Posted in Indian Economy

Basel Accords

Read it later

Basel Accords

The Basel Accords (i.e., Basel I, II and now III) are a set of agreements set by the Basel Committee on Bank Supervision (BCBS), which provides recommendations on banking regulations in regards to capital risk, market risk, and operational risk. The purpose of the accords is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses. They are of paramount importance to the banking world and are presently implemented by over 100 countries across the world. The BIS Accords were the outcome of a long-drawn-out initiative to strive for greater international uniformity in prudential capital standards for banks’ credit risk. The objectives of the accords could be summed up as:

(i) to strengthen international banking system;
(ii) to promote convergence of national capital standards; and
(iii) to iron out competitive inequalities among banks across countries of the world.

The Basel Capital Adequacy Risk-related Ratio Agreement of 1988 (i.e., Basel I) was not a legal document. It was designed to apply to internationally active banks of member countries of the Basel Committee on Banking Supervision (BCBS) of the BIS at Basel, Switzerland. But the details of its implementation were left to national discretion. This is why Basel I looked G10- centric.

The first Basel Accord, known as Basel I focuses on the capital adequacy of financial institutions. The capital adequacy risk (the risk a financial institution faces due to an unexpected loss), categorizes the assets of financial institution into five risk categories (0 percent, 10 percent, 20 percent, 50 percent, 100 percent). Banks that operate internationally are required to have a risk weight of 8 percent or less.

The second Basel Accord, known as Basel II, is to be fully implemented by 2015. It focuses on three main areas, including minimum capital requirements, supervisory review and market discipline, which is known as the three pillars. The focus of this accord is to strengthen international banking requirements as well as to supervise and enforce these requirements.

The third Basel Accord, known as Basel III is a comprehensive set of reform measures aimed to strengthen the regulation, supervision and risk management of the banking sector. These measures aim to:

(i) improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source be;
(ii) improve risk management and governance; and
(iii) strengthen banks’ transparency and disclosures.

The capital of the banks has been classified into three tiers as given below:

Tier 1 Capital: A term used to describe the capital adequacy of a bank—it can absorb losses without a bank being required to cease trading. This is the core measure of a bank’s financial strength from a regulator’s point of view (this is the most reliable form of capital). It consists of the types of financial capital considered the most reliable and liquid, primarily stockholders’ equity and disclosed reserves of the bank—equity capital can’t be redeemed at the option of the holder and disclosed reserves are the liquid assets available with the bank itself.

Tier 2 Capital: A term used to describe them capital adequacy of a bank—it can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors. Tier II capital is secondary bank capital (the second most reliable forms of capital). This is related to Tier 1 Capital. This capital is a measure of a bank’s financial strength from a regulator’s point of view. It consists of the accumulated after-tax surplus of retained earnings, revaluation reserves of fixed assets and long-term holdings of equity securities, general loan-loss reserves, hybrid (debt/equity) capital instruments, and subordinated debt and undisclosed reserves.

Tier 3 Capital: A term used to describe the capital adequacy of a bank—considered the tertiary capital of the banks which are used to meet/support market risk, commodities risk, and foreign currency risk. It includes a variety of debt other than Tier 1 and Tier 2 capitals. Tier 3 capital debts may include a greater number of subordinated issues, undisclosed reserves, and general loss reserves compared to Tier 2 capital. To qualify as Tier 3 capital, assets must be limited to 250 percent of a bank’s Tier 1 capital, be unsecured, subordinated47 and have a minimum maturity of two years.

Disclosed Reserves are the total liquid cash and the SLR assets of the banks that may be used any time. This way they are part of its core capital (Tier 1). Undisclosed Reserves are the unpublished or hidden reserves of a financial institution that may not appear on publicly available documents such as a balance sheet, but are nonetheless real assets, which are accepted as such by most banking institutions, but cannot be used at will by the bank. That is why they are part of its secondary capital (Tier 2).

Basel III Provisions

The new provisions have defined the capital of the banks in a different way. They consider common equity and retained earnings as the predominant component of capital (as the past), but they restrict inclusion of items such as deferred tax assets, mortgage-servicing rights and investments in financial institutions to no more than 15 percent of the common equity component. These rules aim to improve the quantity and quality of the capital.

While the key capital ratio has been raised to 7 percent of risky assets, according to the new norms, Tier-I capital that includes common equity and perpetual preferred stock will be raised from 2 to 4.5 percent starting in phases from January 2013 to be completed by January 2015. In addition, banks will have to set aside another 2.5 percent as a contingency for future stress. Banks that fail to meet the buffer would be unable to pay dividends, though they will not be forced to raise cash.

The new norms are based on the renewed focus of central bankers on ‘macro-prudential stability’. The global financial crisis following the crisis in the US sub-prime market has prompted this change in approach. The previous set of guidelines, popularly known as Basel II focused on ‘macro-prudential regulation’. In other words, global regulators are now focusing on the financial stability of the system as a whole, rather than micro-regulation of any individual bank.

Banks in the West, which are market leaders, for the most part, face low growth, an erosion in capital due to sovereign debt exposures and stiffer regulation. They will have to reckon with a permanent decline in their returns on equity thanks to enhanced capital requirements under the new norms. In contrast, Indian banks—and those in other emerging markets such as China and Brazil—are well-placed to maintain their returns on capital consequent to Basel III. Financial experts have opined that Basel III looks changing the economic landscape in which banking power shifts towards the emerging markets.

Basel III compliance of the PSBs & RRBs

The capital to risk-weighted assets ratio (CRAR) of the scheduled commercial banks of India was 13.02 percent by March 2014 (Basel-III) falling to 12.75 percent by September 2014. The regulatory requirement for CRAR is 9 percent for The decline in capital positions at the aggregate level, however, was on account of deterioration in capital positions of PSBs. While the CRAR of the scheduled commercial banks (SCB) at 12.75 percent as of September 2014 was satisfactory, going forward the banking sector, particularly PSBs will require substantial capital to meet regulatory requirements with respect to additional capital buffers.

In order to make the PSBs and RRBs compliant to the Basel III norms,49 the government has been following a recapitalization programme for them since 2011–12. A High-Level Committee on the issue was also set up by the government which has suggested the idea of ‘non-operating holding company’ (HoldCo) under a special Act of Parliament (action is yet to come regarding this).

Meanwhile, the government has infused three tranches of capital into the banks (infused funds go to the RRBs, too through the PSBs under whom they fall) up to March 2015:

(i) Rs. 12,000 crore infused during 2012–13 in seven PSBs.
(ii) Rs. 12,517 crore infused in 2013–14 in 8 PSBs.
(iii) In 2014–15, the PSBs were recapitalised with Rs. 6,990 crore. This capital infusion was based on some new criteria— asset quality, efficiency and strength of the banks.
(iv) During 2015–16, the government released Rs. 19,950 crore to 13 PSBs (Economic Survey 2015–16).
(v) For the year 2016-17, the government has announced a sum of Rs. 25,000 crore for the purpose of recapitalizing the PSBs (Union Budget 2016–17).
(vi) The Indradhanush scheme was launched (in 2015-16) by the Government under which the PSBs are to be infused with Rs. 70,000 crore by March 2019 to enable them meet to the ‘global risk norms’ (i.e., Basel III norms).
(vii) The ongoing recapitalisation process of the PSBs got a big boost when the Government announced (February 2018) a hefty sum of Rs. 2.11 lakh crores for it. Infused into the PSBs upto October 2019, a part of it (Rs. 1.35 lakh crores) will be mobilised through Recapitalisation Bonds while rest of it (Rs. 76,000 crores) will be raised by the banks from market (disinvestment process) and budgetary support. This process will help the banks in meeting their capital adequacy targets also.

As per the latest Economic Survey 2017-18, by September, the capital to risk-weighted asset ratio (CRAR) of the scheduled commercial banks (SCBs) was 13.9 percent (it was 13.6 percent by March 2017)—largely due to improvement among the PVBs (private sector banks).

PS : How to prepare Indian Economy for UPSC ?

Help us by contributing and making this site better by commenting below or mailing us at . You can send us articles and suggestions .

Read it later

Add Value by comment