Basel Norms for Banking

Banks lend to different types of borrowers and each carries its own risk. They lend the deposits of public
as well as money raised from the market – equity and debt. The intermediation activity exposes the bank
to a variety of risks. Cases of big banks collapsing due to their inability to sustain the risk exposures are
readily available. Therefore, Banks have to keep aside a certain percentage of capital as security against
the risk of non – recovery.
Basel committee has produced norms called Basel Norms for Banking to tackle the risk.
Basel is a city in Switzerland. It is the headquarters of Bureau of International Settlement
(BIS), which fosters cooperation among central banks with a common goal of financial
stability and common standards of banking regulations. Every two months BIS hosts a meeting
of the governor and senior officials of central banks of member countries.
Basel guidelines refer to broad supervisory standards formulated by these groups of central
banks – called the Basel Committee on Banking Supervision (BCBS). The set of the
agreement by the BCBS, which mainly focuses on risks to banks and the financial system is
called Basel accords/Basel Norms. The purpose of the accord is to ensure that financial
institutions have enough capital on account to meet obligations and absorbs unexpected losses.
India has accepted Basel Norms for Banking. In fact, on a few parameters, the RBI has
prescribed stringent norms as compared to the norms prescribed by BCBS.
Basel I:
In 1988, BCBS introduced capital measurement system called Basel capital accord, also called
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). RWA means assets with different risk profiles. For e.g.: An asset backed by collateral
would carry lesser risks as compared to personal loans, which have no collateral.
Assets of banks were classified and grouped into five categories according to credit risk,
carrying risk weights of:
 0% (for example cash, home country debt like Treasuries),

 20% (securitizations such as MBS rated AAA)

 50%,

 100% (for example, most corporate debt), and

1. The twin objectives of Basel I was To ensure an adequate level of capital in the international
banking system
2. To create a more level playing field in the competitive environment
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.
The guidelines were based on three parameters:
1. Banks should maintain a minimum capital adequacy requirement of 8% of risk assets.

2. Banks were needed to develop and use better risk management techniques in monitoring
and managing all the three types of risks

3. Banks need to mandatorily disclose their risk exposure, etc. to the central bank.

Basel III:
Basel III or Basel 3 released in December 2010 is the third in the series of Basel Accords.
These guidelines were introduced in response to the financial crisis of 2008. These accords deal
with risk management aspects for the banking sector. In a nutshell, we can say that Basel iii is
the global regulatory standard (agreed upon by the members of the Basel Committee on
Banking supervision) on bank capital adequacy, stress testing, and market liquidity risk.
 Objectives/aims of the Basel III:
 Improve the banking sector's ability to absorb shocks arising from financial and
economic stress, whatever the source
 Improve risk management and governance
 Strengthen banks' transparency and disclosures
Pillars of the Basel Norms for Banking
→ Pillar 1:

Minimum Regulatory Capital Requirements based on Risk Weighted Assets (RWAs):

→ Pillar 2:
Supervisory Review Process: Regulating tools and frameworks for dealing with
peripheral risks that banks face.
→ Pillar 3:
Market Discipline: Increasing the disclosures that banks must provide to increase the
transparency of banks
Major Changes proposed in Basel 3 over Basel 1 and Basel 2 are:
 Better Capital Quality: One of the key elements of Basel 3 is the introduction of a
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 indicated 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 a 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.
According to new Basel-III norms, which will kick in from January 2022 now, Indian banks
need to maintain a minimum capital adequacy ratio (CAR) of nine percent, in addition to a
capital conservation buffer, which would be in the form of common equity at 2.5 percent of the
risk-weighted assets.

Basel III guidelines are aimed at to improve the ability of banks to withstand periods of economic
and financial stress as the new guidelines are more stringent than the earlier requirements for
capital and liquidity in the banking sector.