“Far better an approximate answer to the right question than an exact answer

to the wrong one – the latter of which may be made arbitrarily precise via a
redefinition of the question”
Various Authors

i
“The greatest gift I ever had, came from God, and I call him Dad! In loving
memoriam of my Dad who passed away during the course of this project”

ii
Acknowledgements:
My Sincere thanks goes to all the people who had directly or indirectly helped me in the
successful completion of my project. Special thanks to the all the wonderful people I met at
the Reserve Bank Regional Office, Chennai. Some of whom need a special mention, Shri.
Anandha (Current Regional Director, RBI), Mr.F.R.Joseph (the then Regional Director, RBI)
for providing me with audience at different situations to clear my doubts, and always eager to
meet us youngsters. Special Thanks to my mentor Mr. Manoranjan Misra (Deputy General
Manager, Department of Banking Supervision) who has helped me a lot right from deciding
the topic and questionnaire to fixing up appointments with different bank heads and to the
complete freedom he has given me in going about my project. Special mention also goes to
Mr.Agarwal and Mr. Saurav Sinha (Deputy General Managers, Department of Banking
Supervision) for sparing their valuable time in advising me at various levels of the project. I
also thank Mr.Rangarajan, Deputy General Manager, (DAPM), Mr.Chari, General Manager,
Space for Bonafide
(DAPM) for understanding my needs and providing me with prompt approvals whenever
needed. Thanks to Shri. Anantaswamy, Director, Department of Economic Analysis and
Planning (DEAP) and his colleagues in his department for bearing with us and providing us
unrestricted library access. I’m also indebted to thank Mrs. Reecy Johnson and Mr. Khan,
Assistant Managers, Human Resource Development (HRD). Thanks to Mr. Satyajit Deb,
Assistant General Manager for advising me at the initial stages of the project.
I’m obliged to thank the below mentioned officials of various banks for providing me with an
appointment some of which were at critical times for them.
Shri. R. Shaktivelu, General Manager, Karur Vysya Bank Ltd.
Shri. R. M. Patnaik, General Manager, Indian Overseas Bank.
Shri. Sri Ramanan, General Manager, Indian Bank.
iii
Shri. Sheshadri Rao, Assistant General Manager, Indian Bank.
Mr. S. Sundar, General Manager, City Union Bank.
Shri. Naganna Prabhakaran, General Manager, Lakshmi Vilas Bank.
Officials at Tamil Nadu Mercantile Bank.
Special thanks to Sir.P.V. Alexander and Dr.Victor Louis Anthuvan for guiding me through the
project. Thanks also to the all the teaching and non teaching staff at the college. Special
thanks to the placement team, without whom I wouldn’t have had the opportunity to work
with the Reserve Bank.
Last but not the least, I’m grateful to my Mom, Brother, relatives and friends at LIBA and
RBI for providing me with mental and moral support, for the situation I was in during the
course of this project.

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 EXECUTIVE SUMMARY
KEYWORDS: Basel II, regulation, supervision, data, knowledge, implementation

Basel II is basically 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 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 is believed to 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. The Basel Committee on Banking Supervision has come up with three
pillars namely, minimum capital requirements, supervisory review process and market
discipline, the first one which tries to ensure that capital allocation is more risk sensitive, the
second tries to separate the operational risk from credit risk, and quantifying both of them, the
third attempts to align economic and regulatory capital more closely to reduce the scope for
regulatory arbitrage.

In the current thesis I have done a interview based research to get a knowledge of the
challenges faced by the commercial banks during the process of implementing Basel II norms.
The interview was done using an interview protocol prepared in consultation with my mentor
at office. The mentor then helped me in securing appointments with General Managers of six
different banks which have their head offices in Tamil Nadu. The interviews were taped and
their transcripts used to arrive at the findings of the study. The major limitation of the project
has been that the research, suggestions and conclusions have been confined to the banks in

v
Tamil Nadu. There were different findings from the survey like; there has been a change in the
quantum and quality of data being collected for the purpose of rating which had an impact on
the manpower requirements of the banks. Most of the banks did not face any privacy or data
security issues with regards to data collection. All of the banks surveyed either had separate
set of people in the organization to implement the Basel II. The banks had their manpower
trained at either the staff college or by National Institute for Banking Management; the need
for more branches of the later banks is felt among the banks. Short term lending is being seen
as an opportunity by the banks to divert the excess liquidity available with the banks and for
better utilization of the short term resources.

The banks which had actually calculated their capital requirements based on internal capital
appraisal methods had their capitals well above the 9% limit set by the central bank. The
variables considered for calculation varied from bank to bank. Pro-cyclicality did not seem to
be a major issue with the bankers as they found the counter cyclical measures of the central
bank very effective. With the advent of Basel II the amount available with the banks for
lending has come down and tends to increase again when the advanced credit measurement
approaches are introduced.

Further suggestions and conclusions on how to better the implementation of Basel II have also
been given, which are not confined to the Reserve Bank alone, but also to the Indian Banking
Association.

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 TABLE OF CONTENTS

QUOTATIONS............................................................................................................i
DEDICATION.............................................................................................................ii
BONAFIDE CERTIFICATE.......................................................................................iii
ACKNOWLEDGEMENTS......................................................................................... iv
EXECUTIVE SUMMARY......................................................................................... vi
LIST OF TABLES................................................................................................................xiii
LIST OF FIGURES...............................................................................................................xiii
ABBREVIATIONS...............................................................................................................xiv

CHAPTER 1 RESERVE BANK OF INDIA

1.1 Introduction about RBI........................................................................1
1.2 Establishment of the Bank....................................................................1
1.3 Core Functions of the Bank..................................................................2

CHAPTER 2 BANK FOR INTERNATIONAL SETTLEMENTS

2.1 About BIS.............................................................................................4
2.2 BIS Mission Statement.........................................................................5

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CHAPTER 3 DEPARTMENT OF BANKING SUPERVISION (DBS)

3.1 Functions and working of DBS

3.1.1 Organization of the Supervision Function............................................6
3.1.2 Supervisory Process of DBS.................................................................6
3.1.3 Onsite Inspections—Banks...................................................................7
3.1.4 Off-Site Monitoring and Surveillance Systems (OSMOS)—Banks.....7
3.1.5 All India Development Financial Institutions.......................................9
3.1.6 Non-Banking Financial Companies......................................................9
3.2 Future agenda Of DBS
3.2.1 Consultative Process.............................................................................9
3.2.2 Risk-Based Supervision........................................................................9
3.2.3 Prompt Corrective Action.....................................................................10
3.2.4 Consolidated Supervision.....................................................................10
3.2.5 Skills up Gradation..............................................................................11

CHAPTER 4 CAPITAL STANDARDS

4.1 The evolution of capital standards.......................................................12

4.2 Drawbacks of Basel i and the road to Basel ii .....................................13

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CHAPTER 5 BASEL II
5.1 Scope of application of Basel ii............................................................16
5.2 Basel ii: Implementation.......................................................................16
5.2.1 What is parallel run...............................................................................17

CHAPTER 6 PILLAR I – MINIMUM CAPITA

REQUIREMENTS (MCR)

6.1 The Standardized Approach.................................................................19

6.1.1 Claims against Corporations.................................................................20
6.1.2 Retail Exposures (Loans to Individuals and Small Businesses)............21
6.1.6 Claims on Banks and Securities Firms..................................................22

6.2 The Foundation Internal Ratings Based Approach...............................22

6.2.1 Probability of Default (PD) ..................................................................22
6.2.2 Loss Given Default (LGD)...................................................................23
6.2.3 Exposure at Default (EAD)..................................................................23
6.3 Advanced Internal Rating Based Approach ........................................24

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6.4 Market Risk under Pillar I ......................................................................26
6.4.2 Market Risk— The Maturity Method.......................................................28
6.5 Operational Risk ......................................................................................29
6.5.1 Basic Indicator Approach (BIA)..............................................................30
6.5.2 The Standard Approach (TSA).................................................................31
6.5.3 Advanced Measurement Approaches (AMA)..........................................32

CHAPTER 7 PILLAR 2: SUPERVISORY REVIEW PROCESS (SRP)

7.1 Importance of supervisory review.............................................................37
7.3 Principles of supervisory review...............................................................38
7.3.1 Principle 1.................................................................................................39
7.3.2 Principle 2.................................................................................................42
7.3.3 Principle 3.................................................................................................43
7.3.4 Principle 4.................................................................................................44

CHAPTER 8 PILLAR 3: MARKET DISCIPLINE

8.1 Scope of Application.................................................................................45
8.2 The Purpose...............................................................................................45
8.3 Interaction with Accounting Disclosures..................................................46
8.4 Materiality.................................................................................................47
8.4 Frequency.................................................................................................47
8.5 Proprietary and Confidential Information.................................................48
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CHAPTER 9 RESEARCH METHODOLOGY and LIMITATIONS
9.1 What Is Expert Interview.........................................................................49
9.2 Why Expert Interview...............................................................................49
9.3 How Was It Done.....................................................................................49
9.4 Limitations................................................................................................49

CHAPTER 10 FINDINGS FROM THE INTERVIEWS.................................50

CHAPTER 11 SUGGESTIONS AND CONCLUSION...................................53

Appendix -1 Interview Protocol.........................................................................56

References........................................................................................................................60
Resume..............................................................................................................................61

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 LIST OF TABLES
6.1 External rating models............................................................................................20
6.2 Capital Charges under specific risk.........................................................................28
6.3 Maturity methods: Time Bands and Weights.........................................................29
6.4 Business Line-wise Betas (β)..................................................................................31

LIST OF FIGURES

5.1 Classification under three Pillars.............................................................................15

6.1 Methods of calculation of Pillar I MCR.................................................................19

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 Abbreviations
SFT- Securities Financing Transactions
OTC- Over The Counter
BCBS- Basel Committee on Banking Supervision
BIA- Basic Indicator Approach
SDA- Standardized Duration Approach
CRAR- Capital to Risk Weighted Assets Ratio
ICAAP- Internal Capital Adequacy Assessment Process
OSMOS- Off-Site Monitoring and Surveillance systems
NIBM- National Institute of Bank Management
SRP- Supervisory Review Process
LDA- Loss Distribution Approach
IMA- Internal Measurement Approach
AMA- Advanced Measurement Approach
TSA- The Standard Approach
EAD- Exposure at Default
LGD- Loss Given Default
PD- Probability of Default
MCR- Minimum Capital Requirements
NPA- Non Performing Assets
SA- Standardized Approach

xiii