Basic about Basel

BASEL Committee on Banking Supervision

The  BASEL  Committee  is  a  committee  of  bank  supervisors  consisting  of  members from  each  of  the  G10  countries.  The Committee is a forum for discussion on the handling of specific supervisory problems.  It coordinates  the haring  of  supervisory  responsibilities  among  national  authorities  in  respect  of banks'  foreign  establishments  with  the  aim  of  ensuring  effective  supervision  of banks' activities worldwide.

BASEL Capital accord

Basel II is still in different stages of implementation around the globe, and Basel III is around the corner. What is this new financial order all about and why the buzz around the new regulation?

Capital regulations under Basel I came into effect in December 1992 (after development and consultations since 1988). The aims were: first, that banks were to maintain enough capital to absorb losses without causing systemic problems and, second, to level the playing field internationally (to avoid competitiveness conflicts).

However, Basel I was criticised as a ‘broad-brush' structure, as it failed to differentiate among the risk sensitivities of the borrowers. The Basel I norms also gave banks the ability to control the amount of capital they required by shifting between on-balance sheet assets, and by securitising assets and shifting them off the balance sheet. Banks quickly accumulated capital well in excess of the regulatory minimum and capital requirements, which, in effect, had no constraining impact on bank risk-taking.

A ‘revised framework' known as Basel II was released in June 2004. The simplified Basel II approach was more ‘granular' than Basel I, but retains its basic features.

The Basel II is more risk-sensitive than Basel I and also covers new risk classes like ‘Operational Risks'. While the leading economies of the world were in different stages of its implementation, they were hit by the financial crisis.

With these economies slowly finding their feet again, regulators and analysts have started pointing out deficiencies in the Basel II regulatory regime.

Grey areas

There are some areas where the present Basel II accord falls short. The system is known to be pro-cyclical as it underestimate risks in good times and overestimate them in bad times. Counterparty credit policies are easy in good times and tough in bad; and profit recognition schemes encourage short-term risk-taking, but are not adjusted for risk over the business cycle.

For the mathematical model underlying the Basel II the basic assumptions are: each exposure's contribution to value-at-risk (VaR) is portfolio invariant only if: (a) dependence across exposures is driven by a single systemic risk factor — a global risk factor, and (b) each exposure is small. However, this may not always be the case in real life. In the sub-prime crisis, for instance, the source was the US housing market and exposures were quite large. The composition of capital is not standardised among the countries. Many countries factored in hybrid capital (like goodwill, deferred tax assets, bank investments in own shares, etc.) in capital computation. This means that, in a crisis, the ability of banks to absorb losses is compromised and varies across countries — exactly as happened in the crisis.

The BASEL Capital Accord is an Agreement concluded among country representatives in 1988 to develop standardised risk-based capital requirements for banks across countries.  The Accord was  replaced  with  a  new  capital adequacy  framework  (BASEL  II),  published in June  2004.  BASEL II is based on three  mutually  reinforcing  pillars  hat  allow  banks  and  supervisors  to  evaluate properly  the  various  risks  that  banks  face.

 These three pillars are:

1)   Minimum capital requirements, which seek to refine the present measurement framework

2)   Supervisory review of an institution's capital adequacy and internal assessment process;

3)   Market  discipline  through  effective  disclosure  to  encourage  safe  and  sound banking practices 

Credit Risk

The risk that a party to a contractual agreement or transaction will be unable to meet its obligations or will default on commitments.  Credit risk can be associated with almost any financial transaction. BASEL-II provides two options for measurement of capital charge for credit risk

1.standardised  approach  (SA)  -  Under  the  SA,  the  banks  use  a  risk-weighting schedule  for  measuring  the  credit  risk  of  its  assets  by  assigning  risk  weights based  on  the  rating  assigned  by  the  external  credit  rating  agencies.

2. Internal rating based approach (IRB) - The IRB approach, on the other hand, allows banks to use their own internal ratings of  counterparties and  exposures, which  permit  a  finer  differentiation  of  risk  for  various  exposures  and  hence delivers capital requirements that are better aligned to the degree of risks. The IRB approaches are of two types:

a) Foundation IRB (FIRB): The bank estimates the Probability of Default (PD) associated with each borrower, and the supervisor supplies other inputs such as Loss Given Default (LGD) and Exposure at Default(EAD).

b) Advanced IRB (AIRB): In addition to Probability of Default (PD), the bank estimates other inputs such as EAD and LGD.  The requirements for this approach are more exacting.  The adoption of advanced approaches would require the banks to meet minimum requirements relating to internal ratings at the  outset  and  on  an  ongoing  basis  such  as  those  relating  to  the  design  of  the rating  system,  operations,  controls,  corporate  governance,  and  estimation  and validation  of  credit  risk  components,  viz.,  PD  for  both  FIRB  and  AIRB  and  LGD and  EAD  for  AIRB.  The  banks  should  have,  at  the  minimum,  PD  data  for  five years and LGD and EAD data for seven years.

 In India, banks have been advised to compute capital requirements for credit risk adopting the SA. 

Market risk

Market  risk  is  defined  as  the  risk  of  loss  arising  from  movements  in  market prices  or  rates  away  from  the  rates  or  prices  set  out  in  a  transaction  or agreement.  The  capital  charge  for  market  risk  was  introduced  by  the  BASEL Committee  on  Banking  Supervision  through  the  Market  Risk  Amendment  of January 1996 to the capital accord of 1988 (BASEL I Framework). There are two methodologies available to estimate the capital requirement to cover market risks: 

1) The Standardised Measurement Method: This method, currently implemented by the Reserve Bank, adopts a ‘building block’ approach for interest-rate related and equity instruments which differentiate capital requirements for ‘specific risk’ from  those  of  ‘general  market  risk’.  The ‘specific risk charge’ is designed to protect  against  an  adverse  movement  in  the  price  of  an  individual  security  due to  factors  related  to  the  individual  issuer.  The ‘general market risk charge’ is designed  to  protect  against  the  interest  rate  risk  in  the  portfolio.

2) The Internal Models Approach (IMA): This method enables banks to use their proprietary  in-house  method  which  must  meet  the  qualitative  and  quantitative criteria  set  out  by  the  BCBS  and  is  subject  to  the  explicit  approval  of  the supervisory authority. 

Operational Risk

The  revised  BASEL  II  framework  offers  the  following  three  approaches  for estimating capital charges for operational risk:

1)  The Basic Indicator Approach (BIA):  This approach sets a charge for operational  risk  as  a  fixed  percentage  ("alpha  factor")  of  a  single  indicator, which      serves   as            a              proxy    for          the         bank’s   risk         exposure.

2)  The Standardised Approach (SA):  This approach requires that the institution separate its operations into eight standard business lines, and the capital charge for each business line is calculated by multiplying gross income of that business line by a factor                 (denoted             beta)     assigned              to            that        business              line.

3) Advanced Measurement Approach (AMA): Under this approach, the regulatory capital requirement will equal the risk measure generated by the banks’ internal operational risk measurement system. In India, the banks have been advised to adopt  the  BIA  to  estimate  the  capital  charge  for  operational  risk  and  15%  of average  gross  income  of  last  three  years  is  taken  for  calculating  capital  charge for operational risk. 

Internal Capital Adequacy Assessment Process (ICAAP)

In terms of the guidelines on BASEL II, the banks are required to have a board-approved  policy  on  internal  capital  adequacy  assessment  process  (ICAAP)  to assess the capital requirement as per ICAAP at the solo as well as consolidated level.  The  ICAAP  is  required  to  form  an  integral  part  of  the  management  and decision-making  culture  of  a  bank.  ICAAP document is required to clearly demarcate the quantifiable and qualitatively assessed risks.  The ICAAP is also required  to  include  stress  tests  and  scenario  analyses,  to  be  conducted periodically,  particularly  in  respect  of  the  bank’s  material  risk  exposures,  in order  to  evaluate  the  potential  vulnerability  of  the  bank  to  some  unlikely  but plausible  events  or  movements  in  the  market  conditions  that  could  have  an adverse impact on the bank’s capital.

Supervisory Review Process (SRP)

Supervisory review process envisages the establishment of suitable risk management  systems  in  banks  and  their  review  by  the  supervisory  authority.

The  objective  of  the  SRP  is  to  ensure  that  the  banks  have  adequate  capital  to support all the risks in their business as also to encourage them to develop and use better risk management techniques for monitoring and managing their risks.

Market Discipline

Market Discipline seeks to achieve increased transparency through expanded disclosure requirements for banks.

Capital

Capital Funds

Equity contribution of owners.  The basic approach of capital adequacy

framework  is  that  a  bank  should  have  sufficient  capital  to  provide  a  stable resource  to  absorb  any  losses  arising  from  the  risks  in  its  business.  Capital  is divided  into  different  tiers  according  to  the  characteristics  /  qualities  of  each qualifying  instrument.

For supervisory purposes capital is split into two categories: Tier I and Tier II.

Tier I Capital

A term used to refer to one of the components of regulatory capital. It consists  mainly  of  share  capital  and  disclosed  reserves  (minus  goodwill,  if  any).  Tier I items are deemed to be of the highest quality because they are fully available to cover losses Hence it is also termed as core capital.

Tier II Capital

Also  known  as supplementary  capital,  it  consists  of  certain  reserves  and  certain  types  of subordinated  debt.  Tier  II  items  qualify  as  regulatory  capital  to  the  extent  that they  can  be  used  to  absorb  losses  arising  from  a  bank's  activities.  Tier II’s capital loss absorption capacity is lower than that of Tier I capital.

Revaluation reserves

Revaluation reserves are a part of Tier-II capital.  These reserves arise from revaluation  of  assets  that  are  undervalued  on  the  bank's  books,  typically  bank premises and  marketable  securities.  The extent to which the revaluation reserves can be relied upon as a cushion for unexpected losses depends mainly upon the level of certainty that can be placed on estimates of the market values of the relevant assets and the subsequent deterioration in values under difficult market conditions or in a forced sale.

Subordinated debt

Refers to the status of the debt. In the event of the bankruptcy or liquidation of the debtor, subordinated debt only has a secondary claim on repayments, after other debt has been repaid. 

Hybrid debt capital instruments

In  this  category,  fall  a  number  of  capital  instruments,  which  combine  certain characteristics of equity and certain characteristics of debt. Each has a particular feature,  which  can  be  considered  to  affect  its  quality  as  capital.  Where these instruments have close similarities to equity, in particular when they are able to  support  losses  on  an  ongoing  basis  without  triggering  liquidation,  they  may  be included in Tier II capital.

Risk Weighted Asset

The notional amount of the asset is multiplied by the risk weight assigned to the asset to arrive at the risk weighted asset number.  Risk weights for different assets vary e.g. 0% on a Government Dated Security, 20% on a AAA rated foreign bank, 100% on unrated accounts and 150% on BB below rated borrower etc. 

CRAR (Capital to Risk Weighted Assets Ratio)

Capital  to  risk  weighted  assets  ratio  is  arrived  at  by  dividing  the  capital  of  the bank  with  aggregated  risk  weighted  assets  for  credit  risk,  market  risk  and operational risk. The higher the CRAR of a bank the better capitalized it is

Leverage

  Ratio of assets to capital.

Capital reserves

That  portion  of  a  company's  profits  not  paid  out  as  dividends  to  shareholders.

They are also known as undistributable reserves and are ploughed back into the business.