General Knowledge of Basel III

The role of banks in global and national economies is very important. The banking industry holds reliance of the entire economy and it is important for the authorities to maintain control over the practices of banks. The most common objectives of banking regulations are as follows:

  • Prudential Objectives:to reduce the level of risk to bank creditors i.e. to protect the depositors.
  • Systemic risk reduction—to reduce the risk of failure of banks
  • Avoid misuse of banks—to reduce the risk of banks being used for criminal purposes such as money laundering
  • To protect banking confidentiality
  • Credit allocation—to direct credit to favored sectors

General Principles of Banking Regulation

The general principles that deal with the banking regulation are as follows:

Minimum requirements

Certain minimum requirements are imposed on banks, which are closely tied to the level of risk exposure for a certain sector of the bank. The most important minimum requirements include the Capital Requirements and Reserve Requirements.

  • Capital Requirements:The capital requirement sets a framework on how banks must handle their capital in relation to their assets. The first international level capital requirements were introduced by the Basel Capital Accords in 1988. The current framework of capital requirements is called Basel III.
  • Reserve Requirements:The reserve requirement sets the minimum reserves each bank must hold to demand deposits and banknotes. Reserve requirements have also been used in the past to control the stock of banknotes and/or bank deposits. Required reserves have at times been gold coin, central bank banknotes or deposits, and foreign currency.

Supervisory review

This includes licensing by the regulator, obtaining undertakings, giving directions, imposing penalties or revoking the bank’s license.

Market discipline

The central bank requires the banks to publicly disclose financial and other information, and depositors and other creditors. The bank is thus made subject to market discipline.

Basel Committee on Banking Supervision

The secretariat of Bureau of International Settlement (BIS); which fosters co-operation among central banks with a common goal of financial stability and common standards of banking regulations; are located in Basel, a city in Switzerland. The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory authorities established in 1974 by the governors of the central banks of G-10. This committee provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide.  It has 27 members including India and major economies of the world.

The 27 countries are Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. Out of them 12 are permanent members.

Basel Accords

The Basel Committee formulates broad supervisory standards and guidelines and recommends statements of best practice in banking supervision, which are currently known as Basel III Accord. The Basel Accord norms are “Voluntary” in nature and BCBS expects that the member authorities and other nations’ authorities will take steps to implement them through their own national systems, whether in statutory form or otherwise. Thus, the main purpose of the BCBS is to convergence toward common approaches and standards. There is no founding treaty that establishes the BCBS. It does not issue binding regulation; rather, it functions as an informal forum in which policy solutions and standards are developed.

Capital Adequacy

In Banking Industry, Capital refers to the stock of Financial Assets which is capable of generating income. The Capital Adequacy Ratio is a thermometer of Bank’s health, because it is the ratio of its capital to its risk. So simply, Capital Adequacy Ratio = Capital ÷Risk Thus, Capital Adequacy can indicate the capacity of the Bank’s ability to absorb the possible losses. The Regulators check CAR to monitor the health of the Bank, because a good CAR protects the depositors and maintains the faith and confidence in the banking system.

Capital to Risk (Weighted) Assets Ratio (CRAR)

CRAR is a standard metric to measure balance sheet strength of banks. BASEL I and BASEL II are global capital adequacy rules that prescribe a minimum amount of capital a bank has to hold given the size of its risk weighted assets. The old rules mandate banks to back every Rs. 100 of commercial loans with Rs. 9 of capital irrespective of the nature of these loans. The new rules suggest the amount of capital needed depends on the credit rating of the customer.

The Tier-1 and Tier-2 Capital

The Basel accords define two tiers of the Capital in the banks to provide a point of view to the regulators. The Tier-I Capital is the core capital while the Tier-II capital can be said to be subordinate capitals. The following table shows the 2 tiers of the Capital Fund.

Tier-I Capital Tier-II Capital
Paid up Capital Undisclosed reserves and cumulative perpetual preference shares.
Statutory Reserves Revaluation Reserves
Other disclosed free reserves General Provisions and loss reserves
Capital Reserves which represent surplus arising out of the sale proceeds of the assets. Hybrid debt capital instruments such as bonds.
Investment Fluctuation Reserves Long term unsecured loans
Innovative Perpetual Debt Instruments (IPDIs) Debt Capital Instruments.
Perpetual Noncumulative Preference Shares. Redeemable cumulative Preference shares
Minus: Perpetual cumulative preference shares.
Equity Investment in subsidiaries.
Intangible assets.
Losses (Current period + past carried forward)

Basel III Requirements

BCBS had issued a comprehensive reform package entitled “Basel III: A global regulatory framework for more resilient banks and banking systems” in December 2010, with the objective to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy. A summary of Basel III capital requirements is as follows:

The objectives

The Objectives of the Basel III are as follows:

  • Improve the banking sector’sability to absorb shocks arising from financial and economic stress.
  • Improve risk management and governance
  • Strengthen banks’ transparency and disclosures.

Basel III: Three Pillars

Basel III akin to Basel II has three mutually reinforcing pillars as follows:

  • Pillar 1 :Minimum Regulatory Capital Requirements based on Risk Weighted Assets (RWAs) : Maintaining capital calculated through credit, market and operational risk areas.
  • Pillar 2 :Supervisory Review Process : Regulating tools and frameworks for dealing with peripheral risks that banks face.
  • Pillar 3:Market Discipline : Increasing the disclosures that banks must provide to increase the transparency of banks

More Emphasis on Common Equity component of Tier-I Capital

Currently, the bank’s capital comprises Tier 1 and Tier 2 capital. The restriction is that Tier 2 capital cannot be more than 100% of Tier 1 capital. Under Basel III, with an objective of improving the quality of capital, the Tier 1 capital will predominantly consist of Common Equity. Common Equity is the amount that all common shareholders have invested in a company. Most importantly, this includes the value of the common shares themselves. It also includes retained earnings and additional paid-in capital. Thus, most important part of the common equity comprises the Paid up Capital + retained earnings. 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.

The Capital Conservation Buffer

The banks will require 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

The countercyclical buffer has been introduced 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.

Leverage Ratio

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. A 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 has to 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.

A comparison of Basel II and Basel III Requirements
Requirements Basel II Basel III
Minimum Ratio of Total Capital To RWAs 8% 10.50%
Minimum Ratio of Common Equity to RWAs 2% 4.50% to 7.00%
Tier I capital to RWAs 4% 6.00%
Core Tier I capital to RWAs 2% 5.00%
Capital Conservation Buffers to RWAs None 2.50%
Leverage Ratio None 3.00%
Countercyclical Buffer None 0% to 2.50%
Minimum Liquidity Coverage Ratio None TBD (2015)
Minimum Net Stable Funding Ratio None TBD (2018)

Impact on Indian Banks

As per RBI Guidelines, Indian banks will have to maintain their capital adequacy ratio at 9 per cent as against the minimum recommended requirement of 8 per cent. Banks have to maintain Tier-one capital (equity and reserves) at 7 per cent of risk weighted assets (RWA) and a capital conservation bugger of 2.5 per cent of RWA. According to the recent RBI financial stability report, Indian banks will require an additional capital of Rs. five trillion to comply with Basel III norms, including Rs 3.25 trillion as non-equity capital and Rs 1.75 trillion in the form of equity capital over the next five years.

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