Basel Norms II Basel Accords : Risks Management in Banking

Basel II Accord

What is BIS?

The BIS, set up in 1930, in Swiss city Basel, the oldest 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.

What is BCBS (Basel Committee on Banking Supervision)

This is a committee appointed by BIS to look into the adequacy of capital of banks with international presence. And the most far reaching of these initiatives was the laying down of minimum capital standards in 1988, known as Basel Capital accord.

Capital adequacy ratio (CAR)

It is the ratio of the banks capital to its risk weighted assets. To assess the capital adequacy of banks based on this ratio it is essential to understand three aspects: Composition of Capital Composition of Risk weighted assets Assigning Risk Weights

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It is the most important measure of banks soundness. It acts as a buffer. Adequacy is expressed as a minimum numerical ratio which the banks are expected to maintain. CAR= Capital / RWAs

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 should be assigned a risk weight of 2.5 % for market risk. (addition to credit risk)

On balance sheet item: Cash, deposit balance with other banks, mortgage loan, commercial loan to corporations etc Off balance sheet item: Letter of credit, commitment to customers for credit limits.

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 Patra where adequate margin is available would carry Zero weight. Loans to staff would also carry Zero weight.

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 readily available support against unexpected losses.
Tiers II Tiers II capital will consist of elements that are not permanent in nature or are not readily available

Tier - I

1.
2. 3.

4.

Tier I capital in the case of Indian Banks consist of: (Core capital) Paid up capital Statutory reserves Disclosed free reserves Capital reserves representing surplus arising out of sale proceeds of assets. Disclosed free reserve: retained earning, general reserve, profit and loss

Tier II Capital

Tier II capital in the case of Indian Banks consist of: (Supplementary capital) * Undisclosed reserves * Asset revaluation reserves * Hybrid Capital instruments

Undisclosed free reserve:

These elements have the capacity to absorb unexpected losses and can be included as capital. It should not be routinely used for absorbing normal loan or operating looses. Asset revaluation reserve: Arising out of revaluation of assets that are under valued on the 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 a profit of rs 2.

Hybrid debt capital instrument: A number of capital instrument which combine certain characteristic of equity and certain characteristics of debt.

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%

What are the shortcomings of Basel I accord?

1. This is a straight forward one-size-fits-all approach 2. It doesnt distinguish between risk profile and risk management standards across banks 3. All advances carried equal risk weights of 100%. 4. It does not account past payment record, a favorable credit history in respect of the activity or the region where the borrower operated, availability of good collateral while assigning risk weights. 5. Basel-I concentrated only on credit risk and avoided any effort to address other significant banking risks such as market risk, and operational risk

What are the risks banks/FIs usually face and their respective intensities?
Out of so many risks the Basel Committee clubbed various risks situation 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 of liquidity constraints, prices and exchange rates. It constitutes 4% Operational risks-results from inadequate or failed internal process, people and systems or external events. It constitutes 1% The above percentage is only indicative and may widely vary in different banking environment and again bank to bank position

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. 2. 3. Minimum Capital Requirement Supervisory review Market Discipline

Minimum capital requirements : It covers the calculation of risk weight of assets to determine the basic minimum capital required.

What is Pillar - 1?
Pillar - 1 is the minimum capital requirement
Minimum Capital Requirements

Credit Risk

Market Risk

Operational Risk

Standardized Approach
Foundation IRB

IRB

Advanced measurement approach

Internal Model Approach

Basic Indicator Approach Standardized Approach Advanced Measurement Approach

Advanced IRB

Credit risk

Standardized approach: Here the lender set risk weights of some assets classes and others to be determined by the rating agency. Internal rating based approach : under this the lender use their own risk weight models to determine the minimum capital.

The first internal ratings based approach is known as the Foundation IRB. In this approach, banks, with the approval of regulators, can develop probability of default models that provide in-house risk weightings for their loan books. Regulators provide the assumptions in these models, namely the probability of loss of each type of asset.

The second internal ratings based approach, Advanced IRB, is essentially

the same as Foundation IRB,

except for one important difference: the banks themselvesrather than regulatorsdetermine the assumptions of proprietary credit default models. Therefore, only the largest banks with the most complex modes can use this standard.

Operational risk

Basic indicator approach:The first method,

known as the Basic Indicator Approach, recommends that banks hold capital equal to fifteen percent 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 a bank by its business lines to determine the amount of cash it must have on hand to protect itself against operational risk.

Advanced measurement approach:The third method, the Advanced Measurement

Approach, is much less arbitrary than its rival

methodologies. On the other hand, it is much more demanding for regulators and banks alike: it allows banks to develop their own reserve calculations for operational risks.

Market risk

Advanced Measurement Approach:

determine the reserves needed to protect against interest rate and volatility risk for fixed income assets on a position-by-position basis. Again, regulators must approve of such an action.

Banks can develop their own calculations to

Internal model approach:

This methodology group encourages banks to develop their own internal models to calculate 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 market risk modelling.

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 ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors expect banks to operate the minimum regulatory 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.

What is the Pillar 3?

Third pillar is about Market Discipline. This tells about self disclosure regarding. The lender should disclose 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

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 of borrowers in all cases an uphill task and sometimes it feared of biasing.

Basel iii
Risk: credit + market + operational+ systemic Systematic risk: The portion of risk that is caused by factors which affect the returns on all securities with changes in the market. ex The govt changes the interest rate The inflation rate increases/decreases.

First, the quality, consistency, and transparency of the capital base will be raised. Second, the risk coverage of the capital framework will be strengthened.

Conclusion:
It has been described as a long journey rather than a destination by itself. Undoubtedly it would require commitment of substantial capital and human resources on the part of both banks and the supervisors. RBI has decided to follow a consultative process while implementing Basel - II norms and move in a gradual, sequential and coordinate manner.

Thank You!!!