Investment Banking (All about Basel III)

1. Risk-weighted assets: This term refers to how many assets banks must have to prevent or
reduce the chance of not being able to meet financial obligations.
2. Liquidity: How much cash assets are available right now.
3. Why do we need Capital -- While bank’s assets (loans & investments) are risky and prone to
losses, its liability (deposits) are certain.
4. Bank failures -- mainly by losses in assets – default by borrowers (Credit Risk), losses of
investment in different securities (Market Risk) and frauds, system and process failures
(Operational Risk).
5. Basel norms are international banking regulations issued by the Basel Committee on Banking
Supervision (BCBS).
6. Its secretariat (administrative office) is located at the Bank of International Settlements (BIS)
headquartered in the city of Basel in Switzerland.
7. The Basel Committee on Banking Supervision (BCBS) consists of representatives from central
banks and regulatory authorities of 27 countries (including India).
8. There are 3 main accords ,
• Basel I - introduced in year 1988. It focused primarily on credit risk
• Basel II –introduced in 2004. Had 3 main pillars. Minimum capital requirements, Regulatory
supervision and Market Discipline.
• Basel III – introduced in 2009-10.
9. Basel –I focused primarily on credit (default) risk faced by the banks. As per Basel-I, all banks
were required to maintain a capital adequacy ratio of 8 %.
10. The capital adequacy ratio is the minimum capital requirement of a bank and is defined as the
ratio of capital to risk-weighted assets. The capital was classified into Tier 1 and Tier 2 capital. ▪
Tier 1 capital is the core capital of a bank that is permanent and reliable. It includes equity
capital and disclosed reserves. Tier 2 capital is the supplementary capital. It includes undisclosed
reserves, general provisions, provisions against Non-performing Assets, cumulative non-
redeemable preference shares, etc.
11. The risk-weighted asset is the bank’s assets weighted according to risks. The assets of the bank
were classified into 5 risk categories of 0 % or 0, 10 % or 0.1, 20 % or 0.2, 50 % or 0.5 and 100 %
or 1.
Example- Cash into 0 % risk category, home mortgage into 20 % risk category and corporate
debt into 100 % risk category. Lets say-a bank has Rs.100 as cash reserves, Rs.200 as home
mortgage and Rs.300 as loans given out to companies. The risk-weighted assets= (Rs.100 * 0 ) +
(Rs.200 * 0.2) + (Rs.300 * 1) = 0 + 40 + 300 = Rs340 ▪ Therefore, this bank has to maintain 8 % of
Rs.340 as minimum capital.(at least 4 % in tier-1 capital).
12. Basel-II was issued in 2004. This framework is based on three parameters
▪ Minimum capital requirements: Banks should continue to maintain a minimum capital
adequacy requirement of 8% of risk-weighted assets. However, Basel-II divides the capital into 3
tiers. Tier-3 capital includes short-term subordinated loans. (sub ordinated loans means lower in
the ranking. It is repaid after other debts in case of bank liquidation).
 ▪ Regulatory supervision: According to this, banks were required to develop and use better risk
management techniques in monitoring and managing all the three types of risks that a bank
faces, viz. credit, market, and operational risks
▪ Market Discipline: Banks need to mandatorily disclose their CAR, risk exposure, etc. to the
central bank.
13. Under Basel 2 – Calculation of Credit Risk Approach :-
Standardized Approach - It directs banks to use ratings from external credit rating agencies to
compute capital requirements.
Foundation –Internal Rating Based (FIRB) Model – gives banks the freedom to develop their own
models to ascertain risk weights for their assets. *They are subject to the approval of the
banking regulator*. Further, the regulators provide the model assumptions – Loss given default
(LGD) and Exposure at Default (EAD). Banks are however allowed to use their own estimates of
Probability of Default (PD).
Advanced IRB (AIRB) – Banks are free to use their own assumptions of PD, LGD and EAD in the
models they develop. However, this approach can only be used by selected set of banks without
*regulators approval*.
14. Under Basel 2 – Calculation of Operational Risk Approach :-
Basic Indicator Approach - It suggests that the banks hold 15 percent of their average annual
gross income (over past 3 years) as capital. On basis of risk assessments of individual banks,
regulators may adjust the 15 percent threshold.
Standardized Approach – splits a bank based on its business lines. The idea is that the business
with lower operational risk would translate into lower reserve requirement.
Advanced Measurement Approach–Banks are free to use their own computations for
operational risks. However they are subject to regulatory approval.
15. Under Basel 2 – Calculation of Market Risk Approach :-
Standard Approach – It splits assets into different compartments based on certain parameters :
type, origin, maturity and volatility. It then gives risk weights – from 2.25 percent for the least
risky assets to 100 % for the most risky assets.
Scenario Analysis - the risk weights are assigned by taking into consideration the scenarios that
could exist in each country’s market. This method is less conservative and allows banks to be
more experimental.
Internal Model Approach–Banks are free to design their own market risk models.

Exactly What happened in 2008 Crisis?

Mortgaged Paper (CDO- Collateralized debt obligation) were the assets that bank gets when
they provide housing loan to people. Whenever they default in payment bank gets right to sale
the house in market. In 2000s, it was considered a great opportunity by retail investors to buy
these Mortgage papers from bank and earn interest on same. Therefore, bank started creating
more of these financial assets by giving more house loan and even with less security. Thereafter,
people defaulted in paying against mortgage paper, which led to crisis in market (Example -
Lehman brothers {Investment Bank}) as the demand of Mortgage paper decreased and supply
 increased as investor wanted to sell them. Also instruments like CDS (credit default swap)
resulted increased crisis.

Despite having BASEL II norms we had faced a terrible financial crisis in 2008, so it was decided
that some improvisation was required in Basel II. Basel II had clearly failed to strengthen
financial stability and had inadequate risk management approach. It also lacked uniform
definition of capital which led to the birth of Basel III norms in 2010

16. Basel III is a global regulatory standard on capital adequacy, stress testing and liquidity risk.
The essence of Basel III involves around 2 sets of compliance: - Capital and Liquidity
 Minimum Total Capital Ratio remains at 8%. The addition of the capital conservation
buffer increases the total amount of capital a financial institution must hold to 10.5% of
risk weighted assets, of which 8.5% must be tier 1 capital. Tier 2 capital instruments are
harmonized, and tier 3 capital is abolished.
 Inclusion of Leverage Ratio (3%) and Liquidity Ratios.
 Counter Cyclical Buffer (0 - 2.5%) and Capital conservation Buffer to RWA (2.5%).
17. Main Elements of Basel III :-
 Introduction of CVA (Credit Valuation Adjustment) framework for Counterparty Credit Risk -
The Basel III reforms introduced a new capital charge for the risk of loss due to the
deterioration in the creditworthiness of the counterparty to a derivatives transaction or
an SFT. This potential mark-to-market loss is known as CVA risk. It captures changes in
counterparty credit spreads and other market risk factors.
 Internal Rating Based framework on Credit Risk – Changes are made to the calculation
of RWA under IRB. Major changes were also done to the IRB methodology which
resulted in redevelopment of credit models.
 Standardized Approach to Credit Risk (SA – CR) – Major changes in Standardized
Approach for Credit Risk across all product types.
18. Liquidity Coverage Ratio was introduced to promote short term resilience of a bank’s liquidity
risk profile. The LCR is a requirement under Basel III whereby banks are required to hold an
amount of high-quality liquid assets that's enough to fund cash outflows for 30 days.
LCR is expressed as Stock of HQLA/ Total net cash outflows, in case of no stress scenario it
should be at least 1:1.
19. Liquidity NSFR (Net stable funding ratio): Net Stable Funding Ratio takes a longer term look at
liquidity on a financial institution’s balance sheet . This longer term liquidity ratio requires a
minimum amount of stable funding to be held over a one year time horizon based on liquidity
risk factors assigned to liquidity exposures of off and on balance sheet assets. Hence, NSFR aims
to promote more medium and long term funding activities of banking organizations by ensuring
that the investment activities are funded by stable liabilities.
NSFR is calculated as: Available amount of Stable fund > 100%
Required amount of Stable fund
20. LRD: A critical characteristic of 2007-08 financial crisis was the overuse of on and off balance
sheet leverage in the banking sector. Banks portrayed healthy risk based capital ratios .
However, when banks had no choice but to reduce leverage in the worst part of crisis, a vicious
circle was created. The leverage ratio is calculated by dividing Tier 1 capital by the bank's
average total consolidated assets (Exposures). Ideal ratio should be more than 3%.