Effects of BASEL II Implementation on Indian Banking System

Effects of Basel II Implementation on Indian Banking System Bank of Baroda

1. INTRODUCTION

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COMPANY INTRODUCTION

The founder, Maharaja Sayajirao Gaekwad had an uncanny foresight into the future of trade and enterprising in his country. On 20th July 1908, under the Companies Act of 1897, and with a paid up capital of Rs 10 Lakh started the legend that has now translated into a strong, trustworthy financial body, THE BANK OF BARODA.

Bank of Baroda is a leading 100 years old Public Sector Bank in India with modern and contemporary personality, offering banking products and services to industrial and commercial, retail and agricultural customers across the country. Between 1913 and 1917, as many as 87 banks failed in India. Bank of Baroda survived the crisis, mainly due to its honest and prudent leadership. This financial integrity, business prudence, caution and an abiding care and concern for the hard earned savings of hard working people, were to become the central philosophy around which business decisions would be effected.

The bank has a strong domestic presence through 2,884 branches across the country. The Overseas business operations extend across 25 countries through 72 branches/offices. The bank provides Financial Services to over 36.5 million customers globally.

The bank has an uninterrupted record in profit-making and dividend payment over the years and has pioneered in many Customer-centric initiatives. It is the first PSB to receive Corporate Governance Rating (CAGR – 2).

Bank of Baroda’s share is listed on BSE and NSE and in ‘Future and Options’ segment also. BOB is a part of BSE 100, BSE 200 and BSE 500 Indexes. The Net worth of Bank of Baroda was Rs. 11,387.19 crore as on 31st March, 2009 and the no. of shares was 364.27 million.

Global Business was up by 30% (Y-o-Y) to Rs. 3,36,383 crore out of which domestic business rose by 26.0% (Y-o-Y) to Rs. 2,60,692 crore as on 31st March, 2009. Global Deposits was up by 26.6% (Y-o-Y) to Rs. 1,92,397 crore out of which domestic deposits rose by 23.6% (Y-o-Y) to Rs. 1,51,409 crore as on 31st March, 2009. Global Advances was up by 34.9% (Y-o-Y) to Rs. 1,43,986 out of which domestic advances rose by 29.3% to Rs. 1,09,283 crore as on 31st March, 2009.

The Capital Adequacy Ratio as per BASEL II was 14.05% for the year ended 31st

March, 2009.

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BRANCH AND DEPARTMENT INTRODUCTION

Sir. P. M. Road Branch of Bank of Baroda is situated in Laxmi Insurance Building, Sir. P.M. Road in the Fort area. The Branch is named on the road where it is situated. It also has another premises at Sheel chambers.

Sir. P. M. Road branch was started its operations on 10th August, 1958. The branch has a huge customer base. The bank has a huge customer base including the corporate as well as the retail customers. The branch is headed and is under total control of Mr. D. P. Srivastava, Asst. General Manager.

Many departments work in tandem for the smooth functioning of this branch. A special foreign exchange department has been set up in this branch so as to facilitate the customers with easy transactions of foreign currencies.

The branch is one of the major contributors in terms of business in Mumbai Metro South region of Bank of Baroda. The total business for the year ended march, 2009 is Rs. 2497.29 crore.

The Loans and Advances Department is headed by Chief Manager and is ably supported by a Senior Manager and a Manager. The department contributed Rs. 1399.48 crore in the annual business of the branch for the year ended 31 st March, 2009. The major work handled by the loans and advances department is of accepting loan applications and forwarding it to the SME loan factory and keeping a track of these activities as well as reviewing the advances that have been already distributed. Other than SME loans are processed at branch level and forwarded to the respective authorities. Overall monitoring of all advances accounts are done and facilities of different advances are reviewed at regular intervals for their credibility.

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2. LITERATURE REVIEW

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RISK

There are many definitions of risk depending on the specific application and situational contexts. In general, every risk (indicator) is proportional to the expected losses, which can be caused by a risky event, and to the probability of this event. Risk can be defined as the variability in the expected earnings of a company. Therefore, differentiation of risk definitions depends on the losses context, their assessment and measurement, as well as when the losses are clear and variable, for example in the case of a human life, the Risk Assessment is focused on the probability of the event, event frequency and its circumstances.

Engineering Definition of Risk:

Financial Definition of Risk:

It is “the chance that an investment’s actual return will be different than expected. This includes the possibility of losing some or all of the original investment. It is usually measured by calculating the standard deviations of the historical returns or average returns of a specific investment”.

Risk in finance is defined as a general method to assess risk as an expected after-the-fact level of regret. Such methods have been successful in limiting interest rate risk in financial markets. Financial markets are proving ground for general methods of risk assessment. A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take, the greater the potential return he will get. The reason for this is that investors need to be compensated for taking an additional risk.

TYPES OF RISKS

Credit Risk:

The risk of loss of principal or loss of a financial reward stemming from a borrower's failure to repay a loan or otherwise meets a contractual obligation. Credit risk arises whenever a borrower is expecting to use future cash flows to pay a current debt. Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation. Credit risk is closely tied to the potential return of an investment, the most notable being that the yields on bonds correlate strongly to their perceived credit risk.

The higher the perceived credit risk, the higher the rate of interest that investors will demand for lending their capital. Credit risks are calculated based on the borrowers' overall ability to repay. This calculation includes the borrowers' collateral assets, revenue-generating ability and taxing authority (such as for government and municipal bonds).

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Operational Risk:

A form of risk that summarizes the risks a company or firm undertakes when it attempts to operate within a given field or industry. Operational risk is the risk that is not inherent in financial, systematic or market-wide risk. It is the risk remaining after determining financing and systematic risk, and includes risks resulting from breakdowns in internal procedures, people and systems.

Operational risk can be summarized as human risk; it is the risk of business operations failing due to human error. Operational risk will change from industry to industry, and is an important consideration to make when looking at potential investment decisions. Industries with lower human interaction are likely to have lower operational risk.

Interest Rate Risk:

The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve or in any other interest rate relationship. Such changes usually affect securities inversely and can be reduced by diversifying (investing in fixed-income securities with different durations) or hedging (e.g. through an interest rate swap).

Interest rate risk affects the value of bonds more directly than stocks, and it is a major risk to all bondholders. As interest rates rise, bond prices fall and vice versa. The rationale is that as interest rates increase, the opportunity cost of holding a bond decreases since investors are able to realize greater yields by switching to other investments that reflect the higher interest rate. For example, a 5% bond is worth more if interest rates decrease since the bondholder receives a fixed rate of return relative to the market, which is offering a lower rate of return as a result of the decrease in rates.

Market Risk:

A bank’s investment portfolio is impacted by the fluctuation in prices of securities. Even in respect of sovereign exposure there will be change in market price because of interest rate movements. When the prices of securities are marked to market, a bank may incur loss if the prices have declined. Change in interest rates, foreign exchange rates and prices of equity, corporate debt instruments and commodities may involve market risk for the bank. Mismatches in interest rates on assets and liabilities may also entail risk for the bank. The investment portfolio has to be divided into the trading book and the banking book. While the trading book has to be valued on a daily basis on mark to market basis, for the banking book, there should be frequent assessment of shock absorption capacity of the portfolio to interest rate movements.

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Liquidity Risk:

Liquidity risk is considered to be major risk in the bank. It is the risk of loss arising due to adverse changes in the cash flow on transactions. It can be defined in different ways, such as, extreme liquidity, the safety caution provided by the portfolio of liquid asset, or the ability to raise fund at normal cost.

Liquidity risk is the normal outcome of standard transaction. These transactions tend to generate a maturity gap between assets and liabilities. Often, bank collect short term resources and lend long term. Given this gap between maturity, there exists always a liquidity risk and a cost of liquidity.

Foreign Exchange Risk:

The risk of an investment's value changing due to changes in currency exchange rates or the risk that an investor will have to close out a long or short position in a foreign currency at a loss due to an adverse movement in exchange rates. It is also known as "currency risk" or "exchange-rate risk".

This risk usually affects businesses that export and/or import, but it can also affect investors making international investments. For example, if money must be converted to another currency to make a certain investment, then any changes in the currency exchange rate will cause that investment's value to either decrease or increase when the investment is sold and converted back into the original currency.

Settlement Risk:

Settlement risk is the risk that a counterparty does not deliver a security or its value in cash as per agreement when the security was traded after the other counterparty or counterparties have already delivered security or cash value as per the trade agreement.

Reputation Risk:

Reputation risk is the current and prospective impact on earnings and capital arising from negative public opinion. This affects the institution’s ability to establish new relationships or services or continue servicing existing relationships. This risk may expose the institution to litigation, financial loss, or a decline in its customer base. Reputation risk exposure is present throughout the organization and includes the responsibility to exercise an abundance of caution in dealing with its customers and the community.

Systemic Risk:

Systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries". It refers to the risks

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http://en.wikipedia.org/wiki/Trade

http://en.wikipedia.org/wiki/Counterparty

http://en.wikipedia.org/wiki/Value_(economics)

http://en.wikipedia.org/wiki/Security_(finance)

http://en.wikipedia.org/wiki/Counterparty

http://en.wikipedia.org/wiki/Risk


imposed by inter linkages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or bring down the entire system or market. It is also sometimes erroneously referred to as "systematic risk".

RISK MANAGEMENT

Risk management is the process of identifying risk, assigning appropriate values, identifying threats to those assets, measuring or assessing risk and then developing strategies to manage the risk. In risk management the following steps are taken to minimize the risk.

Step 1: Identification of assets at Risk

The first step in the Risk management process is to identify the assets in support of critical business operations. The assets could fall under different groups, which are physically tangible and conceptual assets.

Step 2: Valuation of Assets

The assets so identified and grouped in the previous step are to be valued and categorised into different classes, such as critical and essential.

Step 3: Identifying the threats

Threats can be defined as anything that contributes to the interruption or destruction of any service/product. Various threats can be grouped into environmental, internal and external threats.

Step 4: Risk Assessment

The process of Risk Assessment includes not only assessment as to the provability of occurrence but also the assessment as to the potential severity of loss, if risk materialises. This will assist in determining the appropriate risk mitigation strategy, the residual risk and investment required to mitigate the risk.

Step 5: Developing Strategies for Risk Management

Once risks have been identified and assessed, the strategies to manage the risk fall into one or more of these four categories:

1. Risk Avoidance: Not doing an activity that involves risk and losing out on the potential gain that accepting risk might have provided.

2. Risk Mitigation: Implementing controls to protect infrastructure and to reduce the severity of the loss.

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http://en.wikipedia.org/wiki/Systematic_risk

http://en.wikipedia.org/wiki/Cascading_failure


3. Risk Reduction/Acceptance: Formally acknowledge that the risk exists and monitoring it. In some cases it may not be possible to take immediate action to avoid/mitigate the risk. All risks that are not avoided or transferred are retained by default.

4. Risk Transfer: Causing another party to accept the risk i.e. sharing risk with partners or insurance coverage.

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3. OBJECTIVE OF THE PROJECT

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OBJECTIVE OF THE PROJECT

The objective of the project is to study BASEL II, a norm of Banking Supervision, and its effects on the Indian Banking System.

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.

The Reserve Bank of India (RBI) has ensured the implementation of BASEL II Accord which has been accepted by over 100 nations, including India. BASEL II Accord has mainly emphasized on the maintenance of Capital Adequacy Ratio (CAR) for managing Credit, Market and Operational risks which has become mandatory now.

BASEL II Accord is primarily based on three pillars:

Pillar 1: Minimum Capital Requirements

Pillar 2: Supervisory Review Process

Pillar 3: Market Discipline and Disclosure

Indian Banks complied with BASEL I norms until BASEL II norms were introduced. Basel II insists on setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk. The underlying assumption behind these rules is 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. It will also oblige banks to enhance disclosures.

The Implementation of BASEL II in Indian Banks has prompted the banks to take necessary measures so as to comply with these stringent norms. BASEL II has had many positive as well as negative effects on the Indian Banking System. This project tries to encapsulate these effects in brief.

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4. BANKS

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INTRODUCTION:

A bank is a financial institution licensed by a government. The name bank derives from the Italian word banco meaning "desk/bench", used during the Renaissance by Florentine bankers, who used to make their transactions above a desk covered by a green tablecloth.

A bank is a financial institution where an individual can deposit money. Banks provide a system for easily transferring money from one person or business to another. Using banks and the many services they offer saves an incredible amount of time, and ensures that the funds of micro as well as macroeconomic agents "pass hands" in a legal and structured manner.

The definition of a bank varies from country to country. Banking Regulation Act of India, 1949 defines Banking as "accepting, for the purpose of lending or investment of deposits of money from the public, repayable on demand or otherwise and withdraw able by cheques, draft, and order or otherwise".

Bank regulations are a form of government regulation which subject banks to certain requirements, restrictions and guidelines.

Functions of a Bank

Functioning of a Bank is among the more complicated of corporate operations. Since Banking involves dealing directly with money, governments in most countries regulate this sector rather stringently. In India, the regulation traditionally has been very strict and in the opinion of certain quarters, responsible for the present condition of banks, where NPAs are of a very high order. The process of financial reforms, which started in 1991, has cleared the cobwebs somewhat but a lot remains to be done. The multiplicity of policy and regulations that a Bank has to work with makes its operations even more complicated, sometimes bordering on illogical. This section attempts to give an overview of the functions in as simple manner as possible. Viewed solely from the point of view of the customers,

Banks essentially perform the following functions:

1. Accepting Deposits from public/others (Deposits)

2. Lending money to public (Loans)

3. Transferring money from one place to another (Remittances)

4. Credit Creation

5. Acting as trustees

6. Keeping valuables in safe custody

7. Investment Decisions and analysis

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8. Government business

9. Other types of lending and transactions

In addition to providing a safe custodian of money, banks also loan money to businesses and consumers. A large portion of a bank's business is lending. How do banks get the money they loan? The money comes from depositors who intend to save a portion of their wealth. Banks acting as intermediaries use these deposits as loans to prospective borrowers. The objective of commercial banks like any other organization is profit maximisation. This profit generally originates from the interest differential between borrowers and lenders. In the present day, however, the banking operation has extended much beyond simple lending exercise. So there are other different channels of profit ensuing from other investment programmes as well. However, it should be mentioned in this context that the entire deposit held by a bank cannot be given as loans as the Central Bank retains a portion of this money in the form of cash-reserve for unforeseen circumstances.

Other Services Offered by Banks Include:

Credit Cards Debit Cards Personal Loans Home and Car Loans Business Loans Mutual Funds Safe Deposit Boxes Trust Services Signature Guarantees Issuance of guarantees on behalf of customers Establishment of Letter of credit on behalf of Customer

… and many other investment services.

Types of Banks

Different types of banks specialize in different lines of business. Banks come with a variety of names, and one bank can function as several different types of banks. Some of the most common types of banks are:

Central Bank:

A central bank, reserve bank, or monetary authority is the entity responsible for the monetary policy of a country or of a group of member states. Its primary responsibility is to maintain the stability of the national currency and money supply, but more active duties include controlling subsidized-loan interest rates, and acting as a lender of last resort to the banking sector during times of financial crisis (private banks often being integral to the national financial system). It may also have supervisory powers, to ensure that banks and other financial institutions do not behave recklessly or fraudulently.

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Commercial Bank:

A Commercial Bank performs all kinds of banking functions such as accepting deposits, advancing loans, credit creation & agency functions. They generally advance short term loans to their customers; in some cases they may give medium term loans also.

Commercial banks handle banking needs for large and small businesses, including:

Basic accounts such as savings and checking Lending money for real and capital purchases

Lines of credit

Letters of credit

Lockbox services

Payment and transaction processing

Foreign exchange

Commercial banks often function as retail banks as well, serving individuals along with businesses.

Retail Bank:

A retail bank is a bank that works with consumers, otherwise known as 'retail customers'.

Retail banks provide basic banking services to the general public, including:

Checking and savings accounts CDs

Safe deposit boxes

Mortgages and second mortgages

Auto loans

Unsecured and revolving loans such as credit cards

Retail banks are the banks you most often see in cities on crowded intersections, the ones you probably use for your personal checking account. In addition to helping consumers, retail banks often serve businesses as well - so they can also serve as commercial banks.

Investment Banks:

Investment banks help organizations use investment markets.

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For example, when a company wants to raise money by issuing stocks or bonds, an investment bank helps them through the process. Investment banks also consult on mergers and acquisitions, among other things.

Investment banks primarily work in the investment markets and do not take customer deposits. However, some large investment banks also serve as commercial banks or retail banks.

Industrial Banks:

Ordinarily, the industrial banks perform three main functions: Firstly, Acceptance of Long term deposits: Since the industrial bank give long term loans, they cannot accept short term deposits from the public. Secondly, Meeting the credit requirements of companies: Firstly the industries require to purchase land to erect buildings and purchase heavy machinery. Secondly the industries require short term loans to buy raw materials & to make payment of wages to workers. Thirdly it does some Other Functions - The industrial banks tender advice to big industrial firms regarding the sale & purchase of shares & debentures

Agricultural Banks:

As the commercial & the industrial Banks are not in a position to meet the credit requirements of agriculture, there arises the need for setting up special types of banks to finance agriculture. Firstly, the farmers require short term loans to buy seeds, fertilizers, ploughs and other inputs. Secondly, the farmers require long term loans to purchase land, to effect permanent improvements on the land to buy equipment & to provide for irrigation works.

Foreign Exchange Banks:

Their main function is to make international payments through the purchase and sale of exchange bills. As is well known, the exporters of a country prefer to receive the payment for their exports in their own currency. Hence there arises the problem of converting the currency of one country into the currency of another. The foreign exchange banks try to solve this problem. These banks specialize in financing foreign trade.

Indigenous Banks:

According to the Indian Enquiry Committee, “Indigenous banker is a person or a firm which accepts deposits, transacts business in hundies and advances loans etc.”

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5. BANKING SECTOR IN INDIA

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HISTORY OF INDIAN BANKING

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 Nationalisation 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 And

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 Europeans 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 day’s public had less confidence in the banks. As an aftermath deposit mobilisation was slow. Abreast of it the savings bank facility provided by the Postal department was comparatively safer. Moreover, funds were largely given to traders.

Phase II

Government took major steps in this Indian Banking Sector Reform after independence. In 1955, it nationalised 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 nationalised in 1960 on 19th July, 1969, major process of nationalisation was carried out. It was the effort of the then

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Prime Minister of India, Mrs. Indira Gandhi 14 major commercial banks in the country were nationalised.

Second phase of nationalisation 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 core.

After the nationalisation 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%. 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. 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.

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Banking Sector in India

Central Bank:

The Reserve Bank of India is the Central Bank that is fully owned by the Government. It is governed by a central board (headed by a Governor) appointed by the Central Government. It issues guidelines for the functioning of all banks operating within the country.

The main objectives for the establishment of the Central Bank were as follows:

To manage the monetary and credit system of the country. To stabilizes internal and external value of rupee. For balanced and systematic development of banking in the country. For the development of organized in the money market in the country. For proper arrangement of Agriculture Finance. For proper arrangement of Industrial Finance. To establish monetary relations with other countries of the world & international

financial institutions. For proper management of public debts. For centralization of cash reserves of commercial banks. To maintain balance between the demand and supply of currency.

Public Sector Banks:

a. State Bank of India and its associate banks called the State Bank Groupb. 20 nationalized banksc. Regional rural banks mainly sponsored by public sector banks

Some of the Public Sector Banks in India are:

Allahabad Bank Andhra Bank

Bank of Baroda

Bank of India

Bank of Maharashtra

Canara Bank

Central Bank of India

Corporation Bank

Dena Bank

Indian Bank

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Oriental Bank of Commerce

Punjab National Bank

Syndicate Bank

UCO Bank

Union Bank of India

United Bank of India

Vijaya Bank

List of State Bank of India and its subsidiary Public Sector Banks:

State Bank of Bikaner & Jaipur State Bank of Hyderabad State Bank of Indore State Bank of Mysore State Bank of Saurastra State Bank of Travancore

Private Sector Banks:

a. Old generation private banksb. New generation private banksc. Foreign banks operating in Indiad. Scheduled co-operative bankse. Non-scheduled banks

Co-operative Sector:

The co-operative sector is very much useful for rural people. The co-operative banking sector is divided into the following categories.

a. State co-operative Banksb. Central co-operative banksc. Primary Agriculture Credit Societies

Development Banks/Financial Institutions:

The Industrial Finance Corporation of India (IFCI),

Industrial Development Bank of India (IDBI),

Industrial Credit and Investment Corporation of India (ICICI) Bank,

Industrial Investment Bank of India (IIBI),

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Shipping Credit and Investment Corporation of India (SCICI) Ltd,

National Bank for Agricultural and Rural Development (NABARD),

Export-Import Bank of India,

National Housing Bank,

Small Industries Bank of India (SIDBI)

6. ROLE OF BANKS IN ECONOMY

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Role of Banks in Economy

Banks create money in the economy by making loans. The amount of money that banks can lend is directly affected by the reserve requirement set by the Central Bank (RBI). The reserve requirement is currently 3 percent to 10 percent of a bank's total deposits. This amount can be held either in cash on hand or in the bank's reserve account with the Fed. To see how this affects the economy, think about it like this. When a bank gets a deposit of $100, assuming a reserve requirement of 10 percent, the bank can then lend out $90. That $90 goes back into the economy, purchasing goods or services, and usually ends up deposited in another bank. That bank can then lend out $81 of that $90 deposit, and that $81 goes into the economy to purchase goods or services and ultimately is deposited into another bank that proceeds to lend out a percentage of it.

In this way, money grows and flows throughout the community in a much greater amount than physically exists. That $100 makes a much larger ripple in the economy than you may realize!

A proper financial sector is of special importance for the economic growth of developing and underdeveloped countries. The commercial banking sector which forms one of the backbones of the financial sector should be well organized and efficient for the growth dynamics of a growing economy. No underdeveloped country can progress without first setting up a sound system of commercial banking.

The importance of a sound system of commercial banking for a developing country may be depicted as follows:

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Capital Formation:

The rate of saving is generally low in an underdeveloped economy due to the existence of deep-rooted poverty among the people. Even the potential savings of the country cannot be realized due to lack of adequate banking facilities in the country. To mobilize dormant savings and to make them available to the entrepreneurs for productive purposes, the development of a sound system of commercial banking is essential for a developing economy.

Monetization:

An underdeveloped economy is characterized by the existence of a large non monetized sector, particularly, in the backward and inaccessible areas of the country. The existence of this non monetized sector is a hindrance in the economic development of the country. The banks, by opening branches in rural and backward areas, can promote the process of monetization in the economy.

Innovations:

Innovations are an essential prerequisite for economic progress. These innovations are mostly financed by bank credit in the developed countries. But the entrepreneurs in underdeveloped countries cannot bring about these innovations for lack of bank credit in an adequate measure. The banks should, therefore, pay special attention to the financing of business innovations by providing adequate and cheap credit to entrepreneurs.

Finance for Priority Sectors:

The commercial banks in underdeveloped countries generally hesitate in extending financial accommodation to such sectors as agriculture and small scale industries, on account of the risks involved there in. They mostly extend credit to trade and commerce where the risk involved is far less. But for the development of these countries it is essential that the banks take risk in extending credit facilities to the priority sectors, such as agriculture and small scale industries.

Provision for Medium and Long term Finance:

The commercial banks in underdeveloped countries invariably give loans and advances for a short period of time. They generally hesitate to extend medium and long term loans to businessmen. As is well known, the new businesses need medium and long term loans for their proper establishment. The commercial banks should, therefore, change their

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policies in favour of granting medium and long term accommodation to business and industry.

Cheap Money Policy:

The commercial banks in an underdeveloped economy should follow cheap money policy to stimulate economic activity or to meet the threat of business recession. In fact , cheap money policy is the only policy which can help promote the economic growth of an underdeveloped country . It is heartening to note that recently the commercial banks have reduced their lending interest rates considerably.

Need for a Sound Banking System:

A sound system of commercial banking is an essential prerequisite for the economic development of a backward country.

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7. BASEL

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BASEL COMMITTEE

The Basel Committee on Banking Supervision (BCBS) was formed in response to the messy liquidation of a Cologne-based bank in 1974. On 26 June 1974, a number of banks had released Deutsche Mark (German Mark) to the Bank Herstatt in exchange for dollar payments deliverable in New York. On account of differences in the time zones, there was a lag in the dollar payment to the counter-party banks, and during this gap, and before the dollar payments could be effected in New York, the Bank Herstatt was liquidated by German regulators.

This incident prompted the G-10 nations to form towards the end of 1974, the Basel Committee on Banking Supervision, under the auspices of the Bank of International Settlements (BIS) located in Basel, Switzerland.

The Committee was established to facilitate information sharing and cooperation among bank regulators in major countries. The Basel Committee was constituted by the Central Bank Governors of the G-10 countries. The G-10 Committee consists of members from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, The Netherlands, Spain, Sweden, Switzerland, The UK and The US. These countries are represented by their Central Bank and also by the authority with onus for the prudent supervision of banking business where this is not the central bank.

The Committee's Secretariat is located at the Bank for International Settlements in Basel, Switzerland. This committee meets four times in a year. The present Chairman of this committee is Mr. Nout Wellink (President of The Netherlands Bank). The Secretary General of the Basel Committee is Mr. Stefan Walter.

This 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 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.

The committee's efforts over the last three decades have made Basel synonymous with the best practices and standards in banking regulation and supervision. Perhaps the most far-reaching of these initiatives was the laying down of minimum capital standards in 1988, known as the Basel Capital Accord, to ensure a level playing field in terms of capital required to be maintained by internationally active banks. The fact that Basel Committee’s capital standards were implemented by more than 100 countries points to their near universal acceptance. The Basel Committee does not possess any formal supranational supervisory authority and its conclusions do not have any legal or binding force. It merely formulates broad-based supervisory principles or strategies. However, it recommends statements of best practice, keeping in mind that individual authorities will undertake steps to implement them through detailed arrangements in a way that suits them best.

A.I.M.S. 27


BASEL I

In 1988, the BASEL Committee on Banking Supervision introduced global standards for regulating the capital adequacy of banks.

Basel I, that is, the 1988 Basel Accord, primarily focused on credit risk. Assets of banks were classified and grouped in five categories according to credit risk, carrying risk weights of zero (for example home country sovereign debt), ten, twenty, fifty, and up to one hundred percent (this category has, as an example, most corporate debt). Banks with international presence are required to hold capital equal to 8 % of the risk-weighted assets.

Since 1988, this framework has been progressively introduced in member countries of G-10, currently comprising 13 countries, namely, Belgium, Canada, France, Germany, Italy, Japan, Luxemburg, Netherlands, Spain, Sweden, Switzerland, United Kingdom and the United States of America.

Most other countries, currently numbering over 100, have also adopted, at least in name, the principles prescribed under Basel I. The efficiency with which they are enforced varies, even within nations of the Group of Ten.

The original accord, was quite simple and adopted a straight-forward ‘one size fits all approach’ that does not distinguish between the differing risk profiles and risk management standards across banks.

TRANSITION FROM BASEL I TO BASEL II

Basel I concentrated on credit risk alone being the biggest risk a bank assumes and arising out of its lending/investment operations. It prescribed risk weights for different loan assets essentially on the basis of security available after classifying the assets as standard or non-standard on the basis of payment record. Basel I did not draw a distinction for the purpose of capital allocation between loan assets based on the intrinsic risk in lending to individual counterparties. Security in the form of tangible assets and/or guarantees from governments/banks is the sole distinguishing factor. Credit extended on secured basis to a small-scale unit and to a large corporate was put in the same category in so far as minimum capital requirement was concerned. The higher probability of default in respect of a loan to, say, a proprietorship compared to the large professionally managed corporate did not get reflected in the capital requirement.

Basel II addresses this issue by factoring in the differential risk factor in loans made to different types of businesses, entities, markets, geographies, and so on, and allowing banks to have different levels of minimum capital taking into account intrinsic riskiness of the exposure. Three methods, increasing in sophistication, for assessing credit risks have been recommended for adoption. Assets are to be risk weighted based on a rational approach cleared in advance by the regulator and then aggregated to arrive at the minimum capital requirement. Higher the risk, higher the weightage, and more the capital allocation required.

A.I.M.S. 28


In the proposed scheme of things, weak credits can carry a weightage of up to 150 per cent.

The objective of the recommendation of Basel II on credit risk is that banks should be more risk-sensitive than hitherto in their lending/investment activity and derive the benefit from lesser capital engagement for high quality credit risks. In addition to credit risk, Basel II recognizes the operational risks arising out of the day-to-day running of banks in the form of service quality shortcomings, non-adherence to policy and procedures, staff malfeasances, and so on, the capital charge for which is linked to operational income through a multiplier to be given by the regulator based on its assessment of the quality of banks operational instructions, style of functioning, control of top management and audit quality.

BASEL II TO INDIA

The Basel I recommendations on minimum capital requirement were accepted by most countries for adoption by the banks operating within their boundaries. In India, too, a Minimum Required Capital (MRC) was accepted and a timetable prescribed for banks to exceed the minimum capital requirement prescribed by the Basel Committee. Today, banks in India take pride in indicating in their balance sheets the extent to which they exceed the minimum Capital Adequacy Requirement (CAR). Banks in India also adopted the asset classification and provisioning norms prescribed by the Basel Committee and as directed by the Reserve Bank of India. The general belief now is that the commercial banks' balance sheets are comparable with most of the banks in the developing world and many in the developed world too.

Though not mandatory for non Basel II countries including India, majority of them are also going to implement Basel II. Some great opportunities for India are coming out of Basel II implementation. These opportunities can be classified in two categories - Banking and Non - Banking. With second highest growth rate in the world and huge scientific and general work force, India is now well recognized as one of the fast emerging nations in the world. Goldman Sachs and many other research reports have predicted a robust growth of Indian economy in the coming decades. A sound and evolved banking system would be a prime requirement to support the hectic and enhanced levels of domestic and international economic activities in the country.

Though India is credited with a very strong banking system, in comparison to many peer group countries, still some better risk practices by Indian banks are required. The majority of Indian banks are either nascent or at a very low level of competence in all, Credit, Market and Operational risk measurement and management system. They are lagging behind in the use of modern risk methodologies and tools in comparison to their western counterparts. Economic reforms, higher market dynamics and large-scale globalization demand a robust Risk Management System in the Indian banks. The current level of Risk Based Supervision and Market disclosures are also not very satisfactory in the Indian

A.I.M.S. 29


Banking system. This is more evident from the recent problems in one well-known private sector bank and in some co-operative banks. Basel II gives an opportunity and a framework for improvement to the Indian banks. A Basel II compliant banking system will further enhance the image of India in the League of Nations. The country rating of India will surely improve, and consequently facilitate a higher capital inflow in the country. This will tremendously help India to move on the higher growth trajectory in the coming decades.

The explanation why countries such as India are eager to adopt the new framework perhaps lies in the Basel II authors' contention that "by motivating banks to upgrade and improve their risk management systems, business models, capital strategies and disclosure standards, the Basel II framework should improve their overall efficiency and resilience." Even Basel I was originally meant for internationally active banks in the G-10 countries but it was soon accepted universally as a benchmark measure of a bank's solvency and was, subsequently, adopted in some form by more than 100 countries.

Introduction of Basel I coincided with the initiation of financial reforms in India in the early 1990s. The prudential norms set out by Basel I came as a timely solution to the ills affecting the Indian banks, particularly the public sector banks (PSBs) after two decades of nationalization. That these banks despite the differences in their strengths and weaknesses could switch over to the international standards without much hiccups has surprised many a critic.

There was so much talk of weak banks, merger of banks, and closure of overseas branches and so on when the reforms began. But the same banks in question are now posting impressive profits year after year, opening new overseas branches and are even looking for banks to take over. Evidently, it is this successful switchover that has made the country eager to adopt the Basel II framework as well.

A.I.M.S. 30


8. BASEL II

A.I.M.S. 31


BASEL II

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 efforts of the Basel Committee on Banking Supervision to revise the standards governing the capital adequacy of internationally active banks achieved a critical milestone in the publication of an agreed text in June 2004. In November 2005, the Committee issued an updated version of the revised Framework incorporating the additional guidance set forth in the Committee's paper The Application of Basel II to Trading Activities and the Treatment of Double Default Effects (July 2005).

On 4 July 2006, the Committee issued a comprehensive version of the Basel II Framework. Solely as a matter of convenience to readers, this comprehensive document is a compilation of the June 2004 Basel II Framework, the elements of the 1988 Accord that were not revised during the Basel II process, the 1996 Amendment to the Capital Accord to Incorporate Market Risks, and the 2005 paper on the Application of Basel II to Trading Activities and the Treatment of Double Default Effects. No new elements have been introduced in this compilation.

On 16th January, 2009, the Basel Committee announced a series of proposals to enhance the Basel II framework.

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. Guidelines for computing capital for incremental risk;

4. Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.

A.I.M.S. 32


SCOPE OF BASEL II IN BANKS

To the greatest extent possible, all banking and other relevant financial activities (Both regulated and unregulated) conducted within a group containing an internationally active bank will be captured through consolidation. Thus, majority-owned or –controlled banking entities, securities entities (where subject to broadly similar regulation or where securities activities are deemed banking activities) and other financial entities should generally be fully consolidated.

Supervisors will assess the appropriateness of recognising in consolidated capital the minority interests that arise from the consolidation of less than wholly owned banking, securities or other financial entities. Supervisors will adjust the amount of such minority interests that may be included in capital in the event the capital from such minority interests is not readily available to other group entities.

There may be instances where it is not feasible or desirable to consolidate certain securities or other regulated financial entities. This would be only in cases where such holdings are acquired through debt previously contracted and held on a temporary basis, are subject to different regulation, or where non-consolidation for regulatory capital purposes is otherwise required by law. In such cases, it is imperative for the bank supervisor to obtain sufficient information from supervisors responsible for such entities.

If any majority-owned securities and other financial subsidiaries are not consolidated for capital purposes, all equity and other regulatory capital investments in those entities attributable to the group will be deducted, and the assets and liabilities, as well as third-party capital investments in the subsidiary will be removed from the bank’s balance sheet.

Supervisors will ensure that the entity that is not consolidated and for which the capital investment is deducted meets regulatory capital requirements. Supervisors will monitor actions taken by the subsidiary to correct any capital shortfall and, if it is not corrected in a timely manner, the shortfall will also be deducted from the parent bank’s capital.

Significant minority investments in banking, securities and other financial entities, where control does not exist, will be excluded from the banking group’s capital by deduction of the equity and other regulatory investments. Alternatively, such investments might be, under certain conditions, consolidated on a pro rata basis. For example, pro rata consolidation may be appropriate for joint ventures or where the supervisor is satisfied that the parent is legally or de facto expected to support the entity on a proportionate basis only and the other significant shareholders have the means and the willingness to proportionately support it. The threshold above which minority investments will be deemed significant and be thus either deducted or consolidated on a pro-rata basis is to be determined by national accounting and/or regulatory practices.

The Committee reaffirms the view set out in the 1988 Accord that reciprocal crossholdings of bank capital artificially designed to inflate the capital position of banks will be deducted for capital adequacy purposes.

A.I.M.S. 33


BASEL II - THE THREE PILLARS

While Basel I framework was confined to the prescription of only minimum capital requirements for banks, the Basel II framework expands this approach not only to capture certain additional risks in the minimum capital ratio but also includes two additional areas, viz. Supervisory Review Process and Market Discipline through increased disclosure requirements for banks. Thus, Basel II framework rests on the following three mutually- reinforcing pillars:

Pillar 1: Minimum Capital Requirements — prescribes a risk-sensitive calculation of capital requirements that, for the first time, explicitly includes operational risk along with market and credit risk.

Pillar 2: Supervisory Review Process — envisages the establishment of suitable risk management systems in banks and their review by the supervisory authority.

Pillar 3: Market Discipline and Disclosures — seeks to achieve increased transparency through expanded disclosure requirements for banks.

PILLAR 1: MINIMUM CAPITAL REQUIREMENTS

Pillar 1 offers distinct options for computing capital requirements for "Credit Risk", "Operational Risk" and "Market Risk".

Credit Risk:

Pillar 1 stipulates the following options for assigning capital to meet credit risk: 1. Standardised Approach 2. Internal Rating Based (IRB) Approach 3. Advanced IRB Approach.

1. Standardised Approach:

Banks may use external credit ratings by institutions recognized for the purpose by the central bank for determining the risk weight. Exposure on sovereigns and their central banks could vary from zero percent to 150 percent depending on credit assessment from ‘AAA’ to below B- . Similarly, exposure on public sector entities, multilateral development banks, other banks, securities firms and corporates also may have risk weights from 20 percent to 150 percent. Exposure on retail portfolio may carry risk weight of 75 percent.

While Basel II stipulates minimum capital requirement of 8 percent on risk weighted assets, India has prescribed 9 percent. Under Basel II exposure on a corporate with ‘AAA’ rating will have a risk weight of only 20 percent. This implies that for Rs. 100 crore exposure

A.I.M.S. 34


on a ‘AAA’ rated corporate the capital adequacy will be only Rs.1.8 crore (100 x 20% x 9%) compared to the earlier requirement of Rs. 9 crore. However, claims on a corporate with below BB- rating will carry a risk weight of 150 percent and the capital requirement will be Rs.13.50 crore (100 x 150% x 9%). Thus, a bank with a credit portfolio with superior rating may be able to save capital while banks having lower rated credit exposure will have to mobilize more capital. Risk weights can go beyond 150 percent in respect of exposures with low rating. For example, securitisation tranches with rating between BB+ and BB- may carry risk weight of 350 percent. In order to adopt standardized approach, banks will have to encourage their corporate customers to go in for ‘obligor (borrower) rating’ and get themselves rated. The central bank has to accredit External Credit Assessment Institutions (ECAI) who satisfies defined criteria of objectivity, independence, international access, transparency, disclosure, resources and credibility.

2. Internal Ratings Based (IRB) Approach:

It is also called Foundation Internal ratings Based Approach. Banks, which have developed reliable Management Information System (MIS) and have received the approval of the central bank, can use the IRB approach to measure credit risk on their own. The bank should have reliable data on Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD) and effective Maturity (M) to make use of IRB approach. Minimum requirements to adopt the IRB approach are:

1. Bank’s overall Credit Risk management practices must be consistent with the sound practice guidelines issued by the Basel committee and the National Supervisor.

2. Rating dimensions to include both Borrower Rating and Facility Rating and has to be applied to all asset classes.

3. The Rating Structure adopted need to have minimum 7 grades of performing borrowers and a minimum 1 Grade of non-performing borrowers and Enough grades to avoid undue concentrations of borrowers in particular grades.

4. Criteria of Rating Systems to be documented and have the ability to differentiate risk, predictive and discriminatory power.

5. Assessment Horizon for PD estimation to be 1 year.6. Use of models to be coupled with the use of human judgement and oversight. 7. Rating Assignment and Rating Confirmation to be independent. 8. The PD to be a long run average over an entire economic cycle (at least 5 years) 9. Banks should have confidence in the robustness of PD estimates and the underlying

statistical analysis. 10. Data collection and IT systems to improve the predictive power of rating systems

and PD estimates. 11. Validation of internal Rating systems/ Models by the Supervisor. 12. Streamlining use of credit risk mitigants and ensuring legal certainty of executed

documents.

A.I.M.S. 35


3. Advanced Internal Rating Based (IRB) Approach:

Under foundation approach banks provide more of their own estimates of Probability of Default (PD) and rely on supervisory estimates for other risk components. In the case of advanced approach banks provide more of their own estimate of Loss Given Default (LGD), Exposure at Default (EAD) and effective Maturity (M), subject to meeting minimum stipulated standards.

Market Risk:

A bank’s investment portfolio is impacted by the fluctuation in prices of securities. Even in respect of sovereign exposure there will be change in market price because of interest rate movements. When the prices of securities are marked to market, a bank may incur loss if the prices have declined. Change in interest rates, foreign exchange rates and prices of equity, corporate debt instruments and commodities may involve market risk for the bank. Mismatches in interest rates on assets and liabilities may also entail risk for the bank. The investment portfolio has to be divided into the trading book and the banking book. While the trading book has to be valued on a daily basis on mark to market basis, for the banking book, there should be frequent assessment of shock absorption capacity of the portfolio to interest rate movements.

The approaches for Market risk are Standardised Approach and Internal Model Based Approach.

Operational Risk:

A bank also encounters risks other than on account of default by a third party or adverse market rate movements. These risks can be attributed to failed internal systems, processes, people and external events. Mistakes committed because of weak internal systems may lead to losses. Frauds may be committed on the bank by some customers, outsiders and even by employees. If a proper KYC system is not in place, a bank may be exposed to loss of money and reputation in a punitive action by the regulators. To minimize operational risks Know your Employee (KYE) principles are also to be observed before employees are entrusted with sensitive assignments.

The approaches for Operational Risk are Basic Indicator Approach, Standardised Approach and Advanced Measurement Approach.

Pillar 1 envisages that banks assess credit risk, market risk and operational risk and provide for adequate capital to cover the risks. PILLAR 2: SUPERVISORY REVIEW PROCESS

Compliance of requirements under Pillar 1 and providing adequate capital alone may not be enough to prevent bank failures and to protect the interests of depositors. Therefore, under Pillar 2 which deals with key principles of supervisory review, risk management

A.I.M.S. 36


guidance and supervisory transparency and accountability with respect to banking risks, including guidance relating to the treatment of interest rate risk in the banking book, credit risk (stress testing, definition of default, residual risk and credit concentration risk), operational risk, enhanced cross border communication and co-operation and securitisation, supervisors are expected to evaluate how well banks are assessing their capital needs relative to their risks and to intervene where appropriate. This interaction is intended to foster an active dialogue between banks and supervisors so that when deficiencies are identified, prompt and decisive action can be taken to reduce risk or restore capital. Supervisors may focus more intensely on banks with risk profiles or operational experience, which warrants such attention.

There are the following four main areas to be treated under Pillar 2:

1. Risks considered under Pillar 1 that are not fully captured by Pillar 1 process (e.g credit concentration risk);

2. Those factors not taken into account by Pillar 1 process (e.g. interest rate risk in the banking book, business and strategic risk).

3. Factors external to the bank (e.g. business cycle effects). 4. Assessment of compliance with minimum standards and disclosure requirements of

the more advanced methods under Pillar 1.

Supervisors have to ensure that these requirements are being met both as qualifying criteria and on a continuing basis.

The four key principles of supervisory review are:

Principle 1:

Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.

The five main features of a rigorous process are as follows:

1. Board and senior management oversight; 2. Sound capital assessment; 3. Comprehensive assessment of risks; 4. Monitoring and reporting; and 5. Internal control review.

Principle 2:

Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory

A.I.M.S. 37


capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.

Principle 3:

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

Principle 4:

Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

Reserve Bank of India has implemented the risk-based supervision and has made a good beginning in implementation of the guidelines under Pillar 2. Internal inspections of banks in India are also tuned more towards risk-based audit.

PILLAR 3: MARKET DISCIPLINE AND DISCLOSURES

Disclosure requirements are stipulated for banks to encourage market discipline. This will help the market participants to assess the information on capital, risk exposures, risk assessment processes and capital adequacy of the bank. Such disclosures are more important in the case of banks, which are permitted to rely on internal methodologies giving them more discretion in assessing capital requirements. Market discipline supplements regulation as sharing of information facilitates assessment of the bank by others including investors, analysts, customers, other banks and rating agencies. It also leads to good corporate governance.

Supervisors can stipulate the minimum disclosures to be made by banks. Banks can also have Board approved policies on disclosure. A transparent organization may create more confidence in the investors, customers and counter parties with whom the bank has dealings. It would also be easier for such banks to attract more capital.

A.I.M.S. 38


IMPLEMENTATION OF BASEL II NORMS IN INDIA

Basel I Framework was introduced in India in 1988. RBI mandated that all commercial banks in India (excluding Local Area Banks and Regional Rural Banks) should adopt Standardised Approach (SA) for credit risk, Basic Indicator Approach (BIA) for operational risk and Standardised Duration Approach (SDA) for computing capital requirement for market risks under Basel II. Foreign Banks in India and Indian Banks having foreign operational presence migrated to above selected approaches with effect from March 31, 2008. All other commercial banks (except LABs and RRBs) have migrated to these approaches under revised framework not from March 31, 2009. However, the RBI has adopted a gradual approach to Basel II implementation, which stipulates a "prudential floor" for minimum capital. Under this "parallel run" approach, banks are expected to calculate CRAR based on both Basel I and Basel II, but will keep higher of the two as per timeframe shown in Exhibit 3. For example, by 2009-10, banks will adopt CRAR which is higher of two: that calculated through Basel II and 90% of that of Basel I.

Implementation Approach, Minimum Capital Subjected to Prudential Floor

Under parallel run, banks are expected to do the following: -

Banks should apply prudential guidelines on capital adequacy - on an ongoing basis and compute their Capital to Risk Weighted Assets Ratio (CRAR) under both the guidelines.

Analysis under both guidelines should be reported quarterly to the board.

A copy of quarterly report should be submitted to RBI, one each to Department of Banking Supervision and Department of Banking Operations.

To make the process of implementation smoother RBI has taken adequate measures to safeguard interests of Indian banks. To make more capital available to banks, RBI has enabled banks to issue several instruments like innovative perpetual debt instruments, perpetual non-cumulative preference shares and hybrid debt instruments.

A.I.M.S. 39


9. EFFECTS OF BASEL II IMPLEMENTATION

A.I.M.S. 40


SWOT ANALYSIS OF THE BANKING SECTOR W.R.T. BASEL II

A.I.M.S. 41


THE EFFECTS

TYPES OF RISKS INVOLVED / COVERAGE OF RISKS

The principal solecism in the Basel I proposal was that it dealt with credit risk only. Other types of risks faced by a bank like market risk and operational risks were not dealt with at all. Hence there was an inadequate estimation of the overall risks faced by a bank under Basel I. This could result in under-capitalization of the banking sector as a whole and could give rise to systemic risk and bank crises in the long run. Basel II tries to address this systemic risk and other forms of risks like credit risk, operational risk and market-risk.

Risks Handled By Basel-II Norms

SYSTEMIC RISK:

Systemic Risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries". It refers to the risks imposed by interlinkages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or bring down the entire system or market. It is also sometimes erroneously referred to as "Systematic Risk".

The easiest way to understand systemic risk is to consider a bank run which has a cascading effect on other banks which are owed money by the first bank in trouble, causing a cascading failure. As depositors sense the ripple effects of default, and liquidity concerns cascade through money markets, a panic can spread through a market, creating many sellers but few buyers. These interlinkages and the potential "clustering" of bank runs are the issues which policy makers consider when addressing the issue of protecting a system against systemic risk. Governments and market monitoring institutions (such as the RBI) often try to put policies and rules in place to safeguard the interests of the market as a whole, as all the trading participants in financial markets are entangled in a web of dependencies arising from their interlinkages and often policy makers are concerned to protect the resiliency of the

A.I.M.S. 42


system, rather than any one individual in that system. Sometimes "picking winners" and protecting favoured individual participants in a system can engender moral hazard in a system and weaken the resilience of the system as a whole.

CREDIT RISK:

Credit risk is the risk of loss due to a debtor's non-payment of a loan or other line of credit (either the principal or interest or both).

In simple terms credit risk can be defined as the risk that customers default, or rather fail to comply with their obligation to service debt. Credit risk can also be stated as the risk of a decline in the credit standing of counterparty. Such a decline in the value of the debt does not connote default, but implies that the probability of default increases. Credit risk is of enormous importance since the default of a small number of important customers can generate huge losses, which can lead to insolvency. It is important to note that the various market transactions also generate credit risk. The loss in the event of default depends upon the value of the instruments and their liquidity.

APPROACH TO CREDIT RISK

Basel I did not differentiate the quality of credit exposures. The risk weight accorded to a triple-A rated corporate and a retail loan was similar although the risk associated with the exposures varied substantially.

The BASEL II Accord offers three distinct approaches for arriving at the capital requirements arising out of Credit Risk. Some of the key comparative features of these approaches are mentioned below.

CRITERIONSTANDARDIZED

APPROACH

INTERNAL RATING BASED (FOUNDATION)

APPROACH

INTERNAL RATING BASED

(ADVANCED) APPROACH

Rating External Internal Internal

Risk WeightCalibrated on the basis of ratings by Basel Committee

Function provided by Basel Committee

Function provided by Basel Committee

Probability of Default

Implicitly provided by the BASEL

committee through the risk weights

which are based on External ratings

Provided by Bank based on its own internal estimates


Exposure at DefaultSupervisory values provided by Basel

Supervisory values provided by Basel


Loss Given Default Implicitly provided Implicitly provided Provided by Bank

A.I.M.S. 43


by Basel on external estimates

by Basel on external estimates

based on its own

internal estimates

Maturity: The remaining economic

maturity of the exposure

Implicit recognition

To be computed as per guidelines given

by the BASEL Committee Or At

national discretion, provided by bank

based on own estimates


Risk Mitigation

Defined by Regulator and includes

Financial Collaterals, Guarantees, Credit Derivatives Netting (on and off balance

sheet) and Real estate

All in the Standardized

Approach plus Receivables for

goods and services, Other physical

securities subject to criteria.

All types of Collaterals if Bank

can prove by internal estimation.

OPERATIONAL RISK:

An operational risk is a risk arising from execution of a company's business functions. As such, it is a very broad concept including e.g. fraud risks, legal risks, physical or environmental risks, etc. The term operational risk is most commonly found in risk management programs of financial institutions that must organize their risk management program according to Basel II. In many cases, credit and market risks are handled through a company's financial department, whereas operational risk management is perhaps coordinated centrally but most commonly implemented in different operational units (e.g. the IT department takes care of information risks, the HR department takes care of personnel risks, etc)

More specifically, Basel II defines operational risk as the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. Although the risks apply to any organisation in business, this particular way of framing risk management is of particular relevance to the banking regime where regulators are responsible for establishing safeguards to protect against systemic failure of the banking system and the economy.

A.I.M.S. 44


APPROACH OF OPERATIONAL RISK:

The treatment given under different approaches for operational risk is as follows:

APPROACH BASIC INDICATOR STANDARDIZEDADVANCED

MEASUREMENT

Calculation of Capital Charge

Average of Gross Income for 3 years as

indicator Capital charge

equals 15 % of the indicator

Gross income per regulatory

line as indicator

Depending on business line

12, 15 or 18% of the

indicator as Capital charge

Total capital charge equals sum of charge per business

line

Capital charge equals internally

generated measures based on, Internal & External loss data, Scenario

analysis, Business

environment and internal control

factors Recognition of

risk mitigation (upto 20 %)

Qualifying Criteria

No specific criteria

Compliance with the Basel Committee’s

“Sound practices for

the Management

and Supervision of

Operational Risk”

recommended

Active involvement of Board of

Directors and Senior

Management Existence of

OpRisk Management

Function Sound OpRisk

Management System

Systematic tracking of loss data

Same as Standardized plus

Measurement integrated into day-to-day risk management

Review of management and

measurement processes by

internal/external auditor

Numerous quantitative

standards – in particular 3-5

years of historic data

MARKET RISK:

A.I.M.S. 45


Market risk is the risk that the value of an investment will decrease due to moves in market factors.

In the simplest terms, market risk can be defined as the risk of adverse deviations of the mark-to-market value of the trading portfolio during the period that is required to liquidate the transactions. Existence of market risk can be for any period of time. Earnings for the market portfolio are the Profits and Losses (P&L) arising from transactions. The assessment of market risk is based on the instability of market parameters such as interest rates, stock exchange indexes, exchange rates. The instability is measured by market volatilities. With the help of volatilities of market parameters and sensitiveness of instruments, the changes in market value can be quantified.

The components of market risk can be divided into several dimensions. One dimension is the liquidity risk that forms an important component in all markets where the low volume of transactions makes it difficult to find counterparty. Another dimension is the presence of volatility risk arising from the fluctuations over time of the instability of the market parameters.

APPROACH TO MARKET RISK

The standardized approach which specifies the standards in five categories:

1. Interest Rate risk

2. Equity Position Risk

3. Foreign Exchange risk

4. Commodities Risk

5. Options risk

The second approach to deal in the market risk is based on the internal assessments of the banks. The bank needs to consider following five elements in calculating the internal model based risk structure.

1. General criteria, where the approval from the supervisory authority of the bank is mandatory. 2. Qualitative standards regarding the maintenance of the Risk management unit 3. Specification of Market Risk Factors 4. Quantitative standards 5. Stress testing to identify the events that could impact the banks. 6. External Validation by External auditors and Supervisory authorities

ROLE OF CREDIT RATING AGENCIES

A.I.M.S. 46


A Credit Rating Agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In some cases, the servicers of the underlying debt are also given ratings. In most cases, the issuers of securities are companies, special purpose entities, state and local governments, non-profit organizations, or national governments issuing debt-like securities (i.e., bonds) that can be traded on a secondary market. A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued.

Banks will have to depend on the Credit rating Agencies to rate their borrowers. The RBI decided that banks may use the ratings of the following domestic credit rating agencies for the purposes of risk weighting their claims for capital adequacy purposes: a) Credit Analysis and Research Ltd. b) CRISIL Ltd. c) FITCH Ltd. and d) ICRA Ltd. Banks may use the ratings of the following international credit rating agencies for the purposes of risk weighting their claims for capital adequacy purposes a) Fitch; b) Moody's; and c) Standard & Poor's.

Banks should use the chosen credit rating agencies and their ratings consistently for each type of claim, for both risk weighting and risk management purposes. Banks will not be allowed to "cherry pick" the assessments provided by different credit rating agencies.

Banks must disclose the names of the credit rating agencies that they use for the risk weighting of their assets, the risk weights associated with the particular rating grades as determined by RBI for each eligible credit rating agency as well as the aggregated risk weighted assets.

Let us take the example of Bank of Baroda (BOB) who is in MoU with CRISIL for rating purpose to understand how a rating system works.

BOB – CRISIL MODEL CREDIT RATING METHODOLOGY

The CRISIL Rating Model for Commercial Advances is based on two dimensional methodology, specified under Basel II Accord requirements. The credit risk rating process as per CRISIL Rating Models involves three types of ratings for each credit facility viz.

1. Obligor (Borrower) Rating – for credit worthiness indicating the Probability of Default (PD),

2. Facility Rating – representing the Loss Given Default (LGD) and3. Composite Rating – which is indicative of the Expected Loss (EL)

1. OBLIGOR (BORROWER) RATING: The obligor rating is indicative of credit worthiness of an obligor or the

Probability of Default (PD) and it is based on the assessment of past and projected cash flows of the company.

A.I.M.S. 47


For assessment of an obligor, the rating structure consists of evaluation by way of four modules viz. i) Industry Risk, ii) Business risk, iii) Financial Risk and iv) Management Risk.

Industry Risk: The assessment of this module which is external to the borrower and is done by assessment of Industry related macroeconomic parameters like demand supply gap / capacity utilisation level / financial ratios like ROCE / OPM etc. applicable to the specific industry and having different risk weights.Business Risk: The assessment of this module is based on internal working of the borrower and relates to parameters such as after sales service, distribution set up, capacity utilisation etc. The parameters which are only relevant to a particular industry are selected for scoring having different risk weights.Financial Risk: The assessment of this module is based on internal working of the borrower and relates to parameters such as past and project financials. The CMA based data input sheet is uploaded into the software and the same allows computation of financial rating automatically based on the computation of financial ratios like Net Profit Margin, Current Ratio, DSCR, Interest Coverage etc.Management Risk: The assessment of this module is based on internal working of borrower’s management and relates to parameters such as past repayment record, quality of information submitted, group support etc.

Obligor (Borrower) Rating Grades: Depending upon the model used, the rating grades ranging from BOB-1 to BOB-10 or BOB-3 to BOB-10 or BOB-6 to BOB-10 are generated.

MODEL DESCRIPTIONNATURE

OF GRADEGRADE

NO.

A

For Borrowers under Large Corporate

(Mfg./Services), Banks, NBFCs, Broker categories and

Infrastructure projects having operations phase

or expansion/diversification

projects categories

BOB-1 to BOB-10

I to X

B

For Borrowers under SME (Mfg./ Services) and existing and new

borrowers under Trader category

BOB-3 to BOB-10

III to X

C Green Field project borrowers with project under Large Corporate

BOB-6 to BOB-10

VI to X

A.I.M.S. 48


(Mfg. /Services), SME (Mfg. / Services and

Infrastructure (Power/Port

/Road/Telecom) Build Phase categories.

BOB-1 indicates Investment Grade Highest Safety whereas BOB-10 indicates Default.

2. FACILITY RATING:Facility Rating involves assessment of the security coverage for a given

facility and indicates the Loss Given Default (LGD) for a particular facility. Facilities proposed/ sanctioned to a company are assessed separately under this dimension of rating.Facility Rating Grades:

3. COMPOSITE RATING:The Composite rating – which is the matrix or the combination of PD and

LGD, indicates the Expected Loss in case the facility is defaulted. The Composite rating is worked out automatically by the software based on the matrix of Obligor (Borrower) Grade (BOB rating) and Facility Rating (FR).

Composite Rating Grades:GRADE NO. NATURE OF GRADE DESCRIPTION

I CR-1 Minimum (Lowest)

A.I.M.S. 49

GRADE NO. NATURE OF GRADE DESCRIPTIONI FR-1 Highest SafetyII FR-2 Higher SafetyIII FR-3 High SafetyIV FR-4 Adequate SafetyV FR-5 Reasonable SafetyVI FR-6 Moderate SafetyVII FR-7 Low Safety

VIII FR-8Lowest Safety/Clean

Loans/Totally Unsecured


Expected Loss

II CR-2Lower

Expected Loss

III CR-3 Low Expected LossIV CR-4 Reasonable Expected Loss

V CR-5Adequate Coverable

Expected LossVI CR-6 Moderate Expected LossVII CR-7 Extra Expected LossVIII CR-8 High Probability of LossIX CR-9 Higher Probability of LossX CR-10 Highest Expected Loss

CUT – OFF GRADE FOR ACCEPTANCE:

Bank of Baroda has accepted BOB-6 as the cut-off point for the acceptance of an borrower based on Obligor (Borrower) rating. For Borrowers of Type A: The acceptance grade can be any grade from BOB-1 to BOB-6. BOB-6 having the score ranges of above 4.25 to 5.00 out of total 10.00 for these categories of borrowers.For Borrowers of Type B: The acceptance grade can be any grade from BOB-3 to BOB-6. BOB-6 having the score ranges of above 5.00 to 5.75 out of total 10.00 for these categories of borrowers.For Borrowers of Type C with new projects: These borrowers are initially rated under the project risk rating assigned grades from BOBPR-1 to BOBPR-5 and subsequently converted to common obligor rating grade from BOB-6 to BOB-10 automatically. BOBPR-1 under project rating is the only investment grade being equivalent to Obligor rating scale of BOB-6.

PRICING:

The Composite Rating represents the Expected Loss. This loss has to be recovered from the borrower by the way of risk premium over the BPLR. For the purpose of fixing the Rate of Interest the mapping of existing rating grades with the CRISIL Rating Models is done.

GRADE NO.NATURE OF

GRADE

DEFINITION OF COMPOSITE

GRADES

RATE OF INTEREST(ROI)

FOR BORROWERS TO

BE MAPPED WITH EXISTING

RATINGS AS UNDER

I CR-1 Minimum(Lowest) AAA

A.I.M.S. 50


Expected LossII CR-2 Lower Expected Loss AA

III CR-3 Low Expected LossA /

BBB

IV CR-4Reasonable Expected

LossBB

V CR-5Adequate Coverable

Expected LossB

VI CR-6Moderate Expected

LossC

VII CR-7 Extra Expected Loss C

VIII CR-8High Probability of

LossD

IX CR-9Higher Probability of

LossD

X CR-10Highest Expected

LossD

CHANGES IN CAR:

Indian banking companies were required to ensure full implementation of Basel II guidelines by March 31, 2009. The process of implementing Basel II norms in India is being carried out in phases. Phase I has been carried out for foreign banks operating in India and Indian banks having operational presence outside India with effect from March 31,2008.

In phase II, all other scheduled commercial banks (except Local Area Banks and RRBs) will have to adhere to Basel II guidelines by March 31, 2009. With Basel II norms coming into force in 2009, maintaining adequate capital reserves is a priority for banks.

Basel II mandates Capital to Risk Weighted Assets Ratio (CRAR) of 8% and Tier I capital of 6%. The RBI has stated that Indian banks must have a CRAR of minimum 9%, effective March 31, 2009. All private sector banks are already in compliance with the Basel II guidelines as regards their CRAR as well as Tier I capital. Further, the Government of India has stated that public sector banks must have a capital cushion with a CRAR of at least 12%, higher than the threshold of 9% prescribed by the RBI.

CAPITAL ADEQUACY RATIO (CAR):

Capital Adequacy Ratio (CAR) is also known as Capital to Risk Weighted Assets 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.

Under BASEL I,

A.I.M.S. 51


Under BASEL II,

Where RWA = Risk Weighted Asset

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.

Risk Weighted Assets is a measure of the amount of a bank’s assets, adjusted for risk. The nature of a bank's business means it is usual for almost all of a bank’s assets will consist of loans to customers. Comparing the amount of capital a bank has with the amount of its assets gives a measure of how able the bank is to absorb losses. If its capital is 10% of its assets, then it can lose 10% of its assets without becoming insolvent.

The main use of risk weighted assets is to calculate tier 1 and tier 2 capital adequacy ratios. Risk weighting adjusts the value of an asset for risk, simply by multiplying it be a factor that reflects its risk. Low risk assets are multiplied by a low number, high risk assets by 100%.

DOMESTIC RATING

AGENCIESAAA AA A BBB

BB & Below

Unrated

RISK WEIGHT

20 % 30 % 50 % 100 % 150 % 100 %

Risk Weights as per Various Rating Agencies

A.I.M.S. 52

http://moneyterms.co.uk/capital-adequacy/

http://moneyterms.co.uk/tier-2/

http://moneyterms.co.uk/tier-1/

http://moneyterms.co.uk/insolvency/


The higher the CAR, the stronger is the security and safety against bankruptcy and lower is the risk of financial crisis.

Majority of Scheduled Commercial Banks (SCBs) in India have reported a CAR of more than 12 % as prescribed in BASEL II. The average CAR for the SCBs improved dramatically from just 2% in 1997 to 13.08% on March 31, 2008. As per the RBI report, the Indian Banking system needs to increase its capital base from the present level of Rs. 2,96,191 crore to Rs. 8,64,935 crore by March, 2012.

The CRAR of the Bank of Baroda is summarized as under.

DATE BASEL I BASEL II

31.03.2008 12.91 % 12.94 %

31.03.2009 12.88 % 14.05 %

In order to meet the ever increasing capital needs, (which is expected to be around 65 per cent more than the present level of capital base) keeping pace with the Basel II accord, Indian banking system may have to resort to the strategy of entering into both domestic as well as international capital market and enlarge its portfolio in these markets. However, Public Sector Banks (PSBs) may have to face difficulties in raising capital from the capital market since the government holding in such banks cannot be reduced below 51 per cent and that is why many industry experts are in support of reducing such government control in state-owned banks to around 33 per cent.

RISK BASED SUPERVISION

The Risk Based Supervision (RBS) approach aims at overall efficiency and effectiveness of the supervisory process, optimizing supervisory resources. RBI has developed risk profile document for undertaking risk assessment exercise by the banks.

The introduction of risk-based supervision requires bank to reorient their organisational set up. The approach is intended to:

Widen scope of internal audit and redirect resources. Evaluate adequacy and effectiveness of risk management procedures and

internal control systems. Proactive approach to internal auditing. Help management in mitigating risks. Ensure effectiveness of control systems in monitoring inherent risks

Prioritise audit areas Allocate audit resources according to risk assessment.

A.I.M.S. 53


Banking supervision should respond to the changes in the banking sector, and the regulatory instruments should implement changes in their supervisory policies, procedures and practices that will help them assess effectively the safety of individual banks.

Until now the present inspection used to concentrate on transaction testing, accuracy and reliability of accounting records, financial reports, testing of integrity, reliability and timeliness of control reports, review of quality of assets, its classification and adherence to legal and regulatory requirements. Although the risk is inherent in the banking business there is no mention of risk in any inspection report. Therefore, there is a need to move from this inspection system to risk focussed internal audit by setting up necessary risk management architecture in place.

Audit is an important tool of good Corporate Governance. Audits are a reassurance to all those who have a financial interest/stakes in banks. The internal control measures help organisation discharge its functions, more effectively and efficiently. Because of good audit certificate, the organisation as well as people of the organisation is held in high esteem in the eyes of the investors and customers.

Risk Based Internal Audit (RBIA) is based on futuristic approach and it requires necessary steps to identify measure, control and mitigate the risk.

INTERNAL AUDIT RISK BASED INTERNAL AUDITTransaction based. No risk assessment. 100%

transaction testing.Risk based. Level of transaction testing

depends on risk assessment.Process identical for each branch/unit. Process differs according to risk assessment.

Periodicity linked to rating. Periodicity linked to risk assessment.Backward looking – focus on historical

accounts, past performance and compliance because of lack of risk focus.

Forward looking – suggestions for risk mitigation.

Inadequate optimisation of audit resources. Effective optimisation of audit resources.

No direct linkage to supervisory process.Essential for regulatory Risk Based

Supervision.

RBIA has to independently assure Board that Risk management processes is in place and operating as planned Processes are of sound design Management responses to risks are effective and adequate To reduce risk to acceptable level (Board) Appropriate internal controls are in place for risks management intends to treat

(control)

A.I.M.S. 54


The bank has to decide on the level of transaction testing based on its RBIA policy duly approved by its Board. The bank has to prepare a Risk Audit Matrix which would be based on the magnitude and frequency of risk.

Risk Audit Matrix assessing magnitude and frequency of risk and preparing a matrix based on it. Risk Audit Matrix should include inputs like previous Internal Audit reports and compliance thereof, proposed changes in business lines or change in focus, significant change in management/key personnel, results of latest regulatory examination report, reports of external auditors, industry trends and other environmental factors, time lapsed since last audit, volume of business and complexity of activities, substantial performance variations from the budget.

Under the Risk Based Internal Audit branches under low risk shall be inspected at an interval of 18 months, branches under medium risk at an interval of 12 to 15 months, branches under high risk at an interval of 12 months and branches under very high risk/ extremely high risk shall be inspected at the interval of 9 to 12 months. This will optimise utilisation of audit resources available with the Inspection Division and comply with the sound, tested, understandable Risk Based Internal Audit System as required by BASEL II.

DISCLOSURE

The implications of market discipline are varied and have more to do with the stakeholders that are outside the bank. Obviously, most significant amongst the stakeholders are the regulators. The discussions with them about the disclosures to be made, along with their contents and frequency should be the first step. Having a clear idea of the disclosures should facilitate the generation of required information flows as also equipping the staff to comply with the requirements. Either technological or manual preparations for compilation of the disclosures would be necessary. Developing procedures for meeting the disclosure prescriptions should be a focussed task.

BASEL II is not the first time the banks would be making disclosures. Banks do have statutory and traditional forms of disclosures. BASEL II calls for different types of disclosures like risk philosophy, risk profile, exposure classification, etc. It is likely that the existing processes would need certain modifications and action to meet with these emerging data requirements. Identifying the data gaps between present and proposed disclosures should be important task.

Formally and informally, it is necessary to assess the impact of new disclosure on business and public. The customers and shareholders are generally more interested in the disclosures as they provide information normally not available in financial statements. Shareholders asking questions on these disclosures made are being reviewed. The sensitivity of disclosures is also another area to be looked into. For multi-national banks, the disclosure

A.I.M.S. 55


requirements could be contradictory and the bank would have to find a way to address such a situation.

ROLE OF IT

Compliance with BASEL II prescriptions calls for a huge amount of data, as can be seen from the following table.

BANK VARIETY OF DATA

CREDIT RISK MARKET RISKOPERATIONAL

RISK

Transactions Borrower Issue dataData on exchange

ratesLoss event data

Operational CRM data

Guarantor DataAsset specific DataData on collections

Data on interest ratesData on Securities

pricesData on instruments

Casual DataLoss effect

Key risk Indicators

Analytical CRM Data

External Default Data

Data on ratings and migration of ratings

Data on correlationProxies

Risk Inventories

Risk Management data

Industry level DataMacro level Data

Self Assessment Data

Economy and Industry Data

Correlation data

Information Technology has multi faceted role in BASEL II compliance. BASEL II promises significant business benefits to those who have systems in place to access and utilize far more detailed and precise information. It calls for integration of data on finance, operations and risk management. The exercise lends an opportunity to get out of legacy systems and procedures including IT system. Fundamental rethinking on how a bank’s data and information is provided and controlled is required. Three pillars of BASEL II are interdependent and must be addressed to concurrently.

The technology part becomes more prominent when the bank decides to accept internal ratings based approach. Internal Rating based approaches revolve around, probability of default, loss given default, exposure at default and other parameters. To meet this end what is needed is defining and capturing loss data, capturing and extracting exposure data and identifying and capturing risk mitigation data.

Data issues would revolve around sources, data types, quality and granularity of data. More particularly, operational risk management pre-supposes,

Framework and systems in data integration as the banking activities are to be categorized in nine different segments.

A.I.M.S. 56


Taking a view on low frequency – high severity occurrences so as to make judgments about the future.

A well-designed organization structure for risk management to facilitate interaction among functionalities

Examination of the potential for risk mitigation, outsourcing and alike issues Attainment of more synergy and little overlap

The new definition of banking is trading on Information relating to money, market, customer and risks. There is a direct relationship between risk and technology. Risk is a function of uncertainty, which varies according to the quality of information. The components of information quality are accuracy, timelines, relevance and adequacy. Both adequacy and timelines are a function of information technology while relevance and adequacy can be determined through information technology as well as management science or statistical/mathematical models. The entire risk concept and its management in BASEL II thus hover around Information technology.

OTHER EFFECTS

Large Scale Consolidation

The Reserve Bank of India (RBI), in its “road map” for the banking industry, has revealed that the Indian market will be opened for international banks in 2009. This may facilitate the emergence of a large number of foreign banks in India and such foreign banks are expected to tap the huge potentials with their strong capital bases, updated as well as strong IT based infrastructural facilities and customer – centric approaches.

Such forthcoming competition is expected to raise some critical issues such as management of credit, market and operational risks, effective leadership and decision making procedure, attractive policies for retaining global talent, etc. Moreover, banks which do not comply with the BASEL II norms, will have to merge with other larger banks, as a result of which, large scale mergers and acquisitions (M&As) may become very much evident in the days to come.

Consolidation in banking industry is expected to emerge as a key word. Initiatives have already been taken by policy makers for eliminating inherent legal constraints in the process of consolidation. Several branches of State Bank group may shortly be a part of SBI and that synergy is expected to uplift the SBI into one among global giants in banking industry.

Enhanced Role of Regulator

The role of the regulator (RBI) will be greatly enhanced under Basel II. It will be in-charge of the supervisory review process as well as maintaining market discipline. The supervisory review process will involve:

A.I.M.S. 57


Ensuring that banks have adequate capital subject to regulatory approval

Encouraging banks to develop and use better risk management techniques

Evaluate banks on

o Bank's assessment of capital needs relative to risk

o Effectiveness of risk management systems

o Effectiveness of internal control process

In addition, the RBI will also be involved in framing a set of disclosure requirements to maintain market discipline. This will complement the minimum capital requirement (Pillar 1) and supervisory review process (Pillar 2). All this will lead to greater transparency, which should improve the quality of decision-making and benefit the financial sector as a whole.

Impact on Loan Pricing, Portfolio Composition, Bank Performance and the Lending Process as a Whole

It will lead to more efficient loan pricing: The loan pricing will become more fine-tuned and will reflect the risks and the costs involved. This will benefit the more efficient borrowers while the more risky borrowers will be penalized. The most important cost element after the transition to Basel II will be the addition or the reduction in capital requirements for lending to various sectors. This is possible as Basel II involves an individual analysis of the risks for the various sectors and hence the resultant capital required.

The risk appetite of the entire banking sector should decrease with the shift to Basel II. There would be a shift towards higher quality borrowers over time and hence the risk of the overall portfolio should decrease.

Further since the pricing of the loans will be based on the risks assessment and will be done only after proper and thorough screening of the borrower, the efficiency of the entire lending process should improve. Loans will be granted to only good borrowers. The more risky borrowers will have difficulty in finding banks that are willing to lend to them. This should results in reduced Non Performing Assets for the banking sector as a whole resulting in better solvency of the Indian banking system.

It should also result in increased margins for the more efficient banks resulting from savings on account of reduced capital requirement and probable increase in business while the lesser efficient players would find the going tough, as they will be required to provide a higher level of capital and this should reflect on their margins.

Impact on Business Model

A.I.M.S. 58


The impact on the business models of the banks will be as follows:

Effect on Business Model

With the advent of Basel II, banks with a risk appetite, i.e. high risk - high return lending strategy or lending without proper appraisal merely to generate additional business will find the going tough. We believe that such business models, which take disproportionately high risks, will not survive. The business models, which should survive, will be where risks are within acceptance levels for the banks backed by adequate returns.

Impact on Borrowers – Interest Rates

Borrower wise Impact of Basel II

The more efficient borrowers will have easier and larger access to funds while the more risky borrowers will find it tough to garner funds at favourable rates. In the extreme case, some borrowers will find no banks that are willing to lend to them. One can imagine the effect it will have on the companies. Imagine two companies from the same sector - one with a high credit rating say AAA and other with a lower rating say BBB. Even a 2% interest rate differential here can transform into a huge competitive advantage for the AAA rated borrower. This will force the inefficient players to get more disciplined in order to be competitive in the market place. This will promote greater efficiency and led to a more efficient and stronger banking, financial and the corporate sector.

A.I.M.S. 59


Further under Basel II, with the sense of competitiveness introduced within the banking as well as the corporate sector, the competition will become more service based rather than cost based. Banks will need to differentiate based on the services provided rather than the customer segment catered to (low risk/high risk). This is because we do not expect business models that are based on risk appetite to survive under Basel II.

In addition, the inefficient players will be weeded out or will have to fall in line. All this should lead to improved quality of services for the consumer. Further the improved solvency of the banks will also benefits the customers, as the quality of their investments will improve.

Impact on Borrowers - Costs

The costs involved will be: -

IT costs Internal rating costs

Corporate governance, increased control and supervisory costs

The major items of cost here will be the statistical costs to analyze the past data of loans in order to study their behaviour and to come up with any trends. This will involve the use of three-dimensional databases of the type, which are currently not available with the Indian Banks. This will help in deciding the risks involved in lending to various sectors and classes of borrowers. This will be of great aid to the banks in deciding the capital requirements applicable to the borrowings and the sector-wise exposure that it wants to take. These and other costs will be higher for inefficient banks.

Risk-Return Trade Off

It involves a number of risk-return trade-off and hence a proper cost benefit analysis is required. On the cost side there will be tangible costs like IT costs, costs for statistical validation of trends etc. while the intangibles costs may be attributed to the complexity of the rules and the difficulty in complying with them. On the benefit side, will be better risk management and greater efficiency & profitability for the banks. In addition, it will also reduce the operational risks faced by a bank, example frauds, etc.

With increased globalization and integration of the world financial markets, it will offer competitive advantage to the Indian Banks that adopt Basel II. If Indian Banks want to compete in the global space then Basel II will be a necessity and not a choice. The example that follows will prove the same. Consider an Indian Bank, which has not adopted Basel II (after its adoption in other parts of the world) seeking a foreign currency credit line from a multinational bank abroad. It will in all probability be required to recast its capital adequacy as per Basel II. Such a reactive measure at that point could lead to large delays as well as costs for such recasting. Hence it makes sense for Indian banks to move to Basel II as soon as

A.I.M.S. 60


other bigger international banks adopt it. They need not be the first to adopt it but they should not also delay it very much as it will certainly hurt their competitive advantage and the ability to compete on a large scale.

10. CONCLUSION

A.I.M.S. 61


CONCLUSION

The project briefly describes the various effects that the Indian Banking System had on it because of the implementation of BASEL II.

Some of these effects are directly dependent on the pillars of BASEL II framework while some of the effects are because of the changes the banks make in their structure.

The project highlights these effects in a structured manner and scrutinizes the differences in the banking structure under BASEL I and now under BASEL II. Bank of Baroda is considered as an example in some of the effects and these effects are studied. The Capital Adequacy ratio which has to be maintained by bank is highlighted along with the role of the external rating agencies. Also the disclosures and the role of IT play a major role while implementing BASEL II.

The impact on Business model of banks, impact on borrowers, impact on loan pricing and lending process, the enhanced role of the regulator, etc. are some of the other effects that the BASEL II implementation will have on the Indian Banking Sector are also studied in this project.

All this will lead to greater transparency, which should improve the quality of decision-making and benefit the financial sector as a whole. BASEL II implementation will help Indian banks to gain a competitive edge in the global markets and compete with the international banks.

The implementation of BASEL II will elevate the Indian Banking Sector to the international standards and compliance with these norms would help an Indian Bank to thrive, compete and succeed beyond leaps and bounds in the Global Markets.

A.I.M.S. 62


11. FUTURE SCOPE OF

THE PROJECT

A.I.M.S. 63


FUTURE SCOPE OF THE PROJECT

BASEL II framework is revised with every meeting in the BASEL Committee. The RBI mandates these changes regularly in the Banking Sector.

Changes are made in the structure of the Indian Banking Sector because of these implementations.

The future scope of this project is to study these changes in the structure of the Banking Sector caused due to implementation of these revised frameworks under BASEL II.

A.I.M.S. 64


12. BIBLIOGRAPHY

A.I.M.S. 65


BIBLIOGRAPHY

BOOKS:

Risk Management in Banks – ICFAI

Treasury and Risk Management in Banks – Indian Institute of Banking and Finance

Risk Management – Satyajit Das

WEBSITES:

www.bis.org

www.rbi.org.in

www.bankofbaroda.com

www.google.com

www.wikipedia.com

www.investopedia.com

www.bankingindia.com

www.howstuffworks.com

OTHERS:

Bobmaitri – Magazine of Bank of Baroda – Various Editions

THE CHARTERED ACCOUNTANT – ICAI – Various Editions

Various Circulars of Bank of Baroda

A.I.M.S. 66

http://www.howstuffworks.com/

http://www.bankingindia.com/

http://www.investopedia.com/

http://www.wikipedia.com/

http://www.google.com/

http://www.bankofbaroda.com/

http://www.rbi.org.in/

http://www.bis.org/

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Effects of BASEL II Implementation on Indian Banking System

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