CHAPTER-1 INTRODUCTION Today banks have a key role in all countries. And their policies and strategies affect economic development, employment, prices, national income, etc. The operations of banks are known as one of the most important economic activity in the world. Any activity which requires investments and financial resources undoubtedly requires the involvement of banks and financial institutions. Thus banks have the central role in economy. On the other hand, Managing of a country's financial system requires a variety of ways that enable financial institutions to identifying of management problems to be responsible for protecting the citizens and the entire system because existing problems due to poor management of bank, threaten the entire financial system of a country. Achieving to the components of a strong and efficient banking system, achieving goals, efficient use of resources and operating efficiently have been considered for many years so it requires assessment of bank's performance. Evaluation of bank performance is very important for Bankers due to the need to protect the banking operations against continuous risks or due to gambling-incentives related to capital market. In addition, there are numerous studies on financial interventions and its effect on efficiency of economic growth and also other studies on bank failures and its relationship with systemic crisis which 1
Transcript
CHAPTER-1
INTRODUCTION
Today banks have a key role in all countries. And their policies and strategies affect
economic development, employment, prices, national income, etc. The operations of
banks are known as one of the most important economic activity in the world. Any
activity which requires investments and financial resources undoubtedly requires the
involvement of banks and financial institutions. Thus banks have the central role in
economy. On the other hand, Managing of a country's financial system requires a
variety of ways that enable financial institutions to identifying of management problems
to be responsible for protecting the citizens and the entire system because existing
problems due to poor management of bank, threaten the entire financial system of a
country. Achieving to the components of a strong and efficient banking system,
achieving goals, efficient use of resources and operating efficiently have been
considered for many years so it requires assessment of bank's performance. Evaluation
of bank performance is very important for Bankers due to the need to protect the
banking operations against continuous risks or due to gambling-incentives related to
capital market. In addition, there are numerous studies on financial interventions and its
effect on efficiency of economic growth and also other studies on bank failures and its
relationship with systemic crisis which demonstrate the important of performance
evaluation. Today, the bank performance has become a favorite subject for many
stakeholders such as customers, investors and the general public. There is a wide
range of indicators of financial reports to evaluate financial performance. But the
important criteria to determine the compatibility and health of a financial organization act
as some mediators to measure profitability and liquidity of the organization. Among the
various criteria; Basel Committee on Banking Supervision proposed the CAMEL
component to investigate financial organizations in 1988.
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CAMEL model is a simple and appropriate model for managerial and financial
assessment of organizations. It is classified as a modern approach to evaluate the
performance. However, this method has been used more in foreign countries but in our
country little efforts has been done to introduce this model and some banks use it to
measure their performance. But it is not used as a formal method which Central Bank
introduces it. So there is still a need for further investigation in this field. In this study the
CAMEL model was used to measure and compare the financial performance of public
and private commercial banks of Qom city. For this purpose we measure the
dimensions of the CAMEL model such as capital adequacy, asset quality, management
quality, earning performance and liquidity.
HISTORY OF CAMEL FRAMEWORK:-
CAMELS Rating Framework
CAMEL model of rating was first developed in the 1970s by the three federal
banking supervisors of the U.S (the Federal Reserve, the FDIC and the OCC) as part of
the regulators’ “Uniform Financial Institutions Rating System”, to provide a convenient
summary of bank condition at the time of its on-site examination. The banks were
judged on five different components under the acronym C-A-M-E-L: Capital adequacy,
Asset quality, Management, Earnings and Liquidity. The banks received a score of ‘1’
through ‘5’ for each component of CAMEL and a final CAMEL rating representing the
composite total of the component CAMEL scores as a measure of the bank’s overall
condition. The system of CAMEL was revised in 1996, when agencies added an
additional parameter ‘S’ for assessing “sensitivity to market risk”, thus making it
‘CAMELS’ that is in vogue today.
This system has applied by National Credit Union Administration (NCUA) in
October 1987. Also Federal Reserve Bank of America assesses its banks on a scale of
one to five by using the CAMEL model components which is monitoring various aspects
of bank's health. The rank 1 is the highest rank (strongest performance) and rank 5 is
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the lowest rank (weakest performance). Reliability, profitability and liquidity are the most
important criteria for assessing the competency performance of a bank. Therefore,
since 1988 the Basel Committee on Banking Supervision has stated that the CAMEL
model is necessary to evaluate financial institution. In 1997 another component was
added to the CAMEL model which was called market risk (S). However, Most of
developing countries use CAMEL instead of CAMELS to evaluate the performance of
financial organizations. It means they don't consider the market risk. Given that our
country is a developing country so in this Study we used the CAMEL model.
CAMELS’ framework is a common approach to evaluate the financial health of the
organization. This system was created by U.S. bank supervising organizations. Also the
Asian Development Bank, African Development Bank, Central bank of America (the
Federal Reserve Bank) and the World Bank use these parameters to evaluate the
performance of financial organizations. In addition, the International Monetary Fund use
compressed index of financial institutions to evaluate the accuracy of the financial
systems of the members. Testing CAMELS system needs information from various
sources such as balance sheet financing, financing sources, data macroeconomic,
budget and cash flow forecasting, staffing and operation. In this model, the overall
condition of the banks and their strengths and weaknesses are assessed.
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CHAPTER-2
REVIEW OF LITERATURE
In the process of continuous evaluation of the bank’s financial performance both in
public sector and private sector, the academicians, scholars and administrators have
made several studies on the CAMEL model but in different perspectives and in different
periods.
Cole et al. (1995) conducted a study on “A CAMEL Rating's Shelf Life” and their findings
suggest that, if a bank has not been examined for more than two quarters, off-site
monitoring systems usually provide a more accurate indication of survivability than its
CAMEL rating.
Godlewski (2003) tested the validity of the CAMEL rating typology for bank's default
modification in emerging markets. He focused explicitly on using a logical model applied
to a database of defaulted banks in emerging markets.
Said and Saucier (2003) examined the liquidity, solvency and efficiency of Japanese
Banks using CAMEL rating methodology, for a representative sample of Japanese
banks for the period 1993- 1999, they evaluated capital adequacy, assets and
management quality, earnings ability and liquidity position.
Prasuna (2003) analyzed the performance of Indian banks by adopting the CAMEL
Model. The performance of 65 banks was studied for the period 2003-04. The author
concluded that the competition was tough and consumers benefited from better services
quality, innovative products and better bargains.
Derviz et al. (2008) investigated the determinants of the movements in the long term
Standard & Poor’s and CAMEL bank ratings in the Czech Republic during the period
when the three biggest A Camel Model Analysis of Nationalized Banks in India
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K.V.N.Prasad, G. Ravinder -25- banks, representing approximately 60% of the Czech
banking sector's total assets, were privatized (i.e., the time span 1998-2001).
Bhayani (2006) analyzed the performance of new private sector banks through the help
of the CAMEL model. Four leading private sector banks – Industrial Credit & Investment
Corporation of India, Housing Development Finance Corporation, Unit Trust of India and
Industrial Development Bank of India - had been taken as a sample.
Gupta and Kaur (2008) conducted the study with the main objective to assess the
performance of Indian Private Sector Banks on the basis of Camel Model and gave
rating to top five and bottom five banks. They ranked 20 old and 10 new private sector
banks on the basis of CAMEL model. They considered the financial data for the period
of five years i.e., from 2003-07.
MIhir Dash (2009) “A CAMEL analysis of the Indian Banking Industry” compares the
performance of public sector banks with private/foreign banks under the CAMEL
framework. He concluded that private/foreign banks fared better than public sector
banks on most of the CANEL factors in the study period.
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CHAPTER-3
THE INDUSTRY AND COMPANY PROFILE
INTRODUCTION
The banking section will navigate through all the aspects of the Banking System
in India. It will discuss upon the matters with the birth of the banking concept in the
country to new players adding their names in the industry in coming few years. The
banker of all banks, Reserve Bank of India (RBI), the Indian Banks Association (IBA)
and top 20 banks like IDBI, HSBC, ICICI, ABN AMRO, etc. has been well defined
under three separate heads with one page dedicated to each bank. However, in the
introduction part of the entire banking cosmos, the past has been well explained
under three different heads namely:
History of Banking in India
Nationalization of Banks in India
Scheduled Commercial Banks in India
The first deals with the history part since the dawn of banking system in India.
Government took major step in the 1969 to put the banking sector into systems and it
nationalised 14 private banks in the mentioned year. This has been elaborated in
Nationalisation of Banks in India. The last but not the least explains about the scheduled
and unscheduled banks in India. Section 42 (6)(a) of RBI Act 1934 lays down the
condition of scheduled commercial banks.
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History of Banking in India
Without a sound and effective banking system in India it cannot have a healthy
economy. The banking system of India should not only be hassle free but it should be
able to meet new challenges posed by the technology and any other external and
internal factors.
For the past three decades India's banking system has several outstanding
achievements to its credit. The most striking is its extensive reach. It is no longer
confined to only metropolitans or cosmopolitans in India. In fact, Indian banking system
has reached even to the remote corners of the country. This is one of the main reasons
of India's growth process. The government's regular policy for Indian bank since 1969
has paid rich dividends with the nationalization of 14 major private banks of India. Not
long ago, an account holder had to wait for hours at the bank counters for getting a draft
or for withdrawing his own money. Today, he has a choice. Gone are days when the
most efficient bank transferred money from one branch to other in two days. Now it is
simple as instant messaging or dial a pizza. Money have become the order of the day.
The first bank in India, though conservative, was established in 1786. From 1786 till
today, the journey of Indian Banking System can be segregated into three distinct
phases. They are as mentioned below:
Early phase from 1786 to 1969 of Indian Banks
Nationalization of Indian Banks and up to 1991 prior to Indian banking sector
Reforms.
New phase of Indian Banking System with the advent of Indian Financial &
Banking Sector Reforms after 1991.
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The first bank in India, though conservative, was established in 1786. From 1786 till
today, the journey of Indian Banking System can be segregated into three distinct
phases. They are as mentioned below:
Early phase from 1786 to 1969 of Indian Banks
Nationalization of Indian Banks and up to 1991 prior to Indian banking sector
Reforms.
New phase of Indian Banking System with the advent of Indian Financial &
Banking Sector Reforms after 1991.
Phase I
The General Bank of India was set up in the year 1786. Next came Bank of
Hindustan and Bengal Bank. The East India Company established Bank of Bengal
(1809), Bank of Bombay (1840) and Bank of Madras (1843) as independent units and
called it Presidency Banks. These three banks were amalgamated in 1920 and Imperial
Bank of India was established which started as private shareholders banks, mostly
European shareholders. In 1865 Allahabad Bank was established and first time
exclusively by Indians, Punjab National Bank Ltd. was set up in 1894 with headquarters
at Lahore. Between 1906 and 1913, Bank of India, Central Bank of India, Bank of
Baroda, Canara Bank, Indian Bank, and Bank of Mysore were set up. Reserve Bank of
India came in 1935.During the first phase the growth was very slow and banks
also experienced periodic failures between 1913 and 1948. There were approximately
1100 banks, mostly small. To streamline the functioning and activities of commercial
banks, the Government of India came up with The Banking Companies Act, 1949 which
was later changed to Banking Regulation Act 1949 as per amending Act of 1965 (Act
No. 23 of 1965). Reserve Bank of India was vested with extensive powers for the
supervision of banking in India as the Central Banking Authority.
During those days public had lesser confidence in the banks. As an aftermath deposit
mobilization was slow. Abreast of it the savings bank facility provided by the Postal
department was comparatively safer. Moreover, funds were largely given to traders.
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Phase II
Government took major steps in this Indian Banking Sector Reform after
independence. In 1955, it nationalized Imperial Bank of India with extensive banking
facilities on a large scale especially in rural and semi-urban areas. It formed State Bank
of India to act as the principal agent of RBI and to handle banking transactions of the
Union and State Governments all over the country.Seven banks forming subsidiary of
State Bank of India was nationalized in 1960 on 19th July, 1969, major process of
nationalization was carried out. It was the effort of the then Prime Minister of India, Mrs.
Indira Gandhi. 14 major commercial banks in the country were nationalized. Second
phase of nationalization Indian Banking Sector Reform was carried out in 1980 with
seven more banks. This step brought 80% of the banking segment in India under
Government ownership.
The following are the steps taken by the Government of India to Regulate
Banking Institutions in the Country:
1949: Enactment of Banking Regulation Act.
1955: Nationalisation of State Bank of India.
1959: Nationalisation of SBI subsidiaries.
1961: Insurance cover extended to deposits.
1969: Nationalisation of 14 major banks.
1971: Creation of credit guarantee corporation.
1975: Creation of regional rural banks.
1980: Nationalisation of seven banks with deposits over 200 crore.
After the nationalization of banks, the branches of the public sector bank India rose to
approximately 800% in deposits and advances took a huge jump by 11,000%.
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Banking in the sunshine of Government ownership gave the public implicit faith and
immense confidence about the sustainability of these institutions.
Phase III
This phase has introduced many more products and facilities in the banking
sector in its reforms measure. In 1991, under the chairmanship of M Narasimham, a
committee was set up by his name which worked for the liberalisation of banking
practices.
The country is flooded with foreign banks and their ATM stations. Efforts are
being put to give a satisfactory service to customers. Phone banking and net banking is
introduced. The entire system became more convenient and swift. Time is given more
importance than money. The financial system of India has shown a great deal of
resilience. It is sheltered from any crisis triggered by any external macroeconomics
shock as other East Asian Countries suffered. This is all due to a flexible exchange rate
regime, the foreign reserves are high, the capital account is not yet fully convertible, and
banks and their customers have limited foreign exchange exposure.
Scheduled Commercial Banks In India
The commercial banking structure in India consists of:
Scheduled Commercial Banks in India
Unscheduled Banks in India
Scheduled Banks in India constitute those banks which have been included in the
Second Schedule of Reserve Bank of India(RBI) Act, 1934. RBI in turn includes only
those banks in this schedule which satisfy the criteria laid down vide section 42 (6) (a)
of the Act. As on 30th June, 1999, there were 300 scheduled banks in India having a
total network of 64,918 branches. The scheduled commercial banks in India comprise of
State bank of India and its associates (8), nationalized banks (19), foreign banks (45),
private sector banks (32), co-operative banks and regional rural banks.
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Reserve Bank of India
Commercial Banks Co-operative Banks Development Banks
Nationalized Private Short-term credit
Long-term credit
Agricultural Credit
Urban Credit
EXIM Industrial Agricultural
"Scheduled banks in India" means the State Bank of India constituted under the
State Bank of India Act, 1955 (23 of 1955), a subsidiary bank as defined in the State
Bank of India (Subsidiary Banks) Act, 1959 (38 of 1959), a corresponding new bank
constituted under section 3 of the Banking Companies (Acquisition and Transfer of
Undertakings) Act, 1970 (5 of 1970), or under section 3 of the Banking Companies
(Acquisition and Transfer of Undertakings) Act, 1980 (40 of 1980), or any other bank
being a bank included in the Second Schedule to the Reserve Bank of India Act, 1934
(2 of 1934), but does not include a co-operative bank". "Non-scheduled bank in India"
means a banking company as defined in clause (c) of section 5 of the Banking
Regulation Act, 1949 (10 of 1949), which is not a scheduled bank".
Organizational Structure of Banks in India:
In India banks are classified in various categories according to differ rent criteria. The
following charts indicate the banking structure
Broad Classification of Banks in India:
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1) The RBI: The RBI is the supreme monetary and banking authority in the country
and has the responsibility to control the banking system in the country. It keeps
the reserves of all scheduled banks and hence is known as the “Reserve Bank”.
2) Public Sector Banks:
State Bank of India and its Associates (8)
Nationalized Banks (19)
Regional Rural Banks Sponsored by Public Sector Banks (196)
3) Private Sector Banks:
Old Generation Private Banks (22)
Foreign New Generation Private Banks (8)
Banks in India (40)
4) Co-operative Sector Banks:
State Co-operative Banks
Central Co-operative Banks
Primary Agricultural Credit Societies
Land Development Banks
State Land Development Banks
5) Development Banks: Development Banks mostly provide long term finance for
setting up industries. They also provide short-term finance (for export and import
activities)
Industrial Finance Co-operation of India (IFCI)
Industrial Development of India (IDBI)
Industrial Investment Bank of India (IIBI)
Small Industries Development Bank of India (SIDBI)
National Bank for Agriculture and Rural Development (NABARD)
Export-Import Bank of India.
Role of Banks:
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Banks play a positive role in economic development of a country as repositories
of community’s savings and as purveyors of credit. Indian Banking has aided the
economic development during the last fifty years in an effective way.
The banking sector has shown a remarkable responsiveness to the needs of
planned economy. It has brought about a considerable progress in its efforts at
deposit mobilization and has taken a number of measures in the recent past for
accelerating the rate of growth of deposits.
As recourse to this, the commercial banks opened branches in urban, semi-
urban and rural areas and have introduced a number of attractive schemes to
foster economic development.
The activities of commercial banking have growth in multi-directional ways as
well as multi-dimensional manner. Banks have been playing a catalytic role in
area development, backward area development, extended assistance to rural
development all along helping agriculture, industry, international trade in a
significant manner. In a way, commercial banks have emerged as key financial
agencies for rapid economic development.
By pooling the savings together; banks can make available funds to specialized
institutions which finance different sectors of the economy, needing capital for
various purposes, risks and durations.
By contributing to government securities, bonds and debentures of term-lending
institutions in the fields of agriculture, industries and now housing, banks are also
providing these institutions with an access to the common pool of savings
mobilized by them, to that extent relieving them of the responsibility of directly
approaching the saver.
This intermediation role of banks is particularly important in the early stages of
economic development and financial specification. A country like India, with
different regions at different stages of development, presents an interesting
spectrum of the evolving role of banks, in the matter of inter-mediation and
beyond.
Mobilization of resources forms an integral part of the development process in
India. In this process of mobilization, banks are at a great advantage, chiefly
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because of their network of branches in the country. And banks have to place
considerable reliance on the mobilization of deposits from the public to finance
development programmes.
Further, deposit mobilization by banks in India acquired greater significance in
their new role in economic development. Commercial banks provide short-term
and medium-term financial assistance. The short-term credit facilities are granted
for working capital requirements.
The medium-term loans are for the acquisition of land, construction of factory
premises and purchase of machinery and equipment. These loans are generally
granted for periods ranging from five to seven years.
They also establish letters of credit on behalf of their clients favoring suppliers of
raw materials/machinery (both Indian and foreign) which extend the banker’s
assurance for payment and thus help their delivery.
Certain transaction, particularly those in contracts of sale of Government
Departments, may require guarantees being issued in lieu of security earnest
money deposits for release of advance money, supply of raw materials for
processing, full payment of bills on the assurance of the performance etc.
Commercial banks issue such guarantees also.
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PRODUCTS AND SERVICES OFFERED BY BANKS
Products
Investment Banking
Consumer Banking
Commercial Banking
Retail Banking
Private Banking
Asset Management
Pensions
Mortgages
Credit Cards
Broad Classification of Products in a bank:
The different products in a bank can be broadly classified into:
Retail Banking.
Trade Finance.
Treasury Operations.
Retail Banking and Trade finance operations are conducted at the branch level while
the wholesale banking operations, which cover treasury operations, are at the hand
office or a designated branch.
Retail Banking:
Deposits
Loans, Cash Credit and Overdraft
Negotiating for Loans and advances
Remittances
Book-Keeping (maintaining all accounting records)
Receiving all kinds of bonds valuable for safe keepi
Trade Finance:
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Issuing and confirming of letter of credit.
Drawing, accepting, discounting, buying, selling, collecting of bills of exchange,
promissory notes, drafts, bill of lading and other securities.
Treasury Operations:
Buying and selling of bullion. Foreign exchange
Acquiring, holding, underwriting and dealing in shares, debentures, etc.
Purchasing and selling of bonds and securities on behalf of constituents.
The banks can also act as an agent of the Government or local authority. They
insure, guarantee, underwrite, participate in managing and carrying out issue of shares,
debentures, etc.
Apart from the above-mentioned functions of the bank, the bank provides a whole lot
of other services like investment counseling for individuals, short-term funds
management and portfolio management for individuals and companies. It undertakes
the inward and outward remittances with reference to foreign exchange and collection of
varied types for the Government.
Following Services Can Be Availed On The Internet:
Bill Payment
Funds Transfer
Special Promotions & Offers
Ticket Booking
Online loans and credit cards
Online Shopping
Online Tax payment
Prepaid mobile recharge
Banks will expand In overseas market
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In order to sustain the business growth amid highly competitive market and
slowing Indian economy, banks are likely to expand in the overseas market. They will
try to tap emerging opportunities by expanding into newer markets such as Africa,
former Soviet region and other South East Asian countries, in which India has
maintained good trade relations. They can set up captive operations or expand through
inorganic means by undergoing M&A (mergers and acquisitions) with banks in foreign
countries.
Passage of 'Banking Laws (Amendment) Bill' aimed at attracting more foreign
investments
With an aim to reform and strengthen India's banking sector, the Lok Sabha
passed the 'Banking Amendment Bill' in Dec 2012. Once, the bill is passed by Rajya
Sabha as well, it will pave way for RBI to issue new banking licenses to private sector
and attract more foreign investments in the sector.
The Bill also proposes to enhance the voting rights of investors in case of both
public sector and private sector banks from existing 1% to 10% of public sector banks
and from 10% to 26% of private sector banks. This move will attract more foreign
investment in the sector
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MAJOR RECOMMENDATIONS ON BANKING SECTOR REFORMS:
Strengthening Banking System
Capital adequacy requirements should take into account market risks in addition
to the
Credit risks.
In the next three years the entire portfolio of government securities should be
marked to market and the schedule for the same announced at the earliest (since
announced in the monetary and credit policy for the first half of 1998-99);
government and other approved securities which are now subject to a zero risk
weight, should have a 5 per cent weight for market risk.
Risk weight on a government guaranteed advance should be the same as for
other advances. This should be made prospective from the time the new
prescription is put in place.
Foreign exchange open credit limit risks should be integrated into the calculation
of risk weighted assets and should carry a 100 per cent risk weight.
Minimum capital to risk assets ratio (CRAR) be increased from the existing 8 per
cent to 10 per cent; an intermediate minimum target of 9 per cent be achieved by
2000 and the ratio of 10 per cent by 2002; RBI to be empowered to raise this
further for individual banks if the risk profile warrants such an increase. Individual
banks' shortfalls in the CRAR are treated on the same line as adopted for reserve
requirements, viz. uniformity across weak and strong banks. There should be
penal provisions for banks that do not maintain CRAR.
Public Sector Banks in a position to access the capital market at home or abroad
be encouraged, as subscription to bank capital funds cannot be regarded as a
priority claim on budgetary resources.
Systems and Methods in Banks
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There should be an independent loan review mechanism especially for large
borrowal accounts and systems to identify potential NPAs. Banks may evolve a
filtering mechanism by stipulating in-house prudential limits beyond which
exposures on single/group borrowers are taken keeping in view their risk profile
as revealed through credit rating and other relevant factors.
Banks and FIs should have a system of recruiting skilled manpower from the
open market.
Public sector banks should be given flexibility to determined managerial
remuneration levels taking into account market trends.
There may be need to redefine the scope of external vigilance and investigation
agencies with regard to banking business.
There is need to develop information and control system in several areas like
better tracking of spreads, costs and NPSs for higher profitability, , accurate and
timely information for strategic decision to Identify and promote profitable
products and customers, risk and asset-liability management; and efficient
treasury management.
BASEL II ACCORD
Bank capital framework sponsored by the world's central banks designed to
promote uniformity, make regulatory capital more risk sensitive, and promote enhanced
risk management among large, internationally active banking organizations. The
International Capital Accord, as it is called, will be fully effective by January 2008 for
banks active in international markets. Other banks can choose to "opt in," or they can
continue to follow the minimum capital guidelines in the original Basel Accord, finalized
in 1988. The revised accord (Basel II) completely overhauls the 1988 Basel Accord and
is based on three mutually supporting concepts, or "pillars," of capital adequacy. The
first of these pillars is an explicitly defined regulatory capital requirement, a minimum
capital-to-asset ratio equal to at least 8% of risk-weighted assets. Second, bank
supervisory agencies, such as the Comptroller of the Currency, have authority to adjust
capital levels for individual banks above the 8% minimum when necessary. The third
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supporting pillar calls upon market discipline to supplement reviews by banking
agencies. 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.
The final version aims at:
1. ensuring that capital allocation is more risk sensitive;
2. Separating operational risk from credit risk, and quantifying both;
3. 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. The Basel I definition, as
modified up to the present, remains in place.
The Accord in operation 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 Three Pillars of Basel II
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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 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 standardised 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
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 commercial loans. A new 150% rating comes 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
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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
