The Basel Committee on Banking Supervision was established in 1974, by the Bank of International Settlements (BIS).

An international organization founded in Basel, Switzerland in 1930 to serve as a Bank for Central banks.

Committee consisting of members from each of the G10 countries. It is represented by central bank governors of each of the G10 (developed) countries.(NOW 13)

Thirteen industrialized Nations that meet on an annual basis to consult each other on international financial matters.

The member countries are: France, Germany, Belgium, Italy, Japan, the Netherlands, Sweden, the United Kingdom, the United States and Canada, with Switzerland, Luxembourg, Spain It meets regularly 4 times a year.

Basel Committee on Banking Supervision (BCBS) framework on Capital Adequacy takes into account the elements of credit risk to strengthen the capital base of banks. RBI decided in April 1992 to introduce a risk asset ratio system for banks in India as a capital adequacy measure.

The basic approach of capital adequacy framework is that a bank should have sufficient capital to provide a stable resource to absorb any losses arising from the risks in its business.

For supervisory purposes capital is split into two categories: Tier I and Tier II. These categories represent different instruments quality as capital:

 Tier

I Capital consists:

Equity Capital (Shareholders' Funds) Disclosed Reserves:

Premium over shares, Retained earnings, Legal reserve

It is a banks highest quality capital because it is fully available to cover losses.

Legal Reserve:

Legal reserves are the only assets that are permitted by government regulations.
Divided into The two asset categories: Required Reserve (Vault cash & Reserve deposits ) Excess Reserve (Reserve for loan purposes)

Vault Cash (Required Reserve)

Paper bills and metal coins kept on the bank premises, both the vault and teller drawers. To satisfy currency withdrawal demands of depositors. Vault cash is not part of the official M1 money supply.

M1 includes only the paper bills and metal coins that is in circulation and held by the nonbank public.

Reserve deposits regulators require.

are

the

one

that

These are deposits that banks keep with the Reserve Bank Of India System. Required reserves are specified as a fraction of outstanding deposits--usually about 3 percent -15 percent

Any legal (or total) reserves over and above those required by regulators are excess reserves. These excess reserves are used for loans, which makes them exceedingly important to the banking industry. Holding excess reserves means loss of interest revenue.

Tier II capital Consists:

Undisclosed reserves Revaluation reserves General provisions Subordinated debt Hybrid Instruments. This capital is less permanent in nature.

The loss absorption capacity of Tier II capital is lower than that of Tier I capital.

Undisclosed reserves are not common.

They are accepted by some regulators where a bank has made a profit but this has not appeared in normal retained profits or in general reserves of the bank. Many countries do not accept this as an accounting concept or a legitimate form of capital

Revaluation reserve is created when a bank

has an asset revalued and an increase in value is brought to account.

Example: A bank owns the land and building of its head-offices and bought them for $100 a century ago. A current revaluation is very likely to show a large increase in value. The increase would be added to a revaluation reserve.

Adequate care must be taken to ensure that sufficient provisions have been made to meet all known losses and foreseeable potential losses before considering as part of Tier II Capital.

Have some characteristics of both EQUITY.

DEBT and

These are close to equity in nature, in that they are able to take losses on the face value without triggering a liquidation of the bank, they may be counted as capital.

Example: Preferred stock usually carries no voting rights but may carry a dividend and may have priority over common stock in the payment of dividends and upon liquidation.

Such debt is referred to as subordinate, because the debt providers (the lenders) have subordinate status in relationship to the Normal debt. A typical example for this would be when a promoter of a company invests money in the form of debt, rather than in the form of stock. Subordinated debt has a lower priority than other bonds of the issuer in case of liquidation during bankruptcy. It has minimum maturity period is 5 years.

Credit risk is most simply defined as the potential that a banks borrower or counterparty may fail to meet its obligations in accordance with agreed terms.

For most banks, loans are the largest and the most obvious source of credit risk; however, other sources of credit risk exist throughout the activities of a bank like inter-bank transactions, trade financing, foreign exchange transactions,

Market Risk is the risk to the banks earnings and capital due to changes in : Market level of interest rates Prices of securities Foreign exchange Equity Prices

The first accord was the Basel I. It was issued in 1988 and focused mainly on credit risk. Banks with international presence are required to hold capital equal to 8 % of the risk-weighted assets. Carrying risk weights of zero (for glits bond ), ten, twenty, fifty, and up to one hundred percent ( Corporate debt).

It standardizes risk-based capital requirements for banks across countries as per following measurement:

A measure of a bank's capital. It is expressed as a percentage of a bank's risk weighted credit exposures. CAR = Tier I + Tier II Risk Weighted Assets

Risk weighted assets is a measure of the amount of a banks assets, adjusted for risk.

It can be arrived simply by multiplying it with factor that reflects its risk. Low risk assets are multiplied by a low number, high risk assets by 100% (i.e. 1).

Suppose a bank has the following assets:

Rs. 1bn in gilts Rs. 2 bn secured by mortgages Rs. 3bn of loans to businesses. The risk weights used are: 0% for glits (a risk free assets) 50% for mortgages 100% for the corporate loans. The bank's risk weighted assets are 0 1bn + 50% 2bn + 100% 3bn = 4bn.

The main use of risk weighted assets is to calculate Tier1 and Tier 2 capital adequacy ratios. If its capital is 10% of its assets, then it can lose 10% of its assets without becoming Insolvent. (Insolvency is simply being unable to pay liabilities; Liabilities > Assets and liquidate it.

Basel II came into being in 2004.

Basel II is based on 3 pillars: (i) Minimum capital requirements, (ii) Supervisory review of an institution's capital adequacy and internal assessment process; (iii) Market discipline through effective disclosure to encourage safe and sound banking practices.

Pillar 1 includes 3 risks now, operational risk + credit risk + market risk to meet international standards.
Commercial banks in India adopt Standardized Approach (SA) for credit risk. Standardized Approach, the rating assigned by the eligible external credit rating agencies, largely supports the measure of credit risk.

Banks rely upon the ratings assigned by the external credit rating agencies chosen by the RBI for assigning risk weights for capital adequacy purposes. As: a) Credit Analysis and Research Ltd. b) CRISIL Ltd. c) FITCH Ltd. and d) ICRA Ltd. International credit rating agencies : a) Fitch; b) Moody's; and c) Standard & Poor's.

Banks must disclose the names of the credit rating agencies that they use for the risk weighting of their assets.

The risk weights associated with the particular rating grades as determined by RBI for each eligible credit rating agency as well as the aggregated risk weighted assets.

Pillar 2: Supervisory Review Process (SRP)

The establishment of suitable risk management systems in banks and their review by the supervisory authority (RBI). As:

In terms of the Pillar 2 requirements of the New Capital Adequacy Framework, banks are expected to operate at a level well above the

minimum requirement.

Pillar 3: Market Discipline seeks to achieve

increased transparency through disclosure requirements tor banks.

expanded

For such comprehensive disclosure, IT structure must be in place for supporting data collection and generating MIS which is compatible with Pillar 3 requirements.

Basel II Tier I CRAR = Tier I capital / (Credit Risk RWA + Operational Risk RWA + Market Risk RWA)
Basel II Total CRAR = Total capital / (Credit Risk RWA + Operational Risk RWA + Market Risk RWA) RWA - risk weighted assets

Capital to Risk Weighted Assets Ratio (CRAR) of 8% and Tier I capital of 6%.
The RBI has stated that Indian banks must have a CRAR of minimum 9%, effective March 31, 2009.

The Government of India has stated that public sector banks must have a capital cushion with a CRAR of at least 12%, higher than the threshold of 9% prescribed by the RBI.

Failure to adhere to Basel II can attract RBI action including restricting lending and investment activities. However, private sector banks as well as public sector banks are likely to comply with Basel II norms by March 31, 2009

In order to strengthen risk management mechanism: Indian banks should have minimum Tier-I capital of 7 percent of risk-weighted assets.
Total capital must be at least 9 percent of risk-weighted assets.

Besides, it has also suggested for setting up of the capital conservation buffer in the form of Common Equity of 2.5 per cent of RWAs.

Implementation of the minimum capital requirements will begin from January 2013 and should be fully implemented by March 31, 2017. S&P expects all banks that it rates in India to meet the RBI's requirements within the stipulated timeframe

Currently, RBI follows Basel II norms: As Banks are required to maintain a minimum Capital to Risk weighted Assets Ratio (CRAR) of 9 per cent. Tier 1 capital should be at least 6 per cent of risk weighted assets

On aggregate, banks are comfortably placed in terms of capital adequacy, but a few individual banks may fall short due to implementation of Basel III norms.