What are Basel 1 Norms?What are Tier 1 and Tier 2 capital in Basel norms?
Hello, dear friends; if you are searching for the Basel 1 norms and detailed explanation from top to bottom. I am here to explain you. It will boost your knowledge in Banking Awareness. So, In this content, you will learn about What are Basel 1 Norms? What are Basel norms in India? What are the RBI Guidelines under Basel Norms? And, a more important part, What are Tier 1 and Tier 2 capital in Basel norms?
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How Bank Makes Money?
Bank is a financial institution that works as a financial intermediary between people and businesses. It provides deposit accounts to its customer to provide secure places to keep their high-earn money. With this deposit accounts money, the bank provides loans to other people or invests in businesses. With the high rate of interest, the bank lends loans to the lenders, and at the lower interest rate bank provides interest to the depositors. Between the lender’s rate and the depositor’s rate, banks make money.
What is Credit Risk?
Credit risk is the risk when the borrower is unable to pay the borrowing amount to the bank which is also called loan default.
Indirectly, it can be implied that when the lender may not receive the principal and the interest amount. And due to this, the cash flow of the bank is reduced, and then reduced of the cost collection.
Lenders have generally checked the trustworthiness and the financial background of the borrower to reduce the credit risk of providing loans or other debt instruments.
Types of Credit Risk:
1. Default Risk
The default credit risk is the risk when the borrower is either unable to repay the debt obligation or is already 90 days time duration is over of the debt repayment. The default risk refers to all credit transactions such as securities, bonds, loans, and derivatives.
2. Concentration Risk
It is a type of risk when a bank or financial institution has given a large amount of loan to a big industry or any big business tycoon such as a real estate company. If the borrower cannot repay the loan amount in the given period or the borrower is now defaulted, the bank could face significant losses. It is called the Concentration Risk
3. Country Risk
Country Risk has happened when there is political instability, currency fluctuation, economic downfall, or political risk in a particular company in the country. And due to all these factors, risk has been elongated to the investors who invested in that particular company of the country.
4. Downgrade Risk
5. Institutional Risk
Why Bank doesn’t lend 100% of its depositors’ money?
A bank always needs to be in such a position that the money it borrowed from the depositors, can have the ability to repay the borrowed money of the depositors. So, for that bank needs to reserve some of its own principal amounts. This own principal money is known as the Equity/Capital of the Bank.
But if a bank is bankrupt, it will sink with all the depositors’ money and if the bank makes a profit, then the owner of the bank earns more.
Risk of Insolvency
If a bank is unable to repay the depositor’s money, there are rumors spread like the bank is now bankrupt and all other depositors will try to withdraw all of their deposited money in the bank and all of the depositors may come together in front of the bank and raise the slogan, etc. And due to this, the reputation of the bank is going down and the flooding of withdrawal requests of the bank is increased this is called the Risk of Insolvency.
In India, Commercial Banks need to maintain the Capital Adequacy Ratio (CAR) of 9% while the public sector banks are required to maintain a 12% CAR for the Risk of Insolvency.
Note:
1) If the Bank Owner’s investment in the Bank is lesser than the Depositor’s money, then the Bank Owner earns more profit.
2) If the Bank Owner’s investment in the Bank is more than the Depositor’s money, then the Bank Owner books a loss.
That means if the bank holds more capital, the insolvency chance will reduce but the return on equity will reduce as well. However, we must ensure that the bank should be well capitalized. We need to protect the interests of the consumer.
Return of Equity
It is defined as the ratio of the total profit earned by the company and the amount of shareholders’ equity.
Return of Investment
The return on Investment is the ratio of the total gain or loss from an investment to the initial investment cost.
ROI =(Net gain or loss from Investment /Initial Investment Cost) × 100%
What are Basel Norms?
Basel Norms or Basel Accords are the Norms which are issued by the Basel Committee on Banking Supervision (BCBS). The word Basel is the city of Switzerland. The Basel Committee on Banking Supervision is also known as Basel Committee.
The committee’s headquarters is in Bank for International Settlements (BIS), Basel. It was established to strengthen financial stability by highlighting the banking supervision quality worldwide and to act as a forum for regular communication between its member countries on banking supervisory matters.
At the end of 1974, the Central Bank Governors of 10 groups of countries(G10) established this committee due to the effect of serious disturbances in International Currency and also for the failure of the Bankhaus Herstatt in West Germany.
The first meeting of the committee was held in 1975, February, and similarly, on a regular basis, this type of meeting has taken place 3 or 4 times a year.
BIS Objectives
- After World War 1, the compensations imposed on Germany by the Treaty of Versailles is simplified by the BIS and to fulfill the compensation, the German Government International Loan (Young Loan) which was established in 1930 acted as the BIS. The establishment of a dedicated institution for this objective was suggested in 1929 by the Young Committee.
- Later, BIS changed its stance to solve the capital adequacy of banks and the banking system.
In 2009 and again in 2014, the committee extended its membership. From G10 to 45 members of 28 Jurisdictions are the new members of the BIS.
Basel 1 Norms
The Basel 1 norms were introduced in 1988 and in 1999 India adopted Basel -1 Norms. It focuses on only Credit Risk. As said earlier credit risk is happened when the borrower is unable to repay the loan amount. The norms are not legally binding in any country. Still now, Basel has introduced 3 pillars of Basel and others two are Basel 2 Norms and Basel 3 Norms.
Under Basel Norms 1, All International Banks which follow the Basel norms need to maintain a capital adequacy ratio equal to 8% of their Risk-Weighted Assets (RWA). So, according to the Basel 1 accords, there should be at least 4% from Tier-one capital(T1) of the core capital and the remaining percentage from Tier-two capital(T2).
But on October 30, 1998, according to the RBI’s Mid-term review of monetary and credit policy for 1998-99 had improved the CRAR from 8% to 9%.
Risk-Weighted Assets (RWA) of Basel 1 Norms
The minimum amount of capital reserved by a bank according to the risk profile of lending/investment activities and other assets is called the Risk-Weighted Assets (RWA). It will help banks to curtail the risk of insolvency and save the depositors money. If a bank takes more risk, so more capital is required. So, the capital requirement for a bank is determined by assessing the risk of each type of bank asset.
So, Basel 1 Accords tell us how to calculate the Risk-Weighted Assets.
According to the Basel 1 Norms, there is only 1 pillar which is the minimum capital requirement. And pillar 1 is divided into 4 classes of assets.
| Class Name | Class Notification | Percentage of Risk Weights |
|---|---|---|
| Sovereign Debt to OECD Countries and their Central Banks | S | 0% |
| Other Banks and Public Sector Institutions in OECD Countries | B | 20% |
| Any loan secured by Residential property | R | 50% |
| All other loans | O | 100% |
So, the total capital adequacy ratio for Basel 1 = (T1+T2)/RWA >8%
What is T1 Capital? – Basel 1 Norm
It is the Primary core capital or primary funding capital of the Bank and it consists of Shareholders’ equity and disclosed reserves. It may include the rest of the earnings after giving the depositors profit, and it could be the core capital of the bank. It is a highly reliable and liquid asset. As Tier-1 capital has more amount of capital, it can absorb the losses of the borrowers who are unable to repay it.
What is T2 Capital? – Basel 1 Norms
The Tier 2 capital is also known as the supplementary capital. It consists of various elements such as revaluation reserves, hybrid capital instruments, subordinated term debt, general loan-loss reserves, and undisclosed reserves. Due to the complexity of calculating accurately and more difficult to liquidate, Tier 2 capital is less reliable than Tier 1 capital.
Advantages of Basel 1 Norms
1.) This norm is very simple and easy to calculate.
2) This framework helps to determine the risky factors of the firm.
3) It has given the framework for calculating CAR and capital
4) It provides a standard financial mechanism for the company to evaluate the financial information.
Disadvantages of Basel 1 Norms
1) It is an oversimplified norm.
2) It is only talking about credit risk. It doesn’t teach about taking the risk.
3) These norms didn’t talk about market risk, cyber security risk, operational risk, liquidity risk, etc.
4) It is only talking about four different risk weightings (0%,20%,50%, 100%) and it is not even correct in all the way of the risk-weighted percentage.
5) Only 1 pillar is there in the Basel 1 norms.
6) This norm is against the profitability of the firm.
The Tier 1 Capital is the Primary core capital or primary funding capital of the Bank which consists of Shareholders’ capital and disclosed reserves. And therefore, Tier 2 Capital is also known as supplementary capital. It consists of various elements such as revaluation reserves, hybrid capital instruments, subordinated term debt, general loan-loss reserves, and undisclosed reserves.
Because this norm was first introduced in Basel, Switzerland and it was introduced by the Basel Committee on Banking Supervision (BCBS).
The Basel 1 norms were introduced in 1988 and in 1999 India adopted Basel -1 Norms. It focuses on only Credit Risk. These norms were only focused on Credit Risk.
Conclusion
In this article, I have explained the Basal 1 Norms which will help you.
If you have any doubt on basel 1 norms, you can comment below, I will try to help you. Thank You to all.
