THE BASEL COMMITTEE RECOMMENDATIONS

On June 26, 1974, German regulators forced the

troubled Bank Herstatt into liquidation.

That day a number of banks had released payment to

Herstatt in Frankfurt in exchange for US$ that was to be
delivered in New York.

Because of the time- zone differences, Herstatt ceased

operation between the times of the respective payments.

The counter party banks did not receive their US$

payments.

Responding to the cross-jurisdictional implications of

Herstatt debacle, the G-10 countries (the G-10 is
actually eleven countries: Belgium, Canada, France,
Germany, Italy, Japan, Netherlands, Sweden,
Switzerland, the United Kingdom and the United States)
formed a standing committee under the auspices of Bank
of International Settlements (BIS)

Called the Basel Committee or (Basle Committee) on

banking supervision the committee comprises
representatives from central banks and regulatory
authorities.

Its first task was to consider a method of

improving “early warning system”
Over the time the focus of the committee has evolved,
embracing initiative designed to:

Define role of regulators in cross-jurisdictional

situation;

• Ensure that international banks or bank holding

companies do not escape comprehensive
supervision by a “home regulatory authority”.

• Promote uniform capital requirements so that

banks from different countries may compete
with another on a “level playing field”

The first meeting took place in February 1975.

It usually meet at the Bank for International Settlements

in Basel, where it’s permanent Secretariat is located.

The committee brought out a comprehensive set of

Core Principles for effective bank supervision
(Basel Core Principles) and are applicable to G-
10 and non G-10 countries.

In developing the principles, the Basel Committee

has worked closely with non G-10 supervisory
authorities like China, India, and Hong Kong,
Mexico etc.

The IMF and World Bank has also seen and commented
on the work at various stages.

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The 25 core principles for effective Banking
supervisions are as follows:

Preconditions for Effective banking supervision

1. Effective supervision will have clear

responsibilities and objectives. They should
possess operational independence.

A suitable legal framework to support is also

required.

Arrangement for sharing information between

supervisors and protecting the confidentiality of
such information should be in place.

Licensing and structure

2. The permissible activities should be clearly defined

and the use of word “bank” in names should be
controlled.

3. The licensing authorities must have right to set the

criteria and reject the applications that do not meet the
criteria. In case of foreign country’s bank the prior
consent of home country supervisor should be
obtained.

4. Banking supervisors must have the authority to

review and reject any proposal to transfer significant

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 ownership or controlling interest in existing banks to
other parties.

5. Banking supervisors must have the authority to

establish criteria for reviewing major acquisitions or
investment by banks with special reference to risk
associated with it.

Prudential regulations and requirements

6. Banking supervisors must set minimum capital

requirements for banks that reflect the risks that banks
undertake, and must define the component of capital,
bearing in mind the ability to absorb losses.

For Internationally active banks these requirements must

not be less than those established in Basel capital
accord.

7.Banking supervisors must evolve a system of

independent evaluation of a bank’s policies, practices
and procedures related to granting of loans and making
of investments and ongoing management of the loan and
investment portfolios.

8. Banking supervisors must be satisfied that banks

establish and adhere to adequate policies, practices and
procedures for evaluating the quality of assets and the
adequacy of loan loss provisions and reserves.

9. Banking supervisors must be satisfied that banks have

management information systems that enable

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management to identify concentrations within the
portfolio and supervisors must set prudential limits to
restrict bank exposures to single borrowers or groups of
related borrowers.

10.Supervisors must have in place the requirements for

the banks to deal with the abuses of connected lending.

11. Banking supervisors must ensure that the banks

have adequate policies for identifying country risk and
transfer risk in their international lending and investment
activities and for maintaining adequate reserves for such
risks.

12. Banking supervisors must be satisfied that banks

have systems that accurately measure, monitor and
control market risks.

13. Banks have adequate comprehensive risk

management process.

14. Banks must have in place adequate internal control

system and adequate independent internal and external
audit and compliance functions.

15.Banks must have adequate policies, practices and

procedures in place, including strict “know your
customers” rules, that promote high ethical and
professional standards in the financial sector and prevent
the bank being used, intentionally or unintentionally, by
criminal elements.

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Methods of ongoing banking supervision

16. An effective banking supervisory system should

consist of some form of both on-site and off-site
supervision.

17. Banking supervisors must have regular contact with

bank management and thorough understanding of the
institutions operations.

18. Banking supervisors must have means of collecting,

reviewing and analyzing prudential reports and
statistical returns from banks on a solo and consolidated
basis.

19. Banking supervisors must have means of

independent validation of supervisory information either
through on-site examination or use of external auditors.

20. An essential element of banking supervision is the

ability of the supervisors to supervise the banking
organization on a consolidated basis.

Information Requirements

21. Banking supervisors must be satisfied that each bank

maintains adequate records drawn up in accordance with
consistent accounting policies and practices that enable
the supervisor to obtain a true and fair view of the
financial condition of the bank and the profitability of its
business, and that the bank publishes on a regular basis
financial statements that fairly reflect its condition.

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Formal powers of Supervisors

22. Banking supervisors must have at their disposal

adequate supervisory measures to bring about corrective
action when banks fail to meet prudential requirements
(such as minimum capital adequacy ratios), when there
are regulatory violations or where depositors are
threatened in any other way.

Cross-border Banking

23. Banking supervisors must practice global

consolidated supervision, adequately monitoring and
applying appropriate prudential norms to all aspects of
business conducted by banking organizations
worldwide, primarily at their foreign branches and
subsidiaries.

24. A key component of consolidated supervision is

establishing contact and information exchange with
various other supervisors involved, primarily host
country supervisory authorities.

25. Banking supervisors must require local operations of

foreign banks to be conducted to the same high
standards as are required of domestic institutions and
must have powers to share information needed by the
home country supervisors of those banks for the purpose
of carrying out consolidated supervision.

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National agencies should apply the principles in the
supervision of all banks within their jurisdictions.

The principles are minimum requirements and in many

cases may need to be supplemented by other measures
designed to address particular conditions and risks in the
financial systems of individual countries.

Although The Basel Committee does not have any

legislative authority, but participant countries are
implicitly bound to implement its recommendations.

THE BASEL CAPITAL ACCORD

The Basel capital Accord, the current international

framework on capital adequacy was adopted in 1988 by
many banks worldwide and it was adopted in 1992 in
India

The 1988 Basel Accord primarily addressed

banking in the sense of deposit taking and lending
(commercial banking under US laws), therefore its
focus was on credit risk.

Banks were subject to 8% capital requirement.

A bank’s capital was defined as comprising of two

tiers.

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Tier 1(“core”) capital included the book value of
common stock, non-cumulative perpetual preferred
stock and published reserves from post tax
retained earnings.

Tier 2 (“supplementary”) capital was deemed of

lower quality. It included, cumulative and/ or
redeemable preferred stock, assets revaluation
reserves, general loan reserves, subordinated term
debt.

A maximum of 50% of a bank’s capital could

comprise of tier 2 capital.

Credit risk was calculated as the sum of risk–

weighted asset values.

Generally, G-10 Government debt was weighted

0%. G-10 bank debt was weighted 20% and other
debt, including corporate debt and the debt of non-
G-10 Governments, was weighted 100%.

Additional rules applied to mortgages, local

government debts in G-10 countries and contingent
obligations, such as letters of credit or derivatives.

Capital
---------------- ⊇ 8%
Credit risk

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In the early 1990s, the Basel committee decided to
update the 1988 accord to include bank capital
requirements for market risk.

Capital
---------------------------------- ⊇ 8%
Credit risk + market risk

It also liberalized the definition of capital by adding a

third tier. Tier 3 capital comprised short-term
subordinated debt, but it could only be used to cover
market risk.

Market risk: Banks would be required to identify a

trading book and hold capital for trading book market
risk and organization wide foreign exchange exposures.
Trading book is investment of banks in Government
securities and other corporate securities.

BASEL II

In June 1999 the Basel committee on banking

supervision issued a new consultative paper on
New Capital Adequacy framework.

After conducting three quantitative impact studies

to assess those
proposals, the finalized Basel Accord called

“International Convergence of Capital

Measures and Capital Standards: a Revised
Framework”, was adopted on June2004

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It will come into effect by end 2006; the most
advanced approaches to risk measurements will be
effective end 2007.

This will replace the 1988 capital adequacy

framework.

Basel II is based on three pillars

• Minimum capital requirement for banks.

• Supervision to review banks’ capital adequacy

and internal assessment processes.

• Use of Market Discipline for greater

transparency and disclosure encouraging best
international practices.

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 FRAME WORK

Pillar I Pillar II Pillar III

Minimum Capital Supervisory Market

Adequacy Review Discipline

Credit Risk Operational Market Risk

Risk

Capital adequacy

Basel II reflects more risk sensitive requirements of

banks with greater attention to supervision and market
discipline.

• The revised accord has retained the minimum

requirement of 8% of capital to risk weighted assets.

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 Capital
---------------------------------------------------
⊇ 8%
Credit risk + market risk + operational
risk

• The operational risk has been added to take note of

increasing globalization, enhanced use of technology,
product innovations and growing complexity in
operations.

Operational risk has been defined as the “risk of loss

resulting from inadequate or failed internal processes,
people and system or from external events”.

This definition includes legal risks but excludes strategic

and reputational risk. The committee has quantified the
operational risk as 15% of a bank’s average annual gross
income over the previous three years under the basic
indicator approach.

• Under the standardized approach, banks activities are

divided into eight business lines like: corporate
finance, retail banking etc. Banks are required to
calculate capital requirement for each business line
and this is determined by multiplying gross income by
the specific supervisory factors determined by the
committee.

2. Varying Risk weight:

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The biggest change is proposed in the system of risk
weighting so that the rate of interest that is charged to a
borrower reflects the riskiness of the underlying asset.

Therefore, instead of a one–size-fits–all approach

(100%), the committee has proposed reduction in risk
weight for certain high quality assets (20%, 50%) and
increase in risk weight for lower quality assets e.g.
venture capital and private placements (100%, 150%).

3. Credit Rating

Another major change is that under the new accord, risk

weights are to be determined on the basis of ratings
assigned by independent external credit rating agencies.

At present, credit rating is required for debt instruments

only but under the new framework, credit rating will be
extended to bank loans also.

4. Banks Internal Models

The measurement of risk is to be allowed through the

standardized approach or the internal rating based
approach. Thus banks are allowed to use their internal
risk models to assess borrower’s credit worthiness and
estimate weight age for different assets.

However this must receive the approval of bank

supervisors/ central bank and must satisfy certain
criteria:

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• Risk control unit must be independent from trading
units and report directly to senior management.
• Risk management model must be integrated into the
daily management process.
• There must be appropriate stress test and back testing
• Independent review of risk measurement and risk
management system must be conducted annually.

5. Market Discipline:

To aid market discipline, which is seen as a lever to

strengthen the safety and soundness of the system, the
requirement of disclosure by banks has been
strengthened.

For instance, banks will have to disclose additional

details of the way in which they calculate their capital
adequacy, their risk management strategies and practices,
as also credit assessment institutions that they use for the
risk weighting of their assets,

The disclosure relating to comprehensive risk exposures

would include credit risk, market risk, liquidity risk,
operational risk, legal and other risks as well as
accounting policies and information on corporate
governance. The greater transparency and reliable and
timely information will thus allow better counter party
risk assessments.

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CAPITAL ADEQUACY IN THE INDIAN BANKING
CONTEXT

Capital adequacy and other prudential norms, first

introduced as a part of banking sector reforms in 1992
are being fine tuned continuously by RBI aligning them
more closely with international best practices.

The minimum capital to risk asset ratio was raised from

8% to 9% effective March 31,2000.Capital charge to
cover market risk has already been incorporated in
certain items:

• Banks have to assign additional risk weight of 2.5%

on entire investment portfolio.
• Forex /gold open position limits of banks carry 100%
risk weight (from 31.3.99)
• An investment fluctuation reserve has been put in
place from March 31, 2003 with minimum 5% of the
investment portfolio in the Available for Sale (AFS)
and Held for Trading (HFT) categories, as a cushion
for market risk and it will gradually be raised to 10%.
• All investments in bonds /debentures of Fis assigned a
uniform risk weight of 20%.
• Risk weight for State Government guaranteed
advances in default: 20% as on 31.3.2000 and 100%
where default continues even after 31.3.2001.
• Bank loans are to be classified as substandard when
payments remain outstanding for one quarter from the
year ending
March 31, 2004.

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• General provision on standard assets was allowed to
be included in tier 2 capital upto a maximum of 1.25%
of total risk weighted assets in October 2000 in line
with international best practices.
• In may 2004 RBI announced that banks will be
required to provide capital to cover interest rate risk
on their trading book exposures (including derivatives)
by 31 March 2005 and on investments under Available
for Sale category by 31 March 2006.

IMPACT ON INDIAN BANKS

The introduction of Basel II will impact banks in India

also.

The consolidation in banking to overcome

capital constraint, streamlining of risk
management, maximizing return on capital,
greater use of technology for efficiency gains,
more robust risk based pricing and closer
alignment with international best practices will
strengthen the foundation of Indian banking
system.

While the new standards are mandatory for

internationally active banks, even small banks would be
willing to adopt the new system to be more competitive.

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• Consolidation:

The immediate impact of Basel II will be that the

banks will need additional capital to cover market risk
and operational risk besides credit risk.

Also, banks will need more capital to support

expansion. The stronger banks will be able to meet
their need for additional capital by tapping the market-
both domestic and international or by ploughing back
profits.

However the weaker banks may need to merge with

banks having surplus capital or those with ability to
raise capital from the market.
Government will not be willing to continue to
recapitalise weak banks.

• Impact on profitability:

Competition among banks for prime customers will

intensify, pushing down spread even further.

Additional cost on account of rating as also cost of

putting in place risk management system, technology
infrastructure, MIS for building adequate database will
impact profitability.

• Better Risk Management:

The core of the new accord is how to measure and

monitor risk.

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Banks need to identify key risks, map them with the
processes and ensure sufficient controls against those
risks by putting integrated risk management in place.

Banks need to improve management practices,

compliance and sound corporate governance.

• Use of Internal Models

The new accord allows banks to use their internal ratings

to assess risk and allocate capital provided they satisfy
certain basic minimum eligibility criteria including
methodology to make meaningful credit differentiation,
well developed rating system, well functioning data
collection and IT system, estimation of past defaults etc.

At present, banks in India may not meet the minimum

criteria and will therefore need to follow standardized
approach. This is also preferred approach of RBI.

• Impact on Borrowers:

While there will be reduction in borrowing cost for

prime borrowers, the cost of borrowing for non-prime /
unrated borrowers will go up.

• Implication for transfer pricing:

At individual banks level, there is need for greater

consciousness and incentives in transfer pricing to hold
highly rated assets.

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For instance with 8 % capital adequacy, the best
corporate would have 20 % risk weight (which translates
to a capital charge of 1.6%)

While the unrated or low rated customers get risk weight

of 100%
(which translates into a capital charge of 8%) or if the
risk weight is 150% the capital charge will be 12%.

The cost of incremental capital requirements will need to

be factored into transfer pricing formula.

• Treatment of small banks:

The new accord addresses only the large banks

and does help measure risk in smaller banks.

Push to retail:

With almost 70% of India’s population under 50 years

of age, less than 5% of GDP in personal and housing
finance and a booming services sector, there is no doubt
the demographic dynamics will drive retail banking in
India in the years ahead.

The reduction in risk weight for SMEs and housing

under Basel II will only reinforce this trend.

• Greater Use of Technology:

Minimizing risk and maximizing return on capital to

provide risk sensitive products and pricing and the

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enormous data requirement for business and compliance
will require greater use of technology by banks.

The calculation of capital requirements to take into

account credit risk, market risk and operational risk will
put greater responsibility on banks to assess the
adequacy of their capital and encourage efficiency in the
use of capital.

This will encourage banks to invest and to maintain

necessary technology and equipment and also training
and recruiting specialist staff.

• HR Issues:

IT, risk management and increasing sophistication in

other areas will push up the demand for skilled and
specialized staff.

At the same time, the need to redeploy, retrain and reskill

existing staff remain the major challenge before the
Indian banking industry.

• Greater disclosure and transparency:

Markets will demand more information in banks’

balance sheet and analysts will look for more frequent
and transparent data on risk profile.

This will increase the demand on banks’ systems and

therefore, banks must have computer systems backed by

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knowledge and skill in place to provide the needed
information.

Conclusion

Government equity in nationalized banks is proposed to

be brought down and RBI has expressed a desire to move
out of its ownership of SBI where it currently holds
59.7% equity.

To comply with the new regulations to capture market

risk and operational risk, banks will need to augment
their capital base.

Banks also need additional capital to support expansion

in business and fund infrastructure finance and book
long-term assets.

The subordinated debt raised by banks is required to be

discounted annually by 20% for reckoning as Tier 2
capital.

Moreover, as the debt becomes due for redemption,

banks may need to raise additional capital to maintain
their mandated level of capital adequacy. Already
Central Government has pumped in more than Rs 28,000
crore into banking sector to recapitalise weak banks.

At the same time, integration of the Indian financial

sector with global markets and increasing competition in
the domestic markets has exposed banks to new risks.

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In this milieu, Basel II has rightly dovetailed future
growth with attention to risk management and shoring up
the capital base of banks.

As banks in India graduate to new standards, they will

not only come closer to global best practices but also
reinforce the safety and soundness of banking sector in
the country.

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