THE BASEL COMMITTEE ON BANKING SUPERVISION

The Basel Committee on Banking Supervision (BCBS) is the primary global standard setter for the prudential regulation of banks and provides a forum for cooperation on banking supervisory matters. Its mandate is to strengthen the regulation, supervision, and practices of banks worldwide to enhance financial stability. Its 45 members comprise central banks and bank supervisors from 28 jurisdictions. Basel is a city located in Basel City, Switzerland. The Basel Committee on Banking Supervision (BCBS) was founded in 1974. In 2014 it celebrated its 40^th anniversary.

The Basel Committee 1974 – 2014 work on developing banking regulation can be broken into the five following regulatory waves. Names for regulatory waves are proposed to reflect the dominating core document that occupied the minds of central and/or commercial bankers at the time.

1. 1974 – 1986 – Concordat;
2. 1987 – 1998 – Basel I;
3. 1999 – 2008 – Basel II;
4. 2009 – 2011 – Basel III;
5. 2012 – 2014 – Post-Basel III.

BASEL I  ACCORD

Basel I is a set of international banking regulations put forth by the Basel Committee on Bank Supervision (BCBS) that sets out the minimum capital requirements of financial institutions to minimize credit risk. Banks that operate internationally are required to maintain a minimum amount (8%) of capital based on a percent of risk-weighted assets. Basel I is the first of three sets of regulations known individually as Basel I, II, and III and together as the Basel Accords.

The BCBS aims to enhance “financial stability by improving supervisory know-how and the quality of banking supervision worldwide.” This is done through regulations known as accords. Basel I was the first accord. It was issued in 1988 and focused mainly on credit risk by creating a bank asset classification system.

Bank Asset Classification System

The Basel I classification system groups a bank’s assets into five risk categories, classified as percentages: 0%, 10%, 20%, 50% and 100%. A bank’s assets are placed into a category based on the nature of the debtor.

The 0% risk category is comprised of cash, central bank and government debt, and any Organization for Economic Cooperation and Development (OECD) government debt. Public sector debt can be placed in the 0%, 10%, 20%, or 50% category, depending on the debtor. Development bank debt, OECD bank debt, OECD securities firm debt, non-OECD bank debt (under one year of maturity), non-OECD public sector debt, and cash in collection comprise the 20% category. The 50% category is residential mortgages, and the 100% category is represented by private sector debt, non-OECD bank debt (maturity over a year), real estate, plant and equipment, and 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.

Implementation of Basel I

The BCBS regulations do not have legal force. Members are responsible for their implementation in their home countries. Basel I originally called for the minimum capital ratio of capital to risk-weighted assets of 8% to be implemented by the end of 1992. In September 1993, the BCBS issued a statement confirming that G10 countries’ banks with material international banking business were meeting the minimum requirements set out in Basel I.

BASEL II ACCORD

Basel II is a set of international banking regulations put forth by the Basel Committee on Bank Supervision, which leveled the international regulation field with uniform rules and guidelines. Basel II expanded rules for minimum capital requirements established under Basel I, the first international regulatory accord, and provided framework for regulatory review, as well as set disclosure requirements for assessment of capital adequacy of banks. The main difference between Basel II and Basel I is that Basel II incorporates credit risk of assets held by financial institutions to determine regulatory capital ratios.

Basel II is a second international banking regulatory accord that is based on three main pillars: minimal capital requirements, regulatory supervision and market discipline. Minimal capital requirements play the most important role in Basel II and obligate banks to maintain minimum capital ratios of regulatory capital over risk-weighted assets. Because banking regulations significantly varied among countries before the introduction of Basel accords, a unified framework of Basel I and, subsequently, Basel II helped countries alleviate anxiety over regulatory competitiveness and drastically different national capital requirements for banks.

Basel II uses a “three pillars” concept

(1) Minimum capital requirements (addressing risk),

(2) Supervisory review and

(3) Market discipline.

The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk was not dealt with at all.

The First Pillar- Minimum Capital Requirements:

Basel II provides guidelines for the calculation of minimum regulatory capital ratios and confirms the definition of regulatory capital and the 8% minimum coefficient for regulatory capital over risk-weighted assets. Basel II divides the eligible regulatory capital of a bank into three tiers. The higher the tier, the less subordinated securities a bank is allowed to include in it. Each tier must be of certain minimum percentage of the total regulatory capital and is used as a numerator in the calculation of regulatory capital ratios.

Tier 1 capital is the more strict definition of regulatory capital that is subordinate to all other capital instruments, and includes shareholders’ equity, disclosed reserves, retained earnings and certain innovative capital instruments. Tier 2 is Tier 1 instruments plus various other bank reserves, hybrid instruments, and medium- and long-term subordinated loans. Tier 3 consists of Tier 2 plus short-term subordinated loans.

The capital base of the bank consists following three types of capital elements. Tier1, Tier 2, and Tier 3 capital. The sum of Tier1, Tier 2, and Tier 3 elements will be eligible for inclusion in the capital base, subject to the following limits:

1. The total of Tier 2 (supplementary) elements will be limited to a maximum of 100 percent of the total of Tier 1 elements.
2. Subordinate term debt will be limited to a maximum of 50 percent of Tier 1 elements.
3. Tier 3 capital will be limited to 250 percent of a bank’s Tier 1 capital that is required to support market risk.
4. Where general provisions/general loan-loss reserves include amounts reflecting lower valuations of assets or latent but unidentified losses present in the balance sheet, the amount of such provision or reserves will be limited to a maximum of 1.25 percentage points.
5. Asset revaluation reserves, which take the form of latent gains on unrealized securities, will be subject to a discount of 55 percent.

Elements of Tier 1 Capital:

The elements of Tier 1 capital include:

(i) Paid-up capital (ordinary shares), statutory reserves, and other disclosed free reserves, if any;

(ii) Perpetual Non-cumulative Preference Shares (PNCPS) eligible for inclusion as Tier I capital – subject to laws in force from time to time;

(iii) Innovative Perpetual Debt Instruments (IPDI) eligible for inclusion as Tier I capital; and

(iv) Capital Reserves representing surplus arising out of sale proceeds of assets.

Elements of Tier 2 Capital:

The elements of Tier 2 capital include undisclosed reserves, revaluation reserves, general provisions and loss reserves, hybrid capital instruments, subordinated debt and investment reserve account.

Undisclosed Reserves:

They can be included in capital if they represent accumulations of post-tax profits and are not encumbered by any known liability, and should not be routinely used for absorbing normal loss or operating losses.

Revaluation Reserves:

It would be prudent to consider revaluation reserves at a discount of 55 per cent while determining their value for inclusion in Tier II capital. Such reserves will have to be reflected on the face of the Balance Sheet as revaluation reserves.

General Provisions and Loss Reserves:

Such reserves can be included in Tier II capital if they are not attributable to the actual diminution in value or identifiable potential loss in any specific asset and are available to meet unexpected losses. Adequate care must be taken to see that sufficient provisions have been made to meet all known losses and foreseeable potential losses before considering general provisions and loss reserves to be part of Tier II capital. General provisions/loss reserves will be admitted up to a maximum of 1.25 percent of total risk-weighted assets.

‘Floating Provisions’ held by the banks, which are general and not made against any identified assets, may be treated as a part of Tier II capital within the overall ceiling of 1.25 percent of total risk-weighted assets.

Excess provisions that arise on the sale of NPAs would be eligible Tier II capital subject to the overall ceiling of 1.25% of total Risk Weighted Assets.

Hybrid Debt Capital Instruments:

Those instruments which have close similarities to equity, in particular when they are able to support losses on an ongoing basis without triggering liquidation, may be included in Tier II capital. At present the following instruments have been recognized and placed under this category:

(i) Debt capital instruments eligible for inclusion as Upper Tier II capital; and

(ii) Perpetual Cumulative Preference Shares (PCPS) / Redeemable Non-Cumulative Preference Shares (RNCPS) / Redeemable Cumulative Preference Shares (RCPS) as part of Upper Tier II Capital.

Subordinated Debt:

Refers to the status of the debt. In the event of the bankruptcy or liquidation of the debtor, subordinated debt only has a secondary claim on repayments, after other debt has been repaid.

Elements of Tier 3 Capital:

Tertiary capital held by banks to meet part of their market risks, that includes a greater variety of debt than tier 1 and tier 2 capitals. Tier 3 capital debts may include a greater number of subordinated issues, undisclosed reserves and general loss reserves compared to tier 2 capital.

Tier 3 capital is used to support market risk, commodities risk and foreign currency risk. To qualify as tier 3 capital, assets must be limited to 250% of a bank’s tier 1 capital, be unsecured, subordinated and have a minimum maturity of two years.

The Second Pillar – Supervisory Review Process:

This is a regulatory response to the first pillar, giving regulators better ‘tools’ over those previously available. This section discusses the key principles of supervisory review, risk management guidance and supervisory transparency and accountability produced by the Committee with respect to banking risks, including guidance relating to, among other things, the treatment of interest rate risk in the banking book, credit risk (stress testing, definition of default, residual risk, and credit concentration risk), operational risk, enhanced cross-border communication and cooperation, and securitisation.

Importance of supervisory review:

The supervisory review process of the Framework is intended not only to ensure that banks have adequate capital to support all the risks in their business, but also to encourage banks to develop and use better risk management techniques in monitoring and managing their risks.

The supervisory review process recognizes the responsibility of bank management in developing an internal capital assessment process and setting capital targets that are commensurate with the bank’s risk profile and control environment. In the framework, bank management continues to bear responsibility for ensuring that the bank has adequate capital to support its risks beyond the core minimum requirements.

Supervisors are expected to evaluate how well banks are assessing their capital needs relative to their risks and to intervene, where appropriate. This interaction is intended to foster an active dialogue between banks and supervisors such that when deficiencies are identified, prompt and decisive action can be taken to reduce risk or restore capital. Accordingly, supervisors may wish to adopt an approach to focus more intensely on those banks with risk profiles or operational experience that warrant such attention.

The committee recognises the relationship that exists between the amount of capital held by the bank against its risks and the strength and effectiveness of the bank’s risk management and internal control processes. However, increased capital should not be viewed as the only option for addressing increased risks confronting the bank. Other means for addressing risk, such as strengthening risk management, applying internal limits, strengthening the level of provisions and reserves, and improving internal controls, must also be considered. Furthermore, capital should not be regarded as a substitute for addressing fundamentally inadequate control or risk management processes.

There are three areas that might be particularly suited to treatment under Pillar 2: risks considered under Pillar 1 that are not fully captured by the Pillar 1 process (e.g.credit concentration risk); those factors not taken into account by the Pillar 1 process (e.g. interest rate risk in the banking book, business, and strategic risk); and factors external to the bank (e.g. business cycle effects). A further important aspect of Pillar 2 is the assessment of compliance with the minimum standards and disclosure requirements of the more advanced methods in Pillar 1, in particular the IRB framework for credit risk and the Advanced Measurement Approaches for operational risk. Supervisors must ensure that these requirements are being met, both as qualifying criteria and continuingly.

Four key principles of supervisory review:

The Committee has identified four key principles of supervisory review, which complement those outlined in the extensive supervisory guidance that has been developed by the Committee, the keystone of which is the Core Principles for Effective Banking Supervision and the Core Principles Methodology.172 A list of the specific guidance relating to the management of banking risks is provided at the end of this Part of the Framework.

Principle 1:

Banks should have a process for assessing their overall capital adequacy about their risk profile and a strategy for maintaining their capital levels.

Principle 2:

Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.

Principle 3:

Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.

Principle 4:

Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

The Third Pillar- Market Discipline:

This pillar aims to complement the minimum capital requirements and supervisory review process by developing a set of disclosure requirements that will allow the market participants to gauge the capital adequacy of an institution.

Market discipline supplements regulation as sharing of information facilitates assessment of the bank by others, including investors, analysts, customers, other banks, and rating agencies, which leads to good corporate governance. The aim of Pillar 3 is to allow market discipline to operate by requiring institutions to disclose details on the scope of application, capital, risk exposures, risk assessment processes, and the capital adequacy of the institution. It must be consistent with how the senior management, including the board, assess and manage the risks of the institution.

When market participants have a sufficient understanding of a bank’s activities and the controls it has in place to manage its exposures, they are better able to distinguish between banking organizations so that they can reward those that manage their risks prudently and penalize those that do not.

These disclosures are required to be made at least twice a year, except qualitative disclosures providing a summary of the general risk management objectives and policies which can be made annually. Institutions are also required to create a formal policy on what will be disclosed and controls around them along with the validation and frequency of these disclosures. In general, the disclosures under Pillar 3 apply to the top consolidated level of the banking group to which the Basel II framework applies.

BASEL III ACCORD

Basel III released in December 2010 is the third in the series of Basel Accords.  These accords deal with risk management aspects for the banking sector.  In a nutshell we can say that Basel III is the global regulatory standard (agreed upon by the members of the Basel Committee on Banking Supervision) on bank capital adequacy, stress testing, and market liquidity risk.   (Basel I and Basel II are the earlier versions of the same, and were less stringent)

According to the Basel Committee on Banking Supervision “Basel III is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector”.

Thus, we can say that Basel III is only a continuation of the effort initiated by the Basel Committee on Banking Supervision to enhance the banking regulatory framework under Basel I and Basel II.   This latest Accord now seeks to improve the banking sector’s ability to deal with financial and economic stress, improve risk management, and strengthen the banks’ transparency.

Objectives/aims of the Basel III measures:

Basel III measures aim to:

1. Improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source
2. Improve risk management and governance
3. Strengthen banks’ transparency and disclosures.

Thus we can say that Basel III guidelines are aimed at improving the ability of banks to withstand periods of economic and financial stress as the new guidelines are more stringent than the earlier requirements for capital and liquidity in the banking sector.

The basic structure of Basel III remains unchanged with three mutually reinforcing pillars.

 Pillar 1: Minimum Regulatory Capital Requirements based on Risk Weighted Assets (RWAs):

Maintaining capital calculated through credit, market, and operational risk areas.

Pillar 2:  Supervisory Review Process:

Regulating tools and frameworks for dealing with peripheral risks that banks face.

Pillar 3: Market Discipline:  

Increasing the disclosures that banks must provide to increase the transparency of banks.

 Major Changes Proposed in Basel III over Earlier Accords i.e. Basel I and Basel II

Better Capital Quality:

One of the key elements of Basel 3 is the introduction of a much stricter definition of capital.  Better quality capital means a higher loss-absorbing capacity.   This in turn will mean that banks will be stronger, allowing them to better withstand periods of stress.

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 a 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.

Countercyclical Buffer:

This is also one of the key elements of Basel III.   The countercyclical buffer has been introduced with the objective of increasing capital requirements in good times and decreasing the 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 loss-absorbing capital.

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.

Leverage Ratio:

A review of the financial crisis of 2008 has indicated 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 risk-weighted).   This aims to put a cap on the swelling of leverage in the banking sector on a global basis.   The 3% leverage ratio of Tier 1 will be tested before a mandatory leverage ratio is introduced in January 2018.

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.

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-in-debt.

Over View for the RBI Guidelines for Implementation of Basel III guidelines:

The final guidelines were issued by the Reserve Bank of India for implementation of Basel III guidelines on 2nd May 2012. Major features of these guidelines are:

 (a) These guidelines would become effective from January 1, 2013, in a phased manner.   This means that as at the close of business on January 1, 2013, banks must be able to declare or disclose capital ratios computed under the amended guidelines. The Basel III capital ratios will be fully implemented as of March 31, 2018.

 (b) The capital requirements for the implementation of Basel III guidelines may be lower during the initial periods and higher during the later years. Banks need to keep this in view while Capital Planning;

 (c) Guidelines on operational aspects of the implementation of the Countercyclical Capital Buffer. Guidance to banks on this will be issued in due course as RBI is still working on these.   Moreover, some other proposals viz. ‘Definition of Capital Disclosure Requirements’, ‘Capitalization of Bank Exposures to Central Counterparties’ etc., are also engaging the attention of the Basel Committee at present.  Therefore, the final proposals of the Basel Committee on these aspects will be considered for implementation, to the extent applicable, in the future.

 (d) For the financial year ending March 31, 2013, banks will have to disclose the capital ratios computed under the existing guidelines (Basel II) on capital adequacy as well as those computed under the Basel III capital adequacy framework.

 (e) The guidelines require banks to maintain a Minimum Total Capital (MTC) of 9% against 8% (international) prescribed by the Basel Committee of Total Risk Weighted Assets.  This has been decided by Indian regulator as a matter of prudence.   Thus, it requirement in this regard remained at the same level.  However, banks will need to raise more money than under Basel II as several items are excluded under the new definition.

(f) Of the above, Common Equity Tier 1 (CET 1) capital must be at least 5.5% of RWAs;

 (g) In addition to the Minimum Common Equity Tier 1 capital of 5.5% of RWAs, (international standards require these to be only at 4.5%)  banks are also required to maintain a Capital Conservation Buffer (CCB) of 2.5% of RWAs in the form of Common Equity Tier 1 capital.    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.  In case such buffers have been drawn down, the banks have to rebuild them through reduced discretionary distribution of earnings.  This could include reducing dividend payments, share buybacks, and staff bonuses.

 (h) Indian banks under Basel II are required to maintain Tier 1 capital of 6%, which has been raised to 7% under Basel III.  Moreover, certain instruments, including some with the characteristics of debts, will not be now included for arriving at Tier 1 capital;

 (i) The new norms do not allow banks to use the consolidated capital of any insurance or non-financial subsidiaries for calculating capital adequacy.

 (j) Leverage Ratio:

Under the new set of guidelines, RBI has set the leverage ratio at 4.5% (3% under Basel III).   Leverage ratio has been introduced in Basel 3 to regulate banks that have the huge trading books and off balance sheet derivative positions.  However, In India, most banks do not have large derivative activities so as to arrange enhanced cover for counterparty credit risk. Hence, the pressure on banks should be minimal on this count.

(k) Liquidity norms:

The Liquidity Coverage Ratio (LCR) under Basel III requires banks to hold enough unencumbered liquid assets to cover expected net outflows during a 30-day stress period. In India, the burden from LCR stipulation will depend on how much of CRR and SLR can be offset against LCR.  Under present guidelines, Indian banks already follow the norms set by RBI for the statutory liquidity ratio (SLR) – and cash reserve ratio (CRR), which are liquidity buffers.   The SLR is mainly government securities while the CRR is mainly cash. Thus, for this aspect also Indian banks are better placed over many of their overseas counterparts.

(l) Countercyclical Buffer:

Economic activity moves in cycles and the banking system is inherently pro-cyclic. During upswings, carried away by the boom, banks end up in excessive lending and unchecked risk build-up, which carry the seeds of a disastrous downturn. The regulation to create additional capital buffers to lend further would act as a break on unbridled bank lending.  The detailed guidelines for these are likely to be issued by RBI only at a later stage.

 Countercyclical Capital Buffer:

In addition to the capital conservation buffer, Basel III introduces another capital buffer, a countercyclical capital buffer within a range of 0– 2.5% of RWAs in the form of Common Equity or other fully loss-absorbing capital that will implemente according to national circumstances. The purpose of a countercyclical capital buffer is to achieve the broader macro-prudential goal of protecting the banking sector from periods of excess aggregate credit growth. For any given country, this buffer will only be in effect when there is excess credit growth that results in a system-wide build-up of risk. The countercyclical capital buffer, when in effect, would be introduced as an extension of the capital conservation buffer range.

Credit Value Adjustment Risk Capital

At present, the counterparty credit risk in the trading book covers only the risk of default of the counterparty. The reform package includes an additional capital charge for Credit Value Adjustment (CVA) risk which captures the risk of mark-to-market losses due to deterioration in the creditworthiness of a counterparty. The risk of interconnectedness among larger financial firms (defined as having total assets greater than or equal to $100 billion) will be better captured through a prescription of 25% adjustment to the asset value correlation (AVC) under IRB approaches to credit risk. In addition, the guidelines on counterparty credit risk management about collateral, margin period of risk and central counterparties, and counterparty credit risk management requirements have been strengthened.

Revised Basel III Transitional Arrangements

In terms of the Basel III Capital Regulation issued by RBI, the Capital Conservation Buffer (CCB) is scheduled to be implemented from March 31, 2015, in phases and will fully implemente as of March 31, 2019. However, RBI vide circular dated 27.03.2014 has advised that the implementation of CCB will begin as of March 31, 2016. Consequently, the Basel III Capital Regulation was fully implemented as of March 31, 2019.