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By:-
Pratik Shah
Anant Gajjar
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A
COMPREHENSIVE
PROJECT REPORTON
IMPACT OF BASEL II NORMS &
ITS IMPLEMENTATION
Prepared At SLIBM Ahmedabad
In the partial fulfillment of Gujarat technological university requirement for the award of thetitle master of business administration
Under the Guidance Of:
MR. ATUL PARIKH
[Ex. Sr. Vice President (Axis Bank),
Mgmt. Consultant and Trainer]
Submitted to: - Compiled and prepared by:-
GUJARAT TECHNOLOGICAL UNIVERSITY PRATIK SHAH [37]
[Enroll no: - 097780592039]
ANANT GAJJAR [12]
[Enroll no: - 097780592042]
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SOM-LALIT INSTITUTE OF BUSINESS
MANAGEMENT
SLIMS Campus, Near St. Xavires College
Navarangpura , Ahmedabad 380009
CERTIFICATE
This is to certify that the project title IMPACT OF BASEL II NORMS & ITS
IMPLEMENTATION is a bonafide work done by Mr.Pratik Shah and Mr. Anant
Gajjar , students of Som Lalit Institute of Business Management.
They have successfully completed and submitted their project under my guidance,
towards partial fulfilment of MBA Programme, year 2009-11.
I am sure that the experience gained during the project work will enable them to
take similar challenges in future.
Date: 19-04-2011
Place: Ahmedabad
Project Guide
............................
MR.ATUL PARIKH
[Ex Sr. Vice President, Axis Bank]
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DECLARATION
We, Mr Pratik Shah and Mr Anant Gajjar , students of MBA , hereby declare
that the project work presented in this report is our contribution and has been
carried out under supervision and guidance of Mr Atul Parikh.
The objective of the grand project is to gain knowledge about Banking industry
and impact of Basel II norms and its implementation. This work has not been
previously submitted to any other university for any other examination.
Date: 19-04-2011
Place: Ahmedabad
Signature:
Mr Pratik Shah Mr Anant Gajjar
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ACKNOWLEDGEMENT
It takes a combined effort of both of us to complete a report. Through this brief note, we
would like to express our gratitude to all those who contributed to the making of this report.
This report is a step to pen down whatever we have learnt while studying the Project
Management.
We would like to thank our Guide Mr. Atul Parikh for giving us an opportunity to work on
such a broad and interesting topic and help us gaining the maximum out of this whole
process.
We would also like to thank Mr. Atul Parikh, for providing us such a fabulous opportunity
to work on this project. Moreover, we thank our college Som-Lalit Institute of BusinessManagement for availing us such an efficient infrastructural facility throughout the process.
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PREFACE
This report gives an overview of the Banking sector in India. With proposal of the Basel II
Norms, the report explains the scope and applications of Basel II Norms. It states the
particulars about the 3 pillars of the Basel II Norms. It studies the initiatives taken by the RBI
for the implementation of the Basel II Accords.
After studying the framework and implementation of the norms, the report studies the
probable impact of the implementation of Basel II Norms on the Indian Banking Sector. It
considers two points while discussing the impact of Basel II Norms on the emerging
economy like India. The first are the consequences emerging economies will have to face
because of Implementation in advanced countries. The second is the impact because of the
implementation within the emerging economy.
Simple language has been used throughout the report. Report is illustrated with figure,
charts and diagrams as and when required.
Finally we hope that this report will be able to give current scenario of banking sector to the
readers.
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EXECUTIVE SUMMARY
This report gives an overview of the Banking sector in India. With proposal of the Basel II
Norms, the report explains the scope and applications of Basel II Norms. It states the
particulars about the 3 pillars of the Basel II Norms. It studies the initiatives taken by the RBI
for the implementation of the Basel II Accords.
After studying the framework and implementation of the norms, the report studies the
probable impact of the implementation of Basel II Norms on the Indian Banking Sector. It
considers two points while discussing the impact of Basel II Norms on the emerging
economy like India. The first are the consequences emerging economies will have to face
because of Implementation in advanced countries. The second is the impact because of the
implementation within the emerging economy.
The research carried out is basically explanatory type, the problems faced by the emerging
economies and the positive & negative impacts of implementation.
The report also states finding of the current scenario of major banks in India with
respect to Basel II implementation. Further the report talks about possible impact of
Basel II norms on the Indian Banking industry.
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17.1 FOREIGN BANKS 6117.2 NATIONALIZED BANKS 6317.3 NEW PRIVATE BANKS 6517.4 OLD PRIVATE BANKS 6917.5 PUBLIC SECTOR BANK 71
18 FINDINGS 72
19 RECOMMENDATIONS 78
20 CONCLUSION 80
21 BIBLIOGRAPHY 82
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OBJECTIVE OF THE STUDY
The objective of the report is to comprehend the impact of Basel II Norms on the
Indian Banking sector and its implementation thereof.
With the Indian economy moving on to a high growth trajectory, consumption levels
soaring and investment riding high, the Indian banking sector is at a defining
moment.
A rapidly growing economy, financial sector reforms, rising foreign investment,
favorable regulatory climate and demographic profile has led to India becoming one
of the fastest growing banking markets in the world. It is generally agreed the
implementation of Basel II is likely to provide momentum for mergers and
acquisitions in the Indian banking industry.
With all this, there is the proposal for the implementation of Basel II Norms.
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METHODOLOGY
Research type Descriptive Research
Here, we are under going to have descriptive research i.e. analysis of banks financial
statements which will make us understand the position of one bank in comparison
of another and their financial position.
Data Source
1) PRIMARY DATA
Banks balance sheet, Banks income statement & Basel II Disclosures.
2)SECONDARY DATA
Banks prospectus, journals, papers & articles, annual reports and otherrelated websites
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INTRODUCTION TO BANKING SECTOR
Indian Banking Industry
Banking in India originated in the first decade of 18th century with The General
Bank of India coming into existence in 1786. This was followed by Bank of
Hindustan. Both these banks are now defunct. The oldest bank in existence in India
is the State Bank of India being established as "The Bank of Bengal" in Calcutta in
June 1806. A couple of decades later, foreign banks like Credit Lyonnais started their
Calcutta operations in the 1850s. At that point of time, Calcutta was the most active
trading port, mainly due to the trade of the British Empire, and due to which
banking activity took roots there and prospered. The first fully Indian owned bank
was the Allahabad Bank, which was established in 1865.
By the 1900s, the market expanded with the establishment of banks such as Punjab
National Bank, in 1895 in Lahore and Bank of India, in 1906, in Mumbai - both of
which were founded under private ownership. The Reserve Bank of India formally
took on the responsibility of regulating the Indian banking sector from 1935. After
India's independence in 1947, the Reserve Bank was nationalized and given
broader powers.
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Nationalization
By the 1960s, the Indian banking industry had become an important tool to facilitate
the development of the Indian economy. At the same time, it emerged as a large
employer, and a debate has ensued about the possibility to nationalize the banking
industry. Indira Gandhi, the-then Prime Minister of India expressed the intention of
the GOI in the annual conference of the All India Congress Meeting in a paper
entitled "Stray thoughts on Bank Nationalization." The paper was received with
positive enthusiasm. Thereafter, her move was swift and sudden, and the GOI
issued an ordinance and nationalized the 14 largest commercial banks with effect
from the midnight of July 19, 1969.
A second dose of nationalization of 6 more commercial banks followed in 1980. The
stated reason for the nationalization was to give the government more control of
credit delivery. With the second dose of nationalization, the GOI controlled around
91% of the banking business of India.
After this, until the 1990s, the nationalized banks grew at a pace of around 4%, closerto the average growth rate of the Indian economy.
Liberalization
In the early 1990s the then Narasimha Rao government embarked on a policy of
liberalization and gave licenses to a small number of private banks, which came to
be known as New Generation tech-savvy banks, which included banks such as UTI
Bank(now re-named as Axis Bank) (the first of such new generation banks to be set
up), ICICI Bank and HDFC Bank. This move, along with the rapid growth in the
economy of India, kick started the banking sector in India, which has seen rapid
growth with strong contribution from all the three sectors of banks, namely,
government banks, private banks and foreign banks.
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The next stage for the Indian banking has been setup with the proposed relaxation in
the norms for Foreign Direct Investment, where all Foreign Investors in banks may
be given voting rights which could exceed the present cap of 10%,at present it hasgone up to 49% with some restrictions.
The new policy shook the Banking sector in India completely. Bankers, till this time,
were used to the 4-6-4 method (Borrow at 4%; Lend at 6%;Go home at 4) of
functioning. The new wave ushered in a modern outlook and tech-savvy methods of
working for traditional banks. All this led to the retail boom in India. People not just
demanded more from their banks but also received more.
Current Situation
Currently (2007), banking in India is generally fairly mature in terms of supply,
product range and reach-even though reach in rural India still remains a challenge
for the private sector and foreign banks. In terms of quality of assets and capital
adequacy, Indian banks are considered to have clean, strong and transparent balance
sheets relative to other banks in comparable economies in its region. The Reserve
Bank of India is an autonomous body, with minimal pressure from the government.
The stated policy of the Bank on the Indian Rupee is to manage volatility but
without any fixed exchange rate-and this has mostly been true.
With the growth in the Indian economy expected to be strong for quite some time-
especially in its services sector-the demand for banking services, especially retail
banking, mortgages and investment services are expected to be strong. One may also
expect M&As, takeovers, and asset sales.
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In March 2006, the Reserve Bank of India allowed Warburg Pincus to increase its
stake in Kotak Mahindra Bank (a private sector bank) to 10%. This is the first time an
investor has been allowed to hold more than 5% in a private sector bank since the
RBI announced norms in 2005 that any stake exceeding 5% in the private sectorbanks would need to be vetted by them.
Currently, India has 88 scheduled commercial banks (SCBs) - 28 public sector banks
(that is with the Government of India holding a stake), 29 private banks (these do not
have government stake; they may be publicly listed and traded on stock exchanges)
and 31 foreign banks. They have a combined network of over 53,000 branches and
17,000 ATMs. According to a report by ICRA Limited, a rating agency, the public
sector banks hold over 75 percent of total assets of the banking industry, with the
private and foreign banks holding 18.2% and 6.5% respectively.
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INTRODUCTION TO BASEL II NORMS
In the four years since it was introduced by the Basel Committee for Banking
Supervision, the Basel II Capital Accord has evolved as a complex set ofrecommendations that will likely create avariety of regulatory compliance challenges
for banks in Europe and around the globe.
More important, however, are the wide range of business implications and risk
management challenges that Basel II (the New Accord) could trigger for banks,
their non-bank competitors, customers, rating agencies, regulators, and, ultimately,
the global capital markets.
For example:
_ Banks will be asked to implement an enterprise-wide risk management framework
that ties regulatory capital to economic capital.
_ Non-banks outside the scope of Basel II will not face its compliance challenges but
may nonetheless want to use it as a competitive benchmark.
_ Bank customers will need to collect and disclose new information and likely will
face new risk structures as a result of increased transparency.
_ Rating agencies have new prominence under Basel II and thus could experience
new competition.
_ Regulators are asked to provide a level playing field as the Basel Committees
recommendations are implemented by legislatures in various countries.
_ The global banks could experience extended trends toward securitization as
financial institutions adapt to Basel II requirements.
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The complexity of the New Accord, as well as its interdependencies with
International Financial Reporting Standards and local regulation worldwide, makes
implementation of Basel II a highly complex project. For a bank, a project will be
driven by the structure of its business, beginning with its strategy and encompassingits risk management and capital calculation methods, business processes, data
requirements, and IT systems. With a structured and disciplined approach, banks
can begin to achieve the Basel Committees intended benefits of enhanced risk
management and lower capital requirements. Such changes, in turn, could influence
banks strategies, customer relations, and, over time, their business models.
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CAPITAL ADEQUACY
Capital Adequacy is a measure that ensures that the banks have enough capital toabsorb a reasonable amount of loss in any adverse situations. It is calculated using
the Capital Adequacy Ratio (CAR). Capital Adequacy Ratio is also called as called
Capital to Risk Assets Ratio.
Capital adequacy ratio is the ratio, which determines the capacity of the bank in
terms of meeting the time liabilities and other risk such as credit risk, operational
risk, etc. In the simplest formulation, a bank's capital is the "cushion" for potential
losses, which protects the bank's depositors or other lenders. Banking regulators in
most countries define and monitor CAR to protect depositors, thereby maintaining
confidence in the banking system.
Since different types of assets have different risk profiles, CAR primarily adjusts for
assets that are less risky by allowing banks to "discount" lower-risk assets. The
specifics of CAR calculation vary from country to country, but general approaches
tend to be similar for countries that apply the Basel Accords.
In the most basic application, government debt is allowed a zero percent "riskweightage" this is because in case of losses or non-repayment of loans the
government takes care of the payments. Thus they are subtracted from total assets
for purposes of calculating the CAR.
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Objectives of CAR: The fundamental objective behind the norms is to strengthen the
soundness and stability of the banking system.
Capital Adequacy Ratio or CAR or CRAR: It is ratio of capital fund to risk weighted
assets expressed in percentage terms i.e.
Minimum requirements of capital fund in India:
* Existing Banks 09 %
* New Private Sector Banks 10 %
* Banks undertaking Insurance business 10 %
* Local Area Banks 15%
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NEED FOR BASEL II NORMS
In 1988 the Bank for International Settlements Basel Committee on BankingSupervision, commonly known as the Basel Committee, imposed the Basel Capital
Accord. The Basel Capital Accord introduced a system for implementing a credit risk
framework for determining the minimum amount of capital that a bank must hold
as a cushion against risks. The Basel Capital Accord was adopted over time not only
in member countries, but in virtually all countries operating international banks.
One problem with the original Basel Capital Accord was that it took a "one size fitsall" approach, without regard for the actual operational risk incurred by the bank. In
2004, the Basel II Accord was established. The new accord aligns the requirement for
capital on hand with the actual risk involved, providing an incentive for banks to
improve risk management.
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 ofBasel 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 risk 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 requirementsdesigned 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.
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Thus Indian banks require Basel II compliance for the
following reasons:-
1) Basel II norms will facilitate introduction of new complex financial products in
Indian Banking Sector.
2) Indian banks require a more risk sensitive framework. There is improvement in
risk management system by Indian banks.
3) New rules will provide a range of options for estimating regulatory capital and
will reduce gap between regulatory capital & economic capital.
Indian banks today, operate in an environment characterized by progressive
deregulation, in- creased global integration and IT usage which have opened up a
plethora of domestic and international opportunities for them. In light of this, RBI
has enforced mandatory adoption of Basel II guidelines for Indian banks which are a
set of prudential regulatory norms with an almost universal acceptance.
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SCOPE OF APPLICATION
This Framework will be applied on a consolidated basis to internationally activebanks. The scope of application of the Framework will include, on a fully
consolidated basis, any holding company that has the parent entity within a banking
group to ensure that it captures the risk of the whole banking group. The Framework
will also apply to all internationally active banks at every tier within a banking
group, also on a fully consolidated basis. A three-year transitional period for
applying full sub-consolidation will be provided for those countries where this is not
currently a requirement.
Further, as one of the principal objectives of supervision is the protection of
depositors, it is essential to ensure that capital recognized in capital adequacy
measures is readily available for those depositors. Accordingly, supervisors should
test that individual banks are adequately capitalized on a stand-alone basis.
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Diversified Financial
Group
Holding Company
Internationally
Active Bank
Internationally
Active Bank
Domestic
Banks
Internationally
Active Bank
Securities Firm
[1]
[2]
[3] [4]
[1] Boundary of predominant banking group. The framework is applied at this levelon a consolidated basis, i.e. up to holding company level.
[2] [3] & [4] : The framework is also applied to lower levels to all internationally
active banks on a consolidated basis.
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HISTORY OF BASEL II
The initial Basel Accord in 1988 was based on a simple model to measure capital. Intoday's world this approach is less meaningful for many banks. For example, in the
1998 Accord the risk was based across exposure groups and not the individual
elements of credit worthiness within these groups. There have been many advances
which will allow a more detailed approach to calculating Capital, such as better
Credit ratings information and the development of Information technology.
Also, improvements in internal processes and better risk management practices such
as securitisation have changed leading organisations monitoring and management of
exposures and activities. Supervisors and sophisticated banking organisations have
found that the static rules set out in the 1988 Accord have not kept pace with
advances in sound risk management practices. It's likely that existing capital
regulations may not reflect banks actual business practices.
The upgraded Basel II Framework relates more to the underlying risks in banking
and provides better incentives for improved risk management. It builds on the 1988
Accords basic structure for setting capital requirements and improves the capital
frameworks sensitivity to the risks that banks actually face. This will be achieved in
part by aligning capital requirements more closely to the risk of credit loss and by
introducing a new capital charge for exposures to the risk of loss caused by
operational failures.
Basel will demand that a certain minimum Capital requirement is met, as well as
another two important factors, the Supervisory Role and Market Discipline.
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'DRAFT' GUIDELINES FOR IMPLEMENTATION OF BASEL II IN INDIA
The Basel Committee on Banking Supervision (BCBS) has released the document,
"International Convergence of Capital Measurement and Capital Standards: ARevised Framework" on June 26, 2004. The revised Framework has been designed to
provide options for banks and banking systems, for determining the capital
requirements for credit risk and operational risk and enables banks / supervisors to
select approaches that are most appropriate for their operations and financial
markets. The Framework is expected to promote adoption of stronger risk
management practices in banks.
The Revised Framework, popularly known as Basel II, builds on the current
framework to align regulatory capital requirements more closely with underlying
risks and to provide banks and their supervisors with several options for assessment
of capital adequacy. Basel II is based on three mutually reinforcing pillars -
minimum capital requirements, supervisory review, and market discipline. The
three pillars attempt to achieve comprehensive coverage of risks, enhance risk
sensitivity of capital requirements and provide a menu of options to choose for
achieving a refined measurement of capital requirements.
The Revised Framework consists of three-mutually reinforcing Pillars, viz. minimum
capital requirements, supervisory review of capital adequacy, and market discipline.
Under Pillar 1, the Framework offers three distinct options for computing capital
requirement for credit risk and three other options for computing capital
requirement for operational risk. These approaches for credit and operational risks
are based on increasing risk sensitivity and allow banks to select an approach that is
most appropriate to the stage of development of bank's operations.
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The approaches available for computing capital for credit risk are StandardisedApproach, Foundation Internal Rating Based Approach and Advanced Internal
Rating Based Approach. The approaches available for computing capital for
operational risk are Basic Indicator Approach, Standardised Approach and
Advanced Measurement Approach.
With a view to ensuring migration to Basel II in a non-disruptive manner, the
Reserve Bank has adopted a consultative approach. A Steering Committee
comprising of senior officials from 14 banks (private, public and foreign) has been
constituted where Indian Banks' Association is also represented.
Keeping in view the Reserve Bank's goal to have consistency and harmony with
international standards it has been decided that at a minimum, all banks in India
will adopt Standardized Approach for credit risk and Basic Indicator Approach for
operational risk with effect from March 31, 2007. After adequate skills are developed,
both in banks and at supervisory levels, some banks may be allowed to migrate to
IRB Approach after obtaining the specific approval of Reserve Bank.
As the Basel II Capital Accord continues to evolve, the Basel Committee on Banking
Supervision1 moves closer to its goal of aligning banking risks and their
management with capital requirements. By redefining how banks worldwide
calculate regulatory capital and report compliance to regulators and the public,
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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.
While the 1988 Capital Accord addressed market and credit risks, Basel II
substantially changes the treatment of credit risk and also requires that banks have
sufficient capital to cover operational risks. It also imposes qualitative requirements
on the management of all risks as well as new disclosures Basel II is scheduled to be
implemented by various country bank regulators by the end of 2006, but banks must
begin compliance efforts now if they are to strengthen their risk management
capabilities and gather the extensive data that is required in some cases. They should
make these efforts despite uncertainty about how local regulators will ultimately
apply the New Accord to their regulatory capital requirements.
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. Indeed, calculating capital
requirements under the New Accord requires a bank to implement a comprehensive
risk framework across the institution. The risk management improvements that are
the intended result may be rewarded by lower capital requirements. However, large
implementation projects will likely have wide-ranging effects on a banks
information technology systems, processes, people, and businessbeyond the
regulatory compliance and finance functions.
Basel II also encourages ongoing improvements in risk assessment and mitigation.
Thus, over time, it presents banks with the 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 compliance, as envisioned by the Basel Committee.
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Since the first consultative paper on the New Accord was issued in July 1999, some
banks have tended to treat compliance with Basel II as a technical issue. In fact, forinstitutions worldwide, Basel II compliance is a risk management challenge with
strategic business implications. Indeed, even those institutions that are not required
to comply with the New Accord will likely tend to use it as a risk management
benchmark so they may remain competitive with those that must comply.
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TIME LINE FOR BASEL II IMPLEMENTATION
The capital allocation under Basel II is more risk sensitive and comprehensive and its
implementation would result in improved risk management at banks. Nevertheless
the implementation of New Accord is by no means an easy task especially in
countries where risk management in banks is at its infancy stage. The proposed
implementation plan has been prepared on the basis of;
a) Feedback obtained from the banksb) Assessment of financial impact derived from quantitative Impact Study
carried out by Banking Supervision Department
c) Implementation of Basel II across various countries, especially in developingeconomies.
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Basel II Creates Advantages and Disadvantages for Banks Business
With Basel IIs implementation, banks average capital requirements should not
change significantly on an industry level, but an individual bank may experience a
significant change. For example, capital requirements should drop substantially at a
bank with a prime business portfolio that is well collateralized. On the other hand, a
bank with a high-risk portfolio will likely face higher capital requirements and,
consequently, limits on its business potential. Those deemed high risk couldinclude banks that are pure risk takers with a buy-and-hold credit management
approach, no clear customer segmentation, a lack of collateral management as well
as inadequate processes, unstable IT systems, and a poor overall risk management
function. Indeed, such entities may not be able to make the necessary investment in
compliance; thus, consolidation in the banking industry can be expected to continue
in certain regions and markets. As Basel II helps banks differentiate customers by
risk, advantages and disadvantages will likely emerge for bank customers.
Those with a possible advantage:
_ Prime mortgage customers
_ Well-rated entities
_ High-quality liquidity portfolios
_ Collateralized and hedged exposures
_ Small and medium-sized businesses
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Those with a possible disadvantage:
_ higher credit risk individuals_ Uncollateralized credit
_ specialized lending (in some cases)
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PILLAR I: MINIMUM CAPITAL REQUIREMENT
Introduction:
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.
The credit risk component can be calculated in three different ways of varying
degree of sophistication, namely standardized approach, Foundation IRB and
Advanced IRB. IRB stands for "Internal Rating-Based Approach".
For operational risk, there are three different approaches - basic indicator approach
or BIA, standardized approach or TSA, and the internal measurement approach (an
advanced form of which is the advanced measurement approach or AMA).
For market risk the preferred approach is VaR (value at risk).
As the Basel 2 recommendations are phased in by the banking industry it will move
from standardized requirements to more refined and specific requirements that have
been developed for each risk category by each individual bank. The upside for banks
that do develop their own bespoke risk measurement systems is that they will be
rewarded with potentially lower risk capital requirements. In future there will be
closer links between the concepts of economic profit and regulatory capital.
Credit Risk can be calculated by using one of three approaches:
1. Standardized Approach
2. Foundation IRB (Internal Ratings Based) Approach
3. Advanced IRB Approach
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The standardized approach sets out specific risk weights for certain types of credit
risk. The standard risk weight categories are used under Basel 1 and are 0% for short
term government bonds, 20% for exposures to OECD Banks, 50% for residential
mortgages and 100% weighting on unsecured commercial loans. A new 150% ratingcomes in for borrowers with poor credit ratings. The minimum capital requirement
(the percentage of risk weighted assets to be held as capital) remains at 8%.
For those Banks that decide to adopt the standardized ratings approach they will be
forced to rely on the ratings generated by external agencies. Certain Banks are
developing the IRB approach as a result.
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TYPES OF RISKS
Credit risk
A bank always faces the risk that some of its borrowers may renege on their
promises for timely repayments of loan, interest on loan or meet the other terms of
contract. This risk is called credit risk, which varies from borrower to borrower
depending on their credit quality. Basel II requires banks to accurately measure
credit risk to hold sufficient capital to cover it.
Factors affecting credit risk can be summarized by the following formula:
Expected Loss (EL) on a loan = Exposure at default (EAD) * Loss given default
(LGD) * Probability of Default (PD)
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The bank can also suffer losses in excess of expected losses, say, during economic
downturns. These losses are called unexpected losses. Ideally, a bank should recover
expected loss on a loan from its customer through loan pricing. The capital base is
required to absorb the unexpected losses, as and when they arise.
Market risk
As part of the statutory requirement, in the form of SLR (statutory liquidity ratio),
banks are required to invest in liquid assets such as cash, gold, government and
other approved securities. For instance, Indian banks are required to invest 25 per
cent of their net demand and term liabilities in cash, gold, government securities and
other eligible securities to comply with SLR requirements.
Such investments are risky because of the change in their prices. This volatility in the
value of a bank's investment portfolio in known as the market risk, as it is driven by
the market. The change in the value of the portfolio can be due to changes in the
interest rates, foreign exchange rates or the changes in the values of equity or
commodities.
Operational risk
Several events that are neither due to default by third party nor because of the
vagaries of the market. These events are called operational risks and can be
attributed to internal systems, processes, people and external factors.
Pillar I ensures that banks measure their risks properly and maintain adequate
capital to cover them. But can Pillar I alone ensure that there are no more bank
failures? No. As any stable structure cannot stand on a single pillar, Basel II relies on
the pillars of supervisory reviews and market discipline to keep the banks healthy.
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:--The structure of several operational risk measurement methodologies.
The Basic Indicator approach
The Basic Indicator Approach is the simplest, but it will charge the most capital
generally. It's based on a straight percentage of gross income, which includes net
interest income and net non-interest income but excludes extraordinary or irregular
items. While this approach may roughly capture the scale of an institutions
operations, it surely has only the most questionable link to the risk of an expected
loss due to internal or external events.
The Standardized Approach
The concept for applying the Standardized Approach is basically the same as the
Basic Indicator Approach. The main difference between the two is that The
Standardized Approach must divide the banks business operations into 8 business
lines: corporate finance, trading & sales, retail banking, commercial banking,
payment & settlement, agency services, asset management, and retail brokerage.
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Business Lines Risk Weights
Corporate finance 18%Trading and sales 18%
Retail Banking 12%Commercial Banking 15%Payment and Settlement 18%Agency Services 15%Asset Management 12%Retail Brokerage 12%
:--Percentage of the relative weighting of the business lines
In the Standardized Approach, the gross income is measured for each business line,not the whole institution. For example: in corporate finance, the indicator is the gross
income generated in the corporate finance business line.
The Advanced Measurement Approach
As one can see, the gross income is the basis for calculating a capital charge for both
the Basic Indicator and Standardized Approaches. In practice, these two approaches
calculate the most capital charges, compared to the Advanced Measurement
Approach.
The Advanced Measurement Approach (AMA) is the last approach. This approach
charges the least amount of capital; also this approach is comparatively more
sophisticated. However, going by the sophistication of the AMA from the
perspective of the cost beneficial factor, it will perhaps be wrong to conclude that it
is thus far the best approach, for some banks. Consider that only large banks have
the financial power to implement this approach and also make it profitable. The
AMA, however, offers the greatest possibility to reduce capital requirements. It
includes three approaches, namely the internal measurement approach (IMA), the
scorecard approach and the Loss Distribution Approach.
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TIER I CAPITALIn order to protect the integrity of Tier 1 capital, the Committee has determined that
minority interests in equity accounts of consolidated subsidiaries that take the form
of SPVs should only be included in Tier 1 capital if the underlying instrument meets
the following requirements which must, at a minimum, be fulfilled by all
instruments included in Tier 1:
issued and fully paid;
non-cumulative;
able to absorb losses within the bank on a going-concern basis;
junior to depositors, general creditors, and subordinated debt of the bank;
permanent;
neither be secured nor covered by a guarantee of the issuer or related entity or
other arrangement that legally or economically enhances the seniority of the
claim vis--vis bank creditors; and
callable at the initiative of the issuer only after a minimum of five years with
supervisory approval and under the condition that it will be replaced withcapital of same or better quality unless the supervisor determines that the
bank has capital that is more than adequate to its risks.
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TIER II CAPITAL:
1. Undisclosed reserves
Under this heading are included only reserves which, though unpublished, have
been passed through the profit and loss account and which are accepted by the
bank's supervisory authorities.
2. Revaluation reserves
Some countries, under their national regulatory or accounting arrangements, allow
certain assets to be revalue to reflect their current value, or something closer to their
current value than historic cost, and the resultant revaluation reserves to be included
in the capital base.
3. General provisions/general loan-loss reserves
General provisions or general loan-loss reserves are created against the possibility of
losses not yet identified. Where they do not reflect a known deterioration in the
valuation of particular assets, these reserves qualify for inclusion in Tier 2 capital.
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4. Hybrid debt capital instruments
In this category fall a number of capital instruments which combine certain
characteristics of equity and certain characteristics of debt. Each of these has
particular features which can be considered to affect its quality as capital.
5. Subordinated term debt
The Committee is agreed that subordinated term debt instruments have significant
deficiencies as constituents of capital in view of their fixed maturity and inability toabsorb losses except in liquidation.
Both Tier I and Tier II capital were first defined in the Basel I capital accord. More
specifically, Tier I Capital is a measure of capital adequacy of a bank, and is the ratio
of a bank's core equity capital to its total risk-weighted assets.
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TIER III CAPITAL:
Tier III capital consists of short-term subordinated debt maintained for the solepurpose of meeting a portion of the capital requirements for market risks, subject to
the condition that PDs (Perpetual Debts) will be entitled to use Tier-II capital solely
to support market risks. This means that capital requirements arising in respect of
credit and counter-party risk, including the credit counter-party risk in respect of
derivatives, need to be met by Tier-I and Tier-II capital only. The sum total of Tier-II
plus Tier-III capital should not exceed the total Tier-I capital.
Risk weighted assets is the total of all assets held by the bank which are weighted for
credit risk according to a formula determined by the Regulator (usually the country's
Central Bank). Most Central Banks follow the BIS - Bank of International Settlements
guidelines in setting asset risk weights. Assets like cash and coins usually have zero
risk weights, while unsecured loans might have a risk weight of 100%.
The first pillar sets out minimum capital requirement. The new framework
maintains minimum capital requirement of 8% of risk assets. In India though, RBI
norms on capital requirement is at 9%, which is more stringent than the Basel
Committee stipulation of 8%.
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Under the new accord capital adequacy ratio will be measured as under
Capital Adequacy Ratio (CAR) = Total Capital
Risk Weighted Assets
i.e. CAR = Tier I Capital + Tier II Capital +Tier III Capital
Credit risk + Market risk + Operational risk
(Tier III capital has not yet been introduced in India.)
Basel II focuses on improvement in measurement of risks. The revised credit risk
measurement methods are more elaborate than the current accord. It proposes, for
the first time, a measure for operational risk, while the market risk measure remains
unchanged
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PILLAR II: SUPERVISORY REQUIREMENTS
Introduction:This section discusses the key principles of supervisory review, supervisory
Transparency and accountability and risk management guidance produced by the
Committee with respect to banking risks, including guidance pertaining to the
treatment of interest rate risk in the banking book
Pillar II is based on a series of four key principles of supervisory Review. These
principles address two central issues:
1) The need for banks to assess capital adequacy relative to risks overall, and
2) The need for supervisors to review banks assessments and, consequently, to
determine whether to require banks to hold additional capital beyond that required
under Pillar I.
To comply with Pillar II, banks must implement a consistent risk-adjusted
management framework that is comparable in its sophistication to, and closely
linked with, the risk approaches the bank chose under Pillar I. The four principles
provide necessary guidance, as does the Basel Committees other guidance related to
the supervisory review process.
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FOUR KEY PRINCIPLES OF SUPERVISORY REVIEW
The Committee has identified four key principles of supervisory review, which are
discussed in the Supervisory Review Process.
The four key principles complement those outlined in the extensive supervisory
guidance that has been developed by the Basel Committee, the keystone of which is
the Core Principles for Effective Banking Supervision and the Core Principles
Methodology.
Principle 1: Banks should have a process for assessing their overall capitaladequacy in relation to their risk profile and a strategy for maintaining
their capital levels.
Banks must be able to demonstrate that chosen internal capital targets are well
founded and these targets are consistent with their overall risk profile and current
operating environment. In assessing capital adequacy, bank management needs to
be mindful of the particular stage of the business cycle in which the bank is
operating. Rigorous, forward looking stress testing that identifies possible events or
changes in market conditions that could adversely impact the bank should be
performed. Bank management clearly bears primary responsibility for ensuring that
the bank has adequate capital to support its risks.
The five main features of a rigorous process are as follows:
1. Board and senior management oversight;2. Sound capital assessment;3. Comprehensive assessment of risks;4. Monitoring and reporting; and5. Internal control review.
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1. BOARD AND SENIOR MANAGEMENT OVERSIGHT
A sound risk management process is the foundation for an effective assessment of
the adequacy of banks. Capital positions. Bank management is responsible forunderstanding the nature and level of risk being taken by the bank and how these
risks relate to adequate capital levels. It is also responsible for ensuring that the
formality and sophistication of the risk management processes are appropriate in
light of the risk profile and business plan. The analysis of banks. current and future
capital requirements in relation to strategic objectives is a vital element of the
strategic planning process.
This section of the paper refers to a management structure composed of a board of
directors and senior management. The Committee is aware that there are significant
differences in legislative and regulatory frameworks across countries as regards the
functions of the board of directors and senior management. In some countries, the
board has the main, if not exclusive, function of supervising the executive body
(senior management, general management) so as to ensure that the latter fulfils its
tasks. For this reason, in some cases, it is known as a supervisory board. This means
that the board has no executive functions. In other countries, by contrast, the board
has a broader competence in that it lays down the general framework for the
management of the bank.
Owing to these differences, the notions of the board of directors and senior
management are used in this section not to identify legal constructs but rather to
label two decision-making functions within a bank. clearly outline the banks capital
needs, anticipated capital expenditures, desirable capital level, and external capital
sources. Senior management and the board should view capital planning as a crucial
element in being able to achieve its desired strategic objectives. The banks board of
directors has responsibility for setting the banks tolerance for risks. They should
also ensure that management establishes a measurement system for assessing the
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various risks, develops a system to relate risk to the banks capital level, and
establishes a method for monitoring compliance with internal policies. It is likewise
important that the board of directors adopts and supports strong internal controls
and written policies and procedures and ensures that management effectivelycommunicates these throughout the organisation.
2. SOUND CAPITAL ASSESSMENT
Fundamental elements of sound capital assessment include:
1. Policies and procedures designed to ensure that the bank identifies, measures,and reports all material risks;
2. a process that relates capital to the level of risk;3. a process that states capital adequacy goals with respect to risk, taking
account of the banks strategic focus and business plan; and
4. a process of internal controls, reviews and audit to ensure the integrity of theoverall management process.
3. COMPREHENSIVE ASSESSMENT OF RISKS
All material risks faced by the bank should be addressed in the capital assessment
process. While it is recognised that not all risks can be measured precisely, a process
should be developed to estimate risks. Therefore, the following risk exposures,
which by no means constitute a comprehensive list of all risks, should be considered.
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Credit risk: Banks should have methodologies that enable them to assess the credit
risk involved in exposures to individual borrowers or counterparties as well as at the
portfolio level. For more sophisticated banks, the credit review assessment of capital
adequacy, at a minimum, should cover four areas: risk rating systems, portfolioanalysis/aggregation, securitisation/complex credit derivatives, and large exposures
and risk concentrations. Internal risk ratings are an important tool in monitoring
credit risk. Internal risk ratings should be adequate to support the identification and
measurement of risk from all credit exposures, and should be integrated into an
institutions overall analysis of credit risk and capital adequacy. The ratings system
should provide detailed ratings for all assets, not only for criticised or problem
assets. Loan loss reserves should be included in the credit risk assessment for capital
adequacy.
The analysis of credit risk should adequately identify any weaknesses at the
portfolio level, including any concentrations of risk. It should also adequately take
into consideration the risks involved in managing credit concentrations and other
portfolio issues through such mechanisms as securitisation programs and complex
credit derivatives. Further, the analysis of counterparty credit risk should include
consideration of public evaluation of the supervisors compliance with the Core
Principles of Effective Banking Supervision.
Market risk: This assessment is based largely on the banks own measure of value-
at-risk. Emphasis should also be on the institution performing stress testing in
evaluating the adequacy of capital to support the trading function.
Interest rate risk in the banking book: The measurement process should include all
material interest rate positions of the bank and consider all relevant reprising and
maturity data. Such information will generally include: current balance and
contractual rate of interest associated with the instruments and portfolios, principal
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payments, interest reset dates, maturities, and the rate index used for reprising and
contractual interest rate ceilings or floors for adjustable-rate items. The system
should also have well-documented assumptions and techniques. Regardless of the
type and level of complexity of the measurement system used, bank managementshould ensure the adequacy and completeness of the system. Because the quality
and reliability of the measurement system is largely dependent on the quality of the
data and various assumptions used in the model, management should give
particular attention to these items.
Liquidity Risk: Liquidity is crucial to the ongoing viability of any banking
organisation. Banks. Capital positions can have an effect on their ability to obtain
liquidity, especially in a crisis. Each bank must have adequate systems for
measuring, monitoring and controlling liquidity risk. Banks should evaluate the
adequacy of capital given their own liquidity profile and the liquidity of the markets
in which they operate.
Other risk: The Committee recognises that within the other risk category,
operational risk tends to be more measurable than risks such as strategic and
reputational. The Committee wants to enhance operational risk assessment efforts by
encouraging the industry to develop methodologies and collect data related to
managing operational risk. For the purposes of measurement under Pillar 1 the
Committee expects the industry to focus primarily upon the operational risk
component of other risks. However, it also expects the industry to further develop
techniques for measuring, monitoring and mitigating all aspects of other risks.
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4. MONITORING AND REPORTING
The bank should establish an adequate system for monitoring and reporting risk
exposures and how the banks changing risk profile affects the need for capital. Thebanks senior management or board of directors should, on a regular basis, receive
reports on the banks risk profile and capital needs.
These reports should allow senior management to:
1. evaluate the level and trend of material risks and their effect on capital levels;2. evaluate the sensitivity and reasonableness of key assumptions used in the
capital assessment measurement system;
3. determine that the bank holds sufficient capital against the various risks andthat they are in compliance with established capital adequacy goals; and
4. assess its future capital requirements based on the bank.s reported risk profileand make necessary adjustments to the banks strategic plan accordingly.
5. INTERNAL CONTROL REVIEW
The banks internal control structure is essential to the capital assessment process.
Effective control of the capital assessment process includes an independent review
and, where appropriate, the involvement of internal or external audits. The banks
board of directors has a responsibility to ensure that management establishes ameasurement system for assessing the various risks, develops a system to relate risk
to the bank.s capital level, and establishes a method for monitoring compliance with
internal policies. The board should regularly verify whether its system of internal
controls is adequate to ensure well-ordered and prudent conduct of business. The
bank should conduct periodic reviews of its risk management process to ensure its
integrity, accuracy, and reasonableness.
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Areas that should be reviewed include:
1. the appropriateness of the bank.s capital assessment process given the nature,scope and complexity of its activities;
2. the identification of large exposures and risk concentrations;3. the accuracy and completeness of data inputs into the banks assessment
process;
4. the reasonableness and validity of scenarios used in the assessment process,and
5. stress testing and analysis of assumptions and inputs.
Principle 2: Supervisors should review and evaluate banks internal capitaladequacy assessments and strategies, as well as their ability to monitor and
ensure their compliance with regulatory capital ratios. Supervisors should
take appropriate supervisory action if they are not satisfied with the result
of this process.
The supervisory authorities should regularly review the process by which banks
assess their capital adequacy, the risk position of the bank, the resulting capital
levels and quality of capital held. Supervisors should also evaluate the degree to
which banks have in place a sound internal process to assess capital adequacy. Theemphasis of the review should be on the quality of the bank.s risk management and
controls and should not result in supervisors functioning as bank management.
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The periodic review can involve some combination of:
1. on-site examinations or inspections;2. off-site review;3. discussions with bank management;4. review of work done by external auditors (provided it is adequately focused
on the necessary capital issues), and
5. periodic reporting.
The substantial impact that errors in the methodology or assumptions of formal
analyses can have on resulting capital requirements requires a detailed review by
supervisors of each banks internal analysis.
(i) Review of adequacy of risk assessment
Supervisors should assess the degree to which internal targets and processes
incorporate the full range of material risks faced by the bank. Supervisors should
also review the adequacy of risk measures used in assessing internal capital
adequacy and the extent to which these risk measures are also used operationally in
setting limits, evaluating business line performance and evaluating and controlling
risks more generally. Supervisors should consider the results of sensitivity analyses
and stress tests conducted by the institution and
how these results relate to capital plans.
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(ii) Assessment of capital adequacy
Supervisors should review the banks processes to determine:
1. that the target levels of capital chosen are comprehensive and relevant to thecurrent operating environment;
2. that these levels are properly monitored and reviewed by seniormanagement; and
3. that the composition of capital is appropriate for the nature and scale of thebanks business.
Supervisors should also consider the extent to which the bank has provided for
unexpected events in setting its capital levels. This analysis should cover a wide
range of external conditions and scenarios, and the sophistication of techniques and
stress tests used
should be commensurate with the bank.s activities.
(iii) Assessment of the control environment
Supervisors should consider the quality of the banks management information
reporting and systems, the manner in which business risks and activities are
aggregated, and managements record in responding to emerging or changing risks.
In all instances, the economic capital levels at individual banks should be
determined according to the banks risk profile and adequacy of its risk management
process and internal controls. External factors such as business cycle effects and themacroeconomic environment should also be considered.
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(iv) Supervisory review of compliance with minimum standards
In order for certain internal methodologies, credit risk mitigation techniques and
asset securitisations to be recognised for regulatory capital purposes, banks willneed tomeet a number of requirements, including risk management standards and
disclosure. Inparticular, banks will be required to disclose features of their internal
methodologies used in calculating minimum capital requirements. As part of the
supervisory review process,supervisors must ensure that these conditions are being
met on an ongoing basis.The Committee regards this review of minimum standards
and qualifying criteria asan integral part of the supervisory review process under
Principle 2. In setting the minimum criteria the Committee has considered current
industry practice and so anticipates that these minimum standards will provide
supervisors with a useful set of benchmarks which are aligned with bank
management expectations for effective risk management and capitalallocation.There
is also an important role for supervisory review of compliance with certain
conditions and requirements set for standardised approaches. In this context, there
will be aparticular need to ensure that use of various instruments that can reduce
Pillar 1 capitalrequirements are utilised and understood as part of a sound, tested,
and properlydocumented risk management process.
(v) Supervisory response
Having carried out the review process described above, supervisors should take
appropriate action if they are not satisfied with the results of the banks own riskassessment and capital allocation. Supervisors should consider a range of actions,
such as those set out under Principle 3 and 4 below.
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Principle 3: Supervisors should expect banks to operate above theminimum regulatory capital ratios and should have the ability to require
banks to hold capital in excess of the minimum.
Pillar 1 capital requirements will include a buffer for uncertainties surrounding the
Pillar 1 regime which affect the banking population as a whole. Bank-specific
uncertainties will be treated under Pillar 2. It is anticipated that such buffers under
Pillar 1 will be set to provide reasonable assurance that banks with good internal
systems and controls, a well diversified risk profile and a business profile well
covered by the Pillar 1 regime, and who operate with capital equal to Pillar 1
requirements will meet the minimum goals for soundness embodied in Pillar 1.
Supervisors will need to consider, however, whether the particular features of the
markets for which it is responsible are adequately covered.
Supervisors will typically require (or encourage) banks to operate with a buffer, over
and above the Pillar 1 standard.
Banks should maintain this buffer for a combination of the following:
(a) Pillar 1 minimums are anticipated to be set to achieve a level of bank
creditworthiness in markets that is below the level of creditworthiness sought by
many banks for their own reasons. For example, most international banks appear to
prefer to be highly rated by internationally recognised rating agencies. Thus, banksare likely to chose to operate above Pillar 1 minimums for competitive reasons.
(b) In the normal course of business, the type and volume of activities will change, as
will the different risk requirements, causing fluctuations in the overall capital ratio.
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(c) It may be costly for banks to raise additional capital, especially if this needs to be
done quickly or at a time when market conditions are unfavourable.
(d) For banks to fall below minimum regulatory capital requirements is a seriousmatter. It may place banks in breach of the relevant law and/or prompt non-
discretionary corrective action on the part of supervisors.
(e) There may be risks, either specific to individual banks, or more generally to an
economy at large, that are not taken into account in Pillar 1.
There are several means available to supervisors for ensuring that individual banks
are operating with adequate levels of capital. Among other methods, the supervisor
may set trigger and target capital ratios or define categories above minimum ratios
(e.g. well capitalised and adequately capitalised) for identifying the capitalisation
level of the bank.
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Principle 4: Supervisors should seek to intervene at an early stage toprevent capital from falling below the minimum levels required to support
the risk characteristics of a particular bank and should require rapidremedial action if capital is not maintained or restored.
Supervisors should consider a range of options if they become concerned that banks
are not meeting the requirements embodied in the supervisory principles outlined
above. These actions may include intensifying the monitoring of the bank; restricting
the payment of dividends; requiring the bank to prepare and implement a
satisfactory capital adequacy restoration plan; and requiring the bank to raise
additional capital immediately. Supervisors should have the discretion to use the
tools best suited to the circumstances of the bank and its operating environment.
The permanent solution to banks difficulties is not always increased capital.
However, some of the required measures (such as improving systems and controls)
may take a period of time to implement. Therefore, increased capital might be used
as an interim measure while permanent measures to improve the bank.s position are
being put in place. Once these permanent measures have been put in place and have
been seen by supervisors to be effective, the interim increase in capital requirements
can be removed.
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PILLAR 3 : MARKET DISCIPLINE
Market discipline imposes strong incentives to banks to conduct their business in asafe, sound and effective manner. It is proposed to be effected through a series of
disclosure requirements on capital, risk exposure etc. so that market participants can
assess a banks capital adequacy. These disclosures should be made at least semi-
annually and more frequently if appropriate. Qualitative disclosures such as risk
management objectives and policies, definitions etc. may be published annually.
The third pillar greatly increases the disclosures that the bank must make. This is
designed to allow the market to have a better picture of the overall risk position of
the bank and to allow the counterparties of the bank to price and deal appropriately.
The new Basel Accord has its foundation on three mutually reinforcing pillars thatallow banks and bank supervisors to evaluate properly the various risks that banks
face and realign regulatory capital more closely with underlying risks. The first
pillar is compatible with the credit risk, market risk and operational risk. The
regulatory capital will be focused on these three risks. The second pillar gives the
bank responsibility to exercise the best ways to manage the risk specific to that bank.
Concurrently, it also casts responsibility on the supervisors to review and validate
banks risk measurement models.
The third pillar on market discipline is used to leverage the influence that other
market players can bring. This is aimed at improving the transparency in banks and
improves reporting.
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IMPLEMENTATION OF BASEL II NORMS
RBIs Initiative:
The Reserve Bank of India (RBI) has asked banks to move in the direction of
implementing the Basel II norms, and in the process identify the areas that need
strengthening. In implementing Basel II, the RBI is in favour of gradual convergence
with the new standards and best practices. The aim is to reach the global best
standards in a phased manner, taking a consultative approach rather than a directive
one. In anticipation of Basel II, RBI has requested banks to examine the choices
available to them and draw a roadmap for migrating to Basel II. The RBI has set up a
steering committee to suggest migration methodology to Basel II. RBI expects banks
to adopt the Standardized Approach for the measurement of Credit Risk and the
Basic Indicator Approach for the assessment of Operational Risk. RBI has also
specified that the migration to Basel II will be effective March 31, 2007 and has
suggested that banks should adopt the new capital adequacy guidelines and parallel
run effective April 1, 2006.
Gaining Benefit from Basel II
Reducing the Operational Risk chargeThe first pillar of the new accord includes the setting of an operational riskcharge. This charge is based on the banks risk of exposure to unexpected
internal and/or external losses. It is possible to reduce this charge by
increasing the sophistication of the operational risk assessment and
management processes employed.
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Measuring Operational RiskAlthough the activity of measuring indirect losses is recognized as being
difficult the Regulators consider a certain amount of capital necessary, to
cover expected as well as unexpected loss. This is due to the fact thatrelatively few banks make provision for expected operational risk loss.
Three approaches are proposed by the BASEL Accord for calculating the operational
risk capital charge:
Approach 1: The basic indicator approach
Approach 2: The standardized approach
Approach 3: The internal measurement approach.
The Basic Indicator ApproachCHARGE = GROSS REVENUE x FACTOR
This is the most likely approach to be adopted by non-G10 organizations. There are
no qualifying criteria and it requires very little change to current practices.
The Standardized ApproachCHARGE = BUSINESS LINE STANDARD RISK INDICATOR x FACTOR
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The firm is divided by business line, with each business line having its own standard
risk indicator. The charge to be levied will represent the standard risk indicator, for
each business line, multiplied by a factor. The total charge is the sum total of the
business line charges.
The Internal Measurement ApproachCHARGE = EXPECTED LOSS x FACTOR EXPECTED LOSS = EXPOSURE
INDICATOR x PROBABILITY OF LOSS EVENT x LOSS GIVEN EVENT
A process similar to stage 2 is followed; however individual risk types will be
identified per business line. For each business line/risk type, a bank will have to
provide an exposure indicator, probability of loss event and loss given event in order
to calculate their expected loss. The charge for operational risk will therefore
correspond with the expected loss multiplied by a factor. The benefit with stage 3 is
that a firm can use its own internal loss data to demonstrate to the regulatory body
that it should qualify for a further reduced charge.
The banks are not restricted as to which approach they adopt; it is generally accepted
that recognized internationally active banks will use either Approach 2 or 3. Banks
wishing to use Approach 2 or 3 will have to satisfy criteria relating
to operational risk management. As a rule of thumb, the more complex the solution
that is adopted, the greater the charge reduction will be.
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RBI Suggests Standardized Approach:Standardized approach as suggested by RBI may not significantly alter Credit Risk
measurement for Indian banks. In the Standardized approach proposed by Basel II
Accord, credit risk is measured on the basis of the risk ratings assigned by external
credit assessment institutions, primarily international credit rating agencies like
Moodys Investors Service
This approach is different from the one under Basel I in the sense that the earlier
norms had a one size fits all approach, i.e. 100% risk weight for all corporate
exposures. Thus, the risk weighted corporate assets measured using the
standardized approach of Basel II would get lower risk weights as compared with
100% risk weights under Basel I accords.
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EXPECTED IMPACT OF BASEL II NORMS
Depending on its current risk management processes, size, customers, portfolio, andmarket, a particular bank is likely to experience varying effects of Basel II on at least
four levels, as described below.
Reward Credit Quality:The new norms bring forward the issues of bank-wide risk measurement and active
risk management. These norms will help in better pricing of the loans in alignment
with their actual risks. The beneficiary will be the customers with high credit-
worthiness and ratings as they will be able to get cheaper loans.
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Benefits for IT Sector:Basel II norms require vast amount of historical data and advanced techniques and
software for calculation of risk measures. This will lead to huge demand for IT, BPO
and outsourcing services.(According to estimates, cost of implementation of the newnorms may range from $10 million to $150 million depending on the size of the
bank.)
For India, these norms provide massive opportunities in the form of software
services, outsourcing and consultancy services.
Dearth of Skilled Professionals & Training Costs:The implementation of the Basel II norms will require skilled manpower. There is an
unavailability of trained manpower for risk management & audits. Many countries
have a paucity of skilled manpower in this area. The training cost will be a major
expense for the implementation of Basel II Norms, especially in state owned banks
where majority of workforce needs to be trained.
The availability of trained risk auditors is another problem. Basel II calls for a Risk
Management structure in banks with Risk Management committees for Credit,
Market & operational Risk formulating the Risk Management standards. While
banks in India are implementing this, it has remained a ceremonial process without
the training at the grass root level to see every activity with the lens of risk.
Multiple Supervisory Bodies:As per Basel IIs definition of banking company is very broad and includes banking
subsidiaries such as insurance companies. In India there is no single regulator to
govern the whole bank as per Basel II. Here we have IRDA, SEBI, NABARD & RBI
would regulate different aspects of Basel II.
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The complex banking structure in India is another stumbling block. The Pillar II
implementation is the more difficult portion of the three pillars. Risk Audits in banks
are still in their nascent stages in India.
Entry Barriers:The flip side is that the knowledge acquired by the big banks due to the
implementation of complex norms would act as an entry barrier to any new
competition entering into the market, as international markets provide incentive to
sovereigns and banks that have implemented Basel II.
Mergers and AcquisitionsWith the capital requirements loaded in favour of larger banks having better systems
and ability to benefit from the lower capital requirement that goes with
implementing the more advanced approaches, there could be a spate of large-scalebank mergers worldwide, especially among internationally active banks in their
struggle to remain competitive.
Another reason for the Merger and Acquisitions is the small and medium sized
banks that will find it difficult to finance high implementation costs of the norms. If
national supervisors make the norms compulsory to implement, these banks might
have no other option but to merge with other banks. Therefore, consolidation in
banking industry with increased mergers and acquisitions is expected.
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Free Market Play:Higher risk sensitivity of the norms provides no incentive to lend to borrowers with
declining credit quality. During economic downturns, corporate profits and ratings
tend to decline. This can lead to banks pulling the plugs on lending to corporate withfalling credit ratings, at a time when these companies will be in desperate need of
credit.
The opposite is expected during economic booms, when corporate credit worthiness
improves and banks will be more than willing to lend to corporate.
Appropriate Capital Allocation:With better risk measurement practices in place the capital allocation for loans to
sub-standard quality borrowers are going to decrease. Banks can use this capital for
other purposes to increase profits. But the population of rated corporate is small in
India.
The benefit of lower risk weight of 20 % and 50 % would, therefore, be available only
for loans to a few corporate. The cover required for bad loans will increase
exponentially with deteriorating credit quality, which can lead to an increase in
capital requirement.
Better Risk Management:Sophisticated banks with better risk management and data collection mechanisms
can choose to introduce these norms, with the approval of their supervisors. These
methods are expected to entail lower capital requirements, thereby giving banks an
incentive to adopt better risk management practices.
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Effect on Small Sector:Risk-aversion of banks with regard to loans to the small and medium industries
have their origin in the quick adoption of the Basel-approved credit risk adjusted
ratios (CRAR: Capital To Risk Weighted Assets Ratio) for capital. ImplementingBasel II will further emphasize the ongoing trend by moving credit away from the
deserving industrial units in the small sector.
The Vicious Circle of Curtailment of Credit:The lower ratings will reduce the availability of funds in the emerging countries.
This has the potential to deteriorate the situation in these countries leading to further
recession. The reduced market access and high costs of funding will further impact
the ratings of these countries leading to a vicious circle with each aspect feeding the
other in a downward spiral.
Higher Interest Costs & Competitive advantage of corporate borrowers:Globalization has meant increased competition with financial engineering an
important source of the competitive advantage, more so for emerging economies
where the strength has been cost competitiveness. The Higher Interest costs to the
banks will ultimately translate into higher cost of borrowing for the corporate
skewing the playing field in favour of the developed countries.
Hampering Infrastructure Development:Major sources of funding for infrastructure in India and in many other emerging
market countries have been multilateral lending institutions such as World Bank.
The Basel II document impacts the interest rate determination process and attributes
higher risk to project finance than corporate finance. All the emerging economies like
India have been suffering from lack of infrastructure to sustain development and
this has the potential of severely hampering the infrastructure development process.
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Impact on Companies:The Shortened term funding of banks will find its way to the balance sheets of
companies because of the need for matching maturities. This would impact outputlevels in corporate and an imbalanced capital structure in favor of short-term
borrowings and working capital finance. The Liquidity position and the companies
ability to globalize would be hampered by this difficulty in raising long-term capital.
Sovereign ratings have a significant impact on stock returns:Studies conducted on this topic have shown that sovereign ratings have a signific