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Understanding Basel Norms

This article explains the Basel I and II frameworks in banking and discusses developing countries' perspectives on these norms.

Understanding Basel Norms

This article explains the Basel I and II frameworks in banking and discusses developing countries’ perspectives on these norms.

MANDIRA SARMA International Settlement (BIS) in 2006 re

T
he international financial system has seen an unprecedented growth in the last two decades. In this period, national and international financial systems have witnessed several significant developments in the area of prudential regulation and banking supervision. In 1988, the Basel Committee on Banking Supervision (BCBS) introduced risk-based capital adequacy norms through the Basel I accord [BCBS 1988]. Capital adequacy is an indicator of the health of a financial system and is measured by the ratio of total capital to total risk-weighted assets of a financial institution. Capital adequacy standards are imposed by financial regulators on their banking and financial systems in order to provide for a buffer to absorb unforeseen losses and prevent the cascading effect of these losses. Basel I recommended that a bank’s capital to riskweighted asset ratio (CRAR) should be at least 8 per cent. Under the initial Basel I norms, assets were risk-weighted according to their credit risk. Through an amendment in 1996, market risk was incorporated in the weighting scheme of Basel I along with credit risk [BCBS 1996]. In July 1999, BCBS initiated the process of replacing the Basel I framework with a revised version, the Basel II.

The Basel norms are voluntary and legally non-binding on countries that adopt them, including the 13 member countries of the BCBS. In 2007, more than 100 countries including India are following Basel I for capital adequacy norms. Two reasons have been identified for the popularity of the Basel I. First, Basel I, an important prudential regulation, is recognised for its simplicity of design and implementation [Reddy 2006]. The second important reason for many countries to comply with Basel I norms may be because the International Monetary Fund’s financial sector assessment programme emphasises compliance of Basel I norms [Bailey 2005].

As far as the revised framework, Basel II, is concerned, a survey by the Financial Stability Institute of the Bank of vealed that apart from the 13 BCBS member countries, 82 other countries intended to adopt Basel II norms in some form or the other by 2015. India has committed to implement Basel II norms from March 2008 for internationally active banks and from March 2009 for domestic banks.

In this brief note we discuss the Basel norms and provide some developing country perspectives for these norms. Elsewhere we have discussed India’s experience with Basel I and implementation issues in regard to the Basel II [Sarma and Nikaido 2007].

Basel I

Basel I is a framework for calculating the CRAR. It defines a bank’s capital as two types: core (or tier I) capital comprising equity capital and disclosed reserves; and supplementary (or tier II) capital comprising items such as undisclosed reserves, revaluation reserves, general provisions/ general loan-loss reserves, hybrid debt capital instruments and subordinated term debt. Under Basel I, at least 50 per cent of a bank’s capital base should consist of core capital. In order to calculate the CRAR, the bank’s assets should be weighted by five categories of credit risk

– 0, 10, 20, 50 and 100 per cent. For example, if an asset is in the form of cash or claims on central governments, it will get a risk weight of zero; if it is in the form of a claim on domestic public sector entities, then it will get a risk weight of 10, 20 or 50 per cent at the discretion of the national supervisory authority. Claims on the private sector will get a risk weight of 100 per cent. Table 1 provides the risk weights for different asset classes under Basel I.

Market Risk Amendment

In 1996, an amendment was made to Basel I to incorporate market risk in addition to credit risk in the calculation of the CRAR. To measure market risk, banks were given the choice of two options:1

(1) a standardised approach using building

Economic and Political Weekly August 18, 2007

block methodology; and (2) an “inhouse” approach allowing banks to develop their own proprietary models to calculate capital charge for market risk by using the notion of value-at-risk.

These approaches provide a measure for the capital charges for market risk and not the risk-weighted asset. To obtain estimates of risk-weighted assets, this measure would have to be multiplied by a factor 12.5 (reciprocal of 8 per cent, the minimum regulatory capital adequacy ratio) and then added to the risk-weighted assets computed for credit risk. In the computation of the CRAR, the numerator will be the sum of the bank’s tier I and tier II capital (tier II capital should be limited to a maximum of 100 per cent of tier I capital), plus a tier III capital introduced in the 1996 amendment to support market risk.

Basel II

Basel II is a much more comprehensive framework of banking supervision when compared to Basel I. It not only deals with the CRAR calculation but also has provisions for supervisory review and market discipline. Thus, Basel II stands on three pillars:

  • (1) Minimum regulatory capital (pillar 1): This is a revised and extensive framework for capital adequacy standards, where the CRAR is calculated by incorporating credit, market and operational risks.
  • (2) Supervisory review (pillar 2): This provides key principles for supervisory review, risk management guidance and supervisory transparency and accountability.
  • (3) Market discipline (pillar 3): This pillar encourages market discipline by developing a set of disclosure requirements that will allow market participants to assess key pieces of information on risk exposure, risk assessment process and capital adequacy of a bank.
  • In this note we will discuss only the first pillar, which deals with capital adequacy norms, the focus of this note.

    Minimum Regulatory Capital

    Under Basel II, the CRAR is calculated by taking into account three types of risks: credit risk, market risk and operational risk. The approaches for each one of these risks are described below. Credit risk: There are two approaches for credit risk, viz, the standardised approach (SA) and the internal ratings based (IRB) approach. As per the SA, credit risk is measured in the same manner as in Basel I but in a more risk sensitive manner, i e, by linking credit ratings of credit rating agencies to risk of the assets of the bank. This, according to the BCBS, is an improvement over Basel I, where the categorisation of the assets into five risk-weight categories was an ad hoc one. The BCBS has provided guidelines for linking credit ratings to the riskweights of various assets, under the SA. Based on the BCBS (2006), the riskweights for different asset categories in the SA, under Basel II, are presented in Table 2.

    As far as the IRB approach is concerned, banks will be allowed to use their internal estimates of credit risk, subject to supervisory approval, to determine the capital charge for a given exposure. This would involve estimation of several parameters such as the probability of default, loss given default, exposure at default and effective maturity corresponding to a particular debt portfolio.

    Market risk: As far as market risk is concerned, Basel II retains the recommendations of the 1996 amendment. Operational risk: Basel II has introduced a new kind of risk, called the “operational risk” in calculating the CRAR. It is defined as “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events”. In order to calculate the capital charges for operational risk, three approaches – the basic indicator approach (BIA), SA and advanced measurement approach (AMA) – have been suggested. In the BIA, an estimate of the capital charge for operational risk is provided by averaging over a fixed percentage of positive annual gross income of the bank over the previous three years.2 In this estimate, negative incomes are excluded. Under the SA, at first, the bank’s business activities are divided into eight business lines. For each business line, a capital charge is calculated by multiplying the gross income of the business line by a factor.3 A capital charge for each business line is thus

    Table 1: Risk-Weights of Asset Categories under Basel I

    Risk Weight Asset Category (On-Balance-Sheet Asset)
    0 per cent Cash
    Claims on central governments and central banks denominated in
    national currency and funded in that currency
    Other claims on OECD central governments and central banks
    Claims collateralised by cash of OECD central governments securities
    or guaranteed by OECD central governments
    10,20 or 50 per cent (at the Claims on domestic public sector entities, excluding central government,
    discretion of national authorities) and loans guaranteed by or collateralised by securities issues by such
    entities
    20 per cent Claims on multilateral development banks and claims guaranteed by
    or collateralised by securities issued by such banks
    Claims on banks incorporated in the OECD and claims guaranteed by
    OECD incorporated banks
    Claims on securities firms incorporated in the OECD subject to
    comparable supervisory and regulatory arrangements.
    Claims on banks incorporated in countries outside the OECD with a
    residual maturity up to one year and claims with a residual maturity of
    up to one year guaranteed by banks incorporated in countries outside
    the OECD
    Claims on non-domestic OECD public sector entities, excluding
    central governments; and claims guaranteed by or collateralised by
    securities issued by such entities
    Cash items in process of collection
    50 per cent Loans fully secured by mortgage on residential property that is or will
    be occupied by the borrower or that is rented
    100 per cent Claims to private sector
    Claims on banks incorporated outside the OECD with a residual
    maturity of over one year
    Claims on central governments outside the OECD (unless denominated
    in the national currency and funded in that currency)
    Claims on commercial companies owned by the public sector
    Premises, plant and equipment and other fixed assets
    Real estate and other investments
    Capital instruments issued by other banks
    All other assets

    Source: BCBS (1988), Basel Capital Accord, updated to April 1998.

    Economic and Political Weekly August 18, 2007 calculated for three consecutive years. The overall capital is calculated as the threeyear average of the simple summation of the charges across business lines in each year. Under the AMA, a bank can, subject to supervisory approval, use its own mechanism to determine capital requirement for operational risk. The final formula for the CRAR is as follows: CRAR = (tier I capital + tier II capital + other eligible capital)/(RWA for credit risk

    + RWA for market risk + RWA for operational risk).

    Norms and Developing Countries

    In a globalising financial system, it makes sense to have convergence in prudential regulation and norms, and Basel norms provide a set of supervisory norms comparable across economies. However, from the perspective of developing countries, several drawbacks are evident in the Basel norms. As argued by scholars, Basel norms reflect lack of representation of developing countries in formulating these norms [Griffith-Jones 2003; King et al 2003; Kraussl 2003]. For example, a look at the risk-weights for credit risk of international lending under Basel I (the current regime) reveals that these weights are biased in favour of the Organisation for Economic Cooperation and Development (OECD) countries. As presented in Table 1, claims on OECD countries and OECD central banks are attached with a zero risk-weight under Basel I. Thus, lending to OECD governments is more attractive than lending to non-OECD countries because the former does not impose a regulatory capital charge while the latter, unless denominated in local currency, imposes a 100 per cent capital charge. Similarly, Basel I favours claims on banks and securities firms on the basis of whether or not a financial institution is headquartered in an OECD member country. Further, only short-term lending (with maturity up to one year) to banks outside the OECD receive a low risk-weight of 20 per cent weight, while long-term lending to such banks receives 100 per cent risk-weight. This provides an incentive for short-term lending to emerging economies, leading to high volatility in capital flows into these countries, whereas long-term loans to such countries are discouraged by imposing a 100 per cent risk weight. Studies have found that such volatility in shortterm lending played a major role in exacerbating the 1998 Asian financial crisis [Griffith-Jones et al 1998; Rodrik and Velasco 1999].

    Basel II, which attempts to be more risk-sensitive, has done away with this distinction between OECD and non-OECD countries. Instead, under Basel II, international lending to any country would be risk-weighed according to the risk assessment of the country. Countries can adopt two options for country risk assessment, viz, by using the sovereign credit rating of private credit rating agencies such as Standard and Poor’s, Moody’s and Fitch or by using the country risk scores provided by export credit agencies recognised by the national supervisor of a country.

    While removal of the OECD/non-OECD distinction is a welcome change for non-OECD economies, linking credit rating to regulatory capital may have severe implications against developing countries. Scholars have argued that sovereign ratings of developing and emerging countries are not as high as the industrialised and high income countries and this would have an unfavourable impact on the credit flows to developing and emerging economies. Griffith-Jones et al (2002) have empirically shown that Basel II may significantly overestimate the risk of international lending to developing economies. Further, credit ratings are found to be pro-cyclical in the sense that sovereign ratings are upgraded in times of sound market conditions and downgraded in turbulent times [Ferri et al 1999; Monfort and Mulder 2000]. This has the potential of exacerbating the dynamics of emerging market crises. These studies have pointed out that bank and corporate ratings in emerging countries are linked to their sovereign ratings. In a crisis, when the need for credit is vital, credit flow may diminish due to the downgrading of the sovereign (and consequently the bank and corporate) ratings by external rating agencies, leading to a banking crisis, in addition to the currency/balance of payments crisis, what Kaminsky and Reinhart (1999) call “twin crises”. This may have a severe impact on macroeconomic stability. For example, Ferri et al (2000) show that during the east Asian currency crisis of 1997-98, following Moody’s downgradation of sovereign ratings for Indonesia, Korea and Thailand, corporate ratings were also downgraded sharply in these countries, leading to a sharp decline in the international capital flow to the region. Interestingly, even when the sovereign ratings of Korea and Thailand were upgraded in 1999 following macroeconomic recovery, corporate ratings continued to remain at a “speculative grade”. Further, the study also found that in the short term, the ratings of non-high income countries’ banks are more sensitive to changes in their sovereign ratings

    Table 2: Risk Weights in Standardised Approach of Credit Risk under Basel II

    Risk Weight Asset Category (Per Cent) (On-Balance-Sheet Asset)

    Claims on sovereign

    Option 1: Use of sovereign credit rating 0 AAA to AA20 A+ to A50 BBB+ to BBB100 BB+ to B150 Below B100 Unrated

    Option 2: Use of export credit agencies

    (ECA) score 0 0-1 20 2 50 3 100 4 to 6 150 7

    Claims on banks*

    Option 1: By sovereign rating: 20 AAA to AA50 A+ to A100 BBB+ to BBB100 BB+ to B150 Below B100 Unrated

    Option 2: By rating of the entity

    (i) For long term claims 20 AAA to AA50 A + to A50 BBB + to BBB100 BB + to B150 Below B50 Unrated

    (ii)For short-term claims 20 AAA to AA20 A + to A20 BBB + to BBB50 BB+ to B150 Below B20 Unrated

    Claims on corporates 20 AAA to AA50 A + to A100 BBB+ to BBB150 BB + to B150 Below B100 Unrated 75 Claims in regulatory retail portfolio 35 Claims secured by residential property 100 Claims secured by commercial real

    estate

    Note: Claims on non-central government public sector entities, multilateral development banks (except for World Bank group, IFC, ADB, AfDB, EBRD, IADB, EIB, EIF, NIV, CDB, IDB and CEDB which will have 0 weight) and securities firms will be riskweighted according to one of the options for claims on banks.

    Source: BCBS (2006).

    Economic and Political Weekly August 18, 2007

    in a noticeably asymmetric manner, i e, it is more sensitive for sovereign downgrading than sovereign upgrading.

    Apart from this, the incentive for shortterm lending is not fully removed under Basel II. As shown in Table 2, under option 2 for claims on banks, short-term lending receives much lower risk-weights than long-term lending.

    It is also important to remember that credit rating industries in developing countries are not as mature as in developed countries. Therefore, the adoption of Basel II may not lead to any significant improvement in risk management practices in developing countries as unrated entities would continue to receive a 100 per cent risk-weight, as in the case of Basel I. Effective implementation of the more complex Basel II norms will pose several challenges such as the lack of a mature credit rating industry, high implementation costs arising out of higher requirement of capital due to credit, markets and the newly introduced operational risk, extensive data requirement and software development.

    Despite these drawbacks and challenges, Basel norms, widely accepted around the world, are here to stay. While implementing these norms, the debate over the shortcomings must continue – in search for improvement and fair representation – not only amongst active members of the financial system, bankers and regulations but also among policymakers and academia.

    EPW

    Email: mandira@icrier.res.in

    Notes

    1 For details on these approaches see BCBS

    (1996). 2 This has been currently fixed at 15 per cent. 3 This factor is called the β factor, and pre-fixed

    by BCBS for each business line. For more,

    refer to BCBS (2006).

    References

    Bailey, R (2005): ‘Basel II and Development Countries: Understanding the Implications’, London School of Economics Working Paper, No 05-71.

    BCBS (1988): International Convergence of

    Capital Measurement and Capital Standards,

    BIS.

  • (1996): Amendment to the Capital Accord to Incorporate Market Risks, BIS.
  • (2006): International Convergence of Capital Measurement and Capital Standards: A Revised Framework, BIS.
  • Ferri, G, L Liu and J E Stiglitz (1999): ‘The Procyclical Role of Rating Agencies: Evidence from the East Asian Countries’, Economic Notes, 28 (3): 335-55.

    Ferri, G, L Liu and G Majnoni (2000): ‘How the Proposed Basel Guidelines on Rating-Agency Assessments Would Affect Developing Countries’, Policy Research Working Paper 2369, World Bank.

    Financial Stability Institute (2006): ‘Implementation of the New Capital Adequacy Framework in Non-Basel Committee Member Countries: Summary of Responses to the 2006 Follow-up Questionnaire on Basel II Implementation’, Occasional Paper 6.

    Griffith-Jones, S and J Cailloux (1998): ‘Encouraging the Long-term Institutional Investors and Emerging Markets’, Working Paper of Institute of Development Studies, University of Sussex.

    Griffith-Jones, S, M Sefoviano and S Spratt (2002): ‘Basel II and Developing Countries: Diversification and Portfolio Effects’, Working Paper of Institute of Development Studies, University of Sussex.

    Griffith-Jones, S (2003): ‘How to Prevent the New Basel Capital Accord Harming Developing Countries’, Working Paper of Institute of Development Studies, University of Sussex.

    Kaminsky, G L and C M Reinhart (1999): ‘The Twin Crises: The Causes of Banking and Balance-of-Payments Problems’, American Economic Review, 89 (3): 473-500.

    King, M R and T J Sinclair (2003): ‘Private Actors and Public Policy: A Requiem for the New Basel Capital Accord’, International Political Science Review, 24(3): 354-62.

    Kraussl, R (2003): ‘A Critique on the Proposed Use of External Sovereign Credit Ratings in Basel II’, Centre for Financial Studies Working Paper No 2003/23.

    Monfort, B and C Mulder (2000): ‘The Impact of Using Sovereign Ratings by Credit Rating Agencies on the Capital Requirements for Banks: A Study of Emerging Market Economies’, IMF Working Paper WP/00/69.

    Reddy, Y V (2006): ‘Challenges and Implications of Basel II for Asia’, BIS Review, 37/2006.

    Rodrik, D and A Velasco (1999): ‘Short-term Capital Flows’, NBER Working Paper 7364.

    Sarma, M and Y Nikaido (forthcoming): ‘Capital Adequacy Regime in India: An Overview’, Economic and Political Weekly.

    Economic and Political Weekly August 18, 2007

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