Basel II: Challenges Ahead of the Indian Banking Industry

13 FEB 2010 3 Comments
by Malvaniya Prashant in Uncategorized

About 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. History of Basel The Basel Committee was constituted by the Central Bank Governors of the G-10 countries in 1974. The G-10 Committee consists of members from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, The Netherlands, Spain, Sweden, Switzerland, The UK and The US. These countries are represented by their Central Bank and also by the authority with onus for the prudent supervision of banking business where this is not the central bank. The Committee¶s Secretariat is located at the Bank for International Settlements in Basel, Switzerland. This committee meets four times in a year. The present Chairman of this committee is Mr. Nout Wellink (President of The Netherlands Bank). The Secretary General of the Basel Committee is Mr. Stefan Walter. This committee on banking supervision provides a forum for regular cooperation on banking supervisory matters. 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 Capital Accord The Basel Capital Accord (Basel II) guidelines promulgated by the BIS to establish capital adequacy requirements and supervisory standards for banks to be implemented by 2007 and are structured by three pillars. The Basel II is designed to facilitate a more comprehensive, sophisticated and risk sensitive

In a nut-shell. ‡ Incorporates sensitivity to banks. the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability. Basel II Basel I is very simplistic in its approach towards credit risks. ‡ Providing range of alternatives to choose from. while Basel II tries to ensure that the anomalies existed in Basel I are corrected. In simple terms. The basic purpose of this recommendation is to ensure that capital allocation is more risk sensitive. In practice. Basel II ‡ Provides effective assessment methods. 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. ‡ Allowing capital discrimination of the banking system by allocating proper risk weighs to each asset class. .approach for banks to calculate regulatory capital. ‡ Takes global aspect into consideration for more rational decision making. improving the decision matrix for banks. ‡ Makes better business standards. ‡ Reduces losses to the banks. ‡ Allowing capital allocation based on ratings of the borrower making capital more risksensitive. Advantages of Basel-II It is believed that such an international standard 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. The Committee today consists of central bankers and supervisory regulators from 13 countries. Basel I Vs. the greater risk to which the bank is exposed. and attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage. separating operational risk from credit risk and quantifying both. The above-mentioned advantages of Basel II recommendation are helpful in various ways to the Indian banking industry: ‡ Improving overall efficiency of banking and finance systems. The proposals will enable banks to align regulatory requirements more closely with their internal risk measurement and to improve operational process. It does not distinguish between collateralized and non-collateralized loans.

risk managers and IT across the organizations in their existing set-up. credit and operational risk. Most of these models require minimum historical bank data that is a tedious and high cost process. Operatinal Risk & Market Risk) ‡ Supervisory Review (Provides Framework for Systematic Risk. who also have better capital adequacy ratios and geographically diversified portfolios. ‡ The technology infrastructure in terms of computerization is still in a nascent stage in most Indian banks. Penetration of information technology in banking has been successful in the urban areas. The 3-Pillar Approach of Basel II ‡ Minimum Capital Requirement (Addressing Credit Risk. it aims to give impetus to the use of internal rating system by the international banks. Liquidity Risk & Legal Risk) ‡ Market Discipline & Disclosure (To promote greater stability in the financial system) Challenges With Indian Banking Industry ‡ With the feature of additional capital requirements. which itself would be loss of capital to entire system. Computerization of branches. since most of the banks have poor asset quality leading to significant proportion of NPA. According to . which is the need of the hour to align market.‡ Providing an incentive for better and more objective risk measurement. ‡ Encouraging mergers and acquisitions and more collaboration on the part of the banks. But. will be difficult due to significant disconnect between business. the overall capital level of the banks will see an increase. Thus. More and more banks may have to use internal model developed in house and their impact is uncertain. ‡ Another biggest challenge is re-structuring the assets of some of the banks would be a tedious process. will be a daunting task. This also may lead to Mergers & Acquisitions. The smaller banks are also likely to be hurt by the rise in weightage of inter-bank loans that will effectively price them out of the market. ‡ An integrated risk management concept. ‡ Implementation of the Basel II will require huge investments in technology. the banks that will not be able to make it as per the norms may be left out of the global system. banks will have to re-structure and adopt if they are to survive in the new environment. unlike in the rural areas where it is insignificant. especially for those banks. as most Indian banks do not have such a database. ‡ Since improved risk management and measurement is needed. ‡ The new norms seem to favor the large banks that have better risk management and measurement expertise. which have their network spread out in far-flung areas. this ultimately leads to proper control over their capital and assets. ‡ Experts say that dearth of risk management expertise in the Asia Pacific region will serve as a hindrance in laying down guidelines for a basic framework for the new capital accord.

not for smaller or less developed economies. which are slightly different from that specified by the Basel Committee. it is doubted whether this will be sustainable. the regulatory challenge would be to migrate to Basel II in a non- . However. SWOT Analysis (In Indian Banking Context) Present Scenario in Implementing Basel II in India The deadline for implementing Basel II. announced an indicative set of weights for domestic corporate long-term loans and bonds subject to different ratings by international rating agencies such as Moody¶s Investor Services. while all other scheduled commercial banks will have to adhere to the guidelines by March 31. will need to spend well over $ 50-70 Million on this. which Basel II recommends. therefore. Foreign banks in India and Indian banks operating abroad had to meet those norms by March 31. like asset securitization. Indian banks.estimates. In a nut-shell. the increase in risk weight for residential mortgage loans will make this area less attractive. Whereas some of the large banks say that they are Basel II compliant with the presence of all the requirements. But the decision to implement the guidelines remains unchanged. which unlocks resources and spreads risk. have reported increased CARs. Given recent changes in regulatory charges. In contrast. Its implementation may involve significant changes in business model in which potential economic impacts must be carefully monitored. Conclusion The Basel Committee on Banking Supervision is a Guideline for Computing Capital for Incremental Risk. given their higher lending margins and lower risk weights. has now been extended. originally set for March 31. especially those with a sizeable branch network. This was designed for the big banks in the BCBS member countries. This is true even though the international exposure of even the major Indian banks is still limited. 2007. 2008. a few banks. those with high exposures to higher rated corporate or to the regulatory retail portfolio. The RBI had. By implementing Basel II norms. 2009. The major challenge the country¶s financial system faces today is to bring informal loans into the formal financial system. Banks would find it increasin gly attractive to give out loans to the small business segment that qualify as regulatory retail. are likely to be increasingly used. Most of the Indian banks that have migrated to Basel II have reported a reduction in their total Capital Adequacy Ratios (CARs) due to the new operational risk-based capital charges. we would like to conclude that keeping in view the cost of compliance for both banks and supervisors. Basel II allows national regulators to specify risk weights different from the internationally recommended ones for retail exposures. our formal banking system can learn many lessons from money-lenders. It is a new way of managing risk and asset-liability mis-matches.

India is one of the early countries which subjected itself voluntarily to the FSAP of the IMF. the Indian banking system has shown significant improvement on various parameters. There is. ample evidence of the capacity of the Indian banking system to migrate smoothly to Basel II. therefore. . has become robust and displayed ample resilience to shocks in the economy. 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.disruptive manner. We would like to continue the process of interaction with other countries to learn from their experiences through various international fora.

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