THE BASEL COMMITTEE RECOMMENDATIONSProf.Mishu Tripathi Assistant Professor-Finance Introduction On June 26, 1974, German regulators forced the troubled Bank Herstatt into liquidation. That day a number of banks had released payment to Herstatt in Frankfurt in exchange for US$ that was to be delivered in New York. Because of the time- zone differences, Herstatt ceased operation between the times of the respective payments. The counter party banks did not receive their US$ payments. Responding to the cross-jurisdictional implications of Herstatt debacle, the G-10 countries formed a standing committee under the auspices of Bank of International Settlements (BIS) Called the Basel Committee or (Basle Committee G-10 Countries Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, Switzerland, the United Kingdom and the United States Objectives of the Committee Ensure that international banks or bank holding companies do not escape comprehensive supervision by a ³home regulatory authority´. Promote uniform capital requirements so that banks from different countries may compete with another on a ³level playing field´ Core principles for effective Banking supervisions Principle 1 Objectives, independence, powers, transparency and cooperation 1. Effective supervision will have clear responsibilities and objectives. They should possess operational independence. 2. A suitable legal framework to support is also required. 3. Arrangement for sharing information between supervisors and protecting the confidentiality of such information should be in place. .Principle 2 ² Permissible activities The permissible activities of institutions that are licensed and subject to supervision as banks must be clearly defined and the use of the word ³bank´ in names should be controlled as far as possible. Banking supervisors must have the authority to establish criteria for reviewing major acquisitions or investment by banks with special reference to risk associated with it.Licensing and structure 3. . Banking supervisors must have the authority to review and reject any proposal to transfer significant ownership or controlling interest in existing banks to other parties. 4. including its capital base. internal controls and risk management. and its projected financial condition. at a minimum. . should consist of an assessment of the ownership structure and governance of the bank and its wider group. including the fitness and propriety of Board members and senior management.Principle 3 ² Licensing criteria The licensing process. its strategic and operating plan. Principle 3 ² Licensing criteria Where the proposed owner or parent organization is a foreign bank. the prior consent of its home country supervisor should be obtained. . The licensing authority must have the power to set criteria and reject applications for establishments that do not meet the standards set. .Principle 4 ² Transfer of significant ownership The supervisor has the power to review and reject any proposals to transfer significant ownership or controlling interests held directly or indirectly in existing banks to other parties. including the establishment of cross-border operations. and confirming that corporate affiliations or structures do not expose the bank to undue risks or hinder effective supervision. . against prescribed criteria.Principle 5 ² Major acquisitions The supervisor has the power to review major acquisitions or investments by a bank. At least for internationally active banks. these requirements must not be less than those established in the applicable Basel requirement. and must define the components of capital. . bearing in mind its ability to absorb losses.Principle 6 ² Capital adequacy Supervisors must set prudent and appropriate minimum capital adequacy requirements for banks that reflect the risks that the bank undertakes. These processes should be commensurate with the size and complexity of the institution. monitor and control or mitigate all material risks and to assess their overall capital adequacy in relation to their risk profile.Principle 7 ² Risk management process: Supervisors must be satisfied that banks and banking groups have in place a comprehensive risk management process (including Board and senior management oversight) to identify. evaluate. . the evaluation of the quality of such loans and investments. monitor and control credit risk (including counterparty risk). and the ongoing management of the loan and investment portfolios.Principle 8 ² Credit risk Supervisors must be satisfied that banks have a credit risk management process that takes into account the risk profile of the institution. with prudent policies and processes to identify. This would include the granting of loans and making of investments. measure. . provisions and reserves Supervisors must be satisfied that banks establish and adhere to adequate policies and processes for managing problem assets and evaluating the adequacy of provisions and reserves.Principle 9 ² Problem assets. . Principle 10 ² Large exposure limits Supervisors must be satisfied that banks have policies and processes that enable management to identify and manage concentrations within the portfolio. . and supervisors must set prudential limits to restrict bank exposures to single counterparties or groups of connected counterparties. Principle 11 ² Exposures to related parties In order to prevent abuses arising from exposures (both on balance sheet and off balance sheet) to related parties and to address conflict of interest. appropriate steps are taken to control or mitigate the risks. these exposures are effectively monitored. supervisors must have in place requirements that banks extend exposures to related companies and individuals on an arm¶s length basis. and write-offs of such exposures are made according to standard policies and processes. . Principle 12 ² Country and transfer risks Supervisors must be satisfied that banks have adequate policies and processes for identifying. monitoring and controlling country risk and transfer risk in their international lending and investment activities. . and for maintaining adequate provisions and reserves against such risks. measuring. measure.Principle 13 ² Market risks Supervisors must be satisfied that banks have in place policies and processes that accurately identify. if warranted. . monitor and control market risks. supervisors should have powers to impose specific limits and/or a specific capital charge on market risk exposures. measure. monitor and control liquidity risk. . with prudent policies and processes to identify. and to manage liquidity on a day-to-day basis. Supervisors require banks to have contingency plans for handling liquidity problems.Principle 14 ² Liquidity risk Supervisors must be satisfied that banks have a liquidity management strategy that takes into account the risk profile of the institution. . assess. These policies and processes should be commensurate with the size and complexity of the bank.Principle 15 ² Operational risk Supervisors must be satisfied that banks have in place risk management policies and processes to identify. monitor and control/mitigate operational risk. measure. . these should be appropriate to the size and complexity of such risk. monitor and control interest rate risk in the banking book. including a well defined strategy that has been approved by the Board and implemented by senior management.Principle 16 ² Interest rate risk in the banking book Supervisors must be satisfied that banks have effective systems in place to identify. These should include clear arrangements for delegating authority and responsibility. safeguarding the bank¶s assets. reconciliation of these processes. and appropriate independent internal audit and compliance functions to test adherence to these controls as well as applicable laws and regulations. and accounting for its assets and liabilities. .Principle 17 ² Internal control and audit Supervisors must be satisfied that banks have in place internal controls that are adequate for the size and complexity of their business. separation of the functions that involve committing the bank. paying away its funds. Principle 18 ² Abuse of financial services Supervisors must be satisfied that banks have adequate policies and processes in place. that promote high ethical and professional standards in the financial sector and prevent the bank from being used. including strict ³know-your-customer´ rules. intentionally or unintentionally. for criminal activities. . focusing on safety and soundness. and also of the banking system as a whole.Principle 19 ² Supervisory approach An effective banking supervisory system requires that supervisors develop and maintain a thorough understanding of the operations of individual banks and banking groups. . and the stability of the banking system. Principle 20 ² Supervisory techniques An effective banking supervisory system should consist of on-site and off-site supervision and regular contacts with bank management. . and a means of independent verification of these reports. . through either on-site examinations or use of external experts. reviewing and analyzing prudential reports and statistical returns from banks on both a solo and a consolidated basis.Principle 21 ² Supervisory reporting Supervisors must have a means of collecting. information that fairly reflects its financial condition and profitability.Principle 22 ² Accounting and disclosure Supervisors must be satisfied that each bank maintains adequate records drawn up in accordance with accounting policies and practices that are widely accepted internationally. . and publishes. on a regular basis. This includes the ability. . where appropriate.Principle 23 ² Corrective and remedial powers of supervisors: Supervisors must have at their disposal an adequate range of supervisory tools to bring about timely corrective actions. to revoke the banking license or to recommend its revocation. Principle 24 ² Consolidated supervision An essential element of banking supervision is that supervisors supervise the banking group on a consolidated basis. as appropriate. applying prudential norms to all aspects of the business conducted by the group worldwide. adequately monitoring and. . Banking supervisors must require the local operations of foreign banks to be conducted to the same standards as those required of domestic institutions. primarily host banking supervisors. .Principle 25 ² Home-host relationships Cross-border consolidated supervision requires cooperation and information exchange between home supervisors and the various other supervisors involved. Banks were subject to 8% capital requirement. the current international framework on capital adequacy was adopted in 1988 by many banks worldwide and it was adopted in 1992 in India. The 1988 Basel Accord primarily addressed banking in the sense of deposit taking and lending therefore its focus was on credit risk.THE BASEL CAPITAL ACCORD The Basel capital Accord. . non-cumulative perpetual preferred stock and published reserves from post tax retained earnings.THE BASEL CAPITAL ACCORD Tier 1(³core´) capital included the book value of common stock. Credit risk was calculated as the sum of risk± weighted asset values. It included cumulative and/ or redeemable preferred stock. Tier 2 (³supplementary´) capital was deemed of lower quality. . general loan reserves. subordinated term debt. assets revaluation reserves. A maximum of 50% of a bank¶s capital could comprise of tier-2 capital. After conducting three quantitative impact studies to assess those proposals.BASEL II In June 1999 the Basel committee on banking supervision issued a new consultative paper on New Capital Adequacy framework. the finalized Basel Accord called ³International Convergence of Capital Measures and Capital Standards: a Revised Framework´. was adopted on June2004 . BASEL II Basel II is based on three pillars 1. Use of Market Discipline for greater transparency and disclosure encouraging best international practices . Minimum capital requirement for banks 2. Supervision to review banks capital adequacy and internal assessment processes 3. enhanced use of technology. The revised accord has retained the minimum requirement of 8% of capital to risk weighted assets. Capital --------------------------------------------------. 8% Credit risk + market risk + operational risk The operational risk has been added to take note of increasing globalization. .BASEL II Basel II reflects more risk sensitive requirements of banks with greater attention to supervision and market discipline. product innovations and growing complexity in operations. . people and system or from external events´.Operational Risk Operational risk has been defined as the ³risk of loss resulting from inadequate or failed internal processes. Therefore.Varying Risk weight The biggest change is proposed in the system of risk weighting so that the rate of interest that is charged to a borrower reflects the riskiness of the underlying asset. venture capital and private placements (100%. . instead of a one±size-fits±all approach (100%).g. the committee has proposed reduction in risk weight for certain high quality assets and increase in risk weight for lower quality assets e. 150%). At present.Credit Rating Another major change is that under the new accord. credit rating will be extended to bank loans also. risk weights are to be determined on the basis of ratings assigned by independent external credit rating agencies. . credit rating is required for debt instruments only but under the new framework. Banks Internal Models 1. Independent review of risk measurement and risk management system must be conducted annually. Risk control unit must be independent from trading units and report directly to senior management. . Risk management model must be integrated into the daily management process. 3. There must be appropriate stress test and back testing 4. 2. and also credit assessment institutions that they use for the risk weighting of their assets The disclosure relating to comprehensive risk exposures would include credit risk. . the requirement of disclosure by banks has been strengthened.Market Discipline To strengthen the safety and soundness of the system. their risk management strategies and practices. For instance. liquidity risk. legal and other risks as well as accounting policies and information on corporate governance. market risk. operational risk. banks will have to disclose additional details of the way in which they calculate their capital adequacy. Capital charge to cover market risk has already been incorporated in certain items: Banks have to assign additional risk weight of 2. first introduced as a part of banking sector reforms in 1992 are being fine tuned continuously by RBI aligning them more closely with international best practices.CAPITAL ADEQUACY IN THE INDIAN BANKING CONTEXT Capital adequacy and other prudential norms. FOREX/gold open position limits of banks carry 100% risk weight (from 31.5% on entire investment portfolio. The minimum capital to risk asset ratio was raised from 8% to 9% effective March 31.3.99) . 2000. . All investments in bonds /debentures of FIs assigned a uniform risk weight of 20%.2001. as a cushion for market risk and it will gradually be raised to 10%. Risk weight for State Government guaranteed advances in default: 20% as on 31.2000 and 100% where default continues even after 31.3.CAPITAL ADEQUACY IN THE INDIAN BANKING CONTEXT An investment fluctuation reserve has been put in place from March 31.3. 2003 with minimum 5% of the investment portfolio in the Available for Sale (AFS) and Held for Trading (HFT) categories. In May 2004 RBI announced that banks will be required to provide capital to cover interest rate risk on their trading book exposures (including derivatives) by 31 March 2005 and on investments under Available for Sale category by 31 March 2006. 2004.25% of total risk weighted assets in October 2000 in line with international best practices. General provision on standard assets was allowed to be included in tier 2 capital upto a maximum of 1. .CAPITAL ADEQUACY IN THE INDIAN BANKING CONTEXT Bank loans are to be classified as substandard when payments remain outstanding for one quarter from the year ending March 31. streamlining of risk management. maximizing return on capital. greater use of technology for efficiency gains. more robust risk based pricing and closer alignment with international best practices will strengthen the foundation of Indian banking system. even small banks would be willing to adopt the new system to be more competitive. .IMPACT ON INDIAN BANKS The consolidation in banking to overcome capital constraint. The new standards are mandatory for internationally active banks. However the weaker banks may need to merge with banks having surplus capital or those with ability to raise capital from the market. banks will need more capital to support expansion. . The stronger banks will be able to meet their need for additional capital by tapping the market.Consolidation The immediate impact of Basel II will be that the banks will need additional capital to cover market risk and operational risk besides credit risk. Also.both domestic and international or by ploughing back profits. MIS for building adequate database will impact profitability. Additional cost on account of rating as also cost of putting in place risk management system. . pushing down spread even further. technology infrastructure.Impact on profitability Competition among banks for prime customers will intensify. . Banks need to identify key risks. Banks need to improve management practices. map them with the processes and ensure sufficient controls against those risks by putting integrated risk management in place.Better Risk Management The core of the new accord is how to measure and monitor risk. compliance and sound corporate governance. well developed rating system. estimation of past defaults etc.Use of Internal Models The new accord allows banks to use their internal ratings to assess risk and allocate capital provided they satisfy certain basic minimum eligibility criteria including methodology to make meaningful credit differentiation. . well functioning data collection and IT system. . the cost of borrowing for non-prime / unrated borrowers will go up.Impact on Borrowers While there will be reduction in borrowing cost for prime borrowers. Treatment of small banks The new accord addresses only the large banks and does help measure risk in smaller banks. . . less than 5% of GDP in personal and housing finance and a booming services sector. there is no doubt the demographic dynamics will drive retail banking in India in the years ahead.Push to retail With almost 70% of India¶s population under 30 years of age. Greater Use of Technology Minimizing risk and maximizing return on capital to provide risk sensitive products and pricing and the enormous data requirement for business and compliance will require greater use of technology by banks. . HR Issues IT. risk management and increasing sophistication in other areas will push up the demand for skilled and specialized staff. . retrain and reskill existing staff remain the major challenge before the Indian banking industry. the need to redeploy. At the same time. . banks must have computer systems backed by knowledge and skill in place to provide the needed information. This will increase the demand on banks¶ systems and therefore.Greater disclosure and transparency Markets will demand more information in banks¶ balance sheet and analysts will look for more frequent and transparent data on risk profile. 2009 Basel Committee issued two consultative documents: ± Strengthening the resilience of the banking sector ± International framework for liquidity risk measurement.BASEL-III December 17. standards and monitoring . 2010: ± Basel III: A global regulatory framework for more resilient banks and banking systems ± Basel III: International framework for liquidity risk measurement.BASEL-III The proposals were finalized and published on December 16. standards and monitoring . BASEL-III Objectives ± Improving banking sector¶s ability to absorb shocks ± Reducing risk spillover to the real economy Fundamental reforms proposed in the areas of ± Micro prudential regulation ± at individual bank level ± Macro prudential regulation ± at system wide basis . Raising quality and transparency of capital base 2. Reducing pro-cyclicality and introducing countercyclical capital buffers (0-2. Minimum liquidity standards .Building Blocks of Basel III 1. Supplementing risk based capital requirement with leverage ratio 4. Improving/enhancing risk coverage on account of counterparty credit risk 3.5%) 6. Addressing systematic risk and interconnectedness 5.