What is BASEL Norms in banking

Meaning of Basel Norms:

  • BASEL ACCORD has given us three BASEL NORMS which are BASEL 1,2 and 3.
  • The purpose of the accord is to ensure that financial institutions have enough capital on account to meet the obligations and absorb unexpected losses.
  • The set of the agreement by the BCBS (BASEL COMMITTEE ON BANKING SUPERVISION), which mainly focuses on risks to banks and the financial system are called Basel accord.

Three Pillars of Basel Accord:

basel.JPG
Basel Accord Pillars

Pillar 1 : Minimum Capital Requirement

Different Types of approaches for Minimum Capital Standard:

Credit risk: (Trick to remember SII)

  • Standard Approach
  • Internal Rating based Foundation approach
  • Internal Rating based Advance Approach

Market risk: (Trick to remember SSI)

  • Standard Approach — Maturity Method
  • Standard Approach — Duration Method
  • Internal Models Method

Operational risk: (Trick to remember BSA Cycle)

  • Basic Indicator Approach
  • Standard Approach
  • Advance measurement approach

Capital Standards:

As per BCBS, the banks shall maintain minimum CRAR of 8% but as per RB1 directives on CRAR, the bank in India shall maintain Total CRAR of 9%.

Tier 1 Capital: 

Under Tier 1 which is the core capital for the bank has

  • Common Equity Tier 1 Capital   –   Min 5.5%
    • Paid up capital
    • statuatory and free reserves
    • Revaluation Reserves (@ 45% of face value)
    • Capital reserve
    • any other as permitted by RBI
  • Additional Tier 1 Capital    –   Min 1.5%
    • Innovative Perpetual debt instrument
    • Perpetual non cumulative preference shares(PNCPS)

Totol Tier 1 Minimum CRAR is 5.5%+1.5% = 7%

Tier 2 Capital: Min 2%

Components under Tier 2 are as follows:

  • Hybrid capital
  • Subordinated debt (@ 50% value)
  • Redeemable non cummulative preference shares(RNCPS)
  • Redeemable cummulative preference shares (RCPS)
  • Perpetual cumulative preference shares (PCPS)

Tier I Capital should at no point of time be less than 50% of the total capital.

Tier 1 Capital = Common Equity Tier 1 + Additional Tier 1

Total Capital = Tier 1 Capital + Tier 2 Capital

crar

Risk Weighted Exposures = Credit Risk RWA + Market Risk RWA + Operational Risk RWA

Pillar 2 : SUPERVISORY REVIEW PROCESS

Supervisory review process is intended to ensure that banks have adequate capital to support all the risk in their business and encourage them to develop and use better risk management techniques in monitoring and managing their risk Central banks are to evaluate as to how well banks are assessing their capital needs considering their risk profile.

There are 4 key principles of supervisory review:

  • Principle-I: Banks should have a process for assessing their overall capital ‘adequacy in relation to their risk profile and a strategy for maintaining their capital levels.
  • Principle-2: Supervisors should review and evaluate banks’ internal capital adequacy assessment and strategies, and ability to monitor/ ensure their compliance with regulatory capital ratios.
  • Principle-3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.
  • Principle-4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of the bank. It should require remedial action if capital is not maintained or restored.

Pillar 3 : Market Discipline

The objective of 3rd pillar is to complement the minimum capital requirement and supervisory review process through various kinds of disclosures such as
1. capital structure (Tier I and its components on a quarterly basis),
2. total amount of Tier 2 capital,
3. bank’s approach to assess the capital adequacy to support its current and future activities i.e. capital required for credit risk, market risk or operational risk,
4. interest rate risk in the banking book.

Capital Conservation Buffer: The capital conservation buffer (CCB) is introduced in Basel III and is designed to ensure that banks build up capital buffers during normal times (i.e. outside periods of stress) which can be drawn down as losses are incurred during a stressed period.

Therefore in addition to the minimum total of 8%(As per RBI 9%) as indicated above, banks will be required to hold a capital conservation buffer of 2.5% of RWAs in the form of Common Equity to withstand future periods of stress bringing the total Common Equity requirement of 7% of RWAs and total capital to RWAs to 10.5%.(11.5% as per RBI)


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