Basel Banking Norms: Their Efficacy, Analysis in The Global Context & Future Direction
Basel Banking Norms: Their Efficacy, Analysis in The Global Context & Future Direction
Basel Banking Norms: Their Efficacy, Analysis in The Global Context & Future Direction
Abstract
This article aims to first build a deeper understanding of the emergence of Basel banking norms (Basel I),
and the transition to each of the subsequent regulations (Basel II and Basel III). The primary purpose of
developing this understanding is to further analyze the extent of effectiveness of the Basel norms. To
explore how such regulations impact an economy, we have specifically looked at four economies of the
world, which are geographically apart, in this context. The idea here is to study how, for instance, banking
institutions have shaped up to these norms and whether the effects were favorable or adverse. We then
conclude by conceptually looking at the future direction of regulations such as the Basel norms in the
banking industry.
Introduction
The Basel Banking Accords are norms issued by the Basel Committee on Banking Supervision (BCBS),
formed under the auspices of the Bank of International Settlements (BIS), located in Basel, Switzerland.
The committee formulates guidelines and makes recommendations on best practices in the banking
industry. The Basel Accords, which govern capital adequacy norms of the banking sector, aim to ensure
financial stability and thereby increase risk absorbing capability of the banks.
The first set of Basel Accords, known as Basel I, was issued in 1988, with primary focus on credit risk. It
laid the foundation of risk weighting of assets and set objective targets of capital to be maintained. Basel II
was issued in 2004 with the objective of being more comprehensive. It aimed at increasing capital adequacy
by imposing a buffer for a larger spectrum of risk. As time has gone by, we have witnessed the Basel norms
failing to restrict two major crisis during its tenure, the South Asian Crisis in 1998 and Sub-prime Mortgage
Crisis in 2007, which raises questions about its effectiveness. As the banking world prepares to comply
with Basel III, the effectiveness of the Basel accord has come under the radar.
Basel I: Capital adequacy against credit risk
Basel I Accord attempts to create a cushion against credit risk. It comprises of four pillars, namely
i.
ii.
iii.
Target Standard Ratio: This acted as a unifying factor between the first two pillars. A universal
standard of 8% coverage of risk weighted assets by Tier I and II capital was set, with at least
4% being covered by Tier I capital alone.
iv.
Transitional & implementing arrangements: Phase wise implementation deadlines were set
wherein a target of 7.25% was to be achieved by the end of 1990 and 8% by the end of 1992.
Basel II: Comprehensive framework with buffer for larger spectrum of risks
Basel II retained the pillar framework of Basel I, yet crucially expanded the scope and specifics of Basel
I. The 4 pillars were amended as follows
i.
Minimum Capital Requirements, risks & target adequacy ratio: The primary mandate of
widening the scope of regulation was achieved by expanding the definition of banking
institutions to include them on a fully consolidated basis. Reserves requirement were defined
as follows:
Reserves = 8% * Risk-Weighted Assets + Operational Risk Reserves + Market Risk Reserves
ii.
iii.
b. Net Stable Funding Ratio (NSFR): The objective of long term stability of financial liquidity
risk profile is met by maintaining a ratio of amount available of stable funding to required
amount of stable funding at a minimum of 100%.
ii.
b. Countercyclical Buffer: This buffer can be enacted by national authorities when they
believe that the excess credit growth potentially implies a threat of financial distress.
c. Leverage Ratio:
leverage in the banking sector, despite portraying healthy risk based capital ratios, a
characteristic of the 2007 financial crisis.
The calibration of the capital framework and the time schedule of phase wise implementation of Basel III
can be found in Exhibits 1 and 2 respectively.
Modes of distributing earnings would basically include dividends and share buybacks, discretionary payments on
other Tier 1 capital instruments and discretionary bonus payments to staff as per the Basel III accord (2011
Revision).
Australia: Australia was largely insulated from the 2007 crisis. Two measures saved Australia in this
regard the preventive actions taken prior to 2008, and the extraordinary public sector intervention 2008
onwards.
The key preventive actions in the period prior to 2008 are as follows:
More stringent adoption of Basel II, which actually incorporated several propositions of Basel III.
It is important to note that tough times could indeed arise as a consequence of economic reversals in the
Australian economy. In such a scenario, Australian ADIs would plausibly face a far higher level of capital
stress. Clearly, the Australian Basel II framework might prove to be lacking. This is where the Basel III
framework comes in it incorporates a higher quality as well as quantity of capital.
Brazil: Brazil is expected to implement Basel III norms by October 2013, and will follow the international
schedule as indicated by BCBS, with a few aspects to be implemented by 2012 itself. The requirement of
additional capital to comply with Basel III norms is quite low in Brazil, and hence, is unlikely to have a
negative impact on economic growth. The grey line indicates capital requirement of 11%. Except 3 banks,
most of the banks comply with the regulation. The capital adequacy shall be raised to 13% under Basel III
norms, in which case, 9 banks shall have a shortfall, while 18 banks shall be uncomfortably close to the
regulation. However, banks shall have until 2019 to comply. Refer to Exhibit 4 for the timeline of phased
implementation of Basel III accord in Brazil.
United Kingdom: Across the EU, the Basel norms are implemented under the legal name of Capital
Requirements Directives (CRD). In UK, the responsibility of convergence to CRD is equally shared
between the Financial Services Authority (FSA) and the HM Treasury. Following the 2008 financial turmoil
gripping UK, the Prudential Regulation Authority (PRA) was formed as a successor to Financial Services
Authority (FSA), the banking regulator, in April 2013, as a part of restructuring efforts for more effective
supervision and governance. CRD IV, which directs implementation of Basel III, has been approved by the
EU parliament, with the implementation to commence from January 2014. This creates an obligation to
adopt the Basel III norms on all the member countries including the United Kingdom.
United States of America: Banking regulation is highly fragmented in U.S., because of the existence of
regulation at both the federal and state level. The U.S. has always been a laggard in implementation of
Basel norms. Multiple regulatory bodies have interest in the same issue.
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All the banks in USA continue to follow the revised Basel I norms. Certain portions of advanced approach
of Basel II were implemented, which applies to the most complex banks. This led to the Basel II norms
being applicable for only large financial institutions, keeping the majority of the banking community
outside the purview.
The financial crisis of 2008 called for sweeping changes in banking supervision and regulation standards
in the country. Stringent capital requirements, severe credit analysis of securities rated externally and
enhancement of Pillar 2 (Supervisory and review process) and Pillar 3 (Disclose and market discipline)
were implemented.
Basel III shall be implemented in USA in a phased manner between January 1, 2013 and January 1, 2019.
Implementation of Basel III norms in USA will require an additional Core Tier I Capital to the extent of
$700bn, and total Tier I capital of $870bn, with the gap in long term funding estimated at $3.2trillion. These
shortfalls are expected bring down Return on Equity of banks by 3%.2
Refer to Exhibit 5 for the timeline of phased implementation of Basel III accord in USA.
McKinsey & Company (2010), Basel III and European banking: Its impact, how banks might respond, and the
challenges of implementation, McKinsey Working Papers on Risk, No. 26.
Keywords
Industry: Financial Services
Function: Finance & Control, Economics
Other Keywords: Banking, Regulation, Basel Norms, Capital Adequacy, Liquidity
Contributors
Yatin Mohane (PGP 2012-14) is a Chartered Accountant and holds a B. Com. from R. A. Podar College
of Commerce & Economics, Mumbai and can be reached at yatin.mohane@iimb.ernet.in
Akshay Shenoy (PGP 2012-14) holds a B. Com. (Hons.) from NMIMS University, Mumbai (Narsee
Monjee Institute of Management Studies) and can be reached at akshay.shenoy@iimb.ernet.in
Acknowledgements
The student contributors thank Prof. Charan Singh (Economics & Social Sciences Area, IIM Bangalore)
for his guidance in this work.
References
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International Settlements Publications.
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Exhibits
Exhibit 1: Calibration of the Capital Framework in Basel III
Common
Tier 1
Total
Equity Tier 1
Capital
Capital
Minimum
4.5%
6%
8%
Conservation buffer
2.5%
7.0%
8.5%
10.5%
0% - 2.5%
(Source: Basel III accord, 2011 Revision)
10
Phases
2013
2014
2015
2016
2017
2018
2019
Capital Ratio
Leverage ratio
Migration
to Pillar I
4.0%
4.5%
4.5%
capital ratio
Capital conservation buffer
Minimum common equity 3.5%
plus
capital
0.625%
1.25%
1.875%
2.5%
4.0%
4.5%
5.125%
5.75%
6.375%
7.0%
20%
40%
60%
80%
100%
100%
5.5%
6.0%
conservation
buffer
Phase-in of deductions from
CET1
Minimum Tier I Capital
4.5%
8.0%
8.0%
6.0%
8.0%
8.625%
9.25%
9.875%
10.5%
conservation buffer
60%
70%
80%
90%
(minimum)
Net stable funding ratio
Introduce
minimum
standard
11
100%
Exhibit 3: Different countries are at different stages of banking regulations (September 2011)
(Source: Chabanel, Pierre-Etienne (2011), Implementing Basel III: Challenges, Options &
Opportunities, Moodys Analytics White Paper)
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(Source: Sobreira, Rogerio, and Tarciso Gouveia da Silva (2012), Basel III and Brazilian Banks,
Associao Keynesiana Brasileira)
(Source: PwC (2012), US Basel III Regulatory Capital Regime and Market Risk Final Rule,
PwC ongoing series)
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