The Basel Committee on Banking Supervision (BCBS) is a committee of banking
supervisory authorities that was established by the central bank governors of a group of ten countries in 1985. It consists of senior representatives of bank supervisory authorities and central banks from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and the United States of America. It usually meets at the Bank for International Settlements in Basel, where its permanent secretariat is located.
8.2.1 Basel I Accord
The BCBS first came out with 1988 Capital Accord for banks, taking into account the elements of risk in various types of assets in the balance sheet as well as off-balance sheet business. Essentially, under the above system, the balance sheet assets, non-funded items and other off-balance sheet exposures are assigned weights according to the prescribed risk weights and banks have to maintain unimpaired minimum capital funds equivalent to the prescribed ratio, on the aggregate of the risk weighted assets and other exposures, on an ongoing basis. Under the Basel I Accord, only the credit risk element was considered and the minimum requirement of capital funds was fixed at 8 per cent of the total risk weighted assets. Risk adjusted assets would mean weighted aggregate of funded and non-funded items.
Degrees of credit risk expressed as percentage weightings have been assigned to balance sheet assets and conversion factors to off-balance sheet items.
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In India, however, banks are required to maintain a minimum Capital-To-Risk-Weighted Asset Ratio (CRAR) of 9 per cent on an ongoing basis.
The banks' overall minimum capital requirement will be the sum of the following:
(a) capital requirement for credit risk on all credit exposures excluding items comprising trading book
and including counterparty credit risk on all OTC derivatives on the basis of the risk weights;
and
(b) capital requirement for market risks in the trading book.
The value of each asset/item shall be multiplied by the relevant weights to produce risk adjusted values of assets and off-balance sheet items. The aggregate will be taken into account for reckoning the minimum capital ratio.
8.2.2 Basel II Accord
BCBS brought out a report titled 'International Convergence of Capital Measurement and Capital Standards - A Revised Framework 2004' (also commonly called Basel Report II). The report presents the outcome of the Basel Committee on Banking Supervision's work over recent years to secure international convergence on revisions to supervisory regulations governing the capital adequacy of internationally active banks. Following the publication of the committee's first round of proposals for revising the capital adequacy framework in June 1999, many valuable improvements have been made to the original proposals. The report sets out the details of the agreed framework for measuring capital adequacy and the minimum standard to be achieved which the national supervisory authorities represented on the
committee will propose for adoption in their respective countries. The committee expects its members to move forward with the appropriate adoption procedures in their respective countries and these, therefore, will be available for implementation by the end of the year 2008.
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The fundamental objective of the committee's work towards revision of the 1988 accord has been to develop a framework that would further strengthen the soundness and stability of the international banking system while maintaining sufficient consistency that capital adequacy regulation will not be a significant source of competitive inequality among internationally active banks. The committee believes that the revised framework will promote the adoption of stronger risk management practices by the banking industry and views this as one of its major benefits.
In developing the revised framework, the committee has sought to arrive at significantly more risk-sensitive capital requirements that are conceptually sound and at the same time pay due regard to particular features of the present supervisory and accounting systems in individual member countries. The committee is also retaining key elements of the 1988 capital adequacy framework, including the general requirement for banks to hold total capital equivalent to at least 8 per cent of their risk-weighted assets; the basic structure of the 1996 Market Risk Amendment regarding the treatment of market risk; and the definition of eligible capital.
A significant innovation of the revised framework is the greater use of assessments of risk provided by banks' internal systems as inputs to capital calculations.
The revised framework is more risk sensitive than the 1988 Accord, but countries where risks in the local banking market are relatively high, nonetheless need to consider if banks should be required to hold additional capital over and above the Basel minimum. This is particularly
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the case with the more broad brush standardised approach. Even in the case of the internal ratings-based (IRB) approach, however, the risk of major loss events may be higher than is normally allowed for in this framework.
Three Pillars of Basel II
The Basel Committee's revised framework is based on the following three pillars:
The First Pillar: Minimum capital requirements
(a) Calculation of minimum capital requirements and constituents of capital (b) Credit Risk
- Standardised Approach
- Internal Ratings-based Approach - Securitisation Framework
(c) Operational Risk (d) Market Risk.
The Second Pillar: Supervisory review process.
The Third Pillar: Market discipline.
The committee has also highlighted the need for banks and supervisors to give appropriate attention to the second (supervisory review) and third (market discipline) pillars of the revised framework. It is critical that the minimum capital requirements of the first pillar be accompanied by a robust implementation of the second, including efforts by banks to assess their capital adequacy and by supervisors to review such assessments. In addition, the
disclosures provided under the third pillar of this framework will be essential in ensuring that market discipline is an effective complement to the other two pillars.
The First Pillar - Minimum Capital Requirements
The capital base of the bank consists of the following three types of capital elements: Tier 1, Tier 2, and Tier 3 capital. The sum of Tier 1, Tier 2, and Tier 3 elements will be eligible for inclusion in the capital base, subject to the following limits:
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(a) The total of Tier 2 (supplementary) elements will be limited to a maximum of 100 per cent of the
total of Tier 1 elements.
(b) Subordinated term debt will be limited to a maximum of 50 per cent of Tier 1 elements.
(c) Tier 3 capital will be limited to 250 per cent of a bank's Tier 1 capital that is required to support
market risks.
(d) Where general provisions/general loan-loss reserves include amounts reflecting lower valuations
(e) of asset or latent but unidentified losses present in the balance sheet, the amount of such
(f) provisions
or reserves will be limited to a maximum of 1.25 percentage points.
(g) Asset revaluation reserves, which take the form of latent gains on unrealised securities, will be
subject to a discount of 55 per cent.
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(i) Tier 1: Includes only permanent shareholders' equity (issued and fully paid ordinary shares/ common stock and perpetual non-cumulative preference shares) and disclosed reserves (created or increased by appropriations of retained earnings or other surplus, e.g.:
share premiums, retained profit, general reserves and legal reserves).
(ii) Tier 2:
(a) Undisclosed reserves are eligible for inclusion within supplementary elements, provided these
reserves are accepted by the supervisor. Such reserves consist of that part of the accumulated after-tax surplus of retained profits, which banks in some countries may be permitted to maintain as an undisclosed reserve. Apart from the fact that the reserve is not identified in the published balance sheet, it should have the same high quality and character as a disclosed capital reserve. As such, it should not be encumbered by any provision or other known liability,
but should be freely and immediately available to meet unforeseen future losses. This definition
of undisclosed reserves excludes hidden values arising from holdings of securities in the balance sheet that are below current market prices.
(b) Revaluation reserves are included in Tier 2, and could arise in two ways. First, in some
countries, banks (and other commercial companies) are permitted to revalue fixed assets, normally their own premises, from time to time in line with the change in market values. In some of these countries, the amount of such revaluations is determined by law. Revaluations of this kind are reflected on the face of the balance sheet as a revaluation reserve. Second, hidden values of 'latent' revaluation reserves may be present as a result of long-term holdings of equity securities valued in the balance sheet at the historic cost of acquisition. Both types of revaluation reserves may be included in Tier 2, provided that the assets are prudently valued, fully reflecting the possibility of price fluctuation and forced sale. In the case of 'latent' revaluation reserves, a discount of 55 per cent will be applied to the difference between
historic cost book value and market value to reflect the potential volatility of this form of unrealised capital and the notional tax charge on it.
(c) General provisions/general loan - loss reserves (for banks using the standardised approach
for credit risk): These are provisions or loan-loss reserves held against the future. Presently, unidentified losses are freely available to meet losses, which subsequently materialise and, therefore, qualify for inclusion within supplementary elements. Provisions ascribed to identified
deterioration of particular assets or known liabilities, whether individual or grouped should be excluded. Furthermore, general provisions/general loan-loss reserves, eligible for inclusion in Tier 2, will be limited to a maximum of 1.25 percentage points of weighted risk assets.
(d) Hybrid (debt/equity) capital instruments: This includes a range of instruments which combine
characteristics of equity capital and of debt. Their precise specifications differ from country to country, but they should meet the following requirements:
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(i) Unsecured, subordinated and fully paid-up (ii) Not redeemable at the initiative of the holder or without the prior consent sf the
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supervisory authority; (iii) Available to participate in losses without the bank being obliged to cease trading
(unlike conventional subordinated debt);
(iv) Although the capital instrument may carry an obligation to pay interest that cannot permanently be reduced or waived (unlike dividends on ordinary shareholders' equity), it should allow service obligations to be deferred (as with cumulative preference shares), where the profitability of the bank would not support payment.
Cumulative preference shares, having these characteristics, would be eligible for inclusion in this category.
(e) Subordinated term debt: Includes conventional, unsecured, subordinated debt capital instruments, with a minimum original fixed term to maturity of over five years and limited life redeemable preference shares. During the last five years to maturity, a cumulative discount (or amortisation) factor of 20 per cent per year will be applied to reflect the
diminishing value of these instruments as a continuing source of strength. Unlike the hybrid debt instruments, these instruments are not normally available to participate in the losses of a bank that continues trading. For this reason, these instruments will be limited to a maximum of 50 per cent of Tier 1.
(iii) Tier 3: Short-Term Subordinated Debt Covering Market Risk: The principal form of eligible capital to cover market risks consists of shareholders' equity and retained earnings (Tier 1 capital) and supplementary capital (Tier 2 capital) as defined in the above paragraphs.
But banks may also, at the discretion of their national authority, employ a third tier of capital (Tier 3), consisting of short-term subordinated debt for the sole purpose of meeting a
proportion of the capital requirements for market risks, which is subject to the following conditions:
(a) Banks will be entitled to use Tier 3 capital solely to support market risks.
(b) Tier 3 capital will be limited to 250 per cent of a bank's Tier 1 capital that is required to
support market risks. This means that a minimum of about 28.5 per cent of market risks needs to be supported by Tier 1 capital that is not required to support risks in the remainder of the book. Tier 2 elements may be substituted for Tier 3 up to the same limit of 250 per cent insofar as the overall limits are not breached, that is to say the eligible Tier 2 capital may not exceed the total Tier 1 capital, and long-term subordinated debt may not exceed 50 per cent of Tier 1 capital.
(c) The national authorities will have the discretion to refuse the use of short-term subordinated
debt for individual banks or for their banking systems generally. In addition, it is a matter for national discretion, whether or not to apply the principle in the present framework that Tier 1 capital should represent at least half of the total eligible capital, i.e. that the sum of the total of
Tier 2 and Tier 3 capital should not exceed the total of Tier 1 capital.
For short-term subordinated debt to be eligible as Tier 3 capital, it needs, if circumstances demand, to be capable of becoming part of a bank's permanent capital and thus be available to absorb losses in the event of insolvency. It must, therefore, at a minimum:
(a) be unsecured, subordinated and fully paid-up;
(b) have an original maturity of at least two years;
(c) not be repayable before the agreed repayment date unless the supervisory authority agrees;
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(d) be subject to a lock-in clause, which stipulates that neither interest nor principal may be paid (even at maturity), if such payment means that the bank falls below or remains below its minimum capital requirement.
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Deductions from the Capital Base
From Tier 1: Goodwill and increase in equity capital, resulting from a securitisation exposure, will be deducted.
The following elements will be deducted 50 per cent from Tier 1 and 50 per cent from Tier 2 capitals:
(a) Investments in unconsolidated banking and financial subsidiary companies.
N.B.: The presumption is that this framework would be applied on a consolidated basis to banking groups.
(b) Investments in the capital of other banks and financial institutions (at the discretion of national
authorities).
(c) Significant minority investments in other financial entities. Where no deduction is applied, banks'
holdings of other banks' capital instruments will bear a weight of 100 per cent.
8.2.3 The Second Pillar - Supervisory Review Process
This 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 (stress testing, definition of default, residual risk and credit concentration risk), operational risk, enhanced cross-border communication and cooperation and securitisation.
importance of Supervisory Review
The supervisory review process of the framework is intended not only to ensure that banks have adequate capital to support all the risks in their business, but also to encourage banks to develop and use better risk management techniques in monitoring and managing their risks.
The supervisory review process recognises the responsibility of bank management in developing an internal capital assessment process and setting capital targets that are
commensurate with the bank's risk profile and control environment. In the framework, bank management continues to bear the responsibility for ensuring that the bank has adequate capital to support its risks beyond the core minimum requirements.
Supervisors are expected to evaluate how well banks are assessing their capital needs relative to their risks and to intervene, where appropriate. This interaction is intended to foster an active dialogue between banks and supervisors such that when deficiencies are identified, prompt and decisive action can be taken to reduce risk or restore capital. Accordingly, supervisors may wish to adopt an approach to focus more intensely on those banks with risk profiles or operational experience that warrants such attention.
The committee recognises the relationship that exists between the amount of capital held by the bank against its risks and the strength and effectiveness of the bank's risk management and internal control processes. Increased capital should however not be viewed as the only option for addressing increased risks confronting the bank. Other means for addressing risk, such as strengthening risk management, applying internal limits, strengthening the level of provisions and reserves and improving internal controls, must also be considered.
Furthermore, capital should not be regarded as a substitute for addressing fundamentally inadequate control or risk management processes.
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There are three main areas that might be particularly suited to treatment under Pillar 2. These are: risks considered under Pillar 1 that are not fully captured by the Pillar 1 process (e.g.
credit concentration risk); factors that are not taken into account by the Pillar 1 process (e.g.
Interest rate risk in the banking book, business and strategic risk); and factors external to the bank (e.g. business cycle effects). Another important aspect of Pillar 2 is the assessment of compliance with the minimum standards and disclosure
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requirements of the more advanced methods in Pillar 1, in particular the IRB framework for credit risk and the advanced measurement approaches for operational risk. Supervisors must ensure that these requirements are being met, both as qualifying criteria and on a continuing basis.
Four Key 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. The keystone of which is the core principles for effective banking supervision and the core principles methodology. A list of the specific guidance relating to the management of banking risks is also provided 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 banks' 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.
Specific Issues to be Addressed Under the Supervisory Review Process
The committee has identified a number of important issues that banks and supervisors should particularly focus on while carrying out the supervisory review process. These issues include some key risks which are not directly addressed under Pillar 1 and important assessments that supervisors should make to ensure the proper functioning of certain aspects of Pillar 1.
8.2.4 The Third Pillar - Market Discipline Disclosure Requirements
The committee believes that the rationale for Pillar 3 is sufficiently strong to warrant the introduction of disclosure requirements for banks using the framework. Supervisors have an array of measures that they can use to require banks to make such disclosures. Some of these
The committee believes that the rationale for Pillar 3 is sufficiently strong to warrant the introduction of disclosure requirements for banks using the framework. Supervisors have an array of measures that they can use to require banks to make such disclosures. Some of these