BASEL Capital Framework in a Nutshell
By: Joydeep Dass
Faculty – Finance
Overview – Bank for International Settlement (BIS) is a global consortium of 60 central banks and established in the year 1930 with the objective to pursue monetary and financial stability and foster international cooperation in the banking and financial service industry. The headquarter is located in Basel, Switzerland and two representative offices in Hong Kong & Mexico City. BIS is also extensively into research on international banking and do not accept deposit from the public or private individuals or corporate entities. BIS is not permitted to make any advances to Government and only acts as a bank for central banks to all member countries.
Basel I standards are the outcome of intense negotiation to achieve international convergence for supervisory regulations concerning the capital adequacy of banks. The proposals were first published in December 1987 and adopted in G-10 countries. These frameworks were designed to establish minimum levels of capital for international banks but the national banks were free to set higher levels of standard. Basel I standards only considered the credit risk (The risk of counterparty failure). Basel I standard is intended to be applied to all banking and financial business including subsidiaries. These standards were issued in July 1988.
Basel I standards consisted of four sections.
I Components of capital – Tier 1(T1) and Tier 2(T2)
II Risk Weighting System
III Target Standard ratio to be applied
Component of capital – Tier 1 is the base capital and constitutes
- Core capital or the basic equity.
- Disclosed reserves from post tax retained earnings.
Tier 2 is the supplementary capital and constitutes
- Undisclosed or hidden Reserves
- Revaluation Reserves
- General Provisions & Loan Loss Reserve
- Mixed Debt capital instruments
- Subordinated term debts
The total of Tier 1 & Tier 2 would be the Gross capital base for the bank. Deductions from Gross Capital base should be made to arrive at the net capital base for calculating the risk weighted capital ratio.
- Good will
- Investments made in the subsidiaries not consolidated
II Risk Weights – Basel I standards have assigned weights to different categories of assets based on their relative riskiness. The more risky the asset class the more would be the weight. A bank’s assets typically include cash, securities and loans made to individuals, businesses, other banks, and governments. Each type of asset has different risk characteristics. A risk weight is assigned to each type of asset, as an indication of how risky it is for the bank to hold the asset. To work out how much capital banks should maintain to guard against unexpected losses, the value of the asset (i.e. the exposure) is multiplied by the relevant risk weight. Banks need less capital to cover exposures to safer assets and more capital to cover riskier exposures. Five specific weights have been prescribed – 0%, 10%, 20%, 50%, and 100%.
Basel I standards have only captured the credit risk and other kinds of risk – investment risk, interest rate risk, exchange rate risk, concentration risk have been ignored. Independent governing authorities have the discretion to consider other risks but no standardization have been provided in this framework.
III Target Standard Ratio – The BCBS has decided that the target standard ratio of capital to weighted assets should be 8% out of which the core capital component has to be at least 4%. This was the benchmark minimum capital requirement and known by capital adequacy or prudential norms.
IV. Implementation – The minimum common standard ratio is applicable to all member countries and the deadline set to achieve this was the end of year 1992 allowing a transitional period of 4 & ½ year. This standard were required to be implemented in the earliest possible time and the member countries were free to decide the ways of implementation of the recommendation according to their own country specific needs and rules.
The BCBS has issued a new proposal for a new capital adequacy framework in June 1999 after incorporating the shortcomings of Basel I. After the draft release in June 2004, which considered the banking sector, the BCBS also considered the trading activity of banks. After discussion with
the IOSCA (International Body of Security Regulators) for incorporating the banks trading transactions under the new framework, the BCBS released a final comprehensive document in June 2006. This was adopted by all the member countries and known as the Basel II standards.
Basel II guidelines consisted of three pillars as below.
Minimum Capital Requirements – Extending the Minimum capital requirement and rules set forth in the Basel I. Regulatory or the core capital is calculated for three major components – Credit Risk, Operational Risk & Market Risk.
Supervisory Review Process – This provides a framework to deal with other types of risk such as systemic risk, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk, and legal risk. This was introduced to review the risk management system of banks and the objective is to understand the risk profile and sufficiently capitalize to cover those risks.
Market Discipline – This pillar aims to promote stability in the financial system & good corporate governance. Banks are required to provide details of their risk management activities, risk-rating process, and risk mitigation plan adopted and risk distribution in their entire loan portfolio. This will provide insight into banks capitalization & exposures and provide a tool for the sound development of the banking system. Full disclosure to strengthen market discipline and encourage sound banking practices.
Credit Risks – Credit risk, the risk of loss due to a borrower being unable to repay a debt in full or in part, accounts for the bulk of most banks’risk-taking activities and regulatory capital requirements. There are two broad approaches to calculating RWAs for credit risk first, the standardized approach and second is the internal ratings based approach. Basel II recommendation suggest that banks has the discretion to assess their credit risk by using the standard approach or an internal rating based approach.
Standard Approach – Most banks around the world use the Standardized approach (SA) for credit risk. The banks use the external credit rating or supervisory agencies to risk grade their assets to quantify the required capital.
Internal Approach – The internal ratings-based approach (IRB) for credit risks allows banks to estimate credit risks & therefore RWA’s based their own internal model. Banks calculate the probability of default (PD) for the loan portfolio. This is also called the Foundation Internal ratings
based approach. (F-IRB). Banks are also allowed to use their own quantitative models to estimate Probability of default (PD), Exposure at default (EAD), Loss given Default (LGD) and effective maturity (M) to determine the risk weights of the assets. The IRB approach is based on measures
of unexpected losses (UL) and expected losses (EL). However, these internal approaches should have the approval of the Supreme lending authority of the respective countries.
Risk components within the IRB approach
Probability of default (PD) – The likelihood of borrower default over a given time horizon.
Loss given default (LGD) – The proportion of exposure that will be lost if the default occurs
Exposure at default (EAD) – Book value of the asset diminished after a risk mitigation occurs
Expected Maturity (EM) – Remaining economic maturity of the exposure in years.
Unexpected losses (UL) – The loss that was not foreseen in advance
Expected losses (EL) – The loss that was foreseen in advance
Basic Indicator approach – Banks are required to hold capital equal to the average of the last 3 years equivalent to a fixed percentage (15%) of the annual gross income.
Standard approach – Banks are required to calculate operational risk capital in proportion to their income. Bank activities are primarily divided into eight business lines as
- Corporate Finance
- Trading & Sales
- Retail banking
- Commercial banking
- Payments & Settlements
- Agency Services
- Asset management
- Retail Brokerage
The capital requirement of each business line is calculated by multiplying the gross income of that business line. Each business line must determine the cash it needs to protect from operational risk. Example, in asset servicing, the capital requirement would be the gross income generated by
the asset servicing business line.
Advanced measurement approach – Bank is required to provide for operational capital requirement based on their internal loss estimate & own reserve calculations. The more the loss estimate the more would be the reserve requirement of operating capital.
Standard approach – Banks are required to apply weights based on their open market exposure & securitization. Securitization is a process where a pool of similar loans say residential mortgages or other financial instruments are bundled and sold as marketable securities in the secondary market.
Internal Model – Banks may use their own internally developed model for requirement of capital for market risk. However, financial instruments have to be segregated to appropriately determine the risk elements inherent in them and apply weights accordingly.
The BCBS has again formulated the Basel III rules with an intention to strengthen the international banking system in the aftermath of the global financial crisis that hit in 2008-2009. This framework introduced new capital, liquidity, monitoring and supervision norms so that the banking system is able to absorb financial shocks arising out of economic distress. The framework imposed higher capital requirements to systemically important institutions. Basel III standards were issued in 2010, due to be implemented from 2013 until 2015 but changes were made in April 2013, and final implementation was extended until 2018. Basel III comprised of the below guidelines.
1. Increased Quantum of Capital – The changes made under Basel III are below
- Higher percentage of common equity capital, (CET1) which has to be 4.5%
- A higher minimum tier 1 capital of 6%
- Minimum total capital remains unchanged at 8% as initially provided under Basel I
2. Capital Buffers – This consisted of the conservation and the counter cyclical capital buffer.
- Capital conservation buffer of 2.5% of RWA in form of CET1 capital. The capital conservation buffer is designed to ensure that banks build up capital buffers outside periods of stress, which can be drawn down as losses are incurred. The requirement is to avoid breaches of minimum capital requirements and prevent erosion of capital.
- A discretionary countercyclical capital buffer of (0-2.5) percentage has also been provided. The countercyclical capital buffer is an additional safeguard to ensure that bank capital is able to withstand severe pressure from external environment in which banks operate. Its primary objective is to hold capital greater than the regulatory minimum and to sufficiently maintain themselves during a sudden downward spiral.
3. Leverage ratio – Leverage ratio has been introduced as a precautionary measure to cover excessive risk taking. A minimum leverage ratio of 3% has been prescribed.
4. Liquidity ratios – A framework for liquidity risk management has also been introduced consisting of
Liquidity coverage ratio – LCR was developed to improve the banks liquidity position and promote short-term stability by ensuring that the liquid situation is sufficient to cover the 30-day period in times of acute distress.
Net Stable Funding Ratio – NSFR was developed to promote medium and long-term structure for assets and liabilities to cover a longer time horizon extending beyond 30 days.
The BCBS published in December 2017, revised guidelines titled “Basel III: Finalizing post crisis reforms” which the Industry considers as the Basel IV guidelines. Basel IV is an extension of Basel III & contains revision of standardized approach for calculating credit risk (CR) market risk (MR) credit valuation adjustment (CVA) & operational risk (OR). Changes to the internal models were proposed to reduce unwarranted variability in banks calculation of RWA’s. One significant element introduced was the output floor. Output floor is designed to reduce variability in riskweighted assets (RWAs) and to improve the comparability of capital ratios of banks. The output floor is fixed at 50% from 1ST January 2022 and increase by 5% each year until 2026. The final limit is at 72.5% until 2027. Global systemically, important banks (G-SIBs) were recommended to be placed under high leverage ratio requirements of 3% of Tier I capital to total exposure.
Conclusion Basel regime will spur financial stability, and strengthen regulation. The accord has influenced Countries in multiple geographies to raise capital, enhance liquidity and set benchmark standards for risk, supervision and governance. As BASEL continues to evolve, Bank failure will soon be consigned to history and usher for a new dawn in the Banking Industry.
References & Abbreviations used
6. BCBS – Banking Committee on Banking Supervision
7. RWA – Risk Weighted Assets
8. CET – Common Equity Capital
9. IOSCA – International Organization of Securities Commission
10.BIS – Bank For International Settlement