Basel Norms

• issued by Basel Committee on Banking Supervision (BCBS)
• Basel (Switzerland) is HQ for Bureau of International Settlements (BIS)
• BIS promotes cooperation among central banks w/ common goal of financial stability and banking regulatory standards
• Basel Accords: set of agreements by BCBS primarily addressing risks associated w/ banks & financial system
  • accepted by India
  • in fact, RBI has more stringent standards on few parameters than BCBS

Goal of Basel Norms

Ensuring that FI have sufficient capital to meet obligations and absorb expected losses.

Basel I

• introduced capital mgmt system $\to$ Basel Capital Accord 1988
  • India adopted it in 1991
• entirely concerned with credit risk
  • no concern for market & operational risk
• estd. capital and risk weighed structure for bank in form of Capital Adequacy Ratio (CAR 🚗)
• $CAR=\frac{\text{Total Capital}}{\text{Risk Weighted Assets}}$

What are Risk Weighted Assets?

• weighing bank’s assets (i.e. loans) in context of the associated risk
  • eg. credit card loans most risky as they have no security other than promise
  • secured loans safer as collateral can be used to recover loan amount even if borrower does not pay back
• more risk taken by bank $⟹$ more capital needed to protect depositors

• required minimum capital $=$ 8% of RWA
  • but RBI enforces 9%

Types of Capital

Tier I

• bank’s core capital
• primary measure of bank’s financial strength
• very liquid, can be used w/o shutting down operations
• incl. retained earnings
• majority of core capital is made of disclosed reserves, equity
• most of the equity portion will be common equity which will have no conditions attached

Tier II

• used for supplemental funding since less reliable
• incl. undisclosed reserves (from bank owners), preferential shares, subordinate debt

Basel II

• June 2004
• considered to be refined and reformed version of Basel I

Guidelines were formed on 3 pillars:

1. Capital Adequacy Requirements
   • same at 8%, but now considered all 3 risks:
     • credit
     • market
     • operational
2. Supervisory Review
   • banks required to develop & implement better risk mgmt techniques for monitoring & managing all 3 types of risks
3. Market Discipline
   • requires strict disclosure requirements
   • banks must report their CAR, Risk exposure, other info to central bank on regular basis

After 2008 financial crisis & collapse of Lehmann Brothers Bank, the need for better guidelines was seen.

Basel III

• in the wake of Lehmann Brothers collapse & financial crisis, BCBS decided to strengthen norms
• new guidelines intended to promote more resilient banking system, by focusing on 4 critical banking parameters
  • capital
  • leverage
  • funding
  • liquidity
• focus on better capital quality, which came from higher loss absorbing capacity
• also suggested addl. capital conservation buffers and counter cyclical buffers

Capital Conservation Buffer

• banks must hold capital conservation buffer of 2.5%
• focus of this buffer to ensure banks maintain a cushion of capital that can be used to absorb losses during periods of financial & economic stress

Countercyclical Buffer

• introduced w/ objective of:
  • increasing capital requirements during good times
  • decreasing during crisis
  • buffer will slow down banking activities when economy overheats and it’ll encourage lending during crisis
  • buffer will range from 0-2.5% & will consist of common equity or other loss absorbing capital
  • it’s buffer of capital maintained by banks in good times, which may be used to maintain credit flow in difficult times

• will discourage banks from giving too many loans during good economic conditions
  • some of them may become NPA when economic conditions weak
• maintaining CCB will also reduce lending ability of bank
• banks bust set aside CCB so that banks remain adequately capitalized when loans extended by banks start turning into bad loans