Adoption of Basel II Norms:
Are Indian Banks Ready?


By

Radhakrishnan R
PGDM, Class of '09
Ravi Bhatia
PGDCM, Class of '09
Indian Institute of Management Calcutta
(IIM Calcutta)
 


What is Basel II?

Basel II is the second of the Basel Accords recommended on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks (these terms are explained in later sections) banks face. These international standards can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse.

Basel II insists on setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk The underlying assumption behind these rules is 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. It will also oblige banks to enhance disclosures.

Advantages of Basel II over Basel I

Basel 1

Proposed new Accord or Basel II

Focus on a single risk measure, primarily on credit risk. Doesn't cover operation risk

More emphasis on banks' own internal  methodologies, supervisory review, and market discipline

One size fits all

Flexibility, menu of approaches, incentives for better risk management

Broad structure

More risk sensitivity

Uses arbitrary risk categories & risk weights

Risk weights linked to external ratings assigned by ECAI or IRB by bank


Capital Adequacy Requirements

Capital adequacy requirements on the banks not only protect investors, but also safeguard them against possibility of failure of a big-bank. It also strengthens market discipline. In Basel I Capital adequacy is given as a single number that was the ratio of a banks capital to its assets. The key requirement was that tier-I capital was at least 8% of assets

Three pillars of Basel II


Types of risks according to Basel II

Market Risk

Credit Risk

Operational Risk

The risk of losses in on- and off-balance-sheet positions arising from movements in market prices.

Main factors contributing to market risk are: equity, interest rate, foreign exchange, and commodity risk. The total market risk is the aggregation of all risk factors.

The risk that a counterparty will not settle an obligation for full value, either when due or at any time thereafter.

In exchange for-value systems, the risk is generally defined to include replacement risk and principal risk.

(Internal controls & Corporate governance):

The risk of loss resulting from inadequate or failed internal processes people and systems or from external events


Why Indian Banks need Basel II or new accord

India had adopted Basel I guidelines in 1999. Subsequently, based on the recommendations of Steering Committee established in February 2005 for the purpose, the RBI had issued draft guidelines for implementing a New Capital Adequacy Framework, in line with Basel II.

The deadline for implementing Basel II, originally set for March 31, 2007, has now been extended. Foreign banks in India and Indian banks operating abroad will have to adhere to the guidelines by March 31, 2009. But the decision to implement the guidelines remains unchanged.

Apart from the above mentioned advantages of Basel II vis--vis Basel 1, there are certain reasons which manifests why Indian Banks require Basel II compliance:-

  • Basel II norms will facilitate introduction of new complex financial products in Indian Banking Sector
  • Indian banks require a more risk sensitive framework. There is improvement in risk management system by Indian banks
  • New rules will provide a range of options for estimating regulatory capital and will reduce gap between regulatory capital & economic capital

Adoption of BASEL II Norms: Are the Indian Banks Ready?

1. Base II Pillar I Preparedness

RBI has advised the banks to use Standardised Approach for measuring Credit Risk (risk ratings are assigned by credit assessment institutions like Moody's) and Basic Indicator Approach for assessing Operational Risk. Since the loans and advances portfolios of India banks largely covers un-rated entities that are assigned a risk weight of 100 per cent, the impact of the lower risk weights assigned to higher rated corporate would not be significant.

The other major impact will be in the area of short-term assets. Under Basel II norms RBI in its capital adequacy guidelines has provided for lower risk weights for short-term asset exposures. The Indian banks have large short-term portfolio (cash and working capital loans). This lower risk weight can be leveraged by the Indian banks

The Indian banking sector will require an additional capital of Rs 5,68,744 crores in the next 5 years to maintain the Capital Adequacy Ratio at 12% according to the Basel II norms. Major share is of Public Sector


Hence Basel II in spite of its stringent rules for Capital adequacy provides opportunity for the Indian banks to significantly reduce their credit risk weights and reduce the required regulatory capital

To raise the additional capital for maintaining the Capital adequacy requirements the small and medium sized banks will surely face a lot of problems. The advantages that the PSBs and the large private banks have are:

  • The banks can use the capital market to meet the capital requirements and can go for a public issue or can use private placement to garner the capital
  • PSBs are helped by the state and central government which can infuse their funds in the form of recapitalization to fulfill the capital adequacy
  • Significant proportion will be met by internal resources of the banks, like growth in reserves and surplus through efficient operations in the coming years.

Small and medium sized banks in the country may also have to incur enormous costs to acquire the required technology as well as to train staff in terms of the risk management activities.  They also need technological upgradation and access to information like historical data etc.

2. Base II pillar II preparedness

Pillar II requirements are also demanding on the supervisor i.e. RBI to emphasize the following areas of development:

  • Skill development both at RBI level and the banks level
  • Proper framework for the supervisory role
  • Administer and enforce minimum capital requirements from bank even higher than the Basel II specified level based on the risk management skills of the bank.
  • Preparing the banks for the IRB method and facilitate them to develop their risk management systems
  • Validating and upgrading the Indian banks IRB model and help them develop the required IT architecture and upgrade its MIS systems

3. Basel II Pillar III preparedness

Pillar III according to Basel II Accord demands comprehensive disclosure requirements from the banks. For such comprehensive disclosure the IT structure must be in place for the supporting data collection and for generating MIS which is compatible with Pillar III requirements

For this a data roadmap must be developed. IT structure required must be defined with technology architecture with focus on

  • Scalability
  • Availability
  • Security
  • Generation of MIS

Possible dynamics in the Indian Banking Sector

In all the regards the big banks (read PSB and large private banks) will have the marked advantage over the small and medium sized banks. This might lead to considerable level of consolidation in the Indian Banking Industry. In the present market scenario, the banks might find it difficult to raise funds through the capital markets to raise funds for servicing the capital adequacy requirements. The maximum level of dilution allowed of government's stake is 51% in PSB which might cap their capital market funding. The nationalized banks can access the market up to the level of Rs5, 171 crores still maintaining the government's stake. To solve this there needs to be a relaxation in the allowed dilution level up to atleast 33%.

An area of relaxation is in the case of private banks which are allowed to access capital from foreign sources up to 74% with no single entity allowed to have an FDI of above 10%. This is leading to foreign firms having substantial stake in Indian private banks

Hence, regarding the opening of Indian banking sector to foreign banks RBI is going for a measured and synchronized manner with the maturity of the Indian Banking sector in terms of size and risk management. It is taking a measured approach instead of directly opening the gates for the foreign banks.

References

    1. ICRA -  www.icraratings.com

    2. Master Circular Prudential Guidelines on Capital Adequacy and Market Discipline Implementation of the New Capital Adequacy Framework (NCAF) by Reserve Bank of India

    3.  BASEL II ACCORD: IMPACT ON INDIAN BANKS BY ICRA

    4. Master Circular Prudential Guidelines on Capital Adequacy and Market

    5. Discipline Implementation of the New Capital Adequacy Framework (NCAF) by RBI

    6. Basel Committee on Banking Supervision International Convergence of Capital Measurement and Capital Standards A Revised Framework Comprehensive Version

    7. Risk Management and Capital Adequacy by  Reto R. Gallati
     


Radhakrishnan R
PGDM, Class of '09
Ravi Bhatia
PGDCM, Class of '09
Indian Institute of Management Calcutta
(IIM Calcutta)
 

Source: E-mail November 4, 2008

 

        

 

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