1974, the collapse of the German Herstatt Bank, was an eye-opening event for banks. It triggered the necessity to establish standardized norms for maintaining capital adequacy to prevent such a financial crisis in future. As a result, The Basel Capital Accord (Basel I) came into being.

 

Set up with the aim of establishing a minimum level of capital as a function of risk-weighted assets, an 8% standard of capital maintenance was introduced to absorb losses in case of bank insolvency.

For example, Government securities carried zero risk weight while on the other hand were corporate exposures, which carried 100% risk weight. In India, the RBI stipulated higher minimum capital adequacy of 9%. Basel I broke ground mainly in generating awareness of the importance of capital in managing banking risk.

However, as is said, in economics there are no labs, no kits to evaluate policies, and hence it is the course of events that reveal their effectiveness and paves the way for alternative mechanisms. 

Basel I, though credited as being a revolutionary reform in the field of banking regulation, had a major shortcoming.

It assigned a single rate of capital adequacy for credit risk belonging to a particular category, irrespective of the degree of risk within that category. It assumed that all corporate borrowings posed the same credit risk (regardless of their size or characteristics). As a result, banks lent to riskier ventures while keeping the same amount of capital aside.

 

Neither did Basel I take into account different scenarios. A 1 million USD loan to a single entity and multiple loans totalling 1 million USD, clearly held different levels of risk. Such situations were not taken into consideration by Basel I.

 

Considerations over the drawbacks of Basel I led to Basel II, a much more sophisticated successor. It adopted a more comprehensive set of recommendations.

Basel II encouraged banks to adopt modern data-based quantitative risk management capabilities that were equal to the risk of the businesses.

Basel II came up with a three-pillar approach:

•Minimum Capital Requirements were set up for different types of risks.

•Supervisory Review Process by central banks to evaluate banks' assessment of capital needs.

•Market Discipline necessitated stipulated disclosure requirements for banks to help market participants assess the information on capital, risk exposure, risk assessment process and capital adequacy of the bank.

 

Despite the major revisions introduced through Basel II, the 2007-2008 subprime mortgage crisis revealed the inadequacy in capital regulation provided by it.

Basel II gave reduced risk weights to residential mortgages which led to a concentration of bank lending in the mortgage sector, thus fueling the housing bubble. The average level of capital required by the new discipline was still inadequate.  The new Capital Accord interacted with fair-value accounting, causing remarkable losses in the portfolios of intermediaries.

In the Basel II framework, the assessment of credit risk was delegated to non-banking institutions, such as rating agencies. This was subject to conflicts of interest.

The subsequent developments caused regulatory authorities to define corrective measures aimed at removing the weak points of Basel II without modifying the philosophy of the new framework.

Global regulators and central bank governors reached a deal on Basel III, to boost banks’ capital, get them to move away from short term funding, improve risk management and governance as well as strengthen banks' transparency and disclosures.  

 

The major bank-specific proposals under Basel III included raising the key capital to 8% of risky assets in order to enable banks to withstand future shocks. The quality, consistency, and transparency of the capital base were also raised. 

The risk coverage of capital was strengthened, especially in the area of capital market activities, new financial instruments and financial innovations.  

 

Basel III also included measures to introduce capital buffers in good times that could be used in periods of stress (Capital Conservation Buffer: 2.5% of common equity, Countercyclical Buffer: 0.5% to 2.5% of common equity). A liquidity buffer in the form of a Minimum Liquidity Standard for banks was also introduced.  

Basel III also introduced more stringent standards for supervision, risk management and public disclosure.  

 

Concerns regarding Basel III:

Impact on Profitability:

The increase in capital requirements negatively affects ROE.

Impact on Capital Requirements:

There is high dependence on raising equity to meet minimum Tier 1 capital requirements.

The capital crunch may lead to contraction of credit.

Operational Issues:

The PSBs urgently need to improve their systems of risk management and supervision to achieve Basel III norms.

In order to meet the Basel III compliance, banks have to ensure that the risk and finance teams have quick access to centralized, clean and consistent data as the data management requirement of Basel III is significant for calculating capital adequacy, leverage and liquidity effectively as well as accurately. It is imperative for efficient operations.

(Shakdwipee & Mehta, 2017)

 

The following table depicts the minimum capital requirements issued by the Basel Committee for banking regulation and the corresponding levels implemented by RBI:

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