[Economy Q] Basel III Norms: Tier 1 and Tier 2 Capital meaning use

[Economy Q] Basel III Norms: Tier 1 and Tier 2 Capital meaning use

• Keep in mind friends, for a regular Government job recruitment exam [UPSC, State PSC] or MBA admission GDPI, you need to have only a basic idea about BASEL. No need to dwell into extreme details such as exact numbers of Tier 1 and Tier 2, credit valuation adjustment or Net Stable Funding Ratio.

What is BASEL?

It is a city in Switzerland.

Why Do we Need BASEL norms?

Consider these cases

ICICI bank collapse hoax

• Back in 2003, Someone started a rumor in Ahmedabad that ICICI bank is going to collapse. Suddenly thousands of panicked account holders lined up at the nearest ICICI branch to take out their money and hence there was such a money-shortage in ICICI's Ahmedabad branches, they had to actually call up trucks loaded with cash from their Mumbai branches.
• Things settled out after a while and it was confined only to a few cities of Gujarat, but if it was an entire-countrywide hoax, just imagine the fallout!

SBI: Imaginary case

• SBI takes deposits from you and me, pays us 7% interest rate, and gives same money as loan to car-home seekers, businessmen etc at 12% interest rate, thus earning 5% in profit.
• SBI gave Rs.1500 as loan to Kingfisher.
• SBI gave loan of Rs.4500 crores to Telecom players for 2G auction and now the licenses are cancelled.
• What if  those telecom players run away without paying back the loan and Kingfisher goes broke?
• Adding insult to the injuries, someone starts a systematic campaign on facebook and twitter to spread rumors that SBI itself is going to collapse.
• Lakhs of middleclass account holders will run to the nearest SBI branch to take out their deposited money (as it happened in ICICI, Ahmedabad in 2003 in real-life).
• Overnight entire banking sector will collapse and You already know about the sub-prime crisis etc: the aftershocks were felt everywhere in every sector.

Here comes BASEL in picture

• The BASEL Norm is kinda safeguards / backup plan for Banking sector.
• It provides internationally accepted detailed guidelines about how much money should a bank keep aside, to deal with such financial crisis.
• Even if loan-takers run away without paying, Bank should have money to give back to deposit holders.
• More risk the bank takes, more money it has to keep aside in reserve to counter the risk.

What is Tier 1 and Tier 2 Capital?

• Tier 1 and 2 capital is way too technical and detailed, to be asked in a routine Government recruitment exam for Generalist posts, so not much point in getting to that depth and numbers. But still for the sake of discussion:
• Capital= Wealth in form of Money, Property, Bonds etc.
• As we saw earlier, banks need to keep some money aside to deal with crisis. It meant the word "capital".
• If bank keeps aside capital, in form of real-estate investment (say buying 5 farm houses) then during the crisis, it won't be easy to sell away farm-houses and get money within a day or two. So this 'Capital' is not 'liquid'.

Tier 1 and 2 is way of classifying the capital of a bank.

Tier 1

Easily liquid. For example

• currency notes and coins in the bank value
• Stocks held by Bank, can be easily sold off in share-market.

Tier 2

• Not easily Liquid, for example the building or land owned by the bank.

For BASEL norm will be something like this
[technically totally incorrect, just for the purpose of basic understanding]

1. If a Bank loans 1 crore rupee to a company with "B" Credit Rating, it must keep capital worth 20 lakhs aside for crisis.
2. And out of that 20 lakhs, Rs. 15 lakhs must in form of Tier 1 Capital and 5 lakhs can be in form of Tier 2.
3. If the Company has credit rating of "AAA" then Capital worth Rs.xyz and so on.....

Governor of RBI signs on this BASEL agreement, comes back home and forces all the Indian banks to follow these norms. Same thing will be done by French, Chinese, Americans etc. and thus banks in every country will function prudently thus preventing another Global financial crisis.
Latest is BASEL III accord, came in 2010. It has stringent provisions keeping in mind the sub-prime crisis.

Criticism of BASEL

1. One shoe doesn't fit all. 
2. Just because American Banks were so imprudent in their functioning and ran into trouble, doesn't mean WE the Indian banks need be so overcautious and keep so much of money aside for 'safety', it could be used for giving loans to needy people.
3. Already existing complex Monetary policies of Central Banks in each country (example RBI's CRR, SLR, Repo etc.) make it difficult to uniformly implement BASEL norms.