What are BASEL I, II and III norms

On 26 June 1974, a number of banks had released payment of Deutsche Marks (DEM - German
Currency at that time) to Herstatt (Based out of Cologne, Germany) in Frankfurt in exchange for US
Dollars (USD) that was to be delivered in New York. Because of time-zone differences, Herstatt
ceased operations between the times of the respective payments. German regulators forced the
troubled Bank Herstatt into liquidation. The counter party banks did not receive their USD payments.
Responding to the cross-jurisdictional implications of the Herstatt debacle, the G-10 countries, Spain
and Luxembourg formed a standing committee in 1974 under the auspices of the Bank for
International Settlements (BIS), called the Basel Committee on Banking Supervision. Since BIS is
headquartered in Basel, this committee got its name from there. The committee comprises
representatives from central banks and regulatory authorities.

The Basel Committee: Formerly, the Basel Committee consisted of representatives from central
banks and regulatory authorities of the Group of Ten countries plus Luxembourg and Spain. 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.

The committee does not have the authority to enforce recommendations, although most member
countries as well as some other countries tend to implement the Committee's policies. This means
that recommendations are enforced through national (or EU-wide) laws and regulations, rather than
as a result of the committee's recommendations - thus some time may pass between
recommendations and implementation as law at the national level.

Basel I:

In 1988, the Basel Committee on Banking Supervision (BCBS) in Basel, Switzerland, published a set
of minimum capital requirements for banks. These were known as Basel I. It focused almost entirely
on credit risk (default risk) - the risk of counter party failure. It defined capital requirement and
structure of risk weights for banks.

Basel I Accord is primarily focused on credit risk and appropriate risk-weighting of assets. 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 as
mortgage-backed securities (MBS) with the highest AAA rating), 50% (municipal revenue bonds,
residential mortgages), 100% (for example, most corporate debt), and some assets given No rating.
Banks with an international presence are required to hold capital equal to 8% of their risk-weighted
assets (RWA).

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

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

Banks are also required to report off-balance-sheet items such as letters of credit, unused
commitments, and derivatives. From 1988 this framework was progressively introduced in member
countries of G-10, comprising 13 countries as of 2013: Belgium, Canada, France, Germany, Italy,
Japan, Luxembourg, Netherlands, Spain, Sweden, Switzerland, United Kingdom and the United
States of America.
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Over 100 other countries also adopted, at least in name, the principles prescribed under Basel I. The
efficacy with which the principles are enforced varies, even within nations of the Group. One of the
major roles of Basel norms is to standardize the banking practice across all countries. However, there
are major problems with definition of Capital and Differential Risk Weights to Assets across
countries, like Basel standards are computed on the basis of book-value accounting measures of
capital, not market values. Accounting practices vary significantly across the G-10 countries
and often produce results that differ markedly from market assessments.

Other problem was that the risk weights do not attempt to take account of risks other than credit risk,
viz., market risks, liquidity risk and operational risks that may be important sources of
insolvency exposure for banks.

Transition to Basel II from Basel I

Basel II was fundamentally conceived as a result of (a) the banking crisis of 1990s and (b) the
criticism/limitations of Basel I
The main criticism of Basel I
A. Limited Differentiation of Credit Risk: Just Four broad risk weightings (0%, 20%, 50%, and
100%)
B. No Recognition of Term Structure of Credit Risk: Maturity of the credit exposure wasn’t
considered.
C. Simplified calculation of future multi-country counter party risk: Ignored different level of
risk associated with different currencies and their macroeconomic risk
D. Lack of recognition of portfolio diversification effects: In reality, the sum of individual risk
exposures isn’t the same as the risk reduction through portfolio diversification
E. Static measure of default risk: Doesn’t take into account the changing nature of default risk

In September 1998, the Basel Committee announced that it would officially review the 1988 accord
with the aim of replacing it with more flexible rules. In June 1999, it released its first set of proposals
for the new framework. After five years of negotiations, the Committee finally announced that it had
agreed on a new capital adequacy framework, the Basel II Accord.

The main objective of Basel II (Final Version) aims at:

1. Ensuring that capital allocation is more risk sensitive;
2. Enhance disclosure requirements which would allow market participants to assess the capital
adequacy of an institution;
3. Ensuring that credit risk, operational risk and market risk are quantified based on data and
formal techniques;
4. Attempting to align economic and regulatory capital more closely to reduce the scope for
regulatory arbitrage.

The accord in operation: Three pillars

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The new accord rested on three ‘pillars'. In addition to specifying minimum capital requirements
(pillar 1), the new accord provided guidelines on regulatory intervention to national supervisors
(pillar 2) and created new information disclosure standards for banks with a view to enhancing
market discipline (pillar 3).
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
The first pillar deals with maintenance of regulatory capital calculated for three major components of
risk that a bank faces: credit risk, operational risk, and market risk. The credit risk component can
be calculated in different ways of varying degree of sophistication, namely standardized approach
and Internal Rating-Based Approach (IRB). For operational risk, there are three different
approaches – basic indicator approach (BIA), standardized approach (TSA), and the internal
measurement approach (an advanced form of which is the advanced measurement approach or
AMA). For market risk the preferred approach is VaR (value at risk).
The second pillar: Supervisory review Process
It focuses on the aspects of regulator-bank interaction. Specifically, it empowers regulator in matters
of supervision and dissolution of banks. For instance, regulator may supervise internal risk
evaluation mechanism outlined in Pillar I and change them to more conservative or simpler one, as
the case demands. Regulators are permitted to create a buffer capital requirement over and above the
minimum capital requirement in pillar I.
The third pillar: Market discipline
This pillar aims to induce discipline within the banking sector of a country. Basel II suggests that,
disclosures of bank’s capital and risk profiles which were shared solely with regulators till this point
should be made public and available to the market participants. The premise was that information to
shareholders could be widely disseminated. 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.

Transition to Basel III from Basel II

The Basel II Accord was published initially in June 2004 and was intended to amend international
banking standards that controlled how much capital banks were required to hold to guard against the
financial and operational risks banks face. These regulations aimed to ensure that the more
significant the risk a bank is exposed to, the greater the amount of capital the bank needs to hold to
safeguard its solvency and overall economic stability. Basel II attempted to accomplish this by
establishing risk and capital management requirements to ensure that a bank has adequate capital for
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the risk the bank exposes itself to through its lending, investment and trading activities. One focus
was to maintain sufficient consistency of regulations so to limit competitive inequality amongst
internationally active banks.

Basel II was implemented in the years prior to 2008, and was only to be implemented in early 2008
in most major economies; that year's financial crisis intervened before Basel II could become fully
effective. As Basel III was negotiated, the crisis was top of mind and accordingly more stringent
standards were contemplated and quickly adopted in some key countries including in Europe and the
US.

Basel II laid down guidelines for capital adequacy (with more refined definitions), risk management
(Market Risk and Operational Risk) and disclosure requirements.

Uses of external ratings agencies were to set the risk weights for corporate, bank and sovereign
claims.

Operational risk has been defined as the risk of loss resulting from inadequate or failed internal
processes, people and systems or from external events. This definition includes legal risk,
but excludes strategic and reputation risk, whereby legal risk includes exposures to fines,
penalties, or punitive damages resulting from supervisory actions, as well as private settlements.
There are complex methods to calculate this risk.

Disclosure requirements allow market participants assess the capital adequacy of the institution
based on information on the scope of application, capital, risk exposures, risk assessment processes,
etc.

Basel III:

It is widely felt that the shortcoming in Basel II norms is what led to the global financial crisis of
2008. That is because Basel II did not have any explicit regulation on the debt that banks could take
on their books, and focused more on individual financial institutions, while ignoring systemic risk.
To ensure that banks don’t take on excessive debt, and that they don’t rely too much on short term
funds, Basel III norms were proposed in 2010-11, and were scheduled to be introduced from 2013
until 2015. However, changes made from April 2013 extended implementation until March 31, 2018.
Basel III was intended to strengthen bank capital requirements by increasing bank liquidity and
decreasing bank leverage.

The global capital framework and new capital buffers require financial institutions to hold more
capital and higher quality of capital than under current Basel II rules. The new leverage ratio
introduces a non-risk based measure to supplement the risk-based minimum capital requirements.
The new liquidity ratios ensure that adequate funding is maintained in case there are other severe
banking crises.

Minimum Capital Requirements:

The Basel III rule introduced the following measures to strengthen the capital requirement and
introduced more capital buffers:
A. Capital Conservation Buffer is designed to absorb losses during periods of financial and
economic stress. Financial institutions will be required to hold a capital conservation buffer
of 2.5% to withstand future periods of stress, bringing the total common equity requirement

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 to 7% (4.5% common equity requirement and the 2.5% capital conservation buffer). The
capital conservation buffer must be met exclusively with common equity. Financial
institutions that do not maintain the capital conservation buffer faces restrictions on payouts
of dividends, share buybacks, and bonuses.
B. Countercyclical Capital Buffer is a countercyclical buffer within a range of 0% and 2.5% of
common equity or other fully loss absorbing capital is implemented according to national
circumstances. This buffer serves as an extension to the capital conservation buffer.
C. Higher Common Equity Tier 1 (CET1) constitutes an increase from 2% to 4.5%.
D. Minimum Total Capital Ratio remains at 8%. The addition of the capital conservation
buffer increases the total amount of capital a financial institution must hold to 10.5% of risk-
weighted assets, of which 8.5% must be tier 1 capital. Tier 2 capital instruments are
harmonized and tier 3 capital is abolished.

Leverage risk:

Banks can also pile on debt like other companies. This increases the risk in the system. The Basel III
norms limit the amount of debt a bank can owe even further. This is especially applicable for banks
that trade in high-risk assets like derivatives. The leverage ratio was calculated by dividing Tier 1 capital
by the bank's average total consolidated assets; the banks were expected to maintain a leverage ratio in excess
of 3% under Basel III.

Liquidity:

Capital is money that is invested in assets like equity or government bonds. This money, therefore, is
not readily available for day-to-day activities. Moreover, during a crisis, the value of investments can
fall suddenly like the 2008 financial crisis. This means, the capital a bank holds can fall during times
of need. This is why the BASEL III norms ask banks to hold liquid money. Basel III introduced two
required liquidity ratios:

A. Liquidity Coverage Ratio (LCR) ensures that sufficient levels of high-quality liquid assets
are available for one-month survival in a severe stress scenario.
B. Net Stable Funding Ratio (NSFR) promotes resilience over long-term time horizons by
creating more incentives for financial institutions to fund their activities with more stable
sources of funding on an ongoing structural basis.

Changes to Counterparty Credit Risk (CCR)

Basel III introduced capital requirements to cover Credit Value Adjustment (CVA) risk and higher
capital requirements for securitization products.

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Implementation in India

The Reserve Bank of India (RBI) introduced the norms in India in 2003. It now aims to get all
commercial banks BASEL III-compliant by March 2019. So far, India’s banks are compliant with
the capital needs. On average, India’s banks have around 8% capital adequacy. This is lower than the
capital needs of 10.5% (after taking into account the additional 2.5% buffer). In fact, the BASEL
committee credited the RBI for its efforts.

Challenges for Indian banks

Complying with BASEL III norms is not an easy task for India’s banks, which have to increase
capital, liquidity and also reduce leverage. This could affect profit margins for Indian banks. Plus,
when banks keep aside more money as capital or liquidity, it reduces their capacity to lend money.
Loans are the biggest source of profits from banks. Plus, India banks have to meet both LCR as well
as the RBI’s Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR) norms. This means
more money would have to be set aside, further stressing balance sheets.

What are the hurdles to implementation?

The banking regulator introduced Basel III norms in India in 2003 and aims to bring in all
commercial banks by March 2019. At a time when Indian banks are struggling with Rs 8.4 lakh crore
of stressed assets complying with Basel III norms is not an easy task for India’s banks, which have to
increase capital, liquidity and also reduce leverage. As they work towards compliance, Indian lenders
are facing a hit on their profit margins.

For Further Reading:

https://www.moodysanalytics.com/-/media/article/2013/2013-18-10-basel-iii-capital-and-liquidity-
standards-faq.pdf
https://economictimes.indiatimes.com/markets/stocks/news/5-reasons-why-indian-banks-need-to-up-
the-ante-for-basel-iii-compliance/articleshow/62485231.cms
file:///C:/Users/parthajit.kayal/Downloads/Delete%20Further/proceeding-4-19-1713.pdf