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Basel III standards, like other Basel Committee standards, are minimal criteria that apply to globally engaged banks. Members are committed to establishing and applying standards in their jurisdictions within the Committee’s timeframe.
Basel III is an expansion of the current Basel II Framework that provides additional capital and liquidity rules to bolster the banking and financial sector’s regulation, supervision, and risk management.
It was approved by representatives of the Basel Committee on Banking Supervision in 2010–2011, and adoption was set for 2013–2015.
With increased minimum capital and liquidity requirements, Basel III enhances the three Basel II pillars, particularly Pillar 1.
Three pillars
The first pillar is the requirement for a minimum amount of capital.
The first pillar, the Minimum Capital Requirement, is primarily concerned with overall risk, which includes credit risk, market risk, and operational risk.
The Supervisory Review Process is the second pillar.
The supervisory review process, the second pillar, is designed to guarantee that banks have enough capital to handle all of the risks that come with their activities.
In India, the Reserve Bank of India (RBI) has issued rules to banks requiring them to establish an internal supervisory procedure known as ICAAP (Internal Capital Adequacy Assessment Process). Banks can use this tool to examine capital sufficiency in relation to their risk profiles and develop strategies for preserving capital levels.
Aside from that, the RBI has another procedure in place, which is the Independent Assessment of the Banks’ ICAAP. This is known as the Supervisory Review and Evaluation Process, or SREP.
Market Discipline is the third pillar.
The third pillar’s purpose is to complement the first and second. This is a discipline that the bank follows, such as reporting its capital structure, tier-I and tier-II capital, and capital adequacy techniques.
Basel III norms
Basel III standards were published in 2010. In reaction to the financial crisis of 2008, certain recommendations were implemented.
The system needed to be strengthened further since banks in developed nations were undercapitalized, over-leveraged, and reliant on short-term borrowing.
In addition, Basel II’s size and quality of capital were judged insufficient to control any additional risk.
The Basel III standards aim to make most banking operations, such as trading, more capital-intensive.
The rules focus on four key banking parameters: capital, leverage, financing, and liquidity, with the goal of promoting a more robust banking sector.
Capital Adequacy Ratio – CAR
The capital adequacy ratio (CAR) is a measure that analyzes a bank’s available capital to its risk-weighted credit risks. The capital adequacy ratio, commonly known as the capital-to-risk weighted assets ratio (CRAR), is used to safeguard depositors and enhance global financial system stability and efficiency. Tier-1 capital, which can absorb losses without requiring a bank to discontinue operations, and tier-2 capital, which can absorb losses in the case of a winding-up and so provides a reduced level of protection to depositors, are the 2 types of capital that are measured.
Important takeaways
CAR is essential for banks to have an adequate cushion to sustain a decent level of losses before going bankrupt.
Regulators use CAR to measure a bank’s capital adequacy and conduct stress testing.
CAR is used to assess two forms of capital. Tier-1 capital can take a decent amount of loss without causing the bank to halt trading, whereas tier-2 capital can withstand a loss if liquidation is required.
The disadvantage of utilising CAR is that it does not take into consideration the possibility of a bank run or what would happen in a financial crisis.
Calculating CAR
Divide a bank’s capital by its risk-weighted assets to get the capital adequacy ratio. There are two layers of capital used to determine the capital adequacy ratio.
Tier 1 capital, also known as core capital, is made up of equity, common stock, intangible assets, and audited revenue reserves. Tier-1 capital is intended to withstand losses without requiring a bank to shut down. Tier-1 capital is capital that is permanently and readily accessible to cushion a bank’s losses without requiring it to cease operations. Ordinary share capital is an excellent illustration of a bank’s tier one capital.
Tier-2 capital
Unaudited retained profits, unaudited reserves, and general loss reserves make up Tier-2 capital. In the case of a company’s bankruptcy or liquidation, this capital absorbs losses. Tier-2 capital is used to buffer losses in the event of a bank’s failure, therefore it offers less protection to depositors and creditors. It is used to withstand losses if a bank’s Tier-1 capital is depleted.
Risk-Weighted Assets
Banks and other financial institutions must hold risk-weighted assets to establish the minimum amount of capital they must hold to limit the risk of insolvency. For each form of bank asset, the capital need is based on a risk assessment.
A loan secured by a letter of credit, for example, is regarded as riskier and consequently requires more cash than a home loan backed by collateral.
Conclusion
Basel III has significantly reinforced regulatory oversight. The agreement has spurred governments throughout the globe to increase capital requirements, implement liquidity restrictions, and establish governance and compensation standards. Banks will be less likely to fail as a result of this. Efforts to improve supervision would also be fruitful.
