In my project I have studied about applicability and benefits of Basel II norms in Indian banking sector. Basel II Norms aims to encourage the use of modern risk management techniques; and to encourage banks to ensure that their risk management capabilities are commensurate with the risks of their business. Previously, regulators' main focus was on credit risk and market risk. Basel II takes a more sophisticated approach to credit risk, in that it allows banks to make use of internal ratings based Approach - or "IRB Approach" as they have become known - to calculate their capital requirement for credit risk. It also introduces, in addition to the market risk capital charge, an explicit capital charge for operational risk. Together, these three risks - credit, market, and operational risk - are the so-called "Pillar 1" risks.
In my project I have covered
Various risks of Basel II Norms,
BASEL II norms adoption in banking sector
Basel study -Through this I came to know about the performance of banks by implementation of basel II Norms
Benefits for implementing basel II norms
Issues and challenges faced by banks in adopting basel II norms
Public Banks: taken
Punjab National Bank Oriental Bank of commerce
Allahabad Bank Indian Bank
State Bank of India Bank of Baroda
Bank of India
Dena Bank
Vijaya Bank
UCO Bank
INTRODUCTION
Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II, which was initially published in June 2004, 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 risks banks face. Advocates of Basel II believe that such an international standard 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. In practice, Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean 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.
BASEL COMMITTEE:
The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. It seeks to do so by exchanging information on national supervisory issues, approaches and techniques, with a view to promoting common understanding. The Committee's Secretariat is located at the Bank for International Settlements (BIS) in Basel, Switzerland.
OBJECTIVE
The final version aims at:
Ensuring that capital allocation is more risk sensitive;
Separating operational risk from credit risk, and quantifying both;
Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.
While the final accord has largely addressed the regulatory arbitrage issue, there are still areas where regulatory capital requirements will diverge from the economic.
Basel II has largely left unchanged the question of how to actually define bank capital, which diverges from accounting equity in important respects.
NEED FOR SUCH NORMS:
The first accord by the name .Basel Accord I. was established in 1988 and was implemented by 1992. It was the very first attempt to introduce the concept of minimum standards of capital adequacy. Then the second accord by the name Basel Accord II was established in 1999 with a final directive in 2003 for implementation by 2006 as Basel II Norms. Unfortunately, India could not fully implement this but, is now gearing up under the guidance from the Reserve Bank of India to implement it from 1 April, 2009.Basel II Norms have been introduced to overcome the drawbacks of Basel I Accord. For Indian Banks, its the need of the hour to buckle-up and practice banking business at par with global standards and make the banking system in India more reliable, transparent and safe. These Norms are necessary since India is and will witness increased capital flows from foreign countries and there is increasing cross-border economic & financial transactions.
THREE PILLARS OF BASEL NORM II
Basel II uses a "three pillars" concept -
(1) minimum capital requirements (addressing risk),
(2) Supervisory review and
(3) Market discipline - to promote greater stability in the financial system.
The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk was not dealt with at all.
The first pillar
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 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.
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
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% rating comes in for borrowers with poor credit ratings. The minimum capital requirement remains at 9%.
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.
The second pillar
The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputation risk, liquidity risk and legal risk, which the accord combines under the title of residual risk. It gives banks a power to review their risk management system.
The third pillar
It provides a framework for the improvement of banks' disclosure standards for financial reporting, risk management, asset quality, regulatory sanctions, and the like. The pillar also indicates the remedial measures that regulators can take to keep a check on erring banks and
maintain the integrity of the banking system. Further, Pillar 3 allows banks to maintain confidentiality over certain information, disclosure of which could impact competitiveness or breach legal contracts
The Terminology
Capital to Risk Weighted Assets Ratio (CRAR) is also known as Capital Adequacy Ratio which indicates a bank's risk-taking ability. The RBI uses CRAR to track whether a bank is meeting its statutory capital requirements and is capable of absorbing a reasonable amount of loss.
CRAR = (Tier I capital + Tier II capital) / Risk-Weighted Assets
Capital funds are broadly classified as Tier 1 and Tier 2 capital. Two types of capital are measured: Tier one capital, which absorbs losses without a bank being required to cease trading, and Tier two capital, which absorbs losses in the event of winding-up and so provides a lesser degree of protection to depositors.
Tier I capital (core capital) is the most reliable form of capital. The major components of Tier I capital are paid up equity share capital and disclosed reserves viz. statutory reserves, general reserves, capital reserves (other than revaluation reserves) and any other type of instrument notified by the RBI as and when for inclusion in Tier I capital. Examples of Tier 1 capital are common stock, preferred stock that is irredeemable and non-cumulative, and retained earnings.
Tier II capital (supplementary capital) is a measure of a bank's financial strength with regard to the second most reliable forms of financial capital. It consists mainly of undisclosed reserves, revaluation reserves, general provisions, subordinated debt, and hybrid instruments. This capital is less permanent in nature.
The reason for holding capital is that it should provide protection against unexpected losses. This is different from expected losses for which provisions are made.
Computation of Total CRAR and Tier I capital under Basel II
Basel II Tier I CRAR = Tier I capital / (Credit Risk RWA + Operational Risk RWA + Market Risk RWA)
Basel II Total CRAR = Total capital / (Credit Risk RWA + Operational Risk RWA + Market Risk RWA)
RWA - risk weighted assets
Types of risks according to Basel II
As of now 3 types of major risks are addressed in Basel II:
1. Credit Risk: Default by the borrower to repay the borrowings
2. Market Risk: Volatility in the banks' portfolio due to change in market factors.
3. Operational risk: Risk arising out of banks' inefficient internal processes, systems,
people or external events like natural disasters, robbery etc
Market Risk
Credit Risk
Operational Risk
The risk of losses in on- and off-balance-sheet positions arising from movements in market prices.
Main factors contributing to market risk are: equity, interest rate, foreign exchange, and commodity risk. The total market risk is the aggregation of all risk factors.
The risk that a counterparty will not settle an obligation for full value, either when due or at any time thereafter.
In exchange for-value systems, the risk is generally defined to include replacement risk and principal risk.
(Internal controls & Corporate governance):
The risk of loss resulting from inadequate or failed internal processes people and systems or from external events
BASEL II NORMS ADOPTATION IN BANKING SECTOR
It became evident to the RBI that the Basel I guidelines accepted by it, allocating 100 per cent risk-weight to 'all loans and advances', were inadequate (one-shoe-fits-all approach). Risk-weights on assets underwent changes, and provisions on standard assets were introduced. Initially, banks were advised to introduce and implement their own internal risk rating mechanisms to evaluate credit risk, market risk and operational risk, and suitably price their asset products. Following this, bank borrowers had their loan applications and accounts examined under banks' internal risk-management models.
While adopting the Basel II framework, RBI has opted for
(1) the "standardized approach" towards credit risk which called for third-party credit rating, and (2) the "basic indicator approach" towards operational risk, in which case too external rating may be applied to determine capital charge for market and operations risks.
CREDIT RATING OF LAON ASSET INTRODUCED
RBI has prescribed credit rating of all loan assets. Credit rating agencies like ICRA, CARE, CRISIL, and Fitch India-which earlier only evaluated and rated credit and market risks for companies/entities going public, or for listed companies which raised long-term domestic and external debt-have been designated as approved agencies by the RBI for credit rating of all bank borrowers. With this measure, RBI has adopted the global practice of having 'acceptable third-party evaluation' of assets on banks' books.
RBI DEADLINES AND INCENTIVES
RBI had set March 31st 2009 as the deadline for all borrowers with total limits of Rs.10 crores and above to obtain credit rating. RBI has also prescribed 150% risk weight on borrowal accounts that have not obtained such credit ratings upon expiry of this deadline. The underlying implication is that the limits below the threshold limit also need to get the credit rating done.
As an incentive to banks, the RBI had also spelt out reduced risk-weights as under for accounts rated by the accredited agencies:
20% risk-weight: AAA rated
30% risk-weight: AA rated
50% risk-weight: A rated
100% risk-weight for lower ratings
150% for unrated.
Under the above RBI prescriptions, differential risk-weights have a positive impact on a bank's lendable surplus. This has led to banks pressurizing their loan customers to obtain credit rating.
MSME SECTOR: OPPORTUNITIES
Banks have offered to pass on interest rate reductions for credit-rated SMEs.
There is a great need for facilitators to assist the SMEs in
meeting the rating agencies' and banks' requirements
Maintaining requisite data-base and achieving compliance with bank and regulators' requirements.
Set up quality practices to enable participation in global markets.
Aid or play a part in formation of industrial clusters to maximize the benefits.
Develop and maintain compliance software
Also thrown into focus is also the vast training and back-office opportunities that arise if there were collaboration with Small industry service institutes, district industry centres and Industrial training institutes.
RATING METHODOLOGY
CAMEL's model for banks
Banks themselves are rated by RBI under the 'CAMELS' model in accordance with global practice. This model is evolving over time with the accelerating complexities of the market
Capital - structure, nature
Assets - quality
Management - structure, operations, regulatory compliance
Earnings - profitability parameters
Liquidity - composition of assets and liabilities, structural liquidity
Systems - efficiency parameters, corporate governance. Operational reviews
There are huge opportunities that exist in aiding banks and financial institutions to effectively manage each one of the CAMELS areas.
Structured risk assessment
The accredited credit rating agencies use the following structure in assessing/evaluating risk: of industrial and business units
Qualitative analysis: industry risk, operational risk, market position, marketing, corporate governance, accounting, regulatory compliance, promoter background.
Quantitative analysis: cash flow, capital structure, financial flexibility
Earnings: financial analysis of historical cash flows and funds management, financial and coverage ratios.
Profitability: return on capital employed and gearing ratio, .peer-level analysis.
Process
The accredited credit rating agencies follow the process below.
Acceptance by borrower-rating forms/requirements furnished by agency after payment of fee.
Submission of data by borrower with enclosures.
Evaluation of data by rating committee-interaction with borrower for clarifications.
Award rating-3 to 4 weeks from submission of data.
Recommendation
Commercial disasters in banks and financial institutions anywhere in the globe carry the possibilities of adverse impacts on banks in other nations, and thereby nations' economies - a cascade effect. This cascade effect reflects the fluid nature of money flow. As with water, the key to safeguarding against financial cascade effects hence lies in monitoring and controlling money flow - through exploration, supply, regulatory mechanisms, storage and distribution mechanisms, toll mechanisms, constant review and forecasts, periodic checks for quality, and inbuilt risk-management practices. At every stage in monitoring money flow, there exist business opportunities for players in the services sector.
Basel II compliance has thrown up many such opportunities
Global Scenario on Basel II
Banking regulators in around the world are planning to implement Basel II, but with varying timelines and use to the varying methodologies being restricted. European banks already report their capital adequacy ratios according to the new system. European banks implemented Basel II at the start to 2008 whereas Japanese banks implemented in 2007. Australia implemented the Basel II Framework in 2008. US banks are scheduled to switch over in 2009.
Basel II Norms
- Basel II is the international capital adequacy framework tor banks that prescribe capital requirements for credit risk, market risk and operational risk. Basel II is the second of the Basel Accords recommended on banking laws and regulations issued by Basel Committee on Banking Supervision.
- The purpose behind applying Basel II norms to Indian banks is to help them comply with international standards. These international standards can help protect the international financial system from problems that may arise from the collapse of a major bank.
- Basel II is stated to set up rigorous risk and capital management requirements to ensure that banks have capital reserves appropriate to their risk profile.
- The outcome is that the greater the risk to which a bank is exposed, greater is the amount of capital it will require to hold to protect its solvency and overall stability. It will also force banks to enhance disclosures, which will help create more transparency and trust in the banking system itself. We believe transparency in financial reporting will improve.
Basel study
This is done to find out the whether Indian Banks are following guidelines stated as per Basel II Norms. Disclosures by Banks as per Basel Norms
Name of Banks
Pillar 1
(credit risk, operational risk, market risk
Pillar 2
(Supervisory Review Process)
Pillar 3
(Market Discipline)
Tier 1
Tier 2
OBC
YES
YES
YES
YES
YES
PNB
YES
YES
YES
YES
YES
SBI
YES
YES
YES
YES
YES
BOB
YES
YES
YES
YES
YES
UCO
NO
NO
NO
YES
YES
Vijaya
YES
YES
YES
YES
YES
Dena
NO
NO
NO
YES
YES
BOI
YES
YES
YES
YES
YES
Allahabad
YES
YES
YES
YES
YES
Indian
YES
YES
YES
YES
YES
Interpretation: According to data 90% public sector banks are disclosing Basel II norms. Dena and UCO bank do not have disclosed their information as per Basel II.
Comparison of CRAR Basel I - Basel II
Name of Banks
CRAR as per Basel I
CRAR as per Basel II
∆(bps)
PNB
12.75%
14.58%
1.83
OBC
12%
12.92%
0.92
SBI
13.35%
14.06%
0.71
Vijaya Bank
13.08%
13.31%
0.23
UCO Bank
10.68%
11.45%
0.77
Dena Bank
13.38%
13.20%
-0.18
Allahabad Bank
12.23%
15%
2.77
Bank of Baroda
12.75%
14.36%
1.61
Indian Bank
12.68%
13.95%
1.27
Bank of India
13.05%
13.35%
0.30
Changes in Capital Risk Weighted Assets Ratio (CRAR)
Most of the banks are already adhering to the Basel II guidelines. The Government has indicated that a cushion should be maintained by the public sector banks and therefore their CRAR should be above 12%.
Basel I focused largely on credit risk, whereas Basel II has 3 risks to be considered credit risk, operational risk and market risks. As Basel II considers all these 3 risks, there are chances of a decline in the Capital Adequacy Ratio. However, on the basis of above data we analyzed that the above 90% of public sector banks have increased in their CRAR as per Basel II in comparison with Basel 1. Only in case of Dena bank there is decline in CRAR in comparison with Basel I norms but still it is more than 12%
(Note -this interpretation is done by gathering information from the site of banks)
Recommendation
RBI has to introduce some stringent norms so that all the banks should implement Basel II norms.
OBC bank has CRAR 12.92% that is upto the mark of 12%. So they should increase their CRAR.
UCO bank has CRAR 11.45% which is less than 12% as per Basel 2 so they should increase their CRAR.
ISSUES AND CHALLENGES FACED BY BANKS FOR ADOPTING BASEL II NORMS
While there is no second opinion regarding the purpose, necessity and usefulness of the proposed new accord - the techniques and methods suggested in the consultative document would pose considerable implementation challenges for the banks especially in a developing country like India.
Capital Requirement: The new norms will almost invariably increase capital requirement in all banks across the board. Although capital requirement for credit risk may go down due to adoption of more risk sensitive models - such advantage will be more than offset by additional capital charge for operational risk and increased capital requirement for market risk.
Profitability: Competition among banks for highly rated corporate needing lower amount of capital may exert pressure on already thinning interest spread. Further, huge implementation cost may also impact profitability for smaller banks.
Risk Management Architecture: The new standards are an amalgam of international best practices and call for introduction of advanced risk management system with wider application throughout the organization. It would be a daunting task to create the required level of technological architecture and human skill across the institution.
Rating Requirement: Although there are a few credit rating agencies in India, the level of rating penetration is very low. A study revealed that in 1999, out of 9640 borrowers enjoying fund-based working capital facilities from banks, only 300 were rated by major agencies. Further, rating is a lagging indicator of the credit risk and the agencies have poor track record in this respect. There is a possibility of rating blackmail through unsolicited rating. Moreover rating in India is restricted to issues and not issuers. Encouraging rating of issuers would be a challenge.
Choice of Alternative Approaches: The new framework provides for alternative approaches for computation of capital requirement of various risks.. Banks adopting IRB approach will be more sensitive than those adopting standardized approach. This may result in high-risk assets flowing to banks on standardized approach, as they would require lesser capital for these assets than banks on IRB approach. Hence, the system as a whole may maintain lower capital than warranted and become more vulnerable.
Absence of Historical Database: Computation of probability of default, loss given default, migration mapping and supervisory validation require creation of historical database, which is a time consuming process and may require initial support from the supervisor.
Incentive to Remain Unrated: In case of unrated sovereigns, banks and corporates, the prescribed risk weight is 100%, whereas in case of those entities with lowest ratting, the risk weight is 150%. This may create incentive for the category of counterparties, which anticipate lower rating to remain unrated.
Corporate Governance Issues: Basel II proposals underscore the interaction between sound risk management practices and corporate good governance. The bank's board of directors has the responsibility for setting the basic tolerance levels for various types of risk. It should also ensure that management establishes a framework for assessing the risks, develop a system to relate risk to the bank's capital levels and establish a method for monitoring compliance with internal policies.
National Discretion: Basel II norms set out a number of areas where national supervisor will need to determine the specific definitions, approaches or thresholds that they wish to adopt in implementing the proposals. The criteria used by supervisors in making these determinations should draw upon domestic market practice and experience and be consistent with the objectives of Basel II norms.
Disclosure Regime: Pillar 3 purports to enforce market discipline through stricter disclosure requirement. While admitting that such disclosure may be useful for supervisory authorities and rating agencies, the expertise and ability of the general public to comprehend and interpret disclosed information is open to question. Moreover, too much disclosure may cause information overload and may even damage financial position of bank.
External and Internal Auditors: The working Group set up by the Basel Committee to look into implementation issues observed that supervisors may wish to involve third parties, such a external auditors, internal auditors and consultants to assist them in carrying out some of the duties under Basel II.
Recommendations
Implementation of Basel II has been described as a long journey rather than a destination by itself. Undoubtedly, it would require commitment of substantial capital and human resources on the part of both banks and the supervisors. RBI has decided to follow a consultative process while implementing Basel II norms and move in a gradual, sequential and co-coordinated manner. For this purpose, dialogue has already been initiated with the stakeholders. A steering committee comprising representatives of banks and different supervisory and regulatory departments is taking stock of all issues relating to its implementation. As envisaged by the Basel Committee, the accounting profession too, will make a positive contribution in this respect to make Indian banking system stronger
Applicability of Basel II norms to help banks flourish in global market
Basel II norms have an important place in the policies of Indian banks aiming to flourish in the global market as well as protect the international financial system. The norm provides a platform for the banking, sector to maintain a certain level of risks and capital management systems designed to ascertain that bank holds capital reserves appropriate to its related risks. Therefore, an integrated risk management system like Basel II should be given importance in the Indian banking scenario. This is essential if Indian banks are to scale up with the ever-changing economic trends and secure a competitive edge in the global market.
The obstacle, which the banks faces while implementing Basel II norms include, siloed technology, scarcity of skilled resources and limited scope of few rating agencies. Additionally, there are also cost limitations involved. However, the need is to perceive it as a strategic initiative for competitive advantage rather than look at it as another compliance regulation.
Those banks that are unable to attain Basel norm, need to merge with larger banks. Adoption of these recommendations would also mean securing a good rating for India on the global banking map. Also it is important to understand the scope of Basel norm guidelines and then go forward to implement it. She gave prominence to the banking staff as being the primary resource that uses the software application for the advantage of the bank, followed by the resultant capital which would mean knowledge on the capital required. The amount or the capital required can be derived by the bank itself in its own calculation considering the risk factors that are subject to variation. This would form the foundation required for the application of Basel II combined with modern methodologies and tools.
Besides that it is imperative that for the application of Basel II norms at all the stages need to be understood. An organization need to adopt a flexible architecture which in turn supports four values-flexibility, transparency, scalability and integrity .Obviously, good rated borrowers would be naturally attracted towards refined systems that are securities.
SWOT Analysis (In Indian Banking)
Benefits of Implementing Basel II in India
The deadline for implementing Basel II, originally set for March 31, 2007, has now been extended. Foreign banks in India and Indian banks operating abroad had to meet those norms by March 31, 2008, while all other scheduled commercial banks will have to adhere to the guidelines by March 31, 2009. But the decision to implement the guidelines remains unchanged. This is true even though the international exposure of even the major Indian banks is still limited. Whereas some of the large banks say that they are Basel II compliant with the presence of all the requirements, which Basel II recommends. 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 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.Most of the Indian banks that have migrated to Basel II have reported a reduction in their total Capital Adequacy Ratios (CARs) due to the new operational risk-based capital charges. However, a few banks, those with high exposures to higher rated corporate or to the regulatory retail portfolio, have reported increased CARs. Given recent changes in regulatory charges, it is doubted whether this will be sustainable. Banks would find it increasingly attractive to give out loans to the small business segment that qualify as regulatory retail, given their higher lending margins and lower risk weights. In contrast, the increase in risk weight for residential mortgage loans will make this area less attractive.
Conclusion
The Basel Committee on Banking Supervision is a Guideline for Computing Capital for Incremental Risk. It is a new way of managing risk and asset-liability mis-matches, like asset securitization, which unlocks resources and spreads risk, are likely to be increasingly used. This was designed for the big banks in the BCBS member countries, not for smaller or less developed economies.
The major challenge the country's financial system faces today is to bring informal loans into the formal financial system. By implementing Basel II norms, our formal banking system can learn many lessons from money-lenders. Its implementation may involve significant changes in business model in which potential economic impacts must be carefully monitored.
In a nut-shell, we would like to conclude that keeping in view the cost of compliance for both banks and supervisors, the regulatory challenge would be to migrate to Basel II in a non-disruptive manner. We would like to continue the process of interaction with other countries to learn from their experiences through various international fora. India is one of the early countries which subjected itself voluntarily to the FSAP of the IMF, and our system was assessed to be in high compliance with the relevant principles. With the gradual and purposeful implementation of the banking sector reforms over the past decade, the Indian banking system has shown significant improvement on various parameters, has become robust and displayed ample resilience to shocks in the economy. There is, therefore, ample evidence of the capacity of the Indian banking system to migrate smoothly to Basel II.
REFRENCES
www.google.com
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www.sbi.com
www.pnb.com
www.ucobank.com
www.sbi.com
www.greenpeace.org
www.denabank.com
