The Basel Accord on Risk-Based Capital Requirements

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The Basel Accord on Risk-Based Capital Requirements
« on: June 20, 2013, 02:26:32 PM »
The Basel Accord on Risk-Based Capital Requirements

The increased integration of financial markets across countries and the need to make the playing field level for banks from different countries led to the June 1988 Basel accord by the industrialized nations under the auspices of the international banks for settlements in Basel, Switzerland. Under this agreement, proposal for a risk-based capital requirement was discussed. The risk weights currently given to different classes of assets were proposed by the Basel Committee. These were adopted as a basis for common system of prudential banking control in all industrial countries in 1993. The assets are divided into five categories on the basis of risk with lower weights given to less risky assets. Thus, cash has a weight of zero, loans to the discount market are weighted at 0.1, local authority bonds 0.2, mortgage loans 0.5, while commercial loans have a full weight of 1. The method of assessment, broadly speaking, is to multiply the market value of each asset by its risk factor and then to aggregate the risk-adjusted value. This is then compared with the bank’ capital base. This involves a two tier classification of capital.

Tier-1 or core capital consists essentially of shareholders’ equity, disclosed reserves and the current year’s retained profits, which are readily available to cushion the losses- these must be verified by the bank’s auditors.

Tier-2 or supplementary capital comprises funds available but not fully owned or controlled by the institution, such as general provisions that the bank has set aside against unidentified future losses and medium and long-term subordinated debt issued by the bank. Tier 2 elements were not permitted to make up more than 50 percent of an institution’s own fund.

The Basel Committee recommended a lower limit of 8 percent for the ratio of total capital to risk adjusted assets, though national bank supervisors had some discretion in applying this to different types of bank. The basic principle of such a ratio was that the risk of carrying on a banking business should be borne by the shareholders, rather than the bank’s clients, and that the bank’s capital should be sufficient to absorb any losses that could not be met out of current profits. Adjustments were later made to the Basel system, in particular to measure market risk- the risk that movements in the prices of financial instruments lead to loss. It is alleged that one of the crucial flaws in the existing framework-called Basel I is that it is too simple. Banks lending to a blue chip client have to set aside the same amount of capital to cover the possibility of risk as they would have to with a much lower quality borrower. One consequence is that the more sophisticated banks have “securitized some of their best loans—selling them on to other investors. That has left them with a riskier loan which, pay higher returns—to match the higher risk-- but, because the capital requirements are the same, produce a higher return on equity.

Therefore, the existing framework, brought in during the 1980s, is already regarded as inadequate. The top central bankers have been trying for sometime to finalize a new framework governing the amount of capital which commercial banks must set aside to meet individual or industry crisis. Now Basel II is aiming at providing a more flexible approach, matching the amount of capital that needs to be aside more closely to the risks attached to different types of loan and different borrowers. It will take, for example, a different approach towards commercial lending, credit cards lending, mortgage lending and between big and small companies. The Basel II proposals elicited great deal of comment: Each of the issues covered affected some banks one way or other banks another way, and many were expected to have unintended consequences. So, the Basel II comment- period was extended, and the definitive application of Basel II capital adequacy rules were differed. Complicating matters further was the fact that the Basel II proposals cover “operational risks”- risk associated with compliance failures, system failures, civil litigation and the like. Nobody knows how to measure these things, much less how to price them in order to provide adequate capital. So the initial Basel II proposals suggested a 20% capital charge—a simple heads-up, galvanizing banks into getting to work on the issue. But a final solution is sometime away, and its specifics remain far from obvious. The central bank officials involved are busy drawing up a new framework for Basel II the provisions of which are likely to be effective from 2010.

BB requirements for meeting banks' capital need under Basel-II (revised)

The Bangladesh Bank (BB) has revised guidelines allowing the capital market investments as supplementary capital of the banks to meet overall capital requirement under Basel-II framework. Under the revised guidelines, 10 per cent of revaluation reserves for equity instruments are eligible for tier-2 capital, generally known as supplementary capital.

Under the amended guidelines, the banks will have to comply with the minimum capital required (MCR) at 8.0 per cent from January 1, 2010 to June 30, 2010 while a rate of 9.0 per cent will be maintained from July 1, 2010 to June 30, 2011. The banks, however, must comply with the MCR at 10 per cent from July 1 next year (2011) and onwards.

The MCR had been set at 9.0 per cent with the risk-weighted assets of the banks or Tk 4.0 billion of total capital, whichever is higher, that would be treated as MCR of the banks under the Basel-II accord. The Basel-II accord came into force in Bangladesh from January 1 this year (2010) to consolidate capital base of the banks in line with the international standard.

The new Basel accord has been prepared on the basis of three pillars: minimum capital requirement, supervisory review process and market discipline. Three types of risks -- credit risk, market risk and operational risk -- have to be considered under the minimum capital requirement.

Professor Rafiqul Islam
Faculty of Business & Economics (FBE)