Basics revisited – Basel I, II and III

Before we delve deep into understanding banking industry risks under various categories let us look at what world-wide regulators prescribe as norms to be followed

We all know that Banks play a crucial and important role in the national and global economy. Banks on the one hand bring in deposits from individuals, corporates and other institutions and on the other hand offer loans to borrowers and other financial products. The inflows include the Banks’ own capital plus the liabilities in the form of deposits mobilized and the outflow represents loans and borrowings to their clients on which the banks earn interest, other charges and commissions. These earnings are supposed to cover the operating / administrative expenses of the bank and pay interest to depositors and other borrowers of the bank itself. The banks also have the responsibility to operate in a safe and stable manner that they meet the commitments through maintaining adequate liquidity and creditworthiness. They also have to meet their shareholder expectations and comply with the national regulators norms for the banking industry.

Thus Banks are exposed to various kinds of expected risks and unexpected risks whether related to the market or non-market activities. The risk potential and impact is loss of depositors’ money, loss of trust in the bank leading to a Domino effect that can cascade to several other inter-connected banks and transactions.

While the anticipated or expected losses can be mitigated by Banks through several strategies like product pricing, accounting provisions for Non Performing Assets (NPAs), etc, the unexpected losses arising out of the choice of the banks’ activities and portfolio has to be met through the Banks’ own capital funds in order to protect the depositor’s money.

Banking regulation is complex in several countries – it involves licensing norms (such as for setting up a new bank) and supervisory controls, reporting and disclosures of its various activities. Many banks and financial institutions have a stronghold on the economy with enormous consequences in the event of a failure or collapse of the banking system. This is the reason why Governments come up with bail-out schemes to prevent rippling effects throughout the economy leading to a systemic failure.

What is Basel I?

The formal framework for banks’ capital structure was evolved in 1988 with the introduction of the “International Convergence of Capital Measurement and Capital Standards”, popularly known as Basel I, issued by the Basel Committee on Banking Supervision (BCBS).

Following Basel I, banks were required to maintain a minimum capital adequacy of 8% against risk weighted assets (RWA). Here Basel suggested a portfolio approach to credit risk by assigning appropriate risk weights against each asset (for example, housing loans carry 50% risk weight and corporate loans carry 100% risk weight). The capital components include long term debt funds also by categorising qualitative equity capital as Tier I and others as Tier II. Although the Basel Accord was signed only by the G-10 countries plus two more nations, more than 100 countries across the globe have made these norms mandatory in their domestic banking systems. In India, the Reserve Bank of India (RBI) implemented Basel I norms from 1992 onwards.

Why Basel II?

Basel I was criticised for its rigidity of “one-size fits” approach for banks of all sizes and absence of risk sensitivity in estimating capital requirements. In 2004 the BCBS came out with a comprehensive framework of capital regulation popularly known as Basel II.

Basel II was built up on three pillars – minimum capital requirements, supervisory review process, and market discipline. Under Basel II, banks were required to maintain the minimum capital requirement of 8% against the risk weighted assets, while RWA was computed by considering the three major generic risks

1. Credit risks,

2. Market risks, and

3. Operational risks.

To estimate the capital requirements for credit risk and operational risk, Basel-II proposed a menu of approaches – standardised, foundation internal ratings, and advanced internal ratings approach. However, for market risk Basel II continued with the 1996 framework which suggested both standardised and internal measurement models.

In India, from 2007 / 2008 onwards, banks have followed estimation of capital requirements by following the standardised approach for all the three risks, viz. credit, market and operational risks.

Why Basel III?

Although Basel II was a very comprehensive capital regulation framework architected on sophisticated risk quantification models, it failed to address certain issues which emerged during the financial crisis of 2007-08.

Issues that were noticed:

  1. In good times, when banks were doing well, and the market was willing to invest capital in them, Basel II did not impose additional capital requirement on banks. On the other hand, in stressed times, when banks required additional capital and markets were wary of supplying that capital, Basel II required banks to bring in more of it.

  2. By following value at risk (VaR) models, banks maintained capital requirements against trading book exposures assuming that these could be liquidated, and substantial banking book assets were parked in trading book, which helped banks to optimise the capital requirements.

  3. Basel II assumed that its risk based capital requirement would implicitly mitigate the risk of excessive leverage. Unfortunately, excessive leverage of banks was one of the prime causes of the crisis.

  4. Basel II did not consider liquidity risk as part of capital regulation.

  5. Basel II focussed more on individual financial institutions and ignored the systemic risk arising from the interconnectedness across institutions and markets, which led the crisis to spread to several financial markets.

The BCBS released the Basel III framework entitled “Basel III: A Global Regulatory Framework for more Resilient Banks and Banking systems” in December 2010 (revised in June 2011).

The enhancements of Basel III over Basel II came in four distinct areas:

1. augmentation in the level and quality of capital requirements.

2. introduction of liquidity standards.

3. modifications in provisioning norms, and,

4. introduction of leverage ratio.

The above information should give an idea of the evolution of Basel regulations and its main objectives and provisions.