The standardized approach is conceptually the same as the present Accord, but is more risk sensitive. The bank allocates a risk-weight to each of its assets and off-balance-sheet positions and produces a sum of risk-weighted asset values. Individual risk weights currently depend on the broad category of borrower (i.e. sovereigns, banks or corporates). Under the new Accord, the risk weights are to be refined by reference to a rating provided by an external credit assessment institution that meets strict standards.

Under the IRB approach, distinct analytical frameworks will be provided for different types of loan exposures. The framework allows for both a foundation method in which a bank estimate the probability of default associated with each borrower, and the supervisors will supply the other inputs and an advanced IRB approach, in which a bank will be permitted to supply other necessary inputs as well. Under both the foundation and advanced IRB approaches, the range of risk weights will be far more diverse than those in the standardized approach, resulting in greater risk sensitivity.

2. Operational Risk:

Basel II Accord set a capital requirement for operational risk. It defines operational risk as "the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events". Banks will be able to choose between three ways of calculating the capital charge for operational risk – the Basic Indicator Approach, the Standardized Approach and the advanced measurement Approaches.

The Second Pillar: Supervisory Review Process

The supervisory review process requires supervisors to ensure that each bank has sound internal processes in place to assess the adequacy of its capital based on a thorough evaluation of its risks. Supervisors would be responsible for evaluating how well banks are assessing their capital adequacy needs relative to their risks. This internal process would then be subject to supervisory review and intervention, where appropriate.

The Third Pillar: Market Discipline

The third pillar of the new framework aims to bolster market discipline through enhanced disclosure by banks. Effective disclosure is essential to ensure that market participants can better understand banks' risk profiles and the adequacy of their capital positions.  The new framework sets out disclosure requirements and recommendations in several areas, including the way a bank calculates its capital adequacy and its risk assessment methods. The core set of disclosure recommendations applies to all banks, with more detailed requirements for supervisory recognition of internal methodologies for credit risk, credit risk mitigation techniques and asset securitization.

CHALLENGES FOR INDIAN BANKING SYSTEM UNDER
BASEL II

A feature, somewhat unique to the Indian financial system is the diversity of its composition. We have the dominance of Government ownership coupled with significant private shareholding in the public sector banks and we also have cooperative banks, Regional Rural Banks and Foreign bank branches. By and large the regulatory standards for all these banks are uniform.

Costly Database Creation and Maintenance Process: 

The most obvious impact of BASEL II is the need for improved risk management and measurement. It aims to give impetus to the use of internal rating system by the international banks. More and more banks may have to use internal model developed in house and their impact is uncertain. Most of these models require minimum 5 years bank data which is a tedious and high cost process as most Indian banks do not have such a database

Additional Capital Requirement:

In order to comply with the capital adequacy norms we will see that the overall capital level of the banks will raise a glimpse of which was seen when the RBI raised risk weightages for mortgages and home loans in October 2004. Here there is a worrying aspect that some of the banks will not be able to put up the additional capital to comply with the new regulation and they may be isolated from the global banking system.

Large Proportion of NPA's:

A large number of Indian banks have significant proportion of NPA's in their assets. Along with that a large proportion of loans of banks are of poor quality. There is a danger that a large number of banks will not be able to restructure and survive in the new environment. This may lead to forced mergers of many defunct banks with the existing ones and a loss of capital to the banking system as a whole.

Relative Advantage to Large Banks:

The new norms seem to favor the large banks that have better risk management and measurement expertise. They also have better capital adequacy ratios and geographically diversified portfolios. The smaller banks are also likely to be hurt by the rise in weightage of inter-bank loans that will effectively price them out of the market. Thus banks will have to restructure and adopt if they are to survive in the new environment.

Increased Pro-Cyclicality:

NOT WHEN BUT HOW?

The important decision for India is not whether to stay on Basel I or move to Basel II, but of which of the many alternatives on offer, should be adopted. Given the lack of rating penetration, the Standardized Approach yields little in linking capital to risk while the IRB approach looks complex to implement and difficult to monitor. In the event of some banks adopting IRB Approach, while other banks adopt Standardised Approach, banks adopting IRB Approach will be much more risk sensitive than the banks on Standardised Approach, since even a small change in degree of risk might translate into a large impact on additional capital requirement for the IRB banks.

For banks adopting Standardised Approach the relative capital requirement would be less for the same exposure and would be inclined to assume exposures to high risk clients, which were not financed by IRB banks. As a result, high risk assets could flow towards banks on Standardised Approach which need to maintain lower capital on these assets. Similarly, low risk assets would tend to get concentrated with IRB banks which need to maintain lower capital on these assets. Hence, system as a whole may maintain lower capital than warranted.

Keeping in view the above complications we suggest as a transitional tool, a Centralized Rating Based(CRB) approach where the RBI dictates a rating scale and asks banks to rate borrowers according to that centralized scale. The great benefit of the approach is that the RBI would be able to monitor and control banks' ratings and hence monitor and control their capital sufficiency in relation to risk much more effectively. These kinds of comparisons combined with simple procedures for spotting outliers and keeping a track of the different banks' ratings of the main borrowers from the financial system will be extremely valuable tools for a RBI.

Finally the CRB approach should be used as a precursor to IRB. Once the CRB approach is working the RBI could then work with banks to approve their own rating scales and rating methodology using the basic CRB approach as a reference tool.

REFRENCES

The Basel II Capital Accord, www.bis.org,

Implementation Of The New Basel Capital Accord In Emerging Market Economies – Problems And Alternatives, Marusa Mrak

Will Basel II Affect International Capital Flows To Emerging Markets?, Beatrice Weder and Michael Wedow