By Mohita Bagati,
ILS Law College, Pune.




Forces of deregulation, technological innovation and globalization unleashed a tremendous growth in global banking in the 1980s. Basel I was the first to arrive at an internationally accepted definition of bank capital to prescribe a minimum acceptable level of capital for banks. These norms were announced in 1988 and were adopted by the banks by the end 1992.

But, subsequent events such as the Asian financial crisis exposed the inadequacies of these norms in dealing with systemic crisis in global banking.  The uncontrolled growth in global banking without adequate regulation and supervision unavoidably led to recurring banking crisis in one economy after another.

To prevent such crises, the Basel Committee in June 1999 proposed a new set of norms to reinforce the structural soundness of the banks, particularly the international banks.  These norms came to be known as Base II Norms which comprised of able risk management, capital adequacy, sound supervision, regulation and transparency of operation. The Bank for International Settlements based in the Swiss City of Basel announced the International Convergences of Capital Measurement and Capital Standards. The Basel Committee consists of central banks from 13 countries making up Basel Committee on Banking Supervision (BCBS) to revise the international standards for measuring adequacy of a bank’s capital. The bank for international Settlement supplies the secretariat for Basel Committee on Banking Supervision (BCBS). Firstly, the Basel II was to be announced in 2004 and later postponed to 2005. The new framework which is now available for implementation, starting 2007 is further extended to 2009.  However, the new framework is expected to maintain the aggregate level of minimum capital requirements as fixed in Basel I.


·        Encourage the use of Modern Risk Management Techniques.

·        To encourage Banks to ensure their Risk Management Capabilities are commensurate with the risk of their business.

·        More sophisticated approach to Credit Risk, in that allows bank to use Internal Rating Based Approach (IRBA Approach) as they are known to calculate their capital requirement for credit risk.


The new proposal is based on the three mutually reinforcing pillars that allow the banks and supervisors to evaluate properly the various risks that banks face and realign regulatory capital more closely the underlying risks.

PILLAR I       :    Minimum Capital Requirements.

PILLAR II      :    Supervisory Review Process.

PILLAR III     :    Market Discipline.


1.      PILLAR I        :    Minimum Capital Requirement:-

This pillar sets out minimum capital requirement. The new framework maintains minimum capital requirement of 8% of risk assets. Under the new accord Capital Adequacy ratio will be measured-

Total capital (unchanged) = (Tier I + Tier II + Tier III)                                                             

Risk Weighed Assets = Credit Risk + Market Risk + Operational Risk


2.       PILLAR II          :    Supervisory Review Process:-

It has been introduced to ensure not only that bank have Adequate Capital to support all risks, but also to encourage them to develop and use better risk management techniques in monitoring and managing their risks. The process has four keys principles-

·        Supervisors should review and evaluate bank’s internal capital adequacy bank’s internal capital adequacy assessment and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios.

·        Supervisors should expect banks to operate above minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.

·        Supervisors should seek to intervene at an early stage to prevent capital from falling below minimum level and should require rapid remedial action if capital is not mentioned or restored.

3.          PILLAR III    :    Market Discipline:-

Imposes strong incentive for banks to conduct their business in a safe, sound and effective manner. It is proposed to be effective through a series of disclosure requirements on capital, risk exposure etc. so that market participants can assess a bank’s capital adequacy. These disclosures should be made at least semi-annually and more frequently if appropriate.


Capital Requirement for Credit Risk:

The new accord provided for the following alternative methods of computing capital requirement for credit risk.




This approach is theoretically 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. A risk weight of 100% means that an exposure is included in the calculation of risk weighted assets value, which translates into a capital charge equal to 9% of that value. 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. The Committee has not proposed significant change in respect of off-balance sheet items except for commitment to extend credit.


Under this approach banks will be allowed by the supervisors to use their internal estimates of risks components to assess credit risk in their portfolio being subject to strict methodological and disclosure standards. Bank estimates each borrower’s creditworthiness and the results are translated into estimates of a future potential loss amount which forms basis of minimum capital requirements.

Risk components include measures of:-

-         Probability of default (PD).

-         Loss of given default (LGD).

-         Exposure at default    (EAD).

-         Effective Maturity      (M).


·                    SECURITIZATION APPROACH :-

Banks must apply the securitization framework for determining regulatory capital requirement on exposure arising from securitization. Banks that apply the standardized approach to credit risk for the underlying exposure must use the standardized approach under the securitization framework. The same way banks that have received approval to use IRB approach for the type of underlying exposure must use the IRB approach for the securitization.

 Capital charge for Market Risk:

The Basel Committee issued “Amendment to the Capital Accord to incorporate Market Risks”. RBI as an interim measure advised banks to assign an additional risk weight of 2.5% on the entire investment portfolio. RBI feels that over the years, bank’s ability to identify and measure market risk has improved and therefore decided to assign explicit Capital charge for market risk in a phased manner over a two year period as under-

a.)    Banks would be required to maintain capital charge for market risk in respect of their trading book exposure (including derivatives) by March 2005.

b.)    Banks would be required to maintain capital charge for market risk in respect of securities under available for sale category by March 2006.

RBI has issued certain guidelines for computation of capital Charge on Market Risk in June 2004. Guidelines seek to establish the issues involved in computing capital charge for interest rate related instruments in the trading book, equities in the trading book and foreign exchange risk in both trading and banking book. As per the guidelines minimum capital requirement is expressed in terms of two separately calculated charges:

·         Specific Risk:-

Capital charge for Specific Risk is designed to protect against an adverse movement in price of an individual security due to factors related to individual issuer, similar to Credit Risk.

·              General Market Risk:-

Capital Charge for general market risk is designed to capture the risk of loss arising from changes in market interest rates.



The Basel Committee for suggested two broad methodologies for computation of capital charge for market risk:

·        Standardized Method

·        Internal Risk Management Model Method

Banks in India are still in an emerging stage of developing internal risk management models. In the guidelines it is been proposed to start with banks may adopt the Standardized Method.

There are two methods of measuring Market Risks:

·        Maturity Method

·        Duration Method

As the Duration Method is a more accurate method of measuring interest rate risk, the RBI prefers that banks measure all of their general market risk by calculating the price sensitivity of each position separately.

Capital Charge for Operational Risk:

The Basel Committee has defined the Operational Risk as “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.” This definition includes legal risk but excludes strategic and reputation risk. The objective of the operational risk management is to reduce the expected Operational losses using a set of key risk indicators to measure and control risk on continuous basis and provide risk capital on operational risk for ensuring financial soundness of the bank.




Under this approach banks are required to hold capital for operational risk equal to the average over the previous three years of a fixed percentage of annual gross income. Gross income is defined as net interest income plus net non-interest income, excluding realized profit/losses from the sale of securities in the banking book and extraordinary and irregular items.

·               STANDARDIZED APPROACH :-

Under this type of approach bank’s activities are divided into eight business lines. Within each business line, gross income is considered as a broad indicator for the likely scale of operational risk. Capital charge for each business line is calculated by multiplying gross income by a factor assigned to that business line.


Under advanced measurement approach, the regulatory capital will be equal to the risk measures generated by the bank’s internal risk measurement system using the prescribed quantitative and qualitative criteria. 


As there is no second opinion regarding the purpose, necessity and usefulness of the new accord, the techniques and methods suggested would pose considerable implementation challenges for the banks especially in developing country like India.


The new norm would invariably increase capital requirement in all banks across the board. This partly explains the current trend of consolidation in the banking industry.


·            PROFITABILITY:-

Huge implementation cost may also impact profitability for smaller bank.  


The new standards are an amalgam of international best practices and calls for introduction of advanced risk management system with wider application throughout the organization. It would be a daunting task to create the required level of technological architecture and human skill across the institution.


Although there are a few credit rating agencies in India-the level of rating penetration is very low. Further rating is a lagging indicator of the credit risk and the agencies have poor track record in this respect. There is a possibility of rating blackmail through unsolicited rating. Moreover rating in India is restricted to issues and not issuers. Encouraging rating of issuers would be a challenge.


The new framework provides for alternative approaches for computation of capital requirement of various risks. However, competitive advantage of IRB approach may lead to domination of this approach among big banks. Banks adopting IRB approach will be more sensitive than those adopting standardized approach. This may result in high-risk assets flowing to banks on standardized approach - as they would require lesser capital for these assets than banks on IRB approach. Hence, the system as a whole may maintain lower capital than warranted and become more vulnerable. It is to be considered whether in our quest for perfect standards, we have lost the only universally accepted standard.


Computation of probability of default, loss given default, migration mapping and supervisory validation require creation of historical database, which is a time consuming process and may require initial support from the supervisor.




In case of unrated sovereigns, banks and corporate the prescribed Risk weight is 100%, whereas in case of those entities with lowest rating, the risk weight is 150%. This may create incentive for the category of counterparties, which anticipate lower rating to remain unrated.




Implementation of Basel II norms will prove a challenging task for the bank supervisors as well. Given the paucity of supervisory resources – there is a need to reorient the resource deployment strategy. Supervisory cadre has to be properly trained for understanding of critical issues for risk profiling of supervised entities and validating and guiding development of complex IRB models.




Basel II proposals underscore the interaction between sound risks Management practices and corporate good governance. The Bank’s board of directors has the responsibility for setting the basic tolerance levels for various types of risk. It should also ensure that management establishes a framework for assessing the risks, develop a system to related risk to the bank’s capital levels and establish a method for monitoring compliance with internal policies.




Basel II norms set out a number of areas where national supervisor will need to determine the specific definitions, approaches or thresholds that wish to adopt in implementing the proposals. The criteria used by supervisors in making these determinations should draw upon domestic market practice and experience and be consistent with the objectives of Basel II norms.




Pillar 3 purports to enforce market discipline through stricter disclosure requirement. While admitting that such disclosure may be useful for supervisory authorities and rating agencies – the expertise and ability of the general public to comprehend and interpret disclosed information is open to question. Moreover, too much disclosure may cause information overload and may even damage financial position of bank.




The new framework is very complex and difficult to understand. It calls for revamping the entire management information system and allocation of substantial resources. Therefore, it may be out of reach for many smaller banks.




Developing counties have high concentration of lower rated borrowers. The calibration of IRB has lesser incentives to lend to

                such borrowers. This, along with withdrawal of uniform risk         

 weight of 0% on sovereign claims may result in overall reduction in lending by internationally active banks in developing countries and increase their cost of borrowing.




The working Group set up by the Basel Committee to look into implementation issues observed that supervisors may wish to involve third parties, such a external auditors, internal auditors and consultants to assist them carrying out some of the duties under Basel II. The precondition is that there should be a suitably developed national accounting and auditing standards and framework, which are in line with the best international practices. Minimum qualifying criteria for firms should be those that have a dedicated financial services or banking division that is properly researched and have proven ability to respond to training and upgrades required of its own staff to complete the tasks adequately. With the implementation of the new framework, internal auditors may become increasingly involved in various processes, including validation and of the accuracy of the data inputs, review of activities performed by credit functions and assessment of a bank’s capital assessment process.





With the introduction of Basel II, the RBI has moved closer to its goal of correlating banking risks and their management with capital requirements.

By redefining how banks calculate regulatory capital and report compliance to regulators and the public, Basel II is intended to improve safety and soundness in the financial system by placing increased emphasis on banks` own internal control and risk management processes and models, the supervisory review process, and market discipline.

To be able to implement Basel II sufficiently, most banks will need to rethink their business strategies as well as the risks that underlie them. With the improvement in risk management may call for lower capital requirements in future. In a recent review of monetary policy of RBI on October 31, the regulator bank has extended the limit to 2009 for domestic bank to follow these norms.

The implementation of these norms would also have wide-ranging effects on a bank’s information technology systems, processes, people and business – beyond the regulatory compliance, risk management and finance functions.

                                The firm has also presented a view that the Basel II norms will present banks an opportunity to gain competitive advantage by allocating capital to those processes, segments, and markets that demonstrate a strong risk/return ratio. Developing a better understanding of the risk/reward trade-off for capital supporting specific businesses, customers, products, and processes is one of the most important potential business benefits banks may derive from Basel II, as envisioned by the Basel Committee. Thus, in the survey the firm found that every bank has claimed to have either already begun or is about to begin its Basel II programmer.

                                   54 percent of the banks are technologically equipped to face the future challenges being posed by the Basel II norms and these banks have already put in place the core banking solutions. Also enough attention has been focused upon networking the banks.

Mainly there would be an increase in the capital adequacy requirements in banks as a result of these norms.

                                         62 percent of the respondent banks believe that there is a high degree of relationship between the size of the banks and associated risk. Since the complexity of the new framework may be out of

 reach for many smaller banks, this would trigger off a need for consolidation in Indian banking system.

There can be situations that increased capital requirements imposed by the Basel accord will not make the banks more risk averse towards credit dispensation. The implementation of Basel II could have an adverse impact on banks lending to commercial sector. Small and Medium enterprises and Farm and rural sectors are likely to be the most affected sectors.

                                      There should be consistency in implementation of these norms in terms of timing and approach. Further there should be greater consultation with internationally active banks that face significant cross-border implementation challenges. Operational risk measurement is one of the new planks of the Basel II accord, but to certain extent capital allocation to operational risk will not be counter productive, explicit charge on operational risk will direct more focus on it, which will further enhance operational risk management and operational efficiency for the banks and such an allocation would also create a cushion for the claims or losses on this account.

 In the Indian context, capital requirements are too high as the Indian banks, unlike their foreign counterparts are not much involved in speculative activities such as derivatives. Hence the capital requirement for operational risk should be lower for the Indian Banks than what is being specified in Basel II Accord.





The Basel Committee clearly intends to proceed along the supervisory line, but with a one-way ratchet. Supervisors will only be able to impose an additional capital charge if they find that policies, processes and procedures are inadequate, but the capital charge cannot be reduced for institutions that have exemplary controls. Since the Pillar I capital charge is already risk sensitive, the Basel II approach that feeds operational risk into Pillar 1 may only end up distorting competition further.

More fundamentally, the proposal to establish a capital charge for operational risk raises the question of the circumstances under which

Regulators should attempt to hardwire the state of the art in management science in capital regulations. The internal models approach to regulation was designed to change as internal models improve. Since international negotiations are long, bulky and highly political, they take a very long time to complete.

                                      Implementation of Basel II is therefore a long journey rather than a destination by itself. Certainly, it would require commitment of large. The Reserve Bank has decided to follow a consultative process while implementing Basel II norms and move in a gradual, sequential and coordinated manner and dialogue has been initiated with the stakeholders. A steering committee comprising representatives of banks and different supervisory and regulatory departments is taking stock of all issues relating to its implementation of Basel II norms as to make Indian Banking system stronger.

                                         Since these norms are still not efficient to be implemented on the Indian Banks further review of these norms should be made so as to suit the structure of the Indian banks………..