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. 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 the sub-standard loans into instruments known as CDO-s
(Collateral Debt Obligations) and trading of the securities in the stock market
led to the sub-prime crisis of 2008 and resultant recession in the follow-up.
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%.
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 1 capital or core capital of a bank includes the normal paid up share capital of the bank and other disclosed reserves as reduced by the 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 the 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 the Tier 1 capital because of the lack of corroborated
ownership as in the case of 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 the total risk weighted
assets.
‘Risk weighted assets’ is the value of the
assets adjusted for the risk of the asset failing to liquidate as valued.
Risk Weights
Under Basel I, risk weights were classified into 5 Categories namely, 0%, 0% to 50%, 20, 50%, 100%.
- The weight
of zero percent was assigned to assets such as loans lent to OECD states,
Investment with OECD central government’s securities, loans to borrowers,
who are backed by the guaranties of the OECD states or who had given
the securities of the OECD countries 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., in the currency of the borrowing country. This is done
to eliminate the risk of exchange rate movements on the loans advanced in
view of the probable depreciation of the currencies of the non-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 tenor extending upto 1 year, loans guaranteed by OECD
incorporated banks, short term loans guaranteed by non-OECD banks were
assigned a weight of 20%.
- Loans to
non-OECD banks given on a tenor of more than 1 year are assigned a weight
of 50%.
- Loans or
investment with private sector enterprises, Non – OECD banks with tenor
more than 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 ‘Credit conversion factor’ (CCF) was deployed. For
instance :
- General
guarantees against loans were assigned 0%
- Letter
of credits against Shipments were assigned 20%
In 1996, in response to the financial
innovations, as instruments like derivatives were started to be widely used, a
new factor called market risk was introduced to strengthen the standards.
Market risk is the risk of losses on account of movements in market prices
with the on-balance sheet and off-balance sheet positions. (Basel
Committee on Banking Supervision 2005) The
way CAR would be calculated was modified to factor in Market risk and a new
category 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 consists of interest rate risk, equity position risk, foreign exchange
risk and commodities risk. For measuring market risk, BCBS proposed two
approaches namely Standardized approach, where the principles of gauging the
market risk were completely prescribed by the BCBS and Internal grading based
approach, where a certain degree of independence was granted to banks in assessing
market risk.
Basel II
As years passed by, Basel II evolved. Basel II
was given approval in the year 2004. The propositions of Basel II accord
were on three fronts which are given by the three pillars 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 of
risk called Operational risk was introduced. Operational risk is defined as the
risk of loss resulting from the failure of internal processes or from the
external events. For instance, Operational risk includes employee frauds,
sabotage of assets of the bank, external frauds etc… Put simply, the losses
that the bank may suffer, 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)
- 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, 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 in contrast to
the Basel I accord, where all the corporates were assigned a uniform risk
weight of 100%. This might 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. Under the other two approaches, Banks use
their own model to measure the parameters like PD (Probability of default), EAD
(Exposure at default), LGD(Loss given default), which are used in calculating the Risk weighted assets (RWA).
To cover operational risk of loss, Basel II
prescribes three 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 to the
reserves 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 12% to 18%. The past three years average of the gross
annual income of each business line is multiplied with the
respective beta to arrive at the capital charge.
- Under the
Advanced measurement approach banks can quantify the capital to cover
operational risk using their own internal model taking into account
internal risk variables and profiles.
Pillar 2
Pillar 2 specifies the norms for regulatory
authorities. The banks should have deployed a system for assessing the
stability of the 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 the banks from falling below the
minimum level, which is specified.
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 that it follows under the IRB approach
were all specified under Pillar 3.
Indian Scenario
In India, Basel I was implemented 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. It was mandated that the CAR
has to be maintained at 9% level, a step ahead of the prescribed Basel II CAR
of 8%.
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. 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 warranted, given the lessons that history has been teaching time
and again through the financial turmoils 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.
* The article was originally published in the
site Caclubindia.com on
30th June, 2014.
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