IMPLEMENTATION OF BASEL CAPITAL REQUIREMENTS IN INDIA

1. IMPLEMENTATION OF BASEL CAPITAL REQUIREMENTS IN INDIA PRESENTATION BY CA. P.K. AGRAWAL 24TH January 2014

2. INTERNATIONAL REGULATION- Progression • 1988 : Basel Accord (Basel-I) • 1993 Proposal: Standard Model • 1996 Modification: Internal Model • New Basel Accord (Basel-II) • Revised New Accord (Basel-III)

3. BANK SAFETY AND SOUNDNESS • The purpose of prescribing Capital adequacy requirements - Capital serves as a backbone for every Industry. It provides for a buffer against bank losses - It provides protection to its creditors in the event of bank fails • Providing adequate capital serves as a disincentive for excessive risk taking.

4. IMPLEMENTATION OF CAPITAL ADEQUACY IN INDIA • The Revised Framework provides a range of options for determining the capital requirements for credit risk and operational risk so as to allow banks and supervisors to select approaches that are most appropriate for their operations and financial markets.

5. 1988 BASEL ACCORD (BASEL-I) The first Basel Accord (Basel-I) was completed in 1988 : 1)The purpose was to prevent international banks from building business volume without adequate capital backing 2) The focus was on Credit Risk 3) Sets minimum capital standards for banks 4) Became effective at the end of 1992 5)Basel-I was hailed for incorporating risk into the calculation of capital requirements

6. WHY BASEL-I WAS NEEDED? The reason was to create a level playing field for “Internationally active Banks” • Banks from different countries competing for the same loans would have to set aside roughly the same amount of capital on the loans

7. “CAPITAL ADEQUACY ” RATIO • Capital adequacy ratio is also called as “Cooke Ratio. • It has been named after Mr. Peter Cooke (Bank of England), the Chairman of the Basel committee) • Cooke Ratio=Capital/ Risk Weighted Assets≥8%, i.e., Capital Adequacy Ratio • Definition of Capital Capital= Core Capital + Supplementary Capital - Deductions

8. BASEL-I CAPITAL REQIREMENTS • Capital was set at 8% and was adjusted by a loan’s credit risk weights • Credit risk was divided into different categories: 0% to 125% respectively • Commercial loans, for example, were assigned to the 100% risk weight category

9. CALCULATION OF REQUIRED CAPITAL • To calculate required capital, a bank would multiply the assets in each risk category by the category’s risk weight and then multiply the result by 8% • Thus a Commercial Loan for Rs. 100.00, would attract 100% risk weight and is to be multiplied by 100% and then by 8%, resulting in a capital requirement of Rs. 8.00

10. CORE & SUPPLEMENTARY CAPITAL • Core Capital (Tier I Capital) i) Paid Up Capital ii) Disclosed Reserves (General and Legal Reserves) • Supplementary Capital (Tier II Capital): i) General Loan-loss Provisions (Restricted to 1.25% of RWA) ii) Undisclosed Reserves (other provisions against probable losses) iii) Asset Revaluation Reserves iv) Subordinated Term Debt (5+ years maturity) v) Hybrid (debt/equity) instruments Tier II Capital would be restricted to 100% of the Tier I Capital.

11. DEDUCTIONS FROM THE CAPITAL • Investments in unconsolidated banking and financial subsidiary companies and investments in the capital of other banks & financial institutions • Goodwill, Intangible Assets and Deferred tax Assets.

12. DEFINITION OF CAPITAL IN BASEL-I(1) TIER 1 • Paid-up share capital/common stock • Disclosed reserves (legal reserves, surplus and/or retained profits)

13. DEFINITION OF CAPITAL IN BASEL-I(2) TIER 2 • Undisclosed reserves (bank has made a profit but this has not appeared in normal retained profits or in general reserves of the bank.) • Asset revaluation reserves (when a company has an asset revalued and an increase in value is brought to account) • General Provisions (created when a company is aware that a loss may have occurred but is not sure of the exact nature of that loss) /General loan-loss reserves • Hybrid debt/equity instruments (such as preferred stock) • Subordinated debt

14. RISK WEIGHT CATEGORIES IN BASEL-I (1) 0% Risk Weightage • Cash, Balances with RBI • Investments in Govt. Securities, Investments in other approved securities guaranteed by Central/ State Governments. • Investments in other securities where payment of interest and repayment of principal are guaranteed by Central Govt. (This includes instruments such as Indira/Kisan Vikas Patra (IVP/KVP) and investments in Bonds and Debentures, where payment of interest and principal is guaranteed by Central Govt.) • However, where Government Guaranteed securities have remained in default for a period exceeding 90 days, banks should assign 100% risk weight. However, the banks need to assign 100% risk weight only on those State Government guaranteed securities issued by the defaulting entities and not on all the securities issued or guaranteed by that State Government.

15. RISK WEIGHT CATEGORIES IN BASEL-I (2) 20% Risk Weightage • Balances in current account with other banks , Claims on Commercial Banks • Investments in other approved securities where payment of interest and repayment of principal are not guaranteed by Central/State Governments • Investments in bonds issued by other banks • Investments in securities which are guaranteed by banks as to payment of interest and repayment of principal.

16. RISK WEIGHT CATEGORIES IN BASEL-I (3) 50 % Risk Weightage • Investment in Mortgage Backed Securities (MBS) of residential assets of Housing Finance Companies (HFCs), which are recognised and supervised by National Housing Bank • Investment in Mortgage Backed Securities (MBS), which are backed by housing loan qualifying for 50% risk weight • Investment in securitised paper pertaining to an infrastructure facility. • Loans up to Rs. 1 lakh against gold and silver ornaments • Advances covered by DICGC/ECGC

17. RISK WEIGHT CATEGORIES IN BASEL-I (4) 100% Risk Weight • Investments in subordinated debt instruments and bonds issued by other banks or Public Financial Institutions for their Tier II capital • Deposits placed with SIDBI/NABARD in lieu of shortfall in lending to priority sector. • Investments in debentures/ bonds/ security receipts/ Pass Through Certificates issued by Securitisation Company/ SPVs/ Reconstruction Company and held by banks as investment • All other investments including investments in securities issued by PFIs. • NPA Investment purchased from other banks • Premises, plant and equipment and other fixed assets

18. RISK WEIGHT CATEGORIES IN BASEL-I (5) 125% Risk Weightage • Direct investment in equity shares, convertible bonds, debentures and units of equity oriented mutual funds including those exempted from Capital Market Exposure • Housing loans of Rs. 75 lakh and above sanctioned to individuals • Consumer credit including personal loans and credit cards • Capital Market Exposures

19. RISK WEIGHT CATEGORIES IN BASEL-I (6) Off-Balance Sheet items • The credit risk exposure attached to off-Balance Sheet items has to be first calculated by multiplying the face value of each of the off-Balance Sheet items by ‘credit conversion factors. This will then have to be again multiplied by the weights attributable to the relevant counter-party . • The credit conversion factors range from 20% to 100% depending upon the type and nature of the off balance sheet item.

20. CRITIQUE OF BASEL-I Basel-I accord was criticized i) for taking a too simplistic approach to setting credit risk weights and ii) for ignoring other types of risk

21. THE PROBLEM WITH THE RISK WEIGHTS • Risk weights were based on what the parties to the Accord negotiated rather than on the actual risk of each asset • Risk weights did not flow from any particular insolvency probability standard, and were for the most part, arbitrary.

22. OPERATIONAL AND OTHER RISKS • The requirements did not explicitly account for operating and other forms of risk that may also be important • Except for trading account activities, the capital standards did not account for hedging, diversification, and differences in risk management techniques

23. 1993 PROPOSAL: STANDARD MODEL • Total Risk= Credit Risk+ Market Risk • Market Risk= General Market Risk+ Specific Risk • General Market Risk= Interest Rate Risk+ Currency Risk+ Equity Price Risk+Commodity Price Risk • Specific Risk= Instruments Exposed to Interest Rate Risk and Equity Price Risk

24. 1996 MODIFICATION: INTERNAL MODEL • Internal Model→Value at Risk Methodology • Tier III Capital (Only for Market Risk) i) Long Term subordinated debt ii) Option not to pay if minimum required capital is <8%

25. BANKS’ OWN CAPITAL ALLOCATION MODELS • Advances in technology and finance allowed banks to develop their own capital allocation (internal) models in the 1990’s • This resulted in more accurate calculations of bank capital than possible under Basel-I • These models allowed banks to align the amount of risk they undertook on a loan with the overall goals of the bank

26. INTERNAL MODELS AND BASEL I • Internal models allow banks to more finely differentiate risks of individual loans than is possible under Basel-I • Risk can be differentiated within loan categories and between loan categories • Allows the application of a “capital charge” to each loan, rather than each category of loan

27. VARIATION IN RISK QUALITY • Banks discovered a wide variation in credit quality within risk-weight categories • Basel-I sums all commercial loans into the 8% capital category • Internal models calculations can lead to capital allocations on commercial loans that varies (from 1% to 30%) depending on the loan’s estimated risk

28. BASEL-II

29. NEW APPRACH TO RISK-BASED CAPITAL • By the late 1990s, growth in the use of regulatory capital arbitrage led the Basel Committee to begin work on a new capital regime (Basel-II) • Effort focused on using banks’ internal rating models and internal risk models • June 1999: Committee issued a proposal for a new capital adequacy framework to replace the 1998 Accord

30. Basel I to Basel II • Minimum capital requirements → 3 Pillars • New credit risk approaches • Market risk - unchanged • Add operational risk portion

31. The Basel II Framework • Credit Risk • Market Risk • Operational Risk Pillar 1: Minimum capital requirements • A guiding principle for banking supervision • Disclosure requirements Pillar 2: Supervisory review Pillar 3: Market discipline

32. Pillar 1: Minimum Capital Requirements • The calculation of regulatory minimum capital requirements:

33. Pillar 2: Supervisory Review • Principle 1: Banks should have a process for assessing and maintaining their overall capital adequacy. • Principle 2: Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies.

34. Pillar 3: Market Discipline • The purpose of pillar three is to complement the pillar one and pillar two. • Develop a set of disclosure requirements to allow market participants to assess information about a bank’s risk profile and level of capitalization.

35. Calculation of Capital Tier One Capital • the ordinary share capital (or equity) of the bank; and • audited revenue reserves e.g.. retained earnings; less • current year's losses; • future tax benefits; and • intangible assets, e.g., goodwill.

36. Calculation of Capital Lower Tier Two Capital • Subordinated debt with a term of at least 5 years; • Sedeemable preference shares which may not be redeemed for at least 5 years.

37. Total Capital This is the sum of tier 1 and tier 2 capital less the following deductions: • equity investments in subsidiaries; • shareholdings in other banks that exceed 10 percent of that bank's capital; • unrealized revaluation losses on securities holdings.

38. Calculation of Capital Upper Tier Two Capital • Un-audited retained earnings; • revaluation reserves; • general provisions for bad debts; • perpetual cumulative preference shares (i.e. preference shares with no maturity date whose dividends accrue for future payment even if the bank's financial condition does not support immediate payment); • perpetual subordinated debt (i.e. debt with no maturity date which ranks in priority behind all creditors except shareholders).

39. The Capital and Assets Definition of capital: • Tier 1 capital + Tier 2 capital + adjustments Total risk-weighted assets are determined by: • multiplying the capital requirements for market risk and operational risk by 12.5 • and adding the resulting figures to the sum of risk-weighted assets for credit risk.

40. BASEL-II Basel-II consists of three pillars: • Minimum capital requirements for credit risk, market risk and operational risk—expanding the 1988 Accord (Pillar I) • Supervisory review of an institution’s capital adequacy and internal assessment process (Pillar II) • Effective use of market discipline as a lever to strengthen disclosure and encourage safe and sound banking practices (Pillar III)

41. IMPLEMENTATION OF THE BASEL II ACCORD • Implementation of the Basel II Framework continues to move forward around the globe. A significant number of countries and banks have already implemented the standardized and foundation approaches as of the beginning of 2007. • In many other jurisdictions, the necessary infrastructure (legislation, regulation, supervisory guidance, etc) to implement the Framework is either in place or in process, which will allow a growing number of countries to proceed with implementation of Basel II’s advanced approaches in 2008 and 2009. • This progress is taking place in both Basel Committee member and non-member countries.

42. BASEL-II (1) Minimum Capital Requirement (MCR)

43. BASEL-II (2) PILLAR I: Minimum Capital Requirement • Capital Measurement: New Methods • Market Risk: In Line with 1993 & 1996 proposals • Operational Risk: Working on new methods

44. BASEL-II (3) Pillar I is trying to achieve • If the bank’s own internal calculations show that they have extremely risky, loss-prone loans that generate high internal capital charges, their formal risk-based capital charges should also be high • Likewise, lower risk loans should carry lower risk-based capital charges

45. BASEL-II (4) Credit Risk Measurement 1) Standard Method: Using external rating for determining risk weights 2) Internal Ratings Method (IRB) a) Basic IRB: Bank computes only the probability of default b) Advanced IRB: Bank computes all risk components (except effective maturity)

46. BASEL-II (5) Operational Risk Measurement 1) Basic Indicator Approach 2) Standard Approach 3) Internal Measurement Approach

47. BASEL-II (6) • Pillar I also adds a new capital component for operational risk • Operational risk covers the risk of loss due to system breakdowns, employee fraud or misconduct, errors in models or natural or man-made catastrophes, among others

48. BASEL-II (7) PILLAR 2: Supervisory Review Process • Banks are advised to develop an internal capital assessment process and set targets for capital to commensurate with the bank’s risk profile • Supervisory authority is responsible for evaluating how well banks are assessing their capital adequacy

49. BASEL-II (8) PILLAR 3:Market Discipline Aims to reinforce market discipline through enhanced disclosure by banks. It is an indirect approach, that assumes sufficient competition within the banking sector.

50. ASSESSING BASEL-II • To determine if the proposed rules are likely to yield reasonable risk-based capital requirements within and between countries for banks with similar portfolios, four quantitative impact studies (QIS) have been undertaken