CHAPTER I
INTRODUCTION

1.1 Background
Basel Capital accord is a capital adequacy framework developed by the Basel committee. In 1988, the Basel Committee decided to introduce a capital measurement system commonly referred to as the Basel Capital Accord. This system provided for the implementation of a credit risk measurement framework with a minimum capital requirement of 8% on banks Risk Weighted Assets (RWA). The 1988 framework is also known as "Basel – I". Since 1988, this framework has been progressively introduced not only in member countries but also virtually in all other countries.
The "international convergence on capital measurement and capital standard -2004" is popularly known as Basel-II. It is a capital adequacy related standard framed by Basel committee. After the successful implementation of 1988 accord in more than 100 countries, the Basel Committee on Banking Supervision reached an agreement on a number of important issues for promoting best and uniform banking practices as well as setting standards and guidelines for supervisory function. Following extensive interaction with banks, industry groups and supervisory authorities that are not members of the Committee, the revised framework was issued on 26 June 2004, which is being regularly revised and updated.
The Basel-II aims to replace Basel I and to make the capital framework more risk sensitive. Basel II has recommended major revision on the international standard on bank's capital adequacy, which requires banks to implement risk management policies that closely align banks capital with its economic capital. The Basel II has been introduced basically for the protection of depositor's interest by preserving the integrity of capital in Banks.
The Basel Committee formulated a set of new global regulatory standards for bank capital, liquidity and macro prudential regulations, collectively called Basel III
1.2 Introduction
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). They are called the Basel Accords as the BCBS maintains its secretariat at the Bank for International Settlements in Basel, Switzerland and the committee normally meets there. The Basel Accords is a set of recommendations for regulations in the banking industry.
1.2.1 Basel I
Basel I was a regulatory capital measurement system that required internationally active banks from G10 countries to hold a minimum ratio of capital to risk-weighted assets of 8% by 1992. Two tiers of capital were distinguished depending of their ability to absorb losses. Tier 1 included shareholders‟ equity and retained earnings and Tier 2, supplementary internal and external capital resources such as general provisions and subordinated debt. To measure risk-weighted assets, assets were classified into four buckets, 0%, 20%, 50% and 100%, according to their riskiness, which in the case of Basel I varied by who the debtor was. Capital was not required against government assets such as Treasury bills and bonds whist claims on banks attracted a 20% weight, which translated into a capital charge of 1.6% of the value of the claim. Claims on the non-bank private sector generally received the standard 8% capital requirement. Basel I was supplemented a number of times mostly to deal with the treatment of off-balance-sheet activities, although the most significant amendment was made in 1996 with the Market Risk Amendment. This required the removal of trading positions in bonds, equities, foreign exchange and commodities from the credit risk framework in place for explicit capital charges related to the bank's open position in each instrument.
1.2.2 Basel II
Due to rapid developments in financial markets, the simple and ad hoc bucket approach in Basel I created incentives for banks to move high quality assets off the balance sheet, thus reducing the average quality of banks, and became increasingly outdated as regulatory capital requirements conflicted with sophisticated internal measures of economic capital. The rationale of Basel II was to reduce the scope for regulatory arbitrage and make regulatory capital requirements more risk-sensitive by incorporating advances made in banks‟ internal risk management practices in calculating regulatory capital requirements. The „International Convergence of Capital Measurement and Capital Standards: A revised Framework‟, known as Basel II, was agreed in 2004 and consisted of three pillars corresponding to minimum regulatory capital requirements in Pillar 1, the supervisory review process in Pillar 2 and market discipline in Pillar 3. 1. First Pillar
The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk, and market risk. Other risks are not considered fully quantifiable at this stage.

Credit Risk | Operational Risk | Market Risk | -Standardized Approach-Foundation IRB Approach-Advanced IRB Approach | -Basic Indicator Approach- Standardized Approach-Advanced Measurement Approach | -Standardized Approach-Internal Model Approach |

2. Second Pillar
This is a regulatory response to the first pillar, giving regulators better 'tools' over those previously available. It also provides a framework for dealing with systemic risk, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk and legal risk, which the accord combines under the title of residual risk. Banks can review their risk management system.

3. Third Pillar
This pillar aims to complement the minimum capital requirements and supervisory review process by developing a set of disclosure requirements which will allow the market participants to measure the capital adequacy of an institution.

1.2.3 Basel III
Basel III (or the Third Basel Accord) is a global, voluntary regulatory standard on bank capital adequacy, stress testing and market liquidity risk. It was agreed upon by the members of the Basel Committee on Banking Supervision in 2010–11, and was scheduled to be introduced from 2013 until 2015; however, changes from April 1, 2013 extended implementation until March 31, 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 was supposed to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage.
Basel III has included some micro-prudential elements so that risk is managed in each individual institution and macro-prudential elements will take care of issues relating to the systemic risk. The main elements are as follows:
The micro-prudential elements of Basel III are: * Definition of capital * Better risk Coverage * Leverage ratio; and * International liquidity framework

The macro-prudential elements of Basel III are: * Leverage ratio * Capital conservation buffer * Counter cyclical capital buffer * Forward looking and dynamic provisioning * Addressing systemic risk and interconnectedness * Loan to value ratio, debt to income ratio and credit to GDP ratio * Macroeconomic policy reform (including monetary and fiscal reform, institutional and structural reform)
Basel III has made a significant change in the definition of regulatory capital. To enhance the quality, consistency and transparency of regulatory capital, the new capital framework has prescribed that Tier 1 capital should consist of common equity and retained earnings. New capital framework is raising the quality of capital to ensure banks are better able to absorb losses and raising the level of the minimum capital requirements.
Total regulatory capital consists of the sum of the following elements: 1. Tier 1 Capital:
Tier 1 Capital must be at least 6.0% of risk-weighted exposures at all times. * Common Equity Tier 1: Common Equity Tier 1 must be at least 4.5% of risk weighted exposures at all times. * Additional Tier 1: 1.5 percent

2. Tier 2 Capital:
Total Capital (Tier 1 Capital plus Tier 2 Capital) must be at least 8.0% of risk-weighted exposure at all times.

CHAPTER II ANALYSIS AND PRESENTATION 2.1 Capital regulation in Nepal There are four types of Banks and Financial Institutions; Class A (Commercial Banks), Class B (Development Banks), Class C (Finance Company) and Class D (Micro-credit Financial Institutions) licensed by the Nepal Rastra Bank. Class A institutions (commercial banks) are reporting their capital adequacy requirement in accordance with the new capital adequacy framework under Basel II issued through Directive No.1 of the Unified Directives. Other institutions are still computing and reporting their capital adequacy according to Basel I framework. The new framework is under parallel run for the national level Development Banks (B class financial institutions) in Nepal. Capital Adequacy Framework 2007 which is updated in 2012, issued for the first time in 2007. Implementation of Basel II initiated after one year of parallel run of Basel I and Basel II (simultaneously) in Commercial Banks. After the parallel run of one year, Commercial Banks (A class) have been reporting their capital adequacy ratios in accordance with the new capital adequacy framework. It has been six years of successful implementation of Basel II in Nepalese Commercial Banks. The new capital adequacy framework, also known as Basel II, includes three pillar approach; Minimum Capital Requirements, Supervisory Review and Disclosure. The first pillar includes the risk measurement approaches viz; Simplified Standardized Approach (SSA) for credit risk, Basic Indicator Approach (BIA) for operational risk and Net Open Position Approach (NOPA) for market risk. These approaches seem to be the simplest approaches for measurement of risks under Basel II although there are also other advanced approaches for risk measurement. Nepal could not move beyond the Simplified Standardized Approach for credit risk because there was no credit rating agency in Nepal.

After the global financial crisis of 2007-09, there has been significant development and addition in the existing capital framework all over the world. Basel II enhancement, Basel 2.5 and Basel III are some of the recent developments towards capital regulation in banking. Most of the issues included in the new capital regulations were the issues observed during and after the global financial crisis. Additions made in the Basel II framework were especially the efforts to solve the problems faced during the global financial crisis. According to the new capital adequacy framework 2007, In Nepal minimum capital requirements for Commercial Banks are; Tier I capital = 6% of RWE Total Capital= 10% of RWE These ratios are already higher than the global standard for capital adequacy prescribed by Basel II. Under Basel III, minimum Tier I capital should be 6% of RWE and there will not be necessity of any change in total capital requirements. There is no specific regulatory requirement for common equity tier 1 capital under Simplified Standardized Approach of Basel II. But banks are required to have minimum paid up capital (including proposed bonus share) of Rs 2 billion by mid July 2014. The following table presents the status of CAR of Commercial Banks as on Mid July 2013: S.N. | Bank | Paid up Capital | Tier 1 Capital | Total Capital | Total RWE | Paid up capital to RWE % | Tier 1 Capital % | Total Capital % | 1 | NBL | 3716 | -346 | -346 | 71150 | 5.22% | -0.49% | -0.49% | 2 | RBB | 8588 | 1115 | 1959 | 58891 | 14.58% | 1.89% | 3.33% | 3 | NABIL | 2436 | 7315 | 8338 | 63319 | 3.85% | 11.55% | 13.17% | 4 | NIBL | 3768 | 7852 | 8849 | 68106 | 5.53% | 11.53% | 12.99% | 5 | SCBL | 1853 | 5013 | 5574 | 38508 | 4.81% | 13.02% | 14.48% | 6 | HBL | 2760 | 5541 | 6774 | 55767 | 4.95% | 9.94% | 12.15% | 7 | NSBL | 2355 | 3960 | 5071 | 39440 | 5.97% | 10.04% | 12.86% | 8 | NBBL | 2009 | 2451 | 2672 | 22101 | 9.09% | 11.09% | 12.09% | 9 | EBL | 1761 | 5449 | 6587 | 49834 | 3.53% | 10.93% | 13.22% | 10 | BOK | 1684 | 2983 | 3944 | 31254 | 5.39% | 9.54% | 12.62% | 11 | NCCBL | 1470 | 2160 | 2328 | 19479 | 7.55% | 11.09% | 11.95% | 12 | NIC | 2311 | 4831 | 5173 | 35993 | 6.42% | 13.42% | 14.37% | 13 | LUBL | 1601 | 2180 | 2274 | 10545 | 15.18% | 20.67% | 21.57% | 14 | MBL | 2478 | 2775 | 3002 | 23711 | 10.45% | 11.70% | 12.66% | 15 | KBL | 1604 | 2657 | 2862 | 23404 | 6.85% | 11.35% | 12.23% | 16 | LXBL | 1694 | 2569 | 3297 | 26862 | 6.31% | 9.57% | 12.27% | 17 | SBL | 1619 | 2646 | 3685 | 30001 | 5.40% | 8.82% | 12.28% | 18 | ADBL | 9636 | 15298 | 18125 | 101324 | 9.51% | 15.10% | 17.89% | 19 | GBL | 2418 | 3532 | 4220 | 35101 | 6.89% | 10.06% | 12.02% | 20 | CTZBL | 2101 | 2662 | 2846 | 20955 | 10.03% | 12.70% | 13.58% | 21 | PCBL | 2340 | 3070 | 3283 | 23750 | 9.85% | 12.93% | 13.82% | 22 | SUBL | 2015 | 2437 | 2619 | 22031 | 9.15% | 11.06% | 11.89% | 23 | GrBL | 2000 | 2360 | 2502 | 17847 | 11.21% | 13.22% | 14.02% | 24 | NMB | 2000 | 2507 | 2689 | 21209 | 9.43% | 11.82% | 12.68% | 25 | KIST | 2000 | 2138 | 2297 | 19547 | 10.23% | 10.94% | 11.75% | 26 | JBNL | 2000 | 2256 | 2376 | 14882 | 13.44% | 15.16% | 15.97% | 27 | MEGA | 2330 | 2660 | 2776 | 14216 | 16.39% | 18.71% | 19.53% | 28 | CTBN | 2000 | 2096 | 2185 | 10869 | 18.40% | 19.28% | 20.11% | 29 | CIVIL | 2000 | 2153 | 2278 | 14563 | 13.73% | 14.78% | 15.64% | 30 | CCBL | 1080 | 1223 | 1314 | 10381 | 10.40% | 11.78% | 12.66% | 31 | SANIMA | 2016 | 2410 | 2575 | 17252 | 11.69% | 13.97% | 14.93% | CHALLENGES Another greatest challenge facing the domestic institutions is their ability to compete effectively in a more liberalized environment due to skill gaps which are still lacking in critical areas, particularly in the area of credit and treasury risk management. In the banking sector, it was acknowledged by the Basel Committee on Banking Supervision on the New Capital Accord that the emerging economies in Asian do face difficulties in implementing the BASEL requirements due to the lack of skills. For safeguarding the Nepalese banking sector provisions has been made in the specific schedules of commitments such that financial institutions will not be permitted to deal in derivative products under sub-sector and settlement of and clearing services for financial assets, including securities, derivative products, and other negotiable instruments until Nepal Government determines what types of entities can conduct these services, the related laws and regulations are established and such business is authorized by the government or other designated authority. As the provision made is only intended for safeguarding and not for restricting it is necessary to identify that sooner or later Nepalese financial sector will have to develop its skills in order to compete with foreign financial institutions. Hence, keeping this in mind policies regarding settlement of and clearing services for financial assets, including securities, derivative products, and other negotiable instruments should be prepared at the earliest such that the Nepalese banking sector can gain enough know how before 2010.