Management of banks

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Contents
International Settlements .......................................................................................................... 3 History of Formation of Basel Accords ...................................................................................... 3 Basel I ......................................................................................................................................... 4 The Purpose of Basel I............................................................................................................ 4 Two-Tiered Capital ................................................................................................................. 4 Market risk ............................................................................................................................. 5 Pitfalls of Basel I ..................................................................................................................... 5 Conclusion .............................................................................................................................. 5 Basel II ........................................................................................................................................ 6 Basel II Is Complicated ........................................................................................................... 6 Basel II is Three Pillars ............................................................................................................ 6 Basel Guidelines ..................................................................................................................... 7 How bankers interpreted Basel II? ........................................................................................ 7 Pitfalls of Basel II .................................................................................................................... 8 Basel II and the 2008 crisis ..................................................................................................... 9 Corrections to Basel II ............................................................................................................ 9 Problems with this design ...................................................................................................... 9 Basel III ..................................................................................................................................... 10 RBI on Basel III norms .......................................................................................................... 10 Comparison of Basel II and III .............................................................................................. 11 How much will Indian banks need to comply with BASEL III guidelines? ............................ 11 Shortcomings of Basel III ...................................................................................................... 12 Conclusion ................................................................................................................................ 12 References ........................................................................................................................... 1313

International Settlements
It is an international organization with a mission of helping central banks across the world in pursuing monetary and financial stability. It is considered to be a bank for central banks. Its head office is located in Basel, Switzerland. The mission of the Bank for International Settlements (BIS) is to serve central banks in their pursuit of monetary and financial stability, to foster international cooperation in those areas and to act as a bank for central banks. In broad outline, the BIS pursue its mission by: 1. Promoting discussion and facilitating collaboration among central banks; 2. Supporting dialogue with other authorities that are responsible for promoting financial stability; 3. Conducting research on policy issues confronting central banks and financial supervisory authorities; 4. Acting as a prime counterparty for central banks in their financial transactions; and 5. Serving as an agent or trustee in connection with international financial operations. The head office is in Basel, Switzerland and there are two representative offices: in the Hong Kong Special Administrative Region of the People's Republic of China and in Mexico City. Established on 17 May 1930, the BIS is the world's oldest international financial organization.

History of Formation of Basel Accords
From 1965 to 1981 there were about eight bank failures (or bankruptcies) in the United States. Bank failures were particularly prominent during the '80s, a time which is usually referred to as the "savings and loan crisis." Banks throughout the world were lending extensively, while countries' external indebtedness was growing at an unsustainable rate. As a result, the potential for the bankruptcy of the major international banks because grew as a result of low security. In order to prevent this risk, the Basel Committee on Banking Supervision, comprised of central banks and supervisory authorities of 10 countries, met in 1987in Basel,Switzerland. The committee drafted a first document to set up an international 'minimum' amount of capital that banks should hold. This minimum is a percentage of the total capital of a bank, which is also called the minimum risk-based capital adequacy. In 1988, the Basel I Capital Accord (agreement) was created. The Basel II Capital Accord follows as an extension of the former, and was implemented in 2007.

Basel I
The Purpose of Basel I
In 1988, the Basel I Capital Accord was created. The general purpose was to: 1. Strengthen the stability of international banking system. 2. Set up a fair and a consistent international banking system in order to decrease competitive inequality among international banks. The basic achievement of Basel I have been to define bank capital and the so-called bank capital ratio. In order to set up a minimum risk-based capital adequacy applying to all banks and governments in the world, a general definition of capital was required. Indeed, before this international agreement, there was no single definition of bank capital. The first step of the agreement was thus to define it.

Two-Tiered Capital
Basel I defines capital based on two tiers: 1. Tier 1 (Core Capital): Tier 1 capital includes stock issues (or share holders equity) and declared reserves, such as loan loss reserves set aside to cushion future losses or for smoothing out income variations. 2. Tier 2 (Supplementary Capital): Tier 2 capital includes all other capital such as gains on investment assets, long-term debt with maturity greater than five years and hidden reserves (i.e. excess allowance for losses on loans and leases). However, short-term unsecured debts (or debts without guarantees), are not included in the definition of capital.

Credit Risk is defined as the risk weighted asset (RWA) of the bank, which are banks
assets weighted in relation to their relative credit risk levels. According to Basel I, the total capital should represent at least 8% of the bank's credit risk (RWA). In addition, the Basel agreement identifies three types of credit risks: The on-balance sheet risk. The trading off-balance sheet risk. These are derivatives, namely interest rates, foreign exchange, equity derivatives and commodities. The non-trading off-balance sheet risk. These include general guarantees, such as forward purchase of assets or transaction-related debt assets. As per Basel I norms, 5 risk categories were identified a. Cash, central bank, Government debt b. Public sector debt c. Development bank debt, non OECD bank debt, non OECD public sector debt

d. Residential mortgages e. Private sector debt, real estate, plant equipment

Market risk includes general market risk and specific risk. The general market risk
refers to changes in the market values due to large market movements. Specific risk refers to changes in the value of an individual asset due to factors related to the issuer of the security. There are four types of economic variables that generate market risk. These are interest rates, foreign exchanges, equities and commodities. The market risk can be calculated in two different manners: either with the standardized Basel model or with internal value at risk (VaR) models of the banks. These internal models can only be used by the largest banks that satisfy qualitative and quantitative standards imposed by the Basel agreement. Moreover, the 1996 revision also adds the possibility of a third tier for the total capital, which includes short-term unsecured debts. This is at the discretion of the central banks.

Pitfalls of Basel I
Basel I Capital Accord has been criticized on several grounds. The main criticisms include the following: 1. Static measurement of default risk at 8% ignoring default probability of different players 2. The capital charges are set at same levels regardless of maturity of credit exposure 3. Limited differentiation of credit risk into 5 categories and 4 risk weightings 4. Capital requirements ignore currency and macroeconomic risks

Conclusion
The Basel I Capital Accord aimed to assess capital in relation to credit risk, or the risk that a loss will occur if a party does not fulfill its obligations. It launched the trend toward increasing risk modeling research; however, its over-simplified calculations, and classifications have simultaneously called for its disappearance, paving the way for the Basel II Capital Accord and further agreements as the symbol of the continuous refinement of risk and capital. Nevertheless, Basel I, as the first international instrument assessing the importance of risk in relation to capital, will remain a milestone in the finance and banking history.

Basel II
Basel II Is Complicated
The new accord is called Basel II. Its goal is to better align the required regulatory capital with actual bank risk. This makes it vastly more complex than the original accord. Basel II has multiple approaches for different types of risk. It has multiple approaches for securitization and for credit risk mitigants (such as collateral).

Basel II is Three Pillars
Basel II has three pillars: minimum capital, supervisor review and market discipline.

Minimum Capital is the technical, quantitative heart of the accord. Banks must hold capital against 8% of their assets, after adjusting their assets for risk. Supervisor review is the process whereby national regulators ensure their home country banks are following the rules. If minimum capital is the rulebook, the second pillar is the referee system. Market discipline is based on enhanced disclosure of risk. This may be an important pillar due to the complexity of Basel. Under Basel II, banks may use their own internal models (and gain lower capital requirements) but the price of this is transparency.

Basel II Charges for Three Risks
The accord recognizes three big risk buckets: credit risk, market risk and operational risk. In other words, a bank must hold capital against all three types of risks. A charge for market risk was introduced in 1998. The charge for operational risk is new and controversial because it is hard to define, not to mention quantify, operational risk (The basic approach uses a bank's gross income as a proxy for operational risk. It is not hard to challenge this idea.)

Basel Guidelines

Original Basel Accord Applies to all internationally active banks and on a consolidated basis to majorityowned or controlled banking entities, securities entities and financial entities, not including insurance. The total capital ratio must be no lower than 8%. Banks have been permitted to adopt the Standardized method, Internal Rating Based or Advanced Measurement Approach

RBI Guidelines Applies to all scheduled commercial banks both at solo and consolidated level and group entities, which include a licensed bank. Banks are required to maintain a minimum capital to Risk-weighted assets ratio (CRAR) of 9% on an ongoing basis. Banks mandated to use Standardized Approach for credit risk and Basic Indicator Approach for operational risk. Banks to make a road map for migration to advanced approaches only after obtaining specific approval of RBI. Exposures to domestic sovereigns (Central & States) rated at 0%

Claims on sovereigns to be risk weighted from 0% to 150% depending upon the credit assessments – AAA to BLending against fully secured mortgages on Lending against fully secured mortgages if residential property will be risk weighted at the loan to value ratio (LTV) is not more than 35%. 75%, on residential property will be risk weighted at 75%, except where loan value is below Rs.30 lacs which is risk weighted at 50%. In the case of past due loans where specific Lending for acquiring residential property, provision are no less than 50% of the which meets the above criteria but have LTV outstanding amount of the loan the risk ratio of more than 75 percent, will attract a risk weight of 100 %. weights of 100%.

How bankers interpreted Basel II?
Some bank managers seem to have interpreted Basel II’s minimum capital requirement as a maximum capital limit. To overcapitalize a bank (and hence to under-leverage it) beyond Basel II’s minimums was to leave profits on the table. Compliance with the Basel II rules was also subject to gaming by bank management, encouraging the shift of investments between relatively favored and disfavored asset classes. Basel II guided management in choosing between two assets with identical

risk/reward profiles—in facing such a choice, the bank will select the asset that requires the lesser amount of capital.

Pitfalls of Basel II
1. Basel II had created an illusion of safety—an illusion that compliance with Basel II meant that bank capital would be “adequate” to withstand a crisis 2. The second weakness is the negative spiral effect resulting from the interplay between asset value declines occasioned by market-to-market accounting and Basel II’s rigid capital demands 3. Basel II acceded to the credence that banks inevitably know their risk exposures and know how to manage risks better than their regulators 4. Banks were granted broad discretion to set their own risk preferences, with the understanding that riskier institutions would pay higher costs for the privilege through higher mandated capital. The national regulator verified the presence of such internally developed risk management systems, but did not verify their effectiveness 5. Banks and other financial actors took comfort from the generalized presence of Basel II-compliant national regulation in assessing systemic risk 6. It assuaged any of the banks’ or their regulators’ incipient concerns about counterparty and broader systemic risk during the credit bubble leading to the Crisis 7. The complacency engendered by Basel II resulted from two levels of trust. The first was the trust that other actors were following Basel II rules —and Basel II had been designed well enough that when financial institutions complied, a systemic meltdown was so remote as to be virtually impossible 8. Credit rating agencies failed to appreciate the risk of certain innovative financial assets. ratings did not reflect the heightening of correlated defaults during periods of financial stress 9. Credit enhancement was used frequently by banks and other originators of asset backed securitizations to “bulk up” ratings to investment grade, permitting risk averse institutions to hold these assets, including other banks 10. The inherent conflict-of-interest facing rating agencies contributed to the problem — credit rating agencies were hired by the very promoters who desired to sell the rated assets 11. One of the major critiques of the Basel II design assails its pro-cyclical tendencies. In good times, when asset value increases, capital is generated to support asset growth. In difficult times, as asset value declines, banks are constrained to raise additional capital to support the same asset portfolio they previously held. During periods of expansion, increases in asset values (when market to market) generate shadow increases in regulatory capital, which permit banks to further increase the origination and acquisition of assets, and thus increase intrinsic leverage. When

returns on assets fall or defaults increase, declines in asset values creates negative feedback loop which is explained below. 12. Banks respond to falling asset values by liquidating assets, converting these assets into cash. Disposing of assets further gluts markets, leading to further declines in asset values—a quintessential negative feedback loop. Rigid Basel II-based capital requirements had an adverse effect on the pricing of assets during the Crisis.

Basel II and the 2008 crisis
The 2008 Crisis resulted from some combination of unsustainable asset bubbles, excess credit, poor underwriting standards, inappropriate incentives created by bonus compensation schemes, etc. Basel II did not and was not intended to address the eventualities that occurred. Basel II does not address valuation and underwriting standards.

Corrections to Basel II
Capital adequacy may continue to be a useful tool, but it may no longer be the primary tool. Traditional supervision has to be part of the system. New requirements involving procyclicality buffers, leverage limitations, and liquidity maintenance requirements will augment capital adequacy. To counter this procyclical trend, Basel II joint note, 2010 came out with a framework that would have 2 elements: Promotion of the accretion of countercyclical buffers at banks that could be drawn against during periods of stress The second element would involve the applications of braking mechanisms that would prevent the buildup of excessive credit growth during the expansion phase of the business cycle.

Problems with this design
It is very difficult for the bank regulators to estimate business cycles Countries experience the business cycle at different times. There is no precise mapping of peaks and valleys across nations and currency areas. Third, using multiple cycles poses a problem for banks with substantial international operations (eg) A banking group with operations in the United States, Europe, and Japan might be subject to procyclical capital charges based on the current point of progress through three different business cycles.

Basel III
Basel III is aimed at strengthening both sides of balance sheets of banks by (a) Enhancing the quantum of common equity; (b) Improving the quality of capital base (c) Creation of capital buffers to absorb shocks; (d) Improving liquidity of assets (e) Optimizing the leverage through Leverage Ratio (f) Creating more space for banking supervision by regulators under Pillar II and (g) Bringing further transparency and market discipline under Pillar III

RBI on Basel III norms
1. The guidelines require banks to maintain a Minimum Total Capital (MTC) of 9% against 8% (international) prescribed by the Basel Committee of Total Risk Weighted Assets (RWA). This has been decided by RBI as a matter of prudence 2. Indian banks under Basel II are required to maintain Tier 1 capital of 6%, which has been raised to 7% under Basel III. Of the above, Common Equity Tier 1 (CET 1) capital must be at least 5.5% of RWAs; 3. In addition to the Minimum Common Equity Tier 1 capital of 5.5% of RWAs, (international standards require these to be only at 4.5%) banks are also required to maintain a Capital Conservation Buffer (CCB) of 2.5% of RWAs in the form of Common Equity Tier 1 capital. CCB is designed to ensure that banks build up capital buffers during normal times (i.e. outside periods of stress) which can be drawn down as losses are incurred during a stressed period. In case such buffers have been drawn down, the banks have to rebuild them through reduced discretionary distribution of earnings. This could include reducing dividend payments, share buybacks and staff bonus. 4. Leverage Ratio: Under the new set of guidelines, RBI has set the leverage ratio at 4.5% (3% under Basel III; the leverage ratio is calculated by dividing Tier 1 capital by the bank's average total consolidated assets) Leverage ratio has been introduced in Basel 3 to regulate banks which have huge trading book and off balance sheet derivative positions. However, In India, most of banks do not have large derivative activities so as to arrange enhanced cover for counterparty credit risk. Hence, the pressure on banks should be minimal on this count.

5. Liquidity norms: The Liquidity Coverage Ratio (LCR) under Basel III requires banks to hold enough unencumbered liquid assets to cover expected net outflows during a 30-day stress period In India, the burden from LCR stipulation will depend on how much of CRR and SLR can be offset against LCR. Under present guidelines, Indian banks already follow the norms set by RBI for the statutory liquidity ratio (SLR) – and cash reserve ratio (CRR), which are liquidity buffers. The SLR is mainly government securities while the CRR is mainly cash. Thus, for this aspect Indian banks are better placed over many of their overseas counterparts. The guidelines, related to Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) for funding liquidity will become binding for banks from 1 January 2015 and 1 January 2018, respectively. (NSFR promotes resilience over longer-term time horizons by creating additional incentives for banks to fund their activities with more stable sources of funding on an ongoing structural basis)

Comparison of Basel II and III
Requirements Minimum ratio of total capital to RWAs Minimum ratio of common equity to RWAs Capital Conservation Buffers to RWAs Leverage ratio (Tier I capital/Total exposure) Countercyclical buffer Liquidity Coverage Ratio (LCR) Net Stable Funding Ratio (NSFR) Basel II 8% 2% Basel III 10.5% (including buffer) 4.5% 2.5% 3% Upto 2.5% >= 100% >=100%

conservation

How much will Indian banks need to comply with BASEL III guidelines?
The banks in India may require additional capital of upto Rs2.6 lakh crore by 2018 as they migrate to the capital intensive Basel-III framework, according to a study by Standard & Poor’s (S&P) Additional common equity requirements of Indian banks (Rs in billion): Public sector banks Additional equity capital requirements 1400 -1500 under Basel III (A) Additional equity capital requirements 650 – 700 under Basel II (B) Net equity capital requirements under 750 – 800 Basel III (A–B) Private sector banks 200 – 250 20 -25 180 – 225 Total 1600 – 1750 670 – 725 930 – 1025

Additional equity capital requirements under Basel III for public sector banks Government share (if present 880 -910 shareholding pattern is maintained) Government share (if shareholding is 660 – 690 brought down to 51%) Market share (if the Government's 520 - 590 shareholding pattern is maintained at present level) Note: i. ii. LCR = High quality liquid assets/Total net liquidity outflows over 30 day time period NSFR = Available stable funding/Required stable funding

Shortcomings of Basel III
1. Despite the promise of higher capital levels and better quality capital, Basel’s new minimum leverage ratio requirement is only 3 per cent, about the same as that of the largest US banks when the global crisis erupted. 2. Countercyclical capital buffers will be introduced to promote the buildup of capital in “good times” that can be drawn upon in periods of stress (“bad times”), hence reducing the procyclicality of the banking industry. 3. The problem is that identifying “good times” and “bad times” is subjective at worst and rather difficult at best. There is no way of coming up with a figure for the capital buffer that will absorb losses in bad times. 4. Allowing banks to use internal models to calculate regulatory capital, reliance on rating agencies can lead to similar crisis in the future 5. Concept of risk weighting involves subjectivity and it is not fool proof 6. The consequence of this Basel II reform was to discourage banks from lending to risky enterprises, and to encourage the accumulation of apparently risk-free assets. This was a primary contributor to the structured finance craze, as securitization was a way to “manufacture” apparently risk-free assets out of risky pools. 7. The regulatory framework recommended by Basel II assumes that banks are in the best position to measure their own risks, and that a regulatory framework that aligns regulatory capital requirements with the risk being taken is to be desired

Conclusion
Basel III norms are expected to come into force by 2018. However it has to be understood that Basel III norms have been designed to address shortcomings of Basel II at the fallout of 2008 crisis. Following Basel III norms does not guarantee any protection against future financial crisis.

They are at best, an attempt to address all known risk factors. Basel II was not designed to address valuation, securitization and underwriting standards. Similarly Basel III may also end up facing newer challenges which it is not equipped to handle. As far as Indian banking system is concerned, given the limited exposure to derivatives, securitization market (as compared to other global banks) and the current RBI regulations (CRR, SLR, Basel III norms), one may safely assume that it has adequate safeguards in place. However whether it will be adequate to deal with future challenges, (just like 2008 crisis, which banks didn’t expect to face), is something that remains to be se en

References
1. http://www.investopedia.com/articles/07/baselcapitalaccord.asp 2. http://www.investopedia.com/terms/b/basel_i.asp 3. http://www.slideshare.net/sanskruta/basel-iii-and-its-impact-on-banking-system-inindia 4. http://blogs.reuters.com/felix-salmon/2010/09/15/the-biggest-weakness-of-baseliii/ 5. http://www.sciencedirect.com/science/article/pii/S0970389613000293 6. www.rbi.org

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