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What are Basel Accords?

The banking industry is the lifeline of any economy. It is one of the most important pillars of the financial sector. Development of any country is highly dependent on the performance of the banking industry. For an economy to remain healthy and going, it is important that the banking system grows fast and yet be stable.

Due to the importance in the financial stability of the country, banks are highly regulated in most of the countries.

The collapse of financial institution in one country can also lead to sequential collapse of financial institutions in other countries. Hence to regulate the banking system, Basel Accord has been set up by the Basel Committee on Banking Supervision (BCBS), a committee created by Bank for International Settlements (BIS).
  • Bank for International Settlements (BIS):
    The Bank for International Settlements is an international financial institution owned by central banks which encourages international monetary and financial cooperation and serves as a bank for central banks. It carries out its work through its meetings, programmes and through the Basel Process.The customers of the BIS are central banks and international organizations. As a bank, the BIS doesnot accept deposits from, or provide financial services to, private individuals or corporate entities.
     
  • Basel Committee on Banking Supervision (BCBS)
    To help promote monetary and financial stability, the Basel Committee on Banking Supervision was set up by BIS in 1974. It was designed as a medium for regular cooperation between its member countries on banking supervisory matters. In 1980's the committee created a multinational accord to strengthen the stability of the international banking system. A capital measurement system commonly referred to as the Basel Capital Accord was released to Banks in 1988. Ultimately this framework was introduced not only in member countries but in all countries with active International Banks.

What are Basel Accords?

The Basel accords are a set of recommendations for regulations in banking industry. The Basel Committee consists of central bankers from several countries who often met at Basel, Switzerland and they have come up with set of rules and regulations for the banking industry.

Initially there were Central bankers from only 10 countries but now it has extended to all G 20 countries and even beyond that. So far there has been three versions of Basel Accords : Basel I (1988), Basel II (2004) and Basel III (2010).

Basel I
This was the first basel accord, which was meant for only Capital Requirement of the banks. Many a times because of defaults or customers defaulting in the payments of loans, the banks face a huge loss of money and there is a problem of capital.

Without money the banks go bankrupt and become insolvent, i.e the bank cannot exist anymore and hence it has to be rescued by the government or any other organization. So the emphasis of Basel I was on Capital requirement, hence determining the capital a bank should always hold in order to avoid the lending risk, i.e when people default on their loans, the bank can avoid insolvency.

Law:
The banks had to set aside atleast 8% of the capital against the nominal size of their Loan.
Nominal size of the loan is also known as Risk Weighted Asset (RWA). So according to the Basel I law, 8% of the RWA has to be kept with the bank in order to prevent insolvency.

Risk Weights:
It is defined as the % of assets under Risk.
All assets of the bank donot carry the same amount of risk. For example, if a bank provides loan to the Government the risk is much less compared to when provided to a private party. A government bond has much lesser risk when compared to an equity. Hence the assets of the bank has been classified into different categories and different risk weight has been assigned.

Cash, Home Country Bond 0% risk weights
Securities with good ratings 20% risk weights
Municipal Bonds, Residential Mortgages 50% risk weights
Bonds with no Rating 100% risk weights

Explanation: Suppose a bank carries 100 million of municipal bond, then 50 million of that is very risky. Hence, here RWA is 50 million. So the bank needs to keep aside 8% of RWA, i.e 8% of 50 million which is 4 million, in order to meet the regulatory criteria.

Main Weakness of Basel I:
It didn't take into account the quality of the counterparty.
The counterparty could be a very big organization like Apple, Microsoft etc or it could be a very small company or one with not a very good cashflow, like a small tea selling company or a small restruant. Now when a big company like Microsoft when compared to a small restruant in a city, the credit worthiness of the parties will differ a lot. So there was no classification or any strict rule classifying the counterparties. There was no segmentation rule set out. Although the banks do segment these counter parties into different groups but there was no rule set out in Basel I.

Basel II
It was the second of the basel accords, and was published in 2004. Basel II accord made it mandatory for the banks to set aside sufficient capital to be able to withstand any losses resulting from credit risk, market risk and operational risk. In the Basel I, all we had to worry was the loss arising from the capital risk, i.e, the loss arising from the defaulting of the customers. In the Basel II, market risk and operational risk were introduced. Market Risk arises from the movement of the market.

The bank holds lot of positions inn the capital market because of which the bank can incur a lot of losses. Operational risk is because of bad incidences like fraud or any kind of natural cataustrophe or any kind of issue with the local or foreign government where the bank is operating. Loss happening because of any of these three risk will have to be taken into consideration while calculating the capital requirement, unlike the Basel I where there was only credit risk.

It also put emphasis on Risk management process followed in bank which was not the case prior to that. Regulators now can intervene into how the management structure is or how the management structure has been put into action within the bank or how the bank really measures or quantifies the risk.

Laws:
  • Internal Capital Adequacy Assessment Process (ICAAP)
    Bank must have risk management process to manage risk.
  • External Reports
    Bank must show how it measures risk and quantify it.

Weighting Factor:
The weighting factor almost remained samed. It changed a bit in terms of percentage while the methodology remained same. There was segmentation among different types of asset classes.
Bonds AAA- AA- A+ A- BBB+ BBB- Below B- Unrated
Government 0% 20% 50% 100% 150%
Banks 20% 50% 100% 150% 150%
Corporates 20% 50% 100% 100% 150%
Explanation:
Government Bond carries the least risk and the banks and the corporate carry higher risk. And also it depends on ratings. Good ratings got less weight in calculating the RWA whereas assets with lower ratings got higher weight in calculating RWA.

Analysis of Basel I and Basel II
  • Basel I didn't differentiate creditworthiness of the counterparty while determining the risk capital. While Basel II made the distinction between the creditworthiness of customers.
  • Basel II also took care of the market risk and the operational risk, which was absent in Basel I.
  • The 8% capital requirement, also known as BIS ratio remained the same.
Hence, Basel II served as an update of Basel I.

Basel III
Basel III came after the 2008 financial crisis where there was a credit crisis, in which not only the customers defaulted in loans but also the banks ran out of cash and the banks didn't have enough liquidity for daily work. Hence Basel III was introduced in December 2010.

It intends to address the shortcomings of Basel II to create more stable banking and financial sector. It gave a stricter definition of capital (what qualifies to be called a capital and what not). Also it made clear that its not just the loss that matter to the regulators but also the capital and the liquidity scenario of the bank is taken into account

Laws:
  • Base III introduced leverage ratio and it was fixed at 3%.
  • Basel III introduced a new term “Capital Conservation Buffer” also called the additional buffer which puts a condition to the bank to save money or to have buffer money to withstand the bad economic conditions. It was set at 2.5 %, increasing the total capital requirement from 8% to 10.5%. Regulators now put an emphasis that when there is good time, the banks make money.
  • It also introduced Counter Cyclical Buffer. It is meant to be used in bad times. It can be kept at 0% during bad times but needs to be kept at min 3% during good times.

The main aim of Basel III can be stated as:
  • Improve bank's ability to absorb losses/ shocks.
  • Improve risk management and governance.
  • Strenghten bank's transperancy and disclosure.

Analysis of Basal II and Basal III
The Basel III framework prescribes higher ratio in comparison to Basel II
  • Minimum Capital Requirement : 8% under Basel II increased to 10.50% under Basel III
  • Comman Equity Tier 1 (CET1) : 2% under Basel II increased to (4.50% to 7.00%) under Basel III
  • Tier I capital : 4% under Basel II increased to 6% under Basel III
  • Capital Conservation Buffers : none under Basel II increased to 2.50% under Basel IIIf) Leverage ratio under Basel IIfrom none to 3.00% under Basel III
  • Countercyclical Buffer : none under Basel II to (0% to 2.50%) under Basel III

Important Terms:
  1. Tier 1 capital
    It is essentially the most perfect form of a bank's capital—the money the bank has stored to keep it functioning through all the risky transactions it performs, such as trading/investing and lending. It is used to describe the capital adequacy of a bank and refers to core capital that includes equity capital and disclosed reserves.

    Tier 1 capital = CET1 capital + additional Tier 1 capital (AT1).
     
  2. Comman Equity Tier (CET1)
    It is a component of Tier 1 capital that comprises a bank's core capital and includes common shares, stock surpluses resulting from the issue of common shares, retained earnings, common shares issued by subsidiaries and held by third parties and accumulated other comprehensive income ( unrealized gains and losses reported in the equity section of the balance sheet ). These are the most important assets of any bank.
     
  3. Additional Tier 1 (AT1)
    It is defined as instruments that are not common equity. An example of AT1 capital is a contingent convertible ( debt instrument issued by European financial institutions), which has a perpetual term i.e no fixed term and can be converted into equity when a trigger event occurs.
     
  4. Tier2 Capital
    It is the secondary component of bank capital, in addition to Tier 1 capital, that makes up a bank's required reserves. It is designated as supplementary capital and is composed of items such as revaluation reserves, undisclosed reserves, hybrid instruments, and subordinated term debt.
     
  5. Leverage ratio
    It is meant to evaluate a company's debt levels. The most common leverage ratio is the debt ratio. A debt ratio is simply a company's total debt divided by its total assets. The formula is:

    Debt Ratio = Total Debt / Total Assets

    A ratio above 1.0 indicates that the company has more debt than assets.

Conclusion
Basel Accord has created a major difference to the operation of the financial system. Banking has become safer. The features of Basel Accord such as higher risk coverage, thrust on loss-absorbing capital in periods of stress, improving liquidity standards, creation of capital buffers in good times and prevention of excess buildup of debt during boom times has helped in creating a resilient banking system.

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