The Basel Committee on Banking Supervision (BCBS) issues Basel Norms for international banking regulations. The goal of these norms is to strengthen the international banking system by coordinating banking regulations around the world. BCBS is made up of 27 representatives from various countries around the world, including India. The Basel Committee has currently issued three guidelines to achieve its goal: Basel I, II, and III. Basel is a city in Switzerland. It is the headquarters of the Bureau of International Settlements (BIS), which promotes cooperation among central banks with a common goal of financial stability and banking regulatory standards. Every two months, the BIS hosts a meeting of the governors and senior officials of member countries' central banks.

What are Basel Norms?

• The Basel accord refers to a set of agreements by the BCBS that primarily address risks to banks and the financial system.
• The agreement's goal is to ensure that financial institutions have sufficient capital on hand to meet obligations and absorb unexpected losses.
• The Basel accords for the banking system have been accepted by India. In fact, the RBI has imposed more stringent standards on a few parameters than the BCBS has.

Historical Perspective

• The Basel Committee, originally known as the Committee on Banking Regulations and Supervisory Practices, was established at the end of 1974 by the central bank Governors of the Group of Ten countries in the aftermath of serious disruptions in international currency and banking markets (notably the failure of Bankhaus Herstatt in West Germany).
• The Committee, headquartered at the Bank for International Settlements in Basel, was formed to improve financial stability by improving the quality of banking supervision around the world, as well as to serve as a forum for regular cooperation among its member countries on banking supervisory matters.
• The first meeting of the Committee was held in February 1975, and meetings have been held three or four times a year since then.
• The Basel Committee's membership has grown from the G10 to 45 institutions from 28 jurisdictions since its inception.
• Beginning with the Basel Concordat, which was first issued in 1975 and has been revised several times since.
• The Committee has established a series of international standards for bank regulation, most notably its landmark publications of the capital adequacy accords known as Basel I, Basel II, and, most recently, Basel III.

BASEL I

• BCBS introduced the capital measurement system called Basel capital accord in 1988. It was also known as Basel 1.
• It was almost entirely concerned with credit risk.
• It established the capital and risk-weighting structure for banks.
• The required minimum capital was set at 8% of risk-weighted assets (RWA).
• RWA refers to assets with varying risk profiles. For example, an asset backed by collateral would be less risky than a personal loan with no collateral.
• Capital is divided into two categories: Tier 1 capital and Tier 2 capital.
  • Tier 1 capital is the bank's core capital because it is the primary measure of the bank's financial strength.
    • The majority of core capital is made up of disclosed reserves (also known as retained earnings) and paid-up capital.
    • It also includes non-cumulative and non-redeemable preferred stock.
  • Tier 2 capital – It is used as supplemental funding since it is less reliable than the first tier.
    • It consists of undisclosed reserves, preference shares, and subordinate debt.
    • In 1999, India adopted the Basel 1 guidelines.

BASEL II

• BCBS published Basel II guidelines in June 2004, which were considered to be refined and reformed versions of the Basel I accord.
• The guidelines were founded on three pillars, as the committee refers to them:
  • Capital Adequacy Requirements: Banks should keep a minimum capital adequacy requirement of 8% of risk assets.
  • Supervisory Review: According to this, banks were required to develop and implement better risk management techniques for monitoring and managing all three types of risks that a bank faces: credit, market, and operational risks.
  • Market Discipline: This necessitates stricter disclosure requirements. Banks must report their CAR, risk exposure, and other information to the central bank on a regular basis.

BASEL III

• The Basel III guidelines were published in 2010.
• These guidelines were put in place in response to the 2008 financial crisis.
• There was a need to further strengthen the system because banks in developed economies were undercapitalized, over-leveraged, and relied more on short-term funding.
• Furthermore, the quantity and quality of capital required under Basel II were deemed insufficient to contain any additional risk.
• The Basel III norms aim to make most banking activities, such as trading books, more capital-intensive.
• The guidelines are intended to promote a more resilient banking system by focusing on four critical banking parameters: capital, leverage, funding, and liquidity.

Capital

• The capital adequacy ratio should be kept at 12.9 percent.
• The minimum Tier 1 and Tier 2 capital ratios must be maintained at 10.5 percent and 2 percent of risk-weighted assets, respectively.
• Furthermore, banks must maintain a capital conservation buffer of 2.5 percent.
• The counter-cyclical buffer should also be kept at 0-2.5 percent.

Leverage

• The leverage rate must be at least 3%.
• The leverage rate is the ratio of a bank's tier-1 capital to average oftotal consolidated assets.

Funding and Liquidity

• Basel-III established two liquidity ratios: LCR and NSFR.
• Liquidity coverage ratio (LCR) will require banks to maintain a buffer of high-quality liquid assets sufficient to deal with cash outflows encountered in an acute short-term stress scenario as specified by regulators.
  • This is done to avoid situations like the "Bank Run." The goal is to ensure that banks have enough liquidity to weather a 30-day stress scenario if it occurs.
• Net Stable Funds Rate (NSFR) mandates that banks maintain a consistent funding profile in relation to their off-balance-sheet assets and activities.
  • The NSFR requires banks to fund their operations with stable sources of funding (reliable over the one-year horizon).
  • The NSFR must be at least 100 percent.
• As a result, LCR assesses short-term (30-day) resilience while NSFR assesses medium-term (1-year) resilience.

Implementation in India

• In India, the deadline for implementing Basel-III was March 2019. It was pushed back to March 2020.
• Due to the coronavirus pandemic, the RBI decided to postpone the implementation of Basel standards for another 6 months.
• Extending the time period under Basel III results in a lower capital burden on banks in terms of provisioning requirements, including NPAs.
• This extension would have an impact on how Indian banks and central bank is perceived by global players.

How Does Basel III Affect Banks?

• The cost of increasing capital ratios may cause banks to raise lending rates, resulting in a decrease in lending.
• This will have a significant impact on the economy because it will result in lower investment, exports, and consumption.

Conclusion

The RBI has implemented these guidelines in the country in order to bring bank regulation and compliance processes in line with those of other global banks, ensuring that Indian banks are in a strong position to absorb any financial risk.

FAQs

Q1: What are Basel Norms?

Q2: How many versions of Basel Norms are there?

Q3: What was the primary objective of Basel I?

Q4: What additional risks were covered in Basel II?

Q5: What are the key features of Basel III?

MCQs

1. Which of the following was the main focus of Basel I?

a) Operational risk

b) Credit risk

c) Market risk

d) Liquidity risk

2. What is a key feature introduced in Basel III?

a) Capital Adequacy Ratio

b) Leverage Ratio and Liquidity Coverage Ratio

c) Market Discipline

d) Operational Risk Coverage

3. Which of the following risks is not covered under Basel II?

a) Credit risk

b) Market risk

c) Operational risk

d) Environmental risk

4. The Basel Norms were established by which committee?

a) International Monetary Fund

b) World Bank

c) Basel Committee on Banking Supervision

d) Financial Stability Board

5. Basel III was introduced after which global event?

a) Asian Financial Crisis

b) Great Depression

c) 2008 Global Financial Crisis

d) Dot-com bubble

GS Mains Questions and Model Answers

Q1: Discuss the significance of Basel III norms in strengthening global banking systems post-2008 financial crisis.

Answer: Basel III norms were introduced in response to the 2008 global financial crisis, which exposed weaknesses in the banking sector, particularly related to inadequate capital and liquidity management. Basel III aims to enhance the resilience of banks by improving capital adequacy requirements, introducing the leverage ratio, and establishing liquidity standards like the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR).
The significance of Basel III lies in its focus on high-quality capital, particularly common equity, which can absorb losses in times of stress. The new liquidity ratios ensure that banks maintain enough liquid assets to meet short-term obligations during periods of financial stress. Moreover, the leverage ratio prevents excessive borrowing, ensuring that banks have a strong capital base relative to their total assets. By implementing these norms, Basel III helps create a more robust and stable banking system, reducing the likelihood of future banking crises and enhancing global financial stability.

Q2: Analyze the role of Basel II in addressing operational and market risks in the banking sector.

Answer: Basel II expanded upon the framework set by Basel I by addressing not only credit risk but also operational and market risks, thereby providing a more comprehensive approach to risk management in the banking sector. Basel II introduced a three-pillar structure: minimum capital requirements, supervisory review process, and market discipline.
Operational risk, which encompasses risks arising from failed internal processes, human error, and system failures, was included to ensure that banks are adequately prepared for non-financial risks. Market risk, arising from fluctuations in market prices, was also given prominence, requiring banks to hold sufficient capital to cover potential losses. The risk-weighted assets approach under Basel II allowed banks to calculate their capital needs more accurately based on the actual risk profile of their assets. Overall, Basel II marked a significant step forward in ensuring that banks are better equipped to manage diverse types of risks, promoting a more stable banking environment.

Q3: Evaluate the impact of Basel I on international banking and how it set the foundation for subsequent Basel norms.

Answer: Basel I, introduced in 1988, was the first set of international banking regulations that aimed to standardize capital adequacy requirements across the globe. Its primary focus was on credit risk, and it established the Capital Adequacy Ratio (CAR), which required banks to maintain a minimum capital level equal to 8% of their risk-weighted assets.
The impact of Basel I was significant in promoting stability in international banking by ensuring that banks held sufficient capital to absorb losses from credit risks. It created a common framework for capital regulation, facilitating smoother cross-border banking operations and reducing systemic risks in global finance. However, Basel I was criticized for its simplistic approach to risk management, as it did not account for market and operational risks. Nevertheless, Basel I laid the foundation for more sophisticated frameworks, such as Basel II and Basel III, which expanded on its principles to include broader risk categories and improve banking sector resilience.

Previous Year Questions on  Basel Norms

1. UPSC CSE 2019

Question: How have Basel III norms improved banking stability post the 2008 financial crisis? 

Answer: Basel III norms were introduced after the 2008 financial crisis to address the deficiencies in the banking sector that led to the global financial collapse. One of the main features of Basel III is the increased focus on the quality of capital, requiring banks to hold a higher proportion of common equity, which is capable of absorbing losses. The introduction of the Liquidity Coverage Ratio (LCR) ensures that banks maintain enough high-quality liquid assets to survive short-term financial stress, while the Net Stable Funding Ratio (NSFR) promotes longer-term stability by ensuring banks have stable funding sources.
Additionally, Basel III introduced the leverage ratio to prevent excessive risk-taking and over-leveraging, which were major contributing factors to the 2008 crisis. By enhancing capital buffers, improving liquidity management, and introducing macro-prudential tools, Basel III has significantly improved the ability of banks to withstand financial shocks, thereby promoting greater global financial stability.

2. UPSC CSE 2018

Question: Analyze the relevance of Basel II norms in the Indian banking sector. 

Answer: Basel II norms were highly relevant to the Indian banking sector as they introduced a more comprehensive framework for risk management, which was crucial for India’s growing and globalizing economy. The three-pillar structure of Basel II—capital adequacy, supervisory review, and market discipline—allowed Indian banks to strengthen their risk assessment practices. The focus on operational risk under Basel II was particularly important for Indian banks, as it encouraged them to develop better internal controls and processes to manage risks arising from internal failures.
The introduction of risk-weighted assets allowed Indian banks to tailor their capital requirements more effectively based on the actual risks associated with their assets. This was especially beneficial for enhancing the robustness of the banking sector in the face of global financial volatility. However, the implementation of Basel II in India also posed challenges, particularly for smaller banks with limited resources to comply with the advanced risk management systems required. Overall, Basel II helped improve the risk management capabilities of Indian banks, contributing to a more stable and resilient financial system.