Context: Recently, Reserve Bank of India (RBI) proposed to replace existing approaches for measuring minimum operational risk capital requirements of banks with a new Basel-III standardised approach.

• Note: ‘Operational risk’ refers to the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.

Key Points

• RBI issued the ‘Draft Master Direction on Minimum Capital Requirements for Operational Risk’ as part of the convergence of its regulations for banks with Basel-III standards.
• The central bank has sought comments on the draft by January 31, 2022.
• All existing approaches – Basic Indicator Approach (BIA), The Standardised Approach (TSA)/ Alternative Standardised Approach (ASA) and Advanced Measurement Approach (AMA) for measuring minimum operational risk capital requirements – are proposed to be replaced by the new standardised approach (Basel-III Standardised Approach).

About Capital Requirements of a Bank

• Capital requirements are standardized regulations in place for banks and other depository institutions that determine how much liquid capital must be held of a certain level of their assets.
• They are set to ensure that banks and depository institutions’ holdings are not dominated by investments that increase the risk of default.
• They also ensure that banks and depository institutions have enough capital to sustain operating losses (OL) while still honoring withdrawals.

Why need such a requirement?

• An angry public and uneasy investment climate usually prove to be the catalysts for capital requirements provisions.
• This is essential when irresponsible financial behavior by large institutions is seen as the culprit behind a financial crisis, market crash, or recession.

What are the risks for a Bank?

• There are many types of risks that banks face like Credit risk; Market risk; Operational risk; Liquidity risk; Business risk; Reputational risk; Systemic risk and Moral hazard.

About Operational Risk

• ‘Operational risk’ refers to the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
• This has been defined by the Basel Committee on Banking Supervision I as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
• This definition includes legal risk, but excludes strategic and reputational risk.

Pros of Capital Requirements

• Ensure banks stay solvent, avoid default
• Ensure depositors have access to funds
• Set industry standards
• Provide way to compare, evaluate institutions
• Unwanted consequences of such move
• Raise costs for banks and eventually consumers
• Inhibit banks’ ability to invest
• Reduce availability of credit, loans

Basel Accords

• They refer to the banking supervision Accords (recommendations on banking regulations)—Basel I, Basel II and Basel III—issued by the Basel Committee on Banking Supervision (BCBS).
• They are called the Basel Accords as the BCBS maintains its secretariat at the Bank for International Settlements in Basel, Switzerland and the committee normally meets there.
• These are a set of recommendations for regulations in the banking industry.
• India has accepted Basel accords for the banking system.

A) Basel I

• In 1988, BCBS introduced capital measurement system called Basel capital accord, also called as Basel 1.
• It focused almost entirely on credit risk. It defined capital and structure of risk weights for banks.
• The minimum capital requirement was fixed at 8% of risk-weighted assets (RWA).
• RWA means assets with different risk profiles.
• For example, an asset backed by collateral would carry lesser risks as compared to personal loans, which have no collateral. India adopted Basel 1 guidelines in 1999.

[2] Basel II

• In June ’04, 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, which the committee calls it as pillars:

• Capital Adequacy Requirements: Banks should maintain a minimum capital adequacy requirement of 8% of risk assets.
• Supervisory Review: According to this, banks were needed to develop and use better risk management techniques in monitoring and managing all the three types of risks that a bank faces, viz. credit, market and operational risks.
• Market Discipline: This need increased disclosure requirements. Banks need to mandatorily disclose their CAR, risk exposure, etc to the central bank. Basel II norms in India and overseas are yet to be fully implemented.

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.