Basel Norms: Understand Version 1, 2 & 3

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The Basel norms are international banking regulations that are meant to ensure that the sanctity of the banking sector is maintained by reducing the possibility of failure in a bank. These norms set minimum capital requirements, therefore ensuring that banks have the liquidity that would absorb the loss if it occurs. Basel norms were introduced during the last years of the 20th century. These were developed over three versions—Basel I, Basel II, and Basel III—to mitigate the challenges emerging in the financial sector.

What Are Basel Norms in Banking?

The Basel norms in banking refer to a set of international banking standards developed to assure that banks have adequate capital reserves to meet possible financial and operational risks. The BCBS designates these guidelines to improve the stability of the international banking system, especially about risk, capital, and liquidity requirements.

Key Objectives of Basel Norms

There are several advantages to Basel. These include:

Risk Management: It will help the banks to decrease credit risk, market risk, and operational risk.
Capital Adequacy: This is for ensuring an adequate amount of capital in the bank to meet its liabilities.
Global Financial Stability: To prevent financial crises by keeping the banking system stable throughout the world.
Uniform Standards: It will create a level playing field for international banks so that people have trust in the global financial market.

Basel 1 Norms

Basel I was the first accepted framework in 1988. It refers to the first global regulatory framework ever introduced by BCBS to meet the capital adequacy issue in the banking sector. It focused majorly on credit risk, and minimum capital requirements were imposed on banks.

Key Features of Basel 1 Norms

1. Minimum Capital Requirement: Basel I prescribed a minimum capital adequacy ratio (CAR) of 8% to the bank’s risk-weighted assets.

2. Risk Weights: Different risk weights were assigned between 0% and 100% to different assets. Examples include:

0% Risk Weight: Cash, government securities.
20% Risk Weight: Interbank lending.
50% Risk Weight: Residential mortgages.
100% Risk Weight: Corporate loans.

3. Tier 1 and Tier 2 Capital: The amount of capital of the bank was to be rated through two tiers. These were introduced by Basel I. Tier 1 and Tier 2, namely, core capital and supplementary capital.

Tier 1 Capital: Tier 1 captures equity capital and disclosed reserves.
Tier 2 Capital: This comprises subordinated debt, hybrid instruments, and undisclosed reserves.

Impact and Criticism of Basel 1 Norms

Simple Model: It used too simple a model for categorizing risk in Basel I, where all loans of the same class bore a rather uniform weight without distinction for varying degrees of risk incidence.
No Market Risk: Basel I did not take into account any kind of market risks due to changes in interest rates, currency movements, and fluctuations in stock prices.
Creating Leverage for Regulatory Arbitrage: The banks structured their portfolio and then made changes to it to minimize capital requirements without decreasing overall risk exposure.

Why Did Basel 1 Norms Fail?

The limitations of Basel 1 norms became evident as financial markets evolved. Perhaps, the need for a more comprehensive framework became apparent.

Reasons for the Failure of Basel 1 Norms

Static Risk Weights: There was a case of improper risk-weighting procedures since the risk weights were not based on actual risk attached to each asset. Therefore, the wrong bank health was calculated.
Operational and Market Risk Uncovered: Basel I focused only on credit risk and overlooked other critical risks faced by banks. These were market risk and operational risk.
Innovation in Financial Products: Basel I could not capture the complexity of the newer financial instruments, such as derivatives. In turn, the newer instruments could not capture the risks attached to them.

Basel 2 Norms

Basel II was introduced in 2004. It aimed to correct all those deficiencies that were found in Basel I. Thus, by making the new framework much more sophisticated and more sensitive to risks. It introduced an approach that dealt with credit risk, market risks, and operational risks comprehensively.

Pillars of Basel Norm 2

Pillar 1: Minimum Capital Requirements-Capital adequacy has been the focus of maintaining sufficient capital in respect of credit, market, and operational risks.
Pillar 2: Supervisory Review Process-They emphasize regulatory supervision to ensure that banks operate with sound inner processes in controlling their risks.
Pillar 3: Market Discipline-Increased transparency for better disclosure by banks about information related to their risk exposure and capital adequacy.

Key Features of Basel 2 Norms

Internal Ratings-Based Approach (IRB): In this approach, the use of internal models by a bank to measure its credit risk would be permissible. But only if these internal models met some regulatory standards.
Introducing Operational Risk: Basel II introduced operational risk as part of the body of regulatory capital adequacy by requiring banks to hold capital for losses that may flow from operational failures.

Advantages and Challenges of Basel 2 Norms

Advantages:

Risk Sensitivity: Better risk sensitivity was achieved by looking at the specifics of risk presented by a particular loan within a portfolio.
Increased Disclosure: Enhancing market discipline with greater transparency and information disclosure.

Challenges:

Complexity: The IRB approach added a layer of complexity that was not easy for the smaller banks to handle.
Implementation Costs: High costs associated with the development and validation of internal risk models.

Basel 3 Norms

Basel III was developed after the 2008 financial crisis to further strengthen the framework of regulations. Thereby, sort out the issues exposed during the financial crisis. Third Basel enhances the resilience of banks through the consolidation of a strong capital base and enhanced risk management practices.

Key Features of Basel III Norms

1. Increased Minimum Requirements:

Common Equity Tier 1 (CET1): Increased to 4.5% risk-weighted assets.
Total Capital Ratio: Whereas as in the previous model, increased to 10.5% with a capital conservation buffer of 2.5%

2. Leverage Ratio: A new ratio was introduced called the leverage ratio. It prohibits banks from taking excessive borrowings and thereby maintaining a minimum of 3%.

3. Liquidity Standards:

Liquidity Coverage Ratio (LCR): This ratio requires that the banks be able to hold enough high-quality liquid assets to cover net cash outflows for 30 days.
Net stable funding ratio (NSFR): Ensures that banks have a stable funding profile in relation to their assets and liabilities.

4. Countercyclical Buffer: The buffer is meant to protect the banks from excessive credit growth during the boom phase of the cycle, ranging between 0% and 2.5% of risk-weighted assets.

Benefits of Basel 3 Norms

Strengthened Capital Base: Thus, banks would come out to withstand shocks from a stronger capital base.
Better Risk Management: There would be an incentive toward more robust risk assessment and management strategies. Especially regarding liquidity and leverage.
Better Stability: Chances of systemic banking failure are lowered through being heavily disciplined financially.

Why Is Basel So Important?

The Basel norms are extremely important for maintaining the integrity and stability of the global banking system. They give a comprehensive framework that the banks must adhere to to properly manage risk and to ensure long-term sustainability.

Importance of Basel Norms

Financial Stability: While imposing minimum capital requirements, Basel norms prevent the occurrence of bank insolvency and subsequently reduce the chances of financial crisis.
Global Consistency: They make sure that across the globe, banks have to strictly adhere to the same standards that give rise to transparency in the financial sphere.
Risk Management: Forces banks to employ the best risk assessment and managing practices. These would protect them from market risks, credit risks, and operational risks.
Regulatory Framework: It will present a framework according to which the regulators can monitor and assess the soundness of financial institutions.

Conclusion

Basel norms have significantly transformed the global banking landscape, ensuring that financial institutions maintain sufficient capital to cover potential risks. From Basel I’s focus on credit risk to Basel III’s comprehensive framework addressing market and operational risks. These norms have evolved to meet the changing needs of the financial sector. As the global economy continues to face new challenges, the Basel norms will remain a cornerstone in promoting financial stability, transparency, and resilience.

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Basel Norms FAQs

What are Basel norms in banking?

Basel norms are a series of international banking regulations that aim to ensure financial stability by requiring banks to maintain adequate capital and manage risks effectively.

Why did Basel 1 norms fail?

Basel 1 norms failed because they oversimplified the risk assessment process and did not address market and operational risks, leading to inadequate risk coverage.

What is the focus of Basel 2 norms?

Basel 2 norms focus on three pillars: minimum capital requirements, supervisory review, and market discipline, emphasizing a more comprehensive risk management approach.

How did Basel 3 norms improve the banking system?

Basel 3 norms introduced higher capital requirements, liquidity standards, and leverage ratios to enhance the resilience of banks against financial shocks.

Why are Basel norms important for global banking?

Basel norms are crucial for maintaining financial stability, promoting transparency, and ensuring that banks can withstand economic stress and unexpected losses.