Current Level of Basel II Implementation

Basel History
Basel Committee was constituted by the Central Bank Governors of the G-10 countries The Committee's Secretariat is located at the Bank for International Settlements in Basel, Switzerland Its objective is to enhance understanding of key supervisory issues and quality improvement of banking supervision worldwide This committee is best known for its international standards on capital adequacy; the core principles of banking supervision and the concordat on cross-border banking supervision

Basel II
Basel II is a type of recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision that was initially published in June 2004 The objective of Basel II is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face Basel II includes recommendations on three main areas: risks, supervisory review, and market discipline

Environment of Basel II

The Accord in operation

The 3 Pillar Approach
Minimum Capital Requirements Supervisory Review

Market Discipline & Disclosure

Pillar 1 :Minimum Capital Requirements

Market Risk
No changes from Basel I

Credit Risk
Significant change from Basel I Three different approaches to the calculation of minimum capital requirements Capital incentives for banks to move to more sophisticated credit risk management approaches based on internal ratings

Operation Risk
Not explicitly covered in Basel I Three different approaches to the calculation of minimum capital requirements Adoption of each approach subject to compliance with defined qualifying criteria

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

Pillar 2 :Supervisory Review

Banks should have a process for assessing their overall capital adequacy and strategy for maintaining capital levels Supervisors should review and evaluate banks internal capital adequacy assessment and strategies

Supervisors should expect banks to operate above the minimum capital ratios and should have the ability to require banks to hold capital in excess of the minimum Supervisors should seek to intervene at an early stage to prevent capital from falling below minimum level

Pillar 3 :Market Discipline & Disclosure

Market discipline reinforces efforts to promote safety and soundness in banks
Core disclosures (basic information) and supplementary disclosures to make market discipline more effective

Basel II Project Management

Phase Approach

Bank
Current Situation

Effect of BASEL II
Need to choose

Challenges
Interpret new regulations and understand effects on business Secure and maintain board and senior management sponsorship Face new expectations from regulators, rating agencies, and Customers Need to consider whether to target certain customers/products or eliminate others

Risk
Interpret new regulations and understand effects on business Manage change to risk culture Secure and maintain board and senior management sponsorship Face new expectations from regulators, rating agencies, and customers

Use one-size-fitsall regulatory capital approach

credit and operational risk approaches (Pillar I) Need to gather, store, and analyze wide array of new data Need to embed new/enhanced practices across the organization

Customer
Current Situation Often unable to generate sufficient internal cash flow to realize all necessary investments Depend on external resources, which could be debt or equity Effect of BASEL II Need external/internal rating to obtain credit Face increased transparency of account profitability Need to collect and disclose new Information Face possibility of reduced service, standardized products, higher interest rates Challenges Face new costs resulting from need to provide lenders with new, timely information Improve lending terms Improve connections with enders/investors through enhanced disclosures and structured debt holders Relationship management Risk Reduced credit lines Increased collateral Requirements Fewer refinancing opportunities Higher interest an general Costs

Regulators
Current Situation Effect of BASEL II Challenges Risk Operate in a fragmented Environment Need enhanced information to be able to anticipate bank problems (vs. respond in crisis/default) Gain access to more and timely information through the new disclosures Basel requires of banks Gain power to set incentives, penalize wrong-doers, and act (not react)thus contributing to increased financial stability and transparency Need well-trained, educated professionals to fill roles that are traditionally not as well paid as comparable positions within financial institutions Create regulation that reflects the linkages among risks May create new costs for banks and ultimately for Customers Impose numerous locally specific choices that diminish the effects of the levelled playing field that Basel II seeks to create

Rating Agency
Current Situation Effects of Basel II Challenges Seek to improve reputation (national agencies) Obtain approval (supervisory criteria) for banks to use Standard Approach Maintain high quality of ratings Benefit from intermediation Process Risk Face reduced market share because most banks will likely use IRB approaches Fail to benefit from increased competition if smaller agencies cannot surmount barriers to entry Operate in an Grow based on oligopolistic new need for environment ratings by banks dominated by and capital Standard & Poors, market participants Moodys, and Fitch Compete with (Europe); others new, smaller face high barriers to players allied in entry new associations designed to improve their competitiveness and reputation Respond to requirements for greater transparency in rating components

Capital Markets
Current Situation Face trend toward securitization, including credit derivatives Effects of Basel II Challenges Risk Securitization, and Face reduced Volatility in the growth in customer base as debt market derivatives markets low-quality corporations avoid Reduced liquidity Risks (e.g., debt capital markets corporate bonds) in favor of stable Corporations offered in smaller relationships with facing difficulties in parcels banks offering bonds New growth of debt market Create investor trust and reduce volatility by encouraging the development of a regulatory framework, by market Companies running out of Capital

Financial Institutions of Basel II

Current Situation Not covered by financial regulation comparable to the Basel regime Effects of Basel II Do not need to gather or disclose the same information as Basel-compliant institutions Need to consider the extent to which complying with Basel II is strategically important to help the institution remain competitive and to signal quality Challenges Face reduced customer base as low-quality corporations avoid debt capital markets in favor of stable relationships with banks Risk Volatility in the debt market Reduced liquidity Corporations facing difficulties in offering bonds

Create investor trust and reduce volatility by encouraging the development of a regulatory framework, by market

Companies running out of Capital

Challenges with Indian Banking Industry..

With the feature of additional capital requirements, the overall capital level of the banks will see an increase. But, the banks that will not be able to make it as per the norms may be left out of the global system Another biggest challenge is re-structuring the assets of some of the banks would be a tedious process, since most of the banks have poor asset quality leading to significant proportion of NPA. This also may lead to Mergers & Acquisitions, which itself would be loss of capital to entire system. The new norms seem to favor the large banks that have better risk management and measurement expertise, who also have better capital adequacy ratios and geographically diversified portfolios.

Implications..
The Basel Committee on Banking Supervision is a Guideline for Computing Capital for Incremental Risk.

It is a new way of managing risk and asset-liability mismatches, like asset securitization, which unlocks resources and spreads risk, are likely to be increasingly used.
The major challenge the country's financial system faces today is to bring informal loans into the formal financial system. By implementing Basel II norms, our formal banking system can learn many lessons from money-lenders. This was designed for the big banks in the BCBS member countries, not for smaller or less developed economies.

Implications..
Keeping in view the cost of compliance for both banks and supervisors, the regulatory challenge would be to migrate to Basel II in a non-disruptive manner. India is one of the early countries which subjected itself voluntarily to the FSAP of the IMF, and our system was assessed to be in high compliance with the relevant principles. With the gradual and purposeful implementation of the banking sector reforms over the past decade, the Indian banking system has shown significant improvement on various parameters, has become robust and displayed ample resilience to shocks in the economy. There is, therefore, ample evidence of the capacity of the Indian banking system to migrate smoothly to Basel II.

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