THE BASEL COMMITTEE RECOMMENDATIONS On June 26, 1974, German regulators forced the troubled Bank Herstatt into liquidation. That day a number of banks had released payment to Herstatt in Frankfurt in exchange for US$ that was to be delivered in New York. Because of the time- zone differences, Herstatt ceased operation between the times of the respective payments. The counter party banks did not receive their US$ payments. Responding to the cross-jurisdictional implications of Herstatt debacle, the G-10 countries (the G-10 is actually eleven countries: Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, Switzerland, the United Kingdom and the United States) formed a standing committee under the auspices of Bank of International Settlements (BIS) Called the Basel Committee or (Basle Committee) on banking supervision the committee comprises representatives from central banks and regulatory authorities. Its first task was to consider a method of improving early warning system

Over the time the focus of the committee has evolved, embracing initiative designed to: Define role of regulators in cross-jurisdictional situation;

Ensure that international banks or bank holding companies do not escape comprehensive supervision by a home regulatory authority. Promote uniform capital requirements so that banks from different countries may compete with another on a level playing field

The first meeting took place in February 1975. It usually meet at the Bank for International Settlements in Basel, where its permanent Secretariat is located. The committee brought out a comprehensive set of Core Principles for effective bank supervision (Basel Core Principles) and are applicable to G10 and non G-10 countries. In developing the principles, the Basel Committee has worked closely with non G-10 supervisory authorities like China, India, and Hong Kong, Mexico etc. The IMF and World Bank has also seen and commented on the work at various stages.2

The 25 core principles for effective Banking supervisions are as follows: Preconditions for Effective banking supervision 1. Effective supervision will have clear responsibilities and objectives. They should possess operational independence. A suitable legal framework to support is also required. Arrangement for sharing information between supervisors and protecting the confidentiality of such information should be in place. Licensing and structure 2. The permissible activities should be clearly defined and the use of word bank in names should be controlled. 3. The licensing authorities must have right to set the criteria and reject the applications that do not meet the criteria. In case of foreign countrys bank the prior consent of home country supervisor should be obtained. 4. Banking supervisors must have the authority to review and reject any proposal to transfer significant

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ownership or controlling interest in existing banks to other parties. 5. Banking supervisors must have the authority to establish criteria for reviewing major acquisitions or investment by banks with special reference to risk associated with it. Prudential regulations and requirements 6. Banking supervisors must set minimum capital requirements for banks that reflect the risks that banks undertake, and must define the component of capital, bearing in mind the ability to absorb losses. For Internationally active banks these requirements must not be less than those established in Basel capital accord. 7.Banking supervisors must evolve a system of independent evaluation of a banks policies, practices and procedures related to granting of loans and making of investments and ongoing management of the loan and investment portfolios. 8. Banking supervisors must be satisfied that banks establish and adhere to adequate policies, practices and procedures for evaluating the quality of assets and the adequacy of loan loss provisions and reserves. 9. Banking supervisors must be satisfied that banks have management information systems that enable4

management to identify concentrations within the portfolio and supervisors must set prudential limits to restrict bank exposures to single borrowers or groups of related borrowers. 10.Supervisors must have in place the requirements for the banks to deal with the abuses of connected lending. 11. Banking supervisors must ensure that the banks have adequate policies for identifying country risk and transfer risk in their international lending and investment activities and for maintaining adequate reserves for such risks. 12. Banking supervisors must be satisfied that banks have systems that accurately measure, monitor and control market risks. 13. Banks have adequate comprehensive risk management process. 14. Banks must have in place adequate internal control system and adequate independent internal and external audit and compliance functions. 15.Banks must have adequate policies, practices and procedures in place, including strict know your customers rules, that promote high ethical and professional standards in the financial sector and prevent the bank being used, intentionally or unintentionally, by criminal elements.

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Methods of ongoing banking supervision 16. An effective banking supervisory system should consist of some form of both on-site and off-site supervision. 17. Banking supervisors must have regular contact with bank management and thorough understanding of the institutions operations. 18. Banking supervisors must have means of collecting, reviewing and analyzing prudential reports and statistical returns from banks on a solo and consolidated basis. 19. Banking supervisors must have means of independent validation of supervisory information either through on-site examination or use of external auditors. 20. An essential element of banking supervision is the ability of the supervisors to supervise the banking organization on a consolidated basis. Information Requirements 21. Banking supervisors must be satisfied that each bank maintains adequate records drawn up in accordance with consistent accounting policies and practices that enable the supervisor to obtain a true and fair view of the financial condition of the bank and the profitability of its business, and that the bank publishes on a regular basis financial statements that fairly reflect its condition.6

Formal powers of Supervisors 22. Banking supervisors must have at their disposal adequate supervisory measures to bring about corrective action when banks fail to meet prudential requirements (such as minimum capital adequacy ratios), when there are regulatory violations or where depositors are threatened in any other way. Cross-border Banking 23. Banking supervisors must practice global consolidated supervision, adequately monitoring and applying appropriate prudential norms to all aspects of business conducted by banking organizations worldwide, primarily at their foreign branches and subsidiaries. 24. A key component of consolidated supervision is establishing contact and information exchange with various other supervisors involved, primarily host country supervisory authorities. 25. Banking supervisors must require local operations of foreign banks to be conducted to the same high standards as are required of domestic institutions and must have powers to share information needed by the home country supervisors of those banks for the purpose of carrying out consolidated supervision.

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National agencies should apply the principles in the supervision of all banks within their jurisdictions. The principles are minimum requirements and in many cases may need to be supplemented by other measures designed to address particular conditions and risks in the financial systems of individual countries. Although The Basel Committee does not have any legislative authority, but participant countries are implicitly bound to implement its recommendations.

THE BASEL CAPITAL ACCORD The Basel capital Accord, the current international framework on capital adequacy was adopted in 1988 by many banks worldwide and it was adopted in 1992 in India The 1988 Basel Accord primarily addressed banking in the sense of deposit taking and lending (commercial banking under US laws), therefore its focus was on credit risk. Banks were subject to 8% capital requirement. A banks capital was defined as comprising of two tiers.

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Tier 1(core) capital included the book value of common stock, non-cumulative perpetual preferred stock and published reserves from post tax retained earnings. Tier 2 (supplementary) capital was deemed of lower quality. It included, cumulative and/ or redeemable preferred stock, assets revaluation reserves, general loan reserves, subordinated term debt. A maximum of 50% of a banks capital could comprise of tier 2 capital. Credit risk was calculated as the sum of risk weighted asset values. Generally, G-10 Government debt was weighted 0%. G-10 bank debt was weighted 20% and other debt, including corporate debt and the debt of nonG-10 Governments, was weighted 100%. Additional rules applied to mortgages, local government debts in G-10 countries and contingent obligations, such as letters of credit or derivatives. Capital ---------------- 8% Credit risk

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In the early 1990s, the Basel committee decided to update the 1988 accord to include bank capital requirements for market risk. Capital ---------------------------------- 8% Credit risk + market risk It also liberalized the definition of capital by adding a third tier. Tier 3 capital comprised short-term subordinated debt, but it could only be used to cover market risk. Market risk: Banks would be required to identify a trading book and hold capital for trading book market risk and organization wide foreign exchange exposures. Trading book is investment of banks in Government securities and other corporate securities. BASEL II In June 1999 the Basel committee on banking supervision issued a new consultative paper on New Capital Adequacy framework. After conducting three quantitative impact studies to assess those proposals, the finalized Basel Accord called International Convergence of Capital Measures and Capital Standards: a Revised Framework, was adopted on June200410

It will come into effect by end 2006; the most advanced approaches to risk measurements will be effective end 2007. This will replace the 1988 capital adequacy framework. Basel II is based on three pillars Minimum capital requirement for banks. Supervision to review banks capital adequacy and internal assessment processes. Use of Market Discipline for greater transparency and disclosure encouraging best international practices.

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FRAME WORK

Pillar I Minimum Capital Adequacy

Pillar II Supervisory Review

Pillar III Market Discipline

Credit Risk

Operational Risk

Market Risk

Capital adequacy Basel II reflects more risk sensitive requirements of banks with greater attention to supervision and market discipline.

The revised accord has retained the minimum requirement of 8% of capital to risk weighted assets.12

Capital -------------------------------------------------- 8% Credit risk + market risk + operational risk

The operational risk has been added to take note of increasing globalization, enhanced use of technology, product innovations and growing complexity in operations.

Operational risk has been defined as the risk of loss resulting from inadequate or failed internal processes, people and system or from external events. This definition includes legal risks but excludes strategic and reputational risk. The committee has quantified the operational risk as 15% of a banks average annual gross income over the previous three years under the basic indicator approach.

Under the standardized approach, banks activities are divided into eight business lines like: corporate finance, retail banking etc. Banks are required to calculate capital requirement for each business line and this is determined by multiplying gross income by the specific supervisory factors determined by the committee.

2. Varying Risk weight:

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The biggest change is proposed in the system of risk weighting so that the rate of interest that is charged to a borrower reflects the riskiness of the underlying asset. Therefore, instead of a onesize-fitsall approach (100%), the committee has proposed reduction in risk weight for certain high quality assets (20%, 50%) and increase in risk weight for lower quality assets e.g. venture capital and private placements (100%, 150%). 3. Credit Rating Another major change is that under the new accord, risk weights are to be determined on the basis of ratings assigned by independent external credit rating agencies. At present, credit rating is required for debt instruments only but under the new framework, credit rating will be extended to bank loans also. 4. Banks Internal Models The measurement of risk is to be allowed through the standardized approach or the internal rating based approach. Thus banks are allowed to use their internal risk models to assess borrowers credit worthiness and estimate weight age for different assets. However this must receive the approval of bank supervisors/ central bank and must satisfy certain criteria:

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Risk control unit must be independent from trading units and report directly to senior management. Risk management model must be integrated into the daily management process. There must be appropriate stress test and back testing Independent review of risk measurement and risk management system must be conducted annually.

5. Market Discipline: To aid market discipline, which is seen as a lever to strengthen the safety and soundness of the system, the requirement of disclosure by banks has been strengthened. For instance, banks will have to disclose additional details of the way in which they calculate their capital adequacy, their risk management strategies and practices, as also credit assessment institutions that they use for the risk weighting of their assets, The disclosure relating to comprehensive risk exposures would include credit risk, market risk, liquidity risk, operational risk, legal and other risks as well as accounting policies and information on corporate governance. The greater transparency and reliable and timely information will thus allow better counter party risk assessments.

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CAPITAL ADEQUACY IN THE INDIAN BANKING CONTEXT Capital adequacy and other prudential norms, first introduced as a part of banking sector reforms in 1992 are being fine tuned continuously by RBI aligning them more closely with international best practices. The minimum capital to risk asset ratio was raised from 8% to 9% effective March 31,2000.Capital charge to cover market risk has already been incorporated in certain items:

Banks have to assign additional risk weight of 2.5% on entire investment portfolio. Forex /gold open position limits of banks carry 100% risk weight (from 31.3.99) An investment fluctuation reserve has been put in place from March 31, 2003 with minimum 5% of the investment portfolio in the Available for Sale (AFS) and Held for Trading (HFT) categories, as a cushion for market risk and it will gradually be raised to 10%. All investments in bonds /debentures of Fis assigned a uniform risk weight of 20%. Risk weight for State Government guaranteed advances in default: 20% as on 31.3.2000 and 100% where default continues even after 31.3.2001. Bank loans are to be classified as substandard when payments remain outstanding for one quarter from the year ending March 31, 2004.

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General provision on standard assets was allowed to be included in tier 2 capital upto a maximum of 1.25% of total risk weighted assets in October 2000 in line with international best practices. In may 2004 RBI announced that banks will be required to provide capital to cover interest rate risk on their trading book exposures (including derivatives) by 31 March 2005 and on investments under Available for Sale category by 31 March 2006.

IMPACT ON INDIAN BANKS The introduction of Basel II will impact banks in India also. The consolidation in banking to overcome capital constraint, streamlining of risk management, maximizing return on capital, greater use of technology for efficiency gains, more robust risk based pricing and closer alignment with international best practices will strengthen the foundation of Indian banking system. While the new standards are mandatory for internationally active banks, even small banks would be willing to adopt the new system to be more competitive.

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Consolidation: The immediate impact of Basel II will be that the banks will need additional capital to cover market risk and operational risk besides credit risk. Also, banks will need more capital to support expansion. The stronger banks will be able to meet their need for additional capital by tapping the marketboth domestic and international or by ploughing back profits. However the weaker banks may need to merge with banks having surplus capital or those with ability to raise capital from the market. Government will not be willing to continue to recapitalise weak banks.

Impact on profitability:

Competition among banks for prime customers will intensify, pushing down spread even further. Additional cost on account of rating as also cost of putting in place risk management system, technology infrastructure, MIS for building adequate database will impact profitability.

Better Risk Management:

The core of the new accord is how to measure and monitor risk.18

Banks need to identify key risks, map them with the processes and ensure sufficient controls against those risks by putting integrated risk management in place. Banks need to improve management practices, compliance and sound corporate governance.

Use of Internal Models

The new accord allows banks to use their internal ratings to assess risk and allocate capital provided they satisfy certain basic minimum eligibility criteria including methodology to make meaningful credit differentiation, well developed rating system, well functioning data collection and IT system, estimation of past defaults etc. At present, banks in India may not meet the minimum criteria and will therefore need to follow standardized approach. This is also preferred approach of RBI.

Impact on Borrowers:

While there will be reduction in borrowing cost for prime borrowers, the cost of borrowing for non-prime / unrated borrowers will go up.

Implication for transfer pricing:

At individual banks level, there is need for greater consciousness and incentives in transfer pricing to hold highly rated assets.

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For instance with 8 % capital adequacy, the best corporate would have 20 % risk weight (which translates to a capital charge of 1.6%) While the unrated or low rated customers get risk weight of 100% (which translates into a capital charge of 8%) or if the risk weight is 150% the capital charge will be 12%. The cost of incremental capital requirements will need to be factored into transfer pricing formula.

Treatment of small banks:

The new accord addresses only the large banks and does help measure risk in smaller banks. Push to retail: With almost 70% of Indias population under 50 years of age, less than 5% of GDP in personal and housing finance and a booming services sector, there is no doubt the demographic dynamics will drive retail banking in India in the years ahead. The reduction in risk weight for SMEs and housing under Basel II will only reinforce this trend.

Greater Use of Technology:

Minimizing risk and maximizing return on capital to provide risk sensitive products and pricing and the20

enormous data requirement for business and compliance will require greater use of technology by banks. The calculation of capital requirements to take into account credit risk, market risk and operational risk will put greater responsibility on banks to assess the adequacy of their capital and encourage efficiency in the use of capital. This will encourage banks to invest and to maintain necessary technology and equipment and also training and recruiting specialist staff.

HR Issues:

IT, risk management and increasing sophistication in other areas will push up the demand for skilled and specialized staff. At the same time, the need to redeploy, retrain and reskill existing staff remain the major challenge before the Indian banking industry.

Greater disclosure and transparency:

Markets will demand more information in banks balance sheet and analysts will look for more frequent and transparent data on risk profile. This will increase the demand on banks systems and therefore, banks must have computer systems backed by

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knowledge and skill in place to provide the needed information. Conclusion Government equity in nationalized banks is proposed to be brought down and RBI has expressed a desire to move out of its ownership of SBI where it currently holds 59.7% equity. To comply with the new regulations to capture market risk and operational risk, banks will need to augment their capital base. Banks also need additional capital to support expansion in business and fund infrastructure finance and book long-term assets. The subordinated debt raised by banks is required to be discounted annually by 20% for reckoning as Tier 2 capital. Moreover, as the debt becomes due for redemption, banks may need to raise additional capital to maintain their mandated level of capital adequacy. Already Central Government has pumped in more than Rs 28,000 crore into banking sector to recapitalise weak banks. At the same time, integration of the Indian financial sector with global markets and increasing competition in the domestic markets has exposed banks to new risks.

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In this milieu, Basel II has rightly dovetailed future growth with attention to risk management and shoring up the capital base of banks. As banks in India graduate to new standards, they will not only come closer to global best practices but also reinforce the safety and soundness of banking sector in the country.

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