Assignment

Prepared for:

Ms. Mahfuza Khatun

Lecturer and Course instructor

Bank Fund Management (FNB 402)

Prepared by:

Md. Tareq Aziz

(Student ID. 2154)

September 03, 2014

Department of Finance & Banking

Jahangirnagar UniversityIntroduction

Basel I is the round of deliberations by central bankers from around the world, and in 1988, the Basel

Committee on Banking Supervision (BCBS) in Basel, Switzerland, published a set of minimum capital

requirements for banks. This is also known as the 1988 Basel Accord, and was enforced by law in

the Group of Ten (G-10) countries in 1992. A new set of rules known as Basel II was later developed with

the intent to supersede the Basel I accords. However they were criticized by some for allowing banks to

take on additional types of risk, which was considered part of the cause of the US subprime financial

crisis that started in 2008. In fact, bank regulators in the United States took the position of requiring a

bank to follow the set of rules (Basel I or Basel II) giving the more conservative approach for the bank.

Because of this it was anticipated that only the few very largest US Banks would operate under the Basel

II rules, the others being regulated under the Basel I framework. Basel III was developed in response to

the financial crisis; it does not supersede either Basel I or II, but focuses on different issues primarily

related to the risk of a bank run.

Basel II is the second of the Basel Accords which are recommendations on banking laws and regulations

issued by the Basel Committee on Banking Supervision.

Basel II, initially published in June 2004, was intended to create an international standard for banking

regulators to control how much capital banks need to put aside to guard against the types of financial and

operational risks banks (and the whole economy) face. One focus was to maintain sufficient consistency

of regulations so that this does not become a source of competitive inequality amongst internationally

active banks. Advocates of Basel II believed that such an international standard could help protect the

international financial system from the types of problems that might arise should a major bank or a series

of banks collapse. In theory, Basel II attempted to accomplish this by setting up risk and capital

management requirements designed to ensure that a bank headquarter for the risk the bank exposes itself

to through its lending and investment practices. Generally speaking, these rules mean that the greater risk

to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its

solvency and overall economic stability.

Basel III (or the Third Basel Accord) is a global, voluntary regulatory standard on bank capital

adequacy, stress testing and market liquidity risk. It was agreed upon by the members of the Basel

Committee on Banking Supervision in 2010–11, and was scheduled to be introduced from 2013 until

2015; however, changes from 1 April 2013 extended implementation until 31 March 2018 and again

extended to 31 March 2019. The third installment of the Basel Accords  was developed in response to the

deficiencies in financial regulation revealed by the late-2000s financial crisis. Basel III was supposed to

strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage.

Comparison among Basel I, Basel II & Basel III:

Basel I: Basel I, that is, the 1988, Basel Accord, is primarily focused on credit risk and appropriate risk-

weighting of assets. Assets of banks were classified and grouped in five categories according to credit

risk, carrying risk weights of 0% (for example cash, bullion, home country debt like Treasuries), 20%

(securitizations such as mortgage-backed securities (MBS) with the highest AAA rating) 50%, 100% (for

example, most corporate debt), and some assets given No rating. Banks with an international presence are

required to hold capital equal to 8% of their risk-weighted assets (RWA).

The tier 1 capital ratio = tier 1 capital / all RWA

The total capital ratio = (tier 1 + tier 2 + tier 3 capital) / all RWA

Leverage ratio = total capital/average total assets

Banks are also required to report off-balance-sheet items such as letters of credit, unused commitments,

and derivatives. These all factor into the risk weighted assets. The report is typically submitted to the

Federal Reserve Bank as HC-R for the bank-holding company and submitted to the OCC as RC-R for just

the bank. Over 100 other countries also adopted, at least in name, the principles prescribed under Basel I.

The efficacy with which the principles are enforced varies, even within nations of the Group.

Basel II:

Basel II uses a "three pillars" concept – (1) minimum capital requirements (addressing risk),

(2) supervisory review and (3) market discipline.

The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the first

Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an

afterthought; operational risk was not dealt with at all.

The first pillar

The first pillar deals with maintenance of regulatory capital calculated for three major components of risk

that a bank faces: credit risk, operational risk, and market risk. Other risks are not considered fully

quantifiable at this stage.

The credit risk component can be calculated in three different ways of varying degree of sophistication,

namely standardized approach, Foundation IRB, Advanced IRB and General IB2 Restriction. IRB stands

for "Internal Rating-Based Approach". For operational risk, there are three different approaches – basic

indicator approach or BIA, standardized approach or TSA, and the internal measurement approach (an

advanced form of which is the advanced measurement approach or AMA).

For market risk the preferred approach is VAR (value at risk).

As the Basel II recommendations are phased in by the banking industry it will move from standardized

requirements to more refined and specific requirements that have been developed for each risk category

by each individual bank. The upside for banks that do develop their own be spoke risk measurement

systems is that they will be rewarded with potentially lower risk capital requirements. In the future there

will be closer links between the concepts of economic and regulatory capital.

The second pillar

This is a regulatory response to the first pillar, giving regulators better 'tools' over those previously

available. It also provides a framework for dealing with systemic risk, pension risk, concentration

risk, strategic risk, reputational risk, liquidity risk and legal risk, which the accord combines under the

title of residual risk. Banks can review their risk management system.

It is the Internal Capital Adequacy Assessment Process (ICAAP) that is the result of Pillar II of Basel II

accords.

The third pillar

This pillar aims to complement the minimum capital requirements and supervisory review process by

developing a set of disclosure requirements which will allow the market participants to gauge the capital

adequacy of an institution.

Market discipline supplements regulation as sharing of information facilitates assessment of the bank by

others, including investors, analysts, customers, other banks, and rating agencies, which leads to good

corporate governance. The aim of Pillar 3 is to allow market discipline to operate by requiring institutions

to disclose details on the scope of application, capital, risk exposures, risk assessment processes, and the

capital adequacy of the institution. It must be consistent with how the senior management, including the

board, access and manage the risks of the institution.

Moreover, Basel I was an international accord to set minimum levels of capital for banks. It was designed

to ensure that lenders were sufficiently well capitalized to protect depositors and the financial system. The

first Basel Accord however was replaced by a new accord, Basel II. The new accord was introduced to

keep pace with the increased sophistication of lenders' operations and risk management and overcome

some of the distortions caused by the lack of risk assessment divisions in Basel I. Basel I required lenders

to calculate a minimum level of capital based on a single risk weight for each of a limited number of asset

classes, e.g., mortgages, consumer lending, corporate loans, exposures to sovereigns. Basel II goes well

beyond this, allowing some lenders to use their own risk measurement models to calculate required

regulatory capital whilst seeking to ensure that lenders establish a culture with risk management at the

heart of the organization up to the highest managerial level.

Basel III:

Capital requirements

The original Basel III rule from 2010 was supposed to require banks to hold 4.5% of  common equity (up

from 2% in Basel II) and 6% of Tier I capital (including common equity and up from 4% in Basel II) of

"risk-weighted assets" (RWA).[3] Basel III introduced "additional capital buffers", (i) a "mandatory capital

conservation buffer" of 2.5% and (ii) a "discretionary counter-cyclical buffer", which would allow

national regulators to require up to another 2.5% of capital during periods of high credit growth.

Leverage ratio

Basel III introduced a minimum "leverage ratio". The leverage ratio was calculated by dividing Tier 1

capital by the bank's average total consolidated assets. The banks were expected to maintain a leverage

ratio in excess of 3% under Basel III. In July 2013, the US Federal Reserve Bank announced that the

minimum Basel III leverage ratio would be 6% for 8 systemically important financial institution (SIFI)

banks and 5% for their insured bank holding companies.

Liquidity requirements

Basel III introduced two required liquidity ratios. The "Liquidity Coverage Ratio" was supposed to

require a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30

days; the Net Stable Funding Ratio was to require the available amount of stable funding to exceed the

required amount of stable funding over a one-year period of extended stress.

The U.S. LCR proposal came out significantly tougher than BCBS’s version, especially for larger bank

holding companies. The proposal requires financial institutions and FSOC designated nonbank financial

companies to have an adequate stock of High Quality Liquid Assets (HQLA) that can be quickly

liquidated to meet liquidity needs over a short period of time.

The LCR consists of two parts: the numerator is the value of HQLA, and the denominator consists of the

total net cash outflows over a specified stress period (total expected cash outflows minus total expected

cash inflows).

The US proposal divides qualifying High Quality Liquid Assets into three specific categories (Level 1,

Level 2A, and Level 2B). Across the categories the combination of Level 2A and 2B assets cannot exceed

40% HQLA with 2B assets limited to a maximum of 15% of HQLA.

Level 1 represents assets that are highly liquid (generally those risk-weighted at 0% under the Basel

III standardized approach for capital) and receive no haircut. Notably, the Fed chose not to include

GSE-issued securities in Level 1, despite industry lobbying, on the basis that they are not guaranteed

by the full faith and credit of the US government.

Level 2A assets generally include assets that would be subject to a 20% risk-weighting under Basel

III and includes assets such as GSE-issued and -guaranteed securities. These assets would be subject

to a 15% haircut which is similar to the treatment of such securities under the BCBS version.

Level 2B assets include corporate debt and equity securities and are subject to a 50% haircut. The

BCBS and US version treats equities in a similar manner, but corporate debt under the BCBS version

is split between 2A and 2B based on public credit ratings, unlike the US proposal. This treatment of

corporate debt securities is the direct impact of DFA’s Section 939 and further evidences the

conservative bias of US regulators’ approach to the LCR.

Lastly, the proposal requires both sets of firms (large bank holding companies and regional firms) subject

to the LCR requirements to submit remediation plans to U.S. regulators to address what actions would be

taken if the LCR falls below 100% for three consecutive days or longer.

Compared to Basel iii is an enhancement over Basel ii brought out with the experience of global financial

turmoil - the enhancements are primarily under two heads primarily one is capital and other is liquidity

Capital there is a minimum prescription of capital by way of common equity under Basel iii. That is to

say all the capital that was reckoned under Basel ii will not be eligible for such reckoning. Ex capital debt

instruments with step up option after certain period are not eligible. Deduction from the capital was

earlier considered from tier i and tier ii equally. Under Basel iii deductions will be made from tier i capital

only. Counter cyclical buffer for rainy day is introduced under Basel iii. Further additional capital for

systematically important financial institutions introduced so that large misgauge risks properly and not

ignite contagion risk for the system. Liquidity in order to improve the liquidity within as also across the

system liquidity coverage ratio and net stable funding ratio are introduced

The implementation is phased out from 2013 to 2018 so that there is no strain on the system and adequate

discretion is provided to the local regulator for fine tuning