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All about BASEL Framework
Bank for International Settlements (BIS)
- Established on 17 May 1930, the BIS is the world's oldest international financial organisation.
- It has its head office in Basel, Switzerland and two representative offices: in the Hong Kong Special Administrative Region of the People's Republic of China and in Mexico City.
- BIS fosters co-operation among central banks and other agencies in pursuit of monetary and financial stability. It fulfills this mandate by acting as:
- a forum to promote discussion and policy analysis among central banks and within the
- international financial community
- a centre for economic and monetary research
- a prime counterparty for central banks in their financial transactions
- agent or trustee in connection with international financial operations
- Every two months, the BIS hosts in Basel, meetings of Governors and senior officials of member central banks. The meetings provide an opportunity for participants to discuss the world economy and financial markets, and to exchange views on topical issues of central bank interest or concern. The Basel Committee on Banking Supervision comprises representatives from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States.
- BIS also organises frequent meetings of experts on monetary and financial stability issues, as well as on more technical issues such as legal matters, reserve management, IT systems, internal audit and technical cooperation.
- BIS is a hub for sharing statistical information among central banks. It publishes statistics on global banking, securities, foreign exchange and derivatives markets.
- Through seminars and workshops organised by its Financial Stability Institute (FSI), the BIS disseminates knowledge among its various stake-holders.
- The role of BIS has been changing in line with the times. Initially, it handled the payments that Germany had to make consequent to the First World War. Following the Second World War and until the early 1970s, it focused on implementing and defending the Bretton Woods system.
- In the 1970s and 1980s, it had to manage the cross-border capital flows following the oil crises and the international debt crisis. The economic problems highlighted the need for effective supervision of internationally active banks. This culminated in the Basel Capital Accord on international convergence of capital measurement and capital standards, in 1988.
The Basel Accord of 1988 (Basel I) focused almost entirely on credit risk. It defined capital, and a structure of risk weights for banks. Minimum requirement of capital was fixed at 8% of risk-weighted assets. The G-10 countries agreed to apply the common minimum capital standards to their banking industries by end of 1992. The standards have evolved over time.
In 1996, market risk was incorporated in the framework. In June 2004, a revised international capital framework was introduced through Basel II.
The following year, an important extension was made through a paper on the application of Basel II to trading activities and the treatment of double default effects. In July 2006, a comprehensive document was brought out, which integrated all applicable provisions from the 1988 Accord, Basel II and the various applicable amendments.
The Basel II framework is based on three pillars:
- The first Pillar – Minimum Capital Requirements
- Three tiers of capital have been defined:
- Tier 1 Capital includes only permanent shareholders’ equity (issued and fully paid ordinary shares and perpetual non-cumulative preference shares) and disclosed reserves (share premium, retained earnings, general reserves, legal reserves)
- Tier 2 Capital includes undisclosed reserves, revaluation reserves, general provisions and loan-loss reserves, hybrid (debt / equity) capital instruments and subordinated term debt. A limit of 50% of Tier 1 is applicable for subordinated term debt.
- Tier 3 Capital is represented by short-term subordinated debt covering market risk. This is limited to 250% of Tier 1 capital that is required to support market risk.
- The second Pillar – Supervisory Review Process
- Four key principles have been enunciated:
- Principle 1: Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.
- Principle 2: Supervisors should review and evaluate the bank’s internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Appropriate corrective action is to be taken, if required.
- Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.
- Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.
- The third Pillar – Market Discipline
- This is meant to complement the other two pillars. Market discipline is to be encouraged by developing a set of disclosure requirements that will allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes and overall capital adequacy of the institution. The bank’s disclosures need to be consistent with how senior management and the Board of Directors assess and manage the risks of the bank.
- The capital adequacy requirement was maintained at 8%. However, the whole approach is considered to be more nuanced than Basel I. The stresses caused to institutions and the markets during the economic upheaval in the last couple of years, created a need for further strengthening of the framework. At its 12 September 2010 meeting, the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision, announced a substantial strengthening of existing capital requirements. These capital reforms, together with the introduction of a global liquidity standard, deliver on the core of the global financial reform agenda (Basel III).
Basel III is a comprehensive set of reform measures to strengthen the regulation, supervision and risk management of the banking sector. These measures aim to:
- improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source
- improve risk management and governance
- strengthen banks' transparency and disclosures.
The reforms target:
- Bank-level, or micro-prudential regulation, which will help raise the resilience of individual banking institutions to periods of stress.
- • Macro-prudential, system wide risks that can build up across the banking sector as well as the pro-cyclical amplification of these risks over time. These two approaches to supervision are complementary as greater resilience at the individual bank level reduces the risk of system wide shocks.
The Committee's package of reforms will increase the minimum common equity requirement from 2% to 4.5%. In addition, banks will be required to hold a capital conservation buffer of 2.5% to withstand future periods of stress bringing the total common equity requirements to 7%. This reinforces the stronger definition of capital agreed by Governors and Heads of Supervision in July and the higher capital requirements for trading, derivative and securitization activities to be introduced at the end of 2011.
Anand B. Rana
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