Risk Management; Basel I, II & III Accords: An Overview

07/02/2020

Risk Management; Basel I, II & III Accords: An Overview

Dear bankers,

As we all know that is Risk Management; Basel I, II & III Accords for JAIIB Exam. JAIIB exam conducted twice in a year. So, here we are providing the Risk Management; Basel I, II & III Accords (Unit-7), Indian Financial system (Module A), Principle & Practice of Banking JAIIB Paper-1.

Table of Contents

♦Risk Management

In the course of their operations, banks are invariably faced with different types of risks that may have a potentially adverse effect on their business. Banks are obliged to establish a comprehensive and reliable risk management system, integrated in all business activities and providing for the bank risk profile to be always in line with the established risk propensity.

♥Risk Management Function

Risk management strategy and policies, as well as procedures for risk identification and measurement, i.e. for risk assessment and risk management;
Appropriate internal organisation, i.e. bank’s organizational structure;
Effective and efficient risk management process covering all risks the bank is exposed to or may potentially be exposed to in its operations;
Adequate internal controls system;
Appropriate information system;
Adequate process of internal capital adequacy assessment.
Strong MIS for reporting, monitoring and controlling risks
Well laid out procedures, effective control and comprehensive risk reporting framework.
Periodical review and evaluation.

♥Type of Risk Management

Liquidity risk is the risk of potential occurrence of adverse effects on the bank’s financial result and capital due to the bank’s inability to meet the due liabilities caused by the withdrawal of the current sources of funding, that is, the inability to raise new funds (funding liquidity risk), aggravated conversion of property into liquid assets due to market disruption (market liquidity risk).
Credit risk is the risk of potential occurrence of adverse effects on the bank’s financial result and capital due to debtor’s default to meet its obligations to the bank.

Credit risk may take the following forms:

(a)Direct lending: Principal and/or interest amount may not be repaid.

(b)Guarantees or letter of credit: Funds may not be forthcoming from the constituents upon crystallization of the liability.

(c) Securities trading business: Funds/ securities settlement may not be effected.

(d)Cross-border exposure: The availability and free transfer of foreign currency funds may either cease or restrictions may be imposed by the sovereign.

Market risks entail foreign exchange risk, price risk on debt securities, price risk on equity securities, and commodity risk.
Interest rate risk is the risk of possible occurrence of adverse effects on the bank’s financial result and capital on account of banking book items caused by changes in interest rates.
Foreign exchange risk is the risk of possible occurrence of adverse effects on the bank’s financial result and capital on account of changes in foreign exchange rates.
Operational risk is the risk of possible adverse effects on the bank’s financial result and capital caused by omissions (unintentional and intentional) in employees’ work, inadequate internal procedures and processes, inadequate management of information and other systems, as well as by unforeseeable external events. Operational risk also includes legal risk.

♦BASEL Accords

Basel is a city in Switzerland which is also the headquarters of Bureau of International Settlement (BIS).
The Bank for International Settlements (BIS) established on 17 May 1930, is the world’s oldest international financial organisation. There are two representative offices in the Hong Kong and in Mexico City.

♥BASEL- I

In 1988, The Basel Committee on Banking Supervision (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).
India adopted Basel 1 guidelines in 1999.
In India, however banks are required to maintain a minimum Capital-to-risk weighted Asset ratio (CRAR) of 9% on an ongoing basis.

♥BASEL- II

In 2004, Basel II guidelines were published by BCBS, which were considered to be the refined and reformed versions of Basel I accord.

Three Pillars of Basel II

First Pillar: Minimum capital Requirement

(a)Calculation of minimum capital requirements and constituents of capital

(b)Credit Risk

Standardized Approach
Internal Ratings-based Approach
Securitisation Framework

(c)Market Risk

(d)Operational Risk

Second Pillar: Supervisory review process
Third Pillar: Market Discipline.

First Pillar: Minimum capital Requirement

The Capital base of the bank consist of the following three types of capital element. Tier 1, Tier 2 and Tier 3 capital. The sum of Tier 1, Tier 2 and Tier 3 element will be eligible for inclusion in the capital base, subject to the following limits.

Total of Tier 2 (Supplementary) elements will be limited to a maximum of 100% of the Tier 1 element.
Subordinated term debt will be limited to a maximum of 50% of Tier 1 elements.
Tier 3 capital will be limited to 250% of a bank’s Tier 1 capital that is required to support market risks.
Where general provisions/general loan –loss reserves include amounts reflecting lower valuations of assets or latent but unidentified losses present in the balance sheet, the amount of such provisions or reserves will be limited to a maximum of 1.25% point.
Asset revaluation reserves, which take the form of latent gains on unrealized securities, will be subject to a discount of 55%.

Second Pillar: Supervisory review process

The section discusses the key principles of supervisory review, risk management guidance and supervisory transparency and accountability, produced by the committee with respect to banking risks. This includes guidance relating to, among other things, the treatment of interest rate risk in the banking book, credit risk, operational risk etc.

Four key of Principles of Supervisory Review:

The Committee has identified four key principles of supervisory review, which complement those outlined in the extensive supervisory guidance that has been developed by the committee.

Principle 1: Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.
Principle 2: Supervisors should review and evaluate Bank’s internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.
Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.
Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

Third Pillar: Market Discipline

Disclosure Requirements
Guiding Principles
Achieving Appropriate Disclosure

♥BASEL – III

Basel III or Basel 3 released in December, 2010 is the third in the series of Basel Accords. These accords deal with risk management aspects for the banking sector. So we can say that Basel III is the global regulatory standard on bank capital adequacy, stress testing and market liquidity risk. (Basel I and Basel II are the earlier versions of the same, and were less stringent).
The RBI issued Guidelines based on the Basel III reforms on capital regulation on May 2 2012, to the extent applicable to banks operating in India. The Basel III capital regulation has been implemented form April 1, 2013 in India in phase and it will be fully implemented as on March 31, 2019.

Aims of the Basel III

Improve the banking sector’s ability to absorb ups and downs arising from financial and economic instability
Improve risk management ability and governance of banking sector
Strengthen banks’ transparency and disclosures

♥What are the major changes proposed in Basel iii over earlier accords i.e. Basel I and Basel II?

Better Capital Quality: One of the key elements of Basel 3 is the introduction of much stricter definition of capital. Better quality capital means the higher loss-absorbing capacity. This in turn will mean that banks will be stronger, allowing them to better withstand periods of stress.
Capital Conservation Buffer: Another key feature of Basel iii is that now banks will be required to hold a capital conservation buffer of 2.5%. The aim of asking to build conservation buffer is to ensure that banks maintain a cushion of capital that can be used to absorb losses during periods of financial and economic stress.
Countercyclical Buffer: This is also one of the key elements of Basel III. The countercyclical buffer has been introduced with the objective to increase capital requirements in good times and decrease the same in bad times. The buffer will slow banking activity when it overheats and will encourage lending when times are tough i.e. in bad times. The buffer will range from 0% to 2.5%, consisting of common equity or other fully loss-absorbing capital.
Minimum Common Equity and Tier 1 Capital Requirements: The minimum requirement for common equity, the highest form of loss-absorbing capital, has been raised under Basel III from 2% to 4.5% of total risk-weighted assets. The overall Tier 1 capital requirement, consisting of not only common equity but also other qualifying financial instruments, will also increase from the current minimum of 4% to 6%. Although the minimum total capital requirement will remain at the current 8% level, yet the required total capital will increase to 10.5% when combined with the conservation buffer.
Leverage Ratio: A review of the financial crisis of 2008 has indicted that the value of many assets fell quicker than assumed from historical experience. Thus, now Basel III rules include a leverage ratio to serve as a safety net. A leverage ratio is the relative amount of capital to total assets (not risk-weighted). This aims to put a cap on swelling of leverage in the banking sector on a global basis. 3% leverage ratio of Tier 1 will be tested before a mandatory leverage ratio is introduced in January 2018.
Liquidity Ratios: Under Basel III, a framework for liquidity risk management will be created. A new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are to be introduced in 2015 and 2018, respectively.
Systemically Important Financial Institutions (SIFI): As part of the macro-prudential framework, systemically important banks will be expected to have loss-absorbing capability beyond the Basel III requirements. Options for implementation include capital surcharges, contingent capital and bail-in-debt.

♥Comparison of Capital Requirements under Basel II and Basel III

As a percentage of risk weighted assets

		Basel II	Basel III (January 2019)
A= (B+D)	Minimum Total Capital	8.0	8.0
B	Minimum Tier 1 Capital	4.0	6.0
C	Of which: Minimum common equity Tier 1 capital	2.0	4.5
D	Maximum Tier 2 Capital (Within Total capital)	4.0	2.0
E	Capital conservation buffer (CCB)	—	2.5
F=C+E	Minimum Common Equity Tier 1 capital +CCB	2.0	7.0
G=A+E	Minimum Total capital +CCB	8.0	10.5

♥Minimum Regulatory Capital Prescriptions (as percentage of risk weighted assets)

RBI Prescriptions

		Basel II Current	Basel III (March 31, 2018)	Basel II (January 2019)
A= (B+D)	Minimum Total Capital	9.0	9.0	8.0
B	Minimum Tier 1 Capital	6.0	7.0	6.0
C	Of which: Minimum common equity Tier 1 capital	3.6	5.5	4.5
D	Maximum Tier 2 Capital (Within Total capital)	3.0	2.0	2.0
E	Capital conservation buffer (CCB)	—	2.5	2.5
F=C+E	Minimum Common Equity Tier 1 capital +CCB	3.6	8.0	7.0
G=A+E	Minimum Total capital +CCB	—	11.5	10.5
H	Leverage Ratio (Ratio to total Assets)	—	4.5	3.0

Risk Management; Basel I, II & III Accords: An Overview

Risk Management; Basel I, II & III Accords: An Overview