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BASEL-3 Norms Decoded

On the demand of some of our fervent readers, today we will try to explain what BASEL-3 is all about.

First, let’s see what BASEL is ?

BASEL is a city of Switzerland. BASEL norms were initially designed in 1988, later updated in 2004 and 2011. They prescribe “safe lending” norms to the banks. At present, we are at BASEL-3 norms, however in India timeline earlier to implement BASEL-3 was March 2018, but the inability shown by the Indian Banks to raise required capital, Raghuram sir extended this timeline to March 2019.

According to BCBS (Basel Committee on Banking Supervision), “BASEL-3 is a comprehensive set of reform measures, developed by the BCBS, to strengthen the regulation, supervision and risk management of the banking sector.

Why BASEL-3 ?

BASEL-3 aims to:

  • improve the banking sector’s ability to withstand shocks arising from economic stress or financial stress.
  • Improve risk management and governance.
  • Strengthen Banks’ transparency.

In 2007-08 subprime crisis of US, after their banks loaned money to “subprime” borrowers i.e. people without capacity to repay the loan. Result was, economic downturn throughout the country. To prevent such crisis in future,there is need for common banking regulation across the globe, which was being provided by basel norms.

What are BASEL Capital Adequacy Requirements ?

First, a Bank needs to calculate it’s risk weighted assets. Let’s have an example of ABC bank, now to calculate the risk weighted assets of this bank.

PRODUCT

RISK

Total Amount Loaned

Home loan30.00%20cr
Commercial loan60.00%30cr
G-sec10.00%60cr
Total Risk Weighted Assets100.00%100cr

Now, to sustain this loan business, a Bank must have sufficient capital mentioned under BASEL-3 norms. If as shown above, a Bank has total risk weighted assets worth 100cr.

Then, bank must have total capital adequacy of 9cr rupees. (out of which 7cr in tier-1, and 2cr in tier-2).

Basel Capital Adequacy Requirement (CAR) = 9% of RWA (Risk Weighted Assets )

Classification of Bank Capital

TIER-1

TIER-2

Common sharesDebts (bonds)
Preference shares Less liquid than tier-1 capital
Highest liquid,i.e. Can be sold easily to gather cash and ward off any kind of crisis.Capital further classified in upper T2 and lower T2.

Now, if a Bank wants to loan money worth 100cr, it has to maintain 9cr as “total capital adequacy”. If not then they need to arrange money by borrowing (via debt or equity route, equity route is same as share route).

basel

Classification of Bank Capital

CRITICISM of BASEL norms:

  1. RBI already has sufficient “backup” mechanisms to prevent banking crisis in India – such as CRR and SLR, all banks are required to make fortnightly reporting to RBI about their finance and operations and so on.
  2. Just because american banks failed immensely in their functioning and ran into trouble, doesn’t mean Indian banks have to keep so much money aside for ‘safety’. It could be given to needy customers and businessmen.

Three pillars of BASEL-3 norms:

  • minimum regulatory capital requirement based on RWA’s
  • supervisory review process
  • market discipline (to increase the transparency of banks)

REQUIREMENTS

TIER-2

TIER-3

Minimum ratio of total capital to RWA’s8.00%10.50%
Tier-1 capital to RWA’s4.00%6.00%
Core tier-1 capital to RWA’s2.00%5.00%
Leverage rationone3.00%

We Hope This article is sufficient to clear your doubt related to BASEL 3 norms (if any). What you think about this? Do let us know. Put your comment in Comment Box below.

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