International Journal of Pure and Applied Management Sciences;

Vol. 2016.1.2; pp. 36-43, ISSN: 2456-4516

EFFECTIVENESS OF BASEL BANKING NORMS

Mr. Himanshu Gupta
Research Scholar, Mohanlal Sukhadia University, Udaipur
(In affiliation with Jaipuria Institute of Management, Noida)

&
Dr. Pratibha Wasan
Associate Professor, Jaipuria Institute of Management, Noida

Date of revised paper submission: 07/12/2016; Date of acceptance: 16/12/2016

Date of publication: 31/12/2016; *First Author / Corresponding Author; Paper ID: MS16207.
Reviewers: Dr. A. K. Singh; Dr. Shabi Raza (India)

Abstract
Basel norms are set of reforms which help the banks to improve their ability to
absorb financial and economic stress. It was developed to improve risk management and strengthen
the banks transparency and disclosures by the Basel committee on Banking Supervision. Basel norms
is fundamentally emphasizes the need for improvements in corporate governance that are essential to
deal with contagion and counterparty risk. It also provides a sound framework for addressing
increasingly complex risks faced by banks with an objective to foster a secure and reliable banking
sector.
This paper aims to first build a deeper understanding of the emergence of Basel
banking norms (Basel I), the transition to each of the subsequent regulations (Basel II and Basel III)
and to further analyses the effectiveness of Basel norms in Indian banking Industry. This paper will
also ascertain the impact of Basel norms in Indian banks and what all Indian banks could do to
mitigate and curtail the risk they have been facing on day to day basis especially in areas such as
augmentation of capital resources, growth versus financial stability, challenges for enhanced
profitability, deposit pricing, cost of credit, maintenance of liquidity standards, and strengthening of
risk architecture.
Keywords: Banking, Financial Services, Basel Norms, Capital Adequacy, Liquidity, Basel I, II & III.
1. Introduction
Banks by very nature of their business attracts several types of risks, viz., operational
risk, market risk (which includes interest rate risk, foreign exchange risk and liquidity risk), credit
risk, reputational risk, business risk, systematic risk, strategic risk and they are exposed to these risks
because of the banking business which they undertake, which is defined in section 5 (b) of the
Banking Regulation Act, 1949. To mitigate these risks and providing a sound financial system, the
birth of Basel banking rules is attributed to the incorporation of the Basel Committee on Banking
Monitoring (BCBS), established by the Central Bank of the G-10 in 1974. This came into existence
under the auspices of the Bank for International Settlements (BIS), Basel, Switzerland.
1.1: Basel I: The Capital Accord
The first set of the Basel Accords, known as Basel I, was published in 1988 with the
main objective of credit risk. In Basel-I, creating a classification system of banking assets on the basis
of the inherent risk of the asset was proposed. The second set of the Basel Accords- Basel-II was
published in June 2004 - in order to control the misuse of the rules of Basel I, especially through
36 | P a g e
h t t p s : / / w w w. i j o p a a r. o r g /

International Journal of Pure and Applied Management Sciences;

Vol. 2016.1.2; pp. 36-43, ISSN: 2456-4516
regulatory arbitrage. Basel II rules were intended to create a uniform international standard for the
amount of capital that banks need to protect themselves against financial and operational risks with
more emphasis on disclosure requirements. The third set of the Basel Accords - Basel III was
introduced in response to the global financial crisis. The Basel-III is scheduled to be implemented in
2018. Further strengthening of capital requirements, bank liquidity and bank leverage is requested in
Basel-III. However, critics argue that implementing these rules may hinder further stability of the
financial system and thereby providing greater incentive to circumvent regulations. Basel norms are
mainly dealt with the following risks:
Credit Risk is defined as the possibility or probability of losses associated with
diminution in the credit quality of borrowers or counterparts. In banking fraternity, these losses occur
due to the inability or unwillingness of a customer or counterparty to meet commitments in relation to
lending, trading settlement and any other financial transactions.
Market Risk is primarily changes in market variables such as interest rate, foreign
exchange rate, etc. Changes in any variables of the market have a huge impact in the banks income
and economic value.
Operational Risk is a risk pertaining to operational issues occurred from any
breakdowns in internal controls and corporate governance. In order to safeguard the global banking
fraternity from going bankrupt further leading to economy collapse and other several and severe
financial issues, Basel Committee on Banking Supervision (BCBS) was formed by the head authority
of central banks of different nations.
In 1988, the Basel Committee on Banking Supervision (BCBS) published a set of
minimal capital requirements for banks that mainly focused on credit risk which was enforced in the
Group of 10 countries in 1992 as the Basel I accords.
The second set of the Basel accords, published in 2004, was designed to create an
international standard for the amount of capital that banks need to protect themselves against financial
and operational risks with more emphasis on disclosure requirements. The objective behind designing
of BASEL accord was to increase the safety and soundness of the international banking system and
also to set a level playing field for banking regulation.
Basel II rules were intended to create a uniform international standard
Basel I, also known as the first accord of BASEL, is the framework which relates to the minimum
capital standards required in the banking industry and was introduced in 1988 by BCBS.
For such enterprise, it was equipped with just a minimum capital requirements rule which stated that
the banks having international presence which are involved in risky products need to hold capital
equal to 8 % of the risk-weighted assets.
BASEL I was created with a purpose to:

Strengthen the stability of international banking system

Set up a fair and a consistent international banking system in order to decrease competitive
inequality among international banks
In order to set up a minimum risk-based capital adequacy applying to all banks and
governments in the world, a general definition of capital was framed which was based on two
tiers:
Tier 1 (Core Capital): Tier 1 capital includes stock issues (or shareholders equity)
and declared reserves, such as loan loss reserves set aside to cushion future losses or
for smoothing out income variations.
Tier 2 (Supplementary Capital): Tier 2 capital includes all other capital such as
gains on investment assets, long-term debt with maturity greater than five years and
hidden reserves (i.e. excess allowance for losses on loans and leases). However,

37 | P a g e
h t t p s : / / w w w. i j o p a a r. o r g /

International Journal of Pure and Applied Management Sciences;

Vol. 2016.1.2; pp. 36-43, ISSN: 2456-4516
capital here does not include short-term unsecured debts (or debts without
guarantees).
Basel I Capital Accord was criticized on several grounds. The main criticisms include the following:
1. Limited differentiation of credit risk
2. There were only four-five broad risk weightings which were used to calculate the capital
requirement.
3. Static measure of default risk
4. The guideline of maintaining a minimum capital of 8% capital ratio for credit risk doesnt
takes into account the changing nature of default or credit risk and thus is not appropriate
assumption
Loopholes in Basel I accord compelled the BASEL committee to amend the guidelines and as a result,
BCBS came out with a new Basel Capital Accord which is also known as BASEL II where in new
parameters were added which included operational risk. BASEL II also re-defined the calculation of
credit risk so as to tackle the problem of different layers of risk associated with Banks.
1.2: Transition to Basel II
Baking crises of 1990s and the loopholes of BASELs first accord compelled BASEL
Committee to reframe the BASEL I which resulted in a new accord with revised framework on
International Convergence of Capital Measurement and Capital Standards and was also termed as
Basel II. BASEL II greatly expands the scope, technicality, and depth of the original Basel Accord
and also greatly expanded so as to cover new approaches to credit risk, adapt to the securitization of
bank assets, cover market, operational, and interest rate risk, and incorporate market based
surveillance and regulation.
BASEL II primarily aims at:
1. Allocation of capital is more risk sensitive.
2. Enhance disclosure requirements which will allow market participants to assess the capital
adequacy of an institution;
3. Ensure that credit risk, operational risk and market risk are quantified based on data and
formal techniques;
4. Monitor economic and regulatory capital more closely to meet capital requirement.
Basel II uses a "three pillars" concept which is shown below in the figure:

Basel II was basically conceived as a result of two triggers - the banking crises of the
1990s, on the one hand, and critical Basel I on the other. In 1999, Basel Committee came up with new
measures of capital and formally the accord was known as a revised framework for international
convergence of capital measurements and capital standards (hereinafter referred to as Basel II). This
framework is introduced to improve the capital regulatory requirements to address the risks of the
underlying shares by creating new financial innovation for continuous improvement of risk control.
For the successful implementation of the new framework of actions across borders, committees
Supervision and Implementation Group (SIG) communicated with supervisors outside the
composition of the commission through regional contacts with their associations.
Pillar I - Minimum Capital Requirement:
38 | P a g e
h t t p s : / / w w w. i j o p a a r. o r g /

International Journal of Pure and Applied Management Sciences;

Vol. 2016.1.2; pp. 36-43, ISSN: 2456-4516
The first "pillar" of the minimum capital requirement shows the expansion more
compared to Basel I. The principal mandate accordingly expands the scope. This is achieved by the
inclusion of any holding company that is the parent entity within a banking group to ensure that it
captures the risk of the whole banking group.
Credit risk:
Basel II aims to assess the risk-weighted assets (RWA) of a bank with more care. This
revised framework positioned forward three methodologies to determine the risk rating of the assets
of a bank - both the standard approach and IRB approach.
The standard method directed to use bank ratings of external rating agencies to calculate capital
requirements related to credit risk. There are 13 categories of personal property specifically named in
the accord risk weighting rules Basel II.
Basel II introduced two Internal Ratings Based Approaches the Foundation IRB and the
Advanced IRB which gives freedom to the banks to develop their own models in order to assess the
risk weights of assets.
Operational risk:
Basel II introduced assessment and reduction of operational risks. The methods
introduced to reduce operational risks in Basel-II are - Basic Indicator Approach, Standardized
Approach and Advanced Measurement Method.
The Basic Indicator Approach assessed, that banks have 15 percent of their gross annual average
income (in the last three years) as capital. And based on the risk assessment of individual banks,
regulators can adjust the threshold of 15 percent.
The Standard Approach is segregating the bank into various divisions as per their business segments
so that the divisions with lower operational risk would require lower reserve requirements.
The Advanced Measurement Approach gives banks the freedom to perform their own computations
for operational risk. Once again, these are subject to regulatory approval.
Market Risk:
Market risk is the risk of loss due to movements in the market prices of assets. Here
Basel II came up with two different categories one related to asset categories, and the other is types
of principal risks. In terms of assets, products with fixed income have different category altogether. In
terms of principal risk, there are two segments specifically identified interest rate risk and volatility
risk. These risks come together in overall market risk.
Pillar II Supervisory Review:
The second pillar deals with the supervisory review or the regulatory response to the
first pillar. It gives the regulators much improved 'tools' over those available to them under Basel I and
also provides a framework for dealing with all the other risks a bank may face, such as systemic
risk, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk and legal risk,
which the accord combines under the title of residual risk. The power of risk assessment lies with the
bank.
Pillar III Banking Sector Discipline:
Pillar III main goal is to incorporate financial discipline within the banking sector of a
country. Basel II focuses on the disclosures of the banks capital and risk profiles to the regulators
before it sending it to public should be made public. The same information could be widely
disseminated to shareholders and help them to take more prudence in the risk levels of banks.
1.3: Basel II and the global financial crisis - Emergence of Basel III
In response to the 200709 global financial crisis BCBS issued Basel II, which was
designed to estimate capital requirements for credit risk in the trading book of a bank. In that order,
39 | P a g e
h t t p s : / / w w w. i j o p a a r. o r g /

International Journal of Pure and Applied Management Sciences;

Vol. 2016.1.2; pp. 36-43, ISSN: 2456-4516
the Basel Committee introduced lot of documents to address counterparty risk in derivative
transactions, strengthening of liquidity standards and market risk framework. Consolidating all these,
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).
Basel III has following main objectives:
To strengthen global capital and liquidity regulations.
To prepare the banking sector in order to absorb shocks arising from financial and
economic stress.
To improve risk management and governance.
To strengthen banks' transparency and disclosures.
Strengthening of provisioning norms
Another issue raised by the Basel III reforms is of provisioning norms; currently there
is a standardized approach to provisioning in the banking system but Basel III is talking about a move
from incurred loss approach to expected loss approach.
The Basel III Accord is also known as the International framework for liquidity risk measurement,
standards and monitoring. A Basel III guideline is mainly introduced to improve the ability of banks
to withstand periods of economic and financial stress. The capital requirement for banks is a positive
step; it raises the minimum core capital through a capital conservation buffer, which improves the
banks ability in stressed situation. The Basel committee finalized the Basel III guidelines in
December 2010.
Types of Capital Funds:Tier1- Paid up Capital Statutory Reserves Other disclosed free reserves, Capital Reserves which
represent surplus arising out of the sale proceeds of the assets, Investment Fluctuation
Reserves, Innovative Perpetual Debt Instruments (IPDIs), Perpetual Noncumulative
Preference Shares Minus Equity Investment in subsidiaries, Intangible assets, Losses
(Current period + past carried forward)
Tier2- undisclosed reserves and cumulative perpetual preference shares, Revaluation Reserves
General Provisions and loss reserves Hybrid debt capital instruments such as bonds,
Long term unsecured loans Debt Capital Instruments, Redeemable cumulative Preference
shares, perpetual cumulative preference shares.
Basel III has two set of compliance:
Capital
Liquidity
Liquidity Rules
Under Liquidity, Basel III accord wants to strengthen the liquidity profile of the banking industry by
deploying adequate capital where bank does not face difficulty in financial crisis.
Capital Rules
Here Basel III accord wants banks to ensure that banking institutions maintain a sound and stable
capital base. Enhancement of risk coverage and diversification is the objective of Basel III accords by
introduction of capital conservation buffer and countercyclical buffer.
Capital Conservation Buffer
Capital Conservation Buffer is introduced to make certain that banks accumulate capital buffers in
times of low financial stress. Such a buffer would help the Banks in case if banks are hit by losses,
and aims to prevent violations of minimum capital requirements. Banks facing difficulty in
maintaining buffer have an option to raise fresh capital from the private sector.
40 | P a g e
h t t p s : / / w w w. i j o p a a r. o r g /

International Journal of Pure and Applied Management Sciences;

Vol. 2016.1.2; pp. 36-43, ISSN: 2456-4516
This buffer is built out of Common Equity Tier 1 (CETI), only after the 6 percent Tier 1 and 8 percent
total capital requirements have been fulfilled. Table1 below illustrates the minimum capital
conservation ratio that a bank must maintain for different levels of the Common Equity Tier 1 (CET1)
ratio.

Table 1: Individual bank minimum capital conservation standards.

Common Equity Tier 1 Ratio

Minimum Capital Conservation Ratio

(%)

(expressed as a percentage of earnings)

4.5 - 5.125

100

>5.125 - 5.75

80

>5.75 - 6.375

60

>6.375 7

40

>7

20
Source: Basel III Accord, 2011 Revision

2. Review of Literature
There are various significant research literatures available in the field of banking
regulation, particularly in the context of its regulatory framework. The following section reviews
some of the articles.
Jayadev (2013) observed the opinion of senior level executives employed in Indian
banks in addition to various risk management experts to explore the challenges of Basel III
implementation and how it could be dealt in Indian scenario. In regard to the timing of Basel III
implementation, there is a serious concern for maintaining higher capital which coincides with an
ever-expanding credit demand. It is to be noted here that compliance with Basel III suggests a lower
return on equity (ROE) for banks owing to the fall in leverage.
According to Shah (2013) it is certain that banks ROE and profitability will fall in
the next couple of years. Initially Basel III suggests the phased removal of some parts of capital from
Tier 1, which suggests that banks capital is bound to decline by around 60 percent. Secondly, the risk
weightings are expected to go up by approximately 200 percent and the transition from short-term
liquidity to long-term liquidity suggests a higher cost of funds. The paper also enlighten on how these
Indian banks have relatively moderate leverage ratios.
Mehta (2012) cites that it has been a trend in India that the government has been quite
hesitant in disinvesting its shareholding in PSBs, this simply suggests that the capital infusion has to
be brought in from public money. As has been observed in India where the government is always
cash-strapped, it cannot be effortlessly assumed that such capital infusion is practical and/or optimal.
Yan et al. (2012) undertook an insightful study on the long-term cost-benefit of the
Basel III norms for the United Kingdom (UK). According to him the optimal tangible common equity
capital ratio is 10 percent of risk-weighted assets (RWAs) as against the Basel III set benchmark of 7
percent. Hence, according to him, Basel III is having positive and long-term effect on the UK
economy. They also estimated the maximum net benefit when banks meet the Basel III long-term
liquidity requirements.
3. Impact of Basel norms on banking Industry in India
41 | P a g e
h t t p s : / / w w w. i j o p a a r. o r g /

International Journal of Pure and Applied Management Sciences;

Vol. 2016.1.2; pp. 36-43, ISSN: 2456-4516
Basel norms implementation is not an easy task for the Indian Banks which is very
stringent and requires additional capital for meeting various buffers. As Indian Banking Industry is
depriving of the desired capital they needed to sustain an organic growth in their business as the same
only could help them out in balancing their profitability. Base III demands significant shift in the
portfolio composition of the banks to bring stability in the Indian banking Industry. Despite of a
different levels of capital requirements, capital adequacy norms pose a serious challenge for the Banks
since the capital ratios can be improved only by issuing more capital rather than shifting away from
corporate loans to Retail or Government Loans which are termed as risky assets as per the Basel
norms. Today, the banks have been trying to shed their corporate loans and trying to cope up with
their capital ratios thrusting upon the Retail assets which are totally diverse in nature. The Capital
adequacy norms force the Banks to invest into less risky investments by concentrating only on on
Retail or government based Loans.
The Indian banking sector is moving towards a gradual compliance of BASEL III
norms and it witnessed a change in the capital structure and portfolio composition with an increase in
the market share of Retail assets. The Basel norms fostered the idea of credit on the basis of a
borrower's credit worthiness for which Banks have started working on the credit score of the
borrowers for which borrower profile is being assessed on many defined different parameters before
taking a final call of sanction. Today the Banks are facing lot many other difficulties as well to
improve their capital which is mandatory to fulfill Basel norms.

Scarce Capital
Weak and Non-Performing Assets
High Cost Deposits
Technology
Efficient Workers for Monitoring

How banks will mitigate the risk arising out of these changes?
Scarce Capital- Banks has been looking for a capital to fulfill Basel norms by concentrating on
generating capital.
Weak Assets- In last few years, banks has totally stopped funding to all large corporate due to huge
risk which involves provisioning and capital both. Now, all banks are targeting Retail credit which is
widely diversified and helping them to mitigate the risk.
High Cost Deposits- Today, Bank is facing a problem of high cost on deposits. Every Bank wants to
increase their market share on CASA deposits to curtail the cost of funds and for improving their
profitability. Resource mobilization plays an important role and this is how they can mitigate risk of
reducing their cost on deposits.
Non-Performing Assets- Indian Banks are struggling from Non-Performing Assets which require
huge provisioning and in turn deteriorating their capital which we could say are the bad times for the
bank and to overcome from this they are trying to do more settlements and restructuring.
Technology- Since implementing Basel III requires more expenses by way of creating separate cell,
manpower, technology, trained professionals.
Monitoring- Monitoring is the most important tool for optimizing capital like whether security in the
loans account is attached or not, Critical amount in recovery to upgrade bad assets is taken or not,
whether correct rate of interest is charged in all accounts or not, all revenue leakages like processing
fees, documentation fees, renewal fees in running accounts is taken or not. All such expertise is
required to increase Banks profitability and Basel norms have forced the banks to do so.
4. Preparedness of Banks for Basel III
State of Preparedness- Majority of Indian Banks have started working on implementing Basel III
norms by creating the separate vertical of Risk Management in their Banks fully dedicated to improve
their risk management practices.
42 | P a g e
h t t p s : / / w w w. i j o p a a r. o r g /

International Journal of Pure and Applied Management Sciences;

Vol. 2016.1.2; pp. 36-43, ISSN: 2456-4516
Capital Requirement- All Banks are totally equipped with technology and have placed core Banking
Solution and have ascertain the incremental capital they required for Basel III implementation.
Impact on Credit- All Banks wants to increase their capital imposed by Basel norms so that Banks
becomes more risk averse towards credit dispensation. Hence, Banks have targeted their thrust area of
credit which is mainly Retail and Government which is totally risk free and requires less provisioning
as per Basel III norms.
Launching of buffers for unforeseen circumstances- The intention behind the buffer in capital
conservation is to make certain that banks accumulate capital buffers in times of financial stress.
When banks are hit by losses, and aims to prevent violations of minimum capital requirements,
conservation of buffer in capital shall make them handy in taking quick decisions for their financial
stability in the market as per their regulators. Banks will be in a position to manage their capital
through using their discretionary distribution of earnings if any financial crunch they are facing in
those turbulences.
5. Conclusion
The Basel norms, at some level, aim to create a global banking system that is fairly
homogenous and homogeneous banking system could potentially be more vulnerable to a mass failure
or collapse. Hence, diverse group is not an advantage but a curse which is in fact dangerous future for
countries around the world.
The Basel III norms which are implemented in the banking sector from 2013 had
called for a further re-engineering of the capital base of the banks. Also for effective execution of the
Basel III Norms, significant changes in the capital structure of the banks are required to foster the idea
of maintenance of capital adequacy ratio. In order to balance the profitability and stability of the
banks, banks had to re-engineer their assets and investment composition. Here in India, banks are
viewed as sources of credit for the development of the economy including catering various social
needs and the capital adequacy ratio provides a positive impact on the profitability and the efficiency
of the Indian banking without sacrificing productivity and the asset quality. The performance of these
banks suggests enforcement of these norms by reducing the bad debt of the bank and increasing its
profit.
The enforcement of new capital standards in order to improve the quality of the
capital base of the banks under Basel III norms were issued after the financial turmoil of 2007-08.
Implementation of Basel III norms has been described as a long journey and it will surely brought in
significant changes in the requirement of the bank capital for which financial institutions are working
successful. However, banks need to concentrate on important parameter defined in this research for
effective implementation of BASEL III norms by increasing their capital base. Undoubtedly, Basel III
would require substantial capital apart from additional buffer but for that RBI has decided to follow
consultative process and asked all the Indian Banks to move it gradually to effective Banking system
involving different supervisory and regulatory departments to take interest on implementing Basel III
norms by 2018.
References
1. Allen, B. K., (2012); Basel III: Is the Cure wose than the disease? International Review of
Financial Analysis, Vol 25, 159-166.
2. M, J., (2013); IIMB Management Review, Vol 25. Basel III Implementation: Issues and
Challenges for Indian banks, 115-130.
3. Mehta, M., (2012); Demystifying Basel IIIfor Indian Banks. International Conference on
Techonology and Business Management, 92-100.
4. Raj, K., (2013); Basel III Accord in Indian Perspective. International Journal on Global
Business Management and Research, Volume 1, No. 2, 92-100.
43 | P a g e
h t t p s : / / w w w. i j o p a a r. o r g /

International Journal of Pure and Applied Management Sciences;

Vol. 2016.1.2; pp. 36-43, ISSN: 2456-4516
5. Shah, M., (2013); Basel III and Its impact on Indian Banking Sector. Journal of Indian
Research, Volume 1, 53-58.
6. Yan, M. M., (2012); A cost benefit Analysis of Basel III. International Review of Financial
Analysis, Volume 25, 73-82.

44 | P a g e
h t t p s : / / w w w. i j o p a a r. o r g /