Introduction
The Basel norms are the silent guardians of global finance, designed to keep banks resilient and crises at bay. Established by the Basel Committee on Banking Supervision (BCBS), these regulations ensure that banks hold enough capital to withstand a range of risks. As the financial landscape grows more complex, the Basel norms have also evolvedāthrough Basel I, II, and IIIāto tackle new challenges and strengthen the foundation of the global economy.
BCBS was founded in 1974 in response to the collapse of Bankhaus Herstatt, a German bank whose failure exposed critical weaknesses in international banking and the need for a more coordinated regulatory approach. BCBS initially comprised of central bank governors from the G10 countries and today includes 45 regulatory entities from 28 jurisdictions.
In this guide, we will explore the Basel norms in detail, simplifying key concepts to provide a clear understanding of how these regulations work, their evolution, and their importance in maintaining the stability of the global financial system. Part A will provide you a good understanding of key concepts of Basel norms. If you are looking for a good foundational overview, Part A will suffice.
Part B takes a deeper dive into some of important Basel concepts, although still keeping it simple enough to understand. It also discusses gaps in Basel III and more recent discussions.
Part A: UnderstandingĀ Basel I, II, and III
1. Basel I (1988)
Basel I marked the first global attempt to improve stability of banks. It focused primarily on Credit Risk and introduced the concept of Risk-Weighted Assets (RWA), where assets were assigned a risk-weight based on their perceived credit risk. The framework categorised assets into different risk buckets, with risk weights ranging from 0% (for government bonds) to 100% (for commercial loans). This system aimed to standardise how banks calculated their capital requirements through a simplified approach to measuring risk. It stipulated a minimum capital, referred as Capital Adequacy Ratio (CAR), of 8% of their RWA.
The framework laid the foundation for global regulatory standards but had limitations, particularly in dealing with other types of risks. It did not account for the growing complexity of financial markets, such as the rise of derivatives and off-balance-sheet activities. Even, the approach to measuring credit risk had gaps.
2. Basel II (2004)
Basel II introduced a more comprehensive framework, expanding beyond credit risk to include market risk and operational risk. The capital requirement remained at 8% of Risk-Weighted Assets (RWA) although the approach became nuanced with a three-pillar approach.
2.1 Minimum Capital Requirements (Pillar 1)
Basel II refined the calculation of minimum capital requirements (CAR or CRAR) by introducing more sophisticated methods for calculating credit risk, while also incorporating capital charges for market risk and operational risk.
2.1.1 Credit Risk: It allowed banks to choose between different approaches based on their size and complexity
ā Standardised Approach: This method continued the concept of Risk-Weighted Assets (RWA) from Basel I but introduced more granularity by using external credit ratings to assess the risk of different assets.
ā Internal Ratings-Based (IRB) Approach: Larger, more sophisticated banks could use their own internal models to calculate credit risk, subject to regulatory approval. This allowed for a more tailored and risk-sensitive measurement of risk exposure.
2.1.2 Market Risk: Banks were required to hold capital against losses arising from changes in market variables like interest rates, stock prices, and foreign exchange rates. This was introduced through Value-at-Risk (VaR) models.
2.1.2 Operational Risk: Basel II introduced capital charges for operational risk, which include potential losses from inadequate internal processes, human error, system failures, or external events (e.g., fraud or cyberattacks). Based on regulatory guidance, Banks could use either the Basic Indicator Approach (BIA), the Standardised Approach, or the more advanced Advanced Measurement Approach (AMA) to calculate their operational risk capital.
2.2 Supervisory Review Process (Pillar 2)
Basel II introduced a mechanism to ensure that banks not only hold the minimum required capital but also assess their overall risk profile. This process, known as the Internal Capital Adequacy Assessment Process (ICAAP), requires banks to internally assess their capital needs based on their risk exposure. Regulatory authorities, in turn, conduct a Supervisory Review and Evaluation Process (SREP) to evaluate the banksā internal assessments, capital strategies, and risk management practices, and they can impose additional capital requirements if necessary.
2.3 Market Discipline (Pillar 3)
Recognising the importance of transparency, Basel II introduced the concept of market discipline by bringing focus on transparent reporting by Banks. This pillar aimed to enable market participants (investors, analysts, and counterparties) to better understand a bankās risk exposure, capital position and risk management practices, thereby exerting external pressure on banks to manage their risks responsibly. This was achieved through enhanced disclosure requirements, including more detailed reporting on capital adequacy, risk-weighting of assets, and internal risk management processes.
3. Basel III (2010)
The 2008 Global Financial Crisis exposed significant gaps in the Basel II framework. Basel III expanded the framework with focus on improving banks’ resilience during periods of economic distress by introducing stricter capital requirements, new liquidity standards, and measures to mitigate systemic risk.
Key Reforms in Basel III
Basel III introduced several enhancements over Basel II. These can be grouped into six main areas:
3.1. Increase in Capital Requirements
One of the most important reforms in Basel III was the change in the structure of capital requirements by increasing the requirement for CET1 and the Total Tier 1 Capital requirement (CET1 + AT1).
Basel III retained the CRAR benchmark of 8% (same as Basel II) however increased the required Total Tier 1 Capital. This meant reduced reliance on Tier 2 Capital and consequently improvement in the quality of capital.
3.2 Capital Buffers
Basel III introduced new capital buffers designed to ensure banks build up additional capital during periods of economic growth to help absorb losses during downturns.
ā Capital Conservation Buffer (CCB): Requires banks to hold an additional 5% of RWA in CET1, during normal times. The buffer is like building a war-chest during good times which the banks can absorb losses during periods of financial stress. This ensures Banks do not breach minimum capital ratios even during bad times.
ā Countercyclical Buffer: This is an additional buffer ranging from 0% to 2.5% of RWA within CET1 and can be imposed by national regulators during periods of excessive credit growth. It aims to reduce procyclicality (tendency to lend more during good cycle) by forcing banks to build up capital when credit is growing too quickly.
If the regulators activate both these buffers, a Bank would effectively need CET 1 of 9.5% (at max countercyclical buffer)
The below table illustrates the capital changes more intuitively
*Central Banks can stipulate capital requirements higher than the Basel 3 minimum. For example, in India RBI stipulates CRAR requirement of 9% with CET1 at 5.5%. RBI has not currently activated countercyclical buffer but Capital Conservation buffer is applied, taking total minimum capital required at 11.5%.
3.3 Leverage Ratio
To limit excessive leverage and borrowing by banks, Basel III introduced a leverage ratio, which is a non-risk-weighted measure to complement the risk-based capital requirements.
The leverage ratio requires banks to hold at least 3% Tier 1 Capital (CET1+AT1) against their total (non-risk-weighted) exposures, including both on-balance-sheet and off-balance-sheet exposures. This is not an additional capital requirement but a cap on the extent of leverage. More simply, banks must have at least 3 units of Tier 1 Capital for every 100 units of exposure.
3.4 Liquidity Requirements
To strengthen banksā ability to withstand financial stress, Basel III introduced two major liquidity standards, the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR), aimed at ensuring banks maintain adequate levels of liquidity over both short and long-term horizons. These requirements were established in response to the 2008 financial crisis, where excessive reliance on short-term funding led to severe liquidity issues across the banking sector.
ā Liquidity Coverage Ratio (LCR):
The LCR requires banks to hold enough High-Quality Liquid Assets (HQLA)āsuch as cash, central bank reserves, and government bondsāthat can be easily converted to cash. This ensures that banks can meet their expected net cash outflows over short term (30-days). The expected outflow is also referred as ārun-offā This run-off factor is based on the type of liability that the bank may have to service at short notice (30 day stress period). For example, RBI stipulates banks to assume a run-off of 5% for Retails deposits while it is 40% for Corporate deposits held with the bank. From this run-off (outflows), some inflow from bankās own investments may be adjusted to arrive at expected net cash outflow. The minimum LCR requirement is set at 100%, meaning banks must have enough HQLA to meet 100% of their expected cash outflows over this 30 days scenario.
ā Net Stable Funding Ratio (NSFR):
The NSFR is designed to ensure that banks maintain a stable funding base for their long-term assets. It requires banks to have enough Available Stable funding (ASF) to meet their Required Stable Funding (RSF) needs over a one-year period. This ratio reduces dependence on short-term funding, which proved unreliable during the financial crisis, and encourages banks to use more stable sources, like retail deposits and long-term debt, to support long-term assets like loans and investments. More simply, a bank should have stable long term sources Tier1 capital or Retail Deposits to fund long term asset creations like mortgage loans or HQLA. The minimum NSFR is set at 100%, meaning a bankās ASF>=RSF over the year.
3.5 Addressing Interconnectedness
Basel III introduced measures to mitigate the systemic risks posed by large, interconnected banks, specifically targeting Global Systemically Important Banks (G-SIBs) and Domestic Systemically Important Banks (D-SIBs):
ā G-SIB Capital Surcharges: Basel III requires G-SIBs to hold additional capital ranging from 1% to 3.5% of RWA based on their size and interconnectedness, ensuring they have extra buffers to absorb potential losses and avoid destabilising the global financial system. These include large banks like JPMorgan Chase (US), ICBC (China), HSBC (UK)
ā D-SIB Requirements: Countries can designate certain banks as D-SIBs, requiring additional capital to reflect their importance within the national financial system. In India, State Bank of India (SBI), HDFC Bank, and ICICI Bank are classified as D-SIBs by RBI.
For further reading you can refer this article on How are ‘Global Systemically Important Banks’ (G-SIB) monitored under BASEL
3.6 Additional changes
Basel III strengthened the coverage of several types of risk that were inadequately addressed under Basel II, particularly in the areas of market risk and counterparty credit risk. The framework for market risk was enhanced to improve the treatment of complex trading activities and derivatives including capital requirements for securitisation and trading book exposures. Basel III introduced higher capital charges for exposures to financial institutions and over-the-counter (OTC) derivatives to cover potential losses arising from counterparty defaults in these areas, which were a major source of risk during the financial crisis.
Part B: Deeper Dive into Basel norms
In this section we focus on a more detailed understanding of some key aspects of Basel norms. We also look at some of the gaps that need to be addressed as the norms evolve.
4. Measuring Capital Requirement for each Risk
4.1 RWA for Credit Risk
Credit risk refers to the risk that a borrower will default on a loan. Under Basel norms, banks are required to hold capital proportional to the credit risk of their loans. This is done by calculating Risk-Weighted Assets (RWA), where each asset is assigned a weight based on its risk profile. For example, government securities typically carry a lower risk weight compared to loans to corporate borrowers. Below table illustrates how RWA is estimated.
Ā This indicates that for a portfolio of ā¹700 crore, the Bank will consider ā¹480 crore as RWA for estimating capital for credit risk component.
4.2 Capital Charge for Market Risk
Market Risk refers to the risk of losses in a bank’s trading book due to movements in market prices. Banks invest in both debt and equity securities, exposing them to interest rate and equity risk. Apart from this, Forex and Gold positions are also susceptible to market risk. Bankās investments in securities is classified in 3 categories ā Held to Maturity (HTM), Held for Trading (HFT) and Available for Sale (AFS).Ā Market risk estimation focusses on HFT and AFS category along with any open positions in gold, forex or derivatives.
To estimate market risk, there is a capital charge this is applied based on below principles
- All assets are prone to larger market movements and macro considerations. This is incorporated in General Charge
- All assets even within the same class may carry different risk based on the issuer strength. For example, AAA rated bonds are less risky compared to BBB. This part of the risk is incorporated into Specific Charge
The below table summarises how this it is estimated for each market risk category
4.3 Estimation methods for Operational Risk
Operational risk refers to the potential for financial loss due to failures in a bank’s internal processes, systems, people, or external events. Unlike market or credit risk, which can be quantified through changes in financial markets or borrower behavior, operational risk arises from a broad range of unpredictable events, including human errors, fraud, system failures, cyber-attacks, and natural disasters.
Basel III has three main approaches to calculate their operational risk capital requirement, with increasing levels of complexity.
i. Basic Indicator Approach (BIA)
ii. Standardised Approach (TSA)
iii. Advanced Measurement Approach (AMA)
Smaller banks will use the BIA approaches while Banks with required maturity and process controls will move towards TSA and AMA approaches
Below table provides the details of each of these approaches.
5. Gaps in Basel
Basel III has improved global banking stability, but certain gaps remain, especially given the ever increasing complexity of financial markets. Hereās an overview of these gaps for a clearer understanding of Baselās limitations.
5.1 Capital Efficiency and Economic Growth
Basel norms rely heavily on one medicine for most ills- Capital. Maintaining higher capital levels can be expensive for banks and as you focus more on highest quality CET1 , this cost of capital increases. Since capital is linked to quality of assets (RWA), it creates an incentive for banks to prefer lending to higher-rated corporates over riskier segments like SMEs. This approach not only limits credit access for SMEs but also raises loan costs. This can slow down credit growth, especially in developing and credit-reliant economies.
5.2 Procyclicality and Regulatory Arbitrage
Even with the introduction of the countercyclical capital buffer, Basel III can still contribute to procyclicalityāmaking economic booms and busts more extreme. During downturns, higher risk weights force banks to hold more capital, which can reduce lending just when itās most needed. Additionally, Basel rules are strict on traditional banks but less so for shadow banks or non-banking finance companies (NBFCs). This difference encourages regulatory arbitrage, where banks may shift risky activities to these less-regulated entities, weakening the effectiveness of Basel norms.
5.3 Systemic Risks: “Too Big to Fail” and Contagion
While Basel III requires Global Systemically Important Banks (G-SIBs) and Domestic Systemically Important Banks (D-SIBs) to hold extra capital, it may not fully solve the “too big to fail” issue. Large banks are so interconnected that, even with additional capital, their failure could destabilise the financial system. The contagion riskāwhere the collapse of one major bank triggers a chain reactionāis still a major concern, and Basel III offers limited tools to address it.
5.4 Complexity and Compliance Costs
The complexity of Basel IIIās rules creates compliance costs, especially for smaller banks. Advanced risk models and detailed data requirements are both expensive and difficult to implement, particularly for smaller banks in emerging markets. As a result, many smaller banks rely on standardised methods that may not fully reflect their risks, leading to inefficient capital allocation. High compliance costs also make it harder for smaller banks to compete with larger institutions.
5.6 Climate Risk and Other Emerging Risks
As risks evolve, Basel norms will need to adapt to address new threats like climate change and technological disruptions. Climate risks include both physical threats (e.g., extreme weather) and transition risks (e.g., regulatory shifts toward a low-carbon economy). Additionally, increased reliance on digital technologies raises cybersecurity risks, which Basel III doesnāt fully cover.
End Note
In summary, the Basel norms are a set of global banking standards developed by the Basel Committee on Banking Supervision (BCBS) to strengthen financial stability. Through successive iterationsāBasel I, II, and IIIāthe norms have established rigorous capital, liquidity, and risk management requirements, ensuring that banks maintain robust capital and liquidity levels to withstand economic shocks.
While Basel III has made banks more resilient, several gaps remain. The reliance on capital requirements can limit lending, particularly to small businesses, and can amplify economic downturns due to procyclicality. Additionally, systemic risks tied to large, interconnected banks and emerging threats like climate change and cybersecurity are areas that Basel III only partially addresses. Compliance complexity and costs also place smaller banks at a disadvantage.
Recognizing these challenges, the BCBS is exploring additional reforms, often referred to as Basel IV, which may further refine capital and risk standards to address the remaining gaps. These discussions focus on refining risk-weighting methods, addressing climate-related financial risks, and simplifying compliance. The move toward Basel IV highlights an ongoing commitment to adapting global banking standards to meet the needs of an evolving financial landscape.
Further Reading:
To enhance your understanding further do check out some of these (in no particular order)
ā¢RBI Master Circular ā Basel III Capital Regulations , July 2013/April 2024
ā¢RBI draft circular on Basel III Framework on Liquidity Standards, July 2024
ā¢RBI Master Direction on Minimum Capital Requirements for Operational Risk, June 2023
ā¢RBI Basel III Framework on Liquidity Standards ā Net Stable Funding Ratio (NSFR), May 2018
ā¢BCBS Minimum capital requirements for market risk, January 2016
ā¢BCBS Basel III: A global regulatory framework for more resilient banks and banking systems – revised version June 2011
ā¢Cohen, B., & Scatigna, M. (2016). āBanks and capital requirements: channels of adjustment.ā BIS Quarterly Review
ā¢Allen, F., & Gale, D. (2012). Financial Stability and Risk. Oxford University Press.
ā¢Barth, J. R., Caprio, G., & Levine, R. (2013). Guardians of Finance: Making Regulators Work for Us. MIT Press.
Disclaimer: The content is for informational purposes only and not a professional advise. Refer RBI and BCBS website for more info.