Basel Norms with Examples
What are Basel Norms?
Imagine a bank as a big money box where people deposit their money. The bank then lends this money to different people and businesses. However, some borrowers may not return the money, which creates a risk for the bank. If too many loans are not repaid, the bank may collapse, and depositors could lose their money.
To prevent such failures and ensure financial stability, a group of global banking regulators created Basel Norms—a set of rules that banks must follow to manage risks properly.
Why are they called Basel Norms?
These norms are named after Basel, a city in Switzerland, where the Bank for International Settlements (BIS) is located. BIS helps central banks from different countries to work together and maintain global financial stability.
Basel I (1988) – Focus on Credit Risk
💡 Think of it like this: Suppose you lend money to two friends—one has a stable job, and the other is unemployed. Who is more likely to repay you? The one with a stable job, right?
Basel I focused on credit risk (the risk that borrowers may not repay loans). It introduced the concept of Risk-Weighted Assets (RWA)—loans were categorized based on their risk level.
- Example: A home loan (backed by property) has lower risk than a personal loan (no security).
🔹 Key Rule: Banks had to maintain a minimum capital adequacy ratio (CAR) of 8% (meaning, for every ₹100 loaned out, the bank must keep at least ₹8 as a backup).
🔹 India adopted Basel I in 1999.
Basel II (2004) – Improved Risk Management
💡 Imagine a school introducing stricter exam rules to ensure fair evaluation. Similarly, Basel II introduced better ways to measure risks and ensured banks had enough reserves.
Basel II focused on three pillars:
1️⃣ Capital Adequacy – Banks still needed to maintain at least 8% capital reserve.
2️⃣ Supervisory Review – Banks had to improve risk management for three types of risks:
- Credit Risk (loans not being repaid)
- Market Risk (loss due to changes in stock prices, interest rates, etc.)
- Operational Risk (loss due to fraud, system failures, etc.)
🔹 India and many other countries are still implementing Basel II.
Basel III (2010) – Stronger Rules After 2008 Crisis
💡 Imagine a student failing an exam because of poor preparation. Next time, they study harder to avoid failure. Similarly, Basel III was introduced after the 2008 financial crisis, when many banks collapsed due to weak financial health.
New improvements in Basel III:
✅ More Capital Reserve – Banks had to keep a larger backup fund to absorb shocks.
✅ Leverage Control – Banks could not take too much debt compared to their own money.
✅ Better Liquidity Management – Banks had to ensure they had enough cash flow to meet short-term needs.
Basel III norms require a minimum CRAR of 10.9%, including a 2.5% capital conservation buffer. In India, the Reserve Bank of India (RBI) has set a higher requirement of 11.5% to ensure greater stability.
🔹 India is implementing Basel III in phases to strengthen its banking system.
As of March 2025, the Reserve Bank of India (RBI) mandates that scheduled commercial banks maintain a minimum Capital to Risk-Weighted Assets Ratio (CRAR) of 9%. This requirement is higher than the 8% prescribed by the Basel III norms, reflecting India's cautious approach to banking stability.
For Urban Cooperative Banks (UCBs), the RBI has set a phased plan to achieve a CRAR of 12% by March 31, 2026. The targets are as follows:
- 10% by March 31, 2024
- 11% by March 31, 2025
- 12% by March 31, 2026
Additionally, banks identified as Domestic Systemically Important Banks (D-SIBs), such as the State Bank of India (SBI), HDFC Bank, and ICICI Bank, are required to maintain additional capital buffers due to their significant impact on the financial system. Effective April 2025, these additional capital requirements are:
- SBI: An additional capital buffer of 0.80%, up from 0.60%
- HDFC Bank: An increase to 0.40%, up from 0.20%
These measures are designed to enhance the resilience of India's banking sector by ensuring that banks hold sufficient capital to absorb potential losses and maintain financial stability.
Summary Table of Basel Norms
| Basel Norm | Year | Focus Area | Main Rule | Example |
|---|---|---|---|---|
| Basel I | 1988 | Credit Risk | Banks must keep 8% capital reserve | Home loan vs. Personal loan risk |
| Basel II | 2004 | Risk Management | Banks must manage Credit, Market, and Operational risks | Banks must disclose financial health |
| Basel III | 2010 | Post-2008 Crisis | Stronger capital reserves, less debt, better liquidity | Banks must have emergency cash reserves |
Example
The example explains the concept of Capital to Risk Weighted Asset Ratio (CRAR) using two hypothetical banks (Bank 1 and Bank 2). Let's break it down:
1. Balance Sheet of Banks
Each bank has:
- Owners' money (Equity Capital): ₹1 crore
- Deposits from the public: ₹3 crores
- Total funds available (Liability side): ₹4 crores
Each bank gives out loans:
- Bank 1: ₹1 crore as a personal loan + ₹3 crores as a project loan (secured by collateral).
- Bank 2: ₹3 crores as a personal loan + ₹1 crore as a project loan (secured by collateral).
2. Risk Weightage of Loans
RBI assigns different risk weights to various loans based on their riskiness:
- Personal loans: Considered risky, given 100% risk weight.
- Loans against collateral: Less risky, given 50% risk weight.
3. Calculation of CRAR
Bank 1:
-
Risk-Weighted Assets (RWA) Calculation:
- Personal Loan (₹1 crore × 100%) = ₹1 crore
- Project Loan (₹3 crore × 50%) = ₹1.5 crores
- Total RWA = ₹2.5 crores
-
CRAR = Capital / RWA = 1 / 2.5 = 0.4 or 40%
Bank 2:
-
Risk-Weighted Assets (RWA) Calculation:
- Personal Loan (₹3 crores × 100%) = ₹3 crores
- Project Loan (₹1 crore × 50%) = ₹0.5 crores
- Total RWA = ₹3.5 crores
-
CRAR = Capital / RWA = 1 / 3.5 = 0.3 or 30%
4. Interpretation
- Higher CRAR = Safer Bank: Since Bank 1 has a CRAR of 40%, it is safer than Bank 2, which has a CRAR of 30%.
- Depositor Safety: If both banks face NPAs (bad loans), Bank 1 is in a better position to repay depositors because it has more secured loans.
- Regulatory Requirement: Basel III norms require banks to maintain a minimum CRAR of 11.5% (including a 2.5% capital conservation buffer). Hence, banks need to increase their capital through equity or bonds to meet this requirement.
5. Key Takeaways
- CRAR measures the financial health of a bank.
- Higher CRAR means better safety for depositors.
- Banks need sufficient capital to ensure financial stability.
- Governments recapitalize Public Sector Banks (PSBs) using budgetary support or recapitalization bonds to help them maintain CRAR.