The Basel Norms are a set of international banking regulations developed by the Basel Committee on Banking Supervision (BCBS), headquartered at the Bank for International Settlements (BIS) in Basel, Switzerland.
Their primary objective is to:
- Strengthen global banking regulation.
- Ensure financial stability.
- Enhance banks’ ability to absorb shocks arising from financial and economic stress.
Why Were Basel Norms Introduced?
The norms were introduced to address weaknesses in banking systems worldwide and to ensure:
- Banks hold enough capital to mitigate risks.
- Depositors' funds are protected.
- A global standard for evaluating a bank’s financial health is maintained.
Evolution of Basel Norms
Basel I (1988): The Foundation
- Objective: Focused on Capital Adequacy to absorb unexpected losses.
- Banks were required to maintain a minimum Capital Adequacy Ratio (CAR) of 8% of their risk-weighted assets (India adopted 9%).
- Focused on Credit Risk, which is the risk of borrower default.
Drawback:
Basel I didn’t address other critical risks like market risk and operational risk.
Basel II (2004): The Risk-Sensitive Approach
Objective: Improved risk management framework by expanding the scope to include:
- Market Risk: Losses due to changes in market prices.
- Operational Risk: Losses from internal processes, systems, or external events.
Introduced the Three Pillar Approach:
- Minimum Capital Requirements: Banks must hold capital against credit, market, and operational risks.
- Supervisory Review: Regulators must ensure banks follow risk management practices.
- Market Discipline: Enhanced transparency through disclosure requirements.
Drawback:
Basel II relied heavily on banks’ internal risk models, which could be manipulated.
Basel III (2010): The Post-Crisis Framework
- Introduced after the 2008 Global Financial Crisis, which exposed vulnerabilities in Basel II.
- Objective: Address systemic risks, improve liquidity, and ensure resilience during financial stress.
Key Features of Basel III:
Capital Buffers:
- Capital Conservation Buffer: Extra capital during good times to absorb losses during crises.
- Counter-Cyclical Buffer: Additional capital during periods of excessive credit growth.
Leverage Ratio:
- Limits the total amount banks can lend relative to their equity.
- Prevents excessive risk-taking.
Liquidity Standards:
- Liquidity Coverage Ratio (LCR): Banks must hold enough liquid assets to cover potential cash outflows for 30 days.
- Net Stable Funding Ratio (NSFR): Ensures stable funding over a one-year horizon.
Comparison of Basel Norms
| Feature | Basel I | Basel II | Basel III |
|---|---|---|---|
| Focus | Credit Risk | Credit, Market, and Operational Risk | Systemic Risk, Liquidity Risk |
| Capital Adequacy Ratio | 8% | 9% in India | Tiered capital buffers |
| Liquidity Standards | Not covered | Not covered | LCR and NSFR included |
| Leverage Ratio | Not applicable | Not applicable | Introduced |
Impact of Basel Norms on Indian Banking
India adopted Basel norms to align with international standards. Here's how they influenced the Indian banking system:
1. Improved Resilience
- Strengthened the ability of banks to withstand financial crises.
- Enhanced risk management frameworks.
2. Higher Capital Requirements
- Ensured that banks hold adequate capital to absorb unexpected losses.
3. Increased Transparency
- Disclosure norms under Basel II and III improved public confidence in the banking system.
4. Challenges for Indian Banks
- Capital Constraints: Public sector banks often face challenges in raising capital.
- Implementation Costs: Compliance requires significant investments in technology and training.
- Focus on NPAs: High NPAs have made it difficult for some banks to meet Basel III norms.
Visualizing Basel III Capital Structure
| Capital Type | Definition | Example |
|---|---|---|
| Tier 1 Capital | Core capital that absorbs losses immediately | Equity, retained earnings |
| Tier 2 Capital | Supplementary capital that absorbs losses during liquidation | Subordinated debt, hybrid instruments |
Challenges in Implementing Basel Norms in India
Despite their benefits, Basel norms pose challenges for Indian banks:
Resource-Intensive:
- High costs for system upgrades and staff training.
Capital Shortages:
- Public sector banks often struggle to raise Tier 1 capital.
High NPAs:
- Rising non-performing assets affect the ability to meet capital adequacy requirements.
Regulatory Compliance:
- Smaller banks find it challenging to implement complex risk models.
Case Study: Basel III and Indian Banks
The Reserve Bank of India (RBI) mandated the phased implementation of Basel III norms by March 31, 2023. Key observations:
- Banks like SBI and HDFC Bank successfully met the capital requirements.
- Struggling public sector banks received government support through capital infusion.
Looking Ahead: Basel IV?
While Basel III is the current standard, global discussions are already underway for a Basel IV framework. This may further refine capital requirements, focus on climate risks, and enhance technology integration.