Overview of The

Basel Norms I, II
& III

What is CAR?
Capital adequacy provides regulators with a

means of establishing whether banks and

other financial institutions have sufficient
capital to keep them out of difficulty.
Regulators use a Capital Adequacy Ratio
(CAR), a ratio of a banks capital to its assets,
to assess risk.
CAR = (Banks Capital)/(Risk Weighted Assets)
= (Tier I Capital + Tier II Capital)/(Risk
Weighted
Assets)

Concepts of Capital
Adequacy Norms
Tier I Capital
Tier II Capital
Risk Weighted Assets
Subordinated Debts

How do banks make

money?
By playing term of funds: Long v/s short.
By playing risk levels- accept lower risk and

place in higher risk- play safety as a market

mantra
Dispersed source v/s concentrated use.
Trading in the market

Essentially by taking risk

Risk Definition and features

Risk:
Event likely to cause loss/variability/damage to income
and reputation
Features:
Fairly known- Cannot be avoided.
Probabilistic and generic
Ascertainable, although not always quantifiable
Essential for intermediation process.
Risk and Reward go together
Interrelated/ Collectively exhaustive but not
mutually exclusive

Risk is an opportunity

Sources of Risk
Decision ,Indecision
Business cycles/

Seasonality
Economic/Fiscal
changes
Policy Changes
Market movements
Events

Political compulsions
Regulations
Human resources, skill

sets
Competition
Technology
Non-availability of
information

Risks Involved
Credit Risk - Default/delay: Impacts Solvency-Capacity to
service obligation
Market Risk
Interest Rate Risk- Changes in the market rate causing
income variability
b) Foreign Exchange Risk- Fluctuation in currency rates,
prices becoming adverse for the company
c) Commodity Price Risk
a)

Operational Risk - Failure of Men, Machine, Monitoring,

Methods

How to manage risk

Hedging
Exposure limits
Reserves and Provisioning

More importantly by having

adequate capital

Basel I Norms
In 1988, the Basel I Capital Accord was created.
The general purpose was to:
1. Strengthen the stability of international
banking system.
2. Set up a fair and a consistent international
banking system in order to decrease competitive
inequality among international banks.

Basis of Capital in Basel I

Tier I (Core Capital):

Tier I capital includes stock issues (or share

holders equity) and declared reserves, such as loan
loss reserves set aside to cushion future losses or
for smoothing out income variations.
Tier II (Supplementary Capital):

Tier II capital includes all other capital such as

gains on investment assets, long-term debt with
maturity greater than five years and hidden
reserves (i.e. excess allowance for losses on loans
and leases). However, short-term unsecured debts
(or debts without guarantees), are not included in

Risk Categorization
According to Basel I, the total capital should
represent
at least 8% of the banks credit risk.
Risks can be:
The on-balance sheet risk (like risks associated
with cash & gold held with bank, government
bonds, corporate bonds etc.)
Market risk including interest rates, foreign
exchange, equity derivatives & commodities.
Non Trading off-balance sheet risks like forward
purchase of assets or transaction related debt
assets

Limitations of Basel I
Norms
Limited differentiation of credit risk: There are

four broad risk weightings (0%, 20%, 50% and

100%), as shown in Figure1, based on an 8%
minimum capital ratio.
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
current
capital
requirements ignore the different level of risks
associated with different currencies and
macroeconomic risk.

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

Basel II Norms
Basel II norms are based on 3 pillars:

Minimum Capital Banks must hold capital against

8% of their assets, after adjusting their assets for risk

Supervisory Review It is the process whereby

national regulators ensure their home country banks

are following the rules.

Market Discipline It is based on enhanced disclosure

of

risk

Risk Categorization
In the Basel II accord, Credit Risk, Market Risk and
Operational Risks were recognized.
Under Basel II, Credit Risk has three approaches
namely, standardized, foundation internal ratingsbased (IRB), and advanced IRB
Operational Risk has measurement approaches like
the Basic Indicator approach, Standardized
approach
and the Advanced Measurement approach.

Impact on Banking Sector

Capital Requirement
Wider Market
Products
Customers

Advantages of Basel II
over I
The discrepancy between economic capital

and regulatory capital is reduced significantly,

due to that the regulatory requirements will
rely on banks own risk methods.
More Risk sensitive
Wider recognition of credit risk mitigation.

Pitfalls of Basel II norms

Too much regulatory compliance
Over Focusing on Credit Risk
The new Accord is complex and therefore

demanding for supervisors, and

unsophisticated banks
Strong risk differentiation in the new Accord

can adversely affect the borrowing position of

risky borrowers

Basel III Norms

Basel III norms aim to:
Improving the banking sector's ability to

absorb shocks arising from financial and

economic stress
Improve risk management and governance
Strengthen banks' transparency and

disclosures

Structure of Basel III

Accord
Minimum Regulatory Capital Requirements

based on Risk Weighted Assets (RWAs) :

Maintaining capital calculated through credit,
market and operational risk areas.
Supervisory Review Process : Regulating tools
and frameworks for dealing with peripheral
risks that banks face
Market Discipline : Increasing the disclosures
that banks must provide to increase the
transparency of banks

Major changes in Basel III

Better Capital Quality
Capital Conservation Buffer
Counter cyclical Buffer
Minimum Common Equity and Tier I Capital

requirements
Leverage Ratios
Liquidity Ratios
Systematically Important Financial Institutions

Basel III and its impact

On Banks

On Financial Stability

On Investors

Thank You