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Bank for International Settlement (BIS)

The Bank for International Settlement (BIS), established in 1930, is an international financial organisation owned by 60-member countries, representing countries from around the world that together make up about 95% of the world GDP. Its head office is in Basel, Switzerland and it has two representative offices in Hongkong and Mexico City. The objective of 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. The following are the functions of BIS.

• Fostering discussion and facilitating collaboration among central banks;
• Supporting dialogue with other authorities that are responsible for promoting financial stability;
• Carrying out research and policy analysis on issues of relevance for monetary and financial stability;
• Acting as a prime counterparty for central banks in their financial transactions; and
• Serving as an agent or trustee in connection with international financial operations.

With regard to banking activities, the customers of BIS are central banks, and international organisations. As a bank, the BIS does not accept deposits from, or provide financial services to, private individuals or corporate entities.

Basel Committee on Banking Supervision (BCBS)

The Basel Committee on Banking Supervision (BCBS) is the primary global standard setter for the prudential regulation of banks and provides a forum for cooperation on banking supervisory matters. Its mandate is to strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability. The BCBS does not possess any formal supranational authority. Its decisions do not have legal force. However, its recommendations and resolutions are adopted by all the members for the common benefit of all. The members of the BCBS are direct banking supervisory authorities and central banks. The committee is helped by a Secretariat which is situated at BIS in Basel.

Basel Accords

It refers to the banking supervision accords (agreements or resolutions) issued by the Basel Committee on Banking Supervision (BCBS). They are called as Basel accords as the BCBS maintains its secretariat at the BIS in Basel, Switzerland. The Basel Accords is a set of recommendations for regulation in the banking industry. Three such accords have been made till date: Basel I, Basel II and Basel III.

Basel I

This is the first accord agreed by the committee members and the resolutions were finalized in 1988; hence, this is sometimes referred to as the 1988 accord. The Basel I primarily focussed on credit risk and appropriate risk-weighting of assets, thereby setting a minimum capital requirement for banks. The assets of the banks were classified into the following 5 groups.

According to this accord, banks were required to hold capital of at least 8% of their risk-weighted assets (RWA). The Accord also prescribed for valuing the strength of a bank based on four essential features (also known as pillars): Capital, Risk Weighting, Target Standard Ratio, and Transitional and Implementing arrangements.

Pillar I (Capital)
This prescribed the nature of capital that is eligible to be treated as reserves. This was further divided into Tier I and Tier II capital. The Tier I capital (also known as Core capital) consists of elements that are more permanent in nature and as a result have high capacity to absorb losses. This comprised of equity and disclosed reserves. Equity capital includes fully paid ordinary equity shares and non-cumulative perpetual preference capital, while disclosed reserves include post-tax retained earnings. The accord specified that Tier I capital should be at least 50% of the total capital base of the banking institution. Tier II capital includes revaluation reserves, general provisions against non-performing assets, hybrid debt instruments and subordinated term debt.

Pillar II (Risk Weighting)
This creates a comprehensive system to provide weighs to different categories of bank’s assets i.e. loans on the basis of relative riskiness. The capital of the bank is related to risk weighted assets, to determine the capital adequacy. The framework of weights was kept simple with five weights for on-balance sheet assets. Off-balance sheet items such as Letters of credits, guarantees, OTC derivative instruments are subjected to assignment of weights, and hence are used in computation of risk adjusted capital. The risk weighted method is favoured over a simple ratio method due to the following benefits.

• It provides for a fair basis of comparison between international banks with different capital structures;
• It enables accountability of off-balance sheet items; and
• It avoids discouraging banking institutions to hold liquid and low risk assets to manage capital adequacy.

Pillar - III (Target Standard Ratio) This establishes the relationship between the first two pillars. The accord specified that the Tier I and Tier II capital should cover at least 8% of the risk weighted assets of a bank, with at least 4% being covered by Tier I capital.

Pillar – IV (Transitional and Implementing Arrangements) It was agreed among the members that they shall implement the accord in a phased manner – 7.25% by the end of 1990 and 8% by the end of 1992.

Amendments to Basel I

The Basel accord was amended in 1996 for providing for additional buffer for risk due to fluctuations in prices, on account of trading activities carried out by banks. Banks were permitted to use internal models (VAR models) to determine the additional amount of capital required. The capital requirement is determined based on the higher of the following estimates.

• Previous day’s Value at Risk
• Three times the average of the daily value-at-risk of the preceding sixty business days.

Transistion to Basel II

The banking crisis of 1990’s and the shortfalls of the Basel I accord triggered a rethink about the Basel agreements resulting in the Basel II accord in 1999. Formally, the Basel II accord is known as “A Revised Framework on International Convergence of Capital Measurement and Capital Standards”. The new framework was designed to improve the way regulatory capital requirements reflect the underlying risks for addressing the developments in financial innovation. The framework also focussed on the continuous improvements in risk measurement and control.

Basel II

Pillar I (Minimum Capital Requirements) under Basel II The Pillar I framework of the Basel I accord was retained in Basel II. However, the scope of the regulation was broadened by including “on a fully consolidated basis, any holding company that is the parent entity within a banking group to ensure that it captures the risk of the whole banking group”. This was aimed to prevent the possibility of a bank to conceal risk-taking by transferring assets to other subsidiaries. Under the Basel II framework, all risks of a bank are classified into three forms, namely.

1. Credit Risk
2. Operational Risk; and
3. Market risk

Credit Risk
Basel II measures the risk-weighted assets (RWAs) of a bank more carefully than the Basel I. Three methodologies were adopted to determine the risk rating of a bank’s asset – one Standard Approach and two Internal Ratings Based Approaches (IRB approaches).

The Standard approach directed banks to use ratings from external credit rating agencies to compute the capital requirements commensurate with the level of credit risk. It specified 13 categories of individual assets with risk-weighting norms.

The two Internal Ratings Based Approaches (IRB) are: (1) the Foundation IRB (F-IRB); and (2) the Advanced IRB (A-IRB). The Foundation IRB (F-IRB) gives banks the freedom to develop their own models to ascertain risk weights for their assets, subjected to regulatory approvals. The assumption under this model are provided by the regulators.

Advanced IRB (A-IRB) is similar to F-RIB, except that the banks are free to use their own assumptions.
The assumptions, mainly, pertains to the following variable in the models.

• Loss given default (LGD) – It is the percentage of loss (of the total exposure) when the borrower defaults.
• Exposure at default (EAD) – It is the extent to which a bank is exposed, if and when its counterparty or borrower defaults.
• Effective maturity (M) – It is the contractual maturity of the transaction or loan facility.
• Probability of default (PD) – It is the likelihood that the borrower is unable to repay debt over the specified time horizon.

Operational Risk
Basel II aims at measuring the operational risk and provide sufficient capital to guard against such risk. It suggests three methods for the measurement – Basic Indicator Approach, Standardised Approach and Advanced Measurement Approach.

The Basic Indicator Approach suggests banks to hold 15% of their average annual gross income (over the past three years) as capital. The banks may, subject to regulatory approvals, adjust this 15% rate according to their risk assessments.

The Standardised Approach divides the bank’s business into various business lines and specifies the percentage of profits (also known as beta factor) that needs to be set aside in the form of reserves for each of those business lines. The idea is that business lines with lower operational risk would translate into lower reserve requirements. The bank needs to adjust the beta factors of the various business lines by their relative sizes in the firm.

Beta factors for various business lines under Standardised Approach
The Advanced Measurement Approach gives banks the freedom to perform their own computations for operational risk, subject to regulatory approvals.

Market Risk
It is the risk of loss due to movements in the market prices of assets. The Basel II makes two distinctions in this regard – one in respect of asset categories and the other in respect of principal risks.

In terms of assets, each of the assets such as fixed income securities, equity, foreign exchange and commodities are treated separately. Value at Risk (VaR) models can be used to determine the risk of the assets.

In terms of principal risk, two risks are identified by the accord – interest rate risk and volatility risk. In case of interest rate risk, the reserve requirements are mapped to the maturity of the asset. The below table illustrates this.

Interest rate risk weights for market risk

Total Capital Adequacy and Reserve Requirement under Basel II

Just like Basel I, the minimum capital that a bank must maintain is equal to 8% of its risk weighted assets, out of which Tier 1 capital should be at least 4%.

The reserve requirement under Basel II is based on the risk measurements done for operational risk and market risk.

The bank is required to hold both the capital and reserve requirement. This can be summarised as follows.

Total Capital Adequacy = Capital requirement + Reserve requirement

= (0.08 * Risk-weighted assets) + Operational risk reserves + Market risk reserves


Pillar II under Basel II (Regulator-Bank Interaction)
This empowers regulators in matters of supervision and dissolution of banks. The regulator may supervise internal risk evaluation mechanisms outlined in Pillar I. The regulators are also permitted to create and enforce additional buffer requirement over and above the minimum capital requirement as per Pillar I.

Pillar II under Basel II (Banking Sector Discipline)
It aims to induce discipline within the banking sector of a country. For instance, it suggested that disclosure of the bank’s capital and risk profiles which were shared solely with the regulators should be made public. This was to ensure prudence in the risk levels of banks.

Basel 2.5

The financial crisis 2007 and 2008 exposed the limitation of Basel II. There were many risks that were not covered under the Basel II accord and hence revisions had to be made. The revisions were made in the form of amendments to the Basel II accord in 2009. The following were some of the main revisions.

• Augmenting the Value-at-risk (VaR) based trading book framework with an additional charge for risk capital, including mitigation risk and default risk.
• Addition of stressed Value-at-risk condition. This condition takes into account probability of significant loss over a period of one year.

The implementation of the above was scheduled for end of 2010. However, BCBS proposed further improvements and hence the Basel 2.5 and further amendments came into force as Basel III regulations.

Basel III

The BCBS had declared that the Basel II norms were mainly intended for G-10-member states, namely Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, Switzerland, UK and USA.

This leaves out a large number of emerging economies out of the mandatory regulation coverage. This creates problems because a bank located in a G-10 country has to have additional capital for lending to a Non-G-10 country bank, due to non-compliance with Basel II regulations or presumed lower credit rating, irrespective of the actual strength of the bank.

Another drawback of the Basel II is the following. The internal risk measurement models are linked to expected credit performance. The expected credit performance (Probability of default) increases during recessionary times. Banks would be encouraged to call back credit during recessionary times and pump in additional credit during normal or recovery times. This would result in making the recessions even worse, and may cause higher inflation during recovery or growth periods.

A combination of the above problems and the feedback received from the industry resulted in the Basel III norms. The essence of Basel III revolves around two sets of compliance – Capital and Liquidity.

Good quality capital will ensure long term sustenance of a bank, namely Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR).

Liquidity Coverage Ratio (LCR)
The Liquidity Coverage Ratio (LCR) is introduced to increase efficiency in short term liquidity risk management of the banks. The LCR norms require banks to make sufficient investment in short term high quality liquid assets so that it enables the bank to withstand sustained financial stress for 30 days period.

LCR=(Stock of high quality liquid assets)/(Total net cash outflows over the 30 calender days) ≥100 percent

Net Stable Funding Ratio (NSFR)
The Net Stable Funding Ratio is introduced to incentivize banks to obtain financing through stable sources on an ongoing basis. The norms require that a minimum quantum of stable and risk less liabilities are utilized to acquire long term assets. The objective is to deter reliance on short term means of finance, especially during favourable market conditions.

NSFR=(Amount available for stable funding)/(Required amount of stable funding) >100 percent
Buffer Capital Basel III requires banks to provide buffer capital in order to maintain a sound and stable capital base. Two types of buffer capitals are required – Capital conservation buffer and Countercyclical buffer.


Capital Conservation Buffer The regulation requires banks to accumulate additional capital buffers in times of low financial stress. Such a buffer would come handy when losses are high, and also help in preventing violation of minimum capital requirement. If the buffers are utilized, banks need to recreate the buffers by pruning distribution of earnings.

The amount of capital conservation buffer is linked to the Tier I Capital (common equity) and the percentage of earnings. The below table shows the linkage.



Countercyclical Buffer
The period after excessive credit growth and slowdowns are difficult times for banks as they may incur huge losses due to increasing non-performing credits. This can create disorders in the banking system. Banks must thus create capital buffers in times of rapidly growing financial stress. The countercyclical buffers are enacted national authorities, when they believe that the excessive credit growth potentially implies a threat of financial distress. The buffer for internationally active banks is computed as a weighted average of the buffers for all jurisdictions where the bank bears a credit exposure. Banks are required to have a countercyclical buffer between zero (0) and 2.5% of their total risk-weighted assets.

The below table shows the total minimum capital requirement under various capital and buffer requirements.

Pillar I under Basel II (Capital and Risk Coverage) The Pillar I of the Basel III is slightly different than that of Basel II. The difference is mainly in the following.

1. Additional capital buffers (Capital conservation buffer and counter-cyclical buffer)
2. Counterparty specific credit risk measurement (for both loans and trading activities) and provision of additional capital for the same
3. Implementation of Liquidity standards (Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR)).

Pillar II under Basel III (Risk Management and Supervision) Basel III imposes greater focus on firm-wide governance and risk management by capturing off-balance sheet exposures and securitization activities. It also enforces banks to conduct periodic stress testing.


Pillar III under Basel III (Market Discipline) It deals with securitization and other off-balance sheet vehicles. It enforces enhanced disclosures on the detail of the components of regulatory capital.

The following table shows the various pillars under the different Basel accords.