The underlying purpose of Basel
Basel capital adequacy norms are meant for the protection of depositors and shareholders by prescriptive rules for measuring capital adequacy, thereby evolving methods of determining regulatory capital and ensuring efficient use of capital.
Basel III accord strengthens the regulation, supervision and risk management of the banking sector. It is global regulatory standard on capital adequacy of banks, stress testing as well as market liquidity risk.
The three pillars of Basel are:
Pillar 1: Minimum Regulatory Capital Requirements based on Risk Weighted Assets (RWAs): Maintaining capital calculated through credit, market and operational risk areas.
Pillar 2: Supervisory Review Process: Regulatory tools and frameworks for dealing with peripheral risks that banks face.
Pillar 3: Market Discipline: Increasing the disclosures that banks must provide to increase the transparency
The Basel III accord, which stands on three pillars, aims at:
a. improving the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever may be the source;
b. improving risk management and governance practices; and
c. strengthening banks’ transparency and disclosure standards.
Basel II has been fully implemented in all commercial banks (except RRBs and LABs) in India by March 31, 2009. In this regard, the RBI has also issued a Master Circular no. DBR.No.BP.BC.4/21.06.001/2015-16 dated July 1, 2015 on “Prudential Guidelines on Capital Adequacy and Market Discipline – New Capital Adequacy Framework (NCAF)”.
1.09 The major changes made in Basel III over Basel II are as under: (a) Quality of Capital: One of the key elements of Basel III is the introduction of much stricter definition of capital, which means the higher loss-absorption capacity, which in turn would lead to banks becoming stronger with enhanced capacity to withstand periods of stress.
(b) Capital Conservation Buffer: Beginning 31st March, 2016, Banks are required to hold capital conservation buffer of 0.625%, which will gradually increase to 2.5% by 31st March, 2019. This is to ensure that banks maintain a cushion of capital that can be used to absorb losses during periods of financial and economic stress.
(c) Counter cyclical Buffer: The counter cyclical buffer ensures increased capital requirements in good times and decrease the same during bad times.
(d) Minimum Common Equity and Tier 1 Capital Requirement: The minimum requirement for common equity, the highest form of loss-absorbing capital, has been increased to 5.50% of RWA. The Minimum Tier 1 capital has been increased to 7%, which means that Additional Tier I (AT 1) capital can be maximum of 1.50% of RWA. Though, the minimum total capital (Tier I plus Tier II) requirement remains at 9%, which means that the Tier 2 capital can be admitted maximum of 2% of RWA. With the requirement of gradually maintaining 2.5% of RWA as Capital Conservation Buffer in the form of CET 1, the minimum total capital requirement shall increase to 11.50% of RWA by 31st March, 2019.
(e) Leverage Ratio: Analysis of 2008 financial crisis indicates that value of assets went down much more than what was perceived based on their risk rating, which lead to stipulation of Leverage Ratio. Therefore, under Basel III, a simple, transparent, non-risk based leverage ratio has been introduced. A Leverage Ratio is the relative amount of capital to total assets (not risk-weighted). The Basel Committee will use the revised framework for testing a minimum Tier 1 Leverage Ratio of 3% during the parallel run period up to January 1, 2017. The final calibration, and any further adjustments to the definition, will be completed by 2017, with a view to migrating to a Pillar 1 treatment on January 1, 2018.
(f) Liquidity Ratios: Under Basel III, a framework for liquidity risk management has been set up. Liquidity Coverage Ratio (LCR) has become operational since 1st January, 2015.
Basel III capital regulation has been implemented from April 1, 2013 in India in phases and it will be fully implemented as on March 31, 2019. In view of the gradual phase-in of regulatory adjustments to the Common Equity component of Tier 1 capital under Basel III, certain specific prescriptions of Basel II capital adequacy framework (e.g. rules relating to deductions from regulatory capital, risk weighting of investments in other financial entities etc.) will continue to apply till March 31, 2017 on the remainder of regulatory adjustments not treated in terms of Basel III rules. In this regard, the RBI has also issued a Master Circular no. DBR.No.BP.BC.1/21.06.201/2015-16 dated July 1, 2015 on “Basel III Capital Regulations”.