What is the Basel Capital Accord? What was the route of implemantation in Nepal?

Basel Capital accord is a capital adequacy framework developed by the Basel Committee on Banking Supervision (BCBS) popularly referred as Basel Committee. It was established by the central bank Governors of the Group of Ten countries (G-10) at the end of 1974 and meets regularly four times a year. The committee provides guidance on banking supervisory matters to encourage convergence towards common approaches and standards, but can’t legally enforce its suggestions. Thus, the national banking authority or the Central Bank on its discretion adopts Basel Committee’s policies with appropriate customization.

In 1988, the Basel developed the Capital Accord, which is known as Basel I, to align the capital adequacy requirements applicable especially to banks in G-10 countries. Basel I introduced two key concepts of Bank capital (Tier 1 and Tier 2) and risk weighted assets (RWA). On June 26, 2004 BCBS released the "International Convergence of Capital Measurements and Capital Standards: Revised Framework", popularly known as Basel II. This version was later updated in Nov 2005 and comprehensive version was issued in 2006. Basel II framework incorporates three complementary “pillars” namely Minimum capital requirement, Supervisory review process and Market discipline.

In Nepal, the first pillar includes risk measurement approaches viz; Simplified Standardized Approach (SSA) for credit risk, Basic Indicator Approach (BIA) for operational risk and Net Open Position Approach (NOPA) or Standardized approach for market risk. These are the simplest approaches amongst the list of other approaches recommended based on the level of bank’s operation and financial market infrastructure. However, given a bank has adequate resources and capabilities, it can opt for advanced approaches with prior written approval of Nepal Rastra Bank. Basel II was implemented in Nepalese commercial banks from 2007 till 2015. At present, NRB, through its new monetary policy of 2076/77, has made it compulsory for Development banks and Finance Companies to incorporate BASEL II guidelines.

After the global financial crisis of 2007-09, Basel Committee introduced Basel III in Dec 2010 to improve the banking sector’s ability to absorb shocks arising from financial and economic stress. Thus reducing spillover risk from financial sector to real economy. Basel III marks introduction of two buffers: Capital Conservation Buffer (CCB) and Countercyclical Buffer (CCyB), intended to protect the banking sector from periods of excess credit growth. The below table shows Basel III recommendation for minimum capital adequacy.

(Source: Nepal Rastra Bank)

Definitions of some important terms:

Tier 1 Capital: Fully paid up, no fixed servicing or dividend cost, freely available to absorb loss, high degree of permanence. Includes common equity capital, additional tier 1 capital

Tier 2 Capital: includes reserves which have been passed through the profit and loss account and all other capital instruments eligible and acceptable for capital purposes. Eg: general loan loss provision, revaluation reserve, exchange equalization reserve, redeemable preference share and so on. Amount of tier-2 capital shall not exceed tier 1 capital.

Total Capital: Sum of Tier I and Tier 2 capital

Capital Conservation Buffer (CCB): It is a capital buffer of 2.5% of an institution's total exposures that needs to be met with an additional amount of Common Equity Tier 1 capital. The capital conservation buffer is intended to ensure that firms build up buffers of capital outside any periods of stress and is designed to avoid breaches of minimum capital requirements.

Countercyclical Buffer (CCyB): It is a surcharge on the banks’ common equity Tier 1 capital designed to counter the pro-cyclicality of the financial system. The supervisory authority may establish a positive CCyB rate if the aggregate domestic credit growth is excessive. Once the credit growth has returned to normal or the banks suffer losses, the CCyB rate can be decreased to as far as zero. The CCB therefore provides banks with an additional capital buffer for difficult times. It ranges from 0 to 2.5%. At present, CCyB stands at 2% in Nepal.

In Nepal, unlike BASEL III recommendation, NRB has increased the Minimum Total Capital Ratio (MTC) to 8.5% from 8% of total risk weighted assets (RWA), thus increasing total capital adequacy ratio to 11% from 10.5%. However, recent monetary policy has mandated commercial banks to add in extra 2% capital as Countercyclical Buffer, capital adequacy ratio has surged up to 13%. Nepal adopted Basel III from year July 2015 in a phased manner. Table below shows the capital ratios after full implementation of Basel III in Nepalese commercial banks.

Notes:

• Additional Tier 1 capital can be admitted maximum at 1.5% of RWAs.
• If a bank has complied with the minimum Common Equity Tier 1 and Tier 1 capital ratios, then the excess Additional Tier 1 capital can be admitted for compliance with the minimum capital to risk weighted assets (CRAR) of 8.5% of RWAs.
• In addition to the minimum Common Equity Tier 1 capital of 4.5% of RWAs, banks are also required to maintain a capital conservation buffer (CCB) of 2.5% of RWAs in the form of Common Equity Tier 1 capital.
• From 2019 July, banks have to maintain countercyclical buffer between 0-2.5% (rate as per discretion of NRB) of its RWAs. NRB will decide rates depending on the extent of buildup of system-wide risk.

According to the latest Q4 reports of 13 commercial banks, only 7 banks have the required Capital Adequacy Ratio of 13% mandated by Nepal Rastra Bank. Incase these other banks don’t meet CAR requirement of 13% by 2077 Ashad, they’ll face restrictions in distributing cash dividend to their shareholders. Given the scenario, it is likely that the dividend policy of many banks will be inclined towards bonus shares rather than cash dividends. Also, commercial banks are mandated by NRB to issue 25% of paid up capital as debenture by 2077 Ashad, and we have seen many of them already floating it. This will definitely increase Capital Adequacy Ratio of all the banks as debenture fall under “Subordinated Term Debt” in Tier 2 capital.