Professional Documents
Culture Documents
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. 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.
III.
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 NPAs 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.
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 committee regularly meets four times a year at the Bank for International Settlements (BIS) in Basel, Switzerland where its 10 member Secretariat is located.
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.
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 1990s. 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.
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.
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 investment 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).
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 banks 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.
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 banks books because they require less risk-based capital than the banks internal model indicates.
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.
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 NPAs is very pertinent. The proportion of total NPAs to total advances declined from 23.2 per cent in March 1993 to 7.8 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 government'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
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domestic 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 consolidation of banking are inevitable post Basel II.
V.
Conclusion
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
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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--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
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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.
1. Rahul Sharma 2. Abhishek Tulsyan 3. Sikha Kedia 4. Gourav Modi 5. Praveen Didwania
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