Basel Norms — Set 5

Correct Answer: B. They can be converted to equity or written off if capital falls below a threshold

• **They can be converted to equity or written off if capital falls below a threshold** = AT1 bonds are perpetual debt instruments with a mandatory loss-absorption trigger: if a bank's CET1 ratio falls below 5.125%, AT1 bonds are either written down to zero or converted into equity shares. • **AT1 in the capital structure** — AT1 is part of Tier 1 capital (above Tier 2 but below CET1 in loss-absorption priority); they pay coupons but issuers can skip payments without triggering default — unlike regular bonds. • **Indian example** — YES Bank's AT1 bonds were written down to zero during its 2020 RBI rescue, demonstrating exactly this feature; investors lost principal entirely to protect depositors. • 💡 **Never expire** — partially true (they are perpetual) but incomplete; the defining characteristic is the loss-absorption trigger, not just perpetuality; **Fixed 2-year maturity** — false, AT1 bonds have no maturity date; **Government guaranteed** — false, they are the opposite: designed to absorb losses before taxpayers do.

Correct Answer: A. Pillar 2

• **Pillar 2** = The Supervisory Review Process (Pillar 2) allows regulators to go beyond Pillar 1's standardized minimums — if a bank's ICAAP (Internal Capital Adequacy Assessment Process) reveals risks not captured in Pillar 1, supervisors can demand additional capital buffers. • **SREP and ICAAP** — Banks conduct ICAAP to self-assess their capital needs; supervisors then run SREP (Supervisory Review and Evaluation Process) to validate this and may require a Pillar 2 Requirement (P2R) on top of minimums. • **Risks covered by Pillar 2** — Concentration risk, pension risk, IRRBB (Interest Rate Risk in Banking Book), reputational risk — risks that Pillar 1's standardized formulas don't fully capture. • 💡 **Pillar 1** sets the fixed minimum — it cannot exceed itself; **Pillar 3** deals with public disclosure, not capital-setting powers; **Pillar 4** does not exist in the Basel framework.

Correct Answer: C. Risk of a total financial system collapse triggered by an event

• **Risk of a total financial system collapse triggered by an event** = Systemic risk is the danger that a single failure (a large bank, a market freeze, or a sovereign default) cascades through interconnected financial institutions and collapses the entire system — not just one entity. • **2008 crisis context** — Lehman Brothers' collapse triggered systemic risk: interbank lending froze, money markets broke down, and global credit dried up — exactly what Basel III was redesigned to prevent. • **Basel III's systemic risk tools** — G-SIB (Global Systemically Important Banks) surcharge of 1–3.5% extra capital, Countercyclical Capital Buffer (CCyB), and leverage ratio all target systemic risk specifically. • 💡 **Computer system crashing** = IT/Operational Risk; **Bank losing physical keys** = Operational Risk (physical security); **Single bank failing due to internal fraud** = Operational Risk of one institution — none of these involve contagion across the entire system.

Correct Answer: A. To ensure banks have enough cash to meet short-term obligations

• **To ensure banks have enough cash to meet short-term obligations** = Basel III introduced two liquidity standards: LCR (Liquidity Coverage Ratio) for 30-day survival in a stress scenario, and NSFR (Net Stable Funding Ratio) for stable funding over ≥1 year — both ensure banks can meet obligations without emergency government support. • **LCR formula** — LCR = High Quality Liquid Assets (HQLA: cash + G-Secs + central bank reserves) / Net Cash Outflows over 30 days ≥ 100%; banks must hold enough HQLA to survive a 30-day market stress. • **2008 lesson** — Lehman and many banks were solvent on paper but illiquid — they had assets but couldn't convert them to cash fast enough; Basel III's liquidity standards directly addressed this fatal flaw. • 💡 Options B, C, and D are absurd distractors with no connection to banking regulation — the Basel Committee exclusively addresses prudential safety and stability, never operational convenience or real estate investment.

Correct Answer: A. Group of Central Bank Governors and Heads of Supervision

• **Group of Central Bank Governors and Heads of Supervision** = GHOS is the highest governing body overseeing the BCBS — it comprises the governors of central banks and heads of banking supervisory authorities from member jurisdictions. • **Role of GHOS** — It approves the Basel Committee's strategic direction, endorses major standards (like Basel III), and provides political legitimacy to the norms; without GHOS approval, Basel standards have no authority. • **Composition** — GHOS includes the RBI Governor (India), Federal Reserve Chair (USA), ECB representatives, and similar senior officials from all 28 member jurisdictions — reflecting the committee's global mandate. • 💡 The other three options — General House of Overseas Settlements, Global Headquarters of Securities, Governmental Hub for Operations and Safety — are all invented names with no basis in the Basel framework or international financial institutions.

Correct Answer: D. Capital / RWA = Capital Adequacy Ratio

• **Capital / RWA = Capital Adequacy Ratio** = CAR (CRAR) = (Tier 1 + Tier 2 Capital) / Risk-Weighted Assets × 100 — this is the foundational Basel formula showing how much capital a bank holds relative to the risk it has taken. • **Why divide by RWA, not total assets** — A ₹100 G-Sec and a ₹100 personal loan are not equally risky; RWA adjusts each asset by its risk weight (G-Sec = ₹0 RWA, personal loan = ₹75 RWA) so capital requirements reflect actual risk, not just balance sheet size. • **Minimum thresholds** — Basel III: minimum 8% CAR globally; RBI requires 9% for Indian scheduled commercial banks; with CCB included, the effective target is 10.5% (Basel) or 11.5% (India). • 💡 **Capital - RWA** has no financial meaning; **Capital × RWA** produces an irrelevant large number; **Capital + RWA** is mathematically incorrect for any ratio — only division produces the dimensionless percentage that is CAR.

Correct Answer: D. Basel II

• **Basel II** = Basel II (2004) introduced the Internal Ratings-Based (IRB) Approach, allowing sophisticated banks to use their own credit models to estimate Probability of Default (PD), Loss Given Default (LGD), and Exposure at Default (EAD) — replacing the fixed risk weights of Basel I. • **Why Basel I was 'one-size-fits-all'** — Basel I (1988) assigned the same 100% risk weight to all corporate loans regardless of whether the borrower was AAA-rated or near-default; a highly rated company and a junk-rated one consumed the same capital. • **Basel II's limitation** — Banks exploited internal models to minimize capital (model gaming); this contributed to pre-2008 undercapitalization, prompting Basel III to add capital floors and constrain model freedom. • 💡 **Basel I** was the original one-size-fits-all accord — it is what Basel II moved away from; **Basel III** further refined models but didn't introduce them; **Basel 1974** refers to the year the committee was founded, not an accord.

Correct Answer: C. Tier 1

• **Tier 1 (specifically CET1)** = Retained earnings are part of Common Equity Tier 1 (CET1) — the highest quality capital — because they are fully paid-in, permanently available, and the first to absorb losses before any depositor is at risk. • **CET1 composition** — CET1 = Equity share capital + Retained earnings + Other Comprehensive Income − Regulatory deductions (goodwill, deferred tax assets); minimum CET1 required = 4.5% of RWA under Basel III. • **Why retained earnings are best** — Unlike debt, retained earnings don't need to be repaid; unlike AT1 bonds, they have no triggers; they represent real accumulated profits kept inside the bank as a permanent loss cushion. • 💡 **Tier 2** includes subordinated debt (minimum 5-year maturity), general provisions, and revaluation reserves — retained earnings are too high-quality for Tier 2; **Liquid Tier** is not a Basel capital category; **Tier 3** was abolished under Basel III.

Correct Answer: C. Enhance financial stability

• **Enhance financial stability** = The Basel Committee's core purpose is to prevent banking crises that destabilize national and global economies — by requiring adequate capital, sound liquidity, and strong risk management, banks can absorb shocks without taxpayer bailouts. • **Why stability, not profit** — Basel norms sometimes reduce bank profitability (by requiring more capital to be held idle as a buffer), but the social benefit — avoiding financial collapses like 2008 — far outweighs the private cost to shareholders. • **Contagion prevention** — The framework specifically addresses 'too-big-to-fail' systemic risk: G-SIBs must hold extra capital (1–3.5% surcharge) precisely because their failure would threaten the entire financial system. • 💡 **Ensure every bank makes a profit** — false; Basel actually constrains some profit-maximizing behavior through capital requirements; **Control oil prices** — completely unrelated to banking regulation; **Reduce bank employees** — not a regulatory objective.

Correct Answer: B. The ability of capital to cover losses and keep the bank operational

• **The ability of capital to cover losses and keep the bank operational** = Loss absorbency means capital 'soaks up' financial losses as they occur — keeping the bank a going concern — so depositors are protected and the bank doesn't need a bailout. • **Loss absorbency hierarchy** — CET1 absorbs first (best quality, going concern), then AT1 (also going concern, triggered at CET1 < 5.125%), then Tier 2 capital absorbs in gone-concern (liquidation) scenarios. • **Basel III's improvement** — Basel III strengthened loss absorbency by requiring a higher proportion of CET1 (4.5%) versus the older Basel II requirement, and by ensuring AT1 and Tier 2 instruments have genuine contractual loss-absorption features. • 💡 **Losing its license** = bank closure, not loss absorbency — which is specifically about capital absorbing losses while the bank stays open; **Hiding losses** = the opposite of Basel's transparency mandate; **ATM cash** = operational liquidity, unrelated to capital adequacy.