Reforms in the Indian Financial Sector - Need for Basel Norms
Risks carried by banks have multiplied and diversified post 1991 economic reforms due to reforms in banking regulations, increasingly complex financial operations and rapid pace of technological advancements. Financial liberalization involved reducing controls on the interest rates as well as on the entry of new financial firms. Competition in these spheres resulted in price competition that squeezed spreads and forced the banks to depend on volume to increase their bottom line. It also resulted in offers of higher deposit rates for investment in more risky but high return areas.
FiaSummary of financial sector reforms undertaken since 1991
Earlier regulators earlier sought to keep separate the different segments of the financial sector - banking, merchant banking, the mutual fund business and insurance. Institutions in one segment were not permitted to invest in another for fear of conflicts of interest. Liberalisation involved permitting financial agents to invest in areas where they were not allowed to enter earlier. As a result of this, regulatory walls separating these sectors have been broken down today leading to the emergence of "financial supermarkets" which work as a one-stop shop for varied financial services.
Universalization of banking, financial innovation and the proliferation of financial assets involve transformation of traditional role of banking system. Earlier banks worked as principal intermediaries bearing risk, whereas now their focus is on generating financial assets that transfer risks to the portfolio of institutions willing to hold them. Moreover, rapid pace of technological advancement, internationalization of banking services and financial innovation has opened new avenues of growth for banks.
All these changes have exposed banks to higher level of risks. These changes have made it mandatory to evolve new form of regulations which fit within this new environment. A central element of this new form of regulation is a framework to improve the stability and resilience of rapidly evolving banking industry. This has led to adoption of Basel norms by India along with more than 100 other nations.
What are Basel Norms ?
Basel norms are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. Basel norms lays guidelines to estimate how much of capital assets of specific kinds banks should hold to absorb losses. Basel Norms were established with the following objective :
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 risks banks face
Basel I
Committee on Banking Supervision was established in 1974, by the Bank of International Settlements (BIS)in Basel. Members from each of the G10 countries are present in the Basel Committee. Basel Committee published a set of minimum capital requirements for banks which is known as Basel I. Also known as 1988 Basel Accord, it was enforced by G-10 countries in 1992. Basel I introduced risk-based capital adequacy norms which is an indicator of the health of a financial institution. Capital adequacy ratio (CAR) is defined as a ratio of total bank capital to total risk-weighted assets of a financial institution. It defines a bank's capital as two types:
1. Core (or tier I) capital comprising equity capital and disclosed reserves;
2. Supplementary(or tier II) capital comprising items such as undisclosed reserves, general provisions, subordinated term debt, general loan-loss reserves and hybrid debt capital instruments.
While calculating CAR, the bank's assets should be weighted by five categories of credit risk - 0, 10, 20, 50 and 100 percent. If the asset is in the form of a claim on the private sector then it will get a risk weight of 100 percent. Basel I recommends that CAR should be at least 8 percent. Following Table provides the risk weights for different asset classes used in Basel I.
However, Basel I was criticized since it treats all types of borrowers under one risk category irrespective of credit rating and focuses only on credit risk. The major criticisms against Basel I are:
Does not take into account operational risk
Does not take into account quality of credit
Encourages regulatory arbitrage by cherry picking
Moreover, changes in banking practices, risk management practices and technology advances have made Basel I norms outdated and necessitated it to be replaced by a more risk-sensitive framework. In recognition of all these, Basel II was published in 2004.
Basel II
Basel II is based on three mutually reinforcing pillars:
1) Minimum capital requirements (addressing risk)
(2) Supervisory review and
(3) Market discipline.
The first pillar-Minimum capital requirements
Basel II recommends that minimum capital requirement of 8% should be maintained. Capital adequacy ratio (CAR) is defined as
These norms recommend elaborate credit risk measurement as well as measurement of operational risk while calculating risk weighted assets.
Credit risk
While assessing capital requirement for credit risk, three options are available for banks to choose from:
1) Standardized approach
2) Internal rating based approach (IRB)
3) Securitization framework.
1) Standardized approach: The relatively less sophisticated banks are supposed to use the ratings given by external rating agencies to assess the credit quality of borrowers so that regulatory capital requirement can be measured. This method is conceptually the same as Basel I.
2) Internal rating based approach (IRB): Under this approach, banks estimate each borrower's creditworthiness and this is used to measure risks to which banks have been exposed. These internal estimates of risk components are subject to strict methodological and disclosure standards. This approach could be of two types depending upon the components used to measure risk: Foundation IRB and Advanced IRB. Under the 'Foundation IRB approach', banks may use default probability based on their own internal calculation. 'Advanced IRB approach' allows banks to use other key variables based on their own calculations.
Operational Risk
Operational risk has been defined as the risk of loss resulting from inadequate systems, external systems, processes and people. The objective of the operational risk management is to provide regulatory capital on operational risk by measuring and controlling it. Capital requirement for operational risk can be measured in three ways: 1) Basic indicators approach 2) Standardized approach and 3) Advanced measurement approach.
1) Basic indicators approach: Banks are advised to hold capital equal to the fixed percentage(15%) of annual gross income averaged over past three years. Gross income is sum of net interest income and net non-interest income excluding profit and loss realized from the sale of securities.
2) Standardized approach: Capital charge for each business line of the bank is obtained by multiplying gross income by a factor assigned to them(denoted beta) and then summing them.
Market Risk
Market risk is the risk that the value of portfolio will decrease due to change in the value of stock prices, interest rates, foreign exchange rates, and commodity prices. Minimum capital requirement needs to be found for specific risk as well as general market risk.
Implementation of Basel Norms in India
India has been an active participant in the deliberations on the Basel norms since 1997. India was one of 16 non-member countries who were consulted in the drafting of BCP.
Basel II was formally accepted by India in April, 2003. Basel II norms have been implemented by all foreign banks in India as well as Indian banks operating abroad since march 31, 2008. All other scheduled commercial banks implemented these norms since March 31, 2009. All banks in India follow "Standardised Approach" to credit risk and "Basic Indicators Approach" to operational risk. RBI is moving towards "Internal Ratings Based"(IRB) approach in credit and "Advanced Measurement Approach(AMA)" norms for operational risks in banks. Existing RBI norms for banks in India recommends that total capital should be 9 percent of risk weighted assets.
Implementation Issues
Advanced risk management system: Introducing advanced risk management system with wider application is a difficult task which requires creating the required level of technological architecture and human skills across the system.
Low rating penetration: The level of rating penetration is very low in India. Moreover, rating in India is restricted to issues and not issuers. Therefore, there is a need to encourage rating of issuers.
Incentive to remain unrated: Risk weight for those entities with lowest rating is 150 percent whereas risk weight for unrated entities is 100 percent. It may create incentives for some parties to remain unrated.
Disadvantage for smaller banks: Complexity of Basel II norms necessitates revamping management information system and allocation of substantial resources to it. Implementation of these norms will be difficult for smaller banks considering their lack of resources.
Biased against developing countries: Basel II has withdrawn uniform risk weight of 0 percent given to claims of central banks of sovereign countries. It may reduce lending by international banks to developing countries. Moreover, developing countries have large number of lower rated borrowers.
Low profitability: Banks will reduce interest rates to attract highly rated borrowers which will lead to decrease in profitability. Moreover, high implementation costs will also reduce profitability.
Impact on the Banking Sector
Requirement of additional capital
Basel II norms will increase capital requirement in almost all the banks. Even though capital requirement for credit risk may go down. But, this will be offset by additional capital charge for operational risk. According to ICRA, Indian banks would need additional capital to the extent of Rs 120 billion to meet capital requirement for operational risk. ICRA has predicted that capital charge requirement for operational risk would grow by 15-20 percent annually over three years which means that the banks would need to raise Rs 180-200 billion over the medium term. A large number of banks have raised money from capital market to meet this regulatory requirement. Many Public sector banks like BOB, PNB and Dena bank besides private sector banks UTI bank have raised money from market to boost their capital requirements.
Ownership of Banks
There has been growing pressure on the RBI to rethink its policy on the ownership structure of domestic banks. FDI limit in private sector banks has been increased to 74 percent. Apart from that, government is under pressure to dilute its stake in public sector banks. Another consequence of this tendency has been growing pressure to consolidate domestic banks.In a recent report on Financial Assessment, RBI pointed out that some banks may need to merge with the other banks to meet capital requirements laid out by Basel II norms. This applies to banks with the government holding less than 51% or close to 51% such as OBC (51.09%), Dena Bank (51.19%) and Andhra Bank (51.55%).Funding is essential for these banks as they cannot raise capital through equity issues or shareholders and government may find it tough to keep infusing capital into these banks in the long run as their credit portfolios grow. In the long run, the government may have to merge these banks with banks where it has high shareholding.
High investment in government securities
Banks in India, especially public sector banks, have been increasing their investment in risk free government securities far in excess of government stipulated SLR requirements. Currently banks hold 42 percent of net demand of government securities as against 24 percent stipulated by government. On investing in low-risk government securities, banks obtain the advantage of requiring a lower amount of capital to be kept aside to fulfill capital adequacy norms as proposed by Basel norms.
Decreasing lending to Small and medium enterprises (SMEs): Advances to the poor and SMEs are considered more risky as per Basel norms. As a result of this, overall credit to the small sector including SSIs has been falling constantly since late 1990s.
Slowdown of financial inclusion
Implementation of Basel norms shifts focus of banking industry on harmonization and financial stability at the expense of regulation which should be focused on realizing growth. This change in focus means that the banks are no more interested in execution of innovative ideas of credit delivery to cover the hitherto excluded vast sections of society.
The norms and guidelines may not be against bank lending to neglected sections of society. It is the inherent biases in the functioning of the banking system that hinder such lending. For example: banks may be reluctant to open new branches in rural areas and they may shut down rural branches hit by high NPAs.
