Basel Norms in India Free Essays

string(37) " Option 2b applicable from 2006 end\." Challenges In India ver since its introduction in 1988, capital adequacy ratio has become an important benchmark to assess the financial strength and soundness of banks. It has been successful in enhancing competitive equality by ensuring level playing field for banks of different nationality. A survey conducted for 129 countries participating in the ninth International Conference of Banking Supervision showed that in 1996, more than 90% of the 129 countries applied Basel-like risk weighted capital adequacy requirement. We will write a custom essay sample on Basel Norms in India or any similar topic only for you Order Now Reserve Bank of India introduced risk assets ratio system as a capital adequacy measure in 1992, in line with the capital measurement system introduced by the Basel Committee in 1988, which takes into account the risk element in various types of funded balance sheet items as well as non-funded off-balance sheet exposures. Capital adequacy ratio is calculated on the basis of various degrees of risk weights attributed to different types of assets. As per current RBI guidelines, Indian banks are required to achieve capital adequacy ratio of 9% (as against the Basel Committee stipulation of 8%). E Swapan BakshiImplementation of Basel II has been described as a long journey rather than a destination by itself. RBI has decided to follow a consultative process while implementing Basel II norms and move in a gradual, sequential and co-ordinated manner. BASEL CAPITAL ACCORD However, the present accord has been criticized as being inflexible due to focus on primarily credit risk and treating all types of borrowers under one risk category irrespective of credit rating. The major criticism against the existing accord stems from its ? Broad-brush approach – irrespective of quality of counter party or credit ?Encouraging regulatory arbitrage by cherry picking ? Lack of incentives for credit risk mitigation techniques ? Not covering operational risk Moreover, years have passed since the introduction of the present accord. The business of banking, risk management practices, supervisory approaches and financial markets have undergone significant transformation since then. Therefore, the Basel Committee on Banking Supervision thought it desirable that the present accord is replaced by a more risk-sensitive framework. The new accord aims to overcome the anomalies of the present system.It emphasizes on bank’s own internal methodologies, supervisory review and market discipline. (The author is a member of the Institute. He can be reached at swapanbakshi@yahoo. co. in THE CHARTERED ACCOUNTANT 426 OCTOBER 2004 BASEL II The new proposal is based on three mutually reinforcing pillars that allow banks and supervisors to evaluate properly the various risks that banks face and realign regulatory capital more closely with underlying risks. Each of these three pillars has risk mitigation as its central plank. The new risk sensitive approach seeks to strengthen the safety and soundness of the industry by focussing on: ? ? more elaborate than the current accord. It proposes, for the first time, a measure for operational risk, while the market risk measure remains unchanged. The new proposal is based on three mutually reinforcing pillars that allow banks and supervisors to evaluate properly the various risks that banks face and realign regulatory capital more closelyThe Second Pillar with underlying risks. – Supervisory Review Process Supervisory review process has been introduced to ensure not only that banks have adequate capital to support all the risks, but also to encourage them o develop and use better risk management techniques in monitoring and managing their risks. Pillar III The process has Market four key princiDiscipline ples a) Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for monitoring their capital levels. b) Supervisors should review and evaluate 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 the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum. d) 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. Risk based capital (Pillar 1) Risk based supervision (Pillar 2) Risk disclosure to enforce market discipline (Pillar 3) Basel II Framework Pillar I Minimum Capital Requirements Pillar II Supervisory Review Process The First Pillar – Minimum Capital RequirementsThe first 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 as under— Total capital (unchanged) = (Tier I+Tier II+Tier III) Risk Weighed Assets = 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 The Third Pillar – Market Discipline Market discipline imposes strong incentives to banks to conduct their business in a safe, 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 bank’s 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 CHARTERED ACCOUNTANT 427 OCTOBER 2004 BASEL II Timeframe for Implementation The Basel Committee first released the proposal to replace the 1988 Accord with a more risk sensitive framework in June 1999, on which more than 200 comments were received.Reflecting on those comments the Committee presented a more concrete proposal in January 2001 seeking more comments from interested parties. The third consultative paper was released in April 2003. Furthermore Credit the Committee conducted three Assessment quantitative impact studies to assess the impact of the new proposals. Sovereign (Govt. Thereafter, the final version of the Central Bank) New Accord has been published on Claims on Banks June 26, 2004, which is designed to Option 1 establish minimum level of capital for internationally active banks.The Option 2a new framework is to be made Option 2b applicable from 2006 end. You read "Basel Norms in India" in category "Papers" The more advanced approaches will be impleCorporates mented by the end of year 2007. COMPUTATION OF CAPITAL REQUIREMENT Capital Requirement for Credit Risk: The New Accord provided for the following alternative methods for computing capital requirement for credit risk Credit Risk – The Standardized Approach: The standardized approach is conceptually the same as the present accord, but is more risk sensitive. The bank allocates a risk weight to each of its assets and off-balance sheet positions and produces a sum of riskweighted 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 Credit Risk charge equal to 9% of that value. Individual risk weight currently depends on the broad category of borrower (i. e. sovereign, banks or corporates). Under the new accord, the risk weights are to be refined by reference to a rating provided by an external credit assessment institution (such as rating agency) that meets strict standards. Proposed Risk Weight Table AAA to A+ to BBB+ AAA- to BBB0% 20% 50% BB+ to B100% Below Unrated B150% 100% 20% 20% 20% 20% 50% 50% 20% 50% 100% 50% 20% 100% 00% 100% 50% to 150% 150% 150% 150% 100% 50% 20% 100% Option 1 = Risk weights based on risk weight of the country Option 2a = Risk weight based on assessment of individual bank Option 2b = Risk weight based on assessme nt of individual banks with claims of original maturity of less than 6 months. Retail Portfolio (subject to qualifying criteria) 75% Claims secured by residential property 35% Non-performing assets: If specific provision is less than 20% 150% If specific provision is more than 20% 100% The Committee has not proposed significant change in respect of off-balance Sheet items except for commitment to extend credit.The Internal Rating Based Approach (IRB): Under the IRB approach, banks will be allowed by the supervisors to use their internal estimates of risk components to assess credit risk in their portfolios, subject to strict methodological and disclosure standards. A bank estimates each borrower’s creditworthiness and the results are translated into estimates of a future potential loss amount, which form the basis of minimum capital requirements. The risk components include measures of ? Standardized Approach Internal Rating Based approach Securitization Framework Foundation IRB Advanced IRBProbability of Default (PD), THE CHARTERED ACCOUNTANT 428 OCTOB ER 2004 BASEL II ? ? ? Loss Given Default (LGD), Exposure At Default (EAD) and Effective Maturity (M) standardized approach under the securitization framework. Similarly, banks that have received approval to use IRB approach for the type of underlying exposure, must use the IRB approach for the securitization. The differences between foundation IRB and advanced IRB have been captured in the following table: Data Input Probability of Default Foundation IRB Provided by bank based on own estimates Capital Charge for Market RiskAlthough the Basel Committee issued â€Å"Amendment to the Capital Accord to incorporate Market Risks† in 1996, 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 -. Advanced IRB Provided by bank based on own estimates Provided by bank based on own estimates Provided by bank based on own estimates Provided by bank based on own estimatesLoss Supervisory values set Given Default by the Committee Exposure at Default Effective Maturity Supervisory values set by the Committee Supervisory values set by the Committee Or At the national discretion, provided by bank – based on own estimates The IRB approach is based on measures of Unexpected Loss (UL) and Expected Loss (EL). While capital requirement provides for UL portion, EL component is taken care of by provisioning. Securitization Framework: Banks must apply the securitization framework for determining regulatory capital requirement on exposure arising from securitiza tion.Banks that apply the standardized approach to credit risk for the underlying exposure, must use the 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. Market Risk Approaches Market Risk Standardized Approach Internal Model Based approach Maturity Based Duration Based RBI has issued detailed guidelines for computation of capital charge on Market Risk in June 2004.The guidelines seek to address the issues involved in com- THE CHARTERED ACCOUNTANT 429 OCTOBER 2004 BASEL II puting capital charge for interest rate related instruments in the trading book, equities in the trading book and foreign exchange risk (including gold and precious metals) in both trading and banking book. Trading book will include: Securities included under the Held for Trading category Securities included under the Available for Sale category ? Open gold position limits ? Open foreign exchange position limits ? Trading position in derivatives and derivatives entered into for hedging trading book exposures.As per the guideli nes, minimum capital requirement is expressed in terms of two separately calculated charges: a. Specific Risk and b. General Market Risk 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. This is similar to credit risk. The specific risk charges are divided into various categories such as investments in Govt securities, claims on Banks, investments in mortgage backed securities, securitized papers etc. nd capital charge for each category specified. 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 suggested two broad methodologies for computation of capital charge for market risk, i. e. , Standardized Method and Internal Risk Management Model Method. As Banks in India are still in a nascent stage of developing internal risk management models, in the guidelines, it is proposed that to start with, the Banks may adopt the Standardized Method.Again, under Standardized Method, there are two principle methods for measuring market risk – maturity method and duration method. As duration method is a more accurate method of measuring interest rate risk, RBI prefers that Banks measure all of their general market risk by calculating the price sensitivity (modified duration) of each position separately. For this purpose detailed mechanics to be followed, time bands, assumed changes in yield etc. have been provided by RBI. Capital Charge for Equities: Capital charge for specific risk will be 9% of the Bank’s gross equity position. The general market risk charge will also be 9%. Thus the Bank will have to maintain capital equal to 18% of investment in equities (twice the present minimum requirement). Capital Charge for Foreign Exchange Risk: ? ? Foreign exchange open position and gold open position are at present risk weighted at 100%. Capital charge for foreign exchange and gold open position would continue to be computed at 9% as hitherto. Risk Aggregation: The capital charge for specific risk, general market risk and equity and forex position will be added up and the resultant figure will be multiplied by 11. 11 (inverse of 9%) to arrive at the notional risk weighted assets.Capital Charge for Operational Risk The Basel Committee has defined the Operational Risk as â€Å"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 reputational 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. Operational Risk Approaches Operational RiskBasic Indicator Approach Standardized Approach Advanced Measurement Approach Basic Indicator Approach Under the basic indicator approach, Banks are required to hold capital for operational risk equal to the average over the previous three years of a fixed percentage (15% – denoted as alpha) 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 the standardized approach, bank’s activities are divided into eight business lines.Within each business line, gross income is cons idered 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 (denoted beta) assigned to THE CHARTERED ACCOUNTANT 430 OCTOBER 2004 BASEL II This partly explains the current trend of consolidation in the banking industry. Profitability: Competition among banks for highly rated corporates needing lower amount of capital may exert pressure on already thinning interest spread. Further, huge implementation cost may also impact profitability for smaller banks.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. A study revealed that in 1999, out of 9640 borrowers enjoying fund-based working capital facilities from banks – only 300 were rated by major agencies.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 corporates the prescribed risk weight is 100%, whereas in case of those entities with lowest ratting, 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 The final version of the New Accord has been published on June 26, 2004, which is designed to establish minimum level of capital for internationally active banks. The new framework is to be made applicable from 2006 end.The more advanced approaches will be implemen ted by the end of year 2007. that business line. Total capital charge is calculated as the three-year average of the simple summations of the regulatory capital across each of the business line in each year. The values of the betas prescribed for each business line are as under: Business Line Corporate finance Trading and sales Retail banking Commercial banking Payment and settlement Agency services Asset management Retail brokerage Beta Factor 18% 18% 12% 15% 18% 15% 12% 12%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. ISSUES AND CHALLENGES While there is no second opinion regarding the purpose, necessity and usefulness of the proposed new accord – the techniques and methods suggested in the consultative document would pose considerable implementational challenges for the banks especially in a developing country like India.Capital Requirement: The new norms will almost invariably increase capital requirement in all banks across the board. Although capital requirement for credit risk may go down due to adoption of more risk sensitive models – such advantage will be more than offset by additional capital charge for operational risk and increased capital requirement for market risk. THE CHARTERED ACCOUNTANT 431 OCTOBER 2004 BASEL II 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 risk 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 relate 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 th e 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. As Moody’s Investors Services puts it, â€Å"It is unlikely that these banks will have the financial resources, intellectual capital, skills and large scale commitment that larger competitors have to build sophisticated systems to allocate regulatory capital optimally for both credit and o perational risks. 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, alongwith 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.Although the Basel Committee issued â€Å"Amendment to the Capital Accord to incorporate Market Risks† in 1996, RBI as an interim measure, advised banks to assign an additional risk weight of 2. 5% on the entire investment portfolio. External and Internal Auditors: The working Group set up by the Basel Committee to look into implemetational 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 develo ped national accounting and auditing standards and framework, which are in line with the best international practices. A 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. CONCLUSION Implementation of Basel II has been described as a long journey rather than a destination by itself. Undoubtedly, it would require commitment of substantial capital and human resources on the part of both banks and the supervisors.RBI has decided to follow a consultative process while implementing Basel II norms and move in a gradual, sequential and co-ordinated manner. For this purpose, dialogue has already been initiated wi th the stakeholders. As envisaged by the Basel Committee, the accounting profession too, will make a positive contribution in this respect to make Indian banking system stronger.  ¦ THE CHARTERED ACCOUNTANT 432 OCTOBER 2004 How to cite Basel Norms in India, Papers Basel Norms in India Free Essays Technical Paper – Course on General Management and Communication Skills, Institute of Chartered Accountants of India – Batch 129 Basel II Implications on Indian Banks Group Members Rahul Sharma (ERO0097549) Abhishek Tulsyan (CRO0137558) Sikha Kedia (ERO0105399) Gourav Modi (ERO0016925) Praveen Didwania (ERO0110131) Index of Contents Topics Page No. I. Introduction A. We will write a custom essay sample on Basel Norms in India or any similar topic only for you Order Now B. C. D. E. F. G. Background Functions of Basel Committee The Evolution to Basel II – First Basel Accord Capital Requirements and Capital Calculation under Basel I Criticisms of Basel I New Approach to Risk Based Capital Structure of Basel II First Pillar : Minimum Capital Requirement Types of Risks under Pillar I The Second Pillar : Supervisory Review Process The Third Pillar : Market Discipline 3 3 3 3 3 4 4 II. The Three Pillar Approach A. B. C. D. 5 5 6 6 7 7 7 III. Capital Arbitrage and Core Effect of Basel II A. Capital Arbitrage B. Bank Loan Rating under Basel II Capital Adequacy Framework C. Effect of Basel II on Bank Loan Rating IV. Basel II in India A. Implementation C. Impact on Indian Banks D. Impact on Various Elements of Investment Portfolio of Banks E. Impact on Bad Debts and NPA’s of Indian Banks D. Government Policy on Foreign Investment E. Threat of Foreign Takeover 8 8 9 10 10 10 V. Conclusion A. SWOT Analysis of Basel II in Indian Banking Context B. Challenges going ahead under Basel II 11 11 13 13 VI. VII. References The Technical Paper Presentation Team 2 I. Introduction: A. Background Basel II is a new capital adequacy framework applicable to Scheduled Commercial Banks in India as mandated by the Reserve Bank of India (RBI). The Basel II guidelines were issued by the Basel Committee on Banking Supervision that was initially published in June 2004. The Accord has been accepted by over 100 countries including India. In April 2007, RBI published the final guidelines for Banks operating in India. Basel II aims to create international standards that deals with Capital Measurement and Capital Standards for Banks which banking regulators can use when creating regulations about how much banks need to put aside to guard against the types of financial and operational risks banks face. The Basel Committee on Banking Supervision was constituted by the Central Bank Governors of the G-10 countries in 1974 consisting of members from Australia, Brazil, Canada, United States, United Kingdom, Spain, India, Japan, etc to name a few. The ommittee regularly meets four times a year at the Bank for International Settlements (BIS) in Basel, Switzerland where its 10 member Secretariat is located. B. Functions of the Basel Committee The purpose of the committee is to encourage the convergence toward common approaches and standards. However, the Basel Committee is not a classical multilateral organisation like World Trade Organisation. It has no founding treaty and it does not issue binding regulat ions. It is rather an informal forum to find policy solutions and promulgate standards. C. The Evolution to Basel II – First Basel Accord The First Basel Accord (Basel I) was completed in 1988. The main features of Basel I were: †¢ †¢ †¢ Set minimum capital standards for banks Standards focused on credit risk, the main risk incurred by banks Became effective end-year 1992 The First Basel Accord aimed at creating a level playing field for internationally active banks. Hence, banks from different countries competing for the same loans would have to set aside roughly the same amount of capital on the loans. D. Capital Requirements and Capital Calculation under Basel – I Minimum Capital Adequacy ratio was set at 8% and was adjusted by a loan’s credit risk weight. Credit risk was divided into 5 categories viz. 0%, 10%, 20%, 50% and 100%. Commercial loans, for example, were assigned to the 100% risk weight category. To calculate required capital, a bank would multiply the assets in each risk category by the category’s risk weight and then multiply the result by 8%. Thus, a Rs 100 commercial loan would be multiplied by 100% and then by 8%, resulting in a capital requirement of Rs8. E. Criticisms of Basel – I Following are the criticisms of the First Basel Accord (Basel I):†¢ †¢ It took too simplistic an approach to setting credit risk weights and for ignoring other types of risk. Risks weights were based on what the parties to the Accord negotiated rather than on the actual risk of each asset. Risk weights did not flow from any particular insolvency probability standard, and were for the most part, arbitrary. 3 †¢ †¢ †¢ The requirements did not account for the operational and other forms of risk that may also be important. Except for trading account activities, the capital standards did not account for hedging, diversification, and differences in risk management techniques. Advances in technology and finance allowed banks to develop their own capital allocation models in the 1990’s. This resulted in more accurate calculation of bank capital than possible under Basel I. These models allowed banks to align the amount of risk they undertook on a loan with the overall goals of the bank. Internal models allow banks to more finely differentiate risks of individual loans than is possible under Basel – I. It facilitates risks to be differentiated within loan categories and between loan categories and also allows the application of a capital charge to each loan, rather than each category of loan. F. New Approach to Risk-Based Capital †¢ †¢ †¢ By the late 1990’s, growth in the use of regulatory capital arbitrage led the Basel Committee to begin work on a new capital regime (Basel II) Effort focused on using banks’ internal rating models and internal risk models June 1999: The Basel Committee issued a proposal for a new capital adequacy framework to replace Basel – I. In order to overcome the criticisms of Basel – I and for adoption of the new approach to riskbased capital, Basel II guidelines were introduced. G. Structure of Basel – II Basel – II adopts a three pillar approach: †¢ †¢ †¢ Pillar I – Minimum Capital Requirement (Addressing Credit Risk, Operational Risk Market Risk) Pillar II – Supervisory Review (Provides Framework for Systematic Risk, Liquidity Risk Legal Risk) Pillar III – Market Discipline Disclosure (To promote greater stability in the financial system) II. The Three Pillar Approach The first pillar establishes a way to quantify the minimum capital requirements. The main objective of Pillar I is to align capital the adequacy ratios to the risk sensitivity of the assets affording a greater flexibility in the computation of banks’ individual risk. Capital Adequacy Ratio is defined as the amount of regulatory capital to be maintained by a bank to account for various risks inbuilt in the banking system. The focus of Capital Adequacy Ratio under Basel I norms was on credit risk and was calculated as follows: Capital Adequacy Ratio = Tier I Capital+Tier II Capital Risk Weighted Assets Basel Committee has revised the guidelines in the year June 2001 known as Basel II Norms. Capital Adequacy Ratio in New Accord of Basel II: Capital Adequacy Ratio = Total Capital (Tier I Capital+Tier II Capital) Market Risk(RWA) + Credit Risk(RWA) + Operation Risk(RWA) *RWA = Risk Weighted Assets Calculation of Capital Adequacy Ratio: Total Capital: Total Capital constitutes of Tier I Capital and Tier II Capital less shareholding in other banks. Tier I Capital = Ordinary Capital + Retained Earnings Share Premium – Intangible assets. Tier II Capital = Undisclosed Reserves + General Bad Debt Provision+ Revaluation Reserve+ Subordinate debt+ Redeemable Preference shares Tier III Capital: Tier III Capital includes subordinate debt with a maturity of at least 2 years. This is addition or substitution to the Tier II Capital to cover market risk alone. Tier III Capital should not cover more than 250% of Tier I capital allocated to market risk. A. First Pillar : Minimum Capital Requirement B. Types of Risks under Pillar I . Credit Risk Credit risk is the risk of loss due to a debtor’s non-payment of a loan or other line of credit (either the principal or interest (coupon) or both). Basel II envisages two different ways of measuring credit risk which are standarised approach, Internal Rating-Based Approach. The Standardised Approach The standardized approach is conceptually the same as the present Accord, but is more ri sk sensitive. Under this approach the banks are required to use ratings from External Credit Rating Agencies to quantify required capital for credit risk. The Internal Ratings Based Approach (IRB) Under the IRB approach, different methods will be provided for different types of loan exposures. Basically there are two methods for risk measurement which are Foundation IRB and Advanced IRB. The framework allows for both a foundation method in which a bank estimate the probability of default associated with each borrower, and the supervisors will 5 supply the other inputs and an advanced IRB approach, in which a bank will be permitted to supply other necessary inputs as well. Under both the foundation and advanced IRB approaches, the range of risk weights will be far more diverse than those in the standardized approach, resulting in greater risk sensitivity. 2. Operational Risk An operational risk is a risk arising from execution of a company’s business functions. As such, it is a very broad concept including e. g. fraud risk, legal risk, physical or environmental risks, etc. Basel II defines operational risk as the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. Although the risks apply to any organization in business, this particular risk is of particular relevance to the banking regime where regulators are responsible for establishing safeguards to protect against systematic failure of the banking system and the economy. Banks will be able to choose between three ways of calculating the capital charge for operational risk – the Basic Indicator Approach, the Standardized Approach and the advanced measurement Approaches. 3. Market Risk Market risk is the risk that the value of a portfolio, either an nvestment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices. The preferred approach is VAR(value at risk). C. The Second Pillar : Supervisory Review Process Supervisory review process has been introduced to ensure not only that banks have adequate capital to support all th e risks, but also to encourage them to develop and use better risk management techniques in monitoring and managing their risks. The process has four key principles – a) Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for monitoring their capital levels. b) Supervisors should review and evaluate bank’s internal capital adequacy assessment and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. c) Supervisors should expect banks to operate above the 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. D. The Third Pillar : Market Discipline Market discipline imposes strong incentives to banks to conduct their business in a safe, 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 bank’s capital adequacy. These disclosures should be made at least semiannually and more frequently if appropriate. Qualitative disclosures such as risk management objectives and policies, definitions etc. may be published annually. 6 III. Capital Arbitrage and Core Effect of Basel II Regulatory arbitrage is where a regulated institution takes advantage of the difference between its real (or economic) risk and the regulatory position. Securitization is the main means used by Banks to engage in Regulatory Capital Arbitrage. Example of Capital Arbitrage is given below: A. Capital Arbitrage †¢ Assume a bank has a portfolio of commercial loans with the following ratings and internally generated capital requirements – AA-A: 3%-4% capital needed – B+-B: 8% capital needed – B- and below: 12%-16% capital needed Under Basel I, the bank has to hold 8% risk-based capital against all of these loans To ensure the profitability of the better quality loans, the bank engages in capital arbitrage, it securitizes the loans so that they are reclassified into a lower regulatory risk category with a lower capital charge Lower quality loans with higher internal capital charges are kept on the bank’s books because they require less risk-based capital than the bank’s internal model indicates. †¢ †¢ †¢ B. Bank Loan Rating under Basel – II Capital Adequacy Framework †¢ On April 27, 2007, the Reserve Bank of India released the final guidelines for implementation of the New Capital Adequacy Framework (Basel II) applicable to the Banking system of the country The new framework mandates that the amount of capital provided by a bank against any loan and facility will be based on the credit rating assigned to the loan issue by an external rating agency. This means that a loan and a facility with a higher credit rating will attract a lower risk weight than one with a lower credit rating. †¢ †¢ Illustration of capital-saving potential by banks on a loan of Rs 1000 million Rating Basel I Basel II Capital Saved (Rs Long Short Risk Capital Risk Capital Million) Term Term Weight Required* Weight Required Rating Rating (Rs Million) (Rs Million) AAA P1+ 100% 90 20% 18 72 AA P1 100% 90 30% 27 63 A P2 100% 90 50% 45 45 BBB P3 100% 90 100% 90 0 BB P4 P5 100% 90 150% 135 (45) below Unrated Unrated 100% 90 100% 90 0 *Capital required is computed as Loan Amount ? Risk Weight ? 9% C. Effect of Basel – II on Bank Loan Rating †¢ †¢ Banks would either prefer that the Borrower should get itself rated, or, It would prefer that the borrowing institution should pay a higher rate of interest to compensate for the loss. 7 To substantiate the above fact, following example is taken in respect of a strong company: Loan of Rating AAA is taken of Rs 100 Crores @ 12% interest rate Capital Adequacy Rating Risk % Capital Required Opportunity Ratio (Rs Crores) Interest lost by the Bank (Rs Crores) C. A. R. Unrated 100% 9. 00 1. 08 C. A. R. New 20% 1. 80 0. 22 Total Opportunity Interest lost by the Bank (Rs Crores) 0. 86 Hence, Banks would resort to the above-mentioned measures in order to reduce or curb this loss on opportunity interest. Worse affected by this action taken by Banks would be the weaker companies. They would either be charged a higher rate of interest on loans to compensate for the loss or would alternatively have to approach another bank charging a lower rate of interest. The ideal solution to this problem would be that a weaker company should get itself rated and also take steps in order to have a better credit rating. Credit Rating is an evaluation of credit worthiness of a person, company or instrument. Thus, it indicates their willingness to pay for the obligation and the net worth. IV. Basel II in India A. Implementation The deadline for implementing the base approach of Basel II norms in India, was originally set for March 31, 2007. Later the RBI extended the deadline for Foreign banks in India and Indian banks operating abroad to meet those norms by March 31, 2008, while all other scheduled commercial banks were to adhere to the guidelines by March 31, 2009. Later the RBI confirmed that all commercial banks were Basel II compliant by March 31, 2009. Keeping in view the likely lead time that may be needed by the banks for creating the requisite technological and the risk management infrastructure, including the required databases, the MIS and the skill up-gradation, etc. , RBI has proposed the implementation of the advanced approaches under Basel II in a phased manner starting from April 1, 2010 B. Impact on Indian Banks Basel II allows national regulators to specify risk weights different from the internationally recommended ones for retail exposures. The RBI had, therefore, announced an indicative set of weights for domestic corporate long-term loans and 8 bonds subject to different ratings by international rating agencies such as Moody’s Investor Services which are slightly different from that specified by the Basel Committee (Table 1). C. Impact on various elements of the investment portfolio of banks The bonds and debentures portfolio of the banks consist of investments into higher rated companies, hence the corporate assets measured using the standardised approach may be exposed to slightly lower risk weights in comparison with the 100 per cent risk weights assigned under Basel I. The Indian banks have a large short-term portfolio in the form of cash credit, overdraft and working capital demand loans, which were un-rated, and carried a risk weight of 100 per cent under the Basel I regime. They also have short-term investments in commercial papers in their investment portfolio, which also carried a 100 per cent risk weight. The RBI’s capital adequacy guidelines has prescribed lower risk weights for short-tem exposures, if these are rated (Table 2). This provides the banks with an opportunity to benefit from their investments in commercial paper (which are typically rated in A1+/A1 category) and give them the potential to exploit the proposed short-term credit risk weights by obtaining short-term ratings for exposures in the form of cash credit, overdraft and working capital loans. The net result is that the implementation of Basel II provided Indian banks with the opportunity to significantly reduce their credit risk weights and reduce their required regulatory capital, if they suitably adjust their portfolio by lending to rated but strong corporate and increase their retail lending. According to some reports, most of the Indian banks who have migrated to Basel II have reported a reduction in their total Capital Adequacy Ratios (CARs). However, a few banks, those with high exposures to higher rated corporate or to the regulatory retail portfolio, have reported increased CARs. However, a recent study by New Delhi-based industry lobby group Assocham has concluded that Capital Adequacy Ratio (CAR) of a group of commercial banks, which were part of the study improved to 13. 48% in 2008-09 from 12. 35% in 2007-08, due to lower risk weights, implementation of Basel II norms and slower credit growth. 9 D. Bad debts and requirement of additional capital In this context, the situation regarding bad debts and NPA’s is very pertinent. The proportion of total NPAs to total advances declined from 23. 2 per cent in March 1993 to 7. per cent in March, 2004. The improvement in terms of NPAs has been largely the result of provisioning or infusion of capital. This meant that if the banks required more capital, as they would to implement Basel II norms, they would have to find capital outside of their own or the governmentâ₠¬â„¢s resources. ICRA has estimated that, Indian banks would need additional capital of up to Rs. 12,000 crore to meet the capital charge requirement for operational risk under Basel II. Most of this capital would be required by PSBs Rs. 9,000 crore, followed by the new generation private sector banks Rs. 1,100 crore, and the old generation private sector bank Rs. 750 crore. In practice, to deal with this, a large number of banks have been forced to turn to the capital market to meet their additional regulatory capital requirements. ICICI Bank, for example, has raised around Rs. 3,500 crore, thus improving its Tier I capital significantly. Many of the PSBs, namely, Punjab National Bank, Bank of India, Bank of Baroda and Dena Bank, besides private sector banks such as UTI Bank have either already tapped the market or have announced plans to raise equity capital in order to boost their Tier I capital. E. Government Policy on foreign investment The need to go public and raise capital challenged the government policy aimed at restricting concentration of share ownership, maintaining public dominance and limiting foreign influence in the banking sector. One immediate fallout was that PSBs being permitted to dilute the government’s stake to 51 per cent, and the pressure to reduce this to 33 per cent increased. Secondly, the government allowed private banks to expand equity by accessing capital from foreign investors. This put pressure on the RBI to rethink its policy on the ownership structure of domestic banks. In the past the RBI has emphasised the risks of concentrated foreign ownership of banking assets in India. Subsequent to a notification issued by the Government, which had raised the FDI limit in private sector banks to 74 per cent under the automatic route, a comprehensive set of policy guidelines on ownership of private banks was issued by the RBI. These guidelines stated, among other things, that no single entity or group of related entities would be allowed to hold shares or exercise control, directly or indirectly, in any private sector bank in excess of 10 per cent of its paid-up capital. F. Threat of foreign takeover There has been growing pressure to consolidate domestic banks to make them capable of facing international competition. Indian banks are pigmies compared with the global majors. India’s biggest bank, the State Bank of India, which accounts for onefifth of the total banking assets in the country, is roughly one-fifth as large as the world’s biggest bank Citigroup. Given this difference, even after consolidation of 10 omestic banks, the threat of foreign takeover remains if FDI policy with respect to the banking sector is relaxed. Not surprisingly, a number of foreign banks have already evinced an interest in acquiring a stake in Indian banks. Thus, it appears that foreign bank presence and consoli dation of banking are inevitable post Basel II. V. Conclusion A. SWOT Analysis of Basel II in Indian Banking Context Strenghts †¢ †¢ Aggression towards development of the existing standards by banks. Strong regulatory impact by central bank to all the banks for implementation. Presence of intellectual capital to face the change in implementation with good quality. †¢ †¢ †¢ Weaknesses Poor Technology Infrastructure Ineffective Risk Measures Presence of more number of Smaller banks that would likely to be impacted adversely. †¢ Opportunities †¢ †¢ Increasing Risk Management Expertise. Need significant connection among business,credit and risk management and Information Technology. Advancement of Technologies. Strong Asset Base would help in bigger growth. †¢ †¢ Threats Inability to meet the additional Capital Requirements Loss of Capital to the entire banking system, due to Mergers and acquisitions. Huge Investments in technologies †¢ †¢ †¢ B. Challenges going ahead under Basel II †¢ The new norms will almost invariably increase capital requirement in all banks across the board. Although capital requirement for credit risk may go down due to adoption of more risk sensitive models – such advantage will be more than offset by additional capital charge for operational risk and increased capital requirement for market risk. This partly explains the current trend of consolidation in the banking industry. Competition among banks for highly rated corporates needing lower amount of capital may exert pressure on already thinning interest spread. Further, huge implementation cost may also impact profitability for smaller banks. The biggest challenge is the re-structuring of the assets of some of the banks as it would be a tedious process, since most of the banks have poor asset quality leading to significant proportion of NPA. This also may lead to Mergers Acquisitions, which itself would be loss of capital to entire system. The new norms seem to favor the large banks that have better risk management and measurement expertise, who also have better capital adequacy ratios and geographically diversified portfolios. The smaller banks are also likely to be hurt by the rise in weightage †¢ †¢ †¢ 11 of inter-bank loans that will effectively price them out of the market. Thus, banks will have to re-structure and adopt if they are to survive in the new environment. †¢ Since improved risk management and measurement is needed, it aims to give impetus to the use of internal rating system by the international banks. More and more banks may have to use internal model developed in house and their impact is uncertain. Most of these models require minimum historical bank data that is a tedious and high cost process, as most Indian banks do not have such a database. The technology infrastructure in terms of computerization is still in a nascent stage in most Indian banks. Computerization of branches, especially for those banks, which have their network spread out in remote areas, will be a daunting task. Penetration of information technology in banking has been successful in the urban areas, unlike in the rural areas where it is insignificant. An integrated risk management concept, which is the need of the hour to align market, credit and operational risk, will be difficult due to significant disconnect between business, risk managers and IT across the organizations in their existing set-up. Implementation of the Basel II will require huge investments in technology. According to estimates, Indian banks, especially those with a sizeable branch network, will need to spend well over $ 50-70 Million on this. 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. 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. 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. Basel II proposals underscore the interaction between sound risk 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 relate risk to the bank’s capital levels and establish a method for monitoring compliance with internal policies. The risk weighting scheme under Standardised Approach also creates some incentive for some of the bank clients to remain unrated since such entities receive a lower risk weight of 100 per cent vis-a-vis 150 per cent risk weight for a lowest rated client. This might specially be the case if the unrated client expects a poor rating. The banks will need to be watchful in this regard. †¢ †¢ †¢ †¢ †¢ †¢ †¢ †¢ We can conclude by saying that the Basel II framework provides significant incentives to banks to sharpen their risk management expertise to enable more efficient risk-return tradeoffs, it also presents a valuable opportunity to gear up their internal processes to the 12 international best standards. This would require substantial capacity building and commitment of resources through close involvement of the banks’ Top Management in guiding this arduous undertaking. Notwithstanding intense competition, the expansionary phase of the economy is expected to provide ample opportunities for the growth of the banking industry. The growth trajectory, adherence to global best practices and risk management norms are likely to catapult the Indian Banks onto the global map, making them a force to reckon with. VI. References 1. The Evolution to Basel II by Donald Inscoe, Deputy Director, Division of Insurance and Research, US Federal Deposit Insurance Corporation. 2. Basel II – Challenges Ahead of the Indian Banking Industry by Jagannath Mishra and Pankaj Kumar Kalawatia. 3. Basel II Norms and Credit Ratings by CA Sangeet Kumar Gupta. 4. The Business Line Magazine. 5. The Chartered Accountant – Journal of the Institute of Chartered Accountants of India. 6. www. bis. org 7. www. rbi. org. in 8. www. wikipedia. org 9. www. google. com VII. The Technical Paper Presentation Team Name of Member Email ID’s rahulscsharma@icai. org tulsyan. abhishek@yahoo. co. in sikha. kedia0311@gmail. com ca. gouravmodi@gmail. com Praveen_did@yahoo. com 1. Rahul Sharma 2. Abhishek Tulsyan 3. Sikha Kedia 4. Gourav Modi 5. Praveen Didwania 13 How to cite Basel Norms in India, Essay examples