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    • “Banking Sector Reforms-Looking Ahead”-Background Papers for Seminar, 11th June, 2005
                                                                                                                                              

      Dr. Deepali Pant Joshi


Title - Implementation of Basel II: An Indian Perspective

 

 

In the mid-1980s, banks were severely under-capitalised, any collapse could have jeopardized the entire financial system.  Bank regulators led by the Basel Committee intervened to prescribe a capital to assets ratio, which it was hoped would help to build stronger banking systems.  The Committee has done a good job and has achieved much of what it set out to.  By the mid-1990s most Bank regulators around the world enforced the capital to asset ratio of 8%.  The basic principle underlying the prescription of capital to asset ratio – capital adequacy is that a bank must have a layer of capital to cushion it against unexpected shocks.  Thus regulators, rating agencies, equity analysts and economists see bank capital as an important measure of banks’ health.  The Basel Committee’s new risk-based capital framework – Basel-II revolves around how much capital is to be allocated and assigned to differentiate risks. Its basis is a calibration of risk.  The ratio of capital to risk assets has been refined to take into account the riskness of different assets and exposures.

Implementation of Basel-II

India has adopted a gradual and sequenced pace to the implementation of Basel II structured to the needs of its Banking System.  Ensuring gradual convergence with international standards and best practices with suitable country, specific adaptations, we have moved ahead of the Capital Adequacy prescription of 8% prescribed by the New Capital Adequacy Framework (NCAF) of Basel II to 9%. Capital Charge for Market risk is to be implemented, though its earlier surrogates were Investment Fluctuation Reserve (IFR) 5% of the investment portfolio both in Available for Sale (AFS) & Held for Trading (HFT) plus 2.5% risk weight on the entire investment portfolio whereas Basel norms are restricted to the Trading Portfolio.

RBI’s association with the Basel Committee on Banking Supervision dates back to 1997 as India was among the 16 non-member countries that were consulted in the drafting of the Basel Core Principles.  Reserve Bank of India became a member of the Core Principles Liaison Group in 1998 and subsequently became a member of the Core Principles Working Group (CPWG) on capital.  Within the CPWG, RBI has been actively participating in the deliberations on the Accord and had the privilege to lead a group of 16 major non G-10 supervisors, which presented a proposal on a simplified approach for Basel II to the Committee.

Policy Approach:

In general, keeping in view the RBI’s goal of congruence with international standards our approach has been to adopt a sequenced pace appropriate to the context of our country specific needs. The RBI had in April 2003 itself accepted the new capital accord Basel II.  The RBI in its Annual Policy statement in May 2004 announced that banks in India should examine in depth the options available under Basel II and draw

up a road-map by end December 2004 for migration to Basel II.  The Reserve Bank is closely monitoring the progress made by banks in this direction.  At a minimum all banks in India, to begin with, will adopt the Standardised Approach for credit risk and Basic Indicator Approach for operational risk.  After adequate skills are developed, both at banks and at supervisory levels, some banks may be allowed to migrate to IRB Approach.

Regulatory Initiatives

The regulatory initiatives taken by the Reserve Bank of India include:

  • Ensuring that the banks have put in place suitable risk management framework oriented towards their requirements, dictated by the size and complexity of business, risk philosophy, market perceptions and the expected level of capital.  The framework adopted by banks would need to be adaptable to changes in business size, market dynamics and introduction of innovative products by banks in future.
  • Introduction of Risk Based Supervision (RBS) in 23 banks on a pilot basis.
  • Encouraging banks to formalize their Capital Adequacy Assessment Programme (CAAP) in alignment with business plan and performance budgeting system.  This, together with adoption of Risk Based Supervision would aid in factoring the Pillar II requirements under Basel II.
  • Enhancing the area of disclosures (Pillar III), so as to have greater transparency of the financial position and risk profile of banks.
  • Improving the level of corporate governance standards in banks.
  • Building capacity for ensuring the regulator’s ability of identifying and permitting eligible banks to adopt IRB/Advanced Measurement approaches.

 

The key principles of Supervisory Review are also deserving of some attention.

Bank Managements have to develop

  • Internal Capital Assessment Process (ICAP)
  • Set Capital Targets commensurate with banks risk profile plus control environment
  • Bank Managements responsibility is to ensure that bank has adequate capital to support its risks beyond the core minimum requirements.

Capital should not be viewed as the only option for confronting increased risks faced by a bank.  Other means for addressing risk as

  • Strengthening risk Management
  • Applying internal limits
  • Strengthening the level of provisions of reserve
  • Improving Internal Controls should also be considered

 
Capital should not be regarded as a substitute for addressing fundamentally inadequate control or risk management processes

  • Bank Management clearly bears the responsibility for ensuring that the bank has adequate capital to support its risks.
  • Bank Management needs to be mindful of the particular stage of the ‘business cycle’ in which the bank is operating.
  • Rigorous forward looking ‘Stress Testing’ is required that identifies possible events or changes in market conditions that could adversely impact the banks should be performed

 

The five main elements of a rigorous process are:

  • Board and Senior Management oversight
  • Sound Capital Assessment – A process that states capital adequacy goals with respect to risk taking account of the banks strategic focus and business plan.
  • Comprehensive Assessment of risks credit market operational liquidity others
  • Monitoring and Reporting
  • Internal Control review

Supervisory Authorities should regularly review the process by which a bank assesses its Capital Adequacy – risk position – resultant capital levels – quality of capital held.  Positions are not static but dynamic.  The emphasis of the review should be on the ‘quality’ of the banks risk management and control and should not result in supervisors functioning as Bank Management.

Review would imply

  • On-site examination
  • Off-site Reviews
  • Discussions with Bank management
  • Review of work done by external auditors
  • Periodic Reporting

(A)       Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital instead of the minimum.

Capital is a buffer for uncertainties.  Uncertainties are part of the business cycle. They cannot be entirely eliminated.

In the normal course of business the type and volume of activities will change as with the different risk exposures, causing fluctuation in the overall capital ratios. 

(B)       RBI has to intervene through prompt corrective action (PCA) 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 remedial action if capital is not maintained or restored.

  • Intensify monitoring of the bank
  • Restrict payment of dividends
  • Require the bank to prepare and implement a satisfactory capital adequacy restoration plan
  • Raise additional capital immediately

 

(C)       Much as we would like to believe it supervision of banks is not an exact service. Supervisors should match available criteria to be used to set trigger returns for review of banks internal capital assessments.

Challenges Envisaged – Indian Perspective

Against the above background and the complexities involved as also the areas of “constructive ambiguity” in concepts and their application we envisage the following regulatory and supervisory challenges ahead:

  • India has three established rating agencies in which leading international credit rating agencies are stakeholders and also extend technical support.  However, the level of rating penetration is not very significant as, so far, ratings are restricted to issues and not issuers.  While Basel II gives some scope to extend the rating of issues to issuers, this would only be an approximation and it would be necessary for the system to move to ratings of issuers.  Encouraging ratings of issuers would be a challenge.
  • Basel II provides scope for the supervisor to prescribe higher than the minimum capital levels for banks for, among others, interest rate risk in the banking book and concentration of risks/risk exposures.  As already stated, we in India have initiated supervisory capacity building to identify slackness and to access/quantify the extent of additional capital which may be required to be maintained by such banks.  The magnitude of this task is to be completed by December 2006, while we in India have as many as 100 banks, is daunting.
  • Cross border issues have been dealt with by the Basel Committee on Banking Supervision recently.  But, in India, foreign banks are statutorily required to maintain local capital and the following issues would therefore require to be resolved by us.

 

    • Whether the internal models approved by their head offices and home country supervisor adopted by the Indian branches of foreign banks need to be validated again by the Reserve Bank or whether the validation by the home country supervisor would be considered adequate ?
    • Whether the data history maintained and used by the bank should be distinct for the Indian branches compared to the global data maintained and used by the head office ?
    • Whether capital for operational risk should be maintained separately for the Indian branches in India or whether it may be maintained abroad at head office ?
    • Whether these banks can be mandated to maintain capital as per SA/BIA approaches in India irrespective of the approaches adopted by the head office ?
  • Basel II could actually imply that the minimum requirements could become pro-cyclical.  No doubt prudent risk management policies and Pillars II and III would help in overall stability.  We feel that it would be preferable to have consistent prudential norms in good and bad times rather than calibrate prudential norms to counter pro-cyclicality.

 

  • The existence of large and complex financial conglomerates could potentially pose a systemic risk and it would be necessary to put in place supervisory policies to address this.
  • In the event of some banks adopting IRB Approach, while other banks adopt Standardised Approach, the following profiles may emerge:
    • Banks adopting IRB Approach will be much more risk sensitive than the banks on Standardised Approach, since even a small change in degree of risk might translate into a large impact on additional capital requirement for the IRB banks.  Hence IRB banks could avoid assuming high-risk exposures.  Since banks adopting Standardised Approach are not equally risk sensitive and since the relative capital requirement would be less for the same exposure, the banks on Standardised Approach could be inclined to assume exposures to high risk clients, which were not financed by IRB banks.  As a result, high- risk assets could flow towards banks on Standardized Approach, which need to maintain lower capital on these assets than the banks on IRB Approach.
    • Similarly, low risk assets would tend to get concentrated with IRB banks, which need to maintain lower capital on these assets than the Standardised Approach banks.
    • Hence, system as a whole may maintain lower capital than warranted.
    • Due to concentration of higher risks, Standardised Approach banks can become vulnerable at times of economic downturns.

CAVEATS

1.         Like Medieval Crusaders we are building impregnable castles this process carries dangers can capital adequacy be overdone ?  Some argue that an overstrong banking system absorbs economic resources that could be better used elsewhere.

2.         Like Medieval Engineers we may be concentrating too much on our castles and not enough on the surrounding countryside.

Some economists and financial experts take a broader view and liken the world financial system to a biosphere complete with Governments, Banks, Securities firms, Corporate Treasuries, Insurance companies, Pension funds and households. 

If the financial risks contained in the ‘biosphere’ are passed on or managed by one set of risk takers they do not go away/or disappear into thin air they are borne by another set of risk takers in the system.  Banks unbundle risk through interest rate derivatives currency, equity, and commodity futures asset backed securities. A lot of these risks are ‘unbundled’ and passed on to insurance companies.

Dr. Deepali Pant Joshi
Chief General Manager, RBI, Hyderabad
e-mail - deepalipantjoshi@rbi.org.in
The views expressed are personal.

 

 

Reference:

1.         Address by Smt. K. J. Udeshi, Deputy Governor, Reserve Bank of India at the World Bank/MF/US Federal Reserve Board 4th Annual International Seminar on Policy Challenges for the Financial Sector: Basel II at Washington on June 2, 2004

2.         BIS Consultative Paper II.

3.         The Economist June 2005.


 

 

 

 
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