standardized duration method to arrive at the capital charge. For interest rate risk,
depending on the time to maturity/ duration of the fixed income asset, Basel II had
recommended banks to hold capital between 0% and 12.5% of an asset's value to protect
against movements in interest rates.
To guard against the volatility risk of fixed income assets, Basel II recommends risk
weightings tied to the credit risk ratings given to underlying bank assets.

b) Internal risk management Models Approach:

In this methodology banks are encouraged to develop their own internal models to calculate
a stock, currency, or commodity's market risk on a case-by-case basis.
In this banks have to develop their measures to calculate "Value of Risk" (VaR) based on 5
years data on position to position basis. On the basis of Bank's calculation, capital requirements
are predicted. Similar to other advanced measures RBI will supervise this method.

Pillar 2: Supervisory Review:


Basel II had given powers to the regulators to supervise and check bank's risk management
system and capital assessment policy. The regulators can also ask for buffer capital apart from
minimum capital requirement by BCBS.
RBI has asked for 9% CRAR, which is more than 8% prescribed by BCBS . Regulators are
given the power to oversee the internal risk evaluation regimes proposed in Pillar I.

Pillar 3: Market Discipline


The Pillar III had made disclosure of a bank's risk taking positions & capital, mandatory. This
step was targeted to introduce market discipline through disclosure.
Basel II Experience of Indian Banking Industry
In February 2005, RBI issued the first draft guidelines on Basel 2. Initially Basel II implementation
target was set for March 2007 but later on postponed.
RBI had implemented Basel 2 standardized approach (for credit & market risk) and basic
indicator approach in Internationally active banks by March 2008 and other scheduled
commercial banks by March 2009.
RBI has set a standard of minimum 9% CRAR in comparison to minimum 8% CRAR.
Similarly BCBS had set minimum Tier 1 CRAR requirement at 4.5% but RBI has given a
target of 6%.
That means RBI has always took conservative view and set Capital Adequacy standards more
than International Requirements.

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Basel III-Norms

In 2010, Basel III guidelines were released. These guidelines were introduced in response to the
financial crisis of 2008.
These guidelines aim to promote a more resilient banking system by focusing on four vital banking
parameters viz. capital, leverage, funding and liquidity.
Implementation of Basel III regulations: To facilitate implementing Basel norms process, the Basel
Committee adopted in 2012 a comprehensive Regulatory Consistency Assessment
Programme (RCAP).
However they were criticized by some for allowing banks to take on additional types of risk, which
was considered part of the cause of the US subprime financial crisis that started in 2008.
Basel III Capital Regulations are being implemented in India with effect from April 1, 2013 in a
phased manner and it will be fully implemented as on March 31, 2019.
Further, RBI also introduced Basel III Liquidity Coverage Ratio (LCR) to be implemented by
banks in India from January 1, 2015 with full implementation being effective from January 1,
2019.
RBI also issued draft guidelines on implementation of Net Stable Funding Ratio (NSFR).

Major Changes Proposed in Basel III


(a) Better Capital Quality: One of the key elements of Basel 3 is the introduction of much stricter
definition of capital. Better quality capital means the higher loss-absorbing capacity.
(b) Capital Conservation Buffer: Another key feature of Basel III is that now banks will be required
to hold a capital conservation buffer of 2.5%. The aim of asking to build conservation buffer is to
ensure that banks maintain a cushion of capital that can be used to absorb losses during periods of
financial and economic stress.
(c) Countercyclical Buffer: The countercyclical buffer has been introduced with the objective to
increase capital requirements in good times and decrease the same in bad times. The buffer will
slow banking activity when it overheats and will encourage lending when times are tough i.e. in bad
times. The buffer will range from 0% to 2.5%, consisting of common equity or other fully lossabsorbing capital.
(d) Minimum Common Equity and Tier 1 Capital Requirements: The minimum requirement for
common equity, the highest form of loss-absorbing capital, has been raised under Basel III from 2% to
4.5% of total risk-weighted assets. The overall Tier 1 capital requirement, consisting of not only
common equity but also other qualifying financial instruments, will also increase from the current
minimum of 4% to 6%. Although the minimum total capital requirement will remain at the
current 8% level, yet the required total capital will increase to 10.5% when combined with the
conservation buffer.
(e) Leverage Ratio: A review of the financial crisis of 2008 has indicted that the value of many assets
fell quicker than assumed from historical experience. Thus, now Basel III rules include a leverage ratio
to serve as a safety net. A leverage ratio is the relative amount of capital to total assets (not riskweighted). This aims to put a cap on swelling of leverage in the banking sector on a global basis.
3% leverage ratio of Tier 1 will be tested before a mandatory leverage ratio is introduced in
January 2018.
(f) Liquidity Ratios: Under Basel III, a framework for liquidity risk management will be created.
A new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are to be introduced
in 2015 and 2018, respectively.
(g) Systemically Important Financial Institutions (SIFI): As part of the macro-prudential framework,
systemically important banks will be expected to have loss-absorbing capability beyond the Basel
III requirements. Options for implementation include capital surcharges, contingent capital and bail-indebt.

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10

Comparison of Capital Requirements under Basel II and Basel III :


Requirements

Under Basel II Under Basel III

Minimum Ratio of Total Capital To RWAs

8%

10.50%

Minimum Ratio of Common Equity to RWAs

2%

4.50% to 7.00%

Tier I capital to RWAs

4%

6.00%

Core Tier I capital to RWAs

2%

5.00%

Capital Conservation Buffers to RWAs

None

2.50%

Leverage Ratio

None

3.00%

Countercyclical Buffer

None

0% to 2.50%

Minimum Liquidity Coverage Ratio

None

To be Decided (2015)

Minimum Net Stable Funding Ratio

None

To be Decided (2018)

Systemically important Financial Institutions Charge None

To be Decided

Transitional Arrangements-Scheduled Commercial Banks


(excluding LABs and RRBs)

(% of RWAs)
March March March
31,
31,
31,
2017
2018
2019
5.5
5.5
5.5

April
1,
2013
4.5

March
31,
2014
5

March
31,
2015
5.5

March
31,
2016
5.5

0.625

1.25

1.875

2.5

Minimum CET1+ CCB

4.5

5.5

6.125

6.75

7.375

Minimum Tier 1 capital

6.5

Minimum Total Capital*

Minimum Total Capital +CCB

9.625

10.25

10.875

11.5

20

40

60

80

100

100

100

Minimum capital ratios


Minimum Common Equity Tier 1 (CET1)
Capital conservation buffer (CCB)

Phase-in of all deductions from CET1

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11

Types of
Risk
Covered

Main tools
of Risk
Manageme
nt

Comparative Analysis Basel 1, 2 & 3 at a glance


Basel 1
Basel 2
Credit Risk
Credit Risk,
Market Risk
Market Risk &
Operational Risk

Capital to Risk 1. CRAR


Weighted
2. Supervisory Review
Assets Ratio 3. Market Discipline
(CRAR)

Ways of
Simple but
Calculation
standard
of Risk
Weighted 4 major risk
Assets and
categories of
CRAR
assets and
risk weights
according to
it

From Simple to Complex & flexible


Approach
Lesser
Risk
Weights
in
Complex
Approaches
Type of Method 1
Method 2
Method 3
Risk
Credit
Standardize Foundation Advanced
Risk
d Approach Internal
Internal
Rating
Rating
Based
Based
Market
Standardize Internal Model Approach
Risk
d Approach
Operation Basic
Standardize Advanced
al
Indicator
d Approach Measurem
Approach Approach
ent
Approach
Major
First
1. Covered Operational risk apart from credit &
market risk
Contributio International
Measure
to 2. Recognized differentiation & brought flexibility
n
cover banking 3. Better asset quality helped banks to reduce
risk
Capital Requirements

Basel 3
Credit Risk
Market Risk
Operational Risk
Liquidity Risk
Counter Cycle Risk
1.CRAR
2.Supervisory Review
3.Market Discipline
4.Liquidity Coverage
Ratio
5.Counter
cycle
Buffer
6.Capital
Conservation
Buffer
7.Leverage Ratio
Same as Basel 2 but
additional capital for
Capital Conservation
& Contra Cyclical
Buffer

Liquidity
Risk
Management
Will help to build
capital during good
time, which can be
used in stressed
situation by Counter
Cycle Buffer
Introduction
of
Capital
Conservation
Buffer

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Limitations Too simple


to cover all
risks
Banks had to
raise
additional
capital

Minimum
CRAR
according
to BCBS

CRAR= 8%

Minimum
CRAR
according
to RBI
Introductio
n

CRAR= 9%

Implement
ation in
India: Time
line

1988:
Risk
1996:
Risk
1994

1. Additional Capital requirement for Op. Risk


2. Higher capital requirement in stressed situation
as asset quality reduces. Capital markets also dry
at that time.
3. High costs for up gradation of technology,
disclosure & information system
4. Increased supervisory review required in case of
advanced approaches
5. Subprime crises exposed the inadequate credit &
liquidity risk covers of banks
CRAR= 8%
Tier 1= 4%

CRAR= 9%
Tier 1= 6%
Common Equity= 3.6%
GOI recommended CRAR for PSU= 12%
Credit 2004

Requirement
of
additional CRAR
between 2.5% to
5%
Increased
requirement
of
common
equity
share capital also.
CRAR= 10.5% TO
13%
Tier 1= 6%
Common
Equity=
4.5%
CRAR= 11.5%
Tier 1 = 7%
Common
Equity=
5.6%
2010

Market
First Phase: 2008: Foreign Banks in India, Indian 2013 to 2018
Banks with presence outside India: Basic phased manner
Approaches
Second Phase:2009: Other Scheduled Commercial
Banks
Till 2014: Complete Implementation

Basel-III ratios as prescribed by RBI in India


(i)
(ii)
(iii)
(iv)
(v)
(vi)
(vii)
(viii)

Regulatory Capital
Minimum Common Equity Tier 1 ratio
Capital conservation buffer (comprised of
Common Equity)
Minimum Common Equity Tier 1 ratio plus
capital conservation buffer [(i)+(ii)]
Additional Tier 1 Capital
Minimum Tier 1 capital ratio [(i) +(iv)]
Tier 2 capital
Minimum Total Capital Ratio (MTC) [(v)+(vi)]
Minimum Total Capital Ratio plus capital
conservation buffer [(vii)+(ii)]

As % to RWAs
5.5
2.5
8.0
1.5
7.0
2.0
9.0
11.5

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Some Important Basel III Ratios Explained

Counter-cyclical buffer/provision:
o The above provision guidelines are based on the model followed by Spanish
banks that fared better during the recent financial crisis by adhering to this
provision approach.
o For example, in the second half of 2008, in India, the Banks shied away from
lending (credit crunch) triggered by the psychological effect of global financial
crisis, which led to negative effect of our economy and caused major downturn
in the Sensex (From 20,900 as of February, 2008, the Sensex came down to 8,300
in March 2009). The sectors most affected were Realty, Automotive, Textile and
IT.
o Further a downturn in the economy generally leads to deterioration of asset
quality of the Banks, which causes increase in the NPA levels of the Banks. To
overcome this only, RBI had come out with special dispensation of restructuring
of the loans for the sectors, which suffered due to macroeconomic fundamental,
which is outside the control of the borrowers.
o Higher NPA leads to creation of increased provision by banks. To avoid this,
Banks would slow down their lending. In fact, the higher provisioning for NPA
has led to several PSBs showing loss in their financials for the Quarter ended
December, 2015. Such a situation would further tighten the credit, which would
lead to deteriorating borrowers financial position, thus making the general
economy still worse.
o At the peak of the business cycle (boom), the borrowers performances would be
good and the Banks NPA would also be low. Most of the corporates make profit
in their business.
o In the boom time, the Banks tend to reduce the provisions because of lower
NPAs, ease credit terms and expand their loan book. The economy is pushed
into the fast economic growth (leads to high GDP growth).
o The easy credit approach during the boom period results in poor loan selection
(example of Sub-Prime crisis), leading to higher NPAs when the cycle turns into
recession.
o The result is that the Banks actions tend to further amplify the cycle (boom
leading to more boom and recession leading to further recession).
o The alternative for this is recommended in the form of countercyclical
provisioning approach under which, banks build their reserves during good times
when their earnings are high and the accumulated reserves can be used during
the economic slow down.
o One more argument in favor of this provision is that:
During the boom, the loans made are generally poorer in quality requiring
more provision.
The loans made during recession are of superior quality as banks are very
careful and hence need lesser provision.

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o The creation of Capital Conservation Reserve provision is more forward looking


based on expected loss method (EL) rather than the current incurred loss
provisioning model. These concepts would come very handy, when banks adopt
IndAS by March, 2018 as proposed by the Ministry of Corporate Affairs,
Government of India.

Leverage Ratio:
Besides the above, BCBS has also introduced one more ratio called Leverage Ratio.
An underlying cause of the global financial crisis was the build-up of excessive onand off-balance sheet leverage in the banking system. In many cases, banks built up
excessive leverage while apparently maintaining strong risk-based capital ratios.
During most severe part of the crisis, the banking sector was forced by the market to
reduce its leverage in a manner that amplified downward pressure on asset prices.
This deleveraging process exacerbated the feedback loop between losses, falling
bank capital and contraction in credit availability. Therefore, under Basel III, a
simple, transparent, non-risk based leverage ratio has been introduced. The leverage
ratio is calibrated to act as a credible supplementary measure to the risk based
capital requirements and is intended to achieve the following objectives:
Act as a Check on the build-up of leverage in the banking sector to avoid
destabilising and deleveraging processes which can damage the broader financial
system and the economy;
Reinforce the risk-based requirements with a simple, non-risk based backstop
measure.
The Basel III leverage ratio is defined as the capital measure (the numerator) divided
by the exposure measure (the denominator), with this ratio expressed as a
percentage.
Capital Measure
Leverage Ratio =-------------------------Exposure Measure
The BCBS will use the revised framework for testing a minimum Tier 1 leverage ratio
of 3% during the parallel run period up to January 1, 2017. The BCBS will continue to
track the impact of using either Common Equity Tier 1 (CET1) or total regulatory
capital as the capital measure for the leverage ratio. The final calibration, and any
further adjustments to the definition, will be completed by 2017, with a view to
migrating to a Pillar 1 treatment on January 1, 2018. Currently, Indian banking
system is operating at a leverage ratio of more than 4.5%. The final minimum
leverage ratio will be stipulated by RBI taking into consideration the final rules
prescribed by the BCBS by end-2017. In the meantime, these guidelines will serve as
the basis for parallel run by banks and also for the purpose of disclosures as outlined
by RBI. During this period, Reserve Bank will monitor individual banks against an
indicative leverage ratio of 4.5% to curb the build-up of excessive on and off-balance
sheet leverage in the banking system. (Source: RBI).

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Liquidity Risk: BCBS had observed that one of the factors for the recent financial
crises were due to inaccurate and ineffective management of liquidity risk. To
overcome this, BCBS had come out with two ratios Liquidity Coverage Ratio and
Net Stable Funding Ratio (NSFR).
o The Liquidity Coverage Ratio (LCR): This ratio ensures enough liquid assets to
survive an acute stress scenario lasting for 30 days.
o The objective of the LCR is to promote the short-term resilience of the liquidity
risk profile of the banks. This is done by ensuring that banks have an adequate
stock of unencumbered high-quality assets (HQLA) that can be converted easily
and immediately in private markets into cash to meet their liquidity needs for a
30 calendar day liquidity stress scenario. (Source BIS).
o This ratio is introduced from 1st January 2015, after an observation period
beginning in 2011.
o The LCR would be binding on banks from January 1, 2015; with a view to provide
a transition time for banks, the LCR requirement would be minimum 60% for the
calendar year 2015, i.e. with effect from January 1, 2015 and rise in equal steps
to reach 100% on January 1, 2019, as per the time-line given below by RBI.

Minimum
LCR

January 1
2015

January 1
2016

January 1
2017

January 1
2018

January 1
2019

60%

70%

80%

90%

100%

o The formula for arriving at LCR is given below:


LCR = (Stock of HQLA / Total Net Cash Outflows over the next 30 calendar
days) x 100.
It should be minimum 100% or above 100% subject to timelines given by
RBI as above.
o RBI vide its circular of February, 2016 also relaxed the maintenance of HQLA by
the Banks. Presently, the assets allowed as the Level 1 High Quality Liquid Assets
(HQLAs) for the purpose of computing the LCR of banks, inter alia, include
Government securities in excess of the minimum SLR requirement, and within
the mandatory SLR requirement, Government securities to the extent allowed by
RBI, under Marginal Standing Facility (MSF) [presently 2 per cent of the banks
NDTL] and under Facility to Avail Liquidity for Liquidity Coverage Ratio (FALLCR)
[presently 5 per cent of the banks NDTL]. RBI has, in addition to the abovementioned assets, permitted banks to reckon government securities held by
them up to another 3 per cent of their NDTL under FALLCR within the mandatory
SLR requirement as level 1 HQLA for the purpose of computing their LCR. Hence
the total carve-out from SLR available to banks would be 10 per cent of their
NDTL. (Source: RBI)

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o The Net Stable Funding Ratio (NSFR): This ratio aims at promoting medium to
long term structure funding of assets and activities of the Banks. BCBS aims to
trial this ratio from 2012 and makes it mandatory in January 2018.
o RBI released its Draft guidelines on NSFR on May 28, 2015. The objective of
NSFR is to ensure that banks maintain a stable funding profile in relation to the
composition of their assets and off-balance sheet activities. A sustainable
funding structure is intended to reduce the probability of erosion of a banks
liquidity position due to disruptions in its regular sources of funding that would
increase the risk of its failure and potentially lead to broader systemic stress. The
NFSR limits overreliance on short-term wholesale funding, encourages better
assessment of funding risk across all on- and off-balance sheet items, and
promotes funding stability. The Reserve Bank proposes to make NFSR applicable
to banks in India from January 1, 2018. (Source RBI).
o Definition of the Standard Net Stable Funding Ratio =
(Available Stable Funding (ASF))/Required Stable Funding (RSF)) x 100 =
Should be 100% or above.

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Minimum capital conservation standards for individual bank
Table below shows the minimum capital conservation ratios a bank must meet at
various levels of the Common Equity Tier 1 capital ratios.
Table 24: Minimum capital conservation standards for individual bank
Common Equity Tier 1
Minimum Capital Conservation Ratios
Ratio after including the
(expressed as a percentage of earnings)
current periods retained
earnings
5.5% - 6.125%
100%
>6.125% - 6.75%
80%
>6.75% - 7.375%
60%
>7.375% - 8.0%
40%
>8.0%
0%
For example, a bank with a Common Equity Tier 1 capital ratio in the range of
6.125% to 6.75% is required to conserve 80% of its earnings in the subsequent
financial year (i.e. payout no more than 20% in terms of dividends, share buybacks
and discretionary bonus payments is allowed).

The Tier 1 Capital should be in the nature of Going-Concern Capital, i.e., Capital
which can absorb losses without triggering bankruptcy of the Bank.
The Tier 2 Capital should be in the nature of Gone-Concern Capital, i.e., capital
which would absorb losses only in a situation of liquidation of the Bank.

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