PRUDENTIAL NORMSThe norms which are to be followed while investing funds are

called "Prudential Norms." They are formulated to protect the interests of the shareholders and depositors.

Prudential Norms are generally prescribed and implemented by the central bank of the country. Commercial Banks have to follow these norms to protect the interests of the customers.For international banks, prudential norms were prescribed by the Bank for International Settlements popularly known as

BIS. The BIS appointed a Basle Committee on Banking Supervision in 1988.

Introduction of BIS

• Established in 1930• The BIS is located in Basel (A city in Switzerland)

• BIS is an international organization of central banks• BIS is a central bank for central banks• it is the oldest international financial organization• 60 central banks are the member BIS

Subcommittees of BIS:The BIS carries out its work through its subcommittees

• Basel Committee, committee on global financial system (BCBS)

• Committee of payment and settlement system (CPSS)

• Irving Fisher Committee (IFC)

• Financial Stability Institute (FSI)

• Markets committee etc.

BACKGROWND OF BASEL COMMITTEE

• The Basel Committee on Banking Supervision (BCBS) is a committee of Bank for International settlements (BIS)

• Established in 1974, by the central bank governors of the Group of Ten G-10 countries.

• The present Chairman of the Committee is Stefan Ingves, Governor of the central bank of Sweden (Sveriges Riksbank)

• The Committee's members as of September 2013: Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India,

Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, United Kingdom and United States

Why Basel committee was formed?

• Default of Herstatt Bank (German) - foreign exchange exposures was three times then its capital- (1974)

• Default of Franklin National Bank (New York) and- (1972)

• Disruptions in the international financial markets

Objective of the BCBS

• To enhance financial stability by improving the quality of banking supervision worldwide.

• To strengthening the Banks capital

• improving the quality of capital

• Strengthening the banks' transparency• • Improving market discipline

• Improving banking sector’s ability to absorb shocks

. Basel Committee

• Basel committee appointed by BIS formulated rules and regulation for effective supervision of the central banks. For this it, also prescribed international norms to be followed by the central banks.

• This committee prescribed Capital Adequacy Norms in order to protect the interests of the customers.

Basel – I Norms

In 1988, the Basel I Capital Accord was created. The general purpose was to:

1. Strengthen the stability of international banking system.

2. Set up a fair and a consistent international banking system in order to decrease competitive inequality among international banks.

BASEL-I CAPITAL REQIREMENTS

• Capital was set at 8% and was adjusted by a loan’s credit risk weight

• Credit risk was divided into 5 categories: 0%, 10%, 20%, 50%, and 100%– Commercial loans, for example, were assigned to

the 100% risk weight category

CALCULATION OF REQUIRED CAPITAL

• To calculate required capital, a bank would multiply the assets in each risk category by the category’s risk weight and then multiply the result by 8%– Thus a $100 commercial loan would be multiplied

by 100% and then by 8%, resulting in a capital requirement of $8

BASEL 2

• In 2004, Basel II guidelines were published by BCBS, which were considered to be the refined and reformed versions of Basel I accord. The guidelines were based on three parameters.

• Banks should maintain a minimum capital adequacy requirement of 8% of risk assets,

• banks were needed to develop and use better risk management techniques in monitoring and managing all the three types of risks that is credit and increased disclosure requirements.

• Banks need to mandatorily disclose their risk exposure, etc to the central bank. Basel II norms in India and overseas are yet to be fully implemented.

Risk Based Capital Ratio=Capital/Credit Risk+ Market Risk+ Operational Risk

The First Pillar –Minimum Capital Requirement..Minimum capital requirement based on Market, Credit, Operational risk. CREDIT RISKPillar I of Basel II sets out the quantitative and qualitative requirement & formula to calculate capitalfor credit risk.A meaningful differentiation of risk, and reasonablyAccurate and consistent quantitative estimates of risk.

Operational Riskoperational risk (for example, the risk of loss from computer failures, poor documentation or fraud). Many major banks now allocate 20% or more of their internal capital to operational risk.

Market Risk.Market risk is the risk of financial loss relating to a banks trading activities, where the bank may act on its own account or on behalf of its clients in the commodity, foreign exchange, equity, capital and money markets.

.Market risk arises where there are adverse movements in market prices e.g. interest and foreign exchange rates, equity, bond and commodity prices

BASEL III

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

• A need was felt to further strengthen the system as banks in the developed economies were under-capitalized, over-leveraged and had a greater reliance on short-term funding.

• Also the quantity and quality of capital under Basel II were deemed insufficient to contain any further risk.

• Basel III norms aim at making most banking activities such as their trading book activities more capital-intensive. The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz. capital, leverage, funding and liquidity.

• Capital Adequacy Ratio (CAR) is defined as the ratio of bank's capital to its risk assets. Capital Adequacy Ratio (CAR) is also known as Capital to Risk (Weighted) Assets Ratio (CRAR).

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• Capital Adequacy Norms included different Concepts, explained as follows :-

• •

TIER 1 CAPITAL

• Capital which is first readily available to protect the unexpected losses is called as Tier-I Capital. It is also termed as Core Capital.

• Tier-I Capital consists of :-• Paid-Up Capital.• Statutory Reserves.• Other Disclosed Free Reserves : Reserves which are not

kept side for meeting any specific liability.• Capital Reserves : Surplus generated from sale of Capital

Assets.•

• Capital which is second readily available to protect the unexpected losses is called as Tier-II Capital.

• Tier-II Capital consists of :-• Undisclosed Reserves and Paid-Up Capital

Perpetual Preference Shares.• Revaluation Reserves (at discount of 55%).• Hybrid (Debt / Equity) Capital.• Subordinated Debt.• General Provisions and Loss Reserves.

• Capital Adequacy Ratio is calculated based on the assets of the bank. The values of bank's assets are not taken according to the book value but according to the risk factor involved. The value of each asset is assigned with a risk factor in percentage terms.

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• Suppose CRAR at 10% on Rs. 150 crores is to be maintained. This means the bank is expected to have a minimum capital of Rs. 15 crores which consists of Tier I and Tier II Capital items subject to a condition that Tier II value does not exceed 50% of Tier I Capital. Suppose the total value of items under Tier I Capital is Rs. 5 crores and total value of items under Tier II capital is Rs. 10 crores, the bank will not have requisite CRAR of Rs. 15 Crores. This is because a maximum of only Rs. 2.5 Crores under Tier II will be eligible for computation.