Regulatory Frame work for
banks – BASEL II
BASEL - GENESIS
• Herstatt Bank, Frankfurt in Germany failed on
26 June 74. Banking license was withdrawn
after close of banking hours. By then DEM
payments were received locally irrevocably.
Correspondent bank in N.Y. suspended
payments in New York. Banks which were to
receive $ funds did not get the same.
• Failure of many such banks lead to make
regulators think of uniform regulation of
banking sector across the globe.
Need for regulation
• Volume of financial flow is on the increase as
compared to trade flows
• International banking- Wide spread net work of
branches across the globe and wide spread risk.
• Different level of supervisory control
• Quality of assets
• Spate of failure of banks
• Integration of market due to globalization effect
Bank for International
• Established in 1930 to promote co operation
among central banks of member countries.
Members consist of central banks of various
• Up to 1970-focused on implementing and
defending the Bretton Woods system.
• 197o- 80 – focus on managing cross border
• 1988 – Basel I
• 1999- Basel II (Draft guidelines)
BASEL - Genesis
• Basel committee established in 1974 by
central – bank governors of G 10 countries
• Committee meets regularly four times a
• It has 25 technical working groups and
task forces which also meet regularly
BASEL - Genesis
• Committee does not possess super
national supervisory authority
• It formulates broad supervisory standards
• It recommends statements of best
• Recommendations will help countries for
convergence towards common
approaches & standards
• It is widely accepted as international
standard of best practices in banking
• To close gaps in international supervisory
• No foreign banking establishment should
• Supervision should be adequate
• To arrive at significantly more risk
sensitive capital requirements
• Due regard to supervisory & accounting
systems & Market discipline
• Discretion to adopt standards to different
conditions of national market
• First BASEL accord was accepted in 1988 and adopted
internationally in 1992
• RBI introduced BASEL norms in 1992 in phased manner and
all banks were covered by 1996.
• Objectives – ensure adequate level of capital in
the international banking system to with stand
crisis in banking sector.
• Banks to develop business volumes which is
linked to capital. That means, with out capital,
business growth is not possible. Previously, it
was not so i,.e business was not linked to
• In short , BASEL addresses both Liability and
Asset side of Balance sheet of banks.
• Parameters to measure and manage risk
via Prudential accounting norms -
• Capital adequacy
• Income recognition
• Asset classification
Capital Funds include
TIER I CAPITAL: This one can absorb losses
without a bank being required to cease
operation. This is Core Capital. Cushion for
TIER II CAPITAL: This can absorb losses in the
event of a winding up, and also provides
lesser degree of protection to depositors.
• Tier I Capital: • Tier-II Capital:
• Paid-up Share Capital • Undisclosed
• (Common Stock) Reserves
• Disclosed Free Reserves
• Assets Revaluation
• Statutory Reserve Reserves
• Capital Reserves
representing surplus • Hybrid Capital
arising out of sale proceeds Instruments
of Assets • General Provisions
& Loss Reserves
• Subordinated Debt
• Tier I Capital: • Tier II Capital:
• Deductions- • Discounts:
• Equity Investment in • Revaluation Reserves
with 55% discount
Tier II cannot exceed
• Accumulated Losses if Tier I
any • Discounts:
• Intangible Assets like • Subordinated Debt max.
Deferred Tax Assets 100% of Tier I Capital,
• Goodwill Discounted 20-80% for
Basel - I (measurement of capital)
• Minimum capital requirements
• Regulatory capital - Capital is measured on the
basis of Risk Weighted Assets (RWA). It is 8%as
per BASEL and 9% in India.
• Classified bank assets in to 4 groups which
carried respective credit risk weights of
0%,,20%,50%, & 100% based on which
minimum capital requirements to be calculated.
• E.g. cash and G-Sec @ 0%,bank borrowings @
20% and loans to others @ 50 – 100%.
• Elements of Tier I capital: The elements of Tier I capital include
• i) Paid-up capital (ordinary shares), statutory reserves, and other disclosed
free reserves, if any;
• ii) Perpetual Non-cumulative Preference Shares (PNCPS) eligible for
inclusion as Tier I capital - subject to laws in force from time to time;
• iii) Innovative Perpetual Debt Instruments (IPDI) eligible for inclusion as Tier
I capital; and
• iv) Capital reserves representing surplus arising out of sale proceeds of
• Elements of Tier II capital: The elements of Tier II capital include
undisclosed reserves, revaluation reserves, general provisions and loss
reserves, hybrid capital instruments, subordinated debt and investment
reserve account .
• Undisclosed reserves
They can be included in capital, if they represent accumulations of post-tax
profits and are not encumbered by any known liability and should not be
routinely used for absorbing normal loss or operating losses. .
RBI- Procedure for computation of CRAR
• 2.4.1. While calculating the aggregate of funded and non-funded
exposure of a borrower for the purpose of assignment of risk weight,
banks may „net-off‟ against the total outstanding exposure of the
• (a) advances collateralised by cash margins or deposits,
• (b) credit balances in current or other accounts which are not
earmarked for specific purposes and free from any lien,
• (c) in respect of any assets where provisions for depreciation or for
bad debts have been made
• (d) claims received from DICGC/ ECGC and kept in a separate
account pending adjustment, and
• (e) subsidies received against advances in respect of Government
sponsored schemes and kept in a separate account.
• Total capital /(Tier 1 + Tier 2)/ Total RWA
• For Indian banks , it is 9%.
RISK Weighted Assets(RWA)
• RWA determined by multiplying the asset
with risk factor
• E.g. loans to a bank Re 100. RWA @
20%. Capital requirement will be 100 X
20% X 8% = Re 1.6.
• Banks to hold capital equal to 8% of R.W.
Assets. In India RBI prescribed CAR of
RW % for Assets
ASSET RW %
Cash & bal with RBI 0
CD with other banks 20
Loans to corporates etc 100
Staff advances 20
CGF/FD/LIC policy/NSC 0
RW % for Assets
ASSET RW %
Govt.guaranteed sec of PSU 22.5
Loans to PSU 100
Sub.ord. Bonds of PSU/Bks 102
Commercial real estate 150
Adv.covered by ECGC 50
SSIadv.gua.by CGST 0
Venture capital 150
Other Assets 100
Risk Weights for Assets
Credit Off- Balance Sheet items
100% Financial guarantees, LCs, acceptances (Endorsements), Sale and
Purchase agreement and asset sales with recourse, where credit
risk remains with the Bank.
50% Performance guarantee, L/Cs related to particular transaction,
other commitments (formal stand-by facilities and credit lines- over
one year- if maturity Basel Committee within one year and can be
cancelled at any time- Credit conversion factor – 0)
20% Short term self liquidating trade related contingencies
2% Aggregate outstanding foreign exchange contracts of original
maturity-less than one year (for each additional year or part thereof
3%. If original maturity is less than 14 days irrespective of counter
party RWA will be 0%
Computation of Risk
S. Details of Assets Book Risk Weight Risk weighted
No. Value (%) Assets
1 Cash & balances with RBI 200 0 0
2 Bank balances 200 20 40
Government 300 0 0
Banks 0 20 0
Others 200 100 200
4 Advances (net) 2000 100 2000
5 Other Assets 300 100 300
6 Total Assets 3200
7 Total RWAs 2540
• Interest income not to be recognized until
it is realized. Accrual system to actuals.
• One quarter default for recognizing income
• Either installment or interest or both
• Borrower wise and not Facility wise
• Out of order – applicable to cash /overdraft
Non performing Assets
1 An asset, including a leased asset, becomes non performing when it ceases
to generate income for the bank.
A non performing asset (NPA) is a loan or an advance where;
i. interest and/ or installment of principal remain overdue for a period of
more than 90 days in respect of a term loan,
ii. the account remains „out of order‟ as indicated below, in
respect of an Overdraft/Cash Credit (OD/CC),
iii. the bill remains overdue for a period of more than
90 days in the case of bills purchased and discounted,
iv. the installment of principal or interest thereon remains overdue for two
crop seasons for short duration crops,
v. the installment of principal or interest thereon remains overdue for one
crop season for long duration crops,
vi. the amount of liquidity facility remains outstanding for more than 90 days,
in respect of a securitisation transaction undertaken in terms of
guidelines on securitisation dated February 1, 2006.
Banks should, classify an account as NPA only if the interest charged during
any quarter is not serviced fully within 90 days from the end of the quarter.
• Standard asset – servicing of int. &
principal. Normal risk.
• Sub-Standard – NPA for a period up to 12
months. Asset coverage / net worth of
borrower not enough to cover the loan
• Doubtful asset –age of NPA is more than
• Loss Assets – no chance of recovery -
• Loss Assts – 100% of out standing amount
• Doubtful Assets –100% of unsecured,20 to 100% (
1 to >3 years)
• Substandard Asset -10% on the outstanding
• Standard asset –
a) Agricuture/SME- 0.25%
b) Personal loans, stockmarket, commercial real
estate & Non deposit taking NBFC – 2%
c) Others – 0.40%
• 1999 – New Capital Adequacy Frame work –BASEL II
• 2004 – BIS brought out BASEL II Accord( International
Convergence of Capital Measurement and Capital
Standards – A Revised Frame work)
• RBI issued detailed guidelines on 15.02.05 followed by
circular dated 20TH March, 2006.
• Expected to in in place by March,2008 for
internationally active banks like SBI, BOB, ICICI etc & for
others 2009 in India.
* Parallel run already started from April 2006
Why BASEL II ?
• One size fit approach to be replaced by a
menu of options for banks to choose
• More risk sensitive to en compass all risks
especially operational risk.
• To bridge the cap between Regulatory &
• BASEL I did not address risk mitigation
techniques such as collateral, guarantees
• More emphasis on banks‟ internal control
• More disclosure through market discipline
Basel II: New Capital Adequacy
• In June 2004, Central Bank governors in
the G-10 countries endorsed the
publication of International Convergence
of Capital Measurement and Capital
Standards, commonly known as Basel II
• The new accord is making capital
allocation of banks more risk-sensitive.
Objectives of Basel II
• To encourage better and more systematic risk
management practices, especially in the area of credit
risk and to provide improved measure of capital
• Introduction of Basel II has given incentives to many of
the best practices banks, to adopt better risk
management techniques and to evaluate their
performance relative to market expectations and relative
• The new framework proposes a significant refinement of
regulatory and supervisory practice and encourages
increased attention to risk management practices.
Minimum Capital Requirements – Pillar 1
Capital: fundamental thing worth having
Minimum capital requirements –
Regulatory and Economic capital
Minimum Capital Requirements
Supervisory Review Process
Supervisory review process –
trancsaction based to risk based
Market discipline – risk exposure,
migration assets from standard to
Pillar I Pillar II Pillar III
Minimum capital Supervisory review Market discipline
1. Capital for credit risk 1. Evaluate risk 1.Enhance
standardized/Internal 2. Ensure soundness & disclosures
ratings based integrity of banks‟ 2.Core disclosures &
approach – internal process to supplementary
Foundation/Advanced assess the adequacy disclosures
2. Capital for mkt.risk – of capital 3.Period – semi
Standardized method – 3. Ensure maintenance annual.
maturity / duration of minimum capital
method. with PCA for short
3. Capitla for Opr.risk – fall.
basic 4. Prescribe differential
indicator/standardized/ capital , where
advanced necessary i.e. where
measurement internal process is
• It measures operational risk also as
against regulatory capital which measures
only credit & Market risk.
• Operational is the risk of direct or indirect
loss resulting from inadequate or failed
internal processes, people, & systems or
from external events
• Risk assessment either by standardized
or internal rating based approach
• Minimum Capital requirements:
• Credit Risk:
- Standardized approach
- Internal Rating Based Approach
(Foundation IRB/Advanced IRB)
• Operation Risk:
- Basic Indicator Approach
- Standardized approach
- Advanced Measurement Approach
• Market Risk: Market Risk: VaR models for Trading
Book (AFS + HFT) and EaR models for Banking
ON-BALANCE-SHEET = 8%
CREDIT RISK =9% in India
Off-balance-sheet credit risk
• Economic capital is the capital required to
cover credit, market and operational risks of
• Economic Capital = Credit Risk Capital +
market risk capital + operational risk capital
• The economic capital required to support the
activities of a bank can be arrived at in a
number of ways for different types of risks
• Key Changes:
• Wider spectrum of credit risk weights.
• Greater recognition of collaterals.
• More refined treatment of securitisation.
• Charge for Operational Risk introduced
• Standardized Approach
• Foundation Internal Rating Based Approach
• Advanced Internal Rating Based Approach
All commercial banks in India shall adopt
Standardized Approach (SA) for credit risk to
start with. Banks are required to obtain the prior
approval of the RBI to migrate to the Internal
Rating Based Approach.
Credit Risk Mitigation
• In order to obtain relief for use of CRM
techniques, proper documentation used in
collateralized transactions must be binding on all
parties and legally enforceable.
• Banks in India can adopt Comprehensive
approach, which allows fuller offset of collateral
against exposures by the value ascribed to the
• Under this approach, banks which take eligible
financial collateral are allowed to reduce their
credit exposure to a counter party to take
account of the risk mitigating effect.
• The following collateral instruments are eligible
for recognition in comprehensive approach:
Cash, Gold, Securities issued by Central/ State
Governments, IVPs, KVPs, NSCs, LIC policies,
Debt securities, equities etc.,
• In case of NPAs, other collaterals viz., land and
building, plant and machinery will be recognized
for assigning lesser risk weight of 100%, when
provisions reach 15%, only where the bank is
having clear title and the valuation is not more
than 3 years old and value of machinery not
higher than the depreciated value.
• Long term ratings of credit rating agencies under
Standardized approach risk weights:
- AAA 20%
- AA 30%
- BBB 100%
- BB & below 150%
- Un rated 100%
Other Risk Weights
• Exposures to Central Govt.& Inv.in St.Govt 0%
• Exposures guaranteed by State Govt 20%
• Exposures on RBI/DICGC/CGTSI 0%
• Exposures on ECGC 50%
• Staff loans secured by superannuation benefits 20%
• Claims on Multilateral Development Banks 20%
• Claims on Banks (based on CRAR of Bank) 20%-625%
• Claims on Corporates(based on ext.rating) 20%-150%
• Unrated claims in excess of Rs.10 cr 150%
• Claims on Commercial Real Estate 150%
• Consumer credit/personal loans/credit cards 125%
• Claims on restructured/rescheduled a/cs 125%*
• *(till satisfactory performance of one year from the date when
• the first payment of interest/instalment falls due)
External Credit Assessments
• RBI has identified the following domestic
credit rating agencies for the purposes of
risk weighting the claims for capital
a)Credit Analysis and Research Ltd.,
c)FITCH Ratings and
• Banks must disclose the names of the credit rating
agencies that They use for the risk weighting of their
• The rating should be in force and confirmed from the
monthly bulletin of the concerned rating agency. The
rating agency should have reviewed the rating at
least once during the previous 15 months.
• An eligible credit assessment must be publicly
• Even though CC accounts are sanctioned for period
one year or less, these exposures should be reckoned
as long term exposures and accordingly long term
ratings accorded by agencies will be relevant.
• Presently all loans above Re 10 crores will be rated by
outside credit rating agencies under standardized
What is operational risk ?
• Operational - risk of direct or indirect loss
resulting from inadequate or failed internal
processes, people, & systems or from
external events. E.g. fraud, forgery,
negligence, system failure etc.
• Risk assessment either by standardized or
internal rating based approach
• Basel II framework outlines 3 methods for
calculating operational risk capital charge.
- Basic Indicator Approach
- The Standardized Approach
- Advanced Measurement Approach
To begin with banks are required to adopt Basic
Indicator Approach for capital charge under
• Banks are required to provide 15% of average gross
income of the previous three years for which gross
income is positive.
Standardized Approach for Operational Risk
• Under Standardized approach, Bank‟s activities would
be divided into 8 business lines as under:
• Corporate finance, Trading, Retail banking, Commercial
Banking, Payment & settlement, Agency services, Asset
Management and Retail brokerage.
• Under each business line, capital charge is calculated by
multiplying the beta factor assigned to that business line.
Gross income is calculated for each business line and
not for Bank as a whole.
• Under Advanced Measurement Approach, regulatory
capital will equal the risk capital measured by Bank‟s
internal risk measurement.
Measuring operational risk
• Standardized approach – capital charge
against each business to be provided on the
basis of annual average income for 3 years.
• Advanced Measurement Approach –
measured by bank‟s internal risk
measurement system using quantitative and
Risk Based Supervision
• Present audit focuses on transaction testing –
accuracy & reliability of records, financial
reports, adherence to legal & regulatory
• RBS – focus on testing of risk in each
transaction, evaluation of effectiveness risk
management & controls, periodicity of audit,
inherent risks in various activities of institution,
prioritization of audit areas, allocation of audit
• In short, it is a migration form transaction to risk
Pillar II: Supervisory Review
• Banks should have Internal Capital Adequacy
• Supervisor should verify maintenance of minimum
capital requirements by banks.
• Supervisor would take appropriate action if they are
not satisfied with the Bank‟s minimum capital.
• ICAAP should faithfully capture the risks attached in
the bank‟s portfolio.
• Supervisor may take early supervisory action by
asking bank to maintain additional capital.
Pillar III: Market Discipline
• To enable the market to understand the strengths and
weaknesses of the Bank.
• To encourage market discipline by developing a set of
disclosure requirements which allow market participants
to assess key pieces of information on capital, risk
exposure, risk assessment process.
• Providing disclosures that are based on a common
framework is an effective means of informing the market
about a bank‟s exposure to those risks and provides a
comprehensive disclosure framework that enhances
• Board approved policy for disclosures.
• Financial position and performance.
• Risk management strategies and practices.
• Risk exposures.
• Accounting policies.
• Basic business, management and corporate
Market Discipline- Disclosure
• Transparency & more disclosure
• Calculation of capital adequacy
• Risk exposure to sensitive sectors
• Migration of SA to NPA
• Risk assessment methods
• Incentive for improved risk analysis and
pricing of risks.
• Better internal capital management
• Improvement in credit portfolio quality and
better recognition of risk mitigation.
• Control orientation to strategic advantage.
Current directives of RBI
• RBI issued draft guidelines on implemen-tation of Basel
II in India on 15th Feb 05.
• RBI issued revised draft guidelines on Basel II norms on
20th March 2006.
• As per revised guidelines, all Banks in India having
presence outside India will adopt Standardized
approach for credit risk and Basic Indicator Approach
for operational risk w.e.f. 31.03.08 and all other banks
not later than 31.03.09.
• RBI further stated that banks are required to commence
a parallel run of the revised framework and Boards of
the banks should review the results of parallel run on
Implementation - issues
• Banks by manipulating credit risk measurement,
may reduce CAR. Non deliberate under
estimation also may lead to lower CAR.
• Competition among banks for high quality
loans/customers may exert pressure on interest
• Burden of approving internal risk models. It will
lead to regulators identifying them selves the
banks they supervise. It will come difficult not to
bail out of a large problem since supervisors have
validated and approved of internal rating system
of bank facing financial crisis.
Implementation - issues
• Non availability of data over longer time horizon
to measure risk based on historical data.
• Too much disclosure may cause information
over load and may create problem to the
respective bank vis-à-vis competitors.
• RBI may enforce to have a uniform credit
rating approach to measure capital
requirement since credit rating is a yard stick
for capital provisioning .
• Technological up gradation involves huge
capital requirement but return may not
match. Smaller banks may suffer.
• Low penetration of credit rating and it has got
• Social obligation of public sector banks.
It would be a mistake to conclude that
the only way to succeed in banking is
through ever greater size and diversity.
Indeed better risk management may be
the only truly necessary element of
success in banking.
Former Chairman, Federal Reserve
October 5, 2004
Michael E.O‟Neill on SWM (Share
Holder‟s Maximization of Wealth)
• The highest potential for increasing
shareholder value is improving the way
allocate capital to businesses,
(including) taking away capital from
businesses that are not achieving return
CFO, Bank of America
Peter Drucker on SWM
• “What we generally call profits, the
money left to service equity,
is usually not profits at all. Until a
business returns a profit that is greater
than the cost of capital, it operates at a
What is Basel II?
China Banking Regulatory Commission-
“To a large extent we are convinced that
Basel II is more about risk management
than capital regulation, particularly for the