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8/16/2019 7. Basel Framework

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Basel Framework


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Basel Committee on BankingSupervision

• Basel Committee on Banking Supervision was establishedby the central- bank governors of the G10 countries in 19!

- Belgium" Canada" #rance" Germany" $taly"

%apan"" &etherlands" Sweden" Swit'erland" ()"(S

• *rovides a forum for cooperation on banking supervisorymatters+

• $ts ob,ective is to enhance the uality of bankingsupervision worldwide+

• .he Committee develops guidelines and supervisory

standards in areas where they are considered desirable++• .he Committee/s members come from countries

including $ndia+

• rgentina" ustralia" Belgium" Bra'il" Canada" China"#rance" Germany" 2ong )ong S3" $ndia" $ndonesia" $taly" %apan" )orea" 4u5embourg" 6e5ico" the &etherlands"

3ussia" Saudi rabia" Singapore" South frica" Spain"Sweden Swit'erland .urke the (nited )in dom and the


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• BCBS created by G 10 countries in the aftermath of the failureof 2erstatt Bank

• The failure caused signicant disturbances in the currencymarkets throughout the world and disturbed the paymentsystems of other countries

• Though called G 10 countries! actually consisted of 11countries" Swit#erland was the eleventh member" But namewas not changed"

• G 10 countries included 11 industrialised countries and$u%embourg was a non G 10 member" BCBS was establishedby 1& countries

• The Committee has no formal legal e%istence or permanentsta'

• The Secretariat of B(S being used by BCBS


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• )any G 10 countries were using capital ratios in one formor the other but there was no uniformity in the denitionof the ratios or the number"

• *apan for instance had a simple capital + assets ratio

which varied from ,- for banks without internationalpresence to .- for banks with international presence"

• There was no consistency in the denition of capital

• /isk e%posures by way of o'balance sheet e%posureswere growing but was not captured by the simple capital

ratios employed by banks• roding capital levels of banks and failure of Continental

Bank in 123, and reasons that motivated the BCBS toformulate the B1 4ccord


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Basel ( 4ccord

• The Committee is best known for itsinternational standards on capital ade5uacyand the rst ma6or guideline was the Basel (

4ccord 7 8(nternational Convergence ofCapital )easurement and CapitalStandards9"

• The 6ustifying principle for capital

re5uirements limits+ restricts risk taking bybanks" :ell conceived capital re5uirementswill generally discourage undue risk taking"


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• Though the BCBS started with the primary purposeof preventing systemic risk! over a period theregulations were more focussed on the soundnessof individual institutions"

• Capital ade5uacy emerged as the central principleof the Basel framework"

• ;reemptive regulation aimed at avoiding failuresrather than managing them when they occur"

• Fostered the emergence of sound risk managementpractices and re5uired models for 5uantication ofrisks rather than relying on 6udgmental assessmentof risks"


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Basel ( Capital 4ccord

• $ssued in 1977" established minimum ratio of reuiredcapital to risk-weighted assets+

• $nitially" risk weights assignedonly for Credit 3isk" based onsimplistic categori'ation of

obligors+• ccord amended in 1998 to

include assigning of capital for

6arket 3isk+


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C/4/

• Capital to /isk weighted 4ssets /atio

• Tier ( Capital ? Tier (( capital

/isk weighted assets for credit risk

• Capital > /isk weight @ e%posure @2-


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Aey elements of the 4ccord

• enition of capital in two tiers 7 Tier ( and Tier ((

• Bucketing the assets as per the risk

category of the asset only asset bucketsincluding o'balance sheet

• /isk weighting of assets as per the level ofrisk of the asset


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)arket risk amendment

• 4ccord provided transition period until end of 122& for fullimplementation by national supervisors of the minimum capitalre5uirements"

• Dence (ndia 122&

• Banking Book and trading book

• )arket risk amendment – erivatives trading accounted for a large proportion of their business

for ES Banks

– uropean Enion introduced in 122 Capital 4de5uacy irective


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Composition of capital funds

• Tier ( – 5uity reserves

– Tier ( ebt

• Tier (( – Tier (( debt

– General provisions loss reserves

– /evaluation reserves at a discount


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Contribution of Basel (4ccord

• Simplicity of the capital rules

• Stipulated minimum C/4/ and thereby laid thefoundation for risk assessment and addressedcapital re5uirement

• Generally banks9 capital position improved

• Banks were open to dening risks in banking!discuss them openly and develop methods of5uantication

• (n short laid the foundation for the more

sophisticated revised accord"


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Shortcomings of Basel (accord

• Focus on a single risk measure i"e" C/4/

• Hne si#e ts all approach

• id not address operational risk

− Basel $$ ccord• Three ;illar 4pproach

• )enu of approaches available

• Greater risk sensitivity

• /e5uirement of capital charge for operational risk


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Basel (( 7 Three ;illars

;illar ()inimumCapital

;illar ((Supervisory

/eview

;illar ((()arket

iscipline

Credit risk

)arket

risk

Hperationalrisk

(C44; S/;isclosures


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Hb6ectives of Basel ((

−Strengthen the soundness and stability of theinternational banking system

−Maintain suicient consistency that capitaladequacy regulation will not be a signicant

source of competitive inequality−;romote the adoption of stronger risk management

practices by the banking industry! and the BaselCommittee views this as one of its ma6or benets

−)aintain the aggregate level of minimum capitalre5uirements while also providing incentives toadopt the more advanced risk sensitive approachesof the revised framework"


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Safety and soundness

• Failure of one signicant bank couldin an internationally integratedbanking environment create

problems for banks in othercountries"

• (n an e%treme case! a systemic crisis

could develop"


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• Basel (( is not directed at systemicrisk

• (t deals with the safety andsoundness of individual banks byprescribing minimum capital under;illar ( and how regulators would

e%pect banks to operate aboveminimum capital under I;illar (( sothat they remain solvent and hence

the system would be sound


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Competitive e5uality

• (nternational harmoni#ation of capitalstandards play an important role in levellingthe competitive playing eld

• $ower capital re5uirements in one country mayallow banks in that country to maintain lowercapital and earn higher income and prots bydeploying capital

• Hn the other hand! higher capital holdings asstipulated by another country9s bankingsupervisor restrict the bank9s revenueproducing activities"


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4pproaches for ;illar ( /isks


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S.&3$S:**3;C2 #;3 C3:$.3$S)


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Signicant aspects Standardised 4pproach

nhancements to Basel ( Standardised 4pproach

• Capital charges driven by supervisory rules 7 similar to Basel ( 4ccord

• (ntroduction of a number of asset buckets to distinguish the risk prole of di'erent

asset categories+

• (ntroduction of an asset bucket for retail ! acknowledging the diversication benet of

retail

• (ntroduction of an asset bucket for corporates! recognition of e%ternal ratings and

thereby introducing risk sensitivity

• /ecognition of collateral and guarantees for risk mitigation and capital computation

• Concessionary risk weight for residential mortgage recognising the risk mitigating

e'ect of the solid collateral

• Digher capital re5uirement for undrawn commitments emphasising the credit risk

element in the undrawn portion also• Capital re5uirement for pastdue loans based on the provisions


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Comparison of Standardised 4pproach (/Bapproaches

Standardised ppraoch $3B approaches

epends on %ternal ratings epends on (nternal ratings

Jo of asset buckets Five main categories of assets

ligible nancial collateral srecognised

)ore collaterals recognised

Capital computed as perregulatory risk weights

Capital computed as per the riskweight function provided byBCBS

/isk components 7 ;! $G! 4to be computed

Standardised 7 $ess risk sensitive epends on risk components ofeach bank 7 )ore risk sensitive

/isk management practices

re5uired moderate

/isk management practices

sophisticated


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• (/B use by a bank is Sub6ect to Supervisory approval


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Aey elements of (/Bapproach

• For each of the asset classes covered under theF(/B framework! there are three key elementsK

• 3isk components L ;! $G! 4 and )

• 3isk-weight functions L the means by which

risk components are transformed into riskweighted assets and therefore capitalre5uirements"

• 6inimum reuirements L the minimum

standards that must be met in order for a bankto use the (/B approach for a given asset class"


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/isk components

• ; The probability of default of theborrower in one year hori#on

• $G The economic loss to the bankon account of the default of theborrower

• 4 %posure to the borrower at

the time of default

• ) )aturity


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• A > f


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Major Difference between FIRB & AIRB


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S.&3$S: (3.$;&**3;C2

)arket risk


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)arket risk in the Trading Book

• Capital charge for )arket /isk > Specic /isk ? General)arket /isk

• Speci


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3isk Category Capital Charge

(" (nterest /ate


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Hperational risk


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4pproaches to )inimum Capital /e5uirement underH/

Basic $ndicatorpproach

(BIA)

.he Standardi'edpproach (TA!AA)

dvanced6easurement

pproach =6>

1" Capital Charge >

Gross (ncome @ N

&" A B(4 > G( % NwhereKA B(4 > Capitalcharge under Basic(ndicator 4pproach

G( > averageannual grossincome last yrs"

N > 1-

1" Capital Charge >

Business line grossincome @ O the

risk measuregenerated by thebank9s internaloperational riskmeasurement systembased on bank9sinternal models

A licable since #$%$'' :arliest date 1+!+010 arliest date #$%$'#


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Business lines Betavalues

Corporate Finance 13

Trading sales 13

/etail banking 1&

Commercial banking 1

;ayment settlement 134gency services 1

4sset management 1&

/etail brokerage 1&

Basic Indicator A""roac*

15% (alpha) of the gross income of the bank

T*e tandardised A""roac*

Beta of gross income of each business line


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Standardised )easurement4pproach

• Standardised 6easurement pproach =S6>provides a single non-model-based method forthe estimation of operational risk capital"

• Standardised approach! hence simple

• (ncorporates risk sensitivity of an advanced approachby combining in a standardised fashion the useof a bank?s


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4dvanced )easurement4pproach

• 4 bank9s internal loss data may not be suUcient to model theoperational risk e%posures faced by the bank as many of thepotential risks to which the bank is e%posed would not havematerialised during the life of the bank" Basel (( framework!therefore! re5uires that a bank9s 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 re5uired for the purposes of operational riskmanagement also"


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*$443 $$S(*:3@$S;3A 3:@$:


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;illar (( Supervisory review

Consists of two parts(nternal Capital 4de5uacy 4ssessment

by Banks

Supervisory /eview and valuation;rocess by regulator+ supervisor


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(C44;

• (nternal Capital 4de5uacy 4ssessment ;rocess

• The ;rocess focusses on the assessment of risks bythe bank and how much capital is ade5uate withreference to the bank9s risk prole

• 4s such the ob6ective of (C44; is – To ensure appropriate identi


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Supervisory review and valuation;rocess


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Aey principles of S/;

1+ Banks? own assessment ofcapital adeuacy =$C*>

+Supervisory review of suchassessment =S3:*>

+Capital to be above regulatoryminimum

!+Supervisory intervention


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Aey principles

• ;illar & is based on the following fourkey principles – Bank9s own assessment of capital

ade5uacy


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;illar & risks

• /isks that are not fully captured bythe ;illar 1 process =e+g+ creditconcentration risk>D

• /isks that are not at all taken intoaccount by the ;illar 1 process =e+g+liuidity risk" business and

strategic risk>D and• factors e%ternal to the bank =e+g+

business cycle eEects>+


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;illar & risks

• Credit Concentration risk

• (nterest rate risk in the banking book

• $i5uidity risk

• Settlement risk

• /eputational risk• Strategic risk

• /isk of underestimation of credit risk under thestandardised approach

• /isk of underestmation of credit risk under the (/B

approaches • ;ension obligation risk

• /esidual risk in credit risk mitigation


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;rinciple of proportionality

• The guiding principle for (C44; is theprinciple of proportionality

• :hether the bank denes its activities and

risk management practices as – Simple

– )oderately comple%

– Comple%

• The sophistication of the (C44;implementation depends theproportionality principle"


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*$443 $$$63):. $SC$*4$&:


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;illar ((( 7 )arket discipline• Third ;illar complements the rst two pillars

• )arket discipline implies reliance on market forces

• ;rivate parties! who monitor the e5uity or interestrate sensitive instruments in order to assess bankrisk e%ert indirect market discipline

• Banks to make periodic detailed disclosures on risk e%posures! riskassessment! capital! capital ade5uacy etc"! to enable market todiscipline banks

• )arket participants re5uire information and if they have the ability tounderstand and process the information! evaluate the risk prole of thebank then market discipline would be e'ective"

• )arket participants can discipline banks by punishing banks for makingbad 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


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)arket iscipline

The information in the disclosures will helpmarket participants to better understandthe overall risk prole of an institution"

4ll banks with capital funds of /s"00 cr ormore and their signicant banksubsidiaries! must disclose their Tier (capital! total capital! total re5uired capital

and Tier ( ratio and total capital ade5uacyratio on a 5uarterly basis on theirrespective websites"


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etails of disclosures

• Scope of application

• Capital structure

• Capital 4de5uacy

• Credit risk K General isclosures

• Credit risk K isclosures for portfolios sub6ect to Standardised

4pproach• Credit /isk )itigationK isclosures for Standardised 4pproaches

• Securitisation Exposures !isclosure for Standardised "pproac#

• $arket risk in t#e %radin& Book

• 'perational risk

• Interest rate risk in t#e Bankin& Book


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Basel (((

;"Esha


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Basel (( inade5uacies

• Vuality of capital

• $ess emphasis on li5uidity

• )icro prudential

• ;rocyclicality

• Build up of leverage

• $ower level of capital for TradingBook


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BCBS


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BCBS ocuments

• nhancements to Basel (( in *uly &002 Basel (("

• (ssue of two documents in ecember

&010 – 8a global regulatory framework for more

resilient banks and banking systems9 and

– 8(nternational framework for li5uidity risk

measurement! standards and monitoring9• The two documents together are known

as Basel ((( framework"


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(nitiatives of Basel (((

• (ncreasing the 5uality! 5uantity andtransparency of capital especially the corecapital –

Through revision of denition of capital – Build up of capital bu'ers

• (ntroduction of leverage ratio

• (ntroduction of minimum global li5uidity

standards• /aising standards for the S/;


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Basel (( and Basel ((( minimumcapital re5uirements

Basel $$ Basel$$$

1" Tier ( capital

Common 5uity Tier (


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+i,its

• Predominance of common equity and ier 1 in regulatory capital

!ommon equity – "5% of ier 1 capital (B ###)

!ommon equity – "$5"% of ier 1 capital (&B#)

ier 1 ' "5% of total minimum capital (B ###)

ier 1 ' """$% of total minimum capital (&B#)

• ier 1 to act as going concern capital

• ier to act as gone concern capital

• From regulatory capital perspective! goingconcern capitalis the capital which can absorb losses without triggering

bankruptcy of the bank"• Y Goneconcern capital is the capital which will absorb

losses only in a situation of liuidation of the bank"

C it l ti b f


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Capital conservation bufer

• Basel ((( prescribes that a capitalconservation bu'er of &"- of /isk:eighted 4ssets! comprising

common e5uity Tier 1 capital! overand above the minimum commone5uity re5uirement of "- and total

capital re5uirement of 2-! needs tobe built up outside periods of stress"

Capital Conservation Bu'er


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Capital Conservation Bu'er


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Criteria for Additional Tier # instru,ents

• !riteria to be included in the debt instruments to define them

as Basel ### compliant• !onersion of debt to equity

• *rite'off of debt

• +t the point of trigger ,hich is indicated as equity ier # !&+&of -15% #f the bank hits this trigger. then depending on the

clause included in the debt instrument the criteria ,ould be

inoked

• + single instruments can hae both conersion and ,rite'off

(the option to be aailable ,ith the bank)


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:rite up

• (f written o' without infusion ofpublic funds and CT ( ratio shoresup above the trigger point of ."1&-!

then the instrument may be writtenup

• (f ;ublic funds infused then write up

of the instruments not permitted andhas to be written o' permanently

Transition fro, A"ril '#- to Marc* '#


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6inimumcapital ratios=as F of3s>

pr 1"01

6arch1"01!

6arch1"01

6arch1"018

6arch1"01

6arch1"017

6arch1"019

)inimumCommon 5uity

Tier (


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$everage ratio

• Capital measure – Tier ( capital > common e5uity tier ( ? additional Tier (

– %cluding bu'ers

• %posure measure – Hn balance sheet net of specic provisions

– erivatives at current e%posure method

– H' balance sheet at 100- CCF – Enconditionally cancellable commitments at 10- CCF

• $everage ratio > capital measure+ e%posure measure

• uring the period of parallel run! the leverage ratio should not fall below ,"-"

• 4 bank whose leverage ratio is below ,"- may endeavor to bring it above,"- as early as possible"

• Final leverage ratio re5uirement would be prescribed by /B( after the parallelrun taking into account the prescriptions given by the Basel Committee"


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$everage ratio

• $everage ratio is a simple non riskbased measure to prevent build up ofe%cessive on and o' balance sheet

leverage in the banking system"• To Contain the buildup of e%cessive

leverage in the system"

• 4dditional safeguard againstattempts to Zgame[ the riskbasedratio address model risk"

countercyclical capital


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countercyclical capitalbu'er

• 5uity capital C/4/ in the range of 0&"- based on national discretion"

• For any country! bu'er will be in

e'ect when there is e%cess creditgrowth resulting in system wide buildup of risk"


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$i5uidity ratios

• $i5uidity Coverage /atio 7