- It also refers to Basel Accords or Basel Guidelines on banking supervision. These guidelines are formulated by the Basel Committee on Banking Supervision (BCBS).
- These norms are for individual banks and Systemically Important Financial Institutions (SIFI).
- In India, these norms are implemented by the Reserve Bank of India. As of now, the committee has come up with Basel-I, Basel-II and Basel-III.
- RBI began implementing Basel-I in 1992 and Basel-II in 2009. RBI also issued guidelines on implementing Basel-III in a phased manner.
Basel -I Norms
- It is also known as the Basel Capital Accord.
- As per Basel-I, all banks were required to maintain a capital adequacy ratio (CAR) of 8 %.
- CAR is the minimum capital requirement of a bank and is defined as the ratio of capital to risk-weighted assets (RWA).
- RWA is the assets weighted or classified according to the risk (default) profile.
- It also classified bank capital into Tier-I and Tier-2 Capital.
- Tier 1 capital is the core capital of banks and is more permanent in nature (e.g. equity capital, disclosed reserves, etc.).
- Tier 2 capital is supplementary in nature and is fluctuating in nature (e.g. undisclosed reserves, cumulative non-redeemable preference shares, etc.).
- India adopted Basel -I guidelines in 1999.
- It is the revised capital framework of 1988. It comprises three pillars: Pillar 1 (Minimum Capital Requirement), Supervisory Review, and Market Discipline.
Pillar 1: Minimum Capital Requirement (MCR)
- It sets MCR for credit risk, market risk and Operational risk.
- As per Basel-II, the minimum capital requirement is 8% of the risk-weighted assets. Risk-weighted assets means -Classification of assets based on their risk profiles.
- The capital ratio is calculated using the definition of regulatory capital and risk-weighted assets.
- The total capital ratio must not be lower than 8%.
- It also extends banks capital to Tier 3 capital (existing Tier 1 and Tier 2 capital).
- Tier-3 capital includes short-term subordinated loans (lower in ranking).
- Tier 3 capital solely to support market risks.
- For short-term subordinated debt to be eligible as Tier 3 capital, it needs to be capable of becoming part of a bank’s permanent capital and thus be available to absorb losses in the event of insolvency.
Pillar 2: Supervisory review
- It focuses on supervision of institution’s implementing Pillar-1 guidelines. Under it, Banks were required to develop and use better risk management techniques.
Pillar 3: Market Discipline
- It is designed to promote greater stability in the financial system. It increased the disclosure requirements.
- Banks need to mandatorily disclose their CAR, risk exposure, etc to the central bank.
Basel III Norms
- The financial crisis of 2007-08 revealed shortcomings in the Basel norms. Therefore, the previous accords were strengthened in Basel III.
- Increase the level and quality of capital: Banks are required to maintain more capital of higher quality to cover unexpected losses. Moreover, the minimum Tier 1 capital rises from 4% to 6%. It has also mandated that the Global systemically important banks (G-SIBs)are subject to additional capital requirements.
- Maintain Buffer to absorb unexpected loss: Banks have to maintain a capital conservation buffer of 2.5% of RWA. Moreover, banks have to maintain a countercyclical buffer of 0-2.5%.
- Improving Bank Liquidity: It created two liquidity ratios: Liquidity coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR).
- LCR will require banks to have sufficient high-quality liquid assets to withstand a 30-day stressed funding scenario that is specified by supervisors. This is to deal with the cash outflows encountered in an acute short term stress scenario.
- NSFR requires banks to maintain a stable funding profile in relation to their off-balance-sheet assets and activities. NSFR requires banks to fund their activities with stable sources of finance (reliable over the one-year horizon).
- Leverage: A non-risk based leverage ratio including off-balance sheet exposures is meant to serve as a backstop to the risk-based capital requirement.