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Discipline: Risk Management
Subject: Basel
Category: General
Level: Basic
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Basel III: An Overview

1. What is Basel III

Basel III refers to the capital and liquidity standards prescribed by the Bank for International Settlements (BIS) to promote stability of international banking system. BIS is an international financial institution, which acts as a bank of central banks1 .

2. Purpose of Capital and Liquidity Standards

One of the ways of maintaining financial stability of the banking system is to maintain adequate capital. Capital absorbs losses and provides protection to depositors and other creditors in case of liquidation of a bank.

Maintaining liquidity is as equally important as capital to maintain stability of the financial sector. Banks should have sufficient high quality liquid asset to survive in a difficult time. They should also fund the activities with more stable sources of funding and avoid excessive reliance on short term fund to finance the long term asset.

Capital and liquidity standards prescribe minimum level of capital and liquidity that banks should maintain.

3. Basel I, Basel II, Basel III

Basel Committee on Banking Supervision (BCBS) is one of the six committees of BIS. The Committee introduced capital standard in 1988, which is known as Basel I. Due to some shortcomings of Basel I, it was replaced by Basel II in 2004. Again, Basel-II was felt inadequate in the recent global financial crisis. As a result, Basel III was formulated in the year 2010 with the intention of gradual implementation starting from 1 January 2013 and full implementation starting from 1 January 2019. Basel III includes both capital standard and liquidity standard. The earlier versions included capital standard only.

4. Basel III for Islamic Banks

Capital and liquidity standard for Islamic banks should address their uniqueness. At the same time, the standard should converge with international best practices like Basel framework, where applicable, as Islamic financial institutions are also part of global financial sector. In view of the above, Islamic Financial Services Board (IFSB), an international standard setting organization for Islamic financial institutions, adapted and modified the Basel frameworks and issued several standards for Islamic financial institutions. IFSB-15 is the latest standard of IFSB on capital adequacy in line with Basel III which was issued in December 2013 and effective from 1 January 2015.

5. Basel III in Bangladesh

In Bangladesh, Basel I was introduced in the year 1996 and Basel II was introduced in the year 2010 (Parallel run with Basel I started in the year 2009). In line with Basel III, Bangladesh Bank (BB) circulated ‘Guidelines on Risk Based Capital Adequacy’ vide BRPD circular no. 18 dated 21 December 2014 and gradual implementation of Basel III has started from 1 January 2015 in Bangladesh. Full implementation of Basel III in Bangladesh will start from January 2019.

6. Capital Standard

It is said earlier that Basel III has two parts: Capital Standard and Liquidity Standard. Capital Standard of Basel III is structured into three aspects, which are known as three pillars2 :

  1. Pillar 1 covers minimum capital, capital buffer and leverage
  2. Pillar 2 covers Risk management and supervision and
  3. Pillar 3 covers Market Discipline

Pillar 1 of Capital standard prescribes some ratios related to capital, which has to be maintained by banks as a minimum. Two such major ratios are Capital to Risk-weighted Asset Ratio (CRAR) and Leverage Ratio.

6.1 Capital to Risk-weighted Asset Ratio

The Capital to Risk-weighted Asset Ratio (CRAR) is calculated by taking eligible regulatory capital as numerator and total Risk Weighted Asset (RWA) as denominator.

CRAR

Banks in Bangladesh have to maintain minimum total capital ratio of 10% or Tk. 400 crore, whichever is higher3. In addition to this minimum capital, a Capital Conservation Buffer (CCB) of 2.5% is to be built up gradually within year 2019.

The above ratio has two parts: Eligible Capital and Risk Weighted Asset, which are explained below.

6.1.1 Eligible Capital

According to loss absorbance capacity/quality, the eligible capital is divided into two tiers:

  1. Tier 1 Capital: It is better quality capital. Tier 1 capital is further divided into two parts-

    1. Common Equity Tier 1 Capital (CET-1 Capital): CET-1 capital generally includes the following items:
      1. Paid up capital

      2. General reserve

      3. Statutory reserves

      4. Retained earnings etc.

    2. Additional Tier 1 Captial: It includes non-cumulative irredeemable bond/preference shares etc.
  2. Tier 2 Capital: It is lower quality capital than Tier 1 capital. It includes subordinated bond, general provision etc.4

6.1.2 Risk Weighted Asset:

Banks are required to calculate their Risk Weighted Assets (RWA) on the basis of credit (Investment) Risk, market Risk, and operational risk.

6.2 Leverage Ratio:

In order to complement CRAR, a simple non-risk based Leverage Ratio has been introduced. While CRAR uses risk weighted asset/exposure as denominator, leverage ratio uses total exposure. Leverage ratio is calculated as under:

Leverage

Banks have to maintain minimum leverage ratio of 3%. In Bangladesh, the calculation of leverage ratio will be monitored in the year 2016 and readjustment, if required, will be made in the year 2017. From 2018, it will be mandatory for banks to maintain the leverage ratio.

7. Liquidity Standard:

Basel III introduced liquidity standard as a complement to the capital standard. It developed two minimum standards for liquidity. These are Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). Bangladesh Bank, in line with Basel III, has circulated 'Guidance Note on Liquidity Coverage Ratio (LCR) & Net Stable Funding Ratio (NSFR)' through DOS Circular No. 01 dated 1 January 2015.

7.1 Liquidity Coverage Ratio:

LCR aims to ensure that a bank maintains an adequate level of unencumbered, high-quality liquid assets that can be converted into cash to meet its liquidity needs for 30 calendar days in a difficult time. The equation to calculate LCR is as under:

LCR

The minimum standard for LCR shall be greater than or equal to 100.

 7.2 Net Stable Funding Ratio:

The objective of NSFR is to promote resilience over a time horizon of one year by requiring banks to fund the activities with more stable sources of funding. NSFR aims to limit over-reliance on short-term wholesale funding during times of abundant market liquidity.

The equation to calculate NSFR is as under:

Net Stable Funding Ratio

The minimum standard for NSFR shall be greater than 100.

 Summary of Capital and Liquidity Requirements/ Roadmap of implementation of Basel III in Bangladesh

 

2016

2017

2018

2019

2020

Minimum Total Capital Ratio

10.00%

10.00%

10.00%

10.00%

10.00%

Capital Conservation Buffer

0.625%

1.25%

1.875%

2.50%

2.50%

Minimum Total Capital plus Capital Conservation Buffer

10.625%

11.25%

11.875%

12.50%

12.50%

Leverage Ratio

3%

3% Readjustment

Migration to Pillar 1

Liquidity Coverage Ratio

≥ 100%

≥ 100%

≥ 100%

≥ 100%

≥ 100%

Net Stable Funding Ratio

> 100%

> 100%

> 100%

> 100%

> 100%


Footnote:

3 The minimum Paid-up Capital and Reserve Fund of banking companies shall be Taka 400 crore, of which the paid-up capital shall be not less than Taka 200 crore (Reference: Section 13(2) of the Banking Companies Act, 1991, Bangladesh Bank notification no. BRPD(R ‐ 1)717/2008 ‐ 511 dated August 12, 2008 and BRPD Circular Letter No. 11 dated 14 August 2008).

4This is a short-list of components of capital applicable for local banks. For the full list or for the list applicable for foreign banks, please consult Bangladesh Bank Guideline (BRPD Circular 18, 2014)

Reference

BRPD circular no. 18 dated 21 December 2014
BRPD Circular Letter No. 11 dated 14 August 2008
DOS Circular No. 01 dated 1 January 2015
Bangladesh Bank notification no. BRPD(R ‐ 1)717/2008 ‐ 511 dated August 12, 2008
Summary Table of  Basel III reforms
Section 13(2) of the Banking Companies Act, 1991
IFSB-15 Revised Capital Adequacy Standard December 2013

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