Basel Committee on Banking Supervision has given certain guidelines with a view to strengthen the Banking Sector. First Basel accord was done in 1988.
There are three Kinds of Risk which have been categorized:
- Credit Risk: Risk that counterparty will default and will not pay back the amount due.eg a borrower who has taken a loan fails to repay it
- Market Risk: Risk that value of securities held by bank will reduce in value because banks are exposed to markets. For e.g. bank holds bonds whose value fluctuates daily.
- Operational Risk: Risk caused due to people or failed or inadequate processes and systems. For e.g. internal Fraud, external fraud, failure of compute system/ATM
These are 3 categories of risks which a bank faces. All the risks faced by a Bank can be categorized under these 3category.
How to counter these risks:
These risks pose significant challenge to the very survival of Bank. For eg if a Big loan given by Bank fails and it does not have enough capital whole Bank may fail.
One of the classic examples of how operational risk can cause a Bank to fail is failure of Baring Banks. Barings Bank was an English merchant bank based in London, and one of the world’s oldest merchant banks founded in 1762. Due to inadequate processes and checks and Balances one of its trader Nick Leeson caused it a loss of (US$1.3 billion), twice the bank’s available trading capital. Thus a 235 year old bank went Bankrupt and was sold for £1 to ING.
The BASEL Committee is a committee of bank supervisors consisting of members from each of the G10 countries. It aims to ensure effective supervision of banks’ activities worldwide.
It has given comprehensive framework to deal with these categories of risks faced by the Bank and ensure robust banking system which comprises of 3 Pillars.
These three pillars are:
Pillar I- Minimum capital requirement. It means the minimum working capital a Bank must have. It is 8 % of Risk weight asset. Capital to risk weighted assets ratio is arrived at by dividing the capital of the bank with aggregated risk weighted assets for credit risk, market risk and operational risk. The higher the CRAR of a bank the better capitalized it is.
The Capital Adequacy ratio is measured as :
Total Regulatory Capital = Bank’s Capital (minimum 8%)
Credit Risk + Market Risk + Operational Risk
Pillar- II Supervisory Review Process: It envisages better supervision of Banks by the regulator i.e RBI in case of India. It has 4 parts:
1) To see all banks have a process to assess their requirements of capital
2) To see the said process to assess capital by each bank is sound and adequate.
3) To see Banks operate above the minimum capital prescribed.
4) To intervene in case of internal processes are slack
Pillar III Market Discipline: It aims to provide more, better and objective information to all the stakeholders of the bank in the form of enhanced disclosures. Stake holders means creditors, shareholders, any person who wishes to deal or take exposure on the Bank.
An overview of the Basel II accord is as under:
Minimum Capital Requirement
– maturity method
– duration method