Basel I to Basel III

Why Bank Capital?

A bank can finance its operations and carry out lending and investment activity either with debt (borrowings and deposits) or own funds (equity) Borrowings (including primarily insured deposits) generate contractual liabilities, which if not paid when due can cause the bank to fail. In contrast, equity can gain or lose value without causing the bank to default The greater the proportion of equity relative to debt in a banks capital structure, the more likely the bank will be able to meet its obligations, especially during periods of economic adversity Thus, regulatory emphasis on Capital Adequacy as a key element of banks Safety and Soundness

Why Bank Capital?

However, equity capital comes at a much higher cost Higher regulatory requirements of equity capital can constrain the banks capacity to lend and have broader macroeconomic effects on availability of credit Higher bank capital requirements can also reduce banks ability to take advantage of higher financial leverage and tax benefits of debt capital to increase ROE In a competitive market place, if banks ROE is depressed, capital will migrate to other higher return industries / sectors

How Much Bank Capital?

Prior to 1980s, there were no specific numerical capital adequacy standards, only subjective, qualitative regulatory assessments of banks Equity capital to total assets ratio of some of the largest banks in the US had reached a low of 4% In the 1970s and early 1980s, failures of large number of banks in the US and Europe, including large banks, combined with economic recession in 1881 changed regulatory and supervisory perceptions of bank capital Since the late 1980s, bank supervisors, stimulated in part by concerns arising out of bank failures and banking crises attempted to precisely define numerical minimum capital adequacy standards for banks

How Much Bank Capital?

Issues
Banking business defined differently in different countries Banks moving away from safe, low yield assets to riskier on balance sheet assets and off-balance activities which were difficult to quantify Regulators in different countries set capital standards individually, without convergence to any common norms

The Basel Capital Accord

In December 1987 International convergence of capital measures and capital standards was achieved. In July 1988,the Basel I Capital Accord was created and adopted by the Basel Committee for Banking Supervision (BCBS) comprising the Central Bank governors of the Group of Ten (G-10) countries Key objectives of Basel I
Set minimum regulatory capital adequacy requirements for banks that reflect the risks of the banks Define the components of regulatory capital, bearing in mind the ability to absorb losses

Applicable in its original version to large, internationally active commercial and investment banks Applicable, with suitable modifications by local regulators, to domestically operational banks

Minimum Capital Adequacy Standards

Capital Adequacy Ratio (CAR) = Regulatory Capital Funds -------------------------------------------Risk Weighted Assets (On B/S & Off B/S) Minimum CAR under Basel I = 7.25% by 1990 and 8% by 1992

Components of Regulatory Capital

Loss Absorption Tier III Subordinated debt (Dated) Supplementary capital Approved by BIS in 1996 Low

Cost/Risk for investor

Low

Lower Tier II Subordinated debt (Dated)

Approved by BIS in 1988

Max up to 50% of Tier I

Regulatory Capital

Upper Tier II Subordinated debt (Dated & Perpetual)

Approved by BIS in 1988

Max up to 100% of Tier I (along with Lower Tier II

Hybrid Tier I innovative

Approved by BIS in 1998

Max up to 15% of Tier I

Core capital

Tier I Common Equity & Retained earnings

50% at least of minimum capital ratio of 8%

High

High

Risk Weighted Assets

Basel I recommended risk weights to be assigned to different broad categories of assets or off balance sheet exposures based on the relative riskiness of those exposures The risk weighted approach was preferred over a simple gearing ratio because:
(i) it provides a fairer basis for making international comparisons between banking systems whose structures may differ; (ii) it allows off-balance-sheet exposures to be incorporated more easily into the measure; (iii) it does not deter banks from holding liquid or other assets which carry low risk.

Broad brush, judgemental weights were applied to different types of assets and the framework of weights was kept as simple as possible.

Risk Weights Under Basel I

Off Balance Sheet Exposures

Off-balance sheet contingent contracts, such as letters of credit, loan commitments and derivative instruments, which are traded over the counter, needed to be first converted to a credit equivalent based on regulatory specified credit conversion factors (CCF) and then assigned appropriate risk weights

Basel I Supervisory Action

A bank must hold regulatory capital to at least 8 % of its risk-weighted assets and Tier I capital to at least 4% of its risk-weighted assets When capital falls below this minimum requirement, shareholders may be permitted to retain control, provided that they recapitalize the bank to meet the minimum capital ratio. If the shareholders fail to do so, the banks regulatory agency is empowered to sell or liquidate the bank.

Benefits of Basel I
Basel I acted as a stabilizing force in the international banking systems Measured on-balance-sheet capital ratios increased since the Accord's provisions took effect in 1992 to reach industry average of 8% in 1993, without any evident contraction in credit availability as a result Since the implementation of Basel I, banks equity capital, and also reserves and income increased, further strengthening banks total level of protection from credit losses Banks consciously held capital well in excess of regulatory minimum requirements, to avoid consequences of regulatory sanctions that could be imposed during times of adversity There was a marked decline in bank failures

Criticism of Basel I
Could not create a level playing field among banks from different countries due to differences in regulatory actions, tax laws, disclosure requirements, insolvency laws and others Used a one-size-fit-all risk weight approach for all categories of banks irrespective of their risk profile Created incentives for regulatory capital arbitrage using securitisation and off-balance sheet derivatives Failed to recognize the loss reducing effects (risk mitigating effects) of collateralised exposures Assigning favourable weights to claims on OECD banks and countries implied a biased treatment which was not truly a reflection of the risks of such exposures

1996 Amendment to Basel I

An explicit capital cushion for the price risks to which banks are exposed, particularly those arising from their trading activities. The amendment introduced different approaches to the measurement of market risks arising from banks open positions in foreign exchange, traded debt securities, traded equities, commodities and options. For the first time, banks were allowed to use, as an alternative to the standardized risk weight approach, their internal models for measuring the capital charge for market risk

Basel II
Basel Capital Accord II - International Convergence of Capital Measurement and Capital Standards, June 2004 Initiation of revised framework in June 1999; additional proposals in Jan 2001 and April 2003; latest version endorsed by Central Bank Governors and heads of Banking Supervision of G - 10 Countries

Basel II
To align capital adequacy assessment more closely with the key elements of banking risk 3 Pillars to ensure safety and soundness of the banking system
Minimum Capital Requirements Supervisory Review Process Use of Market Discipline

Focus on internationally active banks but can be applied suitably to all types of banks

Basel II
Greater emphasis on banks own assessment of risks to which they are exposed, with special importance to credit and operational risk Banks management ultimately responsibility for managing risks & ensuring that CAR is consistent with the banks risk profile

Basel II
Capital Adequacy Ratio = Regulatory Capital Funds -------------------------------------------------Risk Weighted Assets (On & Off B/S) = Minimum 8% Total Risk Weighted Assets = 12.5 X [Capital Required for Mkt risk + Operational risk + Credit Risk]

Credit Risk in Basel II

Applicable to credit exposures like loans and advances in the banking book and investments in corporate bonds Three Approaches for Credit Risk Capital Charge
Standardized approach based on external rating agency ratings Foundation IRB approach based on bank specific internal ratings and Advanced IRB approach based on bank specific internal ratings and measures of loss

Credit Risk in Basel I

Provide incentives for banks to enhance their risk measurement and management techniques Is more risk sensitive as compared to the previous standardized approach wider differentiation of risk weights wider recognition of credit risk mitigation techniques Reduce incentives for capital arbitrage

Standardized Approach Credit Risk

AAA to A+ to BBB+ to BB+ to B+ to Below AAA- BBB- BBBBUnrated Corporates 20% 50% 100% 100% 150% 150% 100% Sovereign 0% 20% 50% 100% 100% 150% 100% Banks Option I 20% 50% 100% 100% 100% 150% 100% Banks Option IIa 20% 50% 50% 100% 100% 150% 50% Banks Option IIb 20% 20% 20% 50% 50% 150% 20%
Risk weights based on external credit assessments Banks Option I : Risk Weighting based on risk weighting of sovereign in which Bank is incorporated Banks Option IIa: Risk weighting based on assessment of individual bank Banks Option IIb: Risk weighting based on assessment of individual bank with claims of original maturity < 3 months

Market Risk in Basel I

Applicable to Trading books of banks which are affected by price and interest rate variations Two Approaches for Market Risk Capital Charge Standardized Measurement Method (SMM) based on regulatory standards for price and interest rate variations Internal Models Approach (IMA) based on banks internal Value at Risk Models for assessing market risk related losses and capital requirements

Operational Risk in Basel II

Operational risk has been defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Three Approaches for Operational Risk Capital Charge
Basic Indicator Approach (BIA) The Standardised Approach (TSA) Advanced Measurement Approaches (AMA)

Supervisory Review in Basel II

Banks must implement an Internal Capital Adequacy Assessment Process (ICAAP) in relation to their risk profile This includes stress testing for credit, market and operational risk and aligning their capital to the stressed requirements Banks must also outline a strategy for maintaining their capital levels Pillar 2 also requires the supervisory authorities to subject all banks to an evaluation process and to impose any necessary supervisory measures based on the evaluations.

Market Discipline in Basel II

Market discipline is imposed by a set of disclosure requirements included in the Basel II framework to allow market participants assess the capital adequacy of the bank based on information on the capital, risk exposures, risk assessment processes etc.

Basel III
In September 2010, the Basel Committee's oversight body - the Group of Central Bank Governors and Heads of Supervision (GHOS) agreed on the broad framework, measures and transition to stronger capital adequacy measures of Basel III

Basel III: Greater Emphasis on Common Equity

Increase of the minimum common equity requirement to 4.5%, much higher than the minimum ratio of 2% under Basel II The Tier 1 minimum capital requirement increased to 6% as compared to a minimum ratio of 4% under Basel II Banks will also be required to hold an additional capital conservation buffer of 2.5% of common equity to withstand future periods of stress. The closer a banks capital level gets to the minimum requirement, the more constrained its earnings distribution (eg dividend payments, share buybacks and bonuses) will be until capital is replenished. Thus, during normal periods the total common equity requirements for banks will be effectively brought to at least 7%.

Basel III: RWA

Increased the capital required for trading book and complex structured products The risk-based capital requirement measures will be supplemented by a non-risk-based leverage ratio, That is, the risk based capital adequacy ratio will be benchmarked to a non-risk based leverage ratio which uses the banks total non-weighted assets plus off balance sheet exposures This is expected to help contain the build-up of excessive leverage in the system, serve as a backstop to the risk-based requirements and address model risk.

Basel III: Pro-cyclicality

Basel III will promote the build-up of capital buffers in good times that can be drawn down in periods of stress. The countercyclical capital buffer, which has been calibrated in a range of 02.5%, would build up during periods of rapid aggregate credit growth if, in the judgment of national authorities, this growth is aggravating system-wide risk. Conversely, the capital held in this buffer could be released in the downturn of the cycle. This would, for instance, reduce the risk that available credit could be constrained by regulatory capital requirements.

Basel III