Assignment of
Regulatory Framework
Submitted To :
Ms. Nidhi Sareen
Submitted By :
Neha (21067)
Banking & Insurance 2nd year
Basel Norms
Banks lend to different types of borrowers and
each carries its own risk. They lend the
deposits of public as well as money raised from
the market – equity and debt. The inter-
mediation activity exposes the bank to a variety
of risks. Cases of big banks collapsing due to
their inability to sustain the risk exposures are
readily available. Therefore, Banks have to
keep aside a certain percentage of capital as
security against the risk of non –
recovery. Basel committee has produced norms
called Basel Norms for Banking to tackle the
risk.
Basel is a city in Switzerland. It is the
headquarters of Bureau of International
Settlement (BIS), which fosters cooperation
among central banks with a common goal of
financial stability and common standards of
banking regulations. Every two months BIS
hosts a meeting of the governor and senior
officials of central banks of member countries.
Basel guidelines refer to broad supervisory
standards formulated by these groups of central
banks – called the Basel Committee on Banking
Supervision (BCBS). The set of the agreement
by the BCBS, which mainly focuses on risks to
banks and the financial system is called Basel
accords/Basel Norms. The purpose of the
accord is to ensure that financial institutions
have enough capital on account to meet
obligations and absorbs unexpected
losses. India has accepted Basel Norms for
Banking. In fact, on a few parameters, the RBI
has prescribed stringent norms as compared to
the norms prescribed by BCBS.
Basel I:
In 1988, BCBS introduced capital measurement
system called Basel capital accord, also called
Basel 1. It focused almost entirely on credit risk.
It defined capital and structure of risk weights
for banks. The minimum capital requirement
was fixed at 8% of risk-weighted assets (RWA).
RWA means assets with different risk profiles.
For e.g.: An asset backed by collateral would
carry lesser risks as compared to personal
loans, which have no collateral.
Assets of banks were classified and grouped
into five categories according to credit risk,
carrying risk weights of:
0% (for example cash, home country debt
like Treasuries),
20% (securitizations such as MBS rated
AAA)
50%,
100% (for example, most corporate debt),
and
Some assets are given no rating
Two twin objectives of Basel I was:
To ensure an adequate level of capital in
the international banking system
To create a more level playing field in the
competitive environment
CAPITAL ADEQUACY PRINCIPLES
The Basel Committee on Banking Supervision
(Basel Committee), an international banking
standards forum, identified quality of capital as
one of the key causes of the recent financial
crisis and an area of focus for regulation and
supervision. Informed by guidance issued by
the Basel Committee and the Office of the
Superintendent of Financial Institutions (OSFI),
the Credit Union Prudential Supervisors
Association (CUPSA) has established the
following set of common principles to advise
policymakers on the development of regulatory
and supervisory frameworks to ensure capital
adequacy in the credit union system:
1. Principle: Taking into account the unique
structure of credit unions, capital adequacy
standards and requirements should be modeled
on the Basel framework for quality and quantity
of capital, and OSFI’s published guideline
applicable to federal deposit-taking institutions
for risk weighting, including charges for credit
risk, operational risk and market risk.
2. Principle: Capital should be of high quality
and loss absorbing. Quality of capital is
determined through the application of the Basel
III criteria for common equity, and additional tier
1 and tier 2 capital, with emphasis on retained
earnings as the highest quality of capital. Given
the unique structure of credit unions, retained
earnings will parallel Basel III requirements for
common equity.
3. Principle: Capital should adequately protect
against unexpected losses. Quantity of capital
should rest above regulatory minimums and
sufficiently reflect a credit union’s risk appetite
and risk profile capturing all material risks and
taking into account forward-looking factors such
as the credit union’s strategic plans. Quantity of
capital should include appropriate capital
conservation and countercyclical buffers
reflecting international best practices.
4. Principle: Risk coverage for capital with
system-related entities will consider the unique
attributes of the cooperative model. Assets
such as deposits with centrals and/or shares in
centrals and other system-related entities
should hold the appropriate risk-weighting in
capital ratio calculations.
These principles have received broad-based
support from CUPSA members. It is for each
member to make a recommendation to its
respective policy makers and stakeholders on
aligning capital adequacy standards and
requirements with these principles, taking into
account the unique attributes of the jurisdiction.
Where any appropriate changes are identified a
suitable degree of consultation will be
conducted. Results of the consultation process
may then be shared seeking the support of
policymakers.
Drawbacks of Basel 1 Norms
In spite of advantages and positive effects,
weaknesses of Basel I standards eventually
became evident:
The lack of risk sensitivity: For instance, a
corporate loan to a small company with high
leverage consumes the same regulatory
capital as a loan to an AAA-rated large
corporate company—8% because they are
both risk weighted at 100%.
The limited collateral recognition: The list of
eligible collateral and guarantors is rather
limited, compared to those effectively used
by the banks to mitigate their risks.
The incomplete coverage of risk sources:
Basel I focused only on credit risk. An
amendment made to Basel I in 1996—
Market Risk Amendment—filled an
important gap. But there are still other risk
types—like operational risk, reputation risk,
and strategic risk—not covered by the
regulatory requirements.
The “one-size-fits-all” approach: The
requirements are virtually the same, no
matter the bank’s risk level, sophistication,
and activity type.
The arbitrary measure: The 8% ratio for
capital is arbitrary and not based on explicit
solvency targets.
The lack of diversified recognition: The
credit-risk requirements are all additive, and
diversification through granting loans to
various sectors and regions is not
recognized.
Basel I was more relevant for banks that had
retail and commercial banking units, like
JPMorgan (JPM), Wells Fargo (WFC),
and other banks in an ETF like the Financial
Select Sector SPDR Fund (XLF). For
investment banks like Morgan Stanley (MS) and
Goldman Sachs (GS), there was no separate
market risk discussion in Basel I.
Although Basel I was beneficial to
bank supervision, the time had come to move to
a more sophisticated regulatory framework. The
Basel II proposal was the answer to those
shortcomings as we shall see in the next article
of the series.
