The dynamics of the business remains a field that never fails to surprise its stakeholders. From profit levels unprecedented during the 2001 dot com bubble to losses crashing the entire economy like in 2008, one needs to know where it stands. After all that has happened over the years, people have become more cautious about the risk aspect of business, which they aptly should be. This stems from the belief that saturation in many sectors seems to have been hit and to become profitable, organisations would have to venture into risky waters. This makes risk management an integral part of organisations. However, banks stand at the top with the most immediate requirement of managing risks properly. The reason is obvious. Where would one run to keep his/her money safe in terms of any crisis? What are the safest means of keeping money intact?

Yet, banks have also started venturing out into fields of investment which might not be considered as the most ideal.

With a backdrop of such nature, the BASEL Accords were developed by the Bank of International Standards, the head of central banks of all nations, with an aim of setting uniform global risk management standards. The latest update in the Indian context is the necessary implementation of BASEL III reforms in 2019.

The requirements under BASEL III hits the bull’s eye with it primarily targeting facets like minimum capital requirements, liquidity need and leverage limits. With competition reaching unprecedented heights, banks often have a high investments-to-capital ratio in order to survive. BASEL III norms, realising the dangers it entails in terms of capital erosion, make it imperative to secure capital first. In the heart of the 2008 crisis was the subordination of assets. Primarily focusing on that, BASEL III reforms have now made it compulsory for banks to hold at least 7% of their risk-weighted assets in the form of Tier 1 capital and additional tier 1 capital.

This sounds quite impressive. Risk-weighted assets are basically a risk-weighted average of all the risky assets held by any bank. Higher the credit risk of any asset, higher will be its weight and thus, BASEL III would require banks to hold more capital, to provide the banks with a cushion to fall back on. BASEL III even looks out for risks beyond good times; provision of a countercyclical buffer has been introduced. The provision makes it compulsory to set aside a 2.5% of risk weighted assets during favourable times in the economy like high credit growth for banks. These are to be utilised in times of need when there is capital erosion. The balance sheet would be relatively better than in its absence.

The leverage portion under BASEL is way more inclusive now. Leverage here refers to the ratio of the capital measured using Tier 1 capital and the exposure a bank has. The 2008 crisis had derivatives to blame to a great extent. A major problem then was the lack of proper accounting of risks arising from off-the-balance-sheet transactions. However, now banks would be required to include both on-the-balance-sheet and off-the-balance-sheet transactions (like derivative transactions) while calculating its risk exposure. This would also include the counterparty risk, a catastrophic element in all financial crises across history, involved in them. The value of CCR is calculated as a monetary figure, with the process of calculation being quite stringent and as advised by the Bank of International Settlement. The last aspect that BASEL laws deal with is the liquidity of a bank’s operation. Every crisis is preceded and/or succeeded by a liquidity crunch. This being a major concern, BIS has made it compulsory for banks to follow the criteria of a Liquidity Coverage Ratio. The banks will have to ensure that they have adequate stock on highly liquid assets with them. They must be convertible to cash within 30 days so that dues can be met easily. It is speculated that once LCR is fully implemented, BIS will raise the minimum requirement of LCRs to 100% i.e., a 100% provision of highly liquid assets would have to be maintained by banks. These regulations seem viable from a global perspective and also well equipped to handle the past progenitors of financial crises. But a major issue with them is that they are quite expensive by global standards. With maintenance levels of capital as high as 7% and markets expecting more returns on capital raised by banks, the situation looks like a double whammy. These are costs whose benefits are evident but need to be weighed. One thing is for sure though: the world is moving towards an era where a company which manages risks better will be seen in a better light than a company which has higher returns and banks will undoubtedly have to be torchbearers of the same.

By Pratik Saraf