Capital Adequacy- The Basel-II Overview: CAIIB Paper 2 (Module D), Unit 3

Capital Adequacy- The Basel-II Overview: CAIIB Paper 2 (Module D), Unit 3

Dear Bankers,
We all know that CAIIB exams are conducted by the Indian Institute of Banking and Finance (IIBF).  CAIIB is said to be one of the difficult courses to be cleared for the bankers. But we assure you that with the help of our “CAIIB study material”, you will definitely clear the CAIIB exam.
CAIIB exams are conducted twice in a year. Candidates should have completed JAIIB before appearing for CAIIB Exam. Here, we will provide detailed notes of every unit of the CAIIB Exam on the latest pattern of IIBF.
So, here we are providing “Unit 3: Capital Adequacy- The Basel-II Overview” of “Module D: Balance Sheet Management” from “Paper 2: Bank Financial Management (BFM)”

About Basel

Central Bank Governors of Group of Ten Countries formed a Committee of banking supervisory authorities in 1975. This Committee usually meets at the Bank of International Settlement (BIS) in Basel, Switzerland. Hence it has come to be known as the Basel Committee. The Basel Committee provided the framework for capital adequacy in 1988, which is known as the Basel-I accord.

The 1988 Basel Accord led to significant increases in the capital held by banks over the following 10 years, It deserves a great deal of credit for improving the stability of the global banking system. However, it had certain significant weaknesses. The Basel-I norms for risk weights were more of a straightjacket nature. For example, all exposures to sovereigns were given 0% risk weight. All bank exposures had a risk weight of 20%. Corporate advances had a risk weight of 100%.

To overcome the shortcomings of Basel I, the Basel Committee of Banking Supervision (BCBS) released the “International Convergence of Capital Measurement and Capital Standards: A Revised Framework” on June 26, 2004. A comprehensive version of the Revised Framework was issued in June 2006, which is a compilation of the June 2004 Basel II Framework, the elements of the 1988 Accord that were not revised during the Basel II process, the 1996 Amendment to the Capital Accord to Incorporate Market Risks, and the 2005 paper on the Application of Basel II to Trading Activities and the Treatment of Double Default Effects.

BASEL-II – Revised Frame Work

The Revised Framework consists of three-mutually reinforcing Pillars, viz., minimum capital requirements supervisory review of capital adequacy, and market discipline. Under Pillar 1, the Framework offers three distinct options for computing capital requirement for credit risk and three other options for computing capital requirement for operational risk. These options for credit and operational risks are based on increasing risk-sensitivity and allow banks to select an approach that is most appropriate to the stage of development of bank’s operations.

Scope Of Application

The revised capital adequacy norms are applicable uniformly to all Commercial Banks (except Cooperative Banks, Local Area Banks and Regional Rural Banks), both at the solo level (global position) as well as at the consolidated level. A Consolidated bank is defined as a group of entities where a licensed bank is the controlling entity. A consolidated bank will include all group entities under its control, except the exempted entities. A consolidated bank may exclude group companies, which are engaged in insurance business and businesses not pertaining to financial services. A consolidated bank should maintain a minimum Capital to Risk-weighted Assets Ratio (CRAR) as applicable to a bank on an ongoing basis.

THREE PILLARS OF BASELT

 

Pillar I: Minimum Capital Requirement

1. Constituents of capital

2. Capital for Credit Risk

(a) Standardised approach

(b) Internal rating based (IRB) approaches

(i)      Foundation approach;

(ii)    Advanced approach;

3. Capital for Market Risk

(a) Standardised method

(i) Maturity method;

(ii)    Duration method.

(b) Internal models method

3. Capital for Operational Risk

(a)    Basic Indicator Approach (BIA)

(b)   Standardised Approach

(c)    Advanced Measurement Approach

 

Pillar-II: Supervisory Review Process

 

Pillar-III: Market Discipline

 

Pillar-I – Minimum Capital Requirements

The capital ratio continues to be calculated using the definition of regulatory capital and risk-weighted assets. The definition of eligible regulatory capital largely continues to be as defined in the earlier accord of 1988 and amended to include Tier-III capital as prescribed in January 96 and September 97. Thus the term capital would include Tier-I or core capital, Tier-II or supplemental capital, and Tier-III capital. Tier-III capital, which took care of market risk of the banks has since been phased out with the introduction of Basel III guidelines. The total capital ratio must not be lower than 8% (9% in India). Core capital consists of paid up capital, free reserves and unallocated surpluses, less specified deductions.

Supplementary capital comprises subordinated debt of more than five years’ maturity, loan loss reserves, revaluation reserves (which is now part of Tier-I capital in India), investment fluctuation reserves, and limited life preference shares. Tier-II capital is restricted to 100% of Tier-I capital as before.

Tier-III (Presently not allowed by RBI) capital consists of short-term subordinated debt for the sole purpose of meeting a proportion of the capital requirement for market risk. Short-term bond must have an original maturity of at least two years. Tier-III capital will be limited to 250% of a bank’s Tier-I capital that is required to support market risk. This means that a minimum of about 28.5% of market risk needs to be supported by Tier-I capital. Tier-III capital was provided under the Basel II guidelines, but RBI has not permitted this capital for Banks in India.

Pillar 2: Supervisory Review

  • Evaluate risk assessment
  • Ensure soundness and integrity of bank’s internal processes to assess the adequacy of capital
  • Ensure maintenance of minimum capital with prompt corrective action (PCA) for shortfall
  • Prescribe differential capital, where necessary i.e. where the internal processes are slack.

Pillar 3: Market Discipline

  • Enhance disclosure
  • Core disclosures and supplementary disclosures
  • Disclosures should be made on half yearly basis.

Thus the Basel-II accord does not merely prescribe minimum capital requirement, but envisages processes of supervisory review and market discipline. The revised framework is more risk sensitive than the 1988 accord. There are incentives for those banks, which have better risk management capabilities. We shall discuss all the three pillars in more detail in the following sections/units.

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