Current Level of Basel II Implementation

Basel History…

• Basel Committee was constituted by the Central Bank Governors of the G-10 countries

• The Committee's Secretariat is located at the Bank for International Settlements in Basel, Switzerland

• Its objective is to enhance understanding of key supervisory issues and quality improvement of banking supervision worldwide

• This committee is best known for its international standards on capital adequacy; the core principles of banking supervision and the concordat on cross-border banking supervision

Basel II

• Basel II is a type of recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision that was initially published in June 2004

• The objective of Basel II is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face

• Basel II includes recommendations on three main areas: risks, supervisory review, and market discipline

Environment of Basel II

The Accord in operation

Pillar 1 :Minimum Capital Requirements

Market Risk • No changes from Basel

I

Credit Risk • Significant change from

Basel I• Three different

approaches to the calculation of minimum capital requirements

• Capital incentives for banks to move to more sophisticated credit risk management approaches based on internal ratings

• Sophisticated approaches have systems/controls and data collection requirements as well as qualitative requirements for risk management

Operation Risk • Not explicitly

covered in Basel I • Three different

approaches to the calculation of minimum capital requirements

• Adoption of each approach subject to compliance with defined ‘qualifying criteria’

Pillar 2 :Supervisory Review

• Banks should have a process for assessing their overall capital adequacy and strategy for maintaining capital levels

• Supervisors should review and evaluate banks’ internal capital adequacy assessment and strategies

• Supervisors should expect banks to operate above the minimum capital ratios and should have the ability to require banks to hold capital in excess of the minimum

• Supervisors should seek to intervene at an early stage to prevent capital from falling below minimum level

Pillar 3 :Market Discipline & Disclosure

• Market discipline reinforces efforts to promote safety and soundness in banks

• Core disclosures (basic information) and supplementary disclosures to make market discipline more effective

Basel II Project Management

Phase Approach

BankCurrent Situation Effect of BASEL II Challenges Risk• Use “one-size-fits-

all” regulatory capital approach

• Need to choose credit andoperational risk approaches (Pillar I)

•Need to gather, store, and analyzewide array of new data

•Need to embed new/enhancedpractices across the organization

•Interpret new regulations andunderstand effects on business

•Secure and maintain board and senior management sponsorship

•Face new expectations fromregulators, rating agencies, andCustomers

•Need to consider whether totarget certain customers/productsor eliminate others

•Interpret new regulations and understand effects on business

•Manage change to risk culture

•Secure and maintain board and senior management sponsorship

•Face new expectations fromregulators, rating agencies, and customers

CustomerCurrent Situation Effect of BASEL II Challenges Risk

•Often unable to generate sufficientinternal cash flow to realize all necessary investments

•Depend on external resources, which could be debt or equity

•Need external/internal rating to obtain credit

•Face increased transparency ofaccount profitability

•Need to collect and disclose newInformation

•Face possibility of reduced service,standardized products, higher interest rates

•Face new costs resulting from need to provide lenders with new, timely information

•Improve lending terms

•Improve connections with enders/investors through enhanced disclosures andstructured debt holder’sRelationship management

•key performance indicators to monitor performance

•Reduced credit lines

•Increased collateralRequirements

•Fewer refinancing opportunities

•Higher interest an generalCosts

Current Situation Effect of BASEL II Challenges Risk

•Operate in a fragmentedEnvironment

•Need enhanced information to beable to anticipate bank problems(vs. respond in crisis/default)

•Gain access to more and timely information through the new disclosures Basel requires of banks

•Gain power to set incentives, penalize wrong-doers, and act(not react)—thus contributing toincreased financial stability andtransparency

•Need well-trained, educatedprofessionals to fill roles that aretraditionally not as well paid ascomparable positions within financial institutions

•Create regulation that reflects the linkages among risks

•May create new costs forbanks and ultimately forCustomers

•Impose numerous locally specific choices that diminish the effectsof the levelled playing field that Basel II seeks to create

Regulators

Rating Agency Current Situation Effects of Basel II Challenges Risk

•Operate in an oligopolistic

environment dominated by Standard & Poor’s, Moody’s, and Fitch (Europe); others face high barriers to entry

• Grow based on new need for ratings by banks and capital

market participants • Compete with new,

smaller players allied in new associations

designed to improve their competitiveness and reputation• Respond to

requirements for greater transparency in rating components

• Seek to improve reputation (national agencies)• Obtain approval (supervisorycriteria) for banks to use StandardApproach• Maintain high quality of ratings• Benefit from intermediationProcess

•Face reduced market share because most banks will likely use IRB approaches

•Fail to benefit from increasedcompetition if smaller agenciescannot surmount barriers to entry

Capital Markets Current Situation Effects of Basel II Challenges Risk

• Face trend toward securitization,

including credit derivatives

• Securitization, and growth in

derivatives markets

• “Risks” (e.g., corporate bonds)

offered in smaller parcels

• New growth of debt market

• Face reduced customer base as

low-quality corporations avoid debt capital markets in favor of stable

relationships with banks

• Create investor trust and reduce

volatility by encouraging the

development of a regulatory

framework, by market

• Volatility in the debt market

• Reduced liquidity

• Corporations facing difficulties in offering bonds

• Companies running out of Capital

Financial Institutions of Basel II Current Situation Effects of Basel II Challenges Risk

• Not covered by financial regulation

comparable to the Basel regime

•Do not need to gather or disclose

the same information as Basel-compliant institutions •Need to consider

the extent to which “complying”

with Basel II is strategically

important to help the institution remain competitive and to signal quality

• Face reduced customer base as

low-quality corporations avoid debt capital markets in favor of stable

relationships with banks

• Create investor trust and reduce

volatility by encouraging the

development of a regulatory

framework, by market

• Volatility in the debt market

• Reduced liquidity

• Corporations facing difficulties in offering bonds

• Companies running out of Capital

Challenges with Indian Banking Industry..

• With the feature of additional capital requirements, the overall capital level of the banks will see an increase. But, the banks that will not be able to make it as per the norms may be left out of the global system

• Another biggest challenge is re-structuring the assets of some of the banks would be a tedious process, since most of the banks have poor asset quality leading to significant proportion of NPA. This also may lead to Mergers & Acquisitions, which itself would be loss of capital to entire system.

• The new norms seem to favor the large banks that have better risk management and measurement expertise, who also have better capital adequacy ratios and geographically diversified portfolios.

Implications..• 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 mismatches, like asset securitization, which unlocks resources and spreads risk, are likely to be increasingly used.

• 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.

• This was designed for the big banks in the BCBS member countries, not for smaller or less developed economies.

Implications..• 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.

• 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.

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