Banking News

Basel Accords: First,second and third


Basel accord is a global capital measures and capital standards which stipulate on how much capital a bank should have in place in relation to the risk it undertakes.  The guidelines on above regulatory standards are formulated by Basel committee on banking supervision (BCBS). Basel committee is constituted by Governors of Central Banks of G-10 nations in 1974. The first guidelines issued by Basel Committee are known as 1st accord of Basel or BaseI I accord. The second round of formulated guidelines on capital measures and capital standards by Basel Committee came into existence in June 2006 (The detailed guideline issued during 2007). This accord is known as Basel II accord. In July 2009 BCBS formulated guidelines on capital measures and capital standards and made some changes and enhancements to Basel II accord. This is known as 3rd accord of Basel or Basel III accord. Since the committee’s headquarter is in BASEL (Switzerland), it is called Basel Committee. It has now nearly 30 member nations including India, with 12 nations as permanent members.

Minimum total capital requirement

Total Capital Requirements for Indian Banks, are to be implemented in phased manner to meet the criteria of standard of Basel III accord. As per RBI communication the total capital requirements, as a %age to Risk Weighted Assets (RWAs)* will be phased-in between January 1, 2013 (now effective from 01.04.2013) and January 1, 2015. The minimum total capital, prescribed by RBI is as under.

January 1,2013(now effective from 01.04.13) January1,2014 January1,2015
Minimum Common Equity Tier 1 capital 3.5% 4.0% 4.5%
Minimum Tier 1 capital 4.5% 5.5% 6.0%
Minimum Total capital 8.0% 8.0% 8.0%

*The Risk Weighted Asset (RWA) is a measurement designed to evaluate the element of risk involved in each asset held by the bank. For example Cash held by bank is an asset with zero risk, where as other assets of the bank such as loans and advances, guarantees etc., are vulnerable to risk of default. Thus, such assets are called risk weighted assets. Banks make provisions on those risk weighted assets to meet future unforeseen losses.

What are Tier I & Tier II Capital?

Tier 1 capital comprises the following;

  1. Paid up Capital
  2. Statutory Reserve
  3. Other disclosed free reserve.
  4. Capital Reserve which represents surplus arising out of the sale proceeds of the assets.
  5. Investment fluctuation Reserves
  6. Innovative Perpetual Debt Instruments (IPDI)
  7. Perpetual Noncumulative preference shares

Less: ( Equities in subsidiaries, Intangible assets,  Losses (Current period and past carried forward)

 Tier II capital is broader measure of tier I capital. Tier II capital is alienated into lower and upper tiers. The upper tier consists of undated subordinated debt on which the bank can defer the interest payments and assets like revaluation reserves. Other subordinate debts are classified as lower tier II capital.

Tier II capital consist of following;

  1. Undisclosed reserves.
  2. Revaluation Reserves
  3. General provisions and Loss Reserves
  4. Hybrid debt capital such as Bonds.
  5. Long term unsecured loans.
  6. Debt Capital instruments.
  7. Redeemable cumulative Preference Shares.
  8. Perpetual Cumulative preference shares
  9.  Any other type of instrument generally notified by the Reserve Bank from time to time for inclusion in Tier 2 capital;

Less: Regulatory adjustments / deductions applied in the calculation of Tier 2 capital

Basel III accord recommends for the Common Equity component of Tier 1 (CET1) capital

Basel III accord recommends for the Common Equity component of Tier 1 (CET1) capital. It also suggested amendments to, Basel II guidelines in respect of definition of Capital, Risk Coverage, Capital Charge for Credit Risk, External Credit Assessments, Credit Risk Mitigation and Capital Charge for Market Risk. Supervisory Review and Evaluation Process under Pillar 2, is also being modified.

Components of CET1: The Common Equity component of Tier 1 (CET1) capital is bank’s core equity capital compared with its total risk-weighted assets.  The Tier 1 common equity ratio excludes any preferred shares or non-controlling interests while determining the calculation. Thus CET1 ratio differs from the Tier 1 capital ratio which is based on the sum of its equity capital and disclosed reserves, and sometimes non-redeemable, non-cumulative preferred stock. 

CET 1 capital will comprise the following:

1.   Common shares (paid-up equity capital) issued by the bank which meet the criteria

for, classification as common shares for regulatory purposes.

2.   Stock surplus (share premium) resulting from the issue of common shares;

3.   Statutory reserves;

4.   Capital reserves representing surplus arising out of sale proceeds of assets;

5.   Other disclosed free reserves, if any;

6.   Balance in Profit & Loss Account at the end of the previous financial year;

7.   While calculating capital adequacy at the consolidated level, common shares issued by consolidated subsidiaries of the bank and held by third parties (i.e. minority Interest), which meet the criteria for inclusion in Common Equity Tier 1 capital . 

Capital adequacy ratios:

For implementation of Basel III Capital Regulations, a bank has to raise capital in relation to the risk it undertakes. The Capital Adequacy Ratio (CAR), prescribed by RBI under Basel II was, for every Rs.100 of their commercial loans, banks should be backed by Rs.9 of their capital (applicable to public sector and old private sector banks) irrespective of nature of loan. However, the new rule suggests the amount of capital needed, depends upon the credit rating of the customer. The credit rating of the customer is useful in assessing probability of incurring loss on these assets secured from each customer which may vary depending upon quality of securities held. As per Basel III capital regulation the minimum total capital including  capital conservation buffer (CCB) should be 9% up to March 2015 and it should be raised to 9.625%,10.25%,10.875% and 11.5% respectively for the year 2016,2017,2018 and 2019.

Tier I Capital Adequacy Ratio is arrived as under;

Tier I capital adequacy ratio (CAR=Common Equity Tier I capital ×100 ÷ Risk Weighted Assets.

The Tier II, ratio is measured in the same way capital adequacy ratio of Tier 1, is measured.

Tier II capital adequacy ratio (CAR) = Tier II capital ×100÷ Risk Weighted Asset.

The Tier II Capital adequacy ratio is more pertinent and has broader metric compared to Tier I capital. Tier II reveals what magnitude of banks asset could be lost. It also gives hindsight, how entire loss could be wrapped up by different stake holders at a particular point of time.

 

 

Modifications to Basel II framework under Basel III accord:

Keeping in view of Basel III norms, RBI has modified the following existing Basel II framework, which includes the modifications and enhancements announced by BCBS in July 2009. RBI made amendments to, Basel II guidelines in respect of definition of Capital, Risk Coverage, Capital Charge for Credit Risk, External Credit Assessments, Credit Risk Mitigation and Capital Charge for Market Risk. Supervisory Review and Evaluation Process under Pillar 2, is also being modified.

General Provision and Loss Reserve is a provision or loan-loss reserves held against future, presently unidentified losses. The General Provision and Loss Reserve is freely available to meet losses which later materializes, would qualify for inclusion within Tier 2 capital. In the same way General Provisions on Standard Assets, Floating Provisions, Provisions held for Country Exposures, Investment Reserve Account, excess provisions which arise on account of sale of NPAs and countercyclical provisioning buffer will qualify for inclusion in Tier 2 capital. However, these items together will be admitted as Tier 2 capital up to a maximum of 1.25 % of the total credit risk-weighted assets under the standardized approach. Under Internal Ratings Based (IRB) approach, where the total expected loss amount is less than total eligible provisions, banks may recognize the difference as Tier 2 capital up to a maximum of 0.6 % of credit-risk weighted assets calculated under the IRB approach. Provisions qualified to identify corrosion of particular assets or loan liabilities, whether individual or grouped should be excluded. Banks will continue to have the option to net off provisions from Gross NPAs to arrive at Net NPA or reckoning it as part of their Tier 2 capital.

Salient features of Basel I accord & Basel II accord

The aim of Basel committee is to strengthen the soundness and stability of banking system globally. In July 1988 the Basel committee on banking supervision  came up with global capital adequacy rule and released the formulated guidelines on capital measures and capital standards The first guidelines issued by Basel Committee are known as 1st accord of Basel or BaseI I accord. .  RBI has accepted the Basel I accord and implemented the same with effect from 1992. In terms of Basel Accord 1, the capitals of Banks are divided into two categories. The first part is core equity capital of the bank, which is classified as Tier I capital. The second part of the capital is supplementary bank capital that includes items such as revaluation reserve. The supplementary capital of bank is called Tier II capital.

The second round of formulated guidelines on capital measures and capital standards by Basel Committee came into existence in June 2006 (The detailed guideline issued during 2007). This accord is known as Basel II accord.

Three Pillars of Basel II accord: 

First Pillar of Basel II deals with maintenance of regulatory Capital calculated on three major risks the bankers are facing viz. Credit risk, Operation risk and Market risk.

Second Pillar of Basel II deals with the regulatory answer to the first pillar, which enables the banks to review their risk management systems.

Third Pillar aspires to balance the minimum capital requirement and decision-making. The market participants are enabled to gauge the capital adequacy of a Bank with the help of set of mandatory disclosures prescribed in third pillar.

Revised deadline for implementation of Basel III

The Reserve Bank of India (RBI) RBI vides its notification no. RBI/2013-14/538
DBOD.No.BP.BC.102/21.06.201/2013-14 dated March 27, 2014, has deferred the deadline for full implementation of Basel III norms to March 2019 instead of as on March 31, 2018.  The revised deadline for full implementation of Basel III in India is closer to the internationally agreed date of January 1, 2019. Of late, industry-wide concerns have been expressed about the potential stresses on the asset quality and consequential impact on the performance / profitability of the banks. The Commercial banks in India were scrambling to raise thousands of crores of Rupees in the form of hybrid capital in FY15 to be complaint of capital requirement norms, prescribed under Basel III accord. This necessitated RBI to provide some lead time for banks to raise capital within the internationally agreed timeline for full implementation of the Basel III Capital Regulations. The extension of deadline by one year has delivered major respite to banks by removing immediate pressure on them to raise thousands of crores rupees of hybrid capital at a short period. The rescheduled transitional arrangements along with other modifications are as under.

 

Transitional Arrangements-Scheduled Commercial (excluding LABs and RRBs) Banks%The Risk Weighted Asset (%RWA)
 
Minimum capital ratios April 1, 2013 Mar 31,2014 Mar 31,2015 Mar 31,2016 Mar 31,2017 Mar 31,2018 Mar 31,2019
Minimum Common Equity Tier 1 (CET1) 4.5 5 5.5 5.5 5.5 5.5 5.5
Capital conservation buffer (CCB) 0.625 1.25 1.875 2.5
Capital conservation buffer (CCB) 4.5 5 5 6.125 6.75 7.375 8
Minimum Tier 1 capital 6 6.5 7 7 7 7 7
Minimum Total Capital 9 9 9 9 9 9 9
Minimum Total Capital+ CCB* 9 9 9 9.625 10.25 10.875 11.5
Phase-in of all deductions from CET1(in %)# 20 40 60 80 100 100 100

 

*The difference between the minimum total capital requirement of 9% and Tier 1 requirement can be met with Tier 2 and higher forms of capital.

 

# the same transition approach will apply to deductions from additional Tier 1 and Tier 2 capital.

related reference:  Credit Rating Agencies in India

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