FINANCIAL MARKETS & INSTITUTIONS

RESEARCH PAPER

ON

BASEL ACCORD 3

SUBMITTED TO: SUBMITTED BY:

Dr . Divya Verma PRASHANT BEDWAL

09416603909

TABLE OF CONTENTS

OBJECTIVES

LITERATURE REVIEW

INTRODUCTION

IMPORTANCE AND NEED OF BASEL ACCORD

CHALLENGES

CONCLUSION

OBJECTIVES

To understand the concept of Basel Accord 3

To understand the difference between Basel 1,2 and 3

The Basel Accords refer to the banking supervision Accords (recommendations on banking laws and regulations) -- Basel I and Basel II issued and Basel III under development -- by the Basel Committee on Banking Supervision (BCBS).

THE BASEL COMMITTEE

Formerly, the Basel Committee consisted of representatives from central banks and

regulatory authorities of the Group of Ten countries plus Luxembourg and Spain.

Since 2009, all of the other G-20 major economies are represented, as well as some

other major banking locales such as Hong Kong and Singapore.

The committee does not have the authority to enforce recommendations, although

most member countries as well as some other countries tend to implement the

Committee's policies. This means that recommendations are enforced through

national (or EU-wide) laws and regulations, rather than as a result of the committee's

recommendations - thus some time may pass between recommendations and

implementation as law at the national level.

The Basel Committee on Banking Supervision is an institution created by

the central bank Governors of the Group of Ten nations. It was created in 1974 and

meets regularly four times a year.

The Committee's members come

From Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong

Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the

Netherlands, Russia, Saudi Arabia, Singapore, South

Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United

States. The Committee usually meets at the Bank for International Settlements

(BIS) in Basel, Switzerland, where its 12 member permanent Secretariat is located.

The Committee is often referred to as the BIS Committee after its meeting location.

However, the BIS and the Basel Committee remain two distinct entities.

The Basel Committee formulates broad supervisory standards and guidelines and

recommends statements of best practice in banking supervision in the expectation

that member authorities and other nations' authorities will take steps to implement

them through their own national systems, whether in statutory form or otherwise.

The purpose of the committee is to encourage convergence toward common

approaches and standards. Dieter Kerwer reports that "the BCBS is not a classical

multilateral organization. It has no founding treaty, and it does not issue binding

regulation. Rather, its main function is to act as an informal forum to find policy

solutions and to promulgate standards.

The present Chairman of the Committee is Nout Wellink, President of

the Netherlands Bank,  who succeeded Jaime Caruana of the Bank of Spain on 1

July 2006. At present the IMF is collaborating with the Committee to improve bank

regulation.

The Basel committee along with its sister organizations, the International

Organization of Securiti9es Commissions and International Association of Insurance

Supervisors together make up the Joint Forum of international financial regulators.

LITERATURE REVIEW

LEHMANN TWO YEARS ON : BANKS CHEER BASEL ACCORD

Banking shares across Europe sprang to life yesterday as investors took

heart from the agreement by banking watchdogs on how much capital

banks will have to hold. The agreement reached in the Swiss City of Basel

might require banks to hold double the minimum amount of capital before

the financial crisis. But it still gives them until 2015 to sort themselves out

and – given that the stronger banking groups are already there – there

were hopes that some capital might start flowing back into shareholders

pockets, not least because many banks have started to turn fat profits

again.

Nic Clarke, analyst at Charles Stanley, said: "What is clear is that UK

banks with core tier one (capital) ratios of over 9 per cent are all well

above the minimum levels already

"Therefore, although we don't think that this will lead to significant

amounts of capital being returned to shareholders it does put them in a

relatively strong position compared to their international competitors. It is

also positive for the sector because it is a key issue largely dealt with

which lessens regulatory risk."

The industry rather concurs and is relatively upbeat. If there is a trouble, it

may come, as ever, if countries seek competitive advantage for their

banks by not implementing the rules at the cost of the world's financial

stability. The US, for example, had not implemented Basel II prior to the

financial crisis. Now, two years on from the seizure of the financial system

after Lehman's collapse, we are at Basel III.

Irving Henry, director, prudential policy, at the British Bankers Association, said this could become a real danger. "That is the big concern of ours, and not just when it comes to the issue of competitiveness but also for the stability of the financial system as a whole. Inevitably, if it is not implemented then business will drift towards jurisdictions that are less stringent. That might benefit them in the short term but it won't do any favours for anyone long term."

Mr Henry is also concerned that the UK, in the form of the Financial Services Authority, could start "gold plating" the requirements by imposing tougher rules. UK standards are already higher than those agreed at Basel, although to be fair, Switzerland's banks may also find themselves in this position after Finma, the main financial regulator, and the Swiss National Bank indicated they may impose tougher rules to prevent the failure of a major bank dragging down the economy. Tough break for UBS and Credit Suisse then.

Mr Henry called on the FSA not to follow suit "now things are calming down" with all the UK banks currently holding capital in excess of the 4.5 per cent of "at risk assets" together with a 2.5 per cent "buffer" required by the Basel supervisors. He, and the bigger banks, are also nervous about the ill-defined additional requirement for "systemically significant" banks to hold a further buffer in "good times", which in theory affects all of the UK players and which will very much be under the control of national regulators.

Lord Turner, the chairman of the FSA did not have much to say on that, limiting himself to a brief statement hailing the Basel deal as "a major tightening of global capital standards" that "will play a significant role in creating a more resilient global banking system." He also said the transition timescale would "ensure that banking systems can play their role in supporting economic recovery". By lending.

But Ray Barrell, director of Macroeconomics at the National Institute for Economic and Social Research, said the measures should only be seen as "a first step". He said that the most important step ahead was for "greater product regulation in financial markets". "Reducing complexity and off-balance sheet activity are essential if crises are to be avoided. More capital alone is not enough," he added.

B)

David Prosser: Basel allows the banks to breathe a little easier

Is it really only two years since the collapse of Lehman Brothers brought the world's financial system close to meltdown? A visitor from Mars might not think so from a casual reading of the latest developments in the banking sector. Last week, we saw Bob Diamond, the bête noire of those who blame investment bankers for the credit crisis, get the top job at Barclays, and yesterday we watched as bank shares soared following the Basel III agreement. So much for the regulatory backlash that bankers have feared ever since Lehman closed its doors.

It seems memories are short. Share prices rose yesterday because investors think the banks got away more lightly from Basel than they once feared. Those who worry that to give in to the banks' appeals for restraint is to store up trouble for the future are clearly in the minority. The prevailing view in the market is closer to that of the prominent banking analyst who has just published a long note bemoaning the "over-capitalisation" of Lloyds Banking Group these days

There is plenty in the accord to admire. Plainly, the higher tier one capital requirements are to be welcomed – though note that just four of 50-odd decent-sized European banks do not already pass muster – as is the "liquidity coverage ratio", which will act as a brake on gearing.

Moreover, while the Basel Committee's statement makes no mention of the ongoing debate about universal banking, the different weightings attached to bank assets go to the heart of that argument. Broadly speaking, banks will now have to set much more capital aside, both absolutely and proportionally, against their investment banking operations than for more run-of-the-mill retail business.

No enforced break-up of the banks, then, but a more demanding regime for those that want to maintain the universal model.

That sort of pragmatic approach to the too-big-to-fail question was always going to be the sort of consensus outcome arrived at by a committee with representatives from 27 different countries. It will not be enough, however, to satisfy those who continue to demand a more explicit separation of banking activities.

That question remains a matter for national regulators and countries. The danger, however, is that many states will duck the issue, in the fear that acting unilaterally might prompt a departure of financial institutions. That's also the risk with the issue of counter-cyclical requirements where, for now at least, national regulators seem to have been given the job of deciding when banks should be asked to bolster their capital even further in order to tackle problems such as credit bubbles.

Indeed, it is worth remembering that Basel III, across the board, is not quite the unbreakable law some would have you believe. The Basel Committee has no power to actually implement its new rules, or to sanction those banks which break them. And while the next G20 meeting in November will no doubt adopt the regulations with great enthusiasm, many of the countries sending delegates to that summit have yet to implement all the conclusions of Basel II, which were made in the summer of 2004.

Is Basel III a disappointment? Probably not, unless you had unrealistic expectations of an arcane group of banking bureaucrats who have been the subject of sophisticated lobbying from a variety of interested parties since the moment they began their deliberations. It does, however, put the ball back in the court of individual countries, who all now face some difficult dilemmas, both political and economic.

Meanwhile, time continues to fly – every day that goes past without a final blueprint for banking regulation in all those countries where it matters is a day on which memories fade a little further of just how close the world came to the financial abyss.

BASEL 1

Basel I is the round of deliberations by central bankers from around the world, and in

1988, the Basel Committee (BCBS) in Basel, Switzerland, published a set of minimal

capital requirements for banks. This is also known as the 1988 Basel Accord, and

was enforced by law in the Group of Ten (G-10) countries in 1992.

The Committee was formed in response to the messy liquidation of a Cologne-based

bank (Herstatt) in 1974. On 26 June 1974, a number of banks had

released Deutsche Mark (German Mark) to the Bank Herstatt in exchange for dollar

payments deliverable in New York. On account of differences in the time zones,

there was a lag in the dollar payment to the counter-party banks, and during this gap,

and before the dollar payments could be effected in New York, the Bank Herstatt

was liquidated by German regulators. 

Basel I, that is, the 1988 Basel Accord, primarily focused on credit risk. Assets of

banks were classified and grouped in five categories according to credit risk, carrying

risk weights of zero (for example home country sovereign debt), ten, twenty, fifty,

and up to one hundred percent (this category has, as an example, most corporate

debt). Banks with international presence are required to hold capital equal to 8 % of

the risk-weighted assets. However, large banks like JPMorgan Chase found Basel I's

8% requirement to be unreasonable and implemented credit default swaps so that in

reality they would have to hold capital equivalent to only 1.6% of assets.

Since 1988, this framework has been progressively introduced in member countries

of G-10, currently comprising 13 countries,

namely, Belgium, Canada, France, Germany, Italy, Japan, Luxembourg,

Netherlands, Spain, Sweden, Switzerland, United Kingdom and the United States of

America.

Most other countries, currently numbering over 100, have also adopted, at least in

name, the principles prescribed under Basel I. The efficiency with which they are

enforced varies, even within nations of the Group of Ten.

BASEL II 

Is the second of the Basel Accords, which are recommendations on banking laws

and regulations issued by the Basel Committee on Banking Supervision. The

purpose of Basel II, which was initially published in June 2004, is to create an

international standard that banking regulators can use when creating regulations

about how much capital banks need to put aside to guard against the types of

financial and operational risks banks face. Advocates of Basel II believe that such an

international standard can help protect the international financial system from the

types of problems that might arise should a major bank or a series of banks collapse.

In practice,

Basel II attempts to accomplish this by setting up rigorous risk and capital

management requirements designed to ensure that a bank holds capital reserves

appropriate to the risk the bank exposes itself to through its lending and investment

practices. Generally speaking, these rules mean that the greater risk to which the

bank is exposed, the greater the amount of capital the bank needs to hold to

safeguard its solvency and overall economic stability.

OBJECTIVES OF BASEL 2

To encourage better and more systematic risk management practices, especially in

the area of credit risk and to provide improved measure of capital adequacy.

Introduction of Basel II has given incentives to many of the best practices banks, to

adopt better risk management techniques and to evaluate their performance relative

to market expectations and relative to competitors.

The new framework proposes a significant refinement of regulatory and supervisory

practice and encourages increased attention to risk management practices.

3 PILLARS OF BASEL 2

Minimum capital requirements – Regulatory and Economic capital

Supervisory review process – trancsaction based to risk based supervision

Market discipline – risk exposure, migration assets from standard to NPA etc

How Basel II Differs from Basel I

Advances in risk management practices, technology,and banking markets have made the simple approach of Basel I lessmeaningful for many organizations. For example, Basel I set capitalrequirements based on broad classes of exposures and does notdistinguish between relative degrees of creditworthiness amongindividual borrowers. According to the BIS Paper (2004), the Basel IIframework is more reflective of the underlying risks in banking andprovides stronger incentives for improved risk management. It buildson the basic structure of the Basel I for setting capital requirementsand improves the capital framework’s sensitivity to the risks thatbanks actually face. This is deemed to be achieved in part by aligningcapital requirements more closely to the risk of credit loss and byintroducing a new capital charge for risk exposures caused byoperational failures.

To accomplish the goal of adequate capitalization of banks, theBasel II framework has introduced three ‘pillars’ that reinforce eachother and enhance the quality of banks’ control processes. Under ‘Pillar1’, the Basel II improves capital adequacy for banks by requiringhigher levels of capital for high credit-risk borrowers and vice versa.Here, three options are available for banks to choose an appropriateapproach for credit risk assessment. Under the ‘standardized approach’to credit risk, the relatively less sophisticated banks are supposed touse the ratings given by external credit rating agencies to assess thecredit quality of their borrowers for regulatory capital purposes. Banksthat possess sophisticated risk measurement systems may with theapproval of their supervisors, select from one of two ‘internal ratingsbased’ (IRB) approaches (the foundation and advanced models) tocredit risk.

Under these options, banks rely partly on their own measures ofborrowers’ credit risk to determine their capital requirements, subjectto strict data, validation, and operational requirements. Under the‘Foundation IRB Approach’, the banks can use default probabilities forcredit risk based on their own internal risk calculations. However, the‘Advanced IRB Approach’ also lets them supply key variables such asloss given default and other risk measures.3 In addition to the creditand market risk covered by the Basel I framework, Basel II establishesan explicit capital charge for a bank’s exposure to operational risks,i.e., the risk of losses caused by failures in systems, processes or staffor that caused by external events, such as natural disasters. Similar tothe range of options provided for assessing credit risk exposures,banks will choose one of the three options for measuring operationalrisks’ exposures.

These are – the ‘Basic Indicators Approach’ that employs a single proxy for the entire bank such as trading volumes, the ‘Business Line Approach’ that uses the committee imposed capital ratios for different business lines (such as retail banking, corporate financial services, payment and Settlement, etc) and the ‘Advanced Measurement Approach’ that uses a bank’s own loss data within a supervisory specified framework. ‘Pillar 2’ is represented by the effective supervisory review of ‘Pillar 1’, whereby bank supervisors are expected to evaluate the activities and risk profiles of individual banks in order to determine whether those banks have provided adequate capital under ‘Pillar 1’ and suggest ways to set right the discrepancies, if any. ‘Pillar 3’ is represented by the market discipline to ensure prudent management by banks by enhancing the degree oftransparency in banks’ public reporting.

It sets out the public disclosures that banks must undertake tomake adequacy of their ‘capitalization’ more transparent. Keeping inmind the growing complexities of banking operations, the Basel IIframework covers not just banks but also securities firms, assetmanagers, insurance companies, etc, with any involvement in banking,fund or asset management, securitization, long-term equity holdings,etc. The qualitative difference between Basel I and Basel II issummarized in Table 1.

While everybody accepts the significant potential of Basel II framework in improving risk management practices, there are some caveats, especially for its implementation in emerging economies. Basel II framework was originally designed in the context of internationally active banks in G-10 jurisdictions, which are already largely in compliance with Basel I and the Basel Core Principles (BCP). But Basel II, at this stage may not be the priority objective in ‘Banking Supervision’ for many developing countries with less advanced banking systems.

The implementation of Basel II would require both banks and supervisors to invest large resources in upgrading their technology and human resources to meet the minimum standards. This may distract the attention of supervisors from ‘supervision’ to ‘implementation’ issues [Nachane 2003]. As per the International Monetary Fund’s (IMF) Staff Note on Basel II (2004), there are many serious ‘gaps’ in the baseline compliance of several developing countries with respect to BCP. The baseline compliance reflects a system fully or largely compliant with the BCP, which incorporates Basel I as the capital adequacy standard.

ISSUES AND CHALLENGES

While there is no second opinion regarding the purpose, necessity and usefulness of the proposed new accord – the techniques and methods suggested in the consultative document would pose considerable implementation challenges for the banks especially in a developing country like India.

Capital Requirement: The new norms will almost invariably increase capital requirement in all banks across the board. Although capital requirement for credit risk may go down due to adoption of more risk sensitive models – such advantage will be more than offset by additional capital charge for operational risk and increased capital requirement for market risk. This partly explains the current trend of consolidation in the banking industry.

Profitability: Competition among banks for highly rated corporates needing lower amount of capital may exert pressure on already thinning interest spread. Further, huge implementation cost may also impact profitability for smaller banks.

Risk Management Architecture: The new standards are an amalgam of international best practices and calls for introduction of advanced risk management system with wider application throughout the organization. It would be a daunting task to create the required level of technological architecture and human skill across the institution.

Summary of Changes Proposed in Basel III

First, the quality, consistency, and transparency of the capital base will be

raised.

Tier 1 capital: the predominant form of Tier 1 capital must be common

shares and retained earnings

Tier 2 capital instruments will be harmonized

Tier 3 capital will be eliminated

Second, the risk coverage of the capital framework will be strengthened.

Strengthen the capital requirements for counterparty credit exposures

arising from banks’ derivatives, repo and securities financing transactions

Raise the capital buffers backing these exposures

Provide additional incentives to move OTC derivative contracts to

central counterparties (probably clearing houses)

Provide incentives to strengthen the risk management of counterparty

credit exposures

Third, the Committee will introduce a leverage ratio as a supplementary

measure to the Basel II risk-based framework.

The Committee therefore is introducing a leverage ratio requirement

that is intended to achieve the following objectives:

Put a floor under the build-up of leverage in the banking sector

Introduce additional safeguards against model

risk and measurement error by supplementing the risk based measure

with a simpler measure that is based on gross exposures.

Fourth, the Committee is introducing a series of measures to promote the

build up of capital buffers in good times that can be drawn upon in periods of

stress ("Reducing procyclicality and promoting countercyclical buffers").

The Committee is introducing a series of measures to address

procyclicality:

Dampen any excess cyclicality of the minimum capital

requirement;

Promote more forward looking provisions;

Conserve capital to build buffers at individual banks and the

banking sector that can be used in stress; and

Achieve the broader macroprudential goal of protecting the banking

sector from periods of excess credit growth.

Requirement to use long term data horizons to estimate

probabilities of default,

downturn loss-given-default estimates, recommended in Basel

II, to become mandatory

Improved calibration of the risk functions, which convert loss

estimates into regulatory capital requirements.

Banks must conduct stress tests that include widening credit

spreads in recessionary scenarios.

Fifth, the Committee is introducing a global minimum liquidity standard for

internationally active banks that includes a 30-day liquidity coverage ratio

requirement underpinned by a longer-term structural liquidity ratio.

The Committee also is reviewing the need for additional capital, liquidity or

other supervisory measures to reduce the externalities created by systemically

important institutions.

Rating Requirement: Although there are a few credit rating agencies in India – the level of rating penetration is very low. A study revealed that in

1999, out of 9640 borrowers enjoying fund-based working capital facilities from banks – only 300 were rated by major agencies. Further, rating is a lagging indicator of the credit risk and the agencies have poor track record in this respect. There is a possibility of rating blackmail through unsolicited rating. Moreover rating in India is restricted to issues and not issuers. Encouraging rating of issuers would be a challenge.

Choice of Alternative Approaches: The new framework provides for alternative approaches for Computation of capital requirement of various risks. However, competitive advantage of IRB approach may lead to domination of this approach among big banks. Banks adopting IRBapproach will be more sensitive than those adopting standardized approach. This may result in high-risk assets flowing to banks on standardized approach - as they would require lesser capitalfor these assets than banks on IRB approach. Hence, the system as a whole may maintain lower capital than warranted and become more vulnerable. It is to be considered whether in our quest for perfect standards, we have lost the only universally accepted standard. Absence of Historical

Database: Computation of probability of default, loss given default, migration mapping and supervisory validation require creation of historical database, which is a time consuming process and may require initial support from the supervisor. Incentive to Remain Unrated: In case of unrated sovereigns, banks and corporates the prescribed risk weight is 100%, whereas in case of those entities with lowest rating, the risk weight is 150%. This may create incentive for the category of counterparties, which anticipate lower rating to remain unrated.

Supervisory Framework: Implementation of Basel II norms will prove a challenging task for the bank supervisors as well. Given the paucity of supervisory resources there is a need to reorient the resource deployment strategy. Supervisory cadre has to be properly trained for understanding of critical issues for risk profiling of supervised entities and validating andguiding development of complex IRB models.

Corporate Governance Issues:

National Discretion: Basel II norms set out a number of areas where national supervisor will need to determine the specific definitions, approaches or thresholds that wish to adopt in implementing the proposals. The criteria used by supervisors in making these determinations should draw upon domestic market practice and experience and be consistent with the objectives of Basel II norms.

Disclosure Regime: Pillar 3 purports to enforce market discipline through stricter disclosure requirement. While admitting that such disclosure may be useful for supervisory authorities and rating agencies – the expertise and ability of the general public to comprehend and interpret disclosed information is open to question. Moreover, too much disclosure may cause information overload and may even damage financial position of bank.

CONCLUSION

The common objective of all official supervisors is to maintain a strongand vibrant financial system and to achieve this, it is necessary thatbanks, banking supervisors and other market participants becomemore discriminating in their approaches to risks and better equipped toanticipate problems before they turn into crises [Fischer 2002]. AsBasel II precisely tries to achieve this, it is perceived as a logical andappropriate successor to Basel I. India represents a special caseamong emerging economies. As a result of economic liberalization thatwas set into motion in 1991-92, the country has restored the highergrowth momentum of the decade of 1980s since the year 1993-94,and managed to reduce sharply the volatility in its GDP growth.

Its banking system is stable and has been assessed to be in highcompliance with the relevant core principles by the FSAP of the IMF.The RBI’s approach to prudential regulation has always been one ofgradual 1166 Economic and Political Weekly March 19, 2005convergence with international standards with suitable country specificadaptations. During the 1990s, when there were too many occurrences ofbanking crises in emerging economies, the Indian banking systemdisplayed ample resilience to exogenous shocks. As regards theimplementation of Basel II framework, the question before India is not‘whether to implement’ but ‘how and when’. The RBI has activelyparticipated in the deliberations on the Basel II accord and had theprivilege of leading a group of six major non G-10 supervisors, whichpresented a proposal on a simplified approach for Basel II.

The RBI has accepted in principle the New Capital accord (Basel II) in April 2003. To begin with, banks in India will adopt standardized approachfor credit risk and basic indicators approach for operational risk. Buteventually the system as a whole (banks and the supervisor) willmigrate to the IRB approach. The task is intimidating given the factthat 100 Indian banks will have to move to the new system byDecember 2006. The preparation at the bank level is being influenced

by a number of factors such as the state of existing data, ITarchitecture and risk management systems, degree of pressureexerted by the RBI, competitor banks’ actions, and the possibilities of‘mergers and acquisitions’ within the system.

The RBI is trying to resolve a number of regulatory issueskeeping in mind developmental priorities (especially issues likeadequacy of credit flows to critical sectors like agriculture, SMEs andinfrastructure), readiness of the system in terms of the legal andregulatory framework (efficacy of Securitization Act, etc), accountingstandards (domestic versus US GAAP), soundness of corporategovernance (especially in a context of recent episodes of bankfailures), market discipline and most importantly, a competitive orlevel playing field issues among banks of different strengths. Given themonolithic scale of the task involved, it will be best for the RBI and thebanks to move at a measured pace – to commit to a time table that isappropriate given our specific set of circumstances. However, at thebank level, the entire effort should be directed towards the ultimategoal of achieving the advanced IRB and advanced measurementapproaches to credit and operational risks.

The ‘standardized approach’ has to be treated as the transitional solution; otherwise the ‘risk-sensitivity’ aspect for our banks will be affected if migration to IRB is not achieved at the earliest. Instead of looking at Basel II as a G-10 initiative or a global initiative, we should look upon it as the great opportunity to keep our house in order. It is a necessaryframework to improve the stability and resilience of India’s rapidlyevolving banking industry, which is currently placed at a critical phasein its growth cycle. However, it is unfortunate that current Baselproposals do not explicitly incorporate the mutual benefits of lendingby advanced countries to developing countries (internationaldiversification). There is also a fear that too much regulation underBasel II will adversely affect the risk appetite of our banks and theirlending to credit-starved sectors. It will be a major challenge for theRBI to maintain healthy credit momentum amid this tighter risk sensitiveframework.