Final guidelines will be applicable from April 1, 2024.
The Reserve Bank on Friday issued the draft guidelines for minimum capital requirements for market risk – under Basel III framework, wherein it proposes to impose a slew of curbs on a bank’s trading and banking books and steeply increasing the penalties and provisioning ratios.
The regulator said the move is part of converging the Reserve Bank regulations with Basel III standards.
Final guidelines, after modifications if any after public and stakeholder suggestions, will be applicable to all commercial banks, excluding local area banks, payments banks, regional rural banks small finance banks and all types of co-operative banks-urban, state and central co-operative banks and shall come into effect from April 1, 2024.
The central bank has sought comments from both stakeholders and public by April 15.
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What is Basel III framework?
Basel III reforms are the response of Basel Committee on Banking Supervision (BCBS) to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spill over from the financial sector to the real economy.
During Pittsburgh summit in September 2009, the G20 leaders committed to strengthen the regulatory system for banks and other financial firms and also act together to raise capital standards, to implement strong international compensation standards aimed at ending practices that lead to excessive risk-taking, to improve the over-the-counter derivatives market and to create more powerful tools to hold large global firms to account for the risks they take. For all these reforms, the leaders set for themselves strict and precise timetables.
Consequently, the Basel Committee on Banking Supervision (BCBS) released comprehensive reform package entitled “Basel III: A global regulatory framework for more resilient banks and banking systems” (known as Basel III capital regulations) in December 2010.
RBI’s latest draft guidelines for minimum capital requirements for market risk
The new norms clearly draw a boundary between the banking book and the trading book and list out 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 which is subject to credit risk capital requirements.
The capital requirement for both specific risk and general market risk will be 9 per cent each of the core capital of the bank and the exposure to the specified instruments. These capital charges will also be applicable to all trading book exposures, which are exempted from capital market exposure ceilings for direct investments.
The regulator defines a trading book, for the purpose of capital adequacy, all instruments that meet the specifications for trading book instruments such financial instruments and foreign exchange and all other instruments shall be included in the banking book.
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It also defines market risk as the risk of losses in on and off-balance-sheet positions arising from movements in market prices.
Since a financial liability is a contractual obligation to deliver cash or another financial asset, banks shall only include a financial instrument or forex instruments in the trading book when there is no legal impediment against selling or fully hedging it.
The new norms also mandate banks to make fair value daily on any trading book instrument and specify that any instrument a bank holds on when it is first recognised on its books, be designated as a trading book instrument, unless specifically otherwise provided for short-term resale, profiting from short-term price movements; locking in arbitrage profits; or hedging risks that arise from instruments meeting.
The new guidelines assign unlisted equities and equity investments in subsidiaries/ associates; instruments designated for securitisation warehousing; securities with real estate as underlying as well as derivatives thereof; securities with retail and micro, MSME exposure as underlying; equity investments in funds to the banking book.
The new guidelines ban short positions on any instrument except in derivatives and Central government securities. Banks are allowed to engage in the underwriting of issues of shares, debentures and bonds.
But banks shall have the option to deviate from the presumptive list after prior approval from the RBI and board approval. In cases where this approval is not given, the instrument shall be designated into the trading book.
Subject to supervisory review, banks shall have the option to exclude 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 legislated programmes.
The framework also mandates banks to have clearly defined policies, procedures and documented practices to determine which instruments can be included in or excluded from the trading book for calculating regulatory capital, and also to take into account the bank’s risk management capabilities and practices.
There is also a strict limit on the ability of banks to shift instruments between the trading book and the banking book at their own discretion after initial designation and any such shifting for regulatory arbitrage are strictly prohibited.
In practice, shifting should be rare and will be allowed only in extraordinary circumstances, it says, adding shifting can be allowed if there is a major publicly announced event, such as a bank restructuring requiring termination of the business activity applicable to the instrument or portfolio or a change in accounting standards that allows an item to be fair-valued through profit and loss accounts.
Market events, changes in the liquidity of a financial instrument, or a change of trading intent alone are not valid reasons for reassigning an instrument to a different book. When shifting positions, banks shall ensure that all the mandated standards are observed.
But shifting between books is possible if be approved by the board of the bank and RBI after a thoroughly documented process and determined by internal review to be in compliance with the bank’s policies and with prior RBI.
Irrespective of the reporting frequency, banks shall meet all the capital requirements for market risk on a continuous basis-at the close of each business day. Banks shall maintain strict risk management systems to monitor and control intraday exposures to market risks.
The bank will have to document and have available for supervisory review the positions and amounts to be excluded from market risk capital requirements. Forex risk capital requirement shall not apply to positions related to items that are deducted from a bank’s capital when calculating its capital base.
(With PTI inputs)
