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CP-MAY-2011 IMPACT OF BASEL II NORMS & ITS IMPLEMENTATION

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By:-

Pratik Shah

Anant Gajjar


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A

COMPREHENSIVE

PROJECT REPORTON

IMPACT OF BASEL II NORMS &

ITS IMPLEMENTATION

Prepared At SLIBM Ahmedabad

In the partial fulfillment of Gujarat technological university requirement for the award of thetitle master of business administration

Under the Guidance Of:

MR. ATUL PARIKH

[Ex. Sr. Vice President (Axis Bank),

Mgmt. Consultant and Trainer]

Submitted to: - Compiled and prepared by:-

GUJARAT TECHNOLOGICAL UNIVERSITY PRATIK SHAH [37]

[Enroll no: - 097780592039]

ANANT GAJJAR [12]

[Enroll no: - 097780592042]


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SOM-LALIT INSTITUTE OF BUSINESS

MANAGEMENT

SLIMS Campus, Near St. Xavires College

Navarangpura , Ahmedabad 380009

CERTIFICATE

This is to certify that the project title IMPACT OF BASEL II NORMS & ITS

IMPLEMENTATION is a bonafide work done by Mr.Pratik Shah and Mr. Anant

Gajjar , students of Som Lalit Institute of Business Management.

They have successfully completed and submitted their project under my guidance,

towards partial fulfilment of MBA Programme, year 2009-11.

I am sure that the experience gained during the project work will enable them to

take similar challenges in future.

Date: 19-04-2011

Place: Ahmedabad

Project Guide

............................

MR.ATUL PARIKH

[Ex Sr. Vice President, Axis Bank]


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DECLARATION

We, Mr Pratik Shah and Mr Anant Gajjar , students of MBA , hereby declare

that the project work presented in this report is our contribution and has been

carried out under supervision and guidance of Mr Atul Parikh.

The objective of the grand project is to gain knowledge about Banking industry

and impact of Basel II norms and its implementation. This work has not been

previously submitted to any other university for any other examination.

Date: 19-04-2011

Place: Ahmedabad

Signature:

Mr Pratik Shah Mr Anant Gajjar


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ACKNOWLEDGEMENT

It takes a combined effort of both of us to complete a report. Through this brief note, we

would like to express our gratitude to all those who contributed to the making of this report.

This report is a step to pen down whatever we have learnt while studying the Project

Management.

We would like to thank our Guide Mr. Atul Parikh for giving us an opportunity to work on

such a broad and interesting topic and help us gaining the maximum out of this whole

process.

We would also like to thank Mr. Atul Parikh, for providing us such a fabulous opportunity

to work on this project. Moreover, we thank our college Som-Lalit Institute of BusinessManagement for availing us such an efficient infrastructural facility throughout the process.


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PREFACE

This report gives an overview of the Banking sector in India. With proposal of the Basel II

Norms, the report explains the scope and applications of Basel II Norms. It states the

particulars about the 3 pillars of the Basel II Norms. It studies the initiatives taken by the RBI

for the implementation of the Basel II Accords.

After studying the framework and implementation of the norms, the report studies the

probable impact of the implementation of Basel II Norms on the Indian Banking Sector. It

considers two points while discussing the impact of Basel II Norms on the emerging

economy like India. The first are the consequences emerging economies will have to face

because of Implementation in advanced countries. The second is the impact because of the

implementation within the emerging economy.

Simple language has been used throughout the report. Report is illustrated with figure,

charts and diagrams as and when required.

Finally we hope that this report will be able to give current scenario of banking sector to the

readers.


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EXECUTIVE SUMMARY

This report gives an overview of the Banking sector in India. With proposal of the Basel II

Norms, the report explains the scope and applications of Basel II Norms. It states the

particulars about the 3 pillars of the Basel II Norms. It studies the initiatives taken by the RBI

for the implementation of the Basel II Accords.

After studying the framework and implementation of the norms, the report studies the

probable impact of the implementation of Basel II Norms on the Indian Banking Sector. It

considers two points while discussing the impact of Basel II Norms on the emerging

economy like India. The first are the consequences emerging economies will have to face

because of Implementation in advanced countries. The second is the impact because of the

implementation within the emerging economy.

The research carried out is basically explanatory type, the problems faced by the emerging

economies and the positive & negative impacts of implementation.

The report also states finding of the current scenario of major banks in India with

respect to Basel II implementation. Further the report talks about possible impact of

Basel II norms on the Indian Banking industry.


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17.1 FOREIGN BANKS 6117.2 NATIONALIZED BANKS 6317.3 NEW PRIVATE BANKS 6517.4 OLD PRIVATE BANKS 6917.5 PUBLIC SECTOR BANK 71

18 FINDINGS 72

19 RECOMMENDATIONS 78

20 CONCLUSION 80

21 BIBLIOGRAPHY 82


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OBJECTIVE OF THE STUDY

The objective of the report is to comprehend the impact of Basel II Norms on the

Indian Banking sector and its implementation thereof.

With the Indian economy moving on to a high growth trajectory, consumption levels

soaring and investment riding high, the Indian banking sector is at a defining

moment.

A rapidly growing economy, financial sector reforms, rising foreign investment,

favorable regulatory climate and demographic profile has led to India becoming one

of the fastest growing banking markets in the world. It is generally agreed the

implementation of Basel II is likely to provide momentum for mergers and

acquisitions in the Indian banking industry.

With all this, there is the proposal for the implementation of Basel II Norms.


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METHODOLOGY

Research type Descriptive Research

Here, we are under going to have descriptive research i.e. analysis of banks financial

statements which will make us understand the position of one bank in comparison

of another and their financial position.

Data Source

1) PRIMARY DATA

Banks balance sheet, Banks income statement & Basel II Disclosures.

2)SECONDARY DATA

Banks prospectus, journals, papers & articles, annual reports and otherrelated websites


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INTRODUCTION TO BANKING SECTOR

Indian Banking Industry

Banking in India originated in the first decade of 18th century with The General

Bank of India coming into existence in 1786. This was followed by Bank of

Hindustan. Both these banks are now defunct. The oldest bank in existence in India

is the State Bank of India being established as "The Bank of Bengal" in Calcutta in

June 1806. A couple of decades later, foreign banks like Credit Lyonnais started their

Calcutta operations in the 1850s. At that point of time, Calcutta was the most active

trading port, mainly due to the trade of the British Empire, and due to which

banking activity took roots there and prospered. The first fully Indian owned bank

was the Allahabad Bank, which was established in 1865.

By the 1900s, the market expanded with the establishment of banks such as Punjab

National Bank, in 1895 in Lahore and Bank of India, in 1906, in Mumbai - both of

which were founded under private ownership. The Reserve Bank of India formally

took on the responsibility of regulating the Indian banking sector from 1935. After

India's independence in 1947, the Reserve Bank was nationalized and given

broader powers.


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Nationalization

By the 1960s, the Indian banking industry had become an important tool to facilitate

the development of the Indian economy. At the same time, it emerged as a large

employer, and a debate has ensued about the possibility to nationalize the banking

industry. Indira Gandhi, the-then Prime Minister of India expressed the intention of

the GOI in the annual conference of the All India Congress Meeting in a paper

entitled "Stray thoughts on Bank Nationalization." The paper was received with

positive enthusiasm. Thereafter, her move was swift and sudden, and the GOI

issued an ordinance and nationalized the 14 largest commercial banks with effect

from the midnight of July 19, 1969.

A second dose of nationalization of 6 more commercial banks followed in 1980. The

stated reason for the nationalization was to give the government more control of

credit delivery. With the second dose of nationalization, the GOI controlled around

91% of the banking business of India.

After this, until the 1990s, the nationalized banks grew at a pace of around 4%, closerto the average growth rate of the Indian economy.

Liberalization

In the early 1990s the then Narasimha Rao government embarked on a policy of

liberalization and gave licenses to a small number of private banks, which came to

be known as New Generation tech-savvy banks, which included banks such as UTI

Bank(now re-named as Axis Bank) (the first of such new generation banks to be set

up), ICICI Bank and HDFC Bank. This move, along with the rapid growth in the

economy of India, kick started the banking sector in India, which has seen rapid

growth with strong contribution from all the three sectors of banks, namely,

government banks, private banks and foreign banks.


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The next stage for the Indian banking has been setup with the proposed relaxation in

the norms for Foreign Direct Investment, where all Foreign Investors in banks may

be given voting rights which could exceed the present cap of 10%,at present it hasgone up to 49% with some restrictions.

The new policy shook the Banking sector in India completely. Bankers, till this time,

were used to the 4-6-4 method (Borrow at 4%; Lend at 6%;Go home at 4) of

functioning. The new wave ushered in a modern outlook and tech-savvy methods of

working for traditional banks. All this led to the retail boom in India. People not just

demanded more from their banks but also received more.

Current Situation

Currently (2007), banking in India is generally fairly mature in terms of supply,

product range and reach-even though reach in rural India still remains a challenge

for the private sector and foreign banks. In terms of quality of assets and capital

adequacy, Indian banks are considered to have clean, strong and transparent balance

sheets relative to other banks in comparable economies in its region. The Reserve

Bank of India is an autonomous body, with minimal pressure from the government.

The stated policy of the Bank on the Indian Rupee is to manage volatility but

without any fixed exchange rate-and this has mostly been true.

With the growth in the Indian economy expected to be strong for quite some time-

especially in its services sector-the demand for banking services, especially retail

banking, mortgages and investment services are expected to be strong. One may also

expect M&As, takeovers, and asset sales.


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In March 2006, the Reserve Bank of India allowed Warburg Pincus to increase its

stake in Kotak Mahindra Bank (a private sector bank) to 10%. This is the first time an

investor has been allowed to hold more than 5% in a private sector bank since the

RBI announced norms in 2005 that any stake exceeding 5% in the private sectorbanks would need to be vetted by them.

Currently, India has 88 scheduled commercial banks (SCBs) - 28 public sector banks

(that is with the Government of India holding a stake), 29 private banks (these do not

have government stake; they may be publicly listed and traded on stock exchanges)

and 31 foreign banks. They have a combined network of over 53,000 branches and

17,000 ATMs. According to a report by ICRA Limited, a rating agency, the public

sector banks hold over 75 percent of total assets of the banking industry, with the

private and foreign banks holding 18.2% and 6.5% respectively.


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INTRODUCTION TO BASEL II NORMS

In the four years since it was introduced by the Basel Committee for Banking

Supervision, the Basel II Capital Accord has evolved as a complex set ofrecommendations that will likely create avariety of regulatory compliance challenges

for banks in Europe and around the globe.

More important, however, are the wide range of business implications and risk

management challenges that Basel II (the New Accord) could trigger for banks,

their non-bank competitors, customers, rating agencies, regulators, and, ultimately,

the global capital markets.

For example:

_ Banks will be asked to implement an enterprise-wide risk management framework

that ties regulatory capital to economic capital.

_ Non-banks outside the scope of Basel II will not face its compliance challenges but

may nonetheless want to use it as a competitive benchmark.

_ Bank customers will need to collect and disclose new information and likely will

face new risk structures as a result of increased transparency.

_ Rating agencies have new prominence under Basel II and thus could experience

new competition.

_ Regulators are asked to provide a level playing field as the Basel Committees

recommendations are implemented by legislatures in various countries.

_ The global banks could experience extended trends toward securitization as

financial institutions adapt to Basel II requirements.


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The complexity of the New Accord, as well as its interdependencies with

International Financial Reporting Standards and local regulation worldwide, makes

implementation of Basel II a highly complex project. For a bank, a project will be

driven by the structure of its business, beginning with its strategy and encompassingits risk management and capital calculation methods, business processes, data

requirements, and IT systems. With a structured and disciplined approach, banks

can begin to achieve the Basel Committees intended benefits of enhanced risk

management and lower capital requirements. Such changes, in turn, could influence

banks strategies, customer relations, and, over time, their business models.


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CAPITAL ADEQUACY

Capital Adequacy is a measure that ensures that the banks have enough capital toabsorb a reasonable amount of loss in any adverse situations. It is calculated using

the Capital Adequacy Ratio (CAR). Capital Adequacy Ratio is also called as called

Capital to Risk Assets Ratio.

Capital adequacy ratio is the ratio, which determines the capacity of the bank in

terms of meeting the time liabilities and other risk such as credit risk, operational

risk, etc. In the simplest formulation, a bank's capital is the "cushion" for potential

losses, which protects the bank's depositors or other lenders. Banking regulators in

most countries define and monitor CAR to protect depositors, thereby maintaining

confidence in the banking system.

Since different types of assets have different risk profiles, CAR primarily adjusts for

assets that are less risky by allowing banks to "discount" lower-risk assets. The

specifics of CAR calculation vary from country to country, but general approaches

tend to be similar for countries that apply the Basel Accords.

In the most basic application, government debt is allowed a zero percent "riskweightage" this is because in case of losses or non-repayment of loans the

government takes care of the payments. Thus they are subtracted from total assets

for purposes of calculating the CAR.


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Objectives of CAR: The fundamental objective behind the norms is to strengthen the

soundness and stability of the banking system.

Capital Adequacy Ratio or CAR or CRAR: It is ratio of capital fund to risk weighted

assets expressed in percentage terms i.e.

Minimum requirements of capital fund in India:

* Existing Banks 09 %

* New Private Sector Banks 10 %

* Banks undertaking Insurance business 10 %

* Local Area Banks 15%


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NEED FOR BASEL II NORMS

In 1988 the Bank for International Settlements Basel Committee on BankingSupervision, commonly known as the Basel Committee, imposed the Basel Capital

Accord. The Basel Capital Accord introduced a system for implementing a credit risk

framework for determining the minimum amount of capital that a bank must hold

as a cushion against risks. The Basel Capital Accord was adopted over time not only

in member countries, but in virtually all countries operating international banks.

One problem with the original Basel Capital Accord was that it took a "one size fitsall" approach, without regard for the actual operational risk incurred by the bank. In

2004, the Basel II Accord was established. The new accord aligns the requirement for

capital on hand with the actual risk involved, providing an incentive for banks to

improve risk management.

Basel II is the second of the Basel Accords recommended on banking laws and

regulations issued by the Basel Committee on Banking Supervision. The purpose ofBasel II is to create an international standard that banking regulators can use when

creating regulations about how much capital banks need to put aside to guard

against the types of financial and operational risk banks face. These international

standards can help protect the international financial system from the types of

problems that might arise should a major bank or a series of banks collapse.

Basel II insists on setting up rigorous risk and capital management requirementsdesigned to ensure that a bank holds capital reserves appropriate to the risk The

underlying assumption behind these rules is that the greater risk to which the bank

is exposed, the greater the amount of capital the bank needs to hold to safeguard its

solvency and overall economic stability. It will also oblige banks to enhance

disclosures.


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Thus Indian banks require Basel II compliance for the

following reasons:-

1) Basel II norms will facilitate introduction of new complex financial products in

Indian Banking Sector.

2) Indian banks require a more risk sensitive framework. There is improvement in

risk management system by Indian banks.

3) New rules will provide a range of options for estimating regulatory capital and

will reduce gap between regulatory capital & economic capital.

Indian banks today, operate in an environment characterized by progressive

deregulation, increased global integration and IT usage which have opened up a

plethora of domestic and international opportunities for them. In light of this, RBI

has enforced mandatory adoption of Basel II guidelines for Indian banks which are a

set of prudential regulatory norms with an almost universal acceptance.


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SCOPE OF APPLICATION

This Framework will be applied on a consolidated basis to internationally activebanks. The scope of application of the Framework will include, on a fully

consolidated basis, any holding company that has the parent entity within a banking

group to ensure that it captures the risk of the whole banking group. The Framework

will also apply to all internationally active banks at every tier within a banking

group, also on a fully consolidated basis. A three-year transitional period for

applying full sub-consolidation will be provided for those countries where this is not

currently a requirement.

Further, as one of the principal objectives of supervision is the protection of

depositors, it is essential to ensure that capital recognized in capital adequacy

measures is readily available for those depositors. Accordingly, supervisors should

test that individual banks are adequately capitalized on a stand-alone basis.


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Diversified Financial

Group

Holding Company

Internationally

Active Bank

Internationally

Active Bank

Domestic

Banks

Internationally

Active Bank

Securities Firm

[1]

[2]

[3] [4]

[1] Boundary of predominant banking group. The framework is applied at this levelon a consolidated basis, i.e. up to holding company level.

[2] [3] & [4] : The framework is also applied to lower levels to all internationally

active banks on a consolidated basis.


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HISTORY OF BASEL II

The initial Basel Accord in 1988 was based on a simple model to measure capital. Intoday's world this approach is less meaningful for many banks. For example, in the

1998 Accord the risk was based across exposure groups and not the individual

elements of credit worthiness within these groups. There have been many advances

which will allow a more detailed approach to calculating Capital, such as better

Credit ratings information and the development of Information technology.

Also, improvements in internal processes and better risk management practices such

as securitisation have changed leading organisations monitoring and management of

exposures and activities. Supervisors and sophisticated banking organisations have

found that the static rules set out in the 1988 Accord have not kept pace with

advances in sound risk management practices. It's likely that existing capital

regulations may not reflect banks actual business practices.

The upgraded Basel II Framework relates more to the underlying risks in banking

and provides better incentives for improved risk management. It builds on the 1988

Accords basic structure for setting capital requirements and improves the capital

frameworks sensitivity to the risks that banks actually face. This will be achieved in

part by aligning capital requirements more closely to the risk of credit loss and by

introducing a new capital charge for exposures to the risk of loss caused by

operational failures.

Basel will demand that a certain minimum Capital requirement is met, as well as

another two important factors, the Supervisory Role and Market Discipline.


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'DRAFT' GUIDELINES FOR IMPLEMENTATION OF BASEL II IN INDIA

The Basel Committee on Banking Supervision (BCBS) has released the document,

"International Convergence of Capital Measurement and Capital Standards: ARevised Framework" on June 26, 2004. The revised Framework has been designed to

provide options for banks and banking systems, for determining the capital

requirements for credit risk and operational risk and enables banks / supervisors to

select approaches that are most appropriate for their operations and financial

markets. The Framework is expected to promote adoption of stronger risk

management practices in banks.

The Revised Framework, popularly known as Basel II, builds on the current

framework to align regulatory capital requirements more closely with underlying

risks and to provide banks and their supervisors with several options for assessment

of capital adequacy. Basel II is based on three mutually reinforcing pillars -

minimum capital requirements, supervisory review, and market discipline. The

three pillars attempt to achieve comprehensive coverage of risks, enhance risk

sensitivity of capital requirements and provide a menu of options to choose for

achieving a refined measurement of capital requirements.

The Revised Framework consists of three-mutually reinforcing Pillars, viz. minimum

capital requirements, supervisory review of capital adequacy, and market discipline.

Under Pillar 1, the Framework offers three distinct options for computing capital

requirement for credit risk and three other options for computing capital

requirement for operational risk. These approaches for credit and operational risks

are based on increasing risk sensitivity and allow banks to select an approach that is

most appropriate to the stage of development of bank's operations.


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The approaches available for computing capital for credit risk are StandardisedApproach, Foundation Internal Rating Based Approach and Advanced Internal

Rating Based Approach. The approaches available for computing capital for

operational risk are Basic Indicator Approach, Standardised Approach and

Advanced Measurement Approach.

With a view to ensuring migration to Basel II in a non-disruptive manner, the

Reserve Bank has adopted a consultative approach. A Steering Committee

comprising of senior officials from 14 banks (private, public and foreign) has been

constituted where Indian Banks' Association is also represented.

Keeping in view the Reserve Bank's goal to have consistency and harmony with

international standards it has been decided that at a minimum, all banks in India

will adopt Standardized Approach for credit risk and Basic Indicator Approach for

operational risk with effect from March 31, 2007. After adequate skills are developed,

both in banks and at supervisory levels, some banks may be allowed to migrate to

IRB Approach after obtaining the specific approval of Reserve Bank.

As the Basel II Capital Accord continues to evolve, the Basel Committee on Banking

Supervision1 moves closer to its goal of aligning banking risks and their

management with capital requirements. By redefining how banks worldwide

calculate regulatory capital and report compliance to regulators and the public,


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Basel II is intended to improve safety and soundness in the financial system by

placing increased emphasis on banks own internal control and risk management

processes and models, the supervisory review process, and market discipline.

While the 1988 Capital Accord addressed market and credit risks, Basel II

substantially changes the treatment of credit risk and also requires that banks have

sufficient capital to cover operational risks. It also imposes qualitative requirements

on the management of all risks as well as new disclosures Basel II is scheduled to be

implemented by various country bank regulators by the end of 2006, but banks must

begin compliance efforts now if they are to strengthen their risk management

capabilities and gather the extensive data that is required in some cases. They should

make these efforts despite uncertainty about how local regulators will ultimately

apply the New Accord to their regulatory capital requirements.

To be able to implement Basel II sufficiently, most banks will need to rethink their

business strategies as well as the risks that underlie them. Indeed, calculating capital

requirements under the New Accord requires a bank to implement a comprehensive

risk framework across the institution. The risk management improvements that are

the intended result may be rewarded by lower capital requirements. However, large

implementation projects will likely have wide-ranging effects on a banks

information technology systems, processes, people, and businessbeyond the

regulatory compliance and finance functions.

Basel II also encourages ongoing improvements in risk assessment and mitigation.

Thus, over time, it presents banks with the opportunity to gain competitive

advantage by allocating capital to those processes, segments, and markets that

demonstrate a strong risk/return ratio. Developing a better understanding of the

risk/reward trade-off for capital supporting specific businesses, customers,

products, and processes is one\ of the most important potential business benefits

banks may derive from compliance, as envisioned by the Basel Committee.


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Since the first consultative paper on the New Accord was issued in July 1999, some

banks have tended to treat compliance with Basel II as a technical issue. In fact, forinstitutions worldwide, Basel II compliance is a risk management challenge with

strategic business implications. Indeed, even those institutions that are not required

to comply with the New Accord will likely tend to use it as a risk management

benchmark so they may remain competitive with those that must comply.


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TIME LINE FOR BASEL II IMPLEMENTATION

The capital allocation under Basel II is more risk sensitive and comprehensive and its

implementation would result in improved risk management at banks. Nevertheless

the implementation of New Accord is by no means an easy task especially in

countries where risk management in banks is at its infancy stage. The proposed

implementation plan has been prepared on the basis of;

a) Feedback obtained from the banksb) Assessment of financial impact derived from quantitative Impact Study

carried out by Banking Supervision Department

c) Implementation of Basel II across various countries, especially in developingeconomies.


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Basel II Creates Advantages and Disadvantages for Banks Business

With Basel IIs implementation, banks average capital requirements should not

change significantly on an industry level, but an individual bank may experience a

significant change. For example, capital requirements should drop substantially at a

bank with a prime business portfolio that is well collateralized. On the other hand, a

bank with a high-risk portfolio will likely face higher capital requirements and,

consequently, limits on its business potential. Those deemed high risk couldinclude banks that are pure risk takers with a buy-and-hold credit management

approach, no clear customer segmentation, a lack of collateral management as well

as inadequate processes, unstable IT systems, and a poor overall risk management

function. Indeed, such entities may not be able to make the necessary investment in

compliance; thus, consolidation in the banking industry can be expected to continue

in certain regions and markets. As Basel II helps banks differentiate customers by

risk, advantages and disadvantages will likely emerge for bank customers.

Those with a possible advantage:

_ Prime mortgage customers

_ Well-rated entities

_ High-quality liquidity portfolios

_ Collateralized and hedged exposures

_ Small and medium-sized businesses


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Those with a possible disadvantage:

_ higher credit risk individuals_ Uncollateralized credit

_ specialized lending (in some cases)


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PILLAR I: MINIMUM CAPITAL REQUIREMENT

Introduction:

The first pillar deals with maintenance of regulatory capital calculated for three

major components of risk that a bank faces: credit risk, operational risk, and market

risk. Other risks are not considered fully quantifiable at this stage.

The credit risk component can be calculated in three different ways of varying

degree of sophistication, namely standardized approach, Foundation IRB and

Advanced IRB. IRB stands for "Internal Rating-Based Approach".

For operational risk, there are three different approaches - basic indicator approach

or BIA, standardized approach or TSA, and the internal measurement approach (an

advanced form of which is the advanced measurement approach or AMA).

For market risk the preferred approach is VaR (value at risk).

As the Basel 2 recommendations are phased in by the banking industry it will move

from standardized requirements to more refined and specific requirements that have

been developed for each risk category by each individual bank. The upside for banks

that do develop their own bespoke risk measurement systems is that they will be

rewarded with potentially lower risk capital requirements. In future there will be

closer links between the concepts of economic profit and regulatory capital.

Credit Risk can be calculated by using one of three approaches:

1. Standardized Approach

2. Foundation IRB (Internal Ratings Based) Approach

3. Advanced IRB Approach


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The standardized approach sets out specific risk weights for certain types of credit

risk. The standard risk weight categories are used under Basel 1 and are 0% for short

term government bonds, 20% for exposures to OECD Banks, 50% for residential

mortgages and 100% weighting on unsecured commercial loans. A new 150% ratingcomes in for borrowers with poor credit ratings. The minimum capital requirement

(the percentage of risk weighted assets to be held as capital) remains at 8%.

For those Banks that decide to adopt the standardized ratings approach they will be

forced to rely on the ratings generated by external agencies. Certain Banks are

developing the IRB approach as a result.


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TYPES OF RISKS

Credit risk

A bank always faces the risk that some of its borrowers may renege on their

promises for timely repayments of loan, interest on loan or meet the other terms of

contract. This risk is called credit risk, which varies from borrower to borrower

depending on their credit quality. Basel II requires banks to accurately measure

credit risk to hold sufficient capital to cover it.

Factors affecting credit risk can be summarized by the following formula:

Expected Loss (EL) on a loan = Exposure at default (EAD) * Loss given default

(LGD) * Probability of Default (PD)


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The bank can also suffer losses in excess of expected losses, say, during economic

downturns. These losses are called unexpected losses. Ideally, a bank should recover

expected loss on a loan from its customer through loan pricing. The capital base is

required to absorb the unexpected losses, as and when they arise.

Market risk

As part of the statutory requirement, in the form of SLR (statutory liquidity ratio),

banks are required to invest in liquid assets such as cash, gold, government and

other approved securities. For instance, Indian banks are required to invest 25 per

cent of their net demand and term liabilities in cash, gold, government securities and

other eligible securities to comply with SLR requirements.

Such investments are risky because of the change in their prices. This volatility in the

value of a bank's investment portfolio in known as the market risk, as it is driven by

the market. The change in the value of the portfolio can be due to changes in the

interest rates, foreign exchange rates or the changes in the values of equity or

commodities.

Operational risk

Several events that are neither due to default by third party nor because of the

vagaries of the market. These events are called operational risks and can be

attributed to internal systems, processes, people and external factors.

Pillar I ensures that banks measure their risks properly and maintain adequate

capital to cover them. But can Pillar I alone ensure that there are no more bank

failures? No. As any stable structure cannot stand on a single pillar, Basel II relies on

the pillars of supervisory reviews and market discipline to keep the banks healthy.


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:--The structure of several operational risk measurement methodologies.

The Basic Indicator approach

The Basic Indicator Approach is the simplest, but it will charge the most capital

generally. It's based on a straight percentage of gross income, which includes net

interest income and net non-interest income but excludes extraordinary or irregular

items. While this approach may roughly capture the scale of an institutions

operations, it surely has only the most questionable link to the risk of an expected

loss due to internal or external events.

The Standardized Approach

The concept for applying the Standardized Approach is basically the same as the

Basic Indicator Approach. The main difference between the two is that The

Standardized Approach must divide the banks business operations into 8 business

lines: corporate finance, trading & sales, retail banking, commercial banking,

payment & settlement, agency services, asset management, and retail brokerage.


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Business Lines Risk Weights

Corporate finance 18%Trading and sales 18%

Retail Banking 12%Commercial Banking 15%Payment and Settlement 18%Agency Services 15%Asset Management 12%Retail Brokerage 12%

:--Percentage of the relative weighting of the business lines

In the Standardized Approach, the gross income is measured for each business line,not the whole institution. For example: in corporate finance, the indicator is the gross

income generated in the corporate finance business line.

The Advanced Measurement Approach

As one can see, the gross income is the basis for calculating a capital charge for both

the Basic Indicator and Standardized Approaches. In practice, these two approaches

calculate the most capital charges, compared to the Advanced Measurement

Approach.

The Advanced Measurement Approach (AMA) is the last approach. This approach

charges the least amount of capital; also this approach is comparatively more

sophisticated. However, going by the sophistication of the AMA from the

perspective of the cost beneficial factor, it will perhaps be wrong to conclude that it

is thus far the best approach, for some banks. Consider that only large banks have

the financial power to implement this approach and also make it profitable. The

AMA, however, offers the greatest possibility to reduce capital requirements. It

includes three approaches, namely the internal measurement approach (IMA), the

scorecard approach and the Loss Distribution Approach.


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TIER I CAPITALIn order to protect the integrity of Tier 1 capital, the Committee has determined that

minority interests in equity accounts of consolidated subsidiaries that take the form

of SPVs should only be included in Tier 1 capital if the underlying instrument meets

the following requirements which must, at a minimum, be fulfilled by all

instruments included in Tier 1:

issued and fully paid;

non-cumulative;

able to absorb losses within the bank on a going-concern basis;

junior to depositors, general creditors, and subordinated debt of the bank;

permanent;

neither be secured nor covered by a guarantee of the issuer or related entity or

other arrangement that legally or economically enhances the seniority of the

claim vis--vis bank creditors; and

callable at the initiative of the issuer only after a minimum of five years with

supervisory approval and under the condition that it will be replaced withcapital of same or better quality unless the supervisor determines that the

bank has capital that is more than adequate to its risks.


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TIER II CAPITAL:

1. Undisclosed reserves

Under this heading are included only reserves which, though unpublished, have

been passed through the profit and loss account and which are accepted by the

bank's supervisory authorities.

2. Revaluation reserves

Some countries, under their national regulatory or accounting arrangements, allow

certain assets to be revalue to reflect their current value, or something closer to their

current value than historic cost, and the resultant revaluation reserves to be included

in the capital base.

3. General provisions/general loan-loss reserves

General provisions or general loan-loss reserves are created against the possibility of

losses not yet identified. Where they do not reflect a known deterioration in the

valuation of particular assets, these reserves qualify for inclusion in Tier 2 capital.


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4. Hybrid debt capital instruments

In this category fall a number of capital instruments which combine certain

characteristics of equity and certain characteristics of debt. Each of these has

particular features which can be considered to affect its quality as capital.

5. Subordinated term debt

The Committee is agreed that subordinated term debt instruments have significant

deficiencies as constituents of capital in view of their fixed maturity and inability toabsorb losses except in liquidation.

Both Tier I and Tier II capital were first defined in the Basel I capital accord. More

specifically, Tier I Capital is a measure of capital adequacy of a bank, and is the ratio

of a bank's core equity capital to its total risk-weighted assets.
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TIER III CAPITAL:

Tier III capital consists of short-term subordinated debt maintained for the solepurpose of meeting a portion of the capital requirements for market risks, subject to

the condition that PDs (Perpetual Debts) will be entitled to use Tier-II capital solely

to support market risks. This means that capital requirements arising in respect of

credit and counter-party risk, including the credit counter-party risk in respect of

derivatives, need to be met by Tier-I and Tier-II capital only. The sum total of Tier-II

plus Tier-III capital should not exceed the total Tier-I capital.

Risk weighted assets is the total of all assets held by the bank which are weighted for

credit risk according to a formula determined by the Regulator (usually the country's

Central Bank). Most Central Banks follow the BIS - Bank of International Settlements

guidelines in setting asset risk weights. Assets like cash and coins usually have zero

risk weights, while unsecured loans might have a risk weight of 100%.

The first pillar sets out minimum capital requirement. The new framework

maintains minimum capital requirement of 8% of risk assets. In India though, RBI

norms on capital requirement is at 9%, which is more stringent than the Basel

Committee stipulation of 8%.
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Under the new accord capital adequacy ratio will be measured as under

Capital Adequacy Ratio (CAR) = Total Capital

Risk Weighted Assets

i.e. CAR = Tier I Capital + Tier II Capital +Tier III Capital

Credit risk + Market risk + Operational risk

(Tier III capital has not yet been introduced in India.)

Basel II focuses on improvement in measurement of risks. The revised credit risk

measurement methods are more elaborate than the current accord. It proposes, for

the first time, a measure for operational risk, while the market risk measure remains

unchanged


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PILLAR II: SUPERVISORY REQUIREMENTS

Introduction:This section discusses the key principles of supervisory review, supervisory

Transparency and accountability and risk management guidance produced by the

Committee with respect to banking risks, including guidance pertaining to the

treatment of interest rate risk in the banking book

Pillar II is based on a series of four key principles of supervisory Review. These

principles address two central issues:

1) The need for banks to assess capital adequacy relative to risks overall, and

2) The need for supervisors to review banks assessments and, consequently, to

determine whether to require banks to hold additional capital beyond that required

under Pillar I.

To comply with Pillar II, banks must implement a consistent risk-adjusted

management framework that is comparable in its sophistication to, and closely

linked with, the risk approaches the bank chose under Pillar I. The four principles

provide necessary guidance, as does the Basel Committees other guidance related to

the supervisory review process.


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FOUR KEY PRINCIPLES OF SUPERVISORY REVIEW

The Committee has identified four key principles of supervisory review, which are

discussed in the Supervisory Review Process.

The four key principles complement those outlined in the extensive supervisory

guidance that has been developed by the Basel Committee, the keystone of which is

the Core Principles for Effective Banking Supervision and the Core Principles

Methodology.

Principle 1: Banks should have a process for assessing their overall capitaladequacy in relation to their risk profile and a strategy for maintaining

their capital levels.

Banks must be able to demonstrate that chosen internal capital targets are well

founded and these targets are consistent with their overall risk profile and current

operating environment. In assessing capital adequacy, bank management needs to

be mindful of the particular stage of the business cycle in which the bank is

operating. Rigorous, forward looking stress testing that identifies possible events or

changes in market conditions that could adversely impact the bank should be

performed. Bank management clearly bears primary responsibility for ensuring that

the bank has adequate capital to support its risks.

The five main features of a rigorous process are as follows:

1. Board and senior management oversight;2. Sound capital assessment;3. Comprehensive assessment of risks;4. Monitoring and reporting; and5. Internal control review.


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1. BOARD AND SENIOR MANAGEMENT OVERSIGHT

A sound risk management process is the foundation for an effective assessment of

the adequacy of banks. Capital positions. Bank management is responsible forunderstanding the nature and level of risk being taken by the bank and how these

risks relate to adequate capital levels. It is also responsible for ensuring that the

formality and sophistication of the risk management processes are appropriate in

light of the risk profile and business plan. The analysis of banks. current and future

capital requirements in relation to strategic objectives is a vital element of the

strategic planning process.

This section of the paper refers to a management structure composed of a board of

directors and senior management. The Committee is aware that there are significant

differences in legislative and regulatory frameworks across countries as regards the

functions of the board of directors and senior management. In some countries, the

board has the main, if not exclusive, function of supervising the executive body

(senior management, general management) so as to ensure that the latter fulfils its

tasks. For this reason, in some cases, it is known as a supervisory board. This means

that the board has no executive functions. In other countries, by contrast, the board

has a broader competence in that it lays down the general framework for the

management of the bank.

Owing to these differences, the notions of the board of directors and senior

management are used in this section not to identify legal constructs but rather to

label two decision-making functions within a bank. clearly outline the banks capital

needs, anticipated capital expenditures, desirable capital level, and external capital

sources. Senior management and the board should view capital planning as a crucial

element in being able to achieve its desired strategic objectives. The banks board of

directors has responsibility for setting the banks tolerance for risks. They should

also ensure that management establishes a measurement system for assessing the


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various risks, develops a system to relate risk to the banks capital level, and

establishes a method for monitoring compliance with internal policies. It is likewise

important that the board of directors adopts and supports strong internal controls

and written policies and procedures and ensures that management effectivelycommunicates these throughout the organisation.

2. SOUND CAPITAL ASSESSMENT

Fundamental elements of sound capital assessment include:

1. Policies and procedures designed to ensure that the bank identifies, measures,and reports all material risks;

2. a process that relates capital to the level of risk;3. a process that states capital adequacy goals with respect to risk, taking

account of the banks strategic focus and business plan; and

4. a process of internal controls, reviews and audit to ensure the integrity of theoverall management process.

3. COMPREHENSIVE ASSESSMENT OF RISKS

All material risks faced by the bank should be addressed in the capital assessment

process. While it is recognised that not all risks can be measured precisely, a process

should be developed to estimate risks. Therefore, the following risk exposures,

which by no means constitute a comprehensive list of all risks, should be considered.


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Credit risk: Banks should have methodologies that enable them to assess the credit

risk involved in exposures to individual borrowers or counterparties as well as at the

portfolio level. For more sophisticated banks, the credit review assessment of capital

adequacy, at a minimum, should cover four areas: risk rating systems, portfolioanalysis/aggregation, securitisation/complex credit derivatives, and large exposures

and risk concentrations. Internal risk ratings are an important tool in monitoring

credit risk. Internal risk ratings should be adequate to support the identification and

measurement of risk from all credit exposures, and should be integrated into an

institutions overall analysis of credit risk and capital adequacy. The ratings system

should provide detailed ratings for all assets, not only for criticised or problem

assets. Loan loss reserves should be included in the credit risk assessment for capital

adequacy.

The analysis of credit risk should adequately identify any weaknesses at the

portfolio level, including any concentrations of risk. It should also adequately take

into consideration the risks involved in managing credit concentrations and other

portfolio issues through such mechanisms as securitisation programs and complex

credit derivatives. Further, the analysis of counterparty credit risk should include

consideration of public evaluation of the supervisors compliance with the Core

Principles of Effective Banking Supervision.

Market risk: This assessment is based largely on the banks own measure of value-

at-risk. Emphasis should also be on the institution performing stress testing in

evaluating the adequacy of capital to support the trading function.

Interest rate risk in the banking book: The measurement process should include all

material interest rate positions of the bank and consider all relevant reprising and

maturity data. Such information will generally include: current balance and

contractual rate of interest associated with the instruments and portfolios, principal


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payments, interest reset dates, maturities, and the rate index used for reprising and

contractual interest rate ceilings or floors for adjustable-rate items. The system

should also have well-documented assumptions and techniques. Regardless of the

type and level of complexity of the measurement system used, bank managementshould ensure the adequacy and completeness of the system. Because the quality

and reliability of the measurement system is largely dependent on the quality of the

data and various assumptions used in the model, management should give

particular attention to these items.

Liquidity Risk: Liquidity is crucial to the ongoing viability of any banking

organisation. Banks. Capital positions can have an effect on their ability to obtain

liquidity, especially in a crisis. Each bank must have adequate systems for

measuring, monitoring and controlling liquidity risk. Banks should evaluate the

adequacy of capital given their own liquidity profile and the liquidity of the markets

in which they operate.

Other risk: The Committee recognises that within the other risk category,

operational risk tends to be more measurable than risks such as strategic and

reputational. The Committee wants to enhance operational risk assessment efforts by

encouraging the industry to develop methodologies and collect data related to

managing operational risk. For the purposes of measurement under Pillar 1 the

Committee expects the industry to focus primarily upon the operational risk

component of other risks. However, it also expects the industry to further develop

techniques for measuring, monitoring and mitigating all aspects of other risks.


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4. MONITORING AND REPORTING

The bank should establish an adequate system for monitoring and reporting risk

exposures and how the banks changing risk profile affects the need for capital. Thebanks senior management or board of directors should, on a regular basis, receive

reports on the banks risk profile and capital needs.

These reports should allow senior management to:

1. evaluate the level and trend of material risks and their effect on capital levels;2. evaluate the sensitivity and reasonableness of key assumptions used in the

capital assessment measurement system;

3. determine that the bank holds sufficient capital against the various risks andthat they are in compliance with established capital adequacy goals; and

4. assess its future capital requirements based on the bank.s reported risk profileand make necessary adjustments to the banks strategic plan accordingly.

5. INTERNAL CONTROL REVIEW

The banks internal control structure is essential to the capital assessment process.

Effective control of the capital assessment process includes an independent review

and, where appropriate, the involvement of internal or external audits. The banks

board of directors has a responsibility to ensure that management establishes ameasurement system for assessing the various risks, develops a system to relate risk

to the bank.s capital level, and establishes a method for monitoring compliance with

internal policies. The board should regularly verify whether its system of internal

controls is adequate to ensure well-ordered and prudent conduct of business. The

bank should conduct periodic reviews of its risk management process to ensure its

integrity, accuracy, and reasonableness.


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Areas that should be reviewed include:

1. the appropriateness of the bank.s capital assessment process given the nature,scope and complexity of its activities;

2. the identification of large exposures and risk concentrations;3. the accuracy and completeness of data inputs into the banks assessment

process;

4. the reasonableness and validity of scenarios used in the assessment process,and

5. stress testing and analysis of assumptions and inputs.

Principle 2: Supervisors should review and evaluate banks internal capitaladequacy assessments and strategies, as well as their ability to monitor and

ensure their compliance with regulatory capital ratios. Supervisors should

take appropriate supervisory action if they are not satisfied with the result

of this process.

The supervisory authorities should regularly review the process by which banks

assess their capital adequacy, the risk position of the bank, the resulting capital

levels and quality of capital held. Supervisors should also evaluate the degree to

which banks have in place a sound internal process to assess capital adequacy. Theemphasis of the review should be on the quality of the bank.s risk management and

controls and should not result in supervisors functioning as bank management.


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The periodic review can involve some combination of:

1. on-site examinations or inspections;2. off-site review;3. discussions with bank management;4. review of work done by external auditors (provided it is adequately focused

on the necessary capital issues), and

5. periodic reporting.

The substantial impact that errors in the methodology or assumptions of formal

analyses can have on resulting capital requirements requires a detailed review by

supervisors of each banks internal analysis.

(i) Review of adequacy of risk assessment

Supervisors should assess the degree to which internal targets and processes

incorporate the full range of material risks faced by the bank. Supervisors should

also review the adequacy of risk measures used in assessing internal capital

adequacy and the extent to which these risk measures are also used operationally in

setting limits, evaluating business line performance and evaluating and controlling

risks more generally. Supervisors should consider the results of sensitivity analyses

and stress tests conducted by the institution and

how these results relate to capital plans.


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(ii) Assessment of capital adequacy

Supervisors should review the banks processes to determine:

1. that the target levels of capital chosen are comprehensive and relevant to thecurrent operating environment;

2. that these levels are properly monitored and reviewed by seniormanagement; and

3. that the composition of capital is appropriate for the nature and scale of thebanks business.

Supervisors should also consider the extent to which the bank has provided for

unexpected events in setting its capital levels. This analysis should cover a wide

range of external conditions and scenarios, and the sophistication of techniques and

stress tests used

should be commensurate with the bank.s activities.

(iii) Assessment of the control environment

Supervisors should consider the quality of the banks management information

reporting and systems, the manner in which business risks and activities are

aggregated, and managements record in responding to emerging or changing risks.

In all instances, the economic capital levels at individual banks should be

determined according to the banks risk profile and adequacy of its risk management

process and internal controls. External factors such as business cycle effects and themacroeconomic environment should also be considered.


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(iv) Supervisory review of compliance with minimum standards

In order for certain internal methodologies, credit risk mitigation techniques and

asset securitisations to be recognised for regulatory capital purposes, banks willneed tomeet a number of requirements, including risk management standards and

disclosure. Inparticular, banks will be required to disclose features of their internal

methodologies used in calculating minimum capital requirements. As part of the

supervisory review process,supervisors must ensure that these conditions are being

met on an ongoing basis.The Committee regards this review of minimum standards

and qualifying criteria asan integral part of the supervisory review process under

Principle 2. In setting the minimum criteria the Committee has considered current

industry practice and so anticipates that these minimum standards will provide

supervisors with a useful set of benchmarks which are aligned with bank

management expectations for effective risk management and capitalallocation.There

is also an important role for supervisory review of compliance with certain

conditions and requirements set for standardised approaches. In this context, there

will be aparticular need to ensure that use of various instruments that can reduce

Pillar 1 capitalrequirements are utilised and understood as part of a sound, tested,

and properlydocumented risk management process.

(v) Supervisory response

Having carried out the review process described above, supervisors should take

appropriate action if they are not satisfied with the results of the banks own riskassessment and capital allocation. Supervisors should consider a range of actions,

such as those set out under Principle 3 and 4 below.


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Principle 3: Supervisors should expect banks to operate above theminimum regulatory capital ratios and should have the ability to require

banks to hold capital in excess of the minimum.

Pillar 1 capital requirements will include a buffer for uncertainties surrounding the

Pillar 1 regime which affect the banking population as a whole. Bank-specific

uncertainties will be treated under Pillar 2. It is anticipated that such buffers under

Pillar 1 will be set to provide reasonable assurance that banks with good internal

systems and controls, a well diversified risk profile and a business profile well

covered by the Pillar 1 regime, and who operate with capital equal to Pillar 1

requirements will meet the minimum goals for soundness embodied in Pillar 1.

Supervisors will need to consider, however, whether the particular features of the

markets for which it is responsible are adequately covered.

Supervisors will typically require (or encourage) banks to operate with a buffer, over

and above the Pillar 1 standard.

Banks should maintain this buffer for a combination of the following:

(a) Pillar 1 minimums are anticipated to be set to achieve a level of bank

creditworthiness in markets that is below the level of creditworthiness sought by

many banks for their own reasons. For example, most international banks appear to

prefer to be highly rated by internationally recognised rating agencies. Thus, banksare likely to chose to operate above Pillar 1 minimums for competitive reasons.

(b) In the normal course of business, the type and volume of activities will change, as

will the different risk requirements, causing fluctuations in the overall capital ratio.


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(c) It may be costly for banks to raise additional capital, especially if this needs to be

done quickly or at a time when market conditions are unfavourable.

(d) For banks to fall below minimum regulatory capital requirements is a seriousmatter. It may place banks in breach of the relevant law and/or prompt non-

discretionary corrective action on the part of supervisors.

(e) There may be risks, either specific to individual banks, or more generally to an

economy at large, that are not taken into account in Pillar 1.

There are several means available to supervisors for ensuring that individual banks

are operating with adequate levels of capital. Among other methods, the supervisor

may set trigger and target capital ratios or define categories above minimum ratios

(e.g. well capitalised and adequately capitalised) for identifying the capitalisation

level of the bank.


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Principle 4: Supervisors should seek to intervene at an early stage toprevent capital from falling below the minimum levels required to support

the risk characteristics of a particular bank and should require rapidremedial action if capital is not maintained or restored.

Supervisors should consider a range of options if they become concerned that banks

are not meeting the requirements embodied in the supervisory principles outlined

above. These actions may include intensifying the monitoring of the bank; restricting

the payment of dividends; requiring the bank to prepare and implement a

satisfactory capital adequacy restoration plan; and requiring the bank to raise

additional capital immediately. Supervisors should have the discretion to use the

tools best suited to the circumstances of the bank and its operating environment.

The permanent solution to banks difficulties is not always increased capital.

However, some of the required measures (such as improving systems and controls)

may take a period of time to implement. Therefore, increased capital might be used

as an interim measure while permanent measures to improve the bank.s position are

being put in place. Once these permanent measures have been put in place and have

been seen by supervisors to be effective, the interim increase in capital requirements

can be removed.


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PILLAR 3 : MARKET DISCIPLINE

Market discipline imposes strong incentives to banks to conduct their business in asafe, sound and effective manner. It is proposed to be effected through a series of

disclosure requirements on capital, risk exposure etc. so that market participants can

assess a banks capital adequacy. These disclosures should be made at least semi-

annually and more frequently if appropriate. Qualitative disclosures such as risk

management objectives and policies, definitions etc. may be published annually.

The third pillar greatly increases the disclosures that the bank must make. This is

designed to allow the market to have a better picture of the overall risk position of

the bank and to allow the counterparties of the bank to price and deal appropriately.

The new Basel Accord has its foundation on three mutually reinforcing pillars thatallow banks and bank supervisors to evaluate properly the various risks that banks

face and realign regulatory capital more closely with underlying risks. The first

pillar is compatible with the credit risk, market risk and operational risk. The

regulatory capital will be focused on these three risks. The second pillar gives the

bank responsibility to exercise the best ways to manage the risk specific to that bank.

Concurrently, it also casts responsibility on the supervisors to review and validate

banks risk measurement models.

The third pillar on market discipline is used to leverage the influence that other

market players can bring. This is aimed at improving the transparency in banks and

improves reporting.


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IMPLEMENTATION OF BASEL II NORMS

RBIs Initiative:

The Reserve Bank of India (RBI) has asked banks to move in the direction of

implementing the Basel II norms, and in the process identify the areas that need

strengthening. In implementing Basel II, the RBI is in favour of gradual convergence

with the new standards and best practices. The aim is to reach the global best

standards in a phased manner, taking a consultative approach rather than a directive

one. In anticipation of Basel II, RBI has requested banks to examine the choices

available to them and draw a roadmap for migrating to Basel II. The RBI has set up a

steering committee to suggest migration methodology to Basel II. RBI expects banks

to adopt the Standardized Approach for the measurement of Credit Risk and the

Basic Indicator Approach for the assessment of Operational Risk. RBI has also

specified that the migration to Basel II will be effective March 31, 2007 and has

suggested that banks should adopt the new capital adequacy guidelines and parallel

run effective April 1, 2006.

Gaining Benefit from Basel II

Reducing the Operational Risk chargeThe first pillar of the new accord includes the setting of an operational riskcharge. This charge is based on the banks risk of exposure to unexpected

internal and/or external losses. It is possible to reduce this charge by

increasing the sophistication of the operational risk assessment and

management processes employed.


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Measuring Operational RiskAlthough the activity of measuring indirect losses is recognized as being

difficult the Regulators consider a certain amount of capital necessary, to

cover expected as well as unexpected loss. This is due to the fact thatrelatively few banks make provision for expected operational risk loss.

Three approaches are proposed by the BASEL Accord for calculating the operational

risk capital charge:

Approach 1: The basic indicator approach

Approach 2: The standardized approach

Approach 3: The internal measurement approach.

The Basic Indicator ApproachCHARGE = GROSS REVENUE x FACTOR

This is the most likely approach to be adopted by non-G10 organizations. There are

no qualifying criteria and it requires very little change to current practices.

The Standardized ApproachCHARGE = BUSINESS LINE STANDARD RISK INDICATOR x FACTOR


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The firm is divided by business line, with each business line having its own standard

risk indicator. The charge to be levied will represent the standard risk indicator, for

each business line, multiplied by a factor. The total charge is the sum total of the

business line charges.

The Internal Measurement ApproachCHARGE = EXPECTED LOSS x FACTOR EXPECTED LOSS = EXPOSURE

INDICATOR x PROBABILITY OF LOSS EVENT x LOSS GIVEN EVENT

A process similar to stage 2 is followed; however individual risk types will be

identified per business line. For each business line/risk type, a bank will have to

provide an exposure indicator, probability of loss event and loss given event in order

to calculate their expected loss. The charge for operational risk will therefore

correspond with the expected loss multiplied by a factor. The benefit with stage 3 is

that a firm can use its own internal loss data to demonstrate to the regulatory body

that it should qualify for a further reduced charge.

The banks are not restricted as to which approach they adopt; it is generally accepted

that recognized internationally active banks will use either Approach 2 or 3. Banks

wishing to use Approach 2 or 3 will have to satisfy criteria relating

to operational risk management. As a rule of thumb, the more complex the solution

that is adopted, the greater the charge reduction will be.


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RBI Suggests Standardized Approach:Standardized approach as suggested by RBI may not significantly alter Credit Risk

measurement for Indian banks. In the Standardized approach proposed by Basel II

Accord, credit risk is measured on the basis of the risk ratings assigned by external

credit assessment institutions, primarily international credit rating agencies like

Moodys Investors Service

This approach is different from the one under Basel I in the sense that the earlier

norms had a one size fits all approach, i.e. 100% risk weight for all corporate

exposures. Thus, the risk weighted corporate assets measured using the

standardized approach of Basel II would get lower risk weights as compared with

100% risk weights under Basel I accords.


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EXPECTED IMPACT OF BASEL II NORMS

Depending on its current risk management processes, size, customers, portfolio, andmarket, a particular bank is likely to experience varying effects of Basel II on at least

four levels, as described below.

Reward Credit Quality:The new norms bring forward the issues of bank-wide risk measurement and active

risk management. These norms will help in better pricing of the loans in alignment

with their actual risks. The beneficiary will be the customers with high credit-

worthiness and ratings as they will be able to get cheaper loans.


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Benefits for IT Sector:Basel II norms require vast amount of historical data and advanced techniques and

software for calculation of risk measures. This will lead to huge demand for IT, BPO

and outsourcing services.(According to estimates, cost of implementation of the newnorms may range from $10 million to $150 million depending on the size of the

bank.)

For India, these norms provide massive opportunities in the form of software

services, outsourcing and consultancy services.

Dearth of Skilled Professionals & Training Costs:The implementation of the Basel II norms will require skilled manpower. There is an

unavailability of trained manpower for risk management & audits. Many countries

have a paucity of skilled manpower in this area. The training cost will be a major

expense for the implementation of Basel II Norms, especially in state owned banks

where majority of workforce needs to be trained.

The availability of trained risk auditors is another problem. Basel II calls for a Risk

Management structure in banks with Risk Management committees for Credit,

Market & operational Risk formulating the Risk Management standards. While

banks in India are implementing this, it has remained a ceremonial process without

the training at the grass root level to see every activity with the lens of risk.

Multiple Supervisory Bodies:As per Basel IIs definition of banking company is very broad and includes banking

subsidiaries such as insurance companies. In India there is no single regulator to

govern the whole bank as per Basel II. Here we have IRDA, SEBI, NABARD & RBI

would regulate different aspects of Basel II.


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The complex banking structure in India is another stumbling block. The Pillar II

implementation is the more difficult portion of the three pillars. Risk Audits in banks

are still in their nascent stages in India.

Entry Barriers:The flip side is that the knowledge acquired by the big banks due to the

implementation of complex norms would act as an entry barrier to any new

competition entering into the market, as international markets provide incentive to

sovereigns and banks that have implemented Basel II.

Mergers and AcquisitionsWith the capital requirements loaded in favour of larger banks having better systems

and ability to benefit from the lower capital requirement that goes with

implementing the more advanced approaches, there could be a spate of large-scalebank mergers worldwide, especially among internationally active banks in their

struggle to remain competitive.

Another reason for the Merger and Acquisitions is the small and medium sized

banks that will find it difficult to finance high implementation costs of the norms. If

national supervisors make the norms compulsory to implement, these banks might

have no other option but to merge with other banks. Therefore, consolidation in

banking industry with increased mergers and acquisitions is expected.


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Free Market Play:Higher risk sensitivity of the norms provides no incentive to lend to borrowers with

declining credit quality. During economic downturns, corporate profits and ratings

tend to decline. This can lead to banks pulling the plugs on lending to corporate withfalling credit ratings, at a time when these companies will be in desperate need of

credit.

The opposite is expected during economic booms, when corporate credit worthiness

improves and banks will be more than willing to lend to corporate.

Appropriate Capital Allocation:With better risk measurement practices in place the capital allocation for loans to

sub-standard quality borrowers are going to decrease. Banks can use this capital for

other purposes to increase profits. But the population of rated corporate is small in

India.

The benefit of lower risk weight of 20 % and 50 % would, therefore, be available only

for loans to a few corporate. The cover required for bad loans will increase

exponentially with deteriorating credit quality, which can lead to an increase in

capital requirement.

Better Risk Management:Sophisticated banks with better risk management and data collection mechanisms

can choose to introduce these norms, with the approval of their supervisors. These

methods are expected to entail lower capital requirements, thereby giving banks an

incentive to adopt better risk management practices.


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Effect on Small Sector:Risk-aversion of banks with regard to loans to the small and medium industries

have their origin in the quick adoption of the Basel-approved credit risk adjusted

ratios (CRAR: Capital To Risk Weighted Assets Ratio) for capital. ImplementingBasel II will further emphasize the ongoing trend by moving credit away from the

deserving industrial units in the small sector.

The Vicious Circle of Curtailment of Credit:The lower ratings will reduce the availability of funds in the emerging countries.

This has the potential to deteriorate the situation in these countries leading to further

recession. The reduced market access and high costs of funding will further impact

the ratings of these countries leading to a vicious circle with each aspect feeding the

other in a downward spiral.

Higher Interest Costs & Competitive advantage of corporate borrowers:Globalization has meant increased competition with financial engineering an

important source of the competitive advantage, more so for emerging economies

where the strength has been cost competitiveness. The Higher Interest costs to the

banks will ultimately translate into higher cost of borrowing for the corporate

skewing the playing field in favour of the developed countries.

Hampering Infrastructure Development:Major sources of funding for infrastructure in India and in many other emerging

market countries have been multilateral lending institutions such as World Bank.

The Basel II document impacts the interest rate determination process and attributes

higher risk to project finance than corporate finance. All the emerging economies like

India have been suffering from lack of infrastructure to sustain development and

this has the potential of severely hampering the infrastructure development process.


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Impact on Companies:The Shortened term funding of banks will find its way to the balance sheets of

companies because of the need for matching maturities. This would impact outputlevels in corporate and an imbalanced capital structure in favor of short-term

borrowings and working capital finance. The Liquidity position and the companies

ability to globalize would be hampered by this difficulty in raising long-term capital.

Sovereign ratings have a significant impact on stock returns:Studies conducted on this topic have shown that sovereign ratings have a signific

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