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BASEL III

BASEL I TO BASEL III

PRESENTERS:IPSITA PRADHANRAKESH BARLAIPSITA SWAIN

What are Basel Norms?Basel is a city in Switzerland. It is the headquarters

of Bureau of International Settlement (BIS), which fosters co-operation among central banks with a common goal of financial stability and common standards of banking regulations.

 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

OverviewJourney from Basel I to Basel IIIWhat is the Basel III framework relating

to.... Definitions of the three pillars and

relationship among the three AmendmentsChallenges in implementation of these

norms Indian scenario

BASEL IIn 1988, BCBS introduced capital

measurement system called Basel capital accord 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).

India adopted Basel 1 guidelines in 1999.

BASEL IIIntroduced in June 2004 The guidelines were based on three parameters,

which the committee calls it as pillars. Capital Adequacy Requirements: Banks should

maintain a minimum capital adequacy requirement of 8% of risk assets

Supervisory Review: Banks were needed to develop and use better risk management techniques

Market Discipline: This need increased disclosure requirements. Banks need to mandatorily disclose their CAR, risk exposure, etc to the central bank.

Drawbacks of Basel II Reducing profitability of small banks and threat

of takeover Lack of comprehensive approach to address risksLack of safety & Inability to strengthen the

stability of financial system Failure to achieve large capital reductions Failure in enhancing the competitive equality

amongst banks The quantity and quality of capital under Basel II

were also deemed insufficient to contain any further risk.

 

OBJECTIVE OF BASEL IIITO MINIMISE THE PROBABILITY OF

REOCCURENCE OF CRISIS TO A LARGE EXTENT

TO IMPROVE BANKING SECTORS ABILITY TO ABSORB SHOCKS ARISING FROM FINANCIAL AND ECONOMIC STRESS

TO IMPROVE RISK MANAGEMENT AND GOVERNANCE

TO STRENGTHTEN BANK”S TRANSPARENCY & DISCLOSURES

What is "Basel III"A global regulatory standard on bank capital adequacy stress testing and market liquidity risk With a set of reform measures to improve Regulation supervision and risk management

BASEL 3In 2010, Basel III guidelines were released 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.

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 ReformsMain Elements

• Banks to hold more and better quality capital

• Banks to carry more liquid assets

• Limit leverage of banks

• Banks to build capital buffers

AmendmentsBasel III will require banks to hold 4.5% of common equity

(up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) of risk-weighted assets (RWA). Basel III also introduces additional capital buffers

(i) a mandatory capital conservation buffer of 2.5% and (ii) a discretionary countercyclical buffer, which allows

national regulators to require up to another 2.5% of capital during periods of high credit growth.

In addition, Basel III introduces a minimum leverage ratio and two required liquidity ratios.  

The leverage ratio is calculated by dividing Tier 1 capital by the bank's average total consolidated assets the banks area expected to maintain the leverage ration in excess of 3%.

The Liquidity Coverage Ratio requires a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days .

The Net Stable Funding Ratio requires the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress

The quality of the 9% capital required is higher. At present, bank capital is split almost evenly between tier 1 and tier 2. Under Basel 3, tier 1 will constitute 7% out of the total 9%.

Banks will be required to have a capital conservation buffer, comprising common equity, of 2.5%. That takes the total capital requirement to 11.5%

Going by the new rules, the predominant component of capital is common equity and retained earnings.

The new rules restrict inclusion of items such as deferred tax assets, mortgage-servicing rights and investments in financial institutions to not more than 15% of the common equity component.

These rules aim to improve the quantity and quality of the capital.

The new norms are based on renewed focus of central bankers on macro-prudential stability, In other words, global regulators are now focusing on financial stability of the system as a whole rather than micro regulation of any individual bank.

Micro- prudential elementsTo minimize the risk contained with individual

institutions The elements are: Definition of capital Enhancing risk coverage of capital leverage ratio International liquidity framework

Macro- prudential elementsT o take care of the issues relating to the systemic risk The elements are: Leverage ratio Capital conservation buffer Countercyclical capital buffer Addressing the procyclicality of provisioning

requirementsAddressing the too- big to- fail problems Addressing reliance on external credit rating agencies. 

 

PILLAR 1 –MINIMUM CAPITAL REQUIREMENTSCALCULATE REQUIRED CAPITAL BASED ONCREDIT RISKMARKET RISKOPERATIONAL RISKThe norms also require banks to maintain

Tier I capital at 7% of risk weighted assets.Tier I capital, or core capital, includes a

bank’s equity capital and disclosed reserves.

Elements of Tier II capital (i) General Provisions and Loss Reserves (ii) Debt Capital Instruments issued by the

banks; (iii) Preference Share Capital Instruments

[Perpetual Cumulative Preference Shares (PCPS) / Redeemable Non-Cumulative Preference Shares

(RNCPS) / Redeemable Cumulative Preference Shares (RCPS)] issued by the banks

(iv) Stock surplus (share premium) resulting from the issue of instruments

TYPES OF RISKCREDIT RISK- Risk of non payment of debtOPERATIONAL RISK-may be defined as the

risk of loss resulting from inadequate or failed internal process, people and systems

MARKET RISK- is the risk of losses due to change in Market Price of an Asset

Foreign exchange and Commodity Risk are part of it

PILLAR 2-SUPERVISORY REVIEW PROCESSIt is intended to ensure that Banks have

sufficient capital to support all risks associated with business.

BANKS SHOULD HAVE STRONG INTERNAL PROCESS

In India RBI has issued the guidelines to the Banks that they must have an internal supervisory process called ICAAP(Internal Capital Adequacy Process)

PILLAR 3-ENHANCED DISCLOSURE

FOCUSES ON INCREASING THE DISCLOSURES THAT BANKS MUST PROVIDE TO INCREASE THE TRANSPARENCY 

PROVIDE MARKET DISCIPLINEINTENDS TO PROVIDE INFORMATION

ON BANKS EXPOSURE TO RISK SUCH AS THE CAPITAL STRUCTURE AND APPROACHES TO ACCESS THE CAPITAL ADEQUACY

Net Stable Funding Ratio (NSFR)Purpose:

Establish minimum acceptable amount of stable funding based on liquidity characteristics of bank’s assets and activities over one-year horizon

Incentivise structural changes in liquidity risk profile of banks away from short-term funding mismatches and toward

More stable, longer-term funding of assets and business activities

Ensure that investment banking inventories, off-balance sheet exposures, securitisation pipelines and other assets and activities are funded with at least minimum amount of stable liabilities in relation to liquidity risk profile of bank

Available Stable Funding must equal or exceed Required Stable Funding

Current ScenarioIndian banks will have to bring in an additional

capital of Rs 5 lakh crore to meet the Basel III norms, RBI Governor D Subbarao said.  The share of equity capital has to be 1.75 lakh crore and non-equity Rs 3.25 lakh crore.

The government, which owns 70% of the banking system, alone will have to pump in Rs 90,000 crore equity to retain its shareholding in the Public Sector Banks (PSBs) at the current level to meet the norms.

He said the government has two options - either to maintain its shareholding at the current level or bring down its shareholding at 51%.

The new norms are to be implemented in a phased manner by banks by March 2018.

Effects of ImplementationStrengthen the capital base and liquidity of banks

thereby promoting a more resilient banking sectorImprove the banking sector’s ability to absorb

shocks arising from financial and economic stressAddressing systemic risk and interconnectednessBanks with Core Tier I less than 7% would be

negatively impacted.It will impact Bank’s profitability and Return on

equity (ROE) Banks will have to hold more long-term funding,

based on the net stable funding ratio that measures the maturity and liquidity of assets on the balance sheet over a one year period

The definition of what counts as tier one will narrow and Assets will have higher Risk Weightings

There will also be additional requirements for large banks deemed vital to the global financial system, so called Systemically Important Financial Institutions (SIFIs)

The current proposed leverage level is 3 percent of core tier one capital. However, the impact of total capital and common equity will be tracked during testing periods

Measures of leverage will be based on gross exposure, instead of on a risk weighted basis

Banks will have to hold enough cash and other easy-to-sell assets to survive a 30 day-crisis, known as the liquidity coverage

Liquidity Coverage RatioRequires bank to maintain unencumbered high-quality

assets sufficient to meet 100% (or more) of net cash outflows over 30-day period under stipulated stress scenario

Liquid assets would include cash and Central bank reserves, to the extent that they can be drawn down in times of stress

Marketable securities representing claims on or claims guaranteed by sovereigns, central banks, non-central government public sector entities (PSEs) and

Debt securities representing claims on non-0% risk weighted sovereigns or central banks issued in domestic currencies in country in which liquidity risk is being taken or in bank’s home country

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Liquidity Coverage Ratio (LCR)

The ratio is intended to ensure that a bank maintains adequate levels of unencumbered high quality assets to meet its liquidity needs.

Measured as the ratio of the bank’s high quality liquid assets (numerator), divided by its net cash outflows over a 30-day period (denominator)

The high quality assets included in the numerator include onlyCash, central bank reserves that can be accessed during times of stress, marketable securities meeting certain criteria, and government or central bank debt

The denominator will be calculated by taking into account certain “run-off factors”

LCR will be introduced as an observation exercise in 2011, and will be imposed as a rule as from 2015.

A global minimum liquidity standard

LCR =High-quality liquid assets

Net Cash Outflow (30 days)

Capital Conservation BufferThe capital conservation buffer (CCB) is designed

to ensure that banks build up capital buffers during normal times (i.e. outside periods of stress) which can be drawn down as losses are incurred during a stressed period. The requirement is based on simple capital conservation rules designed to avoid breaches of minimum capital requirements.

Therefore, in addition to the minimum total of 8% banks will be required to hold a capital conservation buffer of

2.5% of RWAs in the form of Common Equity to withstand future periods of stress

Banks are required to maintain a minimum Pillar 1 Capital to Risk weighted Assets Ratio (CRAR) of 9 % on an on-going basis (other than capital conservation buffer and countercyclical capital buffer).

The Reserve Bank will take into account the relevant risk factors and the internal capital adequacy assessments of each bank to ensure that the capital held by a bank is commensurate with the bank’s overall risk profile.

This would include, among others, the effectiveness of the bank’s risk management systems in identifying, assessing,measuring, monitoring and managing various risks including interest rate risk in the banking book, liquidity risk, concentration risk and residual risk.

Challenges of basel3 implementation

1. Functional challenges

2. Technical challenges

3. Organizational challenges

Functional challenges Developing specifications for the new regulatory

requirements, such as the mapping of positions (assets and liabilities) to the new liquidity and funding categories in the LCR and NSFR calculations.

The specification of the new requirements for trading book positions and within the CCR framework (e.g. CVA) as well as adjustments of the limit systems with regard to the new capital and liquidity ratios .

Crucial is the integration of new regulatory requirements into existing capital and risk management as some measures to improve new ratios (e.g. liquidity ratios) might have a negative effect on existing figures . 

Technical challengesThe technical challenges includes the

availability of data, data completeness, and data quality and data consistency to calculate the new ratios .

The financial reporting system with regard to the new ratios and the creation of effective interfaces with the existing risk management systems .

 

Operational challenges The technical challenges includes the availability of data, data

completeness, data quality and data consistency to calculate the new ratios .

The financial reporting system with regard to the new ratios and the creation of effective interfaces with the existing risk management systems .

Basel III also introduces a non-risk based leverage ratio of 3 percent. Group1 banks are failed in maintaining the this leverage ratio

The banks will experience increased pressure on their Return on Equity ( RoE ) due to increased capital and liquidity costs, which along with increased RWAs will put pressure on margins across all segments 

Increasing NPAs in PSU banks calls for more capital which will lead to selling off Non Core assets

 

Issues relating to SLR and LCR ….India, banks are statutorily required to hold

minimum reserves of high-quality liquid assets at 24% of net demand and time liabilities.

The proportion of liquid assets in total assets of banks will increase substantially, if the SLR reserves are not reckoned towards the LCR (Liquidity coverage ratio) and banks are to meet the entire LCR with additional liquid assets, thereby lowering their income significantly.

RBI is examining to what extent the SLR requirements could be reckoned towards the liquidity requirement under Basel III.

Effect on ProfitabilityThe impact of credit requirements on the

profitability of banks would depend upon sensitivity of lending rates to capital structure of banks and sensitivity of the credit growth to the lending rates.

When banks with low core Tier I shore up their capital to around 9% required, their return on equity ( RoE ) could drop by 1-4%.

Basel III will force banks to plough back a larger chunk of their profit into the balance sheet.

Banks might have to rationalize dividend policies so that more profit could be retained and used as capital, indicating a lower dividend for the government.

Benefits of Implementation…Strengthen the financial system of both

developing and developed countries by addressing the weaknesses in the measurement of risk under Basel II framework revealed during the crisis.

Delivers a much safer financial system with reduced probability of banking crises at affordable costs. The impact of costs is minimized through long phase-in.

It is expected that as the proportion of equity in the capital structure of banks rises, it would reduce the incremental costs of raising further equity as well as non-common equity capital.

Updates The Reserve Bank today hinted at allowing part of

the statutory liquidity ratio (SLR) holdings of banks to be treated as liquid assets under the Basel-III guidelines, which will come into effect next fiscal.

 The global regulators extended deadline for Basel-III compliance by a year to 2019. They also broadened the definition of liquid assets to include shares, retail mortgage-backed securities, among others.

Dr. Subbarao said that effective implementation of Basel III was going to make Indian banks stronger, more stable and sound so that they could deliver value to the real sectors of the economy.

BUDGET 2013Capital infusion of Rs. 14,000 crore in

public sector banks has been proposed which would focus on the need to strengthen the financial services sector and help to meet the stringent requirements under the BASEL III norms,

THANK YOU FOR YOUR TIME AND PATIENT HEARING!!

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