Published on September 26, 2014
INTRODUCTION OF BASEL BASEL is a city in Switzerland which is also the headquarters of Bank of International Settlement (BIS). In 1988,central bankers from around the world published a set of minimum capital requirements for banks known as “ Basel Accord ” BIS’s common goal: Financial stability Common standards BIS have 27 member nations in the committee. BASEL guidelines refers to broad supervisory standards formulated by the group of central banks-called the Basel Committee On Banking Supervision (BCBS).
BASEL ACCORD The Basel Accords refer to the banking supervision Accords issued by the Basel Committee on Banking Supervision (BCBS). They are called the Basel Accords as the BCBS maintains its secretariat at the Bank for International Settlements in Basel. The Basel Accords is a set of recommendations for regulations in the banking industry. PURPOSE: To ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses. India has accepted Basel Accords for the banking system.
Basel II Basel II is the second of the Basel accords which are recommendations on banking laws and regulations issued by the BCBS. Basel II , initially published in June 2004 Was intended to create an international standard for banking regulators to control how much capital banks need to put aside to guard against the types of financial and operational risks banks face. Basel II attempted was to accomplish by setting up risk and capital management requirements designed to ensure that a bank has adequate capital for the risk the bank exposes itself to through its lending and investment practices.
OBJECTIVE OF BASEL II Ensuring that capital allocation is more risk sensitive. Enhance disclosure requirements which would allow market participants to assess the capital adequacy of an institution. Ensuring that credit risk, operational risk and market risk are quantified based on data and formal techniques. Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.
3 PILLARS OF Basel II FRAMEWORK
PILLAR 1:MINIMUM CAPITAL REQUIREMENT Pillar 1 sets out the minimum capital requirements firms will be required to meet to cover credit, market and operational risk
CREDIT RISK : The risk of loss arising from outright default due to inability or unwillingness of the customer or counter party to meet commitments in relation to lending, trading, settlement and other financial transaction of the customer or counter party to meet commitments MARKET RISK : The possibility of loss caused by changes in the market variables such as interest rate, foreign exchange rate, equity price and commodity price
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 and private settlements. It does not, however, include strategic or reputational risk.
PILLAR 2:SUPERVISORY REVIEW • The 2nd pillar deals with the regulatory response to the 1st pillar, giving regulators much improved tools over those available to them under Basel 1. • It also provides a framework for dealing with all the other risks a bank may face, such as systematic risk, pension risk, concentration risk, strategic risk, reputation risk, liquidity risk and legal risk which the accord combines under the title of residual risk. • It gives the bank a power to review their risk management system.
PILLAR 3: MARKET DISCIPLINE Aims to complement the minimum capital requirements and supervisory review process by developing a set of disclosure requirements which will allow the market participants to gauge the capital adequacy of an institution Aim 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.
ADVANTAGES Takes global aspect into consideration for more rational decision making, improving the decision matrix for banks. Makes better business standards. Reduces losses to the banks. Improving overall efficiency of banking and finance systems. Allowing capital allocation based on ratings of the borrower making capital more risk-sensitive. Provides range of alternatives to choose from. Incorporates sensitivity to banks. Encouraging mergers and acquisitions and more collaboration on the part of the banks, this ultimately leads to proper control over their capital and assets.
DRAWBACKS Dealing with diversity. Lack of data on internal ratings and modeling. Cyclical fluctuations in bank lending. Credit risk reduction. Competition among banks. Financial innovations.
BASEL 3 FRAMEWORK
MAJOR FEATURES OF Basel III Better Capital Quality : One of the key elements of Basel 3 is the introduction of much stricter definition of capital. Better quality capital means the higher loss-absorbing capacity. This in turn will mean that banks will be stronger, allowing them to better withstand periods of stress. Capital Conservation Buffer : Another key feature of Basel iii is that now banks will be 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 : This is also one of the key elements of Basel III. The countercyclical buffer has been introducted 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.
Minimum Common Equity and Tier 1 Capital Requirements : The minimum requirement for common equity, the highest form of loss-absorbing capital, has been raised under Basel III from 2% to 4.5% of total risk-weighted assets. The overall Tier 1 capital requirement, consisting of not only common equity but also other qualifying financial instruments, will also increase from the current minimum of 4% to 6%. Although the minimum total capital requirement will remain at the current 8% level, yet the required total capital will increase to 10.5% when combined with the conservation buffer. Leverage Ratio: A review of the financial crisis of 2008 has indicted that the value of many assets fell quicker than assumed from historical experience. Thus, now Basel III rules 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. 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 will be created. A new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are to be introduced in 2015 and 2018, respectively.
Systemically Important Financial Institutions (SIFI) : As part of the macro-prudential framework, systemically important banks will be expected to have loss-absorbing capability beyond the Basel III requirements. Options for implementation include capital surcharges, contingent capital and bail-in-debt.
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