Basel Framework

Basel Committee on Banking

Supervision

Basel Committee on Banking Supervision was established

by the central- bank governors of the G10 countries in 1974

US

- Belgium, Canada, France, Germany, Italy,

Japan,, Netherlands, Sweden, Switzerland, UK,

Provides a forum for cooperation on banking supervisory

matters.
Its objective is to enhance the quality of banking
supervision worldwide.
The Committee develops guidelines and supervisory
standards in areas where they are considered desirable..
The Committee's members come from 27 countries
including India.
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

 BCBS created by G 10 countries in the aftermath of the failure

of Herstatt Bank
The failure caused significant disturbances in the currency
markets throughout the world and disturbed the payment
systems of other countries
Though called G 10 countries, actually consisted of 11
countries. Switzerland was the eleventh member. But name
was not changed.
G 10 countries included 11 industrialised countries and
Luxembourg was a non G 10 member. BCBS was established
by 12 countries
The Committee has no formal legal existence or permanent
staf
The Secretariat of BIS being used by BCBS

 Many G 10 countries were using capital ratios in one form

or the other but there was no uniformity in the definition
of the ratios or the number.
Japan for instance had a simple capital / assets ratio
which varied from 4% for banks without international
presence to 6% for banks with international presence.
There was no consistency in the definition of capital
Risk exposures by way of of-balance sheet exposures
were growing but was not captured by the simple capital
ratios employed by banks
Eroding capital levels of banks and failure of Continental
Bank in 1984 and reasons that motivated the BCBS to
formulate the B1 Accord

Basel I Accord
The Committee is best known for its
international standards on capital adequacy
and the first major guideline was the Basel I
Accord International Convergence of
Capital Measurement and Capital
Standards.
The justifying principle for capital
requirements - limits/ restricts risk taking by
banks. Well conceived capital requirements
will generally discourage undue risk taking.

 Though the BCBS started with the primary purpose

of preventing systemic risk, over a period the
regulations were more focussed on the soundness
of individual institutions.
Capital adequacy emerged as the central principle
of the Basel framework.
Pre-emptive regulation aimed at avoiding failures
rather than managing them when they occur.
Fostered the emergence of sound risk management
practices and required models for quantification of
risks rather than relying on judgmental assessment
of risks.

Basel I Capital Accord

Issued in 1988, established
minimum ratio of required
capital to risk-weighted assets.
Initially, risk weights assigned
only for Credit Risk, based on
simplistic categorization of
obligors.
Accord amended in 1996 to
include assigning of capital for
Market Risk.

CRAR
Capital to Risk weighted Assets Ratio
(CRAR) =
Tier I Capital + Tier II capital
Risk weighted assets for credit risk
Capital = Risk weight X exposure X
9%

Key elements of the Accord

Definition of capital in two tiers Tier I and
Tier II
Bucketing the assets as per the risk
category of the asset - only 5 asset buckets
including of-balance sheet
Risk weighting of assets as per the level of
risk of the asset (0%, 20%, 50%, 100%)
Allocation of capital for non-fund based
business by introducing Credit Conversion
Factors (ranging from 20% to 100%)

Market risk amendment

Accord provided transition period until end of 1992 for full
implementation by national supervisors of the minimum capital
requirements.
Hence India 1992
Banking Book and trading book
Market risk amendment
Derivatives trading accounted for a large proportion of their business
for US Banks
European Union introduced in 1993 Capital Adequacy Directive (CAD)
covered market as well as credit risk
Basel Committee followed this work and finalised amendment in 1996
The amendment allowed for the first time the use of internal models
a prelude to the models permitted under Basel II accord, eight years
later
Tier III capital was introduced

Composition of capital funds

Tier I
Equity & reserves
Tier I Debt

Tier II
Tier II debt
General provisions & loss reserves
Revaluation reserves at a discount

Contribution of Basel I
Accord
Simplicity of the capital rules
Stipulated minimum CRAR and thereby laid the
foundation for risk assessment and addressed
capital requirement
Generally banks capital position improved
Banks were open to defining risks in banking,
discuss them openly and develop methods of
quantification
In short laid the foundation for the more
sophisticated revised accord.

Shortcomings of Basel I
accord
Focus on a single risk measure i.e. CRAR
One size fits all approach
Did not address operational risk

Basel II Accord
Three Pillar Approach
Menu of approaches available
Greater risk sensitivity
Requirement of capital charge for operational risk

Basel II Three Pillars

Pillar I
Minimum
Capital

Pillar II
Supervisory
Review

Pillar III
Market
Discipline

Credit risk

Market
risk
Operational
risk

ICAAP

SREP

Disclosures

Objectives of Basel II
Strengthen the soundness and stability of the
international banking system
Maintain sufficient consistency that capital
adequacy regulation will not be a significant
source of competitive inequality
Promote the adoption of stronger risk management
practices by the banking industry, and the Basel
Committee views this as one of its major benefits
Maintain the aggregate level of minimum capital
requirements while also providing incentives to
adopt the more advanced risk sensitive approaches
of the revised framework.

Safety and soundness

Failure of one significant bank could
in an internationally integrated
banking environment create
problems for banks in other
countries.
In an extreme case, a systemic crisis
could develop.

 Basel II is not directed at systemic

risk
It deals with the safety and
soundness of individual banks by
prescribing minimum capital under
Pillar I and how regulators would
expect banks to operate above
minimum capital under |Pillar II so
that they remain solvent and hence
the system would be sound

Competitive equality
International harmonization of capital
standards play an important role in levelling
the competitive playing field
Lower capital requirements in one country may
allow banks in that country to maintain lower
capital and earn higher income and profits by
deploying capital
On the other hand, higher capital holdings as
stipulated by another countrys banking
supervisor restrict the banks revenue
producing activities.

Approaches for Pillar I Risks

STANDARDISED
APPROACH FOR CREDIT
RISK

Significant aspects - Standardised Approach

Enhancements to Basel I - Standardised Approach

Capital charges driven by supervisory rules similar to Basel I Accord

Introduction of a number of asset buckets to distinguish the risk profile of diferent

asset categories.

Introduction of an asset bucket for retail , acknowledging the diversification benefit of

retail

Introduction of an asset bucket for corporates, recognition of external ratings and

thereby introducing risk sensitivity

Recognition of collateral and guarantees for risk mitigation and capital computation

Concessionary risk weight for residential mortgage recognising the risk mitigating
efect of the solid collateral

Higher capital requirement for undrawn commitments emphasising the credit risk
element in the undrawn portion also

Capital requirement for past-due loans based on the provisions

Comparison of Standardised Approach & IRB

approaches
Standardised Appraoch

IRB approaches

Depends on External ratings

Depends on Internal ratings

No of asset buckets

Five main categories of assets

Eligible financial collateral s

recognised

More collaterals recognised

Capital computed as per

regulatory risk weights

Capital computed as per the risk

weight function provided by
BCBS
Risk components PD, LGD, EAD
to be computed

Standardised Less risk sensitive Depends on risk components of

each bank More risk sensitive
Risk management practices
required - moderate

Risk management practices sophisticated

IRB use by a bank is Subject to Supervisory approval

(validation, inconsistent Risk weights)
The IRB approach is based on measures of unexpected
losses (UL) and expected losses (EL).
The risk components (PD, LGD, EAD and M) serve as inputs
to the risk-weight functions that have been developed for
separate asset classes by the BCBS.
Under the foundation approach, banks provide their own
estimates of PD and rely on supervisory estimates for other
risk components.

Key elements of IRB

approach

For each of the asset classes covered under the

FIRB framework, there are three key elements:
Risk components PD, LGD, EAD and M
Risk-weight functions the means by which
risk components are transformed into riskweighted assets and therefore capital
requirements.
Minimum requirements the minimum
standards that must be met in order for a bank
to use the IRB approach for a given asset class.

Risk components
PD - The probability of default of the
borrower in one year horizon
LGD - The economic loss to the bank
on account of the default of the
borrower
EAD - Exposure to the borrower at
the time of default
M - Maturity

 K = f(PD, LGD, EAD AND M)

Capital is a function of the risk
components
The risk components are transformed
into risk weighted assets through
the risk weight functions

Major Difference between FIRB & AIRB

Credit Value at Risk

Market risk

STANDARDISED DURATION
APPROACH

Market risk in the

Trading Book
Capital charge for Market Risk = Specific Risk + General
Market Risk
Specific Risk Adverse movement in the price of an
individual security due to factors related to the quality of
individual issuer and this is similar to credit risk of issuer
General Market Risk - Risk of loss arising from changes in
market rates
For fixed income securities, residual maturity and modified
duration (MD) are taken into consideration
MD of each security is supplemented by the expected change
in yield based on residual maturity time bands (provided by
the regulator)
Capital charge = Market value of the security x MD x expected
change in yield

Market Risk: Capital Charge - RBI

guidelines
Risk Category

Capital Charge

I. Interest Rate (a + b)
a. General Market risk
b. Specific risk
II. Equity (a + b)
a. General market risk

9%

b. Specific risk

9%

III. Foreign Exchange & Gold

IV. Total capital charge for market risks (I +II + III)

9%

Operational risk

Approaches for operational

risk
Basic Indicator Approach
The Standardised Approach
Advanced Measurement Approach

Approaches to Minimum Capital Requirement under

OR

Basic Indicator
Approach
(BIA)

The Standardized
Approach (TSA/ASA)

Advanced
Measurement
Approach (AMA)

1. Capital Charge = 1. Capital Charge

= 1. Capital Charge = the
Gross Income X
Business line gross
risk
measure
income X (summed
generated by the
across business lines)
banks
internal
2. KBIA = GI x
8 BLs defined by
operational
risk
where:
Basel
measurement system
KBIA
=
Capital
based
on
banks
charge under Basic 2. KTSA={years
1-3
internal models
Indicator Approach
max[(GI1-8
x
18),0]}/3
GI
=
average
annual
gross
where
income last 3 yrs.
KTSA= capital charge
GI1-8 = Gross Income
= 15%
1-8 = multiplication
factor
Applicable since 1.4.2009

Earliest date 1.4.2010

Earliest date 1.4.2012

Basic Indicator Approach

15% (alpha) of the gross income of the bank
The Standardised Approach
Beta of gross income of each business line
Business lines

Beta
values

Corporate Finance

18

Trading &sales

18

Retail banking

12

Commercial banking

15

Payment & settlement

18

Agency services

15

Asset management

12

Retail brokerage

12

Standardised Measurement
Approach
Standardised Measurement Approach (SMA)
provides a single non-model-based method for
the estimation of operational risk capital.
Standardised approach, hence simple
Incorporates risk sensitivity of an advanced approach
by combining in a standardised fashion the use
of a banks financial statement information and
its internal loss experience.
Internal modelling approaches i.e., AMA for
operational risk regulatory capital to be
withdrawn from the Basel Framework and the
date to be announced

Advanced Measurement
Approach
A banks internal loss data may not be sufficient to model the
operational risk exposures faced by the bank as many of the
potential risks to which the bank is exposed would not have
materialised during the life of the bank. Basel II framework,
therefore, requires that a banks operational risk
measurement system must incorporate four key data inputs.
These four inputs / elements are
Internal data;
Relevant external operational risk data;
Scenario analysis; and
Business environment and internal control factors (BEICFs).
The inputs are required for the purposes of operational risk
management also.

PILLAR II
SUPERVISORY REVIEW

Pillar II Supervisory review

Consists of two parts
Internal Capital Adequacy Assessment
by Banks
Supervisory Review and Evaluation
Process by regulator/ supervisor

ICAAP
Internal Capital Adequacy Assessment Process
The Process focusses on the assessment of risks by
the bank and how much capital is adequate with
reference to the banks risk profile
As such the objective of ICAAP is

To ensure appropriate identification and

assessment of risks
To ensure maintenance of adequate level of
internal capital in relation to the banks risk
profile
To encourage banks to use better techniques
for monitoring and managing their risks

Supervisory review and Evaluation

Process (SREP)
Supervisory Review and Evaluation
Process by regulator/ supervisor
Adequate capital is maintained
Sound risk management systems are in
place
Evaluate how well banks are assessing
capital adequacy & capital requirement in
relation to their risk profile

On site inspection and ofsite inspection

and discussion with banks

Key principles of SREP

1. Banks own assessment of
capital adequacy (ICAAP)
2.Supervisory review of such
assessment (SREP)
3.Capital to be above regulatory
minimum
4.Supervisory intervention

Key principles
Pillar 2 is based on the following four
key principles
Banks own assessment of capital
adequacy (ICAAP)
Supervisory review and evaluation
process (SREP)
Operating above the minimum
regulatory capital requirement
Supervisory intervention

Pillar 2 risks
Risks that are not fully captured by
the Pillar 1 process (e.g. credit
concentration risk);
Risks that are not at all taken into
account by the Pillar 1 process (e.g.
liquidity risk, business and
strategic risk); and
factors external to the bank (e.g.
business cycle effects).

Pillar 2 risks

Credit Concentration risk

Interest rate risk in the banking book
Liquidity risk
Settlement risk
Reputational risk
Strategic risk
Risk of underestimation of credit risk under the
standardised approach
Risk of underestmation of credit risk under the IRB
approaches (Model Risk)
Pension obligation risk
Residual risk in credit risk mitigation

Principle of proportionality
The guiding principle for ICAAP is the
principle of proportionality
Whether the bank defines its activities and
risk management practices as
Simple
Moderately complex
Complex

The sophistication of the ICAAP

implementation depends the
proportionality principle.

PILLAR III
MARKET DISCIPLINE

Pillar III Market discipline

Third Pillar complements the first two pillars
Market discipline implies reliance on market forces
Private parties, who monitor the equity or interest
rate sensitive instruments in order to assess bank
risk exert indirect market discipline
Banks to make periodic detailed disclosures on risk exposures, risk
assessment, capital, capital adequacy etc., to enable market to
discipline banks
Market participants require information and if they have the ability to
understand and process the information, evaluate the risk profile of the
bank then market discipline would be efective.
Market participants can discipline banks by punishing banks for making
bad decisions
Banks have to pay higher rates on their borrowing
Stock prices would be lower
Banks would face challenges in raising any form of capital

Market Discipline
The information in the disclosures will help
market participants to better understand
the overall risk profile of an institution.
All banks with capital funds of Rs.500 cr or
more and their significant bank
subsidiaries, must disclose their Tier I
capital, total capital, total required capital
and Tier I ratio and total capital adequacy
ratio on a quarterly basis on their
respective websites.

Details of disclosures

Scope of application
Capital structure
Capital Adequacy
Credit risk : General Disclosures
Credit risk : Disclosures for portfolios subject to Standardised
Approach
Credit Risk Mitigation: Disclosures for Standardised Approaches
Securitisation Exposures: Disclosure for Standardised Approach
Market risk in the Trading Book
Operational risk
Interest rate risk in the Banking Book

Basel III
P.Usha

Basel II inadequacies

Quality of capital
Less emphasis on liquidity
Micro prudential
Procyclicality
Build up of leverage
Lower level of capital for Trading
Book

BCBS Documents
Enhancements to Basel II in July 2009 Basel II.5
Issue of two documents in December
2010
a global regulatory framework for more
resilient banks and banking systems and
International framework for liquidity risk
measurement, standards and monitoring

The two documents together are known

as Basel III framework.

Initiatives of Basel III

Increasing the quality, quantity and
transparency of capital especially the core
capital
Through revision of definition of capital
Build up of capital bufers

Introduction of leverage ratio

Introduction of minimum global liquidity
standards
Raising standards for the SRP(Pillar 2) and
disclosures (Pillar 3);

Basel II and Basel III minimum

capital requirements
Basel II

Basel
III

Common Equity Tier I (CET 1)

3.6 to
5.1%

5.5%

Additional Tier I

2.4 to
0.9%

1.5%

2.

Minimum Tier I

6%

7%

3.

Capital conservation bufer (CCB)

--

2.5%

4.

Tier I including CCB

6%

9.5%

5.

Tier II

3%

2%

6.

Total capital ratio

9%

9%

Total capital ratio including CCB

11.5%

1.

Tier I capital

Limits

Predominance of common equity and Tier 1 in regulatory capital

Common equity 75% of Tier 1 capital (B III)
Common equity 78.57% of Tier 1 capital (RBI)
Tier 1 - 75% of total minimum capital (B III)
Tier 1 - 77.78% of total minimum capital (RBI)
Tier 1 to act as going concern capital
Tier 2 to act as gone concern capital
From regulatory capital perspective, going-concern capital
is the capital which can absorb losses without triggering
bankruptcy of the bank.
Gone-concern capital is the capital which will absorb
losses only in a situation of liquidation of the bank.

Capital conservation buffer

Basel III prescribes that a capital
conservation bufer of 2.5% of Risk
Weighted Assets, comprising
common equity Tier 1 capital, over
and above the minimum common
equity requirement of 5.5% and total
capital requirement of 9%, needs to
be built up outside periods of stress.

Capital Conservation Bufer

(CCB)
It is designed to ensure that banks build
up capital bufer comprising common
equity of 2.5% of RWAs during normal
time and can be drawn down during a
stressed period.
It is intended to strengthen the banks
resilience to adverse conditions, and
provide the mechanism for rebuilding
capital during the early stages of
economic recovery.

Criteria for Additional Tier 1 instruments

Criteria to be included in the debt instruments to define them
as Basel III compliant
Conversion of debt to equity
Write-off of debt.

At the point of trigger which is indicated as equity Tier I CRAR

of 6.125%. If the bank hits this trigger, then depending on the
clause included in the debt instrument the criteria would be
invoked
A single instruments can have both conversion and write-off
(the option to be available with the bank)

Write up
If written of without infusion of
public funds and CET I ratio shores
up above the trigger point of 6.125%,
then the instrument may be written
up
If Public funds infused then write up
of the instruments not permitted and
has to be written of permanently

Transition from April 2013 to March 2019

Minimum
capital ratios
(as % of
RWAs)

Apr 1,
2013

March
31,
2014

March
31,
2015

March
31,
2016

March
31,
2017

March
31,
2018

March
31,
2019

Minimum
Common Equity
Tier I (CET 1)

4.5

5.0

5.5

5.5

5.5

5.5

5.5

Capital
conservation
bufer (CCB)

0.625

1.25

1.875

2.5

Minimum CET 1
+ CCB

4.5

5.5

6.125

6.75

7.375

Minimum Tier I
capital

6.5

Minimum total
capital

Minimum Total
Capital + CCB

9.625

10.25

10.87
5

11.5

Leverage ratio
Capital measure
Tier I capital = common equity tier I + additional Tier I
Excluding bufers

Exposure measure
On balance sheet net of specific provisions
Derivatives at current exposure method
Of balance sheet at 100% CCF
Unconditionally cancellable commitments at 10% CCF

Leverage ratio = capital measure/ exposure measure

During the period of parallel run, the leverage ratio should not fall below 4.5%.
A bank whose leverage ratio is below 4.5% may endeavor to bring it above
4.5% as early as possible.
Final leverage ratio requirement would be prescribed by RBI after the parallel
run taking into account the prescriptions given by the Basel Committee.

Leverage ratio
Leverage ratio is a simple non risk
based measure to prevent build up of
excessive on and of balance sheet
leverage in the banking system.
To Contain the build-up of excessive
leverage in the system.
Additional safeguard against
attempts to game the risk-based
ratio - address model risk.

countercyclical capital
bufer
Equity capital CRAR in the range of 02.5% based on national discretion.
For any country, bufer will be in
efect when there is excess credit
growth resulting in system wide build
up of risk.

Liquidity ratios
Liquidity Coverage Ratio (LCR)
Net Stable Funding Ratio (NSFR)