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Basel Norms II

Basel Accords : RisksManagement in Banking

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Basel II Accord

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What is BIS?

The BIS, set up in 1930, in Swiss city Basel, theoldest international financial institution. It is

increasingly recognized as the principal center for

international central bank cooperation.

Promote cooperation among the central banks in

their international financial operations and to act as

a trustee or agent in regard to international

settlements entrusted to it by the member

countries.

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What is BCBS (Basel Committee onBanking Supervision)

This is a committee appointed by BIS to look

into the adequacy of capital of banks with

international presence. And the most farreaching of these initiatives was the laying

down of minimum capital standards in 1988,

known as Basel Capital accord.

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Capital adequacy ratio (CAR)

It is the ratio of the banks capital to itsrisk weighted assets. To assess the capital

adequacy of banks based on this ratio itis essential to understand three aspects:

Composition of Capital

Composition of Risk weighted assets

Assigning Risk Weights

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Continue

It is the most important measure of banks

soundness. It acts as a buffer.

Adequacy is expressed as a minimumnumerical ratio which the banks are expected

to maintain.

CAR= Capital / RWAs

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Risk Adjusted Assets & off

B/S items: Risk adjusted assets would mean weighted

aggregate of funded and non-funded items.

For ex. Banks investments in all securities shouldbe assigned a risk weight of 2.5 % for marketrisk. (addition to credit risk)

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On balance sheet item:

Cash, deposit balance with other banks,

mortgage loan, commercial loan tocorporations etc

Off balance sheet item:

Letter of credit, commitment tocustomers for credit limits.

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Overseas operation

Tier I capital should be assigned Zero weight

Tier II capital should be assigned 100 weight

Advances against LIC, FD, and Kisan Vikas Patrawhere adequate margin is available would carryZero weight.

Loans to staff would also carry Zero weight.

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Capital Funds

Basel committee has defined capital in two tiers:

Tiers I Tiers I capital is the core capital, which

provides the most permanent and readilyavailable support against unexpected losses.

Tiers II Tiers II capital will consist of elementsthat are not permanent in nature or are notreadily available

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Tier - I

Tier I capital in the case of Indian Banksconsist of: (Core capital)

1. Paid up capital

2. Statutory reserves

3. Disclosed free reserves4. Capital reserves representing surplus arising

out of sale proceeds of assets.

Disclosed free reserve: retained earning,general reserve, profit and loss

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Tier II Capital

Tier II capital in the case of Indian Banksconsist of: (Supplementary capital)

* Undisclosed reserves

* Asset revaluation reserves

* Hybrid Capital instruments

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Undisclosed free reserve:

These elements have the capacity to absorb

unexpected losses and can be included ascapital. It should not be routinely used forabsorbing normal loan or operating looses.

Asset revaluation reserve: Arising out ofrevaluation of assets that are under valued onthe banks books.

For ex:if you purchased an fixed assets for rs 8 and if

the market price will increase to 10,then you have aprofit of rs 2.

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Hybrid debt capital instrument:

A number of capital instrument which

combine certain characteristic of equityand certain characteristics of debt.

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What is the original accord or

Basel

I accord?The Basel Committee came out with its first document on

International Convergence of Capital measurements and

Capital Standards in 1988 as a harbinger to tone up the

safety and stability of commercial banking in world over.

It requires internationally active banks to hold capital

equal to at least 8% of basket of assets measured in

different weight according to their riskiness .

CAR = Capital / Credit Risk = 8%

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What are the shortcomings ofBasel I accord?

1. This is a straight forward one-size-fits-allapproach

2. It doesnt distinguish between risk profile and riskmanagement standards across banks

3. All advances carried equal risk weights of 100%.

4. It does not account past payment record, afavorable credit history in respect of the activity orthe region where the borrower operated, availability ofgood collateral while assigning risk weights.

5. Basel-I concentrated only on credit risk andavoided any effort to address other significantbanking risks such as market risk, and operationalrisk

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What are the risks banks/FIsusually face and their respective

intensities?Out of so many risks the Basel Committee clubbed various riskssituation in three categories

Credit risks-emanates owing to default of the counter parties in

respect of fund and non-fund exposure. It constitutes 95%

Market risk-arises on change of market variable in the form ofliquidity constraints, prices and exchange rates. It constitutes4%

Operational risks-results from inadequate or failed internalprocess, people and systems or external events. It constitutes 1%

The above percentage is only indicative and may widely vary indifferent banking environment and again bank to bank position

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What is Basel-II?

To make the system more compliance to changing

environment Basel- I has been revised to new accord

Basel - II. Primarily it calls for distinguishing among various

risk and more importantly quantifying them.CAR=Capital/Credit Risk + Market, Risk + Operational Risk

It rests on a set of three mutually reinforcing pillars

namely

1. Minimum Capital Requirement

2. Supervisory review

3. Market Discipline

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Minimum capital requirements :

It covers the calculation of risk weight of

assets to determine the basic minimumcapital required.

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What is Pillar - 1?

Pillar - 1 is the minimum capital requirement

Minimum Capital Requirements

Market RiskCreditRisk

Standardized

Approach

IRBAdvanced

measurement

approach

Internal

Model

Approach

Foundation IRB

Advanced IRB

OperationalRisk

Basic Indicator

Approach

Standardized

Approach

Advanced

Measurement

Approach

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Credit risk

Standardized approach: Here thelender set risk weights of some assetsclasses and others to be determined bythe rating agency.

Internal rating based approach :under this the lender use their own riskweight models to determine the minimum

capital.

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The first internal ratings based approach isknown as the Foundation IRB. In this

approach, banks, withthe approval ofregulators, can develop probability of defaultmodels that provide in-house risk

weightings for their loan books. Regulatorsprovide the assumptions in these models,namely the probability of loss of each type ofasset.

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The second internal ratings basedapproach,Advanced IRB,is essentially

the same as Foundation IRB, except for one important difference: the

banks themselvesrather than

regulatorsdetermine theassumptions of proprietary credit default

models. Therefore, only the largest banks

with the most complex modes can use thisstandard.

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Operational risk

Basic indicator approach:The first method,known as the Basic Indicator Approach,recommends that bankshold capital equal to fifteenpercent of the average gross income earned by a

bank in the past three years. Standardized approach:The second method,

known as the Standardized Approach, divides abank by its business lines todetermine the amount

of cash it must have on hand to protect itselfagainst operational risk.

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Advanced measurement approach:Thethird method, theAdvanced Measurement

Approach, is much less arbitrary than its rival

methodologies. On the other hand, it is muchmore demanding for regulators and banksalike:

it allows banks to develop their own reserve

calculations for operational risks.

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Market risk

Advanced Measurement Approach:Banks can develop their own calculations to

determine the reserves needed to protect againstinterest rate and volatility risk for fixed income

assets on a position-by-position basis. Again,regulators must approve of such an action.

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Internal model approach:

This methodology group encourages banksto develop their own internal models tocalculate a stock, currency, or commoditys

market risk on a case-by-case basis. On average, the IMA is seen to be the most

complex, least conservative, and most

profitable of the approaches toward marketrisk modelling.

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What is Pillar 2? It is Supervisory Review. It is based on four principles.

Banks should have a process for assessing their overall

capital adequacy in relation to their risk profile.

Supervisors should review and evaluate banks internal

capital adequacy assessments and strategies also their abilityto monitor and ensure their compliance with regulatory

capital ratios.

Supervisors expect banks to operate the minimumregulatory capital ratios and should have the ability to

require banks to hold capital in excess of minimum

An early intervention to prevent capital falling from

minimum level.

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What is the Pillar 3? Third pillar is about Market Discipline. This tells

about self disclosure regarding. The lender shoulddisclose or publish all the information regarding:

Financial Performance

Financial Position Risk Management Strategies and Practices

Risk exposure

Accounting Policies Information relating to basic business

Management and corporate governance

practices

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What are the challenges it

faces while implementing it?As it is mandated by the regulator, RBI, to implement the accord

from first fiscal of 2007, but it faces some difficulties.These are

More capital requirements

Absence of historical data base

Impact on profitability due to huge implementation costs,

particularly for smaller banks

As the level of rating penetration is very low, the rating ofborrowers in all cases an uphill task and sometimes it fearedof biasing.

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Basel iii Risk:

credit + market + operational+ systemic

Systematic risk:

The portion of risk that is caused by factorswhich affect the returns on all securitieswith changes in the market.

ex

The govt changes the interest rateThe inflation rate increases/decreases.

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First, the quality, consistency, and

transparency of the capital base will beraised.

Second, the risk coverage of the capital

framework will be strengthened.

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Conclusion:

It has been described as a long journey rather

than a destination by itself. Undoubtedly it

would require commitment of substantialcapital and human resources on the part ofboth banks and the supervisors. RBI has

decided to follow a consultative process while

implementing Basel - II norms and move in agradual, sequential and coordinate manner.

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Thank You!!!