Basel framework on capital adequacy

1.    INTRODUCTION

The Basel Committee was established as the Committee on Banking Regulations and Supervisory  Practices by the Central Bank Governors of the Group of Ten countries  at  the end of 1974  in the aftermath  of serious disturbances in International  Currency and Banking markets. The first meeting took place in February, 1975 and meetings have been held regularly three or four times a year  since.
The Committee’s  members come from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Sweden, Switzerland , U. K. & U.S.A. The committee does not possess any formal transnational supervisory authority. Rather, it formulates broad supervisory standards &  guidelines  and recommends statements of best practices in the expectation that individual  authorities will take steps to implement those which are best suited to their own national systems.
The Committee reports to the Committee of Central Bank Governors of the group of ten Countries, which meets at the Bank for International Settlements (BIS) and seeks the Governor’s endorsement and commitment for its major initiatives.
The topic to which most of the Committee’s time has been devoted in recent years is capital adequacy. A Capital measurement system was released to the Banks in July 1988. However, it was not intended to be static but to evolve over time. In November 1991, it was amended to give clarification of general provisions  which could be included in capital. In April 1995, it issued an amendment to recognise the effects of bilateral netting of bank’s credit exposure in derivative products. Another
task has been to refine the frame work to address risks other than credit risk, which was the focus of the 1988 accord. In January 1996, the market risks arising from bank’s open positions were incorporated.

In addition to the work on capital standards, particular supervisory questions which the Committee has addressed include the supervision of bank’s foreign exchange positions, the management of banks international lending (i.e. country risk ), the management of bank’s off –balance –sheet exposures, the prevention of criminal use of the banking system, the supervision of large exposures, risk management  guidelines for derivatives and the management of interest rate risk . Other topics currently being addressed include the supervision of financial conglomerates, risk management issues relating to reporting, disclosure and accounting. In 1997, the Committee has also preferred a set of “ Core Principles for Effective Banking Supervision”
The Committee’s Secretariat is provided by the BIS in Basle, where nearly all the committee’s meetings take place. From 1997 onwards, Basel Committee has  taken initiative to address the rigidities in 1988 Capital Accord by evolving a comprehensive and risk- sensitive  New Basel Capital Accord. In June 1999, it issued a paper on New Capital adequacy framework and a second revision in January 2001. The paper is open for discussion and comments till March 2002 and it is expected that the final accord will come into effect by 2005. The new proposals, once finalised, will replace the 1988 capital adequacy framework. The New Accord provides a range of options for providing capital, which would facilitate banks with varying degrees of sophistication to adopt appropriate methods with supervisory validations.

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2.    SALIENT FEATURES OF NEW BASLE CAPITAL ACCORD

Due to the rapid transformation of the financial market since the 1988 accord, a situation has arisen where regulatory capital alone may not be a good indicator of the financial condition of banks. It is therefore essential that the capital, which supervisors mandate the institutions to hold, should be adequate to cover the risks to which the institutions are exposed. The new framework is based on three pillars. The three pillar approach will suitably enhance the role of supervisors on the one hand and the ‘market’ on the other, in ensuring that the regulated entities maintain adequate capital at all times with reference to their risk profile. 

The First Pillar – Minimum Capital Requirements

The Minimum Capital Requirements are composed of three fundamental elements: a definition of regulatory capital, risk weighted assets and the minimum ratio of capital to risk weighted assets. While the definition of regulatory capital remains unchanged, there are considerable refinements in the risk weights as also in the calculation of the ratio.
Under the new accord, the denominator of the minimum capital ratio will consist of three parts: the sum of all risk weighted assets for credit risk, plus 12.5 times( reciprocal of 8% minimum risk-based capital ratio) the sum of the capital charges for market risk and the operational risk. The multiplicatory factor of 12.5 has been introduced in order to enable banks to create a numerical link between the calculation of capital requirement for credit risk, where the capital is based on the risk weighted assets and the capital requirement for operational and market risks, where instead capital charge itself is calculated directly.
Regulatory Capital
------------------------                     = Desired Capital Ratio
Risk weighted        12.5(Market + Operational)
Asset for Credit        Risk        Risk
Risk
The regulatory requirements cover three types of risks, viz, credit, market and operational risk. To improve risk sensitivity, the committee is proposing a range of options for addressing credit and operational risks. The committee has decided to treat interest rate risk in the banking book under Pillar II.

Credit Risk

The Committee proposes to permit banks a choice between measuring credit risk in a standardised  manner or use their internal rating systems.

A – The Standardised Approach

The Committee has modified the treatment of banks’ exposures to Sovereigns, Banks and Corporate by providing more than one risk bucket under each category of exposure. For example, for corporate lending, the existing Accord provides only one risk bucket of 100% but the New Accord will provide four categories ( 20%, 50%, 100% & 150%).
In determining risk weights, banks may use assessment by External Credit Assessment Institutions(ECAIs)/ Export Credit Agencies(ECAs) recognised by the national supervisor. The committee is examining the capital treatment of credit risk mitigation techniques e.g. collateral, credit derivatives or netting agreements.

B – The Internal Rating Based Approach

Bank would be required to categorise assets in the six broad classes – Corporate, banks, sovereigns, retail, project finance and equity.  Further, on the basis of a specified and distinct  set of rating criteria, loans would have 6-9 borrower grades.  The bank’s assessment of capital adequacy would be linked with the internal ratings.