Basel-3

Basel, named after a city in Switzerland, where the Bureau of International Settlements (BIS) is situated.

Its goal is to help its member banks to foster their financial stability.

From 1965 to 1981 there were about eight bankruptcies in the United States.

Bank failures were particularly prominent during the '80s, a time which is usually referred to as the “savings and loan crisis."

This was because the Banks throughout the world were lending extensively, while countries' external indebtedness was growing at an unsustainable rate.

To prevent this risk, BIS launched the Basel Committee on Banking Supervision (BCBS).

It comprised of central banks and supervisory authorities of 10 countries (Belgium, Canada, France, Germany, Italy, Japan, Luxemburg, Netherlands, Spain, Sweden, Switzerland, UK, US) which met in 1987 in Basel, Switzerland for the first time

The committee drafted a first document to set up an international 'minimum' amount of capital that banks should hold.

This minimum is a percentage of the total capital of a bank, which is also called the minimum risk-based capital adequacy.

In 1988, the Basel I Capital Accord (agreement) was created. The Basel II Capital Accord follows as an extension of the former, and was

implemented in 2007.

Algeria Argentina Australia Austria Belgium Bosnia and Herzegovina Brazil Bulgaria Canada Chile China Croatia The Czech Republic Denmark Estonia Finland France Germany Greece

Hong Kong SAR Hungary Iceland

India Indonesia, Ireland Israel Italy Japan Korea Latvia Lithuania The Republic of Macedonia Malaysia Mexico the Netherlands New Zealand Norway

the Philippines Poland Portugal Romania Russia Saudi Arabia Singapore Slovakia Slovenia South Africa Spain Sweden Switzerland Thailand Turkey The United Kingdom The United States The European Central Bank

LIST OF MEMBER CENTRAL BANKS

Basel II was intended :– To create an international standard for banking regulators.– To maintain sufficient consistency of regulations.– Protect the international financial system.

Addition of operational risk in the existing norms.

Defined new calculations of credit risk.

Ensuring that capital allocation is more risk sensitive.

Basel II Norms

1. Better Evaluation of Risks.

2. Better Allocation of resources.

3. Supervisors should review each bank’s own risk assessment and capital strategies.

4. Improved Risk management.

5. To strengthen international banking systems.

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Objectives of BASEL II

STRUCTURE OF BASEL II

Pillar 1- Minimum Capital Requirements

Calculate required capital. Required capital based on:-

Market risk. Credit risk. Operational risk. Used to monitor funding concentration.

Pillar 2- Supervisory Review Process

Bank should have strong internal process.

Adequacy of capital based on risk evaluation.

Pillar 3 – Enhanced Disclosure

Provide market discipline.

Intends to provide information about banks exposure to risk.

Banks defined their own risk metrics and derivative investments

Depends on good underlying data

Most of the institutional cogs in the credit crisis aren’t covered

No independent standard.

Wrong assumptions in case of mortgage-related risk calculations.

Inadequate level of capital required by the new discipline

Failure of BASEL II

The quality of capital.

Pro-cyclicality.

Liquidity risk.

Systemic banks.

Weaknesses of Basel II

The G20 endorsed the new ‘Basel 3’ capital and liquidity requirements.

Extension of Basel II with critical additions, such as a leverage ratio, a macro prudential overview and the liquidity framework.

Basel III accord provides a substantial strengthening of capital requirements.

Basel III will place greater emphasis on loss-absorbency capacity on a going concern basis

The proposed changes are to be phased from 2013 to 2015

The creation of a conservation buffer could be set up by banks during the period January 2016 to 2019. 14

BASEL III ACCORD

Special emphasis on the Capital Adequacy Ratio◦ Capital Adequacy Ratio is calculated as – CAR = (Tier 1 Capital + Tier 2 Capital) / Risk Weighted Assets◦ Reducing risk spillover to the real economy

Comprehensive set of reform measures to strengthen the banking sector.

Strengthens banks transparency and disclosures.

Improve the banking sectors ability to absorb shocks arising from financial and economic stress.

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Basel III-Objectives

Revised Minimum Equity & Tier 1 Capital Requirements

Better Capital Quality Backstop Leverage Ratio Short term and long term liquidity funding Inclusion of Leverage Ratio & Liquidity Ratios Rigorous credit risk management Counter Cyclical Buffer Capital conservation Buffer

Major features of Basel III

What’s new in Basel III

OLD* Quantity of

Capital to Cover Risks (CR + MKT +

OP)

NEW* Quality of

Capital * Capital

Conservation Buffer

* Liquidity Ratios (LCR + NSFR)

* Capital Charge on OFF B/S...

OLD* ICAAP

* SREP

NEW* Leverage Ratio

* MIS as a Major Management Tool…

* Stress Tests

* Countercyclical Capital Buffer

OLD* Information

on Risk Management

* Timely quantitative & qualitative information

NEW* Compensation Policy Disclosure

* Corporate Governance Practices

* Pressure to fully implement Pillar 3 + IFRS7…

2009 Basel III 2015 / 2018

PILLAR1

PILLAR2

PILLAR3

(+) (+)(+)

Challenges of basel3 implementation:

Banks usually have 3 types of challenges

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 challenges

•The 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 operational challenges includes stricter capital definition lowers banks’ available capital. At the same time the risk weighted assets (RWA) for securitizations, trading book positions and certain counterparty credit risk exposures are significantly increased.

• The stricter capital requirements, the introduction of the LCR and NSFR will force banks to rethink their liquidity position, and potentially require banks to increase their stock of high-quality liquid assets and to use more stable sources of funding.

•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

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Challenges of Basel 3

IMPACT ON INDIAN BANKS

• High capital ratios at 14.4% in June 2010 which will fall to

11.7%. Tier 1 will fall from 10% to 9% and common equity

from 8.5% to 7.4%.

Most of deductions are already mandated by RBI.

Banks mostly follow a retail business model and do not

depend on wholesale funds.

Indian banks are generally not as highly leveraged as their

global counterparts.

The leverage ratio of Indian banks would be comfortable.

IMPACT ON PUBLIC SECTOR

Public sector banks-needs Rs.1 trillion over 10-5 years.

Some public sector banks are likely to fall short of the revised

core capital adequacy requirement.

Increase in the requirement of capital will affect the ROE of

the Public banks.