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Financial System Stability and Basel II

Financial System Stability and Basel II

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Published by: Balaji.S (ACA) Srirangam on Mar 15, 2010
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SeptemberReserve Bank of India Bulletin2005847
CMYK CMYK
847
Financial System Stability andBasel II-Way Forward
*
KISHORI J. UDESHI
The initiative of the Association of ProfessionalBankers – Sri Lanka in organising this conference onFinancial System Stability and Basel II – Way Forwardis indeed commendable. Basel II is an importantmilestone in banking regulation and supervision andought to be viewed as a necessary process for promotingthe safety and soundness of the banking sector andthereby strengthening financial stability.
 HAT 
 
 IS
 
FINANCIAL
 
STABILITY 
?
2. In a situation of financial stability, financialinstitutions and markets are able to efficiently mobilisesavings, provide liquidity and allocate investment. Thegrowing role of the financial sector in the rightallocation of resources at appropriate prices couldsignificantly enhance the efficiency with which oureconomies function. If financial markets work well,they will direct resources to their most productive uses.Risks will be more accurately priced and will be borneby those who have appetite for absorbing risks. Realeconomic activity with higher investments, in bothquantity as well as quality, would result in growth withmacroeconomic stability and fewer financialuncertainties. The objectives of financial and macro-economic stability are, thus, mutually reinforcing. AsGovernor Reddy has put it, ‘financial stability needsto be particularly ensured when the financial system isundergoing structural changes’.3.Financial stability does not mean total absence ofailure of individual financial institutions, and fluctuationof prices in markets for financial assets. Such eventsbecome a cause for concern only if they lead to animpairment of the basic intermediation function or asevere misallocation of capital.4.Before talking about the Indian financial system Imust commend the efforts made by the Sri Lankanauthorities towards strengthening the financial sector.Its resilience is borne out by the fact that the Tsunamidevastation at the end of 2004 did not affect thestability of the Sri Lankan financial sector.
 I 
 NDIAN 
 
FINANCIAL
 
SYSTEM 
5. In recent years, there has been a considerablewidening and deepening of the Indian financial system,coupled with the increasing globalisation of financialservices. India is fast approaching an era of financialconglomerisation and ‘bundling’ in the provision of financial services. These developments are opportunitiesfor the market participants but nevertheless pose seriouschallenges to regulation and supervision of the bankingsystem.6. In India, the pursuit of financial and macroeconomicstability has emerged as the central plank of financialsector reforms. Stability of the financial system has acritical influence on price stability and sustained growth,which constitute the principal objectives of policy. Astable financial system facilitates efficient transmissionof monetary policy initiatives and the smooth operationof payment systems. From the perspective of regulationand supervision, safeguarding depositors’ interests, andensuring strong risk management within payment,clearing and settlement systems, is the mandate of theReserve Bank of India (RBI). The RBI has put in placePrudential Supervisory Reporting System, covering allvital aspects and a wide range of indicators, which servesas an early warning signal as well. Macro-PrudentialIndicators (MPIs) are being compiled since March 2000,collating data from various reports that are received inthe regulatory and supervisory wings of the Bank. Thereview of MPIs covers the areas of capital adequacy,asset quality, risk management, management soundness,earnings and profitability liquidity, interest rate, maturity
*
Address by Smt. Kishori J. Udeshi, Deputy Governor, Reserve Bank of India, at the 17th Annual Convention of the Associationof Professional Bankers at Colombo, Sri Lanka on August 26, 2005. Acknowledgements for inputs are due to K. Damodaranand Dr. N.D. Jadhav, Reserve Bank of India.
 
SeptemberReserve Bank of India Bulletin2005848
CMYK CMYK
848
structure of assets and liabilities, and various indicatorspertaining to major segments of financial markets suchas debt, forex, capital market segments, besidesmacroeconomic indicators such as growth, inflation,interest rate and exchange rate. The MPI review isaccompanied by a review of developments in the globalenvironment. As part of the efforts to disseminate theseFinancial Soundness Indicators (FSIs), the Reserve Bank has started publishing the core set of indicators in itsvarious publications.7. Financial sector reforms adopted in the 1990s haveenhanced the strength of banks and financial institutionsin India. A striking feature of these institutions has beentheir improved resilience to the domestic and the externalenvironment. The reform process has changed therelationship between the RBI and commercial banksfrom one of micro regulation to that of macromanagement. Aided by the robust macroeconomicenvironment, banks’ bottom lines have improvedsignificantly over the last two years. The aggregatecapital ratios of scheduled commercial banks at 12.83per cent as at end March 2005 have been well abovethe stipulated level of 9 per cent.8. The Reserve Bank, along with the Government, hasinitiated several institutional measures to contain thelevels of NPAs. Notable among these includeestablishment of Debt Recovery Tribunals, Lok Adalats(people’s courts), Asset Reconstruction Companies(ARCs) and Corporate Debt Restructuring (CDR)mechanism. Settlement Advisory Committees have beenformed at regional and head office level of commercialbanks. Enactment of the Securitisation andReconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002 has helped inimproving the recovery climate in the country. TheGovernment amended the relevant provisions of the Actto address the concerns expressed by the Supreme Courtregarding a fair deal to borrowers through an ordinancedated November 11,2004. The declining trend in grossand net NPLs for scheduled commercial banks hascontinued despite the adoption of 90-day delinquencynorm and unprecedented surge in growth of advances.9. Legislation has since been enacted to facilitate thecompilation and dissemination of credit informationincluding data on defaults to the financial system by theCredit Information Bureau of India Ltd. (CIBIL). The legalprovisions and practice in bankruptcy of the real sectorare however still inadequate and need further reform.10. The Reserve Bank is also making efforts to formulatepolicies to deal with risks arising on account of operationsof large and complex financial institutions as these posea systemic risk. As a first step in this direction, an inter-agency Working Group on Financial Conglomerates (FC)comprising three supervisory bodies,
viz.,
the ReserveBank, the Securities and Exchange Board of India andInsurance Regulatory and Development Authority, inJune 2004, identified 23 FCs and a pilot process forobtaining information from these conglomerates has beeninitiated.11. The year 2004-05 has witnessed a surge in creditoff-take leading to a sizeable decline in the liquid assetsof the bank. Consistent with the shift to functioning ina competitive economy and to the adoption of prudentialbest practices, the major challenges facing the bankingsector are the deployment of funds in quality assets andthe management of revenues and costs.
 B
 ASEL
II 
12. Unlike Basel I, which is simple, Basel II is complex.Therefore, the BCBS does not expect Basel II to beadopted widely or quickly. They believe that countriesshould adopt the options and approaches that are mostappropriate for the state of their markets, their bankingsystems, and their supervisory structures. Supervisors canadopt the framework on an evolutionary basis and useelements of national discretion to adapt it to their needs.
 HY 
 
 MOVE 
 
TO
B
 ASEL
II 
13. Under Basel II the capital requirements are more risk sensitive as these are directly related to the credit ratingof each counter-party instead of counter-party categoryas it is under Basel I. Further, it requires banks to holdcapital not only for credit and market risk but also foroperational risk (OR) and where warranted for interestrate risks, credit concentration risks, liquidity risks,
etc.
This makes Basel II more comprehensive than Basel I.Where banks were required to hold a uniform level of 8per cent as minimum capital under Basel I, supervisorshave the discretion to require banks to hold higher levelsof minimum capital under Basel II. Basel II has otheradvantages such as providing a range of options forcounter-party capital requirements and in the processreducing the gap between required capital and regulatorycapital. Basel II recognises a wider range of collaterals
 
SeptemberReserve Bank of India Bulletin2005849
CMYK CMYK
849
and provides incentives for improved risk managementpractices.14. An interesting point to note here is that Basel IIrecognises the element of diversification of risk in theSME sector and has assigned a lower risk weight forretail SME exposure under standardised approach. Thenon-retail SME exposure would also attract a lower risk weight where they have better external ratings under thestandardised approach. Shifting to Basel II, therefore,could be advantageous for economies whose banks havesignificant SME exposure.
 I 
 NDIAN 
A
PPROACH 
 
TO
B
 ASEL
II 
15. With the commencement of the banking sectorreforms in the early 1990s, the RBI has been consistentlyupgrading the Indian banking sector by adoptinginternational best practices. The approach to reforms isone of having clarity about the destination as alsodeciding on the sequence and pace of reforms to suitIndian conditions. This has helped us in moving aheadwith the reforms without disruption. With the successfulimplementation of banking sector reforms over the pastdecade, the Indian banking system has shown substantialimprovement on various parameters. It has becomerobust and displayed significant resilience to shocks.There is ample evidence of the capacity of the Indianbanking system to migrate smoothly to Basel II norms.16. The policy approach to Basel II in India is suchthat external perception about India conforming to bestinternational standards is positive and is in our favour.Commercial banks in India will start implementing BaselII with effect from March 31, 2007. They will initiallyadopt the Standardised Approach for credit risk and theBasic Indicator Approach for operational risk. Afteradequate skills are developed, both by the banks andalso by the supervisors, some banks may be allowed tomigrate to the Internal Rating Based (IRB) Approach.17. Some of the regulatory initiatives taken by theReserve Bank of India, relevant for Basel II are asfollows: First, we have tried to ensure that the bankshave suitable risk management frameworks orientedtowards their requirements dictated by the size andcomplexity of business, risk philosophy, marketperceptions and the expected level of capital. Second,Risk Based Supervision (RBS) in 23 banks has beenintroduced on a pilot basis. Third, we have beenencouraging banks to formalize their capital adequacyassessment process (CAAP) in alignment with theirbusiness plans and performance budgeting systems. This,together with the adoption of RBS, would enablefactoring in of the Pillar II requirements under Basel II.Fourth, we have been expanding the area of disclosures(Pillar III), so as to have greater transparency in thefinancial position and risk profile of banks. Finally, weare trying to build capacity for ensuring the regulator’sability for identifying and permitting eligible banks toadopt IRB/Advanced Measurement approaches.18.As per normal practice, and with a view to ensuringa smooth migration to Basel II, a consultative andparticipative approach has been adopted for bothdesigning and implementing Basel II. A SteeringCommittee comprising senior officials from 14 banks(public, private and foreign) has been constituted withrepresentation from the Indian Banks’ Association andthe RBI. The Steering Committee had formed sub-groupsto address specific issues. On the basis of recommendations of the Steering Committee, draftguidelines to the banks on implementation of the NewCapital Adequacy Framework have been issued.19. Implementation of Basel II will require more capitalfor banks in India due to the fact that operational risk is not captured under Basel I, and the capital charge formarket risk was not prescribed until recently. Thoughthe cushion available in the system, which at presenthas a CRAR of over 12 per cent, is comforting, banksare exploring various avenues for meeting the capitalrequirements under Basel II.20. Even while we have decided to take the Indianbanking system on to the simple approaches under BaselII, we have taken some initiatives which would clearlydemonstrate that we have no intentions of either dilutingthe standards or picking on the less stringent optionslaid down in Basel II. Through these initiatives, we haveprescribed stringent prudential requirements for banks inIndia,
e.g.,
with regard to adoption of risk weights forclaims on State Governments, Public Sector Enterprises,banks and for capital market and real estate exposures.Further even though banks can be allowed to useunsolicited ratings under the Standardised Approach, wewould not allow the use of unsolicited ratings.21. Also, we have been expanding the area of disclosuresso as to have greater transparency with regard to thefinancial position and risk profile of banks. Illustratively,with a view to enhancing further transparency, all casesof penalty imposed by the RBI on the banks as also

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