Basel III An Easy To Understand Summary
Posted: 16 November 2012 | Source: Fintellix Solutions Pvt. Ltd.
Basel II was introduced in the year 2005 to address new risks which had arisen in the world of Banking. Credit Risk was enhanced to evaluate risk at client level for wholesale banking while Basel I evaluated it at a sector level. Banks were given the option to develop their own model for credit risk. There were no new guidelines on market risk but Banks had to provide capital for operational risk as it was seen as a new risk due to increased globalization, outsourcing and use of technology. In addition to the above, two new pillars were introduced to cover risks that were not covered by Pillar I and disclosure of capital adequacy was mandated by the regulators as per pillar III guidelines. A lot of emphasis was placed on independent verification of the ICAAP (Internal Capital Adequacy Assessment Process) which covered all risks not covered under pillar I and results of capital adequacy under stressed conditions.
However, the economic downturn resulting from huge downturn of ratings of sub-prime backed securities and collapse of some banking organizations led BIS (Bank of International Settlements) to strengthen the capital requirements for banks to prevent banks from collapse by taking excessive risks. These revised guidelines are referred to as Basel III. This document explains the changes introduced in Basel III and explains the concepts with some examples to increase understanding of the new guidelines and its impact on banks. The changes introduced under Basel III can be summarized as given below:
- Quality, Consistency and Transparency of Capital will be raised
- Risk Coverage of Capital framework will be strengthened
- Leverage ratio to be introduced as a supplementary measure to the risk framework
- Reducing procyclicality and promoting countercyclical buffers
- Introduction of Liquidity Coverage Ratio (short term) and Net Stable Funding Ratio for long term liquidity measure.
It must be noted that Basel III guidelines are still in the formative stage and not final. As it involves significant changes in the Bank’s capital structure and risk management processes, there is a lead time of more than 6 years before everything will be implemented. Based on events and learning during the next 6 years, the guidelines will be continuously fine-tuned.