Are Basel norms really complicated?

The core business of banks is to take deposit from public and lend to individuals, industries, business etc. These loans carry risk of becoming bad debt (debtor is unable to return its debt) and hence non-performing. Since the major deposit of bank comes from public, the government and regulatory authorities are worried that the bank might be tempted to operate on thin capital and expose the depositors to undue credit risk. Therefore, banks all over world are required to keep a specified percentage of their loan portfolio as capital and if some loan goes bad, the loss is borne by the capital and not by depositors. Banks hence are required to maintain a capital adequacy ratio specified by the regulatory bodies.

Basel norm is a framework of capital adequacy for banks. These norms set the guidelines to estimate the amount of capital assets of specified kind should bank hold to absorb losses. The assessment of such losses that bank can incur decides the proportion of liquid asset banks must have at hand to meet those losses in case they are incurred. The loss can be based on the risk exposure i.e. credit, operational or market risks etc. The higher the risk of loss associated with an investment, the more of liquid asset will have to be maintained. A 100 percent risk-weight loss implies that the whole of the investment can be lost under certain conditions and a zero percent risk-weight indicates that the concerned asset is risk-free.

The Basel II norms is improvement over the earlier Basel I norms. India had adopted Basel I in 1999 and subsequently based upon recommendation of Steering committee , the Reserve Bank of India (RBI) issued draft guidelines for Basel II in 2005. Three major inadequacy of Basel I norms were –

1. Non-differentiation: The norms treated all borrowers alike.
2. No weightage was given to availability of security for credit facility.
3. It treated loans of varying maturity in the same manner.

Regarding the first issue, in Basel I, banks were required to keep 8 percent of loan as capital, whether the borrower is a first class blue chip company, with little or no risk, or it is a third rate company with poor track record. Basel II introduced the concept of 5 different risk weights, 20%, 30%, 50%, 100% and 150%. For the highest rated borrower, banks need to keep only 20% of 8 percent or 1.6 percent (8x 20%) of the credit exposure as capital. The RBI has retained the higher base level of 9 percent against world level of 8%.

For the second issue, value of security has been given due consideration while computing the capital charge for a loan.

Taking the last point, the Basel I rule prescribed the same amount of capital whether the loan was for a short period or for a very long period. As the period gets longer the risk associated with the loan increases. Basel II has made some distinction between short and long-term loans given by one bank to another.

The “credit worthiness” is to be determined by the rating accorded by independent credit rating agencies. And over a period of time, the credit rating given by banks themselves for borrowers could be adopted.

The operational risk is covered by Basic Indicator Approach which prescribes a capital charge of 15 per cent of the average gross income for the preceding three years to be maintained.

The revised framework of Basel II, consists of three-mutually reinforcing pillars –

1. Minimum capital requirements,
   
2. Supervisory review of capital adequacy and
   
3. Market discipline.

The first pillar offers three distinct options for computing capital requirement for credit risk and three other options for computing capital requirement for operational risk. The different options for credit risk are Standardized approach, Foundation Internal Rating-Based approach and Advanced Internal Rating-Based Approach. The available options for computing capital for operational risk are Basic indicator approach, Standardized approach and Advanced Measurement approach.

The second pillar is concerned with supervisory review process by national regulators for ensuring assessment of risk and associated capital adequacy of banking institutions.

The third pillar provides norms of disclosure by banks of key information regarding their risk exposure & capital positions and hence aims at improving market disciple.