Basel is the name of a city in Switzerland. It is a set of standards for supervisory regulations for banks developed internationally to maintain financial stability, capital management, risk control, and supervision. The Basel Committee on Banking Supervision (BCBS) issued the Basel Accord and named it after the city of Basel.
When the Bretton Woods system of exchange rates collapsed in 1973, and Franklin National Bank of New York closed due to massive losses in foreign exchnage transaction, the need for risk management in the banking industry was realized. This incident shows that if the banking system of one country fails, it can severely impact banks in other countries. As a result, the central bank governors of the G10 (The Group of Ten) countries formed the Basel Committee on Banking Supervision (BCBS) in 1974.
G10 (The Group of Ten) countries are Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom, and the United States.
Objectives of Basel
- To develop common guidance for the regulations and supervision of the international banking sector.
- To promote the stability and soundness of the banking sector.
- To exchange supervisory knowledge in the banking sector.
- To ensure financial stability, financial discipline, and sustainable development of the banking sector.
- To make the risk management mechanism of the banking sector effective.
- To protect the rights of the depositors.
- To reduce the risk of a financial crisis.
- To formulate minimum standards and frameworks for the regulation and supervision of the banks.
- To strengthen the capital base of the banks.
- To force banks to hold sufficient capital to bear risks.
- To promote transparency, accoutability and good governance of banks.
- To increase the international competitiveness of banks.
- To make it easier for regulatory bodies to monitor.
- To maintain confidence in the banking and financial systems.
- To prevent financial crimes and fraud.
- To bring uniformity in the operations of banks and financial institutions.
- To improve banks and financial institutions according to the latest risks.
What is Basel-I?
Basel-I is the first international banking regulatory framework to set minimum capital adequacy standards for international banks. It was issued in 1988 bu Basel Committee on Banking Supervision (BCBS). The main objectives of Basel-I are to set minimum capital adequacy and maintain capital based on credit risk.
In Nepal. Nepal Rastra Bank has implemented Basel I since 2007.
Assumptions of Basel-I
- Banking sector risk remains credit risk.
- All credits carry the same risk.
- Banks and financial institutions must maintain capital adequacy based on total risk-weighted assets to manage credit risk.
Pillar of Basel-I
Based on the above-mentioned assumptions, Basel-I has formulated the following pillar or principle to mitigate risks in the banking sector.
Pillar 1: Minimum Capital Adequacy
The major objectives of Basel-I are to ensure minimum capital adequacy of banks. Therefore, banks must maintain a minimum capital adequacy based on total risk-weighted assets to face the risk.
Where total risk-weighted assets include:
- On the balance sheet, risk-weighted assets
- Off-balance sheet risk-weighted assets
- Operational risk-weighted assets
Minimum Capital Adequacy :
- Capital Fund/Total Risk-Weighted Assets
- Tier 1 Capital + Tier 2 Capital/TRWA
- Capital Measure/TRWA
Limitations of Basel-I
Although Basel-I has developed minimum capital adequacy standards, it has the following weaknesses, as it fails to assess risk in a practical and in-depth manner.
- Limited to credit risk only.
- Not all credits carry the same risk.
- Failing to include the concept of leverage.
- There is no provision for liquidity-based prompt corrective action.
- Failure to identify market risk and operational risk.
- Minimum capital adequacy criteria are inadequate.
- Not including new financial instruments.
- No differentiations in regulations based on the size and nature of the business.
- No provision for an internal risk management system, etc.
What is Basel-II?
Basel-II is a modified version of Basel-I. It was developed to address the weakness of Basel-I. Basel-II is a set of standards for capital adequacy, risk management, and banking supervision designed for international banks. Basel-II was issued in 2004 by the Basel Committee on Banking Supervision. In Nepal Rastra Bank started implementing Basel-II in 2010. The main objective of Basel-II is to improve the quality of banks’ capital and conduct a comprehensive risk assessment.
Pillar I: Minimum Capital Adequacy
According to this pillar, banks must maintain a minimum capital adequacy based on total risk-weighted assets to cover market risk, credit risk, and operational risk.
Basel-II identifies and assesses more types of risk than Basel-I.
The following methodologies are used to assess banking risks
- Credit risk is based on the Simplified Standardized Approach (SSA).
- Operational risk is based on the Basic Indicator Approach (BIA).
- Market risk is based on Net Open Position Approach (NOPA).
Pillar II: Supervisoty Review Process
It is a process by which the regulatory body examines a bank’s internal risk assessment process. It includes
- Internal Capital Adequacy Assessment Process (ICAAP): It is a process by which a bank or financial institution internally assesses the capital required based on the nature, size, and strategy of its risk profile. It includes planning for required capital, risk assessment process, supervision, reporting, and review of the internal control system, etc.
- Supervisory Review: The supervisory review process is the regulatory body’s systematic evaluation of the ICAAP report and the risk management systems provided by banks.
- Supervisory Response: It is the process by which a regulatory body takes necessary action after assessing the risk, capital position, or internal systems of a bank or financial institution.
Pillar III: Market discipline, transparency, and good governance
This pillar requires banks to publicly disclose information about their risks, capiral structure, and risk management policies.
Limitations of Basel-II
- There is no provision of liquidity-based prompt corrective action.
- Failing to include the concept of leverage.
- Lack of dynamic and forward provisioning, dynamic.
- Lack of provision for counter-cyclical buffer capiral and conservation buffer capital.
- There is a lack of a concept of comprehensive macro prudential regulation and supervision.
- There is weak management of systematic risk.
- Unable to predict a financial crisis.
What is Basel-III?
Basel-III is an international banking regulatory framework designed to improve bank capital adequacy, risk management, and regulatory effectiveness. Basel-III was designed by the BCBS in 2010 to address the weaknesses of Basel-II as a result of the global financial crisis of 2007/08. The main objectives of Basel-III are to strengthen the capital adequacy of banks to improve liquidity management, reduce systematic risk, and adopt measures to prevent a repeat of the financial crisis.
Problems in the Implementation of Basel in Nepal’s Banking Sector
- There are difficulties in implementing the provisions regarding minimum capital adequacy as per Basel-III.
- The risk assessment and management system is weak.
- There is a weak physical infrastructure for information technology.
- There is a lack of knowledge about the Basel provision among employees.
- There are problems with data collection, processing, and reporting.
- The provisions in Basel are not implemented on time.
- The supervisory monitoring process is weak.
- There are weaknesses in the implementation of ICAAP.
- Cimpliance load is excessive.
- Cybersecurity and operational risks are increasing.
- There are weaknesses in the bank’s internal policies and procedures.
- There is a lack of institutional coordination in Basel implementation.
- Continuous revisions to the Basel criteria.
- There is a weakness in stress testing.
- Lack of regular training for bank employees.
Other Notes