The Reserve Bank on Friday issued draft guidelines for minimum capital requirements for market risk – under the Basel III framework, proposing to impose a slew of restrictions on a bank’s trading and banking books and sharply increase fines and provisioning ratios.
The regulator said the move is part of convergence of Reserve Bank regulations with Basel III standards.
Final guidelines, subject to possible changes following suggestions from the public and stakeholders, will apply to all commercial banks, with the exception of local banks, payment banks, regional rural banks, small financial banks and all types of cooperative banks – city, state and central banks . -operating banks and will take effect from April 1, 2024.
The central bank has sought comment from both stakeholders and the public before April 15.
What is the Basel III framework?
Basel III reforms are the response of the Basel Committee on Banking Supervision (BCBS) to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, regardless of its source, thereby reducing the risk of financial spillovers. sector to the real economy is reduced .
At the Pittsburgh Summit in September 2009, G20 leaders committed to strengthening the regulatory system for banks and other financial companies and also to act together to raise capital standards, to introduce strict international compensation standards aimed at ending practices that lead to excessive risk-taking, improving the over-the-counter derivatives market and creating more powerful tools to hold major global companies accountable for the risks they take. For all these reforms, the leaders have set strict and precise timetables for themselves.
Consequently, in December 2010, the Basel Committee on Banking Supervision (BCBS) released a comprehensive reform package entitled “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems” (known as the Basel III Capital Rules).
RBI’s latest design guidelines for minimum capital requirements for market risk
The new standards clearly draw a line between the banking book and the trading book and list the instruments that can be included in the trading book, which are subject to market risk capital requirements; and those to be included in the banking book subject to capital requirements for credit risk.
The capital requirement for both specific risk and general market risk will be 9 percent of both the bank’s core capital and exposure to the specified instruments. These capital requirements will also apply to all trading book exposures, which are exempt from capital market exposure limits for direct investment.
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The regulator defines a trading book, for the purpose of capital adequacy, all instruments that meet the specifications for instruments in the trading book, such as financial instruments and foreign exchange and all other instruments, are included in the banking book.
It also defines market risk as the risk of losses in on- and off-balance sheet positions due to movements in market prices.
Since a financial obligation is a contractual obligation to deliver cash or another financial asset, banks should only include a financial instrument or forex instruments in the trading book if there is no legal impediment to selling or fully hedging it.
The new standards also require banks to determine a fair value on each trading book instrument on a daily basis and specify that any instrument held by a bank when first recorded on its books qualifies as a trading book instrument unless specifically stated otherwise for short-term transactions. resale, taking advantage of short-term price movements; locking in arbitrage profits; or hedging risks arising from the convergence of instruments.
The new guidelines allocate unlisted shares and equity investments in subsidiaries/associates; instruments intended for securitization warehousing; securities with real estate as underlying asset and derivatives thereof; securities with retail and micro, MSME exposure as underlying asset; equity investments in funds to the banking book.
The new guidelines prohibit short positions on any instrument except derivatives and central government securities. Banks are allowed to engage in underwriting issues of shares, bonds and debentures.
But banks have the option to deviate from the presumptive list after prior approval from the RBI and approval from the board of directors. In cases where this approval is not given, the instrument will be included in the trading book.
Subject to regulatory review, banks have the option of excluding certain listed equities from the market risk framework. For example, equity positions arising from deferred compensation plans, convertible debt securities, bank-owned life insurance products, and statutory programs.
The framework also requires banks to have clearly defined policies, procedures and documented practices for determining which instruments can be included in or excluded from the trading book for the purpose of calculating regulatory capital, and also to take into account the capabilities and practices of the bank in terms of risk management.
There is also a strict limit to banks’ ability to shift instruments between the trading book and the banking book at their discretion after the initial designation and such shifts for regulatory arbitrage purposes are strictly prohibited.
In practice, a shift should be rare and only allowed in extraordinary circumstances, it says, adding a shift could be allowed if there is a major publicly announced event, such as a bank restructuring requiring termination of business. applicable to the instrument or portfolio or a change in accounting standards that allows an item to be measured at fair value through profit and loss statements.
Market events, changes in the liquidity of a financial instrument or a change in trading intent alone are not valid reasons to reassign an instrument to another book. When shifting positions, banks will ensure that all imposed standards are observed.
But book switching is possible if approved by the bank’s board and RBI after a thoroughly documented process and determined by internal review to be consistent with the bank’s policies and previous RBI.
Regardless of the reporting frequency, banks meet all capital requirements for market risk on an ongoing basis, at the end of each business day. Banks maintain strict risk management systems to monitor and control intraday exposures to market risks.
The bank will need to document and make available for regulatory oversight the positions and amounts to be excluded from market risk capital requirements. Capital Requirement for Forex Risk does not apply to positions associated with items deducted from capital in the calculation of a bank’s capital base.
(with PTI inputs)
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