Basel norms and capital regulation: Basel I to Basel III in India

Capital regulation is the backbone of banking regulation, and the Basel accords are how the world agrees on it. Questions range from one-line objective items (which ratio measures 30-day liquidity?) to 15-mark descriptive questions on why Basel III was needed. The calculation of a capital ratio is simple once you see it done, and it makes your descriptive answers far more convincing. This guide covers the logic, the history, the Indian numbers and one full worked example.

Why banks must hold capital

A bank funds most of its assets with deposits and borrowings. Capital, the owners' money, is the thin layer that absorbs losses before depositors are hurt. If loans worth 5% of assets go bad and capital is only 4% of assets, the bank is insolvent.

Owners on their own would hold too little capital. Capital is more expensive than deposits, and deposit insurance plus the expectation of rescue mean that depositors do not demand a higher rate from a thinly capitalised bank. Regulation sets a floor, and ties it to the riskiness of the assets, so that a bank lending to risky borrowers must hold more.

The Basel Committee

The Basel Committee on Banking Supervision (BCBS) was formed in 1974 by the central bank governors of the G10 countries after disruption in international banking markets, including the failure of Germany's Herstatt Bank. It is hosted by the Bank for International Settlements (BIS) in Basel. Its standards are not law; each country adopts them through national rules. India is a member, and the RBI implements the standards through its master circulars.

Evolution of the accords

The three pillars

1. Pillar 1, minimum capital requirements: capital against credit risk (standardised or internal-ratings-based approaches), market risk and operational risk.
2. Pillar 2, supervisory review: each bank runs an Internal Capital Adequacy Assessment Process (ICAAP) covering risks Pillar 1 misses, such as concentration risk and interest rate risk in the banking book. The supervisor reviews it and may ask for more capital.
3. Pillar 3, market discipline: detailed public disclosure of capital, exposures and risk, so that investors and depositors can judge the bank.

Capital components

AT1 bonds made headlines when regulators wrote them down during the Yes Bank reconstruction in India (2020) and the rescue of Credit Suisse in Switzerland (2023). Both cases showed that AT1 is risk capital, not a deposit substitute, and raised questions about mis-selling to retail investors.

What Basel III added

• Capital conservation buffer (CCB): 2.5% of RWA in CET1. A bank that dips into it faces limits on dividends and bonuses until it rebuilds.
• Countercyclical capital buffer (CCyB): 0–2.5% of RWA, built up when credit grows too fast and released in a downturn. India's framework exists, but the buffer has not been activated.
• Leverage ratio: Tier 1 capital divided by total exposure (on- and off-balance sheet, without risk weights). It is a backstop against models that make assets look safer than they are.
• Liquidity Coverage Ratio (LCR): high-quality liquid assets ÷ net cash outflows over a 30-day stress period, at least 100%.
• Net Stable Funding Ratio (NSFR): available stable funding ÷ required stable funding over one year, at least 100%.
• Systemically important banks: an extra CET1 surcharge. In India these are D-SIBs; the RBI's list has included SBI, HDFC Bank and ICICI Bank.

India versus the Basel minimum

The RBI's requirements are stricter than the global floor.

Worked example: computing CRAR

A bank has these assets, with illustrative risk weights:

Add RWA for operational risk of ₹100 crore and for market risk of ₹50 crore.

1. Total RWA = 650 + 100 + 50 = ₹800 crore.
2. Capital: CET1 ₹60 crore, AT1 ₹10 crore, Tier 2 ₹20 crore. Tier 1 = ₹70 crore; total capital = ₹90 crore.
3. CET1 ratio = 60 ÷ 800 = 7.5%. It clears the 5.5% minimum but not 8% (minimum plus CCB). The bank is inside its conservation buffer, so its dividends are restricted.
4. Tier 1 ratio = 70 ÷ 800 = 8.75%, above the 7% minimum.
5. CRAR = 90 ÷ 800 = 11.25%, above 9% but short of 11.5%.
6. To reach CET1 of 8%, it needs 0.08 × 800 = ₹64 crore of CET1, so ₹4 crore more of equity. Or it can cut RWA: at CET1 of ₹60 crore, RWA must fall to 60 ÷ 0.08 = ₹750 crore.
7. Leverage ratio: with off-balance-sheet exposure of ₹50 crore, total exposure is 1,250 + 50 = ₹1,300 crore. Tier 1 ÷ exposure = 70 ÷ 1,300 = 5.4%, above the 3.5% requirement.

Notice the two ways to raise a ratio: more capital (numerator) or less risk (denominator). Banks short of capital often shift towards low-risk-weight assets such as government securities, which is one reason capital shortages can squeeze lending.

Criticisms and trade-offs

• Cost of credit: more equity raises banks' funding costs, which may reduce lending, especially to MSMEs.
• Procyclicality: in a downturn, losses cut capital just when the economy needs credit; the CCyB is meant to offset this.
• Complexity and model risk: internal models can understate risk, which is why Basel III's final reforms put an "output floor" on model-based RWA.
• Public sector banks: meeting Basel III required large government recapitalisation, a fiscal cost.

Model answer outline (15 marks)

Question: How did Basel III respond to the weaknesses revealed by the 2008 global financial crisis? Assess its implementation in India.

1. Introduction: capital as a loss absorber; BCBS standards.
2. Weaknesses in 2008: low-quality capital, excessive leverage, liquidity runs, procyclicality, too-big-to-fail institutions.
3. Responses: CET1 focus; CCB and CCyB; leverage ratio; LCR and NSFR; surcharges for systemic banks.
4. India: higher minimums (CET1 5.5%, CRAR 9%, 11.5% with CCB); D-SIB framework; LCR and NSFR at 100%; government recapitalisation of public sector banks.
5. Assessment: banks better capitalised; trade-off with credit growth; AT1 lessons.
6. Conclusion: capital buys resilience at a cost; the balance must be reviewed with the credit cycle.

Short model answer (10 marks)

Question: Distinguish between the Liquidity Coverage Ratio and the Net Stable Funding Ratio.

Both ratios were introduced by Basel III because the 2008 crisis showed that banks with adequate capital could still fail when funding dried up.

The Liquidity Coverage Ratio addresses short-term liquidity. It requires a bank to hold enough high-quality liquid assets, such as cash and government securities, to cover its net cash outflows over a 30-day stress scenario. The ratio must be at least 100%. It ensures a bank can survive a month of stress while the central bank and management respond.

The Net Stable Funding Ratio addresses structural funding over one year. It compares available stable funding, such as capital, long-term borrowing and stable retail deposits, with the stable funding required by the bank's assets, weighted by how illiquid they are. It too must be at least 100%. It discourages funding long-term loans with volatile short-term money.

In short, the LCR is a survival buffer and the NSFR is a limit on maturity mismatch. The RBI applies both at 100% to scheduled commercial banks.

Practice questions

1. What is India's minimum CRAR, excluding the conservation buffer?
   • 9% of RWA.
2. Which capital absorbs losses on a gone-concern basis?
   • Tier 2.
3. A bank has CET1 of ₹45 crore and RWA of ₹600 crore. Does it meet CET1 plus CCB?
   • No. 45 ÷ 600 = 7.5%, below 8%.
4. Which Basel III ratio ignores risk weights?
   • The leverage ratio.
5. Over what stress horizon is the LCR measured?
   • 30 days.
6. Which buffer is built up in credit booms and released in downturns?
   • The countercyclical capital buffer.

What to do next

• Memorise the India-versus-Basel table; it is the most-tested set of numbers in this topic.
• Rework the CRAR example with corporate loans of ₹700 crore instead of ₹500 crore.
• Read the banking regulation guide to see how PCA uses these ratios.
• Then read the risk management guide for the risks the capital covers.