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Banks are one among the major triggers in most of the economic crises. Banks are the veins of circulation of money in an economy. So the soundness of banking system is imperative to prevent the collapse of the system. The premature liberalization of the local financial markets and the failure to keep adequate checks on lending functions of the banks are the major reasons for the Asian economic crisis of 1997 i.e., Absence of effective regulation and supervision led to large capital inflows in the domestic short term debt market. Banks lent on long term basis using the foreign inflows. Later when signs of pessimism became visible foreign inflows to economies such as Philippines, Malaysia etc... started to decline. (Buckley n.d.) Similarly, in the year 2008 the reckless lending of US banks like Lehman brothers and securitization of those sub standard loans into instruments known as CDO-s (Collateral Debt Obligations) and trading of such securities in the stock market that led to sub-prime crisis, which triggered the recession that followed. Thus a perfect regulation and prudential supervision of banks is tellingly important for the smooth sailing of an economy.

Basel I

Capital is the last recourse that would be available for any bank to prevent its failure. In the year 1974, after the failure of Herstatt bank in Germany the need for regulation of banking sector was felt by G-10 countries. They constituted the Basel Committee for Banking Supervisory practices (BCBS) under the aegis of Bank for International Settlements (BIS).   Basel I was recommended for implementation by the BCBS for mainly addressing the issue of credit risk in the year 1988. Credit risk implies the risk involved in the recovery of loans that were lent. In order to address the issue BCBS fixed a minimum capital adequacy requirement to be maintained by the banks. It pegged the Capital adequacy ratio (CAR) at 8%. (Tarullo n.d.)

Capital Adequacy Ratio (CAR) = Tier 1 Capital + Tier 2 Capital/ Risk Weighted Assets

Tier 1 capital represents the capital that is more permanent in nature and is more reliable.Tier 1capital or core capital of a bank includes the normal paid up share capital of the bank and other disclosed reserves reduced by Intangible assets of the bank such as Goodwill, Fictitious assets such as debit balance to the Profit and loss account, any expenditure that is not written off and Deferred tax asset. The Tier 1 capital should form atleast 50% of the bank’s total capital base.

Tier 2 represents the capital that is not as much reliable as Core capital because of the lack of corroborated ownership as in Tier 1 capital. Tier 2 or supplementary capital consists of Undisclosed reserves, Cumulative non redeemable preference share capital, General provisions and loss reserves written back as surplus if the actual loss or diminution is found to be in excess of the provision or loss reserves created earlier, Revaluation reserves, Hybrid capital instruments and Subordinated debt with minimum maturity of 5 years. There are also restrictions such as subordinated debts could not exceed 50% of the core capital, general provisions and loss reserves could not exceed 1.25% of total risk weighted assets

‘Risk weighted assets’ capture the amount of risk and the uncertainty involved with the assets that it may fail to get liquidated to what it is actually worth for. Under Basel I, risk weights were classified into 5 Categories namely, 0%, 0% to 50%, 20, 50%, 100%. (Tarullo n.d.)

0% weight was assigned to assets such as loans lent to OECD states or Investment with OECD central government’s securities, loans to borrowers, who had provided OECD state’s guarantees or securities as collateral. Since OECD states are considered to be developed countries their securities were assigned zero credit risk. Loans to non – OECD countries and central banks too were assigned 0% risk weights, provided loans advanced to them were in their own currency i.e., borrowing country’s currency. This is done to eliminate the risk of exchange rate movements on the loans advanced since there are more probabilities for the currencies of non- OECD to depreciate than the currencies of OECD countries.

Loans or investment with domestic public sector enterprises that remain outside the ambit of central government were given risk weights ranging from 0% to 50% at the discretion of nation’s regulator , which could be 0%, 10%, 20% and 50%.

Loans or investment with institutions such as Multilateral development banks, OECD banks, Non-OECD banks with the tenor of the loan extending up to 1 year, loans guaranteed by OECD incorporated banks, short term loans (tenor of 1 year) guaranteed by non-OECD banks were assigned a weight of 20%.

Loans to non-OECD banks with tenure of more than 1year are given a weight of 50%.

Loans or investment with private sector enterprises, Non – OECD banks with maturity over one year, capital market instruments issued by other banks were assigned a weight of 100%.

In order to capture the risk that resides with the off – balance sheet items such as contingent liabilities a factor called ‘Credit conversion factor’ was deployed. For example, general guarantees against loans were assigned 0% CCF, letter of credits against Shipments were assigned 20% etc…

In 1996, in response to expanding frontiers of financial innovations, as instruments like derivatives were started to be widely used, a new factor called market risk was introduced to strengthen the standards.  Markert risk is the risk of losses in on and off-balance sheet positions arising from movements in market prices. (Basel Committee on Banking Supervision 2005) The way CAR would be calculated was modified to factor in Market risk and a new compartment of capital called as Tier 3 capital. The Tier 3 capital is composed of Short term subordinated bonds that would exclusively cover market risks. Market risk is composed of interest rate risk, equity position risk, foreign exchange risk and commodities risk. For measuring market risk, BCBS proposed two approaches. They are standardized approach and the bank’s own internal grading based approach.

Basel II

As years passed by, Basel II evolved. Basel II was given approval in the year 2004. The Basel II accord contains three pillars to establish a sound banking system viz: 1.The minimum capital requirement; 2.The supervisory review; 3.The market discipline.

The level of minimum capital requirement was continued to be maintained at 8% under the new framework. A new benchmark called operational risk was included. Operation risk is defined as the risk of loss resulting from inadequate or failed internal processes. For instance, Operation risks include employee frauds, sabotage of assets of the bank, external frauds etc… Put simply, the losses that the bank may suffer from causes other than in the normal course of business.  

Pillar 1

Basel II provided three different approaches for credit risk determination. They are standardized approach, foundation internal rating based approach (F-IRB) and advanced internal rating based approach (A-IRB).

The standardized approach provides that risk weights should be assigned based on the ratings given by the external credit rating institutions (ECAI). Under the new approach risk weights may range from 0% to 150%.Unlike Basel I, where loans to OECD central banks and OECD states where assigned a lower risk weights considering their credibility as the benchmark, in Basel II ratings assigned by the external credit rating agencies were considered as benchmarks and loans to foreign banks were assigned risk weights based on the ratings given by them. However when a foreign bank that is operating in a country lends to the central bank of the country, where it is incorporated then a lower risk weight may be applied to such asset provided the loan is funded and denominated in the domestic currency of the foreign bank. Another prominent feature of the Basel II accord is a corporate may get rated by an ECAI and be assigned a lower risk weight based on the ratings. This stands contrast to the Basel I accord, where corporates were all assigned a uniform risk weight of 100%. This would cause the banks to infer that lending to SME-s (Small and Medium Scale Enterprise) may prove to be expensive. (Francis n.d.)

Internal ratings based approach allows the banks to devise their own models to assess the risk. However the difference between the two IRB approaches (F-IRB and A-IRB) lies in the fact that in the former approach banks can use their own modeling techniques to determine the default risk, but the regulatory authorities have to dictate the parameters for loss given defaults while in the latter it is up to the bank to determine both.

To cover operational risk of loss, Basel II prescribes 3 approaches namely basic indicator approach, standardized approach and advanced measurement approach. Basic indicator approach and standardized approach requires an appropriation of 15%, 12% to 18% respectively of bank’s average annual gross income in the preceding three years. Under the standardized approach, bank’s activities are divided into eight business lines each possessing a different ‘denoted beta’ ranging from the aforesaid 12% to 18%. The past three years average gross annual income of the bank is multiplied with respective beta to arrive at the capital charge.  Advanced measurement approach requires appropriation of the past three years average gross income based on risk determined by the banks operational risk measurement system.

Pillar 2

Pillar 2 specifies the norms for regulatory authorities. The banks should have deployed a system for assessing the health of capital and preclude any fall below the standard level. The regulator should mandate the banks to operate above the minimum capital requirement and should prevent the capital of banks from falling below the minimum specified standard.

Pillar 3

Under the Pillar 3, banks are required to follow a formal disclosure policy. Disclosures regarding capital adequacy, credit risk mitigation, the internal ratings systems it followed under IRB approach were all specified under Pillar 3 of Basel accord.

Indian Scenario

In India, Basel I was first accepted in the year 1999. Later the RBI proposed the initial guidelines for implementation of Basel II in the year 2005. It announced that initially banks would have to adopt the Standardized approach for the determining risk weights for credit risk and the basic indicator for determining operational risk. According to Section 17 of the Banking regulation act, 1947 banks are required to transfer at least 20% of the disclosed profit to a reserve fund every year. This will place the banking practices in India in line with Basel II standards, an act that ensures compliance with pillar 2 propositions of Basel II.  It is mandated CAR has to be maintained at 9% level, a step ahead of Basel II level.

In the aftermath of the global financial meltdown in 2008, the vulnerability of the global financial system was exposed. Basel III guidelines were proposed in the year 2010 by the BIS. Further modified parameters such as leverage ratio, mandatory capital conservation buffers and discretionary counter cyclical buffers were introduced.

While Basel III norms are yet to be implemented in India, the need for strengthening our banking system is telling. Between March 2011 and September 2012, the ratio of gross NPA-s to gross advances in the banks surged from 2.4% to 3.59%. (R.Kannan 2013)Thus a scientific study and review of the banking laws and practices is very much warranted, given the lessons that history has been teaching time and again through the financial turmoil across the globe.

Works Cited

• Basel Committee on Banking Supervision. "Amendment to the Capital Accord to incorporate market risks." 2005.

• Buckley, Ross P. International Finance system - Policy and regulation.

• Francis, Smitha. "The Revised Basel Capital Accord: The Logic, Content and Potential."

• R.Kannan. "How to swat the NPA bug." Business Line, 4 5, 2013.

• Tarullo, Daniel K. Banking on Basel: The Future of International Financial Regulation.

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