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GLOBAL BANKING REGULATIONSAND BASEL ACCORDS

BANKING &GOVERNMENT EXAMS

Global Banking Regulations & Basel Accords Free static e-book

Global Banking Regulations and BASEL Accords is a very important topic when it comes to

Banking and Government Exams especially RBI Grade B, RBI Assistant, SEBI, NABARD, SIDBI,

SBI PO, IBPS PO exams etc.

Here we provide you all with the complete overview of Banking Regulations that Global

Banks follow and a short summary of Basel Accords. Read about them and get yourself

acquainted with the regulations that the Banks need to follow to function in an efficient

manner.

Sample Questions

Q1. Which among the following is not one of the principles of Banking Regulation?

(1) Minimum Requirements

(2) Market Discipline

(3) Licensing & Supervision

(4) Coordination & Control

Correct Answer: (4)

Q2. When were the BASEL III guidelines Issued?

(1) 2010

(2) 2006

(3) 2007

(4) 2015

Correct Answer: (1)

So here we bring to you all the complete overview of Banking Regulations that Global Banks

follow and a short summary of Basel Accords. Go through these thoroughly so that you don’t

miss out on any marks in upcoming Bank and Government Exams.

Global Banking Regulations & Basel Accords Free static e-book

Global Banking Regulations and Basel Accords

Let us learn about the Basic Principles of Banking Regulations in this eBook. There is a brief overview of the BASEL Accords as well.

General Principles of Banking Regulations

What are Banking Regulations?

Banking Regulations are a form of Government Regulations that subject banks to certain guidelines, requirements and restrictions to create market transparency among Banking Institutions, Corporations and Individuals with whom the banking institutions conduct business.

The interconnectedness of the banking industry and the global economy as well as the national economy, it becomes very important to have certain regulatory controls over these banking institutions and maintain a control over the standardized practices that these need to follow.

Objectives

The objectives of Bank regulations are as follows:

• Prudential - To protect the depositor’s money and to reduce the level of risk to which

bank’s creditors are exposed.

• Systemic risk reduction - To reduce the risk of disruption resulting from adverse

trading conditions by banks causing multiple or major bank failures.

• Avoid misuse of banks - To reduce the risk of banks being used for criminal purposes,

for e.g. laundering the proceeds of crime (Money Laundering).

• Protect Banking confidentiality

• Credit allocation - To direct credit to favoured sectors (Sectors requiring credit

allocation).

• It may also include rules about fair treatment of customers and practicing Corporate

Social Responsibility.

Principles of Banking Regulations

The general principles dealing with the Banking Regulations are as follows: Licensing &

Supervision, Minimum Requirements and Market Discipline.

1. Licensing & Supervision:

i) Licensing sets certain requirements for starting a new bank. Licensing provides the

licence holders the right to own and to operate a bank.

Global Banking Regulations & Basel Accords Free static e-book

ii) The licensing process is specific to the regulatory environment of the country

and/or the state where the bank is located.

iii) Licensing involves an evaluation of the entity's intent and the ability to meet the

regulatory guidelines governing the bank's operations, financial soundness, and

managerial actions.

iv) The regulator supervises licensed banks for compliance with the requirements and

responds to breaches of the requirements by obtaining undertakings, giving

directions, imposing penalties or (ultimately) revoking the bank's license.

Supervision is an extension of the licence-granting process and consists of supervision

of the bank's activities by a government regulatory body (central bank or another

independent governmental agency). Supervision ensures that the functioning of the

bank complies with the regulatory guidelines and monitors for possible deviations

from regulatory standards. Supervisory activities involve on-site inspection of the

bank's records, operations and processes or evaluation of the reports submitted by

the bank.

2. Minimum Requirements:

Certain minimum requirements closely related to the level of risk exposure for a

certain sector of the Bank, are imposed by the Central Bank of the country upon every

Banking Entity.

Two of the most important minimum requirements are:

i) Capital Requirements - The capital requirement sets a framework as to how banks

need to handle their capital in relation to their assets. The first international level

capital requirements were introduced by the Basel Accords in 1988. The current

framework of capital requirements is called Basel III.

ii) Reserve Requirements: The reserve requirement sets the minimum reserves each

of the bank must hold in form of demand deposits and banknotes. Required

reserves have at times been gold coin, central bank banknotes or deposits, and

foreign currencies.

3. Market Discipline:

The Central Bank of the country requires all the regulated Banks to publicly disclose

their financial information as well as other information important from the point of

view of the regulator. This disclosure of Financial Information by the Banking Entities

enables the creditors to use this information to assess the level of risk they will be

exposed to and to make important investment decisions.

Global Banking Regulations & Basel Accords Free static e-book

Basel Accords of Banking Supervision

The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory

authorities that was established by the central bank governors of G-10 in 1974.

BCBS provides for a forum for regular cooperation on banking supervisory matters. Its main

objective is to enhance understanding of key supervisory issues and improve the quality of

banking supervision worldwide. The Committee frames guidelines and standards in different

areas – some of them are the international standards on capital adequacy, the Core Principles

for Effective Banking Supervision and the Concordat on cross-border banking supervision. It

has 27 members including India and major economies of the world.

The BSBS Secretariat is located at the Bank for International Settlements (BIS) in Basel,

Switzerland. The Bank for International Settlements (BIS) hosts and supports several

international institutions engaged in standard setting and financial stability, one of which is

BCBS.

Basel I

• Basel I is the first of the three sets of regulations i.e. Basel I, II and III and together as

the Basel Accords.

• It is a set of international banking regulations introduced by the Basel Committee on

Banking Supervision (BCBS) that sets out the minimum capital requirements for

the financial institutions with the goal of minimizing credit risk.

• The focus of Basel-I was completely on credit risk. It provided a structure of risk

weighted assets (RWA). RWA implies that the assets with different risk profiles are

given different risk weights.

• The Basel I classification system categorizes 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,

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

comprises the 20% category.

• The residential mortgages are placed under 50% category.

• The 100% category is represented by private sector debt, non-OECD bank debt, 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 $1000 million, it is

required to maintain capital of at least $80 million.

Global Banking Regulations & Basel Accords Free static e-book

The Basel-I has fixed the minimum capital requirement at 8% of Risk Weighted Assets

(RWA). India adopted Basel 1 guidelines in 1999.

Basel II

• Basel II expanded rules for minimum capital requirements established under Basel I,

and provided framework for regulatory review, as well as set disclosure requirements

for assessment of capital adequacy of banks.

• The main difference between Basel I and Basel II is that Basel II incorporates credit

risk of assets held by financial institutions to determine regulatory capital ratios.

• The Basel-II guidelines were published by BCBS in 2004. These guidelines refined the

Basel-I norms on the base of three parameters as follows:

i) Banks should maintain a minimum capital adequacy requirement of 8% of risk

assets

ii) Banks were needed to develop and use better risk management techniques in

monitoring and managing all the three types of risks

iii) Mandatory disclosure of risk exposure.

Basel II norms in India and overseas are yet to be fully implemented.

Basel III

• The Basel-III guidelines were issued in 2010 as a response to global financial crisis of

2008. A focus of Basel III is to foster greater resilience at the individual bank level in

order to reduce the risk of system-wide shocks.

• Basel III introduced a set of reforms designed to improve the regulation, supervision

and risk management within the banking sector.

• Banks are required to maintain proper leverage ratios and meet minimum capital

requirements.

Three pillars of Basel-III are as follows:

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

It is about maintaining capital calculated through Credit risk, Market risk and Operational risk.

Pillar 2: Supervisory Review Process:

It is about regulating tools and frameworks to deal with peripheral risks that the banks face.

Pillar 3: Market Discipline:

It is about increasing the disclosures that banks must provide in order to increase the

transparency of banks.

Global Banking Regulations & Basel Accords Free static e-book

Capital Adequacy in Banking Industry

• Capital refers to the stock of Financial Assets that can generate income.

• The Capital Adequacy Ratio (CAR) is a measure of Bank’s financial health. It is the ratio

of Banks Capital to its Risk.

• Capital Adequacy Ratio = Capital ÷ Risk

• Capital Adequacy indicates the Bank’s ability to absorb possible losses.

• The Regulators check CAR to monitor the health of the Bank as a good CAR protects

the interest of its depositors and maintains faith and confidence in the Banking

system.

Capital to Risk Weighted Assets Ratio (CRAR)

• CRAR is a standard measure to measure the strength of the balance sheet of Banks.

• BASEL I and BASEL II are global capital adequacy regulations that prescribe a minimum

amount of capital a bank must hold given the size of its risk weighted assets.

• The old rules mandate banks to back every Rs. 100 of commercial loans with Rs. 9 of

capital irrespective of the nature of these loans.

• The new rules suggest the amount of capital needed depends on the credit rating of

the customer.

• Banks compute the CRAR as follows:

Total Capital to Risks Weighted Assets Ratio (CRAR) = Eligible Total Capital / RWA

for Risk (Credit risk + Market risk + Operational risk)

Tier-1 and Tier-2 Capital

• The Basel accords define two tiers of the Capital in the banks

• The Tier-I Capital is the core capital while the Tier-II capital can be said to be

subordinate capitals.

• Tier 1 mainly includes permanent shareholders’ equity (which includes issued and fully

paid ordinary shares / common stock and perpetual non-cumulative preference

shares) and disclosed reserves (or profits created or increased by appropriations of

retained earnings or other surplus, e.g.: share premiums, retained profit, general

reserves and legal reserves). On the other hand,

• Tier-II includes undisclosed reserves and other subordinate capital.

• Apart from the above two, Banks may also at the discretion of their central bank,

employ a third tier of capital which consists of short-term subordinated debt for the

sole purpose of meeting a proportion of the capital requirements for market risks. This

is called Tier-III capital.

Global Banking Regulations & Basel Accords Free static e-book

Common Equity

• Currently, the bank’s capital comprises Tier 1 and Tier 2 capital. The restriction is that

Tier 2 capital cannot be more than 100% of Tier capital.

• Under Basel III, with an objective of improving the quality of capital, the Tier 1 capital

will predominantly consist of Common Equity.

• Common Equity is the amount that all common shareholders have invested in a

company. Most importantly, this includes the value of the common shares

themselves. It also includes retained earnings and additional paid-in capital.

• Thus, most important part of the common equity comprises the Paid-up Capital +

retained earnings.

Although the minimum total capital requirement will remain at the current 8% level, Under

Basel-III, the capital adequacy requirement was raised to 10.50%.

Basel III norms prescribe minimum common equity of 4.5 per cent.

Under Basel-III, banks are to compute ratio as follows:

Common Equity Tier-I Capital Ratio = Common Equity Tier-I Capital / RWA for Risk (Credit

risk + Market risk + Operational risk)

Tier-I capital ratio = Tier-I Capital / RWA for (Credit risk + Market risk + Operational risk) Total

capital ratio (CRAR) = Eligible Total Capital /RWA for Risk (Credit risk + Market risk +

Operational risk)

The Capital Conservation Buffer

• Banks are required to hold a capital conservation buffer of 2.5%.

• The aim of asking to build 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

• The countercyclical buffer was introduced with the objective to increase capital

requirements in good times and decrease the same 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.

Global Banking Regulations & Basel Accords Free static e-book

Leverage Ratio

• Basel III regulations 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 swelling of leverage in the banking sector on a global basis.

• A 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 must be created. A new Liquidity

Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are to be introduced in 2015 and

2018, respectively.

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