Basel Norms — Set 2

Correct Answer: D. Liquidity Coverage Ratio (LCR)

• **Liquidity Coverage Ratio (LCR)** = LCR requires banks to hold a stock of High-Quality Liquid Assets (HQLA — e.g., government bonds, central bank reserves) sufficient to cover 100% of net cash outflows over a 30-day stress period. • **Formula** — LCR = Stock of HQLA ÷ Total net cash outflows over 30 days ≥ 100%; introduced in Basel III to prevent the liquidity freeze experienced in 2008 when interbank markets collapsed. • HQLA are split into Level 1 (0% haircut — cash, central bank reserves, sovereign bonds) and Level 2 assets (subject to haircuts); LCR was fully implemented by 2015. • 💡 Cash Reserve Ratio (CRR) is wrong — CRR is an RBI monetary policy tool requiring banks to hold a fraction of deposits as reserves with RBI; it is not a Basel liquidity metric; Net Interest Margin is wrong — it measures profitability (interest earned minus interest paid), not liquidity; Debt-to-Equity Ratio is wrong — it is a general leverage measure, unrelated to Basel's 30-day liquidity requirement.

Correct Answer: B. One year

• **One year** = NSFR requires that a bank's available stable funding (ASF) be at least equal to its required stable funding (RSF) over a one-year horizon under a stress scenario; NSFR ≥ 100%. • **Structural liquidity** — NSFR addresses long-term structural liquidity risk; it discourages banks from relying on volatile short-term wholesale funding to finance long-term illiquid assets — a key vulnerability exposed in 2008. • NSFR complements LCR (30-day short-term liquidity) by covering the 1-year funding horizon; together they address both immediate and medium-term liquidity resilience. • 💡 Five years is wrong — no Basel liquidity ratio uses a 5-year horizon; 30 days is wrong — that is the time horizon for LCR, not NSFR; Overnight is wrong — overnight liquidity is managed by central bank facilities and the money market, not by the NSFR metric.

Correct Answer: B. To build up capital in good times to be used in periods of stress

• **To build up capital in good times to be used in periods of stress** = CCB is an additional 2.5% CET1 buffer above the 4.5% CET1 minimum; banks accumulate it during profitable periods so it can absorb losses during economic downturns without breaching the regulatory minimum. • **Dividend restriction mechanism** — if a bank's CET1 falls into the CCB range (4.5%–7%), automatic restrictions kick in on dividend payments, share buybacks, and discretionary bonuses — incentivising banks to rebuild capital quickly. • With CCB, the effective CET1 target for unrestricted operation is 7% (4.5% + 2.5%); total CAR target becomes 10.5%; India's RBI also requires CCB of 2.5%. • 💡 Reducing bank branches is wrong — CCB is a capital regulation, not an operational restructuring tool; Increasing executive bonuses is wrong — CCB actually restricts bonuses if the buffer is breached; Lending more to the government is wrong — CCB constrains lending and distributions, it does not direct credit to any sector.

Correct Answer: A. Tier 1 Capital divided by Total Exposure

• **Tier 1 Capital ÷ Total Exposure** = The Basel III Leverage Ratio = Tier 1 Capital ÷ Total Exposure Measure (on-balance sheet assets + off-balance sheet items) × 100; minimum requirement is 3%. • **Non-risk-based backstop** — unlike CRAR which weights assets by risk, the Leverage Ratio treats all exposures equally; this prevents banks from manipulating internal risk models to artificially lower RWAs and thus show inflated capital ratios. • The Leverage Ratio was added to Basel III because pre-2008 banks had dangerously high leverage despite apparently adequate risk-weighted capital ratios; it acts as a hard floor regardless of risk assessment. • 💡 Loans divided by Deposits is wrong — that is the Credit-Deposit (CD) ratio, an RBI monitoring tool for credit flow; Total Assets ÷ Total Liabilities is wrong — that is a general solvency ratio, not the Basel Leverage Ratio definition; Net Profit ÷ Interest Income is wrong — that measures profitability efficiency, completely unrelated to capital leverage.

Correct Answer: D. Curb excessive credit growth during an economic boom

• **Curb excessive credit growth during an economic boom** = CCyB is a discretionary macroprudential tool ranging from 0% to 2.5% CET1; national regulators activate it when credit growth is deemed excessive, forcing banks to build extra capital that can be released during a downturn. • **Counter-cyclical design** — CCyB rises in boom phases (slowing credit expansion) and is released in bust phases (freeing capital to support lending); this smooths the credit cycle and reduces procyclicality in banking. • CCyB differs from CCB: CCB is a fixed 2.5% always required; CCyB varies from 0–2.5% based on each country's economic conditions and is set by the national regulator (in India, by RBI). • 💡 Lowering interest rates for farmers is wrong — that is an agricultural credit policy tool, not a Basel capital buffer; Increasing currency value is wrong — exchange rate management is the domain of monetary policy and foreign exchange intervention; Stopping banking operations is wrong — CCyB slows credit growth by requiring more capital, it does not halt operations.

Correct Answer: B. Operational Risk

• **Operational Risk** = Basel II (2004) was the first accord to formally define and require capital for operational risk — the risk of loss from inadequate or failed internal processes, people, systems, or external events (e.g., fraud, IT failures, legal breaches). • **Three risks in Basel II** — Basel II's Pillar 1 covers three risk types: Credit Risk (retained from Basel I), Market Risk (added in 1996 Market Risk Amendment), and Operational Risk (newly formalised in 2004); Basel I only directly addressed credit risk. • Banks can use three approaches for operational risk capital: Basic Indicator Approach (BIA), Standardised Approach (SA), or Advanced Measurement Approach (AMA). • 💡 Natural Disaster Risk is wrong — it is not a Basel risk category; banks may manage it under Pillar 2 as part of business continuity, but it has no separate Basel capital charge; Political Risk is wrong — it affects country/sovereign risk calculations but is not a standalone Basel risk pillar; Only Credit Risk is wrong — that describes Basel I, not the Basel II transition.

Correct Answer: A. To adjust asset values based on their risk level for capital calculations

• **To adjust asset values based on their risk level for capital calculations** = RWAs assign a risk weight (0%–150%+) to each asset class; riskier assets carry higher weights requiring proportionally more capital — e.g., a government bond has 0% weight (no capital required), while an unsecured corporate loan may have 100% weight. • **CRAR denominator** — RWA is the denominator in the CRAR formula: CRAR = Total Capital ÷ RWA; a bank with ₹1,000 Cr RWA must hold at least ₹80 Cr capital (8%) or ₹90 Cr in India (9%). • Basel II allowed banks to use Internal Ratings-Based (IRB) approaches to estimate their own RWAs; Basel III tightened this with output floors to prevent excessive RWA reduction through model manipulation. • 💡 Calculating total employees is wrong — RWA is a balance-sheet capital metric with no relation to headcount; Determining head office location is wrong — that is a regulatory licensing matter; Fixing working hours is wrong — RWA is purely a financial risk-weighting mechanism with no HR application.

Correct Answer: A. 9%

• **9%** = RBI requires Scheduled Commercial Banks (SCBs) in India to maintain a minimum CRAR of 9% — one percentage point higher than the global Basel III floor of 8% — reflecting RBI's more conservative approach to bank safety. • **India's full capital stack** — RBI's Basel III framework: CET1 ≥ 5.5% (vs 4.5% globally) + AT1 + Tier 2 = 9% minimum CAR; add CCB 2.5% → effective 11.5% CET1 target for unrestricted distributions. • D-SIBs (Domestic Systemically Important Banks) — SBI, ICICI Bank, and HDFC Bank — must hold an additional capital surcharge of 0.2% to 0.8% above the standard minimum. • 💡 12% is wrong — no Basel accord or RBI circular sets 12% as the standard minimum CRAR for SCBs; 8% is wrong — that is the global Basel III minimum, not India's RBI-mandated floor; 10% is wrong — 10% is not the RBI-set minimum (though adding CCB brings India's effective target above 11%).

Correct Answer: B. Basel II

• **Basel II** = Basel II (published June 2004, effective 2007) introduced the Three Pillars framework: Pillar 1 (Minimum Capital Requirements for credit, market, and operational risk), Pillar 2 (Supervisory Review Process), and Pillar 3 (Market Discipline through disclosure). • **Contrast with Basel I** — Basel I (1988) had only minimum capital rules with no supervisory review pillar or disclosure requirements; Basel II transformed the approach from a simple ratio to a comprehensive risk governance framework. • Basel III (2010) retained the Three Pillars but significantly strengthened each one — especially Pillar 1 with CET1 requirements, CCB, CCyB, LCR, and NSFR additions. • 💡 Basel I is wrong — it set the 8% CAR and two-tier capital structure but had no Three Pillars concept; Basel IV is wrong — Basel IV (finalised 2017) refined output floors and standardised approaches but did not introduce the pillars; Basel III is wrong — it enhanced and built upon the Three Pillars introduced by Basel II, not created them.

Correct Answer: A. 2.5%

• **2.5%** = The Capital Conservation Buffer under Basel III is fixed at 2.5% of risk-weighted assets, composed entirely of Common Equity Tier 1 (CET1); it sits above the minimum 4.5% CET1 requirement. • **Effective CET1 target = 7%** — banks must maintain CET1 of at least 7% (4.5% minimum + 2.5% CCB) to operate without restrictions on dividends, buybacks, and bonuses; total CAR with CCB = 10.5%. • India's RBI also mandates the full 2.5% CCB, making India's effective minimum CET1 = 5.5% + 2.5% = 8% and total CAR = 9% + 2.5% = 11.5%. • 💡 1.5% is wrong — that is the minimum requirement for Additional Tier 1 (AT1) capital, not the CCB; 3.5% is wrong — no standard Basel buffer is set at 3.5%; 4.5% is wrong — that is the minimum CET1 ratio itself, not the conservation buffer amount.