Let us Discuss this topic point to point in interactive manner.
Q) What is BIS or ‘Bank for international settlement’ ?
A) BIS is a private company owned by central banks
Q) Why Central banks own BIS ?
A) All chief of Central banks (RBI, in Indian case) come together in BIS and decide the Basel norms for capital adequacy (other important decision & function as well).
Q) What is this capital adequacy ?
A) Here is a simple example: If Bank of India total loan (Or asset) is 100 , it should have 8 rupees of it’s own (or capital). Capital adequacy will be 8% i.e 8/100*100
Q) What is this Basel ?
A) Name of place where the above mentioned private company (BIS) is located. It is in Switzerland.
Q) Can you come again with BIS ?
A) The BIS is a forum for discussion, policy analysis and information-sharing among central banks and within the international financial and supervisory community.
Q) Who decide what amount of money bank should Bank have of it’s own while loaning 100 rs ? or Capital adequacy?
A) Group of Governors and Heads of Supervision (GHOS)
Q) What is BCBS ?
A) In BIS, there are many committees formed which have different functions, BCBS or Basel committee on baking supervision is most important among them.
“The Basel Committee is the primary global standard-setter for the prudential regulation of banks and provides a forum for cooperation on banking supervisory matters. Its mandate is to strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability.”
Q) Is it compulsory to follow these norms?
A) Obviously no one can force any country to follow any rule made outside of the country (Unless it’s a treaty signed by countries, but treaties also fail.)
In Basel norms case, person deciding these norms (capital adequacy norms) are chiefs of central banks of all countries (Obviously they endorse committee work, rather than sitting there and doing committee’s work). Those who are member to BIS, follow these set of rules or capital adequacy norms. Even developing countries banks which are short of cash try to comply to these norms because they want to remain connected to international banking fashion and do not want to alienate themselves from the global banking.
Q) Can you tell me neat and tidy language purpose of these Basel norms ?
A) To formulate some standards which are followed by every bank worldwide, agreed upon by their respective central bank at BIS.
Q) Why ?
A) So that Indian banks and American banks follow same path. Customer in India should feel same sense of security when depositing money with any bank in America.
Q) Sense of security , what’s that bro ?
A) Whole idea of capital adequacy is to make public deposits with the bank safer. Bank provide loan out of same money which is deposited by the general public. If bank keep on loaning to any krack and jack, obviously money deposited by public will not be safe. So there should be sense of security among depositors that bank gives loan responsibly and our money is safe.
Q) Ok, BCBS prepared its report then who endorses them ?
A) The Committee reports to the Group of Governors and Heads of Supervision (GHOS) & seeks their endorsement.
Q) You forgot to tell about Basel 1, Basel 2, Basel 3 ?
A) Yea, but let’s discuss some terms before.
Bank’s capital: It is Bank’s own money, not the money which it has to give back to public (as you and me deposited money with the bank) that is liability of bank. Nor money given loan to public (Used same deposited money to make to loans) That is asset. It is also known as net worth of bank.
Tier 1 capital: It is capital with the bank which is most liquid. To use this capital bank do not shut down it’s operations.
Examples of tier 1:
Shareholder’s money (Equity) or the money people paid when they purchased particular banks shares from security market.
Why it acts as bank’s capital ? Shareholder’s are always paid in last. Debt or bond instrument owner of the bank will be paid first.
Other example: All disclosed reserves i.e earnings retained with the bank. One main example of disclosed reserve is Shareholder premium reserve.
What is Shareholder premium reserve ?
If 10 share worth of 10 rs were sold at 15 rupees due to high demand, bank will get 150 rs for 10 shares, 150-100 = 50 will be the share premium reserve with the bank. It is disclosed earning and appear on balance sheet of bank.
Tier 2 capital: It will be only available when bank will shut down all operations and is Less liquid compared to tier 1.
Ex: Bank’s property, Loan loss reserve, Hybrid instruments (Having both characteristics of debt and equity, The owner can convert debt into equity,if she has hybrid option), subordinated debt (sequence of preference upon liquidation Bondholder > Subordinate debt holder > shareholder).
Loan loss reserve: Bank accepts that 100% loan made by it won’t be repaid. Say it assumes 1% loan will never be paid. This 1% will be loan loss reserve, if borrowers pays money it will shrink, if they don’t obviously it will remain same or more people defaults, it will expand.
Tier 3 capital: Capital under tier 3 is least liquid. It contain further subordinate debt and non disclosed reserve of bank.
Basel Accord Vs Basel framework:
Basel 1 only spoke about how much capital should be with bank in comparison to assets.
While Basel 2 and Basel 3 have 3 pillars which we generally creates Basel framework.
These 3 pillars are namely:–
A) Capital Requirement – Capital adequacy requirement.
B) Supervisory review – Various tools to asses the position of Banks.
C) Market discipline – Different method to make sure banks follow above both pillars of strength. Banks should make disclosure about their capital adequacy compliance, so everyone know which bank is more safer, but it is their choice which bank to choose.
Basel 1 do not contain pillar B and C, hence it is never mentioned as framework.
It is latest basel norm and contain all three pillars, and additionally:-
a) Leverage ratio: Ratio of assets to capital. i.e if leverage ratio is 10, then bank made loan (from public money deposited) of 10rs for every 1 rs of their own, they took 10x risk.
b) Capital conservation buffer: A Piggy bank with bank in which bank keep its earning over and above of capital required for capital adequacy
c) Counter cyclical buffer: To prevent bank from excessive loans during non stress time a mark will be fixed on Credit-to-GDP ratio, if Credit grow not in sync with GDP, this buffer will be imposed to put excessive money (which bank might have given as loan) in it.
d) Liquidity coverage ratio: It means that bank should hold money enough (High quality liquid assets) to survive 30 days cash outflow requirements.
e)Net stable funding ratio: This ratio indicates what amount of liquidity will be available with bank when there is crunch of liquidity in market. LCR says bank should have liquidity (Cash for public and loan) for at least 30 days whereas NSFR help assess banks liquidity (So it can function properly during liquidity crunch) for long run.
“NSFR is defined as a bank’s available stable funding (ASF) divided by its required stable funding (RSF) and should be greater than 100 per cent. The purpose behind the minimum requirement is to ensure that banks maintain ample stable liabilities to fund long and medium term assets.”