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Basel III and its implementation

Basel III and its implementation
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This paper examines the new elements of Basel III accord and its implementation stages with special reference to India. By focusing on strict capital regulation Basel III has introduced higher capital ratios, new buffers and leverage ratio framework which enhances risk management practices and make banking sector robust and shock absorbent.

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Basel III and its implementation

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  1. International Journal of Management
    INTERNATIONAL (IJM), ISSN 0976
    JOURNAL – 6502(Print), ISSN 0976(IJM)
    OF MANAGEMENT – 6510(Online),
    Volume 6, Issue 5, May (2015), pp. 18-24© IAEME

    ISSN 0976-6502 (Print)
    ISSN 0976-6510 (Online)
    IJM
    Volume 6, Issue 5, May (2015), pp. 18-24
    © IAEME: http://www.iaeme.com/IJM.asp ©IAEME
    Journal Impact Factor (2015): 7.9270 (Calculated by GISI)
    www.jifactor.com

    BASEL III AND ITS IMPLEMENTATION

    Dr. Manisha
    Assistant.Prof. Department of Management Studies,
    DeenbandhuChottuRam University of Science &Technology, Murthal
    Sonipat, Haryana

    Mrs. Kaveri Hans*
    *Research Scholar, Department of Management Studies,
    DeenbandhuChottuRam University of Science &Technology, Murthal
    Sonipat, Haryana

    ABSTRACT

    For any business, profits are the important element but for banking business, safety and being
    solvent are foremost. Since banking is that business which deals with depositor’s money, so the
    protection of depositor’s money is important. To safeguard their interest, capital regulation came into
    picture. Basel accords are those guidelines which instruct banks to back up their risk with capital.
    Adequate capital adds cushion to bank’s failure and ensures depositors safety of their money. Basel
    III is the third accord and provides stricter approach towards managing risk and capital. RBI has also
    implemented these norms for Indian banks. This paper examines the new elements of Basel III
    accord and its implementation stages with special reference to India. By focusing on strict capital
    regulation Basel III has introduced higher capital ratios, new buffers and leverage ratio framework
    which enhances risk management practices and make banking sector robust and shock absorbent.

    Keywords: Banks, Capital Regulation, Basel Norms, Risk.

    INTRODUCTION

    In 1969 a revolutionary step was undertaken in Indian banking industry, to nationalised 14
    largest banks which constitute more than 85% of bank deposits in the country. The main motive
    behind this step was to facilitate the development of Indian economy and to generate public
    confidence in banking. Another milestone in banking was in 1990 when policy of liberalisation came
    into existence and various small bankers got licence to work as banking entity. Prior to liberalisation
    need of capital regulation was not felt so desperately. As the banking sector grows and various
    foreign banks came into scenario, complying with international norms became important. Moreover,

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  2. International Journal of Management (IJM), ISSN 0976 – 6502(Print), ISSN 0976 – 6510(Online),
    Volume 6, Issue 5, May (2015), pp. 18-24© IAEME

    after liberalization various banks reported losses as there were no specified rules regarding capital
    and risk taken. Thus, Narasimham committee gives recommendations on banking reforms in 1991.
    On the basis of which Reserve bank of India introduced a risk asset ratio system similar to Basel
    norms covering all banks and enabling a secure and reliable banking environment. By March 1996,
    most banks had attained required CRAR of 8%.
    Capital to risk weighted asset ratio (CRAR) is that amount of bank’s capital which they need
    to keep aside in relation to risk taken by them. Adequate capital adds cushion to bank’s failure and
    ensures depositors safety of their money. Capital adequacy ratio are intended to ensure that banks
    maintain a minimum amount of own funds in relation to the risks they face so that banks are able to
    absorb unexpected losses (RBI, 2008). Basel norms are those regulations which provide guidelines to
    banks as to how much capital they should keep to ensure smooth functioning. Basel II and Basel III
    are improved version of Basel 1988 popularly known as Basel I. The main objective of the present
    study is to analyse Basel III norms and to examine the implementation stages of Basel III issued by
    Reserve Bank of India.

    BASEL NORMS

    Basel 1
    In 1970s breakdown of Bretton Woods’s system led to the failure of various banks globally.
    Closure of BankhausHerstatt’s of Germany and the Franklin National Bank of New York made the
    regulators think about the adverse scenario of financial sector. In order to regulate this situation
    Basel Committee on Banking Supervision (BCBS) under the auspices of Bank for International
    Settlement (BIS) introduced Basel accord popularly known as Basel 1 in 1988. The central bankers
    of the G10 countries established this committee. Its aim was and is to enhance financial stability by
    improving supervisory knowhow and the quality of banking supervision worldwide (BIS, 2013).
    This committee has no legal enforcement; rather it issues guidelines and standards whose
    implementation provides a level playing field and consistency in member countries supervisory
    approaches. Initially, this committee was supposed to draft guidelines for G10 countries only but
    because of its efficient and effective principles, non G10 countries also showed interest for its
    implementation in their individual countries. Thus, this committee expanded its membership in 2009
    and now included 27 jurisdictions (BIS, 2013). Not only G10 countries member implemented this
    accord but all other countries with active international banks also actively participated in this. Later
    on various amendments were done in this accord to make it more reliable and dependable.
    Under these standards banks were instructed to keep capital aside on the basis of risk they are
    undertaking. Basel I set this ratio as 8% of the value of the risk weighted assets whereas RBI set this
    limit as 9% for Indian banks.

    CRAR = Capital > 8%
    Risk Weighted Assets

    Capital as in numerator includes Tier 1 capital and Tier2 capital. Tier1 capital includes paid
    up capital, statutory reserves, capital reserves and other undisclosed free reserves and it is primarily
    used to cover unexpected losses. Tier2 capital includes revaluation reserves, subordinated debt,
    general provisions and loss reserves and it is used to mainly at the time of winding up. Tier2 capital
    cannot exceed more than 50% of Tier 1 capital. Risk weighted assets as in denominator are
    calculated by summing up credit risk weighted assets, market risk weighted assets and operational
    risk weighted assets.
    In 1992, the committee felt the need to make changes in 1988 accord because Basel I was not
    as adequate as it was earlier due to the changing scenario of financial sector. In spite of having

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  3. International Journal of Management (IJM), ISSN 0976 – 6502(Print), ISSN 0976 – 6510(Online),
    Volume 6, Issue 5, May (2015), pp. 18-24© IAEME

    significant impact on international banking Basel I failed to address some important issue such as it
    was dependent only on credit risk and excluded other risks in calculating capital adequacy. It also
    fails to discriminate between different borrowers, their repaying capabilities, their credit rating and
    risk involved. Also, inadequate assessment of risks involved in the use of financial instruments like
    derivatives and securitization led to introduction of Basel II Accord.

    Basel II
    Thus, the committee issued “Revised Capital Framework” in 2004 generally known as Basel
    II (BIS, 2013). Basel II accord was initiated in 1999 and needed to be implemented by 2009. After 6
    years of preparation the accord was presented to banks in June 2004. Keeping the objective of
    financial stability and capital adequacy as same, the Basel II aims to make capital structure more risk
    sensitive as well as to promote risk management practices or to improve risk management structure
    of banks. The second Basel accord, Basel II supplemented the original Basel accord by introducing
    three pillars : First pillar is minimum capital requirement based on risk profiling which deals with
    definition of capital requirements and extended definition of risk which included credit risks, market
    risks and operational risks : Second pillar is supervisory review which requires the supervisory
    authorities to subject all banks to an evaluation process and to impose any necessary supervisory
    measures based on the evaluations (Prakash, 2008): Market discipline forms third pillar which
    enhances the bank’s working framework by ensuring adequate disclosure and clarity in public
    reporting. Following this proposal various guidelines were issued for the successful implementation
    of the accord which was mainly related to focus on trading book, consistent implementation, market
    risk amendment and supervisor’s role. Basel II framework was a successful successor of 1988 accord
    and enhanced form of 1988 accord. But the global financial crisis of 2008 and the collapse of
    Lehman Brother highlighted the defects of Basel II. The committee felt a need to strengthen this
    framework and time came to introduce the third accord i.e. Basel III. Basel II accord failed because
    of problems like portfolio invariant, procyclicality, securitization, biasness related to inputs etc.

    Basel III
    In order to make international banking sector more resilient and more stable, the committee
    introduced new proposed standards ‘Basel III’ in mid-December 2010. The main objective of Basel
    III framework is to improve the banking system’s ability to efficiently absorb shocks arising from
    financial and economic stress and to reduce the risk of spill-over from the financial sector to real
    economy (BCBS, 2010). The focus of Basel III is an even greater risk management at micro and
    macro level, the introduction of leverage and liquidity ratios, counter cyclical and conservation
    buffers as well as the calibration of further buffers for systemically important banks (Dzato, 2012).
    The foundation of Basel III is the three pillars same as of Basel II but now the committee focuses on
    strengthening regulatory capital framework by introducing some key features such as raising the
    quality and quantity of capital base, enhancing risk coverage, introducing leverage ratio, reducing
    procyclicality and promoting counter cyclical buffers and by introducing a global liquidity standards
    such as liquidity coverage ratio and net stable funding ratio. Key features of Basel III capital
    standards are discussed below:
    1) Pillar 1 Minimum capital requirement: while drafting Basel III guidelines emphasis was
    made to make capital base stronger. Three things that need to do to achieve this objective are; to
    cover all risks, to enhance quality of capital and to raise quantity of capital base. Basel III covers
    almost all types of risks included trading and banking book securitization, on and off balance sheet
    activities, counterparty credit risk on OTC derivatives and repos etc. To enhance quality of capital,
    definition of capital has change. Earlier, total regulatory capital was constituted of Tier1 and Tier2
    capital with more emphasis on Tier1 capital ratio and less emphasis on common equity ratio. Also,
    the complexity lie with the components of capital. New definition properly focuses on common

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  4. International Journal of Management (IJM), ISSN 0976 – 6502(Print), ISSN 0976 – 6510(Online),
    Volume 6, Issue 5, May (2015), pp. 18-24© IAEME

    equity Tier1 capital as it has more shock absorbing ability. Tier II capital will also be there as gone
    concern capital and Tier III capital which at one time was used for market risk capital charge, will be
    eliminated. The focus of Basel III was also on raising quantity of capital base by raising requirement
    of capital ratios as under

    Table 1: Summary of capital ratios
    Under Under
    Under Basel III Basel III
    Ratio Calculation
    Basel II Decided by Decided
    BCBS by RBI
    Common equity tier 1 capital
    Common Equity Tier1
    Credit risk RWA+ Market risk RWA+ 2% 4.5% 5.5%
    capital ratio
    Operational risk RWA

    Eligible tier 1 capital
    Tier 1 capital ratio Credit risk RWA+ Market risk RWA+ 4% 6% 7%
    Operational risk RWA

    Eligible total capital
    Total capital ratio
    Credit risk RWA+ Market risk RWA+ 8% 8% 9%
    CRAR
    Operational risk RWA

    Capital conservation
    — 2.5%
    buffer

    Countercyclical buffer — 0 to 2.5%

    Leverage ratio — At least 3%

    Source: created by author

    2) Pillar 2 Supervisory review and evaluation process: supervisors need to evaluate bank’s
    strategies and should intervene if any bank fails to maintain minimum capital requirements.
    Supervisors should ensure that banks are maintaining adequate capital and handling risk efficiently.
    3) Pillar 3 Market discipline: regulators have made disclosures more strict and transparent.
    Banks need to make disclosures under Basel III in its published financial results or at a minimum on
    its websites under regulatory disclosure section. These disclosures should be made by banks as on
    30.9.2013 onwards.
    4) Introduction of new capital buffers: in order to make banks more shock absorbent, capital
    conservation buffer (CCB) and countercyclical capital buffers were introduced. CCB is an additional
    reserve that banks need to maintain in the form of common equity tier 1 capital, at least 2.5% of
    RWAs. This buffer is introduced to ensure that banks have sufficient capital buffer (above minimum
    requirement) which can be used in stressed times. Also, countercyclical capital buffer can be
    imposed by regulators on banks to raise capital. It can range from 0% to 2.5%. It helps in slowing
    down economy if credit expands enormously and encourage lending when economy slowdown.
    5) Introduction of leverage ratio framework: since higher leverage was one of the causes of
    financial crisis, Basel III introduced leverage ratio requirement. The goal of the leverage ratio is to
    potentially capture the risk that may not be captured in the risk weights for capital requirement
    measures and to be a compliment to this measurement (BCBS 2010). At least 3% leverage ratio is to
    be maintained by Indian banks and its disclosure will begin by January 1, 2015.
    6) Introduction of Liquidity risk measurement framework: under this two new ratios are
    introduced. Liquidity coverage ratio (LCR) to maintain adequate level of liquidity in short span of

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  5. International Journal of Management (IJM), ISSN 0976 – 6502(Print), ISSN 0976 – 6510(Online),
    Volume 6, Issue 5, May (2015), pp. 18-24© IAEME

    time of 30 days and Net funding sable ratio (NFSR) which is designed to have enough liquidity for a
    period of 1 year. On the full implementation of Basel III these ratios should not be less than 100%.
    These ratios are to be decided yet and will be implemented in 2015 and2018 respectively.

    IMPLEMENTATION STAGES OF BASEL III

    Basel III capital norms were introduced by BCBS in December 2010 and is to be
    implemented by all banks (Indian or International) with effect from April 2013. For its
    implementation, banks need to make necessary changes in their capital planning by taking various
    considerations such as changing macro-economic conditions and outcomes of periodic stress tests.
    Basel III implementation is phased- in over years to ensure smooth migration which in turn may pose
    higher burden of capital requirement in later years and lesser burden in earlier years of its
    implementation. According to RBI, capital ratios and deductions from common equity will be fully
    implemented by March 31, 2018 (See table 3). 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 (RBI, 2014).
    Thus banks required some more time to raise capital to fully implement Basel III. The
    deadline for its implementation in India is extended up to March 31, 2019 which is also
    internationally agreed timeline, instead of March 31, 2018 (See table 2 & 4). The main amendments
    while revising the timeline was made in the implementation of capital conservation buffer (CCB). It
    has been decided that the implementation of CCB will begin as on March 31, 2016 (RBI, 2014).
    Thus, Basel III will be fully implemented by March 2019. Consequently, minimum capital
    conservation standards for individual bank were also revised (See table 5 & 6).

    CONCLUSION

    Although, Basel III may seems difficult to implement at start because of higher capital
    requirement but at the end it will be beneficial for whole banking system. It is a precautionary
    approach which will help banks to be prepared for any upcoming crisis and make banks strong
    enough to face any downfall without harming depositor’s money, RBI has always taken conservative
    approach and set capital ratio standard higher than prescribed internationally. The phase-in
    implementation will impose lower capital burden in early years and higher capital burden in later
    years. Also, the extended deadline of its full implementation will provide banks some extra time to
    raise capital and to be Basel III compliant.

    REFERENCES

    1. BCBS 2010.Basel committee on banking supervision; Basel III: a global regulatory
    framework for more resilient banks and banking system; available at
    http://www.bis.org/publ/bcbs189.pdf
    2. BIS, 2013.A brief history of the Basel committee available at www.bis.org accessed on 2
    December 2014
    3. Dzato, Robert (2012). Ghana goes Basel II- Key Challenges and Opportunities, Retrieved
    from http://www.fepinternational.org/Ghana%20Goes%20Basel%20II-Article.pdf on
    12.5.2013
    4. Prakash, Anupam (2008). Evolution of the Basel framework on Bank capital Regulation,
    Reserve bank of India occasional papers, Vol. 29 No.2 Monsoon 2008
    5. RBI (2008). Reserve Bank of India, Managing capital and risk; available at
    http://rbi.org.in/scripts/publicationsview.aspx?id=10489

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  6. International Journal of Management (IJM), ISSN 0976 – 6502(Print), ISSN 0976 – 6510(Online),
    Volume 6, Issue 5, May (2015), pp. 18-24© IAEME

    6. RBI (2014). Reserve Bank of India, Master Circular Implementation of Basel III capital
    regulations in India—capital planning Available at www.rbi.org Dated March 27, 2014
    7. R.Shenbagavalli, S.Senthilkumar and Dr.T.Ramachandran, “A Strategy To Manage The
    NPAS of Public Sector Banks” International Journal of Management (IJM), Volume 4, Issue
    3, 2013, pp. 1 – 7, ISSN Print: 0976-6502, ISSN Online: 0976-6510, Published by IAEME.

    ANNEXURE

    Table 2: Basel III phase-in arrangements issued by Bank for International Settlement
    Phases 2013 2014 2015 2016 2017 2018 2019
    Leverage Ratio Parallel run 1 Jan 2013-1 Jan 2017 Migration to
    Disclosures starts 1 Jan 2015 Pillar 1
    Minimum Common Equity 3.5% 4.0% 4.5% 4.5%
    Capital ratio (MCET)
    Capital Conservation Buffer 0.625% 1.25% 1.875% 2.5%
    (CCB)
    MCET + CCB 3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0%
    CAPITAL

    Phase in of deduction from 20% 40% 60% 80% 100% 100%
    CET
    Minimum Tier 1 Capital 4.5% 5.5% 6.0% 6.0%
    Minimum Total Capital 8.0% 8.0%
    Minimum Total capital + 8.0% 8.625% 9.25% 9.875% 10.5%
    Conservation Buffer
    Capital instruments that no Phased out over 10 year horizon beginning 2013
    longer qualify as non-core
    Tier 1 capital or Tier 2
    capital

    Liquidity Coverage ratio 60% 70% 80% 90% 100%
    LIQUIDITY

    Net Stable Funding Ratio Introduce
    minimum
    standard

    Source: www.bis.org

    Table 3: Transitional Arrangements for Scheduled Commercial Banks in India
    (% of RWAs***)
    April 1, March March 31, March 31, March 31, March 31,
    Minimum Capital Ratios
    2013 31, 2014 2015 2016 2017 2018
    CET 1* 4.50 5.00 5.50 5.50 5.50 5.50
    CCB** — — .625 1.25 1.875 2.50
    Minimum CET 1+ CCB 4.50 5.50 6.125 6.75 7.375 8.00
    Minimum Tier 1 capital 6.00 6.50 7.00 7.00 7.00 7.00
    Minimum Total Capital # 9.00 9.00 9.00 9.00 9.00 9.00
    Minimum Total Capital + CCB 9.00 9.00 9.625 10.25 10.875 11.50
    Phase-in of all deductions from CET
    20 40 60 80 100 100
    1 (in %)
    Source: RBI, Master Circular Dated July 1, 2013
    *CET 1: Common equity Tier 1 capital
    **CCB: Capital conservation buffer
    ***RWAs: Risk weighted assets
    #the difference between the minimum total capital requirement of 9% and the Tier 1 requirement can
    be met with Tier 2 and higher forms of capital.

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  7. International Journal of Management (IJM), ISSN 0976 – 6502(Print), ISSN 0976 – 6510(Online),
    Volume 6, Issue 5, May (2015), pp. 18-24© IAEME

    Table 4: Revised Transitional Arrangements for Scheduled Commercial Banks in India
    (% of RWAs***)
    Minimum Capital April 1, March 31, March 31, March March 31, March 31, March 31,
    Ratios 2013 2014 2015 31, 2016 2017 2018 2019
    CET 1* 4.50 5.00 5.50 5.50 5.50 5.50 5.50
    CCB** — — — 0.625 1.25 1.875 2.50
    Minimum CET 1+
    4.50 5.50 5.50 6.125 6.75 7.375 8.00
    CCB
    Minimum Tier 1
    6.00 6.50 7.00 7.00 7.00 7.00 7.00
    capital
    Minimum Total Capital
    # 9.00 9.00 9.00 9.00 9.00 9.00 9.00

    Minimum Total Capital
    9.00 9.00 9.00 9.625 10.25 10.875 11.50
    + CCB
    Phase-in of all
    deductions from CET 1 20 40 60 80 100 100 100
    (in %)
    Source: RBI, Master Circular Dated March 27, 2014
    *CET 1: Common equity Tier 1 capital
    **CCB: Capital conservation buffer
    ***RWAs: Risk weighted assets
    #the difference between the minimum total capital requirement of 9% and the Tier 1 requirement can
    be met with Tier 2 and higher forms of capital

    Table 5: Minimum capital conservation standards for individual bank
    Common Equity Tier 1 Ratio after including the current periods retained Minimum Capital
    earnings Conservation Ratios
    As on As on As on (expressed as % of
    March 31, 2015 March 31, 2016 March 31, 2017 earnings)
    5.5% – 5.65625% 5.5% – 5.8125% 5.5% – 5.96875% 100%
    >5.65625% – 5.8125% >5.8125% – 6.125% >5.96875% – 6.4375% 80%
    >5.8125% – 5.96875% >6.125% – 6.4375% >6.4375% – 6.90625% 60%
    >5.96875% – 6.125% >6.4375% – 6.75% >6.90625% – 7.375% 40%
    >6.125% >6.75% >7.375% 0
    Source: RBI, Master Circular Dated July 1, 2013

    Table 8: Revised minimum capital conservation standards for individual bank
    Common Equity Tier 1 Ratio after including the current periods retained Minimum Capital
    earnings Conservation Ratios
    As on As on As on (expressed as % of
    March 31, 2016 March 31, 2017 March 31, 2018 earnings)
    5.5% – 5.65625% 5.5% – 5.8125% 5.5% – 5.96875% 100%
    >5.65625% – 5.8125% >5.8125% – 6.125% >5.96875% – 6.4375% 80%
    >5.8125% – 5.96875% >6.125% – 6.4375% >6.4375% – 6.90625% 60%
    >5.96875% – 6.125% >6.4375% – 6.75% >6.90625% – 7.375% 40%
    >6.125% >6.75% >7.375% 0
    Source: RBI, Master Circular Dated March 27, 2014

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