Need for Risk-Based Regulation and Basel Evolution - Article

Introduction

Banks perform a special role in the economy.

They:

• accept public deposits;

• provide credit;

• operate payment systems;

• borrow and lend in financial markets;

• undertake foreign-exchange and treasury activities; and

• connect different parts of the financial system.

A serious bank failure can therefore affect more than its shareholders. It can affect:

• depositors;

• borrowers;

• other banks;

• payment systems;

• financial markets; and

• the wider economy.

This is why banking is a highly regulated business.

However, banking regulation itself has changed over time.

Earlier approaches relied more heavily on:

• simple capital ratios;

• transaction-level rules; and

• compliance with prescribed limits.

As banks became more complex, regulators increasingly needed to consider the actual risks being taken by each bank.

The current IIBF CAIIB BFM Module B specifically covers Regulation of Banking Industries – Necessities and Goals; the Need for Risk-based Regulation in a Changed World Environment; Basel I; the 1996 Market Risk Amendment; Basel II; Towards Basel III; and Risk Based Supervision.

The basic evolution can be remembered as:

Simple Capital Rule → More Risk Sensitivity → Wider Risk Coverage → Stronger Capital, Liquidity and System-Wide Resilience

Learning Objectives

After studying this topic, you should be able to:

• explain why banking requires prudential regulation;

• understand why traditional compliance-based regulation became insufficient;

• explain the need for risk-based regulation and supervision;

• trace the evolution from Basel I to Basel III;

• understand why Basel II introduced three pillars; and

• identify the main lessons that led to post-crisis Basel III reforms.

Why Does Banking Need Regulation?

A normal commercial company mainly operates with money belonging to its owners and creditors.

A bank operates extensively with:

• deposits from the public;

• borrowed funds; and

• highly leveraged financial positions.

A relatively small amount of capital can therefore support a much larger amount of assets.

This creates several regulatory concerns.

1. Protection of Depositors

Depositors generally cannot continuously analyse:

• the quality of every bank loan;

• trading positions;

• operational controls;

• liquidity gaps; or

• management decisions.

Regulation provides an external framework intended to ensure that banks operate with adequate:

• capital;

• liquidity;

• governance;

• risk management; and

• internal controls.

2. Financial Stability

Banks are interconnected.

One bank may have:

• deposits with another bank;

• derivatives with counterparties;

• payment obligations;

• securities transactions; and

• interbank borrowings.

Failure of an important bank can therefore transmit stress to other financial institutions.

Bank regulation aims not only at protecting individual institutions but also at reducing systemic risk.

3. Limiting Excessive Risk Taking

Bank shareholders may benefit when a risky strategy succeeds.

However, if the strategy fails severely, losses can affect:

• depositors;

• creditors;

• deposit-insurance systems; and

• financial stability.

Prudential regulation therefore places boundaries on excessive leverage and risk taking.

4. Maintaining Confidence

Banking depends heavily on confidence.

If depositors believe that a bank cannot repay them, withdrawals can accelerate quickly.

Sound regulation and supervision therefore support public confidence in the banking system.

5. Creating Minimum Common Standards

Without common prudential standards, banks operating under weak capital requirements could compete aggressively against banks subject to stronger requirements.

One objective behind the original Basel Accord was therefore to strengthen banking-system stability while reducing competitive inequality arising from different national capital standards.

Why Traditional Regulation Became Insufficient

Banking changed substantially with:

• financial liberalisation;

• globalisation;

• derivatives;

• securitisation;

• complex trading activities;

• technology;

• cross-border banking;

• off-balance-sheet exposures; and

• new financial products.

Two banks with the same amount of assets may therefore have very different risk profiles.

Example

Bank A holds mainly high-quality, low-risk assets.

Bank B has:

• weaker borrowers;

• large trading positions;

• derivatives;

• concentrated funding; and

• complex operational systems.

A regulatory approach based only on the total size of the two banks would fail to recognise this difference.

Regulation therefore increasingly needed to ask:

How risky are the bank’s assets and activities, and is its capital adequate for those risks?

What Is Risk-Based Regulation?

Risk-based regulation links prudential requirements more closely to the nature and level of risk undertaken by a bank.

Instead of treating every exposure identically, it considers factors such as:

• credit quality;

• market exposure;

• operational risk;

• concentration;

• complexity;

• capital;

• liquidity; and

• quality of risk management.

The fundamental principle is:

Greater risk should attract greater regulatory attention and, where applicable, greater capital or stronger controls.

This makes regulation more sensitive to the bank’s actual risk profile.

Risk-Based Regulation vs Risk-Based Supervision

These concepts are related but not identical.

Risk-based regulation establishes the rules.

Risk-based supervision assesses whether the bank’s:

• risk profile;

• capital;

• governance; and

• controls

are acceptable and determines the intensity of supervisory attention.

Why Risk-Based Supervision Is Needed

Supervisory resources are limited.

It is inefficient to devote exactly the same level of supervisory effort to:

• a low-risk activity with strong controls; and

• a rapidly deteriorating high-risk activity.

RBI explains that risk-based supervision identifies material and critical risks and assesses the bank’s ability to manage those risks. It is intended to be more forward-looking and proactive than a predominantly point-in-time compliance approach.

Risk-based supervision therefore focuses more closely on:

• inherent risk;

• quality of controls;

• residual risk;

• capital;

• governance;

• emerging risks; and

• possible future deterioration.

RBI’s Risk-Based Supervisory Approach

RBI moved towards a risk-based supervisory approach for commercial banks following recommendations of a High-Level Steering Committee constituted in 2011.

RBI states that the approach was implemented from 2013 onwards in a phased manner and its risk-based supervisory framework is known as SPARC — Supervisory Program for Assessment of Risk and Capital.

The approach seeks to:

• apply differentiated supervision according to a bank’s risk profile;

• focus more strongly on materially risky areas; and

• improve banks’ risk-management systems, controls and oversight.

Evolution of the Basel Framework

Basel Committee on Banking Supervision

The Basel Committee on Banking Supervision (BCBS) was established in 1974 by the central bank Governors of the Group of Ten countries following serious disruptions in international banking, including the failure of Bankhaus Herstatt.

The Committee develops international standards for prudential banking regulation and supervision.

Basel standards are international supervisory standards.

They are not automatically domestic law merely because the Basel Committee publishes them.

National authorities implement them through their own regulatory frameworks.

This distinction is important for CAIIB:

BCBS sets international standards; RBI implements applicable prudential requirements for banks in India.

Basel I – The 1988 Capital Accord

In July 1988, the Basel Committee issued the first Basel Capital Accord.

Its main objective was to establish a common framework for measuring bank capital adequacy.

Basel I concentrated primarily on credit risk.

It introduced the concept of:

• regulatory capital;

• risk-weighted assets; and

• a minimum capital ratio.

The original Accord required internationally active banks to achieve a minimum total capital ratio of 8% of risk-weighted assets, with implementation targeted by the end of 1992.

Major Contribution of Basel I

Basel I established a revolutionary principle:

Capital should be related to the riskiness of assets rather than only to their absolute size.

This created the foundation for modern risk-based capital regulation.

Limitation of Basel I

Basel I was relatively simple.

Its main focus was credit risk, and its risk categories were broad.

As banking developed, this created limitations.

For example, exposures with materially different actual credit risks could sometimes receive similar regulatory treatment.

Banks were also becoming increasingly active in:

• securities trading;

• foreign exchange;

• derivatives; and

• other market activities.

A credit-risk-focused framework was therefore no longer sufficient.

1996 Market Risk Amendment

In January 1996, the Basel Committee issued an amendment to incorporate market risk into the capital framework, with implementation by the end of 1997.

It introduced capital requirements for market risks associated with areas such as:

• foreign exchange;

• traded debt securities;

• equities;

• commodities; and

• options.

An important development was that qualifying banks could, subject to strict requirements, use approved internal models for measuring market-risk capital.

Why the 1996 Amendment Matters

The amendment demonstrated an important shift:

Basel I originally → mainly Credit Risk

1996 Amendment → Credit Risk + Market Risk

But banking risk had become even more complex.

Basel II – A More Risk-Sensitive Framework

After several years of consultation, the Basel Committee released Basel II in June 2004. A comprehensive version incorporating related material was published in 2006.

Basel II aimed to:

• improve risk sensitivity;

• better align regulatory capital with underlying risk;

• recognise improved risk-management techniques; and

• address developments in modern banking.

Its most important structural innovation was the Three-Pillar Framework.

Basel II Pillar 1 – Minimum Capital Requirements

Pillar 1 deals with regulatory capital requirements for major risks, principally:

• Credit Risk;

• Market Risk; and

• Operational Risk.

Operational risk received a specific capital framework under Basel II.

This recognised that banks can suffer major losses from:

• people;

• processes;

• systems; and

• external events,

even when borrowers do not default and market prices do not move adversely.

Basel II Pillar 2 – Supervisory Review

Pillar 2 recognised an important limitation of mechanical capital formulas:

Not every material banking risk can be fully captured by Pillar 1 calculations.

Banks therefore need internal processes to assess whether their capital is adequate relative to their overall risk profile.

Supervisors review this assessment and can require corrective action where necessary.

Pillar 2 therefore strengthens the link among:

• risk management;

• capital planning;

• governance; and

• supervision.

Basel II Pillar 3 – Market Discipline

Pillar 3 uses disclosure to strengthen market discipline.

The logic is that market participants can make better decisions when banks provide meaningful information about their:

• risks;

• capital;

• risk-management practices; and

• financial condition.

Basel II therefore combined:

Capital Requirements + Supervisory Review + Market Discipline

Why Basel II Was Not the End of the Evolution

The global financial crisis of 2007–09 revealed major weaknesses in the pre-crisis regulatory system.

Problems included:

• insufficient quality and quantity of capital in some banks;

• excessive leverage;

• inadequate liquidity buffers;

• interconnected exposures;

• weaknesses in risk measurement;

• procyclicality; and

• systemic importance of very large institutions.

The crisis demonstrated that a bank could apparently meet risk-based capital requirements yet still remain vulnerable because of:

• poor-quality capital;

• excessive leverage;

• liquidity stress; or

• underestimated risks.

These lessons led to Basel III.

Basel III – Post-Crisis Strengthening

The initial Basel III framework was issued in December 2010 and revised in June 2011.

The Basel Committee describes Basel III as a central part of its response to the global financial crisis and a framework designed to improve banking-system resilience.

Basel III strengthened the framework through measures relating to areas such as:

• quality and quantity of capital;

• capital buffers;

• leverage;

• liquidity;

• counterparty risk; and

• systemic risk.

It therefore did not simply replace Basel II’s three pillars.

Instead, it substantially strengthened and expanded the prudential framework.

Capital Buffers

Basel III introduced capital buffers intended to improve the ability of banks to absorb losses during stress.

Important concepts include:

• Capital Conservation Buffer; and

• Countercyclical Capital Buffer.

Basel explains that capital buffers are intended to allow banks to build resources in normal periods that can absorb losses during periods of stress.

These concepts are studied in greater detail separately in the BFM syllabus.

Leverage Ratio

Risk-weighted capital calculations depend on measurement of risk.

If risk is underestimated, leverage can become excessive.

Basel III therefore introduced a non-risk-based leverage ratio as a complementary backstop to the risk-based capital framework.

Its purpose is to restrict excessive build-up of leverage and complement risk-weighted requirements.

Liquidity Standards

The financial crisis demonstrated that capital adequacy alone is not enough.

A bank can have capital but still fail if it cannot obtain sufficient cash when obligations fall due.

Basel III therefore added major liquidity standards, including:

• Liquidity Coverage Ratio; and

• Net Stable Funding Ratio.

This expanded prudential regulation beyond the narrow question:

“Does the bank have enough capital?”

to include:

“Does it also have adequate liquidity and stable funding?”

Finalisation of Basel III – 2017 Reforms

The Basel Committee completed a major package of post-crisis reforms in December 2017.

The reforms included:

• more robust standardised approaches;

• constraints on the use of certain internal models;

• revised operational-risk treatment;

• revised leverage-ratio arrangements; and

• an output floor designed to limit excessive variation in risk-weighted assets produced by internal models.

These reforms are sometimes informally called “Basel IV” in market discussions.

However, the Basel Committee officially describes them as the finalisation of Basel III.

Basel Evolution at a Glance

Basel Framework Is Still Evolving

Basel regulation should not be viewed as a historical framework frozen in 2017.

The Basel Committee now maintains a consolidated Basel Framework, incorporating standards for:

• capital;

• credit risk;

• market risk;

• operational risk;

• leverage;

• liquidity;

• supervisory review; and

• disclosures.

The framework continues to receive updates. The BIS framework page shows Basel changes effective in 2026 as well as future changes scheduled for later dates.

Therefore, older CAIIB terminology remains important for understanding the evolution, while current regulatory practice should be checked against the applicable framework.

Basel Standards and India

Basel standards are translated into Indian prudential requirements through RBI regulations.

RBI’s published Master Circular – Basel III Capital Regulations dated 1 April 2025 consolidates applicable Basel III capital instructions for scheduled commercial banks covered by that circular.

For CAIIB, remember the distinction:

Basel Committee → International prudential standards

RBI → Applicable Indian regulatory requirements

Not every Basel provision becomes an Indian banking requirement merely because it has been published internationally. Domestic applicability depends on RBI’s regulatory framework.

Practical Banking Application

Consider two banks of similar size.

Bank A

• diversified loan portfolio;

• strong capital;

• stable deposits;

• limited trading activity;

• good operational controls.

Bank B

• concentrated risky lending;

• large derivatives exposure;

• aggressive trading;

• unstable wholesale funding;

• weak operational controls.

A purely size-based supervisory system might treat them similarly.

A risk-based system asks:

• What risks does each bank take?

• How strong are its controls?

• How much residual risk remains?

• Is capital adequate?

• Is liquidity adequate?

• Could failure have a wider systemic impact?

Bank B would normally require greater supervisory attention.

This demonstrates the purpose of risk-based regulation and supervision:

Regulatory attention should reflect risk, not simply institutional size or the number of transactions.

CAIIB Exam Focus

Remember these high-value concepts:

• Banking regulation protects depositors and supports financial stability.

• Risk-based regulation links prudential requirements more closely with actual risk.

• Risk-based supervision directs supervisory attention towards material and emerging risks.

• RBI’s RBS framework is called SPARC and was implemented for commercial banks from 2013 onwards in a phased manner.

• BCBS was established in 1974.

• Basel I was issued in 1988.

• Basel I focused mainly on credit risk and introduced risk-weighted capital.

• Basel I prescribed an 8% minimum total capital-to-RWA ratio for internationally active banks under that framework.

• The 1996 Amendment added market-risk capital requirements.

• Basel II was released in 2004, with a comprehensive version in 2006.

• Basel II introduced the Three-Pillar framework.

• Pillar 1 covers minimum capital requirements.

• Pillar 2 covers supervisory review.

• Pillar 3 promotes market discipline through disclosure.

• The global financial crisis exposed weaknesses involving capital quality, leverage, liquidity and systemic risk.

• Basel III began with post-crisis reforms issued in 2010–11.

• Basel III strengthened capital and added buffers, leverage and liquidity requirements.

• Basel III reforms were further finalised in 2017.

• The 2017 package is officially a finalisation of Basel III, not a separate Basel IV Accord.

• Basel standards are international standards; RBI determines applicable implementation for Indian banks.

Common Exam Traps

Trap 1: “Basel I Covered All Major Banking Risks in Detail”

Incorrect.

It focused mainly on credit risk. Market risk was subsequently incorporated through the 1996 Amendment.

Trap 2: “The 1996 Amendment Created Basel II”

Incorrect.

It amended the Basel I framework to incorporate market risk. Basel II came later.

Trap 3: “Basel II Has Only Capital Requirements”

Incorrect.

Basel II has three pillars: minimum capital, supervisory review and market discipline.

Trap 4: “Operational Risk Was Already the Main Focus of Basel I”

Incorrect.

Specific operational-risk capital treatment became a major element under Basel II.

Trap 5: “Basel III Was Introduced Only to Increase the Credit-Risk Ratio”

Incorrect.

It addressed wider weaknesses involving capital quality, leverage, liquidity and systemic resilience.

Trap 6: “Risk-Based Supervision Means Compliance Is No Longer Checked”

Incorrect.

Compliance remains important, but supervision becomes more forward-looking and risk-focused.

Trap 7: “Basel Standards Automatically Become Indian Law”

Incorrect.

BCBS establishes international standards. RBI issues the applicable regulatory requirements for Indian banks.

Trap 8: “The 2017 Reforms Are Officially Basel IV”

Incorrect.

The Basel Committee describes them as Basel III: Finalising post-crisis reforms.

Memory Technique

Remember the evolution as C-M-3-R:

• C – Credit: Basel I focused mainly on Credit Risk.

• M – Market: 1996 added Market Risk.

• 3 – Three Pillars: Basel II introduced the Three-Pillar framework.

• R – Resilience: Basel III strengthened overall banking resilience.