Basel norms

1. Purpose and institutional setting

Banks accept deposits and other repayable funds, extend loans, and provide payment services. They typically finance relatively long-term, illiquid assets with shorter-term liabilities. This maturity transformation supports investment but creates liquidity risk. Borrower defaults, adverse market movements, fraud and operational failures can also generate losses. Because banks are interconnected, distress at one institution can spread through interbank exposures, payment networks and declining public confidence.

Basel norms provide common minimum prudential standards to contain these risks. The Basel Committee on Banking Supervision was created in 1974 following disturbances in international banking, including the failure of Bankhaus Herstatt in West Germany. Its secretariat is located at the Bank for International Settlements in Basel. The committee develops standards and promotes supervisory cooperation; it is not a supranational regulator and cannot directly enforce its rules against Indian banks.

Member jurisdictions translate Basel standards into domestic regulation. Consequently, national requirements can be stricter than the international minimum and implementation schedules can differ. In India, RBI issues the relevant regulatory directions. Basel regulation complements rather than replaces bank supervision, deposit insurance, resolution arrangements and central-bank liquidity support.

• Microprudential objective: strengthen the safety and soundness of individual banks.
• Macroprudential objective: limit system-wide vulnerabilities, interconnectedness and excessive credit-cycle amplification.

2. Evolution from Basel I to Basel III

Basel I, issued in 1988, introduced a common minimum capital standard focused principally on credit risk. It required total regulatory capital of at least 8% of risk-weighted assets. Assets were grouped into relatively broad risk categories rather than treated identically. A 1996 amendment added capital requirements for market risk. Its simplicity supported international adoption, but broad risk weights could inadequately distinguish the creditworthiness of different borrowers.

Basel II, issued in 2004, made regulation more risk-sensitive through three mutually reinforcing pillars. Pillar 1 specified minimum capital requirements for credit, market and operational risk. Pillar 2 introduced supervisory review of banks’ risk assessment and capital adequacy. Pillar 3 promoted market discipline through public disclosures. Depending on supervisory approval, banks could use standardised approaches or more advanced methodologies for particular risks.

The global financial crisis of 2007–09 exposed weaknesses including excessive leverage, inadequate loss-absorbing capital and dependence on unstable wholesale funding. Basel III, initially published in 2010, strengthened capital quality and quantity, introduced capital buffers and a leverage ratio, and established global liquidity standards. Reforms finalised in 2017 further sought to reduce unwarranted variability in risk-weighted assets, including through an output floor. The informal expression ‘Basel IV’ commonly refers to these finalisation reforms; it is not the committee’s official name for a separate accord.

• Memory distinction: Basel I established the capital baseline; Basel II added three-pillar risk sensitivity; Basel III strengthened resilience after the global financial crisis.

3. Capital adequacy, risk weights and buffers

The Capital to Risk-weighted Assets Ratio, or CRAR, equals eligible regulatory capital divided by risk-weighted assets, multiplied by 100. Risk-weighted assets reflect credit, market and operational risk under prescribed methodologies. A higher-risk exposure generally requires more capital than an equally sized lower-risk exposure. Thus, CRAR is not simply capital divided by total assets. Regulatory capital absorbs losses; it is not a compulsory cash balance parked with the central bank.

Basel III distinguishes Common Equity Tier 1, Additional Tier 1 and Tier 2 capital. CET1, comprising common shares and eligible reserves after regulatory adjustments, is the highest-quality component. AT1 consists of eligible instruments meeting stringent permanence and loss-absorption conditions. Tier 2 provides additional protection, particularly when a bank becomes non-viable. Instruments must satisfy regulatory eligibility criteria; their commercial labels alone do not determine their capital treatment.

Global minimum ratios are 4.5% for CET1, 6% for Tier 1 and 8% for total capital. A capital conservation buffer of 2.5% of risk-weighted assets, met with CET1, sits above minimum requirements. Drawing down this buffer brings restrictions on distributions such as dividends and discretionary bonuses. A countercyclical capital buffer can be imposed when excessive credit growth builds systemic risk and released when conditions deteriorate. Systemically important banks face additional requirements because their failure would impose greater costs on the financial system.

The leverage ratio provides a complementary, non-risk-based safeguard: Tier 1 capital divided by a prescribed exposure measure covering on-balance-sheet and specified off-balance-sheet exposures. The global baseline minimum is 3%. Unlike CRAR, it does not depend on assigning different risk weights to assets, helping constrain excessive balance-sheet expansion and weaknesses in risk modelling.

4. Liquidity standards and Indian implementation

The Liquidity Coverage Ratio requires sufficient high-quality liquid assets to cover net cash outflows under a specified 30-day stress scenario. Its normal minimum is 100%. Qualifying assets must be readily monetisable, subject to regulatory conditions. The Net Stable Funding Ratio requires available stable funding to be at least equal to required stable funding over a one-year horizon. Together, they address short-term liquidity survival and the structural stability of funding.

India began implementing Basel III capital regulations on 1 April 2013. Under RBI’s framework for covered scheduled commercial banks, minimum CET1, Tier 1 and total capital ratios are 5.5%, 7% and 9%, respectively. Adding the fully phased-in 2.5% capital conservation buffer brings the total capital-plus-buffer requirement to 11.5%, before applicable additional requirements. Domestic systemically important banks must maintain additional CET1 according to RBI’s framework.

RBI’s Basel III framework for scheduled commercial banks excludes regional rural banks and local area banks; other categories operate under their respective regulatory frameworks. Candidates should not automatically apply one capital ratio to every Indian financial institution. Likewise, the Cash Reserve Ratio and Statutory Liquidity Ratio are domestic statutory requirements, not substitutes for Basel capital requirements or the LCR and NSFR.

5. Benefits, limitations and examination relevance

Stronger capital and liquidity reduce the probability and social costs of banking crises, support depositor confidence and improve resilience during downturns. However, adjustment can require banks to retain profits, raise equity, change funding structures or moderate asset growth. Compliance costs and greater complexity can be substantial, especially where risk measurement and supervisory capacity are weak.

Basel norms cannot eliminate banking failures. Risk weights may mismeasure exposures, internal models may produce inconsistent outcomes, and risks may migrate to less-regulated non-bank institutions. Sound governance, credible supervision, stress testing and effective resolution therefore remain essential. In examination questions, distinguish solvency from liquidity: a bank may have positive net worth yet lack immediately available cash, while temporary liquidity support cannot by itself repair deep capital losses.

• A sovereign exposure may receive favourable capital treatment under applicable rules without being economically risk-free.
• A buffer is intended to be usable during stress, subject to regulatory consequences; it is not identical to an absolute minimum.
• Higher capital adequacy need not imply lower lending: fresh equity and retained earnings can support credit expansion.

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