Basel Norms — Set 4

Correct Answer: C. Government Securities (G-Secs)

• **Government Securities (G-Secs)** = Sovereign debt issued by the government carries 0% risk weight because the government is assumed to never default in its own currency — no capital needs to be set aside against these. • **Risk weight hierarchy** — Corporate loans = 100%, retail/personal loans = 75%, home loans (mortgages) = 35%; G-Secs stand alone at 0% as the safest asset class. • **Practical impact** — Banks can hold unlimited G-Secs without it increasing their Risk-Weighted Assets (RWA), making them attractive for capital management. • 💡 **Corporate Loans** carry 100% risk weight — corporates can default; **Home Loans** carry 35% — mortgages have collateral but still carry risk; **Personal Loans** carry 75% — unsecured retail credit with moderate default risk.

Correct Answer: D. Loss of market confidence and potential regulatory penalties

• **Loss of market confidence and potential regulatory penalties** = Pillar 3 requires banks to publicly disclose their risk exposures, capital ratios, and risk management practices — non-compliance invites both market punishment and regulatory action. • **Market discipline mechanism** — Investors, depositors, and counterparties use Pillar 3 disclosures to assess a bank's health; opacity signals hidden problems, raising borrowing costs and causing capital flight. • **Regulatory angle** — National regulators (like RBI in India) can impose penalties, restrict dividends, or increase supervisory scrutiny for non-disclosure under their domestic banking laws. • 💡 **Government subsidy** — false; non-disclosure is a negative event, not a reward; **Bank closed immediately** — too extreme; closure follows prolonged insolvency, not one disclosure failure; **Voluntary** — incorrect; Pillar 3 is a mandatory framework requirement, not optional.

Correct Answer: D. Basel II

• **Basel II** = Finalized in 2004, Basel II was the first accord to formally recognize operational risk as a distinct category requiring dedicated capital — defined as risk from failed internal processes, people, systems, or external events. • **Three risk categories under Basel II** — Credit Risk (existed since Basel I), Market Risk (added in 1996 amendment), and Operational Risk (new in Basel II); three approaches: Basic Indicator, Standardised, and Advanced Measurement. • **Real-world trigger** — Events like rogue trader losses (Barings Bank 1995) and IT failures showed that non-financial risks also destroy bank capital, prompting Basel II to quantify them. • 💡 **Basel I (1988)** only covered credit risk; **Basel III (2010)** refined and strengthened capital quality but did not introduce operational risk; **Basel 0** does not exist as a formal accord.

Correct Answer: B. Pillar 1

• **Pillar 1** = Both the Standardised Approach and IRB Approach are methods to calculate minimum capital requirements (the core function of Pillar 1) for credit risk — Pillar 1 sets the floor that every bank must meet. • **Key difference** — Standardised Approach uses fixed external risk weights set by regulators; IRB Approach (Foundation and Advanced) lets banks use their own default probability models with regulatory approval, typically giving lower capital requirements for well-rated portfolios. • **Pillar 2 connection** — If Pillar 1 models underestimate a bank's true risk, Pillar 2 supervisors can impose additional capital buffers on top of Pillar 1 minimums. • 💡 **Pillar 2** is the Supervisory Review Process — it deals with how supervisors evaluate adequacy, not how risk is calculated; **Pillar 3** is Market Discipline (public disclosure); both approaches are specifically Pillar 1 calculation methods.

Correct Answer: B. 10.5%

• **10.5%** = Basel III sets minimum Total Capital at 8% of RWA, plus a mandatory Capital Conservation Buffer (CCB) of 2.5%, giving a combined target of 10.5% — falling below triggers dividend and bonus restrictions. • **Capital structure breakdown** — Of the 10.5%: CET1 must be ≥4.5%, AT1 can top up to 6% (Tier 1 total), Tier 2 adds up to 2%, plus CCB of 2.5% is all CET1. • **India's RBI requirement** — RBI mandates a higher base CRAR of 9% (vs 8% globally), so Indian banks effectively target 11.5% when CCB is included. • 💡 **8.5%** = only Tier 1 (6%) + CCB (2.5%), ignoring Tier 2; **12.5%** = total including Countercyclical Buffer at maximum, not the standard target; **7.0%** = minimum CET1 (4.5%) + CCB (2.5%) only, not total capital.

Correct Answer: C. Fixing the exchange rate of the US Dollar

• **Fixing the exchange rate of the US Dollar** = Exchange rate policy is the domain of central banks and the IMF — the Basel Committee has no mandate over monetary policy or currency management whatsoever. • **What BCBS actually does** — It sets prudential standards for bank capital, liquidity, and risk management; facilitates cooperation among banking supervisors; and issues guidance to prevent regulatory arbitrage between countries. • **Established in 1974** — The Basel Committee was formed after the failure of Herstatt Bank (Germany) exposed cross-border banking risks, specifically to improve supervisory coordination, not macroeconomic policy. • 💡 The other three options — promoting common standards, exchanging supervisory information, and improving banking supervision quality — are all explicitly listed in the BCBS mandate and charter.

Correct Answer: B. Pillar 3

• **Pillar 3** = Pillar 3 (Market Discipline) requires banks to publicly disclose their capital composition — the shift from hidden reserves to disclosed reserves directly serves this transparency objective so markets can assess bank strength. • **Capital quality link** — Disclosed reserves qualify as high-quality Tier 1 capital under Basel norms; undisclosed reserves, being opaque, cannot be verified by markets or regulators and were excluded from recognized capital under Basel III. • **Why this matters** — When reserves are visible in financial statements, investors, depositors, and analysts can price a bank's risk accurately, reinforcing the market discipline that Pillar 3 is designed to create. • 💡 **Pillar 1** sets minimum capital levels but does not deal with disclosure; **Pillar 2** covers supervisory review of internal risk processes; **None** is wrong — this is explicitly a Pillar 3 transparency measure.

Correct Answer: C. A borrower's failure to repay a loan

• **A borrower's failure to repay a loan** = Credit risk is the probability of loss from a counterparty's failure to meet its contractual obligations — the most fundamental and largest risk in traditional banking. • **Basel capital treatment** — Banks must hold capital against credit risk using risk weights: sovereign = 0%, mortgage = 35%, retail = 75%, corporate = 100%; higher-risk borrowers consume more capital. • **Three sub-types under Basel** — Default Risk (borrower cannot pay), Credit Concentration Risk (too much exposure to one borrower/sector), and Counterparty Credit Risk (in derivatives markets). • 💡 **Stock market price changes** = Market Risk (Pillar 1, separate category); **Gold price changes** = Market Risk/commodity risk; **Internal fraud by employees** = Operational Risk (introduced by Basel II) — each has its own capital charge.

Correct Answer: D. Banking Regulation Act, 1949

• **Banking Regulation Act, 1949** = This act grants RBI comprehensive powers to prescribe prudential norms for banks in India — including capital adequacy standards based on the Basel framework — making Basel norms legally enforceable in India. • **Key provisions used** — Sections 11, 17, and 35A of the Act empower RBI to set minimum paid-up capital, reserve requirements, and issue directions on risk management to all scheduled commercial banks. • **RBI's CRAR standard** — Using this legal authority, RBI mandates a minimum CRAR of 9% for Indian banks (higher than the global Basel III minimum of 8%), reflecting India's conservative approach. • 💡 **SEBI Act, 1992** regulates securities markets, not banks; **Negotiable Instruments Act, 1881** governs cheques and bills of exchange; **Companies Act, 2013** applies to corporate entities broadly — none of these give RBI authority over bank capital norms.

Correct Answer: A. Switzerland

• **Switzerland** = Basel (also written as Basle in French) is Switzerland's third-largest city, located at the tripoint where Swiss, French, and German borders meet — making it a natural hub for international institutions. • **BIS headquarters since 1930** — The Bank for International Settlements (BIS), which hosts the Basel Committee's secretariat, has been headquartered in Basel since 1930, giving the city its historic importance in global banking. • **BCBS formed in Basel, 1974** — After the Herstatt Bank crisis, the G10 central bank governors meeting at BIS in Basel established the committee, which then took the city's name. • 💡 **Belgium** hosts NATO and EU institutions (Brussels), not BIS; **Austria** (Vienna) hosts OPEC and IAEA; **France** (Paris) hosts OECD and UNESCO — none are home to the BIS or BCBS.