Banking in India - Economics, UPSC, IAS. UPSC Notes | EduRev

Economy and Indian Economy (Prelims) by Shahid Ali

UPSC : Banking in India - Economics, UPSC, IAS. UPSC Notes | EduRev

The document Banking in India - Economics, UPSC, IAS. UPSC Notes | EduRev is a part of the UPSC Course Economy and Indian Economy (Prelims) by Shahid Ali.
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History of banking in India

  1. The oldest banks in India were the General Bank of India and the Bank of Hindustan, both founded in 1786. However both banks are now defunct
  2. The oldest existing bank in India is the State Bank of India. The origins of the SBI go back to the Bank of Calcutta (founded 1806, renamed Bank of Bengal in 1809)
  3. The Bank of Madras was established in 1843 and the Bank of Bombay in 1868
  4. The Bank of Bengal, Bank of Bombay and Bank of Madras merged to form the Imperial Bank of India in 1921. The Imperial Bank of India was renamed the State Bank of India in 1955. Although a normal commercial bank, the Imperial Bank of India also functioned as a central governmental until 1935
  5. The Reserve Bank of India was established in 1935
  6. The oldest joint stock bank is the Allahabad Bank, established in 1865.
  7. The first entirely Indian joint stock bank was the Oudh Commercial Bank (Faizabad, 1881). However, it failed in 1958. The next oldest is the Punjab National Bank (Lahore, 1895)
  8. The Dakshina Kannada and Udipi districts of Karnataka (called South Canara), is known as the Cradle of Indian Banking

Nationalisation of banks

  • The Government of India nationalised 14 of the largest banks in 1969
  • This achieved by an ordinance to the effect in July 1969. This was formalized by the Banking Companies (Acquisition and Transfer of Undertaking) Bill 1969
  • The banks that were nationalized in 1969 were: Allahabad Bank, Bank of Baroda, Bank of India, Bank of Maharastra, Canara Bank, Central Bank of India, Dena Bank, Indian Bank, Indian Overseas Bank, Punjab National Bank, Syndicate Bank, UCO Bank, Union Bank of India and United Bank of India
  • In 1980, six more banks were nationalized. The banks that were nationalized in 1980 were: Andhra Bank, Corporation Bank, Oriental Bank of Commerce, Punjab and Sind Bank, New Bank of India and Vijaya Bank
  • In 1993, the New Bank of India was merged with Punjab National Bank. There are 19 nationalized banks in operation today
  • Following this, the GoI controlled about 91% of the banking business in India


Reserve Bank of India:

  • It is the Central Bank of the country.
  • It was established on Apr 1, 1935 with a capital of Rs.5 crore. This capital of Rs.5 crore was divided into 5 lakh equity shares of Rs.100 each. In the beginning, the  ownership of almost all the share capital was with the non-government share-holders.
  • It was nationalized on Jan 1, 1949 as govt., acquired the private share holdings.
  • Administration: 14 directors in Central Board of Directors besides the Governor, 4 Deputy Governors and one Government official. The Governor is the Chairman of the board and Chief Executive of the Bank.



  • 1st Governor-Sir Smith ( 1935 – 37 )
  • 1st Indian Governor : CD Deshmukh ( 1948 – 49 )

Reserve Bank of India and its functions:

  • Issue of Notes: Regulates issue of bank notes above 1 rupee. It acts as the only source of legal tender money because the one rupee notes issued by Ministry of Finance are also circulated through it.
  • The Reserve Bank has adopted the Minimum Reserve System for the note issue. Since 1957, it maintains gold and foreign exchange reserve of Rs.200 crore, of which at least 115 crore should be in gold.
  • Banker to the Government: Acts as the banker, agent and advisor the Govt., of India. It also manages the public debt for the Government.
  • Banker’s Bank: The Reserve Bank performs the same function for other banks as the other banks ordinarily perform for their customers.
  • Controller of Credit: The Reserve Bank undertakes the responsibility of controlling credits created by the commercial banks. To achieve this objective, it makes extensive use of quantitative and qualitative techniques to control and regulate the credit effectively in the country.
  • Custodian of Foreign Reserves: For the purpose of keeping the foreign exchange rates stable, the Reserve Banks buys and sells the foreign currencies and also protects the country’s foreign exchange funds.
  • It formulates and administers the monetary policy.
  • Acts as the agent of the Government of Indian in respect to India’s membership of the IMF and the World Bank.
  • No personal accounts are maintained and operated in RBI.

Reserve Bank of India Amendment Bill 2005 Approved:

  • The Reserve Bank of India (Amendment) Bill 2005 has been approved. This bill amends the Reserve Bank Act for providing flexibility to the Central Bank in fixing the cash reserve ratio (CRR) and statutory liquidity ratio (SLR). CRR is the cash that banks deposit with RBI and is one of the key instruments used by the Central Bank to inject or suck out liquidity from the market.
  • SLR specifies the minimum amount that banks must invest in government securities. This bill is to arm RBI with greater autonomy and authority to deal with subjects ( mainly CRR and SLR ) under the Act. This bill also allows the Central Bank to regulate derivatives, repo instruments ( overnight rates used to regulate liquidity ) and securities.
  • The amendments also seek to end the ambiguity about the legal validity of derivatives as it was seen to inhibit the growth of the market.


List of RBI Governors

Banking In India,Economics,UPSC,IAS,Test Preparation


















Sir Osborne






First Governor of the RBI











Did not sign any bank notes

















Sir James Taylor




Governor during WWII






Started the practice of signing bank notes












First Indian Governor of RBI













Oversaw Independence & Partition







Sir C D






Represented India at the Bretton Woods






















Conference 1944













Served as Minister of Finance 1950-1956













Longest serving Governor






Sir Benegal





Was Indian Ambassador to USA prior to RBI








Witnessed commencement of Five Year Plans,




Rama Rao












and transformation of Imperial Bank of India to





















Jan 1957 –



Did not sign any bank notes









Feb 1957



















H V R Iyengar




Witnessed introduction of decimal coinage






Variable cash reserve ration (CRR) introduced






P C Bhattacharya

























L K Jha




Witnessed nationalization of banks (1969)






Appointed as Ambassador to US in 1970






B N Adarkar



May 1970 –



Served as India’s Executive Director at the IMF








June 1970



























Witnessed oil shock, expansion of banking





S Jagannathan




services, shift to floating rates






Relinquished office to serve as Executive












Director at IMF






N C Sen Gupta



May 1975 –











Aug 1975









K R Puri







13       M Narasimhan                            May 1977                           –Nov 1977

Only Governor to be appointed from the Reserve Bank cadreChairperson of Committee on Financial System (1991) and Committee on Banking Sector Reforms (1998)Served as Executive Director for India


Dr. I G Patel


Served as Secretary at the United Nations




at the World Bank and the IMF


















Development Programme (UNDP)























Witnessed demonetisation of high












denomination bank notes and “gold auctions”












Witnessed nationalization of six banks (1980)












Secured IMF’s Extended Fund Facility (1981).












This was the largest arrangement of the IMF at












the time






Dr. Manmohan






Witnessed comprehensive legal reforms in











banking sector
















A Ghosh

Jan 1985 –






Feb 1985









R N Malhotra






Served as Executive Director of IMF prior to RBI










Made efforts to develop money markets













Managed balance of payments crisis












Adopted IMF’s stabilisation programme





S Venkitaraman




Supervised devaluation of the Rupee























Witnessed launch of economic reforms












Ushered in unprecedented central bank activism













Introduced comprehensive measures to













strengthen and improve efficiency of banking







Dr. C





























Establishment of unified exchange rate













Cap on automatic finance by the Bank to the



















Dr. Bimal Jalan




Represented India on the Executive Boards of






the IMF and World Bank prior to RBI






Dr Y V Reddy






Executive Director to IMF prior to RBI













Prior to RBI, he has been












Secretary to the PM’s Economic Advisory












Council (2005-2007)





Dr. D Subbarao




Lead economist in the World Bank (1999-2004)






Finance Secretary to the Government of




















Andhra Pradesh (1993-1998)












Joint Secretary, Dept. of Economic Affairs















  1. The State Bank of India is derived from the Imperial Bank of India (1921), which was nationalised in 1955
  2. The State Bank of India is the oldest bank in India. It traces its ancestry to the Bank of Calcutta, founded in 1806.
  3. It is headquartered in Mumbai
  4. The State Bank of India is also the largest bank in India. It has a market share of about 20% in deposits and advances.
  5. The State Bank Group consists of the SBI and its subsidiary banks viz. State Bank of Indore, State Bank of Bikaner & Jaipur, State Bank of Hyderabad, State Bank of Mysore, State Bank of Patiala, State Bank of Travancore
  6. The SBI is one of the Big Four Banks in India, along with ICICI Bank, Axis Bank and HDFC Bank
  7. The SBI was ranked as the 29th most reputable company in the world by Forbes in 2009.


  1. Commercial Banks
  2. Commercial banks are those that cater to the regular banking and financial needs of the public
  3. Commercial banks include public sector banks and private sector banks.Public sector banks include the State Bank Group and other nationalised banks, while private

sector banks include Indian banks and foreign banks

Cooperative Banks

  1. Cooperative banking is retail and commercial banking organised on a cooperative basis. Cooperative banks include credit unions, savings and loans associations and building societies and cooperatives
  2. Cooperative banks operate on the principles of cooperation – mutual help, democratic decision making and open membership
  3. They are governed by controls of the RBI as well as state governments.Cooperative banks in general operate under the Cooperative Credit Societies Act 1904, but large Urban Cooperative Banks operate under the Banking Regulation Act 1949
  4. Cooperative banks in India are the primary financiers of agricultural activities, small scale industries and self-employed workers
  5. Cooperative banks in India were first established in the late 19th century, following the success of such banks in Britain and Germany


  1. The Anyonya Cooperative Bank Ltd. (ABCL) was the first cooperative bank in

India. It was established Vithal Laxman (aka Bhausaheb Kavthekar) in 1889 under the name Anyonya Sahayakari Mandali Cooperative Bank Ltd. The bank closed functioning in March 2008 following an order by the RBI. Re-opening is under consideration


  1. Regional Rural Banks
  2. Regional Rural Banks (RRBs) were first established in 1975
  3. Initially five RRBs were established at Moradabad (UP), Gorapkhpur (UP), Bhiwani (Haryana), Jaipur (Rajasthan), Malda (WB). Currently there are 91 RRBs
  4. RRBs exist in all states except Goa and Sikkim

The share of RRBs in agricultural credit is around 5%​.

Scheduled Banks

  1. Scheduled Banks are those banks that have been included in Second Schedule of the RBI Act 1934
  2.  Scheduled Banks must fulfil two conditions
  3.  The paid up capital and collected funds of the bank must not be less than Rs 5 lakhs
  4. Any activity of the bank should not adversely affect the interest of deposition 
  5.  Scheduled Banks enjoy the following benefits
  6.  They are eligible for obtaining loans on Bank Rate from the RBI
  7.   They acquire membership of the clearing house
  8. Scheduled Banks include commercial banks, cooperative banks and regional rural banks
  9. There are around 302 Scheduled Banks in operation.
  1. Non-Scheduled Banks


  1. Non-Scheduled Banks are those that are not included in the list of Scheduled Banks
  2. They have to follow the Cash Reserve Ratio (CRR) condition. However, they are not compelled to deposit these funds with the RBI
  3. They can avail loans from the RBI only under emergencies, and not for daily activities
  4. There are only 4 Non-Scheduled Banks in operation


  1. Small Industries Development Bank of India (SIDBI)
  2. Established in 1990, headquarters Lucknow
  3. The main objective of the SIDBI is to aid the growth and development of micro, small and medium scale industries in India
  4. It provides direct credit to micro, small and medium enterprises, supports microfinance institutions and refinancing to state level finance bodies

Industrial Development Bank of India (IDBI)

  1. Established in 1964, headquarters Mumbai
  2. The IDBI is the tenth largest development bank in the world. It is one of India’s largest public sector bank
  3. Its main objective is to provide credit and other banking facilities to industries in India
  4. However, in 2004 the IDBI was re-designated as a commercial bank, following the Industrial Development Bank (Transfer of Undertaking and Repeal) Act 2003, and renamed IDBI Ltd
  5. Following this, the commercial banking division, IDBI Bank was merged into IDBI

Industrial Finance Corporation of India (IFCI)

  1. The IFCI is the first development finance institution in the country to cater to the needs of Indian industry
  2. Established 1948, headquarters New Delhi
  3. The IFCI was established to provide long term low interest credit to corporate borrowers
  4. In 1993, the IFCI was re-registered as a commercial company under the Indian Companies Act 1956, and renamed IFCI Ltd

National Bank for Agricultural and Rural Development (NABARD)

  1. Partly owned by the RBI
  2. Established 1982, headquarters Mumba

NABARD serves as the apex development bank in India for economic activities in rural areas

  1. The main objective of NABARD is to facilitate credit flow for agriculture and small scale industries
  2. NABARD provides refinance to State Cooperative Agriculture and Rural Development Banks (SCARDBs), State Cooperative Banks (SCBs), Regional Rural Banks (RRBs), Commercial Banks and other financial institutions approved by the RBI
  3. NABARD coordinates the rural financing activities of all institutions engaged in developmental work
  4. NABARD has 28 regional offices (state capitals), one Sub Office (in Port Blair) and one Special Cell (in Srinagar)
  5. NABARD is famous for its Self Help Group (SHG) Bank Linkage Programme, which serves as an important tool for microfinance

National Housing Bank (NHB)

  1. Wholly owned subsidiary of the RBI
  2. Established in 1987, headquarters New Delhi
  3. Established mainly to provide long term finance to individual households

Export-Import Bank of India (EXIM Bank)

  1. Established 1981, headquarters Mumbai
  2. The main objective of the EXIM Bank is to provide financial assistance to exporters and importers with a view to promoting the country’s international trade
  3. It acts as the apex financial institution for financing foreign trade in India

Bharatiya Reserve Bank Note Mudran Private Ltd (BRBNMPL)

  1. Wholly owned subsidiary of the RBI
  2. Established in 1995, headquarters Bangalore
  3. Main function is to augment the product of bank notes to meet demand
  4. The company manages two presses: Mysore and Salboni (West Bengal)

Deposit Insurance and Credit Guarantee Corporation (DICGC)

  1. Wholly owned subsidiary of the RBI
  2. Established in 1962, headquarters Mumbai
  3. India was one of the first countries to provide deposit insurance
  4. Main objective is to provide insurance to depositors against collapse and bankruptcy of banks
  5. Provides deposit insurance coverage up to Rs 100,000
  6. Sources: Reserve Bank of India, Government of India, Ministry of Finance, Wikipedia

Banking sector reforms

From the 1991 India economic crisis to its status of third largest economy in the world by 2011, India has grown significantly in terms of economic development. So has its banking sector.

During this period, recognizing the evolving needs of the sector, the Finance Ministry of Government of India (GOI) set up various committees with the task of analyzing India's banking sector and recommending legislation and regulations to make it more effective, competitive and efficient.

Two such expert Committees were set up under the chairmanship of M. Narsimha. They submitted their recommendations in the 1990s in reports widely known as the Narasimham Committee-I (1991) report and the Narasimham Committee-II (1998) Report.

These recommendations not only helped unleash the potential of banking in India, they are also recognized as a factor towards minimizing the impact of global financial crisis starting in 2007.

The purpose of the Narasimham-I Committee was to study all aspects relating to the structure, organization, functions and procedures of the financial systems and to recommend improvements in their efficiency and productivity. The Committee submitted its report to the Finance Minister in November 1991 which was tabled in Parliament on 17 December 1991.

The Narasimham-II Committee was tasked with the progress review of the implementation of the banking reforms since 1992 with the aim of further strengthening the financial institutions of India.It focussed on issues like size of banks and capital adequacy ratio among other things.


Problems Identified By the Narasimham Committee


  1. Directed Investment Programme: The committee objected to the system of maintaining high liquid assets by commercial banks in the form of cash, gold and unencumbered government securities. It is also known as the statutory liquidity Ratio (SLR). In those days, in India, the SLR was as high as 38.5 percent. According to the M. Narasimham's Committee it was one of the reasons for the poor profitability of banks. Similarly, the Cash Reserve Ratio- (CRR) was as high as 15 percent. Taken together, banks needed to maintain 53.5 percent of their resources idle with the RBI.
  2. Directed Credit Programme : Since nationalization the government has encouraged the lending to agriculture and small-scale industries at a confessional rate of interest. It is known as the directed credit programme. The committee opined that these sectors have matured and thus do not need such financial support. This directed credit programme was successful from the government's point of view but it affected commercial banks in a bad manner. Basically it deteriorated the quality of loan, resulted in a shift from the security oriented loan to purpose oriented. Banks were given a huge target of priority sector lending, etc. ultimately leading to profit erosion of banks.
  3. Interest Rate Structure: The committee found that the interest rate structure and rate of interest in India are highly regulated and controlled by the government. They also found that government used bank funds at a cheap rate under the SLR. At the same time the government advocated the philosophy of subsidized lending to certain sectors. The committee felt that there was no need for interest subsidy. It made banks handicapped in terms of building main strength and expanding credit supply.
  4. Additional Suggestions: Committee also suggested that the determination of interest rate should be on grounds of market forces. It further suggested minimizing the slabs of interest.

Along with these major problem areas M. Narasimham's Committee also found various inconsistencies regarding the banking system in India. In order to remove them and make it more vibrant and efficient, it has given the following recommendations.

Narasimham Committee Report I - 1991

The Narsimham Committee was set up in order to study the problems of the Indian financial system and to suggest some recommendations for improvement in the efficiency and productivity of the financial institution.

The committee has given the following major recommendations:-

  1. Reduction in the SLR and CRR: The committee recommended the reduction of the higher proportion of the Statutory Liquidity Ratio 'SLR' and the Cash Reserve Ratio 'CRR'. Both of these ratios were very high at that time. The SLR then was 38.5% and CRR was 15%. This high amount of SLR and CRR meant locking the bank resources for government uses. It was hindrance in the productivity of the bank thus the committee recommended their gradual reduction. SLR was recommended to reduce from 38.5% to 25% and CRR from 15% to 3 to 5%.
  2. Phasing out Directed Credit Programme : In India, since nationalization, directed credit programmes were adopted by the government. The committee recommended phasing out of this programme. This programme compelled banks to earmark then financial resources for the needy and poor sectors at confessional rates of interest. It was reducing the profitability of banks and thus the committee recommended the stopping of this programme.
  3. Interest Rate Determination : The committee felt that the interest rates in India are regulated and controlled by the authorities. The determination of the interest rate should be on the grounds of market forces such as the demand for and the supply of fund. Hence the committee recommended eliminating government controls on interest rate and phasing out the concessional interest rates for the priority sector.
  4. Structural Reorganizations of the Banking sector : The committee recommended that the actual numbers of public sector banks need to be reduced. Three to four big banks including SBI should be developed as international banks. Eight to Ten Banks having nationwide presence should concentrate on the national and universal banking services. Local banks should concentrate on region specific banking. Regarding the RRBs (Regional Rural Banks), it recommended that they should focus on agriculture and rural financing. They recommended that the government should assure that henceforth there won't be any nationalization and private and foreign banks should be allowed liberal entry in India.
  5. Establishment of the ARF Tribunal : The proportion of bad debts and Non-performing asset (NPA) of the public sector Banks and Development Financial Institute was very alarming in those days. The committee recommended the establishment of an Asset Reconstruction Fund (ARF). This fund will take over the proportion of the bad and doubtful debts from the banks and financial institutes. It would help banks to get rid of bad debts.
  6. Removal of Dual control : Those days banks were under the dual control of the Reserve Bank of India (RBI) and the Banking Division of the Ministry of Finance (Government of India). The committee recommended the stepping of this system. It considered and recommended that the RBI should be the only main agency to regulate banking in India.
  7. Banking Autonomy : The committee recommended that the public sector banks should be free and autonomous. In order to pursue competitiveness and efficiency, banks must enjoy autonomy so that they can reform the work culture and banking technology upgradation will thus be easy.

Some of these recommendations were later accepted by the Government of India and became banking reforms.

Narasimham Committee Report II - 1998

In 1998 the government appointed yet another committee under the chairmanship of Mr. Narsimham. It is better known as the Banking Sector Committee. It was told to review the banking reform progress and design a programme for further strengthening the financial system of India. The committee focused on various areas such as capital adequacy, bank mergers, bank legislation, etc.

It submitted its report to the Government in April 1998 with the following recommendations.

  1. Strengthening Banks in India : The committee considered the stronger banking system in the context of the Current Account Convertibility 'CAC'. It thought that Indian banks must be capable of handling problems regarding domestic liquidity and exchange rate management in the light of CAC. Thus, it recommended the merger of strong banks which will have 'multiplier effect' on the industry.

Narrow Banking : Those days many public sector banks were facing a problem of the Non-performing assets (NPAs). Some of them had NPAs were as high as 20 percent of their assets. Thus for successful rehabilitation of these banks it recommended 'Narrow Banking Concept' where weak banks will be allowed to place their funds only in short term and risk free assets.

  1. Capital Adequacy Ratio : In order to improve the inherent strength of the Indian banking system the committee recommended that the Government should raise the prescribed capital adequacy norms. This will further improve their absorption capacity also. Currently the capital adequacy ratio for Indian banks is at 9 percent.
  2. Bank ownership : As it had earlier mentioned the freedom for banks in its working and bank autonomy, it felt that the government control over the banks in the form of management and ownership and bank autonomy does not go hand in hand and thus it recommended a review of functions of boards and enabled them to adopt professional corporate strategy.
  3. Review of banking laws : The committee considered that there was an urgent need for reviewing and amending main laws governing Indian Banking Industry like RBI Act, Banking Regulation Act, State Bank of India Act, Bank Nationalisation Act, etc. This upgradation will bring them in line with the present needs of the banking sector in India.

Apart from these major recommendations, the committee has also recommended faster computerization, technology upgradation, training of staff, depoliticizing of banks, professionalism in banking, reviewing bank recruitment, etc.

Evaluation of Narsimham Committee Reports

The Committee was first set up in 1991 under the chairmanship of Mr. M. Narasimham who was 13th governor of RBI. Only a few of its recommendations became banking reforms of India and others were not at all considered. Because of this a second committee was again set up in 1998.

As far as recommendations regarding bank restructuring, management freedom, strengthening the regulation are concerned, the RBI has to play a major role. If the major recommendations of this committee are accepted, it will prove to be fruitful in making Indian banks more profitable and efficient.

Capital adequacy ratio

Capital adequacy ratios (CARs) are a measure of the amount of a bank's core capital expressed as a percentage of its risk-weighted asset.

Capital adequacy ratio is defined as:

Banking In India,Economics,UPSC,IAS,Test Preparation

TIER 1 CAPITAL - (paid up capital + statutory reserves + disclosed free reserves) - (equity investments in subsidiary + intangible assets + current & b/f losses)TIER 2 CAPITAL -A)Undisclose d Reserves, B)General Loss reserves, C) hybri d debt capital instruments and subordinated de bts where Risk can either be weight ed assets ( ) or the respective national regulator's minimum total capital requirement. If using risk weighted assets,

                                   ≥ 10%.

The percent threshold varies from bank to bank (10% in this case, a common requirement for regulators conforming to the Basel Accords) is set by the national bankin regulator of different countries. Two types of capital are meas ured: tier one capital ( above), which can absorb losses without a bank being required to cease trading, and tier two capital ( above ), which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.

Capital adequacy ratio is the ratio which determines the bank's capacity to m eet the time liabilities and other risks such a s credit risk, operational risk etc. In the simplest formulation, a bank's capital is the "cushion" for potential losses, and protects the bank's d epositors andother    lenders. Banking regulat ors in most countries    define and    monitor CA R to    protect depositors, thereby maintaining    confidence in the banking system. 

CAR    is  similar  to leverage;    in  the    most  basic    formulation,    it  is    comparable  tothe inverse of debt-to-equity leve    rage    formulations    (although    CAR    uses    equityover assets instead of debt-to-eq uity; since assets are by definition equal to deb t plus equity, a transformation is required). Unlike traditional leverage, however, CAR recognizes that assets can have different le vels of risk.  

Basel Accords

The Basel Accords refer to the banking supervision Accords (recommendations on banking

regulations)—Basel I, Basel II and Basel III—issued by the Basel Committee on Banking

Supervision (BCBS).

The Basel Committee

Formerly, the Basel Committee consisted of representatives from central banks and regulatory authorities of the Group of Ten countries plus Luxembourg and Spain. Since 2009, all of the other G-20 major economies are represented, as well as some other major banking locales such as Hong Kong and Singapore. (See the Committee article for a full list of members.)

The committee does not have the authority to enforce recommendations, although most member countries as well as some other countries tend to implement the Committee's policies. This means that recommendations are enforced through national (or EU-wide) laws and regulations, rather than as a result of the committee's recommendations - thus some time may pass between recommendations and implementation as law at the national level.

Basel I

Basel I is the round of deliberations by central bankers from around the world, and in 1988, the Basel Committee (BCBS) in Basel, Switzerland, published a set of minimum capital requirements for banks. This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten (G-10) countries in 1992. Basel I is now widely viewed as outmoded. Indeed, the world has changed as financial conglomerates, financial innovation and risk management have developed. Therefore, a more comprehensive set of guidelines, known as Basel II are in the process of implementation by several countries. New updates, BaselIII, were developed in response to the financial crisis.

Basel II is the second of the Basel Accords, (now extended and effectively superseded by Basel III), which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision.

Basel II, initially published in June 2004, was intended to create an international standard for banking regulators to control how much capital banks need to put aside to guard against the types of financial and operational risks banks (and the whole economy) face.

One focus was to maintain sufficient consistency of regulations so that this does not become a source of competitive inequality amongst internationally active banks. Advocates of Basel II believed that such an international standard could help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse.

In theory, Basel II attempted to accomplish this by setting up risk and capital management requirements designed to ensure that a bank has adequate capital for the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability.

Politically, it was difficult to implement Basel II in the regulatory environment prior to 2008, and progress was generally slow until that year's major banking crisis caused mostly by credit default swaps, mortgage-backed security markets and similar derivatives. As Basel III was negotiated, this was top of mind, and accordingly much more stringent standards were contemplated, and quickly adopted in some key countries including the USA.


The final version aims at:

  1. Ensuring that capital allocation is more risk sensitive;
  2. Enhance disclosure requirements which will allow market participants to assess the capital adequacy of an institution;
  3. Ensuring that credit risk, operational risk and market risk are quantified based on data and formal techniques;
  4. Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.

While the final accord has largely addressed the regulatory arbitrage issue, there are still areas where regulatory capital requirements will diverge from the economic capital.

Basel III (or the Third Basel Accord) is a global regulatory standard on bank capital adequacy, stress testing and market liquidity risk agreed upon by the members of the Basel Committee on Banking Supervision in 2010–11, and scheduled to be introduced from 2013 until 2018.

The third installment of the Basel Accords was developed in response to the deficiencies in financial regulation revealed by the late-2000s financial crisis.Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage.

The OECD estimates that the implementation of Basel III will decrease annual GDP growth by 0.05–0.15%. Critics suggest that greater regulation is responsible for the slow recovery from the late-2000s financial crisis, and that the Basel III requirements will increase the incentives of banks to game the regulatory framework and further negatively affect the stability of the financial system.


Basel III will require banks to hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) of risk-weighted assets (RWA). Basel III also introduces additional capital buffers, (i) a mandatory capital conservation buffer of 2.5% and (ii) a discretionary countercyclical buffer, which allows national regulators to require up to another 2.5% of capital during periods of high credit growth. In addition, Basel III introduces a minimum leverage ratio and two required liquidity ratios. The leverage ratio is calculated by dividing Tier 1 capital by the bank's average total consolidated assets; the banks are expected to maintain the leverage ratio in excess of 3%. The Liquidity Coverage Ratio requires a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days; the Net Stable Funding Ratio requires the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.



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