BASEL II NORMS IMPACT ON INDIAN BANKS
By Mohita
Bagati, Ø
INTRODUCTION:- 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. Ø
AIM AND
OBJECTIVES OF BASEL II:- ·
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. Ø
FRAMEWORK OF
BASEL II:- 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. Ø
COMPUTATION OF CAPITAL REQUIREMENT:- Capital Requirement for Credit Risk: The new accord provided for the
following alternative methods of computing capital requirement for credit risk. · STANDARDIZED APPROACH:- 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. ·
INTERNAL
RATING APPROACH (IRB):- 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. · BASIC INDICATOR APPROACH :- 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. ·
ADVANCED
MEASUREMENT APPROACH :- 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. Ø
CHALLENGES IN IMPLEMENTATION :- 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. ·
CAPITAL
REQUIREMENT:- 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. ·
RISK MANAGEMENT ARCHITECTURE:- 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. ·
RATING
REQUIREMENT:- 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. ·
CHOICE OF ALTERNATIVE APPROACHES:- 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. ·
ABSENCE OF HISTORICAL DATABASE:- 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. ·
INCENTIVE TO REMAIN
UNRATED:- 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. ·
SUPERVISORY FRAMEWORK:- 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. ·
CORPORATE GOVERNANCE
ISSUES:- 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. ·
NATIONAL DISCRETION:- 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. ·
DISCLOSURE REGIME:- 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. ·
DISADVANTAGE FOR SMALLER
BANKS:- 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. ·
DISCRIMINATORY AGAINST
DEVELOPING COUNTRIES:- 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. ·
EXTERNAL AND INTERNAL
AUDITORS:- 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. Ø
IMPACT OF BASEL II NORMS ON INDIAN BANKS
:- 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. Ø CONCLUSION 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………..
ILS Law College, Pune.
