General Knowledge

Basel 1,2 and 3 committee:

1). On 26 June 1974 a number of banks had released Deutschmarks (the German currency) to the Herstatt Bank in exchange for dollar payments deliverable in New York

2). Due to differences in the time zones, Herstatt Bank ceased operatins between the times of the respective payments and before the dollar payments could be effected in New York, the Hersatt Bank was liquidated by German regulators

3). The G-10 nations responded to this incident by forming the Basel Committee Supervision in late 1974, under the Bank for International Settlements (BIS) located in Basel, Switcherland BASEL-I

BASEL  - 1

1). In 1988 the Basel Committee on Banking Supervision (BCBS) in Basel published a set of minimum capital requirements for banks known as Basel I norms

2). Features of Basel I

  • It mainly focused on credit or default risk i.e., the risk of counter party failure
  •  It defined the capital requirement and structure of risk weights for banks

3). Assets of banks were classified and grouped in five categoris according to credit risk, carrying the following risk weights

  • 0% - cash, bullion, home country debt like Treasuries
  •  20% - securitizations such as mortgage-backed securities (MBS) with the highest AAA rating
  • 50% - municipal revenue bonds, residential mortgages
  • 100% - most corporate debt

4). Banks with an international presence are required to hold capital equal to 8% of their risk-weighted assets (RWA).

  • At least 4% in Tier I capital
  • More than 4% in Tier I and Tier II capital

5). From 1988 this framework was introduced within the G-10 nations initially and then ver 100 countries adopted the rules prescribed by the Basel I

 BASEL II

1). Basel II was introduced in 2004 with more refined definations for capital adequacy, risk management and disclosure requirements

2). It used external rating agencies to set the risk weights for corporate and banks

3). Disclosure requirements allowed market participants to access the capital adequacy of the institution based on information on the following aspects

  • Scope of application
  • Capital
  • Risk exposure
  • Risk assessment processes

4). In Basel II norms Operational Riskhas been defined as the risk of loss resulting from inadequate or failed internal processes, people and systems

5). Basel II uses a “three pillars” concept namely

  • Minimum capital requirements
  1. The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach, Foundation IRB, Advanced IRB and General IB2 Restriction. IRB stands for “Internal Rating-Based Approach”
  2. For operational risk, there are the three different approaches – basic indicator approach or BIA, standardized approach or TSA, and the internal measurement approach
  3.  For market risk the preferred output its value at risk
  •  Supervisory review
  1. This is a regulatory response to the first pillar, giving regulators better ‘tools’ over those previously available
  2. It also provides a framework for dealing with systemic risk, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk and legal risk, which the accord combines under the title of residual risk
  3. Banks can review their risk management system
  4.  The Internal Capital Adequacy Assessment Process (ICAAP) is a result of pillar 2 of Basel II accords
  •  Market discipline – It supplements regulation as sharing of information facilitates assessment of the bank by others, including investors, analysts, customers, other banks, and rating agencies, which leads to good corporate governance

BASEL III

1). The Basel II regulations did not have any explicit norm on the debt that banks could take but focused on financial institutional ignoring the systematic risks

2). Therefore to ensure that banks don’t take excessive debt and not rely on short term funds the Basel III norms were proposed in 2010

3). Basel III promoted a more resilient banking system on the following 4 important banking parameters namely

  • Capital
  • Leverage
  • Funding
  • Liquidity

4). Requirements of common equity and Tier 1 capital will be 4.5% and 6% respectively

5). Leverage ratio calculated by dividing Tier I capital by the bank’s average total consolidated assets will be greater than 3% ,in other words is the ratio of relative amount of caital to total assets.

6). The minimum Liquidity Coverage Ratio (LCR) will reach upto 100% by 1st January 2019 to prevent situations like Bank Run.