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BASEL NORMSTheBasel Accords refer to the banking supervision Accords issued by theBasel Committee on Banking Supervision(BCBS).

It includes the Basel I , Basel II andBasel III norms.

They are called the Basel Accords as the BCBS maintains itssecretariat at theBank for International Settlements inBasel,Switzerland and the committee normally meets there.BASEL ACCORDTheBasel Committee on Banking Supervision(BCBS)is a committee of banking supervisory authorities that was established by thecentral bank governors of the G-10 countries in 1974.

Since 2009, all of the other G-20 major economies are represented, as well as some other major banking locales such as Hong Kong and Singapore.BASEL COMMITTEE ON BANKING SUPERVISIONBasel Committee on banking supervision introduced the Basel 1 also known as the 1988 Basel Accord , a set of minimum capital requirements for banks.

Basel I is primarily focused on credit riskand appropriaterisk weighting of assets.BASEL 1 NORMSThe 1988 Accord requires:The bank to hold capital equal to atleast 8% of their risk-weighted assets (RWA).

The definition of capital is set in two tiers:Tiers 1 being of shareholders equity and retained earnings.Tier 2 being additional internal and external resources available to the bank.

Risk-weighted assetis a bank's assets or off-balance sheet exposures, weighted according torisk.

The Committee insisted that the banks use this approach for capital calculation becauseit provides an easier approach to compare banks across different geographiesoff-balance-sheet exposures can be easily included in capital adequacy calculationsbanks are not deterred from carrying low risk liquid assets in their books

Assets of banks were classified and grouped in five categories according to credit risk:carrying risk weights of 0% (for example cash, bullion, home country debt like Treasuries) 20% (securitizations such asmortgage backed securities (MBS) with the highest AAA rating) 50% mortgaged loans 100% (for example, most corporate debt) some assets were given no rating.

The tier 1 capital ratio = tier 1 capital / all RWA

The total capital ratio = (tier 1 + tier 2capital) / all RWA

Leverage ratio = total capital/average total assets

Limited differentiation of credit riskThere are four broad risk weightings (0%, 20%, 50% and 100%), based on an 8% minimum capital ratio.

Static measure of default riskThe assumption that a minimum 8% capital ratio is sufficient to protect banks from failure does not take into account the changing nature of default risk.

No recognition of term-structure of credit riskThe capital charges are set at the same level regardless of the maturity of a credit exposure.

Simplified calculation of potential future counterparty riskThe current capital requirements ignore the different level of risks associated with different currencies and macroeconomicrisk.

Lack of recognition of portfolio diversification effectsIn reality, the sum of individual risk exposures is not the same as the risk reduction through portfoliodiversification. Therefore, summing all risks might provide incorrect judgment of riskPITFALLS OFBASELI Basel 2

Pillar 1 sets out the minimum capital requirements firms will be required to meet to cover credit, market and operational risk.

Pillar 2 sets out a new supervisory review process. Requires financial institutions to have their own internal processes to assess their overall capital adequacy in relation to their risk profile.

Pillar 3 cements Pillars 1 and 2 and is designed to improve market discipline by requiring firms to publish certain details of their risks, capital and risk management as to how senior management and the Board assess and will manage the institution's risks.

Three Pillars of Basel II Framework

Pillar 1 : Minimum capital requirements

Institution's total regulatory capital must be atleast 8% (ratio same as in Basel I) of its risk weighted assets, based on measures of THREE RISKSMeasuring credit risk

Banks can assess risk using three different ways of varying degree of sophistication

Standardized approach

Foundation IRB(Internal Rating-Based Approach)

Advanced IRB

Standardised approachCredit AssessmentAAA TO AA-(%)A+ TO A

(%)BBB+ TOBBB-

(%)BB+ TO BB-

(%)BELOW B-

(%)UNRATED

(%)SOVEREIGN CREDIT02050100150100CLAIMS ON BANKSOPTION12050100100150100OPTION 220505010015050OPTION 32020205015020CORPORATES2050100150150100INTERNAL RATING BASED APPROACHExposure type(IRBF)

Internal data(IRBF)

Regulatory data(IRBA)

Internal data

(IRBA)

Regulatory data

CORPORATES, SOVEREIGN , OTHER BANKSPDLGD, EAD, MPD, LGD, EAD, MSources of risk estimationMeasuring operational risk

Operational risk is risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. It includes legal risk, such as exposure to fines, penalties etc.

Methods to measure operational riskBasic Indicator Approach Standardized ApproachCAPITAL REQUIREMENT

=Average positive gross income over the last three years* 15%

Gross income= net interest and commission income excluding profits/losses from sale of securitiesBASIC INDICATOR APPROACHBUSINESS LINEBETA FACTORCorporate finance18%Trading and sales18%Retail banking12%Commercial banking15%Payment and settlement18%STANDARDISED APPROACHSupervisory review process has been introduced to ensure

banks have adequate capital to support all the risks

to encourage them to develop and use better risk management techniques in monitoring and managing their risks.PILLAR 2: SUPERVISORY REVIEWProcess for assessing overall capital adequacy in relation to risk profile.Review and evaluate banks internal capital adequacy assessment Expect banks to operate above the minimum regulatory capital ratiosIntervene at early stage to prevent capital from falling below minimum levels 4 KEY PRINCIPLESCovers transparency and the obligation of banks to disclose meaningful information to all stakeholders

Clients and shareholders should have sufficient understanding of activities of banks, and the way they manage their risksPillar 3 : Market DisciplineIncreased Capital requirement

Profitability- implementation of models

Rating requirement

Absence of historical database( PD,LGD, EAD, M)

Disadvantages for smaller banks

Issues and challenges BASEL 3RECOMMENDATIONS CAPITAL REQUIREMENTS- Banks to hold 4.5% of common equity & 6% of tier I capital of Risk Weighted Assets (RWA).{Tier 1 capital= common shares+ retained earnings}

ADDITIONAL CAPITAL BUFFERS-Mandatory capital conservation buffer of 2.5% of RWA. banks must hold 7.0% CET 1 capital on an individual and consolidated basis at all times.

CET 1 capital includes

a) A payment of cash dividends; b) A distribution of fully or partly paid bonus shares or other capital instruments; c) A redemption or purchase by an institution of its own shares or other specified capital instruments; d) A repayment of amounts paid up in connection with specified capital instruments;LEVERAGE REQUIREMENTS

Leverage Ratio = Tier 1 capital > = 3% Total exposure

Liquidity coverage ratio(LCR)

The Liquidity Coverage Ratio requires institutions to hold a sufficient buffer of high quality liquid assets to cover net liquidity outflows during a 30-day period of stress.

= High quality liquid assets > = 100% Total net liquidity outflows HIGH QUALITY LIQUID ASSETS-

a) Cash and deposits held with central banks to the extent that these deposits can be withdrawn in times of stress;b) Transferable assets that are of extremely high liquidity and credit quality;c) Transferable assets guaranteed by the central government or a third country if the institution incurs a liquidity risk in that third country that it covers by holding those liquid assets;Listed on a recognized exchange

Net liquidity outflows = Liquidity outflows - liquidity inflows in the stress scenario

Net stable funding ratio The Net Stable Funding Ratio (NSFR) requires institutions to maintain a sound funding structure over one year in an extended firm-specific stress scenario.

NSFR =Available stable funding Required stable funding

AVAILABLE STABLE FUNDINGa) Own funds; items not included in the own funds:i) Retail deposits as defined in the Regulation;ii) All funding obtained from financial customers;iii) Funding from secured lending as specified in the Regulation;