Indian banking scenario is going through a transition and how an industry manages this transition determines its future. This paper will cover the risk management practices in banking sector and explores the necessity of BASEL 2 NORMS in Indian banking. The objective of this paper is to know how banks can strengthen the soundness and stability while maintaining sufficient consistency that capital adequacy regulation will not be significant source of competitive in equality among active banks.
Risk is inherent in any walk of life in general and in financial sectors in particular. Till recently, due to regulate environment, banks could not afford to take risks. But of late, banks are exposed to same competition and hence are compelled to encounter various types of financial and non-financial risks. Risks and uncertainties form an integral part of banking which by nature entails taking risks. There are three main categories of risks; Credit Risk, Market Risk & Operational Risk.
This paper will cover main features of these risks as well as some other categories of risks such as Regulatory Risk and Environmental Risk. Various tools and techniques to manage Credit Risk, Market Risk and Operational Risk and its various components, are also discussed. Very important part of this paper will cover the relevant points of Basel's New Capital Accord' and role of capital adequacy in managing risks in banking sector.
Capital adequacy standards form an integral part of prudential banking sector regulation. Capital standards all over the world are converging at the behest of the Basel Committee on Banking Supervision towards the so called Basel II norms. This paper elaborates on the Indian experience.
In this paper we present an analytical review of the current capital adequacy norms in India's banking system vis-à-vis the Basel framework. This paper also attempts to examine issues and challenges with regard to the implementation of CRAR norms under Basel II regime in India. The paper tries to identify limitations, gaps and inadequacies in the Indian banking system which may hamper the realization of the potential benefits of the new regime
Contents
Executive summary..............................................................................................2
Contents ...............................................................................................................3
1.Introduction..........................................................................................................4
2.Review of literature..............................................................................................5
3. Progress of international capital adequacy norms ..........................................6
An overview of Basel I, market risk amendment of Basel I and Basel II
Basel II: Basel II is a much more comprehensive framework of banking
Supervision
Minimum Regulatory Capital under Basel II
4.Capital adequacy standard in India....................................................................6
5. Implementation of Basel II: the Indian status...................................................9
The present state of capital standards for commercial banks in India
Average CRAR level of Indian banking groups
Policy Response To Capital Adequacy In Indian Banks:-
Indian Banking Sector: capital adequacy ratio
6.Observations and Conclusion……………..........................................................12
Reference .............................................................................................................13
Introduction
During one of the toughest years faced by banks and financial institutions glogally, banking sectors world over was crippled by massive capital depletion caused by losses and the write downs while their balance sheets clogged by complex credit products and other illiquid assests of uncertain value.Failure of number of banks in countries like US, UK, Iceland, Ukraine, Belgium, Ireland, Latvia, Russia and Spain had severe impact on their economy. However, the Indian banking sector not only resisted such a scenario but improved significantly. US alone accounted for as many as 60 banks failure during 2008-2009, costing the FDIC deposit insurance nearly a whopping USD 25billion.
For sound banking practices the BASEL II norms laid strong foundation of a robust banking and financial system. The process of implementing BASEL II norms in India has been carried out in phases. Phases 1 has been carried out for foreign banks operating in India ans Indian banks having operational presence outside India with effect from March 31, 2008. In phase 2, all other scheduled commercial banks have been made adhere to BASEL II guidelines from March 31, 2009. Considering the full implementation of BASEL II norms, banks are looking to maintain a cushion in their respective capital reserves.
The Narasimhan Committee on Financial System suggested several reform measures for India's financial system. The Committee recommended gradual liberalization of the banking sector by adopting measures such as reduction of statutory preemptions, deregulation of interest rates and allowing foreign and domestic private banks to enter the system. Along with these, the Committee also recommended adoption of prudential regulation relating to capital adequacy, income recognition, asset classification and provisioning standards. While the liberalization was aimed at bringing about competition and efficiency into India's banking system, the prudential regulation was aimed at strengthening the supervisory system, which is important in the process of liberalization.
2 Review of literature
Mandira Sarma(2006) present an analytical review of the capital adequacy regime and the present state of capital to risk-weighted asset ratio (CRAR) of the banking sector in India. In the current regime of Basel I, Indian banking system is performing reasonably well, with an average CRAR of about 12 per cent, which is higher than the internationally accepted level of 8 per cent as well as India's own minimum regulatory requirement of 9 per cent. As the revised capital adequacy norms, Basel II, are being implemented from March 2008, several issues emerge. We examine these issues from the Indian perspective.
Diksha Arora(2009)Risk is inherent in every walk of life. Banks are, by definition, in the business of taking and managing risk. The paper deals with the study of Risks associated with commercial banks like risk revolving on capital, credit risk, market risk, liquidity risk, earnings risk, business strategy risk, environmental risk, operational risk, group risk, internal control risk, organizational risk, management risk and compliance risk. In the global scenario, the degree to which the models have been incorporated into the Risk Management and economic capital allocation process varies greatly between banks. Through this paper an attempt was made to construct an optimal model using Analytical Hierarchy Programming to find the risk rating of a bank. This model will bring uniformity and help in assessing performance of a bank vis-a-vis another which also forms a part of RBI supervision.
3 Progress of international capital adequacy norms
The international financial community has witnessed several significant developments in the area of risk management and banking supervision over the last two decades. In 1988, BCBS introduced risk-based capital adequacy norms through Basel I accord (BCBS 1988). Basel I mainly incorporated credit risk in calculating the capital adequacy norms of banks. It recommended a bank's regulatory capital at 8 per cent of its risk-weighted asset, where assets were risk-weighted according to their credit risk. In 1996, an amendment was made to Basel I to incorporate market risk in addition to credit risk in the weighing scheme (BCBS 1996). In July 1999, BCBS initiated the process of replacing the current framework with a revised version, the Basel II. After several rounds of discussions, consultations and deliberations within the global financial and banking institutions, Basel II has evolved as a revised and comprehensive framework for prudential regulations to replace the current Basel I framework.
An overview of Basel I, market risk amendment of Basel I and Basel II
Basel I: Basel I is a framework for calculating 'Capital to Risk-weighted Asset Ratio' (CRAR). It defines a bank's capital as two types: core (or tier I) capital comprising equity capital and disclosed reserves; and supplementary (or tier II) capital comprising items such as undisclosed reserves, revaluation reserves, general provisions/general loan-loss reserves, hybrid debt capital instruments and subordinated term debt. Under Basel I, at least 50 per cent of a bank's capital base should consist of core capital. In order to calculate CRAR, the bank's assets should be weighted by five categories of credit risk - 0, 10, 20, 50 and 100 per cent. For example, if an asset is in the form of cash or claims on central governments, it will get a risk weight of zero, if it is in the form of a claim on domestic public sector entities, then it will get a risk weight of 10, 20 or 50 per cent at the discretion of the national supervisory authority. Claims on the private sector will get a risk weight of 100 per cent.
Market risk amendment : In 1996, an amendment was made to Basel I to incorporate market risk, in addition to credit risk, in the calculation of CRAR. To measure market risk, banks were given the choice of two options:
1. A standardized approach using a building block methodology
2. An 'in-house' approach allowing banks to develop their own proprietary models to calculate capital charge for market risk by using the notion of Value-at-Risk (VaR).
Basel II: Basel II is a much more comprehensive framework of banking supervision.
It not only deals with CRAR calculation, but has also got provisions for supervisory review and market discipline.Basel II stands on three pillars:
Three pillars of Basel II
Basel II
Pillar I
Minimum capital req.
Pillar II
Supervisory review
Pillar III
Market discipline
Pillar II
Supervisory review
Pillar I
Minimum capital req.
1. Minimum regulatory capital (Pillar 1): This is a revised and extensive framework for capital adequacy standards, where CRAR is calculated by incorporating credit, market and operational risks.
2. Supervisory review (Pillar 2): This provides key principles for supervisory review, risk management guidance and supervisory transparency and accountability.
3. Market discipline (Pillar 3): This pillar encourages market discipline by developing a set of disclosure requirements that will allow market participants to assess key pieces of information on risk exposure, risk assessment process and capital adequacy of a bank.
Minimum Regulatory Capital under Basel II
Under Basel II, CRAR is calculated by taking into account three types of risks: credit risk, market risk and operational risk. The approaches for each one of these risks is described below.
Credit risk: There are two approaches for credit risk, viz., the Standardized Approach (SA) and the Internal Ratings Based (IRB) approach. In SA, credit risk is measured in the same manner as in Basel I, but in a more risk sensitive manner, i.e. by linking credit ratings of credit rating agencies to risk of the assets of the bank. This, according to BCBS, is an improvement over Basel I, where categorization of the assets into five risk-weight categories was an ad hoc categorization. BCBS has provided an example of how risk weights can be linked with the credit ratings. The responsibility of providing the risk-weights corresponding to various assets, under SA, lies with the supervisory authority of a country. As far as the IRB approach is concerned, banks will be allowed to use their internal estimates of credit risk, subject to supervisory approval, to determine the capital charge for a given exposure. This would involve estimation of several parameters such as the probability of default (PD), loss given default (LGD), exposure at default (EAD) and effective maturity (M) corresponding to a particular debt portfolio.
Market risk: As far as market risk is concerned, Basel II retains the recommendations of the 1996 Amendment.
Operational risk: Basel II has introduced a new kind of risk, called the 'operational risk' in calculating CRAR. It is defined as "the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events." In order to calculate the capital charges for operational risk, three approaches - Basic Indicator Approach (BIA), Standardized Approach (SA) and Advanced Measurement Approaches (AMA) - have been suggested. In the BIA, an estimate of the capital charge for operational risk is provided by averaging over a fixed percentage of positive annual gross income of the bank over the previous three years.6 In this estimate, negative incomes are excluded. Under SA, at first the bank's business activities are divided into eight business lines. For each business line, a capital charge is calculated by multiplying the gross income of the business line by a factor.7 A capital charge for each business line is thus calculated for three consecutive years. The overall capital charge is calculated as the three-year average of the simple summation of the charges across business lines in each year. Under AMA, a bank can, subject to supervisory approval, use its own mechanism for determining capital requirement for operational risk.
4 Capital adequacy standards in India
In India, at present, there is a 'three track' approach for Basel compliance - the commercial banks are Basel I compliant with respect to credit and market risks; the urban cooperative banks maintain capital for credit risk as per Basel I and market risk through surrogate charges; and the rural banks have capital adequacy norms that are not on par with the Basel norms. The three track approach is justified by the necessity to maintain varying degree of stringency across different types of banks in India reflecting different levels of operational complexity and risk appetite. The three track approach is also justified in order to ensure greater financial inclusion and for an efficient credit delivery mechanism.
India adopted Basel I norms for scheduled commercial banks in April 1992, and its implementation was spread over the next three years. It was stipulated that foreign banks operating in India should achieve a CRAR of 8 per cent by March 1993 while Indian banks with branches abroad should achieve the 8 per cent norm by March 1995. All other banks were to achieve a capital adequacy norm of 4 per cent by March 1993 and the 8 per cent norm by March 1996.8
In its mid-term review of Monetary and Credit Policy in October 1998, the Reserve Bank of India (RBI) raised the minimum regulatory CRAR requirement to 9 per cent, and banks were advised to achieve this 9 per cent CRAR level by March 31, 2000.9 Thus, the capital adequacy norm for India's commercial banks is higher than the internationally accepted level of 8 per cent.10
The RBI responded to the market risk amendment of Basel I in 1996 by initially prescribing various surrogate capital charges such as investment fluctuation reserve of 5 per cent of the bank's portfolio and a 2.5 per cent risk weight on the entire portfolio for these risks between 2000 and 2002. These were later replaced with VaR-based capitalcharges, as required by the market risk amendments, which became effective from March 2005. India has gone a step ahead of Basel I in that the banks in India are required to maintain capital charges for market risk on their 'available for sale' portfolios as well as on their 'held for trading portfolios' from March 2006 while Basel I requires market risk charges for trading portfolios only.
The RBI has announced the implementation of Basel II norms in India for internationally active banks from March 2008 and for the domestic commercial banks from March 2009. Before we go into details of several issues facing the banking industry in India in the wake of Basel II, we briefly describe the current state of affairs with respect to capital adequacy of India's banking industry.
5 Implementation of Basel II: the Indian status
The RBI announced in May 2004 that banks in India should examine the options available under Basel II for revised capital adequacy framework. In February 2005, RBI issued the first draft guidelines on Basel II implementations in which an initial target date for Basel II compliance was set for March 2007 for all commercial banks, excluding Local Area Banks (LABs) and Regional Rural Banks (RRBs). This deadline was, however, postponed to March 2008 for internationally active banks and March 2009 for domestic commercial banks in RBI's mid-year policy announcement of October 30, 2006. Although RBI and the commercial banks have been preparing for the revised capital adequacy framework since RBI's first intimidation on Basel II compliance, the complexity and intense data requirement of Basel II have brought about several challenges in its implementation. Given the limited preparation of the banking system for Basel II implementation, this postponement is not surprising.
According to these guidelines, banks in India will initially adopt SA for credit risk and BIA for operational risk. RBI has provided the specifics of these approaches in its guidelines. After adequate skills are developed, both by banks and RBI, some banks may be allowed to migrate towards more sophisticated approaches like IRB.Under the revised regime of Basel II, Indian banks will be required to maintain a minimum CRAR of 9 per cent on an ongoing basis. Further, banks are encouraged to achieve a tier I CRAR of at least 6 per cent by March 2010. In order to ensure a smooth transition to Basel II, RBI has advised the banks to have a parallel run of the revised norms along with the currently applicable norms.
The present state of capital standards for commercial banks in India
The scheduled commercial banks in India are categorized into the following groups: nationalised banks, other public sector banks, State Bank of India (SBI) group, Indian private banks (further categorized as old private banks and new private banks) and foreign banks. Sometimes the first two categories are clubbed together as there is only one bank in the category 'other public sector bank', the Industrial Development Bank of India (IDBI) bank. The first three categories are commonly known as public sector banks.
The ratio of total assets of the commercial banks to the GDP of India stood at 86.9 per cent
the share of public sector banks in the total banking assets of the country stood at 72.3 per cent.
The average level of CRAR for the Indian banking groups for the period 1999-2006 is presented:
Average CRAR level of Indian banking groups
(Unit: %)
Year
(end March)
Nationalised
banks
SBI
group
Other
Public sector bank
Old
Pvt.
banks
New
Pvt.
banks
Foreign
banks
All
banks
2000
2001
2002
2003
2004
2005
2006
2007
10.6
10.1
10.2
10.9
12.2
13.1
13.2
12.4
12.3
11.6
12.7
13.3
13.4
13.4
12.4
11.9
n.a.
n.a.
n.a.
n.a.
n.a.
n.a.
15.51
14.8
12.1
12.4
11.9
12.5
12.8
13.7
12.5
11.7
11.8
13.4
11.5
12.3
11.3
10.2
12.1
12.6
10.8
11.9
12.6
12.9
15.2
15
14
13
11.3
11.1
11.4
12
12.7
12.9
12.8
12.3
In addition to the credit risk of the banking sector, the BASEL II accord covers a wider spectrum of risks such as operating and market risk. Despite stringent and even rigorous capital adequacy norms, the remarkable performance of the Indian banks during the crisis has defined the withering collapse in the financial sector
The minimum capital to risk-weighted asset ratio (CRAR) in India is placed at 9%, 1% point above the BASEL II requirement.
Policy Response To Capital Adequacy In Indian Banks:-
To avoid any complacency in the banking sector regulations, Indian authorities seek USD 3 billion from the World Bank to infuse funds into public sectors banks to shore up their capital against various risks to ensure credit flow to productive sectors to beat the economic slowdown.
The government injected capital into the public sector banks that had their capital adequacy ratio(CAR) below 12%. Four PSU banks including Union Bank of India, Uco bank, Central Bank of India and Vijaya Bank received fresh doses of capital from the government.
Indian Banking Sector: capital adequacy ratio
S.No.
Name of the bank
BASEL-I
Year ended mar 09
BASEL-I
Year ended mar 08
Change
BASEL-II
Year ended mar 09
BASEL-II
Year ended mar 08
Change
1.
STATE BANK OF BIKANER & JAIPUR
13.18
13.50
-0.32
14.52
12.31
2.01
2.
STATE BANK OF MYSORE
12.41
12.34
0.07
13.38
11.73
1.65
3.
INDIAN OVERSEAS BANK
12.70
11.93
0.77
13.20
11.59
1.61
4.
BANK OF BARODA
12.88
12.91
-0.33
14.05
12.94
1.11
5.
INDIAN BANK
13.27
12.74
0.53
13.98
12.90
1.08
6.
BANK OF INDIA
13.21
12.95
0.53
13.98
12.90
1.08
7.
UCO BANK
9.75
10.09
-0.34
11.93
11.02
0.91
8.
SYNDICATE
BANK
11.37
11.22
0.15
12.68
11.82
0.82
9.
PUNJAB NATIONAL BANK
12.59
12.96
-0.37
14.03
13.46
0.57
10.
STATE BANK OF TRAVANCORE
12.13
12.68
-0.55
14.03
13.53
0.50
AVERAGE
12.35
12.33
0.02
13.48
12.35
1.13
6 Observations and Conclusion
In this article, we have attempted to review the capital adequacy regime in India. In particular our focus is on the present state of capital to risk-weighted asset ratios of the banking sector. We have observed that with respect to the current regime of capital standards, the Basel I, India's banking industry is performing reasonably well, with an average CRAR of about 12 per cent, which is not only higher than the internationally acceptable level of 8 per cent, but also higher than India's own regulatory requirement of 9 per cent.
The RBI has announced that the Indian banking sector should implement the revised capital adequacy norms, Basel II, by March 2008. We have discussed the limitations in the RBI's guidelines on Basel II implementation. Under the Basel II guidelines, the credit rating agencies will play a prominent role in determining regulatory risk capital. The main concerns are the unsatisfactory performance of the credit rating industry in India, the low credit rating penetration and the high costs of credit rating especially for SMEs. Further, the increased requirement of tier I capital, the high cost of implementation and the requirement of extensive data and software for implementation of Basel II will, in our view, pose a major challenge in India's migration towards Basel II regime. We have argued that if these issues are not tackled up front, then the end result would be no different from the current Basel I norms, albeit at higher cost. Despite these challenges, in a globalizing financial system, India will not be able to do away with the recent international developments such as Basel II. In the long run, adherence to Basel II by Indian banks will result in improved accounting, risk management and supervisory principles that are in line with internationally accepted best practices. While the Basel II regime provides the credit rating industry with an opportunity in terms of business expansion, it needs to be seen if the industry is able to perform in terms of the key principles of objectivity, independence, transparency, disclosure, resources and credibility. We argue that solicited ratings scheme is an impediment towards this goal.
Since development of IT infrastructure is very crucial to Basel II implementation, India's growing IT industry is likely to benefit from the increased business opportunities in the long run. Processes such as data analysis, model building and model validation are likely to be outsourced to the BPO (Business Process Outsourcing) sector, increasing the role of by now mature BPO industry in India. Thus, in the long run, adherence to Basel II regime is expected to benefit not only the banking industry, but also several other sectors of Indian economy, such as the credit rating industry, the IT industry and the BPO industry.
Reference:
Bailey, R (2005), "Basel II and Development Countries: Understanding the Implications", London School of Economics Working Paper No. 05-71.
Basel Committee on Banking Supervision (1988), "International Convergence of Capital Measurement and Capital Standards", available at www.bis.org
Basel Committee on Banking Supervision (1996), "Amendment to the Capital Accord to incorporate market risks" available at www.bis.org
Basel Committee on Banking Supervision (2006), "International Convergence of Capital Measurement and Capital Standards: A Revised Framework", available at www.bis.org
Ferri, G., L. Liu and J.E. Stiglitz (1999), "The Procyclical Role of Rating Agencies: Evidence from the East Asian Countries" Economic Notes, 28 (3), pp. 335-355.
Ferri, G., L. Liu and G. Majnoni (2000), "How the Proposed Basel Guidelines on Rating-Agency Assessments Would Affect Developing Countries", Policy Research Working Paper 2369, The World Bank.
