Basel Norms

Last Updated : 06 Oct, 2022

The Basel Committee on Banking Supervision (BCBS) established the Basel Norms as the standards for international banking laws. These standards aim to harmonize international financial legislation and strengthen the global banking system. A total of 27 people from different nations, including India, make up BCBS. Basel, I, II, and III are the three guidelines the Basel Committee has released to achieve its goal. The Basel Committee on Banking Supervision series focuses on the threats to banks and the financial system. Basel-III, the most recent agreement, was approved in November 2010. Basel III mandates a minimum level of common equity and a minimum liquidity ratio for banks. Its administrative headquarters are in the Basel, Switzerland-based headquarters of the Bank of International Settlements (BIS). Thus, the Basel norms’ name.

How do Basel Norms work?

The Basel accord is the name given to a group of BCBS agreements that mainly deal with risks to banks and the financial system.
The agreement sets this as its primary objective to ensure that financial institutions have enough capital to meet obligations and absorb unforeseen losses.
India has agreed to the Basel accords for the banking system.

Why Basel Norms are Essential?

Lending to borrowers that bear their risks exposes banks to various risks and defaults. Banks lend money obtained from the market and people’s deposits, as a result of which they occasionally experience losses. As a result, banks must set aside a specific amount of capital as protection against the risk of non-recovery to handle such situations.

Historical Background of the Basel Committee:

At the end of 1974, following significant disruptions in the global currency and banking markets, the central bank governors of the Group of Ten countries founded the Basel Committee, formerly known as the Committee on Banking Regulations and Supervisory Practices. The Basel Committee now has 45 institutions from 28 jurisdictions as members, up from the original G10 group when it was founded. The Basel Committee established a number of international standards for bank regulation beginning with the Basel Concordat, first published in 1975 and revised several times since. Of particular note are its landmark publications of the capital adequacy accords, commonly referred to as Basel I, Basel II, and most recently, Basel III. The Committee and its oversight body created a reform program in response to the financial crisis of 2008 to address the lessons learned from the crisis and carry out the requirements for banking sector changes set forward by the G20 at their 2009 Pittsburgh summit. Basel III refers to the new international regulations that address both firm-specific and more general systemic risks.

Basel-I:

In 1988, BCBS introduced the Basel Capital Accord, a capital measuring scheme.
Credit risk accounted for almost all of its concerns.
The capital and risk-weighting framework for banks was formed.
The minimum capital requirement was established at 8% of risk-weighted assets (RWA).
Assets having variable risk profiles are referred to as RWA. For instance, a secured asset would be less hazardous than a personal loan with no security.

Fundamentals of Basel-I:

Tier 1 capital and Tier 2 capital are the two kinds of capital. Because it is the primary indicator of the bank’s financial soundness, Tier 1 capital is its core capital. Paid-up capital and stated reserves, referred to as retained earnings, make up most of the core capital. Non-cumulative and non-redeemable preferred stock is also included. Since Tier 2 capital is less dependable than Tier 1, it is used as supplemental finance.
It comprises subordinate debt, preferred shares, and secret reserves. India embraced the Basel 1 principles in 1999.

Tier 1 and Tier 2 Capital:

Tier 1: This category includes a bank’s equity, reported reserves, and core capital, as shown on its financial statements.
A bank’s Tier 1 capital acts as a safety net in the event of substantial losses, enabling it to withstand pressure and continue running its business.
Tier 2: This category describes the additional capital that a bank maintains, such as secret reserves and unsecured subordinated debt instruments with a minimum original duration of five years.

Since it is more difficult to calculate precisely and more difficult to liquidate, Tier 2 capital is regarded as being less dependable than Tier 1 capital.

Basel-II:

Basel II guidelines, which were seen as improved and revised versions of the Basel I agreement,
In June 2004, the Basel II Accord was released.
It is being created to establish global bank regulation norms and lower risk in the worldwide banking system.
Before Basel II could take full effect, the financial crisis of 2007–2008 interfered.

Fundamentals of Basel-II:

The committee refers to the guidelines’ three pillars as follows,

Requirements for Capital Adequacy: A minimum capital adequacy requirement of 8% of risk assets should be maintained by banks.
Review by a supervisor: As a result, banks were compelled to create and put into practice improved risk management strategies for keeping an eye on and managing the three different categories of risks that a bank faces: operational, market, and credit risks.
Market Restrictions: This calls for stricter disclosure regulations. Banks are required to regularly submit reports to the central bank about their CAR, risk exposure, and other data.

Although India complies with these standards, Basel II has not yet been fully applied outside.

Basel-III:

In 2010, Basel III recommendations were released.
The Basel III regulations seek to increase the capital-intensiveness of most banking activities, including trading books.
The rules concentrate on four crucial banking parameters: capital, leverage, funding, and liquidity, to foster a more resilient banking sector.
In reaction to the financial crisis of 2008, several rules were implemented.
Banks in industrialized economies were under-capitalized, over-leveraged, and relied more on short-term funding, necessitating the need to reinforce the system further.
Furthermore, Basel II’s capital amount and quality requirements were deemed insufficient to handle any increased risk.

Fundamentals of Basel-III:

1. Leverage Ratio:

As a backup to the risk-based capital requirements, Basel III included a non-risk-based leverage ratio. Banks must maintain a leverage ratio that is higher than 3%.
Tier 1 capital is divided by a bank’s average total consolidated assets to arrive at the non-risk-based leverage ratio.

2. The Minimum Capital Needs:

A capital to risk-weighted asset ratio of 8% was required under Basel III regulations.
Indian scheduled commercial banks must maintain a CAR of 9% in accordance with RBI regulations.
It is imperative that the public sector banks in India maintain a CAR of 12%.
Banks are required to keep a capital conservation buffer of 2.5%.
Additionally, the counter-cyclical buffer needs to remain at 0-2.5 percent.
Banks now have until January 1, 2022, to implement the modifications initially scheduled to begin in 2013, but the deadline has been repeatedly postponed.

3. Requirements for Liquidity:

The Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) are two liquidity ratios made available by Basel III.
To comply with the Liquidity Coverage Ratio, banks must have enough highly liquid assets to support a 30-day stressed financing scenario as determined by the supervisors.
The Liquidity Coverage Ratio mandate, which was first introduced in 2015 at only 60% of its stated criteria, is expected to rise by 10% per year until it is fully implemented in 2019, which is likely to happen in 2019.
However, the Net Stable Funding Ratio (NSFR) mandates that banks continue to hold more stable funding than is necessary for a year of prolonged stress. The NSFR will begin operating in 2018 and was created to alleviate liquidity shortages.

In relation to their off-balance-sheet assets and activities, banks must maintain a stable funding profile in accordance with the Net Stable Funds Rate (NSFR). NSFR mandates that banks secure steady funding sources for their operations (reliable over the one-year horizon). The NSFR must be at least 100%. LCR thus evaluates resilience over the short term (30 days), whereas NSFR measures resilience over the medium term (1 year).

Basel III Affects Banks: Due to the cost of strengthening capital ratios, which would decrease lending, banks may increase lending rates. This will have a negative impact on the economy because investment, exports, and consumption will all decline.

Implementation in India:

Basel-III implementation in India had to be completed by March 2019. The new date is March 2020.
The RBI choose to delay the implementation of Basel standards by another six months due to the coronavirus outbreak.
Bank capital requirements, such as those related to NPAs, are reduced as a result of Basel III’s time extension.
This extension will affect how foreign players see Indian banks and the central bank.

Conclusion:

These regulations have been put into effect nationwide by the RBI. It was implemented to align bank compliance and regulation procedures with other major international banks. It guarantees that Indian banks are well-positioned to handle any financial risk. By making the banking sector more resilient and increasing the capacity and sustainability of delivering financial services to the real economy, the Basel Committee’s post-crisis reforms have contributed to improving financial stability.