What are Basel Norms?
- The BASEL norms are a set of common standards for banks across countries.
- They were originally set in 1974. The most recent set of norms is the BASEL III, is likely to be implemented in India from 2019. This affects a lot of banks.
- Basel a city in Switzerland is also the headquarters of Bureau of International Settlement (BIS), which fosters co-operation 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. Currently there are 27 member nations in the committee.
- Basel guidelines refer to broad supervisory standards formulated by this group of central banks – called the Basel Committee on Banking Supervision (BCBS).
- The set of agreement by the BCBS, which mainly focuses on risks to banks and the financial system are called Basel accord.
- The purpose of the accord is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses.
- India has accepted Basel accords for the banking system. In fact, on a few parameters the RBI has prescribed stringent norms as compared to the norms prescribed by BCBS.
- Since being established, the BCBS has formulated the Basel I, Basel II, and Basel III accords.
Aim of BASEL norms
- The BASEL norms have three aims: Make the banking sector strong enough to withstand economic and financial stress; reduce risk in the system, and improve transparency in banks.
Basel I Norms
- In 1988, BCBS introduced capital measurement system called Basel capital accord, also called as 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.
Basel II Norms
- Basel II guidelines were published by BCBS, which were considered to be the refined and reformed versions of Basel I accord.
- The guidelines were based on three parameters, which the committee calls it as pillars. – Capital Adequacy Requirements: Banks should maintain a minimum capital adequacy requirement of 8% of risk assets –
- Supervisory Review: According to this, banks were needed to develop and use better risk management techniques in monitoring and managing all the three types of risks that a bank faces, viz. credit, market and operational risks –
- Market Discipline: This need increased disclosure requirements. Banks need to mandatorily disclose their CAR, risk exposure, etc to the central bank. Basel II norms in India and overseas are yet to be fully implemented.
Basel III Norms
- In 2010, Basel III guidelines were released. These guidelines were introduced in response to the financial crisis of 2008.
- A need was felt to further strengthen the system as banks in the developed economies were under-capitalized, over-leveraged and had a greater reliance on short-term funding.
- Also the quantity and quality of capital under Basel II were deemed insufficient to contain any further risk.
- Basel III norms aim at making most banking activities such as their trading book activities more capital-intensive.
- The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz. capital, leverage, funding and liquidity.
Key Principles of Basel III
1. Minimum Capital Requirements
- The Basel III accord raised the minimum capital requirements for banks from 2% in Basel II to 4.5% of common equity, as a percentage of the bank’s risk-weighted assets.
- There is also an additional 2.5% buffer capital requirement that brings the total minimum requirement to 7%.
- Banks can use the buffer when faced with financial stress, but doing so can lead to even more financial constraints when paying dividends.
- As of 2015, the Tier 1 capital requirement increased from 4% in Basel II to 6% in Basel III. The 6% includes 4.5% of Common Equity Tier 1 and an extra 1.5% of additional Tier 1 capital.
- The requirements were to be implemented starting in 2013, but the implementation date has been postponed several times, and banks now have until January 1, 2022, to implement the changes.
2. Leverage Ratio
- Basel III introduced a non-risk-based leverage ratio to serve as a backstop to the risk-based capital requirements. Banks are required to hold a leverage ratio in excess of 3%.
- The non-risk-based leverage ratio is calculated by dividing Tier 1 capital by the average total consolidated assets of a bank.
- To conform to the requirement, the Federal Reserve Bank of the United States fixed the leverage ratio at 5% for insured bank holding companies, and at 6% for Systematically Important Financial Institutions (SIFI).
3. Liquidity Requirements
- Basel III introduced the usage of two liquidity ratios – the Liquidity Coverage Ratio and the Net Stable Funding Ratio.
- The Liquidity Coverage Ratio requires banks to hold sufficient highly liquid assets that can withstand a 30-day stressed funding scenario as specified by the supervisors.
- The Liquidity Coverage Ratio mandate was introduced in 2015 at only 60% of its stated requirements and is expected to increase by 10% each year till 2019 when it takes full effect.
- On the other hand, the Net Stable Funding Ratio (NSFR) requires banks to maintain stable funding above the required amount of stable funding for a period of one year of extended stress. The NSFR was designed to address liquidity mismatches and will start becoming operational in 2018.