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A committee established by the BIS in 1974 G-10 countries To arrive at a set of agreements on Regulations and recommendations on credit risk , market risk and operational risk Purpose to have enough capital on account to meet obligations and absorb unexpected losses No superior authority over the governments and central banks Also known as Basel committee
BASEL I
In 1988, the Basel committee came out with BaselAccord1 or Basel 1 Accords/Norms The accord was an agreement by the members of the BCBS with respect to minimum regulatory capital for credit risk. Regulatory capital refers to the risk-based capital requirements under the Capital Accord.
Ratio is used to protect depositors and promote the stability and efficiency of financial systems around the world.
Tier 2 Capital
Loan-loss reserves + subordinated debt.
Pitfalls of Basel I
Static measure of default risk The assumption that a minimum 8% capital ratio is sufficient to protect banks from failure does not take into account the changing nature of default risk. No recognition of term-structure of credit risk The capital charges are set at the same level regardless of the maturity of a credit exposure. Simplified calculation of potential future counterparty risk The capital requirements ignored the different level of risks associated with different currencies and macroeconomic risk. In other words, it assumes a common market to all actors, which is not true in reality. Lack of recognition of portfolio diversification effects In reality, the sum of individual risk exposures is not the same as the risk reduction through portfolio diversification. Therefore, summing all risks might provide incorrect judgment of risk
Conclusion
Basel 1- Milestone in Finance and Banking History It launched the trend toward increasing risk modeling research However, its over-simplified calculations, and classifications have simultaneously called for its disappearance, paving the way for the Basel II Capital Accord It led to further agreements as the symbol of the continuous refinement of risk and capital
BASEL-II
June 1999,:proposal issued for a new Capital Adequacy framework to replace Basel I. After extensive communication with banks and industry groups, the revised framework, Basel II issued in 2004. Basel II has been or will be implemented by regulators in most jurisdictions but with varying timelines and may be restricted methodologies.
Pillar 1 sets out the minimum capital requirements firms will be required to meet to cover credit, market and operational risk. Pillar 2 sets out a new supervisory review process. Requires financial institutions to have their own internal processes to assess their overall capital adequacy in relation to their risk profile. Pillar 3 cements Pillars 1 and 2 and is designed to improve market discipline by requiring firms to publish certain details of their risks, capital and risk management as to how senior management and the Board assess and will manage the institution's risks.
Implementation progress
Implementation has to accommodate differing cultures, varying structural models, and complexities of public policy and existing regulation. Corporate strategy will be implemented based in part on how Basel II is ultimately interpreted by various countries' legislatures and regulators. The USAs various regulators have agreed on a final approach. They have required the Internal Ratings-Based approach for the largest banks, and the standardized approach will not be available to anyone. In India, RBI implemented Basel II standardized norms on 31st March 2009 and is moving to internal ratings in credit and AMA norms for operational, VaR for market risks in banks. EU has already implemented the Accord via the EU Capital Requirements Directives. Many European banks already report capital adequacy ratios according to the new system. All credit institutions adopted it by 2008.
BASEL-III
"Basel III is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector". Thus, we can say that Basel 3 is only a continuation of effort initiated by the Basel Committee on Banking Supervision to enhance the banking regulatory framework under Basel I and Basel II. This latest Accord now seeks to improve the banking sector's ability to deal with financial and economic stress, improve risk management and strengthen the banks' transparency.
What are the Major Changes Proposed in Basel III over Basel II?
Better Capital Quality Capital Conservation Buffer: Countercyclical Buffer: Minimum Common Equity and Tier 1 Capital Requirements :from 2% to 4.5% of total riskweighted assets Leverage Ratio: capital to total Assets (not risk weighted) Liquidity Ratios: Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR)
Comparison
Exposure
The type of instrument determines the Exposure: For fully funded loans or bonds, the exposure is the face amount. For unfunded commitments : the exposure is 50% of the commitment for undrawn commitments with maturity over 1 year and 0% of the commitment for undrawn commitments with maturity less than one year. For credit products (e.g. guarantees) the exposure is 100% of the notional value of the contract. For derivatives the exposure is determined by the equation: Replacement Costs +(Add-On Percentage Notional Principal).