QA Series No 42 - Basel Accords

 

The Banking Tutor

Question Answer Series 2025

S No 42                                                                  21-08-2025

Basel Accords 

01. What are Basel Accords? 

Basel accords are the recommendations of Basel Committee on Banking Supervision (BCBS) based in Basel, Switzerland, to improve the banking sector’s ability to absorb shocks arising from financial and economic stress due to various factors, thus reducing the risk of spill over from the financial sector to the real economy. 

02. What is full form of BCBS in the context of Basel Accords and when it is originated? 

BCBS has its origins in the financial market turmoil after failure of Breton Woods’s system of managed exchange rates in 1973 which had resulted in large foreign currency losses to many banks the world over. The BCBS was founded in 1974 as an international forum where members could cooperate on banking supervision matters. 

03. What is the main objective of BCBS? 

Objective of the BCBS says is to enhance "financial stability by improving supervisory know-how and the quality of banking supervision worldwide.” This is done through regulations known as accords. 

04. What is Basel I Accord and when it was introduced? 

Basel I is the first of three sets of regulations known individually as Basel I, II, and III, and collectively as the Basel Accords. Basel I was introduced in 1988. 

05. What was the main focus of Basel I Accord ? 

Basel I focused almost entirely on credit risk. 

06. What is meant by Credit Risk? 

Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet contractual obligations. 

07. Which Basel Accord defined Capital Structure and Risk Weights for Banks? 

Basel I defined capital and structure of risk weights for banks. 

08. What is RWA and what is the minimum Capital Adequacy Ratio (CAR) recommended by Basel I Accord? 

RWA stands for Risk Weighted Assets and it refers to assets with different risk profiles. For example, an asset backed by collateral would carry lesser risks as compared to personal loans, which have no collateral. As per Basel I , the minimum capital requirement was fixed at 8% of risk weighted assets (RWA). 

09. In which year India adopted Basel 1 Accord ? 

 India adopted Basel-I guidelines in 1999 

10. Into how many groups banks’ assets are categorised by Basel I accord based on the nature of debtor? 

The Basel I classification system groups a bank's assets into five risk categories, labelled with the percentages 0%, 10%, 20%, 50%, and 100%.  A bank's assets are assigned to these categories based on the nature of the debtor. 

11. In which year Basel II guidelines were published ? 

In 2004, Basel II guidelines were published by BCBS. 

12. What are Basel II guidelines? 

Basel II guidelines were the refined and reformed versions of Basel I accord. . Basel II guidelines  were based on three parameters, which the committee calls as pillars - Capital Adequacy Requirements ; Supervisory Review and Market Discipline. 

13. What is the minimum CAR  recommended by Basel II Accord? 

As per Basel II accord Banks should maintain a minimum capital adequacy requirement of 8% of risk assets. 

14. What is meant by Market Discipline ? 

Market Discipline refers to increased disclosure requirements. Banks need to mandatorily disclose their CAR, risk exposure, etc. to the central bank. 

15. In which year Basel III guidelines were introduced and what is the reason for introducing Basel III Accord? 

In 2010, Basel III guidelines were released. Basel III guidelines were introduced in response to the financial crisis of 2008. 

16. What is the main aim of Basel III Accords? 

Basel III guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz. capital, leverage, funding and liquidity.

17. What are Macro Prudential Norms in the context of Basel III Accord? 

The macro prudential aspects of Basel III are largely enshrined in the capital buffers. Both the buffers i.e. the Capital Conservation Buffer and The Counter Cyclical Buffer are intended to protect the Banking Sector from periods of excess Credit Growth. 

18. In which year Basel III accord was introduced in India? 

The Basel III capital regulations were implemented in India with effect from April 1, 2013 and have been fully implemented as on October 1, 2021. 

19. What is the minimum CAR  recommended by Basel III Accord? 

As per Basel III Accord, the capital adequacy ratio is to be maintained at 9%. The minimum Tier 1 capital ratio and the minimum Tier 2 capital ratio have to be maintained at 7% and 2% of risk-weighted assets respectively. 

20. What are other main recommendations of Basel III, apart from Minium CAR? 

As per Basel III Accord, in addition to minimum CAR, banks have to maintain a Capital Conservation Buffer (CCB)  of 2.5%. Counter-Cyclical Buffer (CCCB) is also to be maintained at 0-2.5%. 

21. What is meant by Leverage Rate (Ratio) and What is the Leverage Rate recommended by Basel III Accord? 

The leverage rate is the ratio of a bank’s tier-1 capital to average total consolidated assets. As per Basel III norms, the leverage rate has to be at least 3 %. However, RBI stipulated the minimum Leverage Ratio at  4% for Domestic Systemically Important Banks (DSIBs) and 3.5% for other banks. 

22. What are the Liquidity Ratios that are recommended by Basel III Accord ? 

Basel-III created two liquidity ratios: LCR and NSFR. 

23. What is the Liquidity Ratios recommended by Basel III Accord ? 

The Liquidity Coverage Ratio (LCR) will require banks to hold a buffer of high-quality liquid assets sufficient to deal with the cash outflows encountered in an acute short term stress scenario as specified by supervisors. 

24. What is the purpose of Liquidity Ratio? 

This is to prevent situations like “Bank Run”. The goal is to ensure that banks have enough liquidity for a 30-days stress scenario if it were to happen. 

25. What is the formula to calculate LCR 

                         Stock of High Quality Liquid Assets (HQLA)

LCR = --------------------------------------------------------------------------

              Total Net Cash Outflows over the Next 30 Calendar Days

 

The assets allowed as the Level 1 High Quality Liquid Assets (HQLAs) for the purpose of computing the LCR of banks, inter alia, include Government securities in excess of the minimum SLR requirement. 

The total net cash outflows is defined as the total expected cash outflows (minus) the total expected cash inflows for the subsequent 30 calendar days. 

26. What is the full form of NSFR and what it is? 

NSFR stands for The Net Stable Funds Rate. It requires banks to maintain a stable funding profile in relation to their off-balance-sheet assets and activities. NSFR requires banks to fund their activities with stable sources of finance (reliable over the one-year horizon). 

27. What is the minimum NSFR recommended by Basel III Accord and how to calculate it ? 

The minimum NSFR requirement is 100%. The NSFR is expressed as a ratio that must equal or exceed 100%. The ratio relates the bank's available stable funding to its required stable funding, as summarised in the following formula:

 

                                    ASF

            NSFR = -----------------    ≥ 100%

                                   RSF

28. What is ASF ? 

ASF stands for Available Stable Funding . ASF is the portion of its capital and liabilities that will remain with the institution for more than one year. 

29. What is RSF ? 

RSF stands for Required Stable Funding. RSF is the amount of stable funding that it is required to hold given the liquidity characteristics and residual maturities of its assets and the contingent liquidity risk arising from its off-balance sheet exposures. 

30. What is the difference between LCR and NSFR ? 

LCR measures short-term (30 days) resilience, and NSFR measures medium-term (1 year) resilience. 

31. What is Tier I Capital and what is it’s importance? 

Tier 1 Capital refers to a bank's core capital, equity, and the disclosed reserves that appear on the bank's financial statements. In the event that a bank experiences significant losses, Tier 1 capital provides a cushion that allows it to weather stress and maintain a continuity of operations. 

32. What is Tier II Capital and what is it’s importance? 

Tier 2 Capital refers to a bank's supplementary capital, such as undisclosed reserves and unsecured subordinated debt instruments that must have an original maturity of at least five years. Tier 2 capital is considered less reliable than Tier 1 capital because it is more difficult to accurately calculate and more difficult to liquidate. 

33. What are the Important Pillars of Basel III Accord? 

The Basel III capital regulations continue to be based on following three-mutually reinforcing Pillars for computation of CRAR:

 

a) Minimum Capital Requirement

b) Supervisory Review of Capital Adequacy

c) Market Discipline

 

34. What is Pillar I of Basel III Accord? 

Pillar 1: Minimum Capital Requirement - Banks are required to maintain a minimum Pillar 1 Capital to Risk-weighted Assets Ratio (CRAR) of 9% on an on-going basis (other than Capital Conservation Buffer and Counter cyclical Capital Buffer etc.). 

35. What factors are taken into account by RBI while assessing Bank’s overall risk profile?

The Reserve Bank will take into account the relevant risk factors and the Internal Capital Adequacy Assessments of each Bank to ensure that the capital held by a bank is commensurate with the bank’s  overall risk profile. 

36. What are the methods recommended by Basel III to calculate Capital Requirements for Credit Risk? 

The Basel II framework provides two broad methodologies to banks to calculate capital requirements for credit risk, namely, Standardised Approach (SA) and Internal Rating Based (IRB) Approach. 

37. What is the Standardised Approach ? 

The Standardised Approach measures credit risk based on external credit assessments. 

38. What are the different Components of Regulatory Capital? 

Total regulatory capital will consist of the sum of the following categories: 

A) Tier 1 Capital (going-concern capital)

 

a) Common Equity Tier 1

b) Additional Tier 1

 

B) Tier 2 Capital (gone-concern capital).

 

a) Going-concern capital is the capital which can absorb losses without triggering bankruptcy of the bank.

 

b) Gone-concern capital is the capital which will absorb losses only in a situation of liquidation of the bank.

 

39. What is IRB Approach? 

The IRB Approach allows banks to use their own internal estimates for some or all of the credit risk components  in determining the capital requirement for a given credit exposure. 

40. On what basis Capital for credit risk is calculated in IRB Approach? 

IRB approach to capital calculation for credit risk is based upon measures of unexpected losses (UL) and expected losses (EL). 

41. What is AIRB in the context of Basel Accords and what it is?

AIRB stands for Advanced Internal Rating Based Approach. The AIRB approach is a set of credit risk measurement techniques and capital adequacy rules used by banks to calculate their required capital for credit risk. The AIRB approach is outlined in the Basel II Accord, a set of recommendations for financial institutions that help form banking laws and financial best practices. 

42. What is AIRB Approach? 

The AIRB approach allows banks to:

 

Develop their own empirical models to quantify inputs

 

Reduce capital requirements and credit risk

 

Determine the risks of default in a variety of fields, including loss given default (LGD), exposure at default (EAD), and probability of default (PD)

 

Banks must meet disclosure requirements as mandated by the Basel framework to use the IRB approach. 

Failure to meet these requirements makes the bank ineligible to use the IRB approach. 

43. What is EL in the context of Risk Management? 

EL stands for Expected Loss (EL). It represents the average or anticipated financial loss over a given period. It's a fundamental concept for businesses to manage risk, ensure financial stability, and make informed decisions. 

44. What is the formula to calculate EL? 

Expected Loss = PD × LGD × EAD 

45. What is Unexpected Loss in the context of Risk Management? 

An unexpected loss refers to a financial loss that exceeds what a company or individual anticipates or plans for, often due to unforeseen circumstances or risks. It's the difference between a worst-case loss and the expected loss, representing the potential for losses beyond what is normally predicted. 

46. What is Economic Capital in the context of Risk Management? 

Economic Capital: Capital held by a financial institution to cover unexpected losses. 

47. What is Loan Loss Reserve in the context of Risk Management? 

Loan Loss Reserves: Reserves set aside to cover expected losses. 

48. What is BIA in the context of Basel Accords and what is it ? 

BIA stands for Basic Indicator Approach. BIA is a straightforward method for calculating the capital charge for operational risk in banks. It's based on a bank's gross income, which is the sum of its net interest income and net non-interest income. 

The BIA is recommended for banks that are not internationally active or that don't yet have risk management systems in place. 

49. What are LGD, EAD and PD  in the context of Risk Management? 

LGD, EAD, and PD are key metrics in credit risk management in the financial industry. 

LGD stands for Loss Given Default. This represents the proportion of the exposure that is lost if a borrower defaults. It's essentially the recovery rate, or 1 - recovery rate, expressed as a percentage. 

ED (or EAD) stands for Exposure at Default. This refers to the total amount of money a lender could lose if a borrower defaults. It includes the outstanding principal and any accrued interest or fees. 

PD stands for Probability of Default. This represents the likelihood that a borrower will fail to repay their debt obligation within a specific time frame.

These metrics are used to assess and quantify potential losses on financial assets, especially loans, and are crucial for regulatory capital requirements. 

50. What is AMA in the context of Basel Accords and what is it? 

AMA stands for Advanced Measurement Approach. AMA is a method for banks to calculate operational risk capital (ORC). However, Basel III regulations have replaced the AMA with a new standardized approach (SA). The SA is based on two main components: a Business Indicator (BI) and an Internal Loss Multiplier (ILM). 

51. What is the Capital Charge in respect of Claims on Central Government? 

Both fund based and non-fund based claims on the central government will attract a zero risk weight. 

52. What is the Capital Charge in respect of Central Government Guaranteed Claims? 

Central Government guaranteed claims will attract a zero risk weight. 

53. What is the Capital Charge in respect of Claims on State Government and investment in State Government Securities ? 

The Direct loan / credit / overdraft exposure, if any, of banks to the State Governments and the investment in State Government securities will attract zero risk weight. 

54. What is the Capital Charge in respect of State Government Guaranteed Claims? 

State Government guaranteed claims will attract 20 per cent risk weight. 

55. What is the Capital Charge in respect of claims on RBI, CGTMSE and CRGFTLIH ? 

The risk weight applicable to claims on central government exposures will also apply to the claims on the Reserve Bank of India, DICGC, Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE) and Credit Risk Guarantee Fund Trust for Low Income Housing (CRGFTLIH). 

56. What is the Capital Charge in respect of claims on ECGC ? 

The claims on ECGC will attract a risk weight of 20 per cent. 

57. What is the Pillar II of Basel III Accord? 

Pillar–II of Basel III Accord is  Supervisory Review Process (SRP).

58. What is LTV Ratio ? 

LTV stands for Loan to Value. LTV ratio should be computed as a percentage with total outstanding in the account (viz. Principal + accrued interest + other charges pertaining to the loan without any netting) in the numerator and the realizable value of the residential property mortgaged to the Bank as denominator. 

59. What are SRP and SREP in the context of Basel III Accord? 

In Basel III, the Supervisory Review Process (SRP) and the Supervisory Review and Evaluation Process (SREP) are essential components of the second pillar, which focuses on supervisory oversight and risk management within banks. They work together to ensure that banks hold adequate capital and effectively manage their risks. 

60. What is objective of SRP? 

The objective of SRP  is to ensure that banks have adequate capital to support the risks in their business. 

61. What is the Objective of SREP? 

The objective of the SREP by RBI is to ensure that banks have adequate capital to support all the risks in their business as also to encourage them to develop and use better risk management techniques for monitoring and managing their risks. This requires a well-defined internal assessment process within Banks through which Banks has to assure the RBI that adequate capital is held towards the various risks to which Banks are exposed. 

62. What is full form of ICAAP and what is it in the context of Basel Accords? 

ICAAP stands for Internal Capital Adequacy Assessment Process. The ICAAP is a process for assessing the overall capital adequacy of the Bank in relation to their risk profile and a strategy for maintaining the capital levels. 

63. What is CCB in the context of Basel Accords? 

CCB stands for Capital Conservation Buffer. CCB is designed to ensure that banks build up capital buffers during normal times (i.e. outside periods of stress) which can be drawn down as losses are incurred during a stressed period. The requirement is based on simple capital conservation rules designed to avoid breaches of minimum capital requirements. 

64. What is CCCB in the context of Basel Accords and what is it ? 

CCCB or CCyB stands for Counter Cyclical Capital Buffer. The aim of the Counter cyclical Capital Buffer (CCCB) regime is twofold. 

Firstly, it requires banks to build up a buffer of capital in good times which may be used to maintain flow of credit to the real sector in difficult times. 

Secondly, it achieves the broader macro-prudential goal of restricting the banking sector from indiscriminate lending in the periods of excess credit growth that have often been associated with the building up of system-wide risk. 

65. What is the difference between CCB and CCyB ? 

The CCB is a mandatory buffer that all banks must maintain, while the CCyB is a variable buffer that regulators can activate during periods of excessive credit growth to mitigate systemic risk.

66. What is the Pillar III of Basel III Accord and What it is? 

Pillar III is Basel III Accord is Market Discipline. The purpose of market discipline is to complement Pillar1and Pillar2. It encourages Market Discipline by developing a set of disclosure requirements, which will allow market participants to assess key pieces of information on the scope of application, capital risk exposures risk assessment processes and hence, the capital adequacy of the institution. 

Sekhar Pariti

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