Basel Norms which is frequently in news, is actually a set of norms prescribed by Bureau of International Settlement (BIS), to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses. Till date, BIS has released three set of norms popularly known as BASEL 1, BASEL 2 and BASEL 3.
Before we move on to defining various stages, let’s understand few banking terminology, which will help us understand the topic well:
Risk Weighted Assets = assets with different risk profiles, eg. Personal loans are riskier than housing loan which is a mortgage loan
Capital Adequacy Ratio = Total Capital / Risk Weighted Assets
Total Capital = Tier 1 capital + Tier 2 capital
Tier 1 Capital = Paid up capital, statutory reserves, other disclosed free reserves
Tier 2 Capital = Undisclosed reserves, revaluation reserves, general provisions and loss reserves etc.
BASEL 1 (Covered only Credit Risk)
- It focused entirely on credit risk – the risk of counter party failure.
- Under these norms, assets of banks were classified and grouped in five categories according to credit risk, carrying risk weights of 0%(Cash, Bullion, Home Country Debt Like Treasuries), 10, 20, 50 and100% and no rating
- Requirement of at least, 4% in Tier I Capital and more than 8% in Tier I and Tier II Capital. [Target – By 1992]
With BASEL 2 and BASEL 3, concept of three pillars came
Pillar 1: Minimum Capital Requirements
Pillar 2: Supervisory Review Process
Pillar 3: Market Discipline
BASEL 2 (Covered Credit Risk, Market Risk and Operational Risk)
- More refined definitions to make the definition consistent across all countries
- Pillar 1: Minimum Capital Requirement
- Credit Risk
- Market Risk
- Operational Risk
- Pillar 2: Supervisory Review Process
- Regulatory framework for banks
- Internal Capacity Adequacy
- Risk Management
- Supervisory framework
- Review of compliance
- Evaluation of internal capacity adequacy
- Pillar 3: Market discipline
- Disclosure requirements of banks
- Enhanced comparability of banks
- Regulatory framework for banks
BASEL 3 (Covered Credit Risk, Market Risk, Operational Risk and Liquidity Risk)
It was widely felt that the shortcoming in Basel II norms is what led to the global financial crisis of 2008. That is because Basel II did not have any explicit regulation on the debt that banks could take on their books, and focused more on individual financial institutions, while ignoring systemic risk. To ensure that banks don’t take on excessive debt, and that they don’t rely too much on short term funds, Basel III norms were proposed in 2010.
- All the pillar’s requirements have been enhanced
- Requirements for common equity and Tier 1 capital will be 4.5% and 6%, respectively.
- The liquidity coverage ratio(LCR) will require banks to hold a buffer of high quality liquid assets sufficient to deal with the cash outflows encountered in an acute short term stress scenario as specified by supervisors
- Leverage Ratio > 3%:The leverage ratio was calculated by dividing Tier 1 capital by the bank’s average total consolidated assets
Steps towards BASEL 3
- RBI target towards achieving Basel 3 norms is 31st March, 2019.
- It is estimated that a huge capital of Rs 2 lakh 40 thousand crores would be needed to achieve the norms
- Government has been disinvesting and re influxing the money to increase the capital adequacy with the banks
- Government has switched to INDRADHANUSH program, to achieve it systematically
- The capital infusion target seems challenging in wake of recent rise in non-performing assets and government falling short of fiscal deficit targets of FRBM act.