M05C03

Overview of Basel One capital adequacy framework, its historical context, risk-weighted assets, and regulatory implications for banks worldwide.

Key Takeaways

Basel One framework is a global standard for capital adequacy introduced in 1988.
Banks must maintain a minimum capital adequacy ratio of 8% based on risk-weighted assets.
Risk weights vary by asset type to reflect the risk profile of bank assets.
Regulators have the authority to enforce capital requirements and take corrective actions if banks fail to comply.
India adopted Basel One norms following the Narasimham Committee reforms in the early 1990s.

What the video covers

The video discusses the historical background of regulatory interference in banking starting from 1900, including key milestones like the Federal Reserve and Glass-Steagall Act.
It introduces the Basel One framework released in 1988, which standardized capital adequacy requirements globally.
Basel One requires banks to maintain capital funds proportional to risk-weighted assets, with risk weights assigned based on asset types and borrower risk.
Examples of risk weights include 0% for government securities, 20% for well-rated banks, and higher percentages for riskier assets.
The concept of risk-weighted assets reduces the balance sheet asset value by applying risk weights to reflect actual risk exposure.
Capital funds include equity capital and reserves, with Basel One emphasizing the quality of capital recognized for regulatory purposes.
The capital adequacy ratio is the ratio of capital funds to risk-weighted assets, with a minimum requirement of 8%.
If banks fail to maintain required capital adequacy, regulators can intervene by demanding recapitalization or taking actions like merging or liquidating the bank.
The Narasimham Committee reforms led to the implementation of Basel One standards in India around 1992-93.
Regulatory bodies worldwide, including the Reserve Bank of India, actively enforce capital adequacy norms to protect the financial system.

Chapters

What is the Basel One framework?

Basel One is a global regulatory framework introduced in 1988 that requires banks to maintain capital funds proportional to their risk-weighted assets, ensuring capital adequacy.

How are risk weights assigned to bank assets under Basel One?

Risk weights are assigned based on the risk profile of assets, such as 0% for government securities, 20% for well-rated banks, and higher percentages for riskier borrowers or assets.

What happens if a bank fails to maintain the required capital adequacy ratio?

Regulators can intervene by requiring recapitalization, demanding additional funds from shareholders, or taking actions like merging, selling, or liquidating the bank to protect the financial system.

Full Transcript — Download SRT & Markdown

Speaker A

So as the regulatory interference is important, how the regulatory interference started has a big historical background. Of course, we don't require to go through each and every level of the chronological developments, but I'm providing you some information on how from 1900 onwards this discussion on capital regulation started. Federal Reserve, Bank of England, Glass-Steagall Act, and several levels of how the capital requirement has been discussed and emphasized on the need for maintaining capital adequacy.

Speaker A

information on how from 1900 onwards uh this discussion on capital regulation started. Federal Reserve, Bank of England, Glastagal Act and several levels how the capital requirement has been uh discussed and uh emphasized on the need for maintaining the capital adequacy.

Speaker A

Basic capital adequacy framework, which is universally applicable to several banks in almost all the countries across the world and especially for Indian banks also, has started with the releasing of Basel One document in 1988.

Speaker A

So this document is a standard document which started the discussion on the uh the capital adequacy requirements where all the banks or all the regulators are on on the same page of the discussion and uh this has become almost mandatory

Speaker A

So this document is a standard document which started the discussion on the capital adequacy requirements where all the banks or all the regulators are on the same page of the discussion, and this has become almost mandatory by all the banks across the world in different countries. What does this Basel Committee One say or Basel One say? As per Basel One, every bank is expected to maintain capital funds as a proportion of risk-weighted assets.

Speaker A

We all know that balance sheet has assets and Basel committee says that Basel one says that each asset carries a risk weight.

Speaker A

We all know that balance sheet has assets, and Basel Committee says that Basel One says that each asset carries a risk weight.

Speaker A

are being suggested depends upon the risk identified with the different type of the borrowers or customers or different type of the assets.

Speaker A

So what are the risk weights the Basel Committee has suggested? It suggested 0% risk weight if the bank has invested in government securities and 20% risk weight if the bank has invested in well-rated banks, and 50, 70, and 100% risk weights are being suggested depending upon the risk identified with the different types of borrowers or customers or different types of assets.

Speaker A

the nursingum committee recommendations. So the one is numerator side the bank is required to have the capital funds on the denominator side risk weighted assets are to be computed and capital funds to risk weighted assets ratio should be not less than

Speaker A

So that's where the concept of risk-weighted assets has come to the balance sheet of the banks in 1988. Of course, in India, it has been implemented sometime in 1992-93 after the introduction of the Narasimham Committee reforms or after responding to the Narasimham Committee recommendations. So the one is numerator side, the bank is required to have the capital funds; on the denominator side, risk-weighted assets are to be computed, and capital funds to risk-weighted assets ratio should be not less than 8%. This is what universally banks have agreed on Basel One document. Basically, G10 countries agreed it; subsequently, the group expanded to G15, G20, it has become, and many other countries who are not members of this G10 group also have become committed to this Basel One regulation because of its importance and protection of the financial system. So that's where the capital funds, capital maintenance of the capital funds and maintenance of the capital adequacy has become a mandatory thing by banks. So

Speaker A

committed to this Basel one regulation because of its uh importance and protection of the financial system. So that's where the capital funds uh cap uh maintenance of the capital funds and maintenance of the capital adequacy has become a mandatory thing by banks. So

Speaker A

let me explain this example of risk-weighted asset for your clarity in a bit more detail.

Speaker A

I'm giving you the balance sheet one side of the balance sheet of the bank that is various types of the assets.

Speaker A

I'm giving you the balance sheet, one side of the balance sheet of the bank, that is various types of the assets.

Speaker A

every bank every commercial bank or every commercial bank in any other country we have one column column which is indicating the actual amount of the assets and the second column is risk weight is given and the third column is

Speaker A

So for example, cash is one of the important assets, then balances with banks, and investment in government securities, investment in corporate bonds, and various types of assets are there on the asset side of the balance sheet. These assets are common for every bank, every commercial bank or every commercial bank in any other country. We have one column which is indicating the actual amount of the assets, and the second column is risk weight is given, and the third column is the asset value multiplied with the risk weight. So the Basel Committee assigned, or Basel One document assigns, various risk weights to different types of assets. So risk weight multiplied by the asset value, we are going to get risk-weighted assets. That means the balance sheet total of the assets is, let us take, 1,000. After application of the risk weights, naturally the number or amount of assets are likely to be less than the balance sheet value of the assets. So the risk-weighted assets are slightly less than the balance sheet value because some of the assets do not carry any risk weight or zero risk weight.

Speaker A

risk weighted assets that means uh the balance sheet total of the assets is let us take 1,000 after application of the risk weights naturally the number of amount of assets are likely to be less than the balance sheet value of the assets. So the risk

Speaker A

Now what are the capital funds? The Basel Committee said equity capital and other types of reserves and various other reserves are recognized.

Speaker A

Now what are the capital funds? The Basel committee said equity capital and other type of the reserves and various other reserves are recognized.

Speaker A

Some reserves are recognized in a proportionate revaluation reserve and other things are recognized only proportionately.

Speaker A

So the basically the basel committee tried to identify the quality of the capital funds for recognizing per capital requis.

Speaker A

So basically, the Basel Committee tried to identify the quality of the capital funds for recognizing per capital requisites.

Speaker A

This is the basel one approach which was introduced in 1988 across in various countries in 9293 in India and subsequently many other countries also followed this approach. Suppose if the bank is not able to meet the capital requirements

Speaker A

So once the capital funds are identified, the ratio between the capital funds to risk-weighted assets is capital adequacy.

Speaker A

and If the shareholders are failed to do the bank regulator is empowered to sell or liquidate the bank or it may go for merging the bank or may take some serious regulatory decision.

Speaker A

This is the Basel One approach which was introduced in 1988 across various countries, in 1992-93 in India, and subsequently many other countries also followed this approach. Suppose if the bank is not able to meet the capital requirements,

Speaker A

So they're just not computing it is maintaining the capital adequacy is essential and if the bank is unable to maintain the capital adequacy then the shareholders has a responsibility to bring the additional funds to the bank's balance sheet and if the shareholders

Speaker A

then there is an obligation, there is regulatory interference, regulators interfering and asking the bank to maintain the capital funds and asking the shareholders to retain the control over that, maintain the minimum capital ratio, recapitalize the bank, bring the additional funds,

Speaker A

to the regulator and in the world in various countries different type of the regent regulators have taken different type of the actions for various banks when the capital requirements are falling below the required level. Capital uh is falling

Speaker A

and if the shareholders fail to do so, the bank regulator is empowered to sell or liquidate the bank or it may go for merging the bank or may take some serious regulatory decision.

Speaker A

Whereas in 1996 even the market risk losses are also identified for the purpose of maintaining the capital. That means banks are trading in various types of the financial assets. It may be investments, bonds, equity shares and various other type of the derivative

Speaker A

And if we look, Reserve Bank of India has taken such decisions on various banks when the capital requirements are falling below the regulatory requirement or capital adequacy of the bank is below the regulatory requirement.

Speaker A

The story went on for several years. So capital adequacy is recognized as an important element for growth and financial planning of the bank.

Speaker A

So they're just not computing it; maintaining the capital adequacy is essential, and if the bank is unable to maintain the capital adequacy, then the shareholders have a responsibility to bring the additional funds to the bank's balance sheet, and if the shareholders

Speaker A

One can estimate on the basis of this formula. That means uh what is the current rate of return the bank is generating return on assets. How much assets are how much of the profits are being paid as dividend

Speaker A

are unable to bring the additional funds, the bank's regulator can take any regulatory action, either it is selling the bank or merging the bank with any other bank or liquidating the bank. All these actions or options are open to the regulator, and in the world in various countries, different types of regulators have taken different types of actions for various banks when the capital requirements are falling below the required level. Capital is falling

Speaker A

just assuming on broader level abstract level total equity to total assets are expected to be 10%age I'm not going to specifically risk weighted assets so suppose equity to total assets required to be maintained is approximately 10%age age and bank's

Speaker A

below the required level. In 1996, Basel Committee has also come out with a market risk amendment. That means in 1988 fundamentally only credit losses are identified for meeting the capital requirement.

Speaker A

Suppose if the bank is increasing the capital adequacy to 11 percentage you are seeing that growth rate in assets is coming down to 8.5%age.

Speaker A

Whereas in 1996, even the market risk losses are also identified for the purpose of maintaining the capital. That means banks are trading in various types of financial assets. It may be investments, bonds, equity shares, and various other types of derivative

Speaker A

That means capital adequacy reduces the if the higher the amount of the capital the growth rate is going to be affected.

Speaker A

instruments. So in that case, bank is expected to maintain the capital adequacy for meeting the unexpected losses of market risk also. So this amendment has come in 1996.

Speaker A

So that means clearly capital adequacy is linked with the expected growth rate in assets of a particular bank.

Speaker A

The story went on for several years. So capital adequacy is recognized as an important element for growth and financial planning of the bank.

Speaker A

is insisting on maintaining of the capital adequacy. So capital adequacy is the critical point for growth of the bank or capital adequacy is the nucleus for growth of the bank.

Speaker A

So for example, at what rate a bank can grow in the next year based upon the current level of the capital adequacy?

Speaker A

So the capital adequacy is linked with the growth of the bank. If the capital requirements are low, high growth in assets is possible. But to meet the unexpected losses, if the regulators are emphasizing on higher capital adequacy requirements, then the growth is going

Speaker A

One can estimate on the basis of this formula. That means what is the current rate of return the bank is generating, return on assets, how much assets are, how much of the profits are being paid as dividend,

Speaker A

lending to a moderately rated customer. As per the Basel one, all the customers are treated with the 100%age credit risk weightage.

Speaker A

and what is the capital required for the bank and how much capital is available after paying the dividend. So if I just give you hypothetical figures, suppose capital adequacy ratio is 10%, that means I'm

Speaker A

So the borrower is credit quality is important in maintaining the capital funds but unfortunately vasel one is rigid enough not to consider this one.

Speaker A

just assuming on a broader level, abstract level, total equity to total assets are expected to be 10%. I'm not going to specifically risk-weighted assets, so suppose equity to total assets required to be maintained is approximately 10%, and bank's

Speaker A

We all know though fundamentally if the assets of portfolio are negatively correlated the risk of the bank is or risk of the portfolio is expected to be low. This is simple lesson coming out of the portfolio theory or simple point

Speaker A

return on assets is 1.5%. Assuming the dividend payout ratio is 30%, by applying the formula which I have shown in the previous slide, the bank can grow its asset p...

Speaker A

proper in a credit decision or there may be a failure of the system and bank may incur losses or there may be theft, there may be fraud.

Speaker A

In all these cases, the bank is likely to incur huge losses and those losses are to be covered out of the capital funds. But uh current definition of the Basel one is only restricted to credit and market risk but not the operational

Speaker A

risk as per the Basel one and risk sensitivity is also limited. The Basel one document is considering high risk and low risk assets on the same line or same level but discrimination of the low risk versus high risk is not so

Speaker A

sensitive in designing the portfolio and in designing the in maintaining the capitaly requirements. To overcome this one, a new document has come and new thinking has come that is called Basel 2 which is uh covering a comprehensive risk

Speaker A

estimation and risk management measure.

Topics:Basel Onecapital adequacyrisk-weighted assetsbank regulationNarasimham Committeefinancial regulationbank capital requirementsReserve Bank of IndiaGlass-Steagall ActFederal Reserve

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