International Credit Market – Basel Accords
Basel I, II, III
Muhammad Yaseen (938)
Student
Institute of Business & Management,
UET Lahore
Muhammad Ali (929)
Student
Institute of Business & Management,
UET Lahore
Ifra Amjad (909)
Student
Institute of Business & Management,
UET Lahore
Saima Kausar
Student
Institute of Business & Management,
UET Lahore
Table of Contents
Abstract 2
International Credit Market 3
Element of International Credit Market 3
How Credit Market Works? 3
Preference of Loan 3
Loan’s Interest Rate 3
Syndicated Loan 4
Features of Syndicated Loan: 4
Introduction and History of Basel Accords: 4
Basel-I 5
Capital Structure under Basel-I 5
Risk Weights under Basel I: 5
Basel-II: 7
Minimum Capital Requirement: 7
Supervisory Review: 7
Market Discipline: 7
Basel III 7
Capital Structure under Basel III 8
Introduction of Capital Conservation Buffer 8
Leverage Ratio 9
State Bank Of Pakistan – Basel III Instructions 9
Instructions on Capital Adequacy Framework: 10
Limits (Minima & Maxima) 11
Leverage Ratio 12
Summary of Implementation in Pakistan 12
References 14
Abstract
The focus of this report is to provide the overview of International Credits Markets and Basel Accords which are issued under the supervision of Basel Committee of Banking Supervision to the students of MBA Finance session of Institute of Business & Administration, University of Engineering & Technology, Lahore. This report also put emphasis on the latest Basel norm adopted by the private banks in Pakistan under the instructions of State Bank of Pakistan.
International Credit Market
Credit market is a market in which companies and government issues debt securities to the investors, such as short term commercial paper or medium term loans to raise funds. It is also known as debt Market.
In credit market, government can raise funds by allowing investors to purchase these debt securities. If more bonds from the government are being purchased, this is a good indicator that means investors are interested in stock market.
Element of International Credit Market
The elements of the International credit market are: commercial banks, organizations, nonbank financial institutions (insurance agencies and pension funds) national banks and other public bodies & governments. In any case, much of the time the crediting is done by the International credit banks.
How Credit Market Works?
Whenever companies, national governments and regions need to acquire cash, they issue bonds. Investors who purchase the securities basically credit the issuer money. Thusly, the guarantors pay the interest on the bonds, and when the bonds develop, the investors offer them back to the guarantors at face value. Investor may also sell their bonds to different investors for pretty much than their face esteems.
Different parts of the credit market are marginally more complicated, and they comprise of consumer debt. Mostly, as the bank gets installments on the obligation, the speculator acquires interest on his security, however if excessively numerous borrowers default on their loan, the investor loses.
Preference of Loan
Borrowers usually prefer that loan be determined in the currency of their primary in which they receive most of their cash flows, which eliminate the borrower exchange rate risk.
Loan’s Interest Rate
Loans interest rate depends on the currency in which the loan is denominated.
A loan denominated in the currency of a country with very low inflation normally has a relatively low interest rate.
Loans denominated in the currency of a country with high inflation rate tend to have higher interest rate.
Syndicated Loan
When single lender is unwilling to process a very large loan or to take large exposure they form or enter in group of lenders known as syndicates or syndicated loan.
In syndicated loans, several banks collectively give loan to single borrower to minimize the risk.
Features of Syndicated Loan:
Following are the features of the syndicated loan:
Huge amount and long term loan
Less pressure on banks and have diversified risk
In syndicated loans, it is given to single borrower with large amount and long term period. Further it’s easy to coordinate with agent bank only.
In this management is much easier compared with loans borrowed separately from different banks
It is cost effective as to deal with only lead bank.
Introduction and History of Basel Accords:
Banks plays an important role in the economic development of a nation. A bank is a financial institution which deals in the business of accepting deposits from general public and lends it to different organizations and individuals. The commercial and traditional banking activities of accepting deposits and lending have been replaced by the concept of universal banking and now international banking. The banks are gradually expanding their operations, entering in new markets and trading in new asset types. With the change in financial system, it has created new opportunities along with new risk.
The Bretton Wood System was failed in 1973 which led to the causalities in German Banking System and UK’s Banking System with huge amount of foreign exchange exposures which was more than the capital of the banks.
To address the risks associated with banking organizations, an international committee was formed by the central bank governors of the G-10 countries in 1974 named as Committee on Banking Regulations and Supervisory Practices. It was later renamed as the Basel Committee on Banking Supervision (BCBS). The Basel Committee on Banking Supervision (BCBS) provides a forum for regular cooperation on banking supervisory matters. This committee was come into being under the supervision and support of Bank for International Settlements (BIS), Basel, Switzerland.
The basic purpose of the Basel Accord is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses. Furthermore, The Basel committee formulates guidelines and provides recommendations on banking regulation based on capital risk, market risk and operational risk. Till now, BCBS has issued 3 sets of regulations, which are collectively known as Basel accords. So, Pakistan being an active participant of international banking transactions have accepted these regulations and have more stringent financial risk measures than recommended by the Basel Committee.
Basel-I
The Basel-I norms were issued in 1988 which was focused on reducing the credit risk of banks by defining the minimum capital adequacy requirement of 8% which could be calculated by dividing the risk weighted assets to the regulatory capital. The committee further suggested the ways to calculate the capital and risk weighted assets.
Capital Structure under Basel-I
Capital was divided in two categories i.e. Tier I and Tier II capital. Tier I capital is based on following items:
Paid-Up Capital
Statutory reserves
Disclosed free reserves
Capital reserves representing surplus arising out of sale proceeds of assets
Tier II Capital is based on the following items:
Undisclosed reserves
Revaluation reserves
General provisions and loss reserves
Risk Weights under Basel I:
Four different types of weights i.e. 0%, 20%, 50% and 100% was provided based on the categories of borrowers. The following table describes the weight given criteria:
Weights
Asset types
0%
Cash held
Claims on OECD central governments
Claims on central governments in national currency
20%
Cash to be received
Claims on OECD banks and regulated securities
Claims on non-OECD banks below 1 year
Claims on multilateral development banks
Claims on foreign OECD public-sector entities
50%
Residential mortgage loans
100%
Claims on the private sector (corporate debt, equity, etc.)
Claims on non-OECD banks above 1 year
Real estate
Plant and Equipment
OECD: Organization for Economic Co-operation and Development
Source: Basel Committee on Banking Supervision (2005), An Explanatory Note on the Basel II Internal Rating Based Risk Weight Functions, BIS, Bank for International Settlements.
In 1996, the Basel Committee on Banking Supervision amended the Basel accord by adding the market risk factor in computation of CAR requirement along with risk weighted assets.
Off balance sheet items i.e letter of credits, guarantee & commitments etc. holds significant amounts in the financial reports. Basel committee also provided the risk weights for these off balance sheet items which need to be assigned appropriate weights as below mentioned table:
Basel-II:
On June 26, 2004, Basel Committee on Banking Supervision revised the Basel I accord and introduced Basel II accords under its published article named as “International Convergence of Capital Measurement and Capital Standards: A revised Framework”.
This accord is comprised of three following pillars:
Minimum Capital Requirement
Supervisory Review
Market Discipline
Minimum Capital Requirement:
This requirement is the extension of Basel I accord in which committee put a limit on tier I capital which should be at least 4% of the total risk weighted assets of the banking organization. The Committee also added a 3rd risk factor i.e. operational risk while calculating the total Capital Adequacy Ratio along with the risk weighted assets and market risk. Furthermore, in this accord the Basel Committee on Banking Supervision suggested the different approaches to calculate the minimum capital requirement and risk weighted assets. The total CAR was remained same at 8%.
Supervisory Review:
Basel II had given powers to the regulators to supervise and check bank’s risk management system and capital assessment policy. The regulators can also ask for buffer capital apart from minimum capital requirement by BCBS. In Pakistan, SBP is supervising these risk related measures and minimum capital requirements of banks.
Market Discipline:
The Pillar III had made disclosure of a bank’s risk taking positions & capital, mandatory. This step was targeted to introduce market discipline through disclosure. While going through the annual report of a local bank of Pakistan, we have observed the disclosure of risk taking positions and capital requirements in a detailed manner.
Basel III
The 2008 financial crises stressed the international regulators to review the risk measures processes which led the establishment of Basel III. These guide lines were issued in December 2010 and the full implementation of which would be exercised till Dec 2019 under the supervision of central banks of respective countries. Basel III focused on enhanced capital requirements along with the addition of leverage ratio.
Capital Structure under Basel III
Under Basel III requirements, the Basel committee has decided to further enhance the capital requirements of the banks by dividing the tier I capital into two following parts:
Tier I Capital:
Common Equity Tier I Capital
Additional Tier I Capital
The composition of tier I capital in the capital structure under Basel III is that, the tier I capital should be at least 4.5% and additional tier I capital should be 1.5% of total risk weighted assets.
Tier II capital should be at-least 2.5% in the total capital structure.
Introduction of Capital Conservation Buffer
The Basel committee introduced the addition of capital conservation buffer first time in the history of Basel accords. This capital conservation buffer should be comprised of 2.5% of common equity tier I capital because it has the maximum ability to absorb the losses. The prime purpose to introduce this buffer was to enable the banks to maintain their capital adequacy requirements in the time of financial stress.
The break-up of capital requirements and their phases of implementation under Basel III are mentioned in the below chart:
Leverage Ratio
The financial crisis of 2008 compelled the international regulators to make more stringent financial risk policies. Basel committee did not point out the concerns over leverage positions earlier these financial crises. Banks were able to comply the minimum capital adequacy requirements under Basel committee instructions, but the leverage positions were started being compromised. So, the Basel committee took into consideration this matter and imposed a leverage ratio requirement as well. This requirement put into place the non-risky assets of the banks into consideration as well.
According to Basel, the leverage ratio was defined as a ratio of tier I capital to total assets ratio. This requirement was set to 3% of its total assets even if the bank’s assets are comprised of zero risky assets.
State Bank Of Pakistan – Basel III Instructions
In Pakistan, State Bank of Pakistan is supervising the implementation of Basel Norms in banking industry. The Banking Policy and Regulation Department of SBP have issued various instructions under Basel norms to the banks under its sole authority to implement these regulations. We are focusing here to discuss the instructions issued by SBP under Basel III.
Instructions on Capital Adequacy Framework:
The calculation of CAR has remained the same as it was in Basel II, the formula of which is given below:
CAR= Total Eligible Capital/Credit Risk Weighted Assets + Market Risk + Operational Risk
Currently, banks/ DFIs are required to maintain a minimum CAR of 10 percent on an ongoing basis at both standalone and consolidated level which will gradually be increased in the light of these instructions.
For the purpose of capital adequacy, the consolidated bank means an entity that is the parent of a group of financial entities, where the parent entity itself may either be a bank or a holding company. This consolidation is to ensure that risk of the whole banking group is captured.
SBP has advised the banks to divide the Capital in two following tiers as per Basel requirements:
Tier 1 Capital
Common Equity Tier 1
Additional Tier 1
Tier 2 Capital
Common Equity Tier 1 shall consist of sum of the following items:
Fully paid up (common shares) capital / assigned capital
Balance in share premium account
Reserve for Issue of Bonus Shares
General/ Statutory Reserves as disclosed on the balance-sheet
Un-appropriated / un-remitted profits (net of accumulated losses, if any)
Less regulatory adjustments applicable on CET1
Additional Tier 1 capital shall consist of the following items:
Instruments issued by the banks
Share premium resulting from the issuance of instruments
Less regulatory adjustments applicable on AT1
The Tier 2 capital (or gone concern capital) shall include the following elements:
Subordinated debt/ Instruments
Share premium resulting from the issue of instruments included in Tier 2
Revaluation Reserves (net of deficits, if any)
General Provisions or General Reserves for loan losses
Foreign exchange translation reserves
Undisclosed reserves
Less regulatory adjustments applicable on Tier-2
Limits (Minima & Maxima)
These instructions/ rules will be adopted in a phased manner starting from the end year 2013, with full implementation of capital ratios by the year-end 2019, as per table mentioned at the end of these limits. All banks will be required to maintain the following ratios on an ongoing basis:
Common Equity Tier 1 of at least 6.0% of the total RWA.
Tier-1 capital will be at least 7.5% of the total RWA which means that Additional Tier 1 capital can be admitted maximum up to 1.5% of the total RWA.
Minimum Capital Adequacy Ratio (CAR) of 10% of the total RWA i.e. Tier 2 capital can be admitted maximum up to 2.5% of the total RWA.
Additionally, Capital Conservation Buffer (CCB) of 2.5% of the total RWA is being introduced which will be maintained in the form of CET1
The excess additional Tier 1 capital and Tier-2 capital can only be recognized if the bank has CET1 ratio in excess of the minimum requirement of 8.5% (i.e. 6.0% plus capital conservation buffer of 2.5%).
For the purpose of calculating Tier 1 capital and CAR, the bank can recognize excess Additional Tier 1 and Tier 2 provided the bank has excess CET1 over and above 8.5%. Further, any excess Additional Tier 1 and Tier 2 capital will be recognized in the same proportion as stipulated above i.e. the recognition of excess Additional Tier 1 (above 1.5%) is limited to the extent of 25% (1.5/6.0) of the CET1 in excess of 8.5% requirement. Similarly, the excess Tier 2 capital (above 2.5%) shall be recognized to the extent of 41.67% (2.5/6.0) of the CET1 in excess of 8.5% requirement.
The transitional arrangements for the implementation of Basel III under SBP directions are mentioned in below chart:
Leverage Ratio
The SBP has imposed a minimum requirement of leverage ratio of 3% for the banks under the Basel III accord. The calculation of the ratio is as follows:
Leverage ratio=Tier I Capital/Total Assets
The banks will maintain leverage ratio on quarterly basis. The calculation at the end of each calendar quarter will be submitted to SBP showing the average of the month end leverage ratios based on the following definition of capital and total assets.
Summary of Implementation in Pakistan
The summary of Basel accords were implemented in Pakistan:
S. No
Date
Development
1
11/1997
Basel I issued
2
12/1997
Basel I implemented
3
08/2004
Market risk amendment issued
4
12/2004
Market risk amendment implemented
5
06/2006
Basel II issued
6
01/2008
Basel II implemented
7
12/2013
Basel III in draft uploaded on SBP web
References
Akshay Uday Shenoy, Yatin Balkrishna Mohane, Charan Singh (2014), “BASEL BANKING NORMS – A PRIMER” WORKING PAPER NO: 470, Indian Institute of Management Bangalore,Bannerghatta Road, Bangalore
Prof. Debajyoti Ghosh Roy, Prof. Debajyoti Ghosh Roy, Prof. Swati Khatkale (2013), “BASEL I TO BASEL II TO BASEL III: A RISK MANAGEMENT JOURNEY OF INDIAN BANKS “AIMA Journal of Management & Research, May 2013, Volume 7, Issue 2/4, ISSN 0974 – 497
Muhammad Ashraf Khan, Shaukat Zaman, Syed Jahangir Shah, Ahsin Waqas (2013), “Instructions for Basel III Implementation in Pakistan” Banking Policy & Regulations Department, BPRD circular # 06 dated August 15, 2013
Jeff Madura, 12th Edition, “ International Financial Management” Chapter # 3, International Financial Markets, Topic: International Credit Markets
Invest word/credit market
Investopedia/credit market
Investopedia/Basel, I, II, III
Wikipedia/ Basel Accords