Basel Norms / Model Simplified

(Theory and Calculations)

- Basel accords: Necessity / Advantage / Shortcomings

- Basel I vs Basel II vs Basel III – risks, pillars and approach
- Different approach for Credit, Operational & Market Risk
- Understand capital adequacy ratio, RWA, T1/T2 etc.
- Introductory sessions leaving out many nitty-gritties

1
Welcome Note
 Welcome to this course!
 You will learn the basics of Basel I , Basel II and Basel III
 These will introduce you to what was the need and what was
recommended by Basel committee
 This should be a quick and interesting way for you to learn Basel
norms
 Represents norms as of Mar 2015
 Please do write to me, if you have any issue / question
 I will add topics / supplementary notes to enhance the usability of
the course over time

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Agenda – 01
 Background of Basel models – why it is needed?
 Why do financial institution prefer less equity?
 Introduction to Basel I
 Interpretation of Basel I formula
 Shortcoming of Basel I
 Securitization / MBS / Regulatory arbitrage
 Methods of increasing capital

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Background – what is the need ?

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Background
 Financial institutes operate as financial intermediary.
People Bank People
Save Borrow
 They take money when people save with them.
 They lend to lend at higher rate and that’s how make money.
 Some borrowers are bound to default, which is called credit risk.
 Financial institutions need to keep some of it’s own money (equity ~
capital) which doesn’t belong to any lender, so that
 Lenders can be paid back. It doesn’t get affected by some defaults.
 It is the asset, that helps a bank to sustain loss without being insolvent.
 Failing to give money back to few account holders can cause panic
and rumours
 Leading to many account holder coming out to take out their savings
simultaneously

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Background
 This will lead to serious issues considering a substantial portion of
saving has been given to borrowers at any given time.
 That’s why financial institutions need liquidity. It works like a cushion
against unexpected loss.
 So it is necessary to keep capital
 But the question is
 How do you decide, how much capital is sufficient
 How will other institutions get to know that a particular bank X has
kept sufficient capital?
 This calls for some norms / guidelines
 Those who are meeting the norms can be assumed little safe to play
with.
 This is good for global financial system. Let me explain you how.

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Background
 Let’s see what happens, when one bank fails…

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background
 Bankruptcy of one financial institution has impact on many other
institution.
 A number of bank
 operates globally or
 Participate with global players
 So one’s issue can potentially become global issue
 How do you know, which are the safe players to play with?
 A norm is defined to let financial institutions
 Consistently define and understand the Risk
 Keep minimal capital to safeguard against risk of insolvency
 Banks tend to keep less of it’s own capital that’s why norm defines
minimum capital requirement.
 But why so?

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Why does bank want less of it’s own
capital (i.e. equity)?

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Understand ROE and ROI
 Say if a financial institution has taken 1 million of it’s own capital
(i.e. equity) and 9 million of borrowed capital (i.e. debt) and makes 1
million final profit (after paying 1 million interest to borrowers), then
 Return on investment (ROI) = 2/ 10 = 20%
 Return on equity (ROE) = 1/1 = 100%
 If it’s equity was 0.5 million and debt was 9.5 million, then 1 million of
final profit (after paying 1.05 million interest to borrowers) will make
ROE = 1/0.5 = 200%
 It’s like by putting your 0.5 million only, you were able to get 1 million
in one year as profit
 Financial institutions measures their success with ROE
 More equity reduces the bankruptcy risk but decreases ROE.
 That’s why banks say holding capital is expensive.
 A norm is defined to let financial institutions
 Consistently define and understand the Risk
 Keep minimal capital to safeguard against risk of insolvency
 Now let’s understand first published norm – Basel 1
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Introduction to Basel I
Capital as per risk

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Basel I : Introduced in 1988
 Brain child of the Bank for International Settlement
 Prepared by specially appointed Basel Committee on Banking
supervision
 Basel – a place in Switzerland, where meeting was held
 It’s purpose was to
 Bring uniformity in recognising risk
 Bring more financial stability by standardizing and increasing reserves
held for credit risk
 Discourage financial institution to take too much risk
 Credit risk : risk associated with borrowers not making payments
 It’s framework is
 Step 1 : a framework to define riskiness of assets
 Step 2: framework to know risk weighted assets (RWA)
 Step 3: a minimum capital adequacy ratio (CAR)
 Now step 1: Framework to define riskiness of assets
 Four classes of assets and weight for riskiness
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Basel I : Introduced in 1988
Class Class Risk
Notification weights
Sovereign debt to OECD countries and their central S 0%
banks
Other banks and public sector institutions in OECD B 20%
countries
Any loan secured by residential property R 50%
All other loans O 100%
OECD counties - stands for countries signed the Convention on the Organisation for Economic Co-
operation and Development

 Step 2 : RWA is defined by = (0% x S) + (20% x B) + (50% x R) + (100%

x O)
 Step 3 : Required capital = 8 % (CAR) of RWA, where
 At least 4 % is from tier-one capital (T1) , which is core capital i.e.
shareholder’s equity and disclosed assets
 Rest from tier-two capital (T2), which is undisclosed reserves and
subordinated debts
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Basel I : Introduced in 1988
 So the total capital requirement is given by equation
(𝑇1+𝑇2)
 >8%
𝑅𝑊𝐴𝑐𝑟𝑒𝑑𝑖𝑡
 Here T1 and T2 and tier 1 and tier 2 capital. It says that T1+ t2 >=
0.08* Risk Weighted Asset
 Note : Credit risk is the only parameter here for capital adequacy

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Tier 1 & Tier 2 capital

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Tier 1 and Tier 2 capital
 Tier I (Core Capital): has Highest capacity to absorb losses for
ongoing operations
 Tier I capital includes
 Common share holder equity
 declared reserves, such as loan loss reserves set aside to cushion
future losses or for smoothing out income variations.
 Non cumulative perpetual preferred stock
 Common stock is fully paid, hence it is available to absorb loss
permanently
 If losses occurs, it is the shareholder, who bear the loss first
 Declared reserves is derived from post tax retained earnings and
after dividend pay-out

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Tier 1 and Tier 2 capital
 Tier II (Supplementary Capital): Tier II capital includes
 all other capital such as gains on investment assets,
 long-term debt with maturity greater than five years and
 Undisclosed reserves (i.e. excess allowance for losses on loans and
leases).
 Please note, short-term unsecured debts (or debts without
guarantees), are not included in the definition of capital.

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Basel I method – pros and cons

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Study of Basel I formula
Class Asset (in Risk Class Asset (in Risk
Notific million) weigh Notific million) weigh
ation ts ation ts
S 100 0% S 0 0%
B 0 20% B 0 20%
R 0 50% R 0 50%
O 0 100% O 100 100%

 RWA = (0% x S) + (20% x B)  RWA = (0% x S) + (20% x B)

+ (50% x R) + (100% x O) + (50% x R) + (100% x O)
=0 = 100
 Step 3 : Required capital = 8  Step 3 : Required capital = 8
% of RWA % of RWA
 = 0 (min)  = 8 million (max)

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Basel I
 So in one word, more the risk, more capital is needed to be kept
 Advantage
 Simplicity
 Framework for measuring risk
 Framework for determining capital requirement
 Shortcomings
 Too coarse classification of assets – only four classes
 Only Credit Risk - Not considering other risks
 Not been able to institutionalize the risk sensitivity
 Not taking care of impact of securitization**
 Making adverse impact … let me explain
 The government loans were least risky (S : 0%) and corporate risk (O
: 100%). Corporate loans were usually more profitable.
 Usually high quality corporate has lesser return than low quality.
 In both high and low quality, banks have to keep same capital as both
will require 100% risk weight
 So to gain more ROE, bank may go for more risky corporate
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Securitization / MBS / Regulatory
arbitrage

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Securitization / MBS / regulatory arbitrage
 Shortcoming of Basel I was leading to regulatory arbitrage.
 To explain you properly let me explain some important terms first
 Arbitrage –
 Arbitrage is the practice of taking advantage of a price difference
between two or more markets.
 This will enable to someone just buy from one market and sale at
another market to make money (after transportation cost)
 Regulatory Arbitrage –Situation where companies take advantage of
loopholes of regulation in order to avoid unprofitable regulations.
 Securitization – let’s say one bank have a portfolio of 1000 million
home loans (R class asset)
 Basel I will require bank to hold = 8%*1000*50% = 40 million as
equity (keep in mind)
 Now think of that
 Based on loan account holder and property characteristics, bank
develops a score to know the riskiness of portfolio

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Securitization / MBS / regulatory arbitrage
 Regulatory arbitrage ….
 Now It divides the portfolio in 10 parts based on score, so that the top
trench is least risky than the next one. And every trench is less risky
than below one.
 Let’s see it graphically

1000 Million
portfolio

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 Securitization / MBS / regulatory arbitrage
 Regulatory arbitrage ….
 Now It sales the top 50% trenches as bonds,
these bonds are backed by the cash flows from
the monthly mortgage payments.
 These bonds will be called mortgage backed
security (MBS)
 As the rest of the portfolio is just 500 million,
hence the equity needed will be just
8%*500*50% = 20 million
 Note – Basel 1 method has failed to detect risk
in the mortgage. For it all the residential
project is same.
 Just by selling half part as security, bank was
able to reduce it’s equity requirement from 40
million to 20 million
 Note in lieu of migrating financial institution
towards less risk, it has actually made them
more risk takers .. Is not it?
 Is it what was required?
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Methods of increasing capital

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How to increase capital
 By retaining it’s profit as capital
 So by not paying dividends to shareholder
 And not investing it back to business for growth
 By selling more shares in the market
 By reducing asset –
 Note this won’t actually increase the capital but
 Will increase capital / asset ratio – which is being looked by regulators

 Now let’s study how Basel 2 evolved to take care of the shortcoming
of Basel 1

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