"A STUDY ON THE ADOPTION OF BASEL II NORMS IN INDIAN BANKING SECTOR WITH SPECIAL REFERENCE TO SOUTH INDIAN

BANK"

A PROJECT REPORT

Submitted by

Mr. ROHITH P

(Reg.No:CUAJMGT033)

in partial fulfillment of the requirement

for the award of the degree

of

MASTER OF BUSINESS ADMINISTRATION

in

DEPARTMENT OF COMMERCE & MANAGEMENT STUDIES

UNIVERSITY OF CALICUT.

JUNE – 2011

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DEPARTMENT OF COMMERCE AND MANAGEMENT STUDIES

UNIVERSITY OF CALICUT

Dr. M.A. JOSEPHHead Of the Department DCMS

University of CalicutMalappuram District

Kerala-673635

Date:………………

CERTIFICATE

This is to certify that ROHITH P is an MBA student of Department Commerce and Management Studies and this project report entitled “A STUDY ON THEA STUDY ON THE ADOPTION OF BASEL II NORMS IN INDIAN BANKING SECTOR WITHADOPTION OF BASEL II NORMS IN INDIAN BANKING SECTOR WITH SPECIAL REFERENCE TO SOUTH INDIAN BANKSPECIAL REFERENCE TO SOUTH INDIAN BANK’’ has been prepared by him in partial fulfillment of the requirement for the Award of Degree of Master of Business Administration (MBA) of the University of Calicut.

Dr. M.A. JOSEPH

Head of the Department

DCMS

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DEPARTMENT OF COMMERCE AND MANAGEMENT STUDIES

UNIVERSITY OF CALICUT

Dr. B. VIJAYACHANDHRAN PILLAI

READER , DCMS

University of Calicut

Malappuram District

Kerala-673635

Date……………

CERTIFICATE

This is to certify that ROHITH P is an MBA student of Department Commerce and Management Studies and this project report entitled “A STUDY ON THE ADOPTION OF BASEL II NORMS IN INDIAN BANKING SECTOR WITH SPECIAL REFERENCE TO SOUTH INDIAN BANK’’ has been prepared by them in partial fulfillment of the requirement for the Award of Degree of Master of Business Administration (MBA) of the University of Calicut.

Dr. B. VIJAYACHANDHRAN PILLAI

READER

DCMS

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UNIVERSITY OF CALICUT

DECLARATION

I hereby declare that the project entitled “A Study on the adoption of Basel II

norms in Indian banking sector with special reference to South Indian Bank” in

partial fulfillment of the requirement for the award of the degree of MASTER OF

BUSINESS ADMINISTRATION is a record of original project work done by me,

during my period of study in Department of Commerce and Management Studies,

University of Calicut 2009-2011 under the guidance of Dr. B.Vijayachandhran Pillai,

Reader DCMS, University of Calicut and no part of it has been submitted for any other

Degree or Diploma.

Signature of the Candidate:

Name of the Candidate: Rohith.P

Date: 24/06/2011

Place: Guruvayoor

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ACKNOWLEDGEMENT

I am extremely thankful to our beloved HOD Dr. M.A Joseph, (DCMS,

University Of Calicut), for showing keen interest in my effort and for being a source of

inspiration throughout the course in this college.

I would like to thank my internal guide Dr. B Vijayachandran Pillai Reader,

DCMS, University Of Calicut for the guidance and support which have been instrumental

in accomplishing this project.

I wish to convey my sincere thanks to all my teaching and non-teaching staff of

the department.

I thank to my Family, Friends and the Almighty for supporting me in every day

they could. At last, I would like to thank all those who helped me directly or indirectly in

conducting the study and preparing the project.

PLACE:

DATE: ROHITH P

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TABLE OF CONTENTS

CHAPTER TITLE PAGE NO

1 CHAPTER- INTRODUCTION

1.1 INTRODUCTION1.2 STATEMENT OF THE PROBLEM1.3 REVIEW OF RELATED LITRATURE1.4 OBJECTIVES, SCOPE AND SIGNIFICANCE OF THE STUDY1.5 RESEARCH METHODOLOGY 1.6 LIMITATIONS OF THE STUDY1.7 SCHEME OF THE PRESENTATION

1

2

5

6

9

9

2 CHAPTER-BASEL NORMS THEORETICAL FRAME WORK

2.1 CONCEPTS OF THE STUDY2.3 INDUSTRY PROFILE2.4 PRODUCT PROFILE

10

31

39

3 CHAPTER-RESULTS OF THE ANALYSIS 49

4 CHAPTER- FINDINGS CONCLUSION AND SUGGESTIONS

5.1 FINDINGS OF THE STUDY

5.2 CONCLUSION

5.3 SUGGESTIONS & RECOMMENDATIONS

82

83

84

6 BIBIOGRAPHY

7 ANNEXURE

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CHAPTER I

INTRODUCTION

BASEL ACCORD

The Basel Accords refer to the banking supervision Accords (recommendations on

banking laws and regulations) by the Basel Committee on Banking Supervision (BCBS).

They are called the Basel Accords as the BCBS maintains its secretariat at the Bank for

International Settlements in Basel, Switzerland and the committee normally meets there.

Formerly, the Basel Committee consisted of representatives from central banks and

regulatory authorities of the Group of Ten countries plus Luxembourg and Spain. Since

2009, all of the other G-20 major economies are represented, as well as some other major

banking locales such as Hong Kong and Singapore. (See the Committee article for a full

list of members.)

The committee does not have the authority to enforce recommendations, although most

member countries as well as some other countries tend to implement the Committee's

policies. This means that recommendations are enforced through national (or EU-wide)

laws and regulations, rather than as a result of the committee's recommendations - thus

some time may pass between recommendations and implementation as law at the national

level.

With a view to adopting the Basel committee on banking supervision (BCBS) framework

on capital adequacy which takes into account the elements of credit risk in various types

of assets in the balance sheet as well as off- balance sheet business and also to strengthen

the capital base of banks, RBI decided in April 1992 to introduce a risk asset ratio system

for banks (including foreign banks) in India as a capital adequacy measure. Essentially,

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under the above system the balance sheet assets, non-funded items and other off-balance

sheet exposures are assigned prescribed risk weights and banks have to maintain

unimpaired minimum capital funds equivalent to the prescribed ratio on the aggregate of

the risk weighted assets and other exposures on an ongoing basis. RBI has issued

guidelines to banks in June 2004 on maintenance of capital charge for market risks on the

lines of ‘Amendment to the capital accord to incorporate market risks’ issued by BCBS in

1996.

The BCBS released the “International convergence of capital measurement and capital

standards: A revised Framework” on June 26, 2004. The revised framework was updated

in November 2005 to include trading activities and the treatment of double defaults

effects and a comprehensive version of the framework was issued in June 2006

incorporating the constituents of capital and the 1996 amendment to the capital accord to

incorporate Marker risk. The revised framework seeks to arrive at significantly more risk-

sensitive approaches to capita; requirements. The Revised frame work provides a range

of options for determining the capital requirements for credit risk and operational risk to

allow banks and supervisors to select approaches that are most appropriate for their

operations and financial markets.

STATEMENT OF THE PROBLEM

Banking operations and system have been facing spectacular reforms in this era of

globalization and liberalisation. It is a herculean task for the economists and banking

experts to frame strategies in order to cope up with these changes and new challenges.

Global economic turmoil which was a wakeup call for every capitalist country threw light

on the importance of risk management in banking sector. Financial giants such as J.P

Morgan, Lehman Brothers etc have bankrupted due to poor risk management. Even

though Indian banks did well during this contagion took place. The main reason observed

was the strict regulatory measures taken by RBI to control the operations of Indian banks.

Moreover majority of public sector and old private sector banks operates in a traditional

way without taking much risk. But the situation prevailing is changing the face of Indian

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banking industry. New generation banks are now competing with global giants. RBI is

promoting all banks to grow aggressively. In this scenario they have to take various risks.

So that underlines the importance of risk management. Basel II norms are now a

inevitable part of banking to ensure a organized and systematic risk management. This

study probes in to the adoption of Basel II norms in Indian banking sector with special

reference to South Indian Bank

REVIEW OF LITERATURE

The relevant studies conducted in the related area are briefly reviewed below:

Daniel Tabbush, Head of CLSA Banking Research (2008) in his report stated

“Mortgage-loan risk weightings drop from 50% to 35% under Basel II, making them

much more profitable in terms of regulatory capital required, while small and

medium-sized enterprise (SME) lending can move from 100% to 75%”

Anand Wadadekar (2008) in his study “Basel Norms & Indian Banking System”

revealed that Basel II Norms offers a variety of options in addition to the standard

approach to measuring risk. Paves the way for financial institutions to proactively

control risk in their own interest and keep capital requirement low.

C.P.Chandrasekhar & Jayati Ghosh(2007) in their study “Basel II and India's banking

structure” examined what the guidelines involve, their effects on the banking structure

and behavior and some likely outcomes of implementing them

Rana Kapoor, managing director, YES Bank (the latest entrant to new generation

private banks in India), holds “Most (Indian) banks are likely to start with simpler,

elementary approaches, just adequate to ensure compliance to Basel II norms and

gradually adopt more sophisticated approaches. The continued regulatory challenge

will be to migrate to Basel II in a non-disruptive manner”.

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P.S. Shenoy, chairman and managing director, Bank of Baroda, believes “Basel II

compliance will eventually result in banks acquiring a competitive edge, stating

`Banks that move proactively in the broad direction outlined by the Basel Committee

will have acquired a definite edge over their competitors when the new accord enters

the implementation phase”.

Niall S.K. Booker, chief executive officer, HSBC India and chairman of the IBA

Committee on Basel II states “There is the possibility that in international markets

access may be easier and costs less for banks adopting a more sophisticated

approach….however in a market like India it seems likely that the large domestic

players will continue to play a very significant role regardless of the model used”.

Mandira Sharma & Yuko Nikaido (2007) in their study on”Capital Adequacy Regime

in India” examined issues and challenges with regard to the implementation of

CRAR norms under Basel II regime in India. They also tried to identify limitations,

gaps and inadequacies in the Indian banking system which may hamper the realization

of the potential benefits of the new regime.

Ernst & Young in their survey in 2008 revealed that Basel II has changed the

competitive landscape for banking. Those organizations with better risk systems are

expected to benefit at the expense of those which have been slower to absorb change

due to increased use of risk transfer instruments. It also concluded that portfolio risk

management would become more active, driven by the availability of better and more

timely risk information as well as the differential capital requirements resulting from

Basel II. This could improve the profitability of some banks relative to others, and

encourage the trend towards consolidation in the sector.

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SCOPE OF THE STUDY:

The project entitled “A study on the adoption of Basel II norms in Indian Banking Sector

with reference to South Indian Bank” mainly comprises of analyzing how south Indian

bank adopted Basel II accord and evaluating India’s top banks like STATE BANK OF

INDIA, Canara bank, Indian bank, HDFC bank, Axis bank, and Indian Bank in terms of

capital adequacy norms. Basel II norms are the international standardization provided to

all the banks in the world. Through the study the performance of banks on the basis of

Basel II norms are evaluated.

The project is analyzed with the help of financial statements of each bank in the past

three consecutive years. Basel II has made certain stipulations to Indian banking sector

regarding the maintenance of minimum regulatory capital. As per the Basel II norms all

the banks should maintain sufficient regulatory capital to cover themselves from various

risks. Basel II is intended to improve safety and soundness in the financial system by

placing increased emphasis on banks` own internal control and risk management

processes and models, the supervisory review process, and market discipline.

OBJECTIVES OF THE STUDY

The main objectives of the study entitled “A study on the adoption of Basel II norms

in Indian Banking System with reference to South Indian Bank” are:

To study how South Indian bank adopted Basel 2 norms

To find out the efficiency of each bank in implementing Basel II norms.

To study about the advantages of Basel II norms implementation in banks.

To analyze various factors influencing Banking operation in BASEL II .

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SIGNIFICANCE OF THE STUDY

As we all know Indian Banking system is one of the best banking structure in the world

due to our banking efficiency and the regulatory measures adopted by RBI. Indian banks

were least affected by the global financial turmoil that hit western countries like America

and other European countries. The Indian banking system has seen structural

improvements during the last few years, including improved solvency, better risk

management systems and greater access to capital. However, the greater complexities

among Indian banks, reinforces the need for stronger risk assessment systems. The

significance in implementing Basel II norms in banks are:

Maintenance of minimum regulatory capital

Effective managerial involvement

Better handling of all risk like credit risk, operators risk and market risk

Managers can easily evaluate the performance of their bank

RESEARCH METHODOLOGY

Research is a scientific and systematic search for pertinent information on a specific

topic. Research methodology is a way to systematically solve the research problem. It

helps the researcher to know the criteria by which they can decide that certain techniques

and procedure will be applicable on certain problem and other will not. In general, it

refers to the research design adopted by the researches, sampling techniques followed,

and data collection details.

RESEARCH DESIGN

Research design is not a highly specific plan to be followed without deviation but rather a

series of guideposts to keep one headed in the right direction. Fundamental to the success

of any formal research project is found research design. The research design is the basic

frame work, which provides guidelines of the rest of the research process. It is a map or

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blue print according to which the research is to be concluded. The research design

specifies the method for data collection and data analysis. It is of three types, exploratory,

experimental and descriptive research design.

Research design is a method the research adopts for the study. The choices of research

desponds on the depth and extend of data requires, the cost and benefits of the research

the urgency of work and the time available for completing it.

DESCRIPTIVE RESEARCH DESIGN

Descriptive studies as the name implies, is designed to describe something in detail. In

descriptive study, data is collected for a definite purpose.

SAMPLING DETAILS

Sampling means when field studies are undertaken in practical life, considering time

and cost almost invariably lead to a selection of respondents i.e. , selection of only few

items. The respondents selected should be representative of the total population as

possible in order to produce a miniature cross-section. The selected respondents

constitute what is technically called as ‘sample’ and the selection process is called as

‘sample technique’. Convenient sampling technique is used in the study.

Size of Sample

Here the size of the sample is taken as 6 Banks. Among six Banks three are from

Nationalized Banks and the rest from Private Banks. The Banks selected for the

analysis are:

1) NATIONALISED BANK

State Bank of India

Indian Bank

Canara Bank

2) PRIVATE BANK

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HDFC Bank

Axis Bank

South Indian Bank

DATA COLLECTION METHOD

For a research the researcher may depend either on primary data or secondary data or

both. Primary data usually collected with the help of the questionnaire, personal interview

etc.

Data collection is a elaborate process in which the researcher makes a planned search for

all relevant data. Data is the foundation for all research data or facts may be obtained

from several sources. Data collected only from primary sources.

SECONDARY DATA

Secondary data is mainly comprises of the information that are collected already for some

other purpose.

The secondary data collected in this project are from

Booklets from the Bank

Magazines

Websites like

www.bis.org

www.rbi.org.in

www.southindianbank.org

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PRIMARY DATA

Primary data is the original data gathered for the first time by the researcher with help of

the questionnaire and from the respondent’s responses. Primary data is the direct method

by which the research will be get the information from the respondents.

In this project study primary data has been collected by conducting expert interview with

the top officials of the bank.

LIMITATIONS:

Under the project entitled “The study of the adoption of Basel II norms in Indian Banking

System with reference to South Indian Bank”

In depth analysis of project was not possible because of the shorter time duration

and unavailability of information.

.

SCHEME OF THE PRESENTATION OF THE PROJECT

Chapter 1: Introduction

Chapter 2: Basel norms- a theoretical frame work

Chapter 3: results of the analysis

Chapter 4: Findings, conclusions and suggestions

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CHAPTER 2

BASEL NORMS - A THEORETICAL FRAMEWORK

BASEL I

The first step towards an organized Risk Management arose through Basel initiatives.

The advent of Basel-II has certainly brought to focus the pressure on capital through

different risk weights. The attempt at harmonizing the capital adequacy standards

internationally date back to 1988, when the “Basle committee on Banking Regulations

and supervisory practices”, released a capital adequacy framework, now known as Basel-

I. This norm was widely adopted in over 100 countries.

The committee expects its members to move forward with the appropriate adoption

procedure in their respective countries. In a number of instances, these procedures will

include additional impact assessment of the Committee’s Framework as well as further

opportunities for comments by interested parties to be available for implementation as of

year-end 2006. However, the committee feels that one further year of impact studies or

will be available for implementation as the year end 2007.

The fundamental objective of the committee’s work to revise the 1988 Accord has been

to develop a framework that would further strengthen the soundness and stability of the

international banking system while maintaining sufficient consistency that capital

adequacy regulation will not be a significant source of competitive inequality among

internationally active banks. The Committee believes that the revised Framework will

promote the adoption of stronger risk management practices by the banking industry, and

views this as one of its major benefits. The committee notes that, in their comments on

the proposals, banks

And other interested parties have welcomed the concept and rationale of the three pillars

approach on which the revised Framework is based. More generally, they have expressed

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support for improving capital regulation to take into account changes in banking and risk

management practices while at the same time preserving the benefits of a framework that

can be applied as uniformly as possible at the national level.

The accord, in its original form, addressed only the credit risks in the bank’s operations.

This meant that a bank with a higher risk profile would have to maintain a higher

quantum of regulatory capital. The framework also stipulated, for the first time, a

regulatory capital charge for the off balance sheet business of the banks, so as to capture

their risk exposures

more comprehensively. Pursuant to the recommendations of the Committee on the

Financial System (the first Narasimham Committee, 1991), this framework was

implemented in India in 1992 in a phased manner. It was only in 1996 that an amendment

was made to cover the market risks also.

BASEL II

Basel II is 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, which was initially published in June 2004, 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.

Advocates of Basel II believe 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. In theory, Basel II attempted to accomplish this by

setting up 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. Generally speaking, these rules mean that the greater risk to which

the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard

its solvency and overall economic stability

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LIMITATIONS OF BASEL-I WHICH PAVED THE WAY TO BASEL-II

First, the Accord had a broad-brush approach under which the entire

THE BIRTH OF BASEL-II FRAMEWORK.

In order to take care of the limitations of Basel-I as discussed above, Basel Committee on

Banking Supervision (BCBS), after a world-wide consultative process and several impact

assessment studies, evolved a new capital regulation framework, widely known as Basel-

II framework (“International Convergence of Capital Measurement and Capital

Standards: A Revised exposures of banks were categorized into three broad risk buckets

viz., sovereign, banks and corporates, with each category attracting a risk weight of zero,

20 and 100 per cent, respectively. Such a risk weighting scheme did not provide for

sufficient calibration of the counterparty risk since, for instance, a corporate with “AAA”

rating and one with “C” rating would attract identical risk weight of 100 per cent and

require the same regulatory capital charge. This, in turn, provided an incentive for the

banks to acquire higher-risk customers in pursuit of higher returns, without necessitating

a higher capital charge. Second, the Accord addressed only the credit risk and market risk

in the banks’ operations, ignoring several other types of risks inherent in banking activity.

For instance, the operational risk, that is, the risk of human error or failure of systems

leading to financial loss, was not at all addressed-as were the liquidity risk, credit

concentration risk, interest rate risk in the banking book, etc. Third, since 1988, the

emergence of innovative financial products had transformed the contours of the banking

industry and its business model. The credit-risk transfer products, such as securitization

and credit derivatives, enabled removal of on-balance sheet exposures from the books of

the banks, when they perceived that the regulatory capital requirement for such exposures

was too high and hiving off such exposures would be a better strategy. The Basel-I

framework did not accommodate such innovations and was, thus, outpaced by the market

developments.

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The objectives of the revised framework, which was released in June 2004, are to

broadly maintain the aggregate level of minimum capital requirements, while providing

incentives to adopt more advanced risk sensitive approaches as envisaged in the revised

framework.

The committee has to designed the revised framework to be a more forward looking

approach to capital adequacy supervision, one that the has capacity to evolve with time.

This evolution is necessary to ensure that the framework keeps pace with market

developments and advanced in risk management practices, and the committee intends to

monitor these developments and to make revisions when necessary In this regard, the

committee has enhanced opportunities for dialogue. The committee also intends to keep

the industry apprised of its future work agenda.

STIPULATIONS OF THE THREE PILLARS UNDER BASEL-II

The Pillar 1 stipulates the minimum capital adequacy ratio and requires allocation of

regulatory capital not only for credit risk and market risk but additionally, for operational

risk as well, which was not covered in the previous accord. The Pillar 2 of the framework

deals with the ‘Supervisory Review Process’ (SRP), and it requires the banks to develop

an Internal Capital Adequacy Assessment Process (ICAAP) which should encompass

their whole risk universe – by addressing all those risks which are either not fully

captured or not at all captured under pillar 1 and assign an appropriate amount of capital

internally. Under the Supervisory Review the supervisors would conduct a detailed

examination of the ICAAP of-2- the banks, and if warranted, could prescribe a higher

capital requirement, over and above the minimum capital adequacy ratio envisaged in

Pillar 1. The Pillar 3 of the framework, Market Discipline, focuses on the effective public

disclosures to be made by the banks, and is a critical complement to the other two Pillars.

It is based on the basic principle that the markets would be quite responsive to the

disclosures made and the banks would be duly rewarded or penalized by the market

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forces. It recognizes the fact that the discipline exerted by the markets can be as powerful

as the sanctions imposed by the regulator.

PREPARATORY MEASURES ADOPTED BY RBI FOR BASEL-II

IMPLEMENTATION

In August 2004, soon after the new framework was released by the BCBS, the banks

were advised to conduct a self-assessment of their risk management systems and to

initiate remedial measures, as needed, keeping in view the requirements of the Basel-II

framework. A Steering Committee was constituted in October 2004, comprising senior

officials from 14 select banks (a mix of public sector, private sector and foreign banks).

In February,2005, based on the inputs received from this committee, the RBI issuedthe

draft guidelines, for public comments, on implementation of Pillar 1 and Pillar 3

requirements of the Basel-II framework. In the light of the feedback received from a wide

spectrum of banks and other stake holders, the draft guidelines were revised and the final

guidelines were issued on

April 27, 2007. As regards the Pillar 2, the banks have been asked to put in place the

requisite internal Capital Adequacy Assessment Process (ICAAP) with the approval of

their Boards. The minimum capital adequacy ratio prescribed under Basel-II norms

continues to be nine per cent.

PRESENT LEVEL OF PREPAREDNESS OF INDIAN BANKS FOR

IMPLEMENTATION OF BASEL-II

Even before the final guidelines were issued, the RBI had asked the banks in May 2006

to begin conducting parallel runs, as per the draft guidelines, so as to familiarize them

with the requirements of the new framework. During the period of parallel run, the banks

are required to compute, on an ongoing basis, their capital adequacy ratio – both under

Basel-I norms, currently applicable, as well as the Basel-II guidelines to be applicable in

future. This analysis, along with several other prescribed assessments, is-3- to be placed

before the Boards of the respective banks every quarter and is also transmitted to the RBI.

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RBI GUIDELINES FOR THE IMPLEMENTATION OF BASEL-II

The foreign banks operating in India and the Indian banks having operational presence

outside India are required to migrate to the Standardized Approach for credit risk and the

Basic Indicator Approach for operational risk with effect from March 31, 2008. All other

Scheduled commercial banks are encouraged to migrate to these approaches under Basel-

II, not later than March 31, 2009. It has been a conscious decision to begin with the

simpler approaches available under the framework. As regards the market risk, the banks

will continue to follow the Standardized-Duration Method, already adopted under the

Basel-I framework, under Basel-II also.

CHALLENGES AHEAD FROM THE ADOPTION OF BASEL-II

First, the new norms might, in some cases, lead to an increase in the overall regulatory

capital requirements for the banks, if the additional capital required for the operational

risk is not offset by the capital relief available for the credit risk. Second, the

Standardized Approach for credit risk leans heavily on the external credit ratings. While

the RBI has accredited four rating agencies operating in India, the rating penetration in

India is rather low and it is confined to rating of the instruments and not of the issuing

entities as a whole. Third, the risk weighting scheme under Standardised Approach also

creates some incentive for some of the bank clients with loan amount less than Rs.10

crores to remain unrated, since such entities receive a lower risk weight of 100 per cent

against 150 per cent risk weight for a lowest rated client. Fourth, the new framework

could also intensify the competition for the best clients with high credit ratings, which

attract lower capital charge, but will put pressure on the net interest margins of the bank.

Finally, implementing the ICAAP under the Pillar 2 of the framework would perhaps be

the biggest challenge for the banks in India as it requires a comprehensive risk modeling

infrastructure to capture all the known and unknown risks that are not covered under the

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other two Pillars of the framework. Though the implementation of Basel-II would be a

challenge for the Indian banks, it provides an opportunity to leverage capital base,

improve the risk management practices and enhance the bottom-line by moving from

capital adequacy to capital efficiency

BASEL II – PILLAR I

The main subtitle comes under PILLAR I are

I) CREDIT RISK

II) OPERATIONAL RISK

III) MARKET RISK

I) CREDIT RISK

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Credit risk still claims the largest share of the regulatory capital and it underscores the

significance of credit risk in bank’s operations. This is hardly surprising reckoning that

the several banking crises in many countries had their roots in lax credit standards, poor

portfolio risk management, and the inability or failure to evaluate the impact of the

changing economic environment on credit worthiness of the banks’ borrowers. The sub-

prime crisis in the USA is the most recent example of the inadequate credit risk

assessment. The advent of advanced approaches for credit risk in India under the Basel II

framework in the days to come ,could be expected to provide an impetus for adopting

more sophisticated credit risk management techniques in banks.

Credit Risk is defined as “The inability or unwillingness of the customer or counter party

to meet commitments in relation to lending, hedging, settlement and other financial

transactions.” Hence Credit Risk emanates when the counter party is unwilling or unable

to meet or fulfill the contractual Obligations / commitments thereby leading to defaults.

THE OPTIONS FOR COMPUTING CAPITAL CHARGE FOR CREDIT RISK

Under Pillar 1, the framework offers three distinct options for computing capital

requirement for credit risk. These approaches for credit risks are based on increasing risk

sensitivity and allow banks to select an approach that is appropriate to the stage of

development of bank’s operations. The approaches available for computing capital for

credit risk are

1. STANDARDISED APPROACH,

2. FOUNDATION INTERNAL RATING BASED APPROACH

RBI has decided to implement the Standardized Approach within the stipulated time

frame. As regards the migration to advanced approaches, the RBI has not indicated any

specific time frame. However, the banks that plan to migrate to the advanced approaches

would need prior approval of RBI – for which requisite guidelines would be issued in due

course.

1) Standardized Approach

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Standardized Approach is the basic approach which banks at a minimum have to use for

moving to Basel II implementation. It is an extension of the existing method of

calculation of capital charge for credit risk. The existing method is refined and made

more risk sensitive by:

• Introducing more number of risk weights thus aiding finer differentiation in risk

assessment between asset groups.

• Assignment of Risk weights based on the ratings assigned by External Credit rating

agencies recognized by RBI, in case of exposures more than Rs.5 crores.

• Recognizing wide range of collaterals (securities) as risk mitigates and netting them off

while determining the exposure amount on which risk weights are to be applied.

• Introducing Retail portfolio with total exposure up to Rs.5 crores and yearly turnover

less than Rs.50 crores as a separate asset group with clear cut definition and criteria.

• Assignment of Risk weight for NPA accounts. The rating assigned by the eligible

external credit rating agencies will largely support the measure of credit risk. Unrated

exposures will normally carry 100% risk weight. But for the financial year 2008-09, all

fresh sanctions or renewals in respect of unrated borrowers in excess of Rs.50 crores will

attract a risk weight of 150%. From 2009-10 onwards, unrated borrowings in excess of 10

crores will attract risk weight of 150%.

Credit Risk Mitigation

CRM refers to permitted methods of netting the exposure value for computing Risk

Weights by using Collateral, Third party guarantee (Guarantee) and On-balance sheet

netting. CRM is available subject to- several conditions. Before netting, Exposure Value

(EV) and Collateral Value (CV) are to be adjusted for volatility and possible future

fluctuations. EV to be increased for volatility (premium factor) and CV to be reduced for

volatility (discount factor). These factors are termed as ‘Haircuts’ (HC).

2) The Internal Ratings Based Approach (IRB)

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Under the IRB approach, different methods will be provided for different types of loan

exposures. Basically there are two methods for risk measurement which are Foundation

IRB and Advanced IRB. The framework allows for both a foundation method in which a

bank estimate the probability of default associated with each borrower, and the

supervisors will supply the other inputs and an advanced IRB approach, in which a bank

will be permitted to supply other necessary inputs as well. Under both the foundation and

advanced IRB approaches, the range of risk weights will be far more diverse than those in

the standardized approach, resulting in greater risk sensitivity.

II) OPERATIONAL RISK

Operational risk is defined as the risk of direct or indirect loss resulting from inadequate

or failed internal processes, people and systems or from external events. The definition

includes legal risks, but excludes strategic and reputation risk. Operational risk is

pervasive and its ownership and measurement are challenges. Some of the important

causes for operational risk are inadequate segregation of duties, insufficient training and

poor HR Policies, lack of management supervision and inadequate security measures and

systems.

METHODOLOGIES FOR CALCULATING OPERATIONAL RISK CAPITAL

Basic indicator approach, Standardised approach and Advanced Measurement Approach

are the three methodologies allowed under Basel II for arriving at the capital charge for

operational risk. RBI has advised the banks to apply the Basic Indicator Approach to

migrate to Basel II in the beginning. Under Basic indicator approach, banks have to hold

capital for operational risk equal to a fixed percentage of the average of positive annual

gross income over the previous 3 years. Thus, capital charge under Basic indicator

approach KBia = (GI / n) x A, where,

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• KBia = Capital charge under Basic Indicator Approach

• GI = Total gross income over the previous three years

• A = 15%

• n = No. of years ie 3 years for which income is positive.

TOTAL CAPITAL REQUIREMENT UNDER BASEL II

Banks in India are required to maintain a minimum Capital to Risk weighted Assets Ratio

(CRAR) of 9% on an ongoing basis (However,

Basel II prescribes 8% only). RBI may consider prescribing a higher level of minimum

capital ratio for each bank under the pillar 2 framework on the basis of their respective

risk profiles and their risk management systems. Banks are also encouraged to maintain a

Tier 1 CRAR of at least 6% and banks which are below this level, must achieve this ratio

on or before 31st March 2010.

III) MARKET RISK

Market Risk is the possibility of loss to a bank caused by changes in market variables.

Market risk is also defined as “the risk that the value of on or off balance sheet

positions will be adversely affected by movements in equity and interest rate markets,

currency exchange rates and commodity prices. Market Risk Management of a bank

thus involves management of interest rate risk, foreign exchange risk, commodity

price risk and equity price risk. Market risk is also concerned about the banks ability

to meet its obligations as and when they fall due, as a consequence of liquidity risk.

Sound liquidity management can reduce the probability of a default. Liquidity risk is

related to banks inability to pay to its depositors. It has a strong correlation with other

risks such as interest rate risk and credit risk. Under Basel II, the present system of

computing capital requirement for Market risk under the standardized – duration

method will continue.

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BASEL II – PILLAR II

INTRODUCTION

One of the unique aspects of Basel II is its comprehensive approach to risk measurement

in the banking entities, by adopting the now-familiar three- Pillar structure, which goes

far beyond the first Basel Accord. To recapitulate, these are: Pillar 1 – the minimum

capital ratio, Pillar 2 – the supervisory review process and Pillar 3 – the market

discipline. The Pillar 1 provides a menu of alternative approaches, from simple to

advanced ones, for determining the regulatory capital towards credit risk, market risk and

operational risk, to cater to the wide diversity in the banking system across the world.

Pillar 2 requires the banks to establish an Internal Capital Adequacy Assessment Process

(ICAAP) to capture all the material risks,

including those that are partly covered or not covered under the other two Pillars. The

ICAAP of the banks is also required to be subject to a supervisory review by the

supervisors. The Pillar 3 prescribes public disclosures of information on the affairs of the

banks to enable effective market discipline on the banks’ operations

THE SECOND PILLAR: SUPERVISORY REVIEW PROCESS

Supervisory review process has been introduced to ensure not only that banks have

adequate capital to support all the risks, but also to encourage them to develop and use

better risk management techniques in monitoring and managing their risks. The process

has four key principles

a) Banks should have a process for assessing their overall capital adequacy in relation to

their

risk profile and a strategy for monitoring their capital levels.

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b) Supervisors should review and evaluate bank’s internal capital adequacy assessment

and

strategies, as well as their ability to monitor and ensure their compliance with regulatory

capital ratios.

c) Supervisors should expect banks to operate above the minimum regulatory capital

ratios and

should have the ability to require banks to hold capital in excess of the minimum.

d) Supervisors should seek to intervene at an early stage to prevent capital from falling

below

minimum level and should require rapid remedial action if capital is not mentioned

or restored

RBI GUIDELINES UNDER PILLAR-2

The Pillar-2 of the framework deal with the “Supervisory Review Process” (SRP). The

objective of the SRP is to ensure that the banks have adequate capital to support all

materials risks in their business as also to encourage them to adopt sophisticated risk

management techniques for monitoring and managing their risks. This, in turn, would

require a well-defined internal assessment process within the banks through which they

would determine the additional capital requirement for all material risks, internally, and

would also be able to assure the RBI that adequate capital is actually held towards their

all material risk exposures. The process of assurance could also involve an active

dialogue between the bank and the RBI so that, when warranted, appropriate intervention

could be made to either reduce the risk exposure of the bank or augment its capital.

Under Pillar-2, the banks have been advised to put in place an ICAAP, with the approval

of the Board. Thus, ICAAP is an important component of the Supervisory Review

Process. What is important to note here is that the Pillar 1 stipulates only the minimum

capital ratio for the banks whereas the Pillar 2 provides for a bank-specific review by the

supervisors to make an assessment whether all

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material risks are getting duly captured in the ICAAP of the bank. If the supervisor is not

satisfied in this behalf, it might well choose to prescribe a higher capital ratio, as per its

assessment.

ICAAP

Pillar II envisages that

• Banks should establish adequate risk assessment processes

• The risk assessment processes should be specific to each individual bank and

• Each bank should develop and implement a comprehensive internal process for

assessing its capital adequacy in relation to - its risk profiles as well as strategy for

maintaining such capital levels.

ICAAP is expected to capture Residuary Risks such as

• Reputation Risk

• Liquidity Risk

• Credit Concentration Risk etc... which are not addressed by Pillar 1 These are to be

captured apart from credit, Market and Operational Risks.

RISK BASED INTERNAL AUDIT

In view of New Basle Capital Accord, Reserve Bank of India has already decided to

move towards Risk Based Supervision (RBS) in place of the present method of Annual

financial Supervision of the Banks. For taking up RBS, Banks have been advised by RBI

to adopt Risk Based Internal Audit. A sound internal audit function plays a significant

role in contributing to the effectiveness of the internal control system and should provide

high quality counsel to management on the effectiveness of risk assessment and internal

controls including regulatory compliance. Traditionally the internal inspection has been

concentrating on transaction based, testing of accuracy and reliability of accounting,

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records and financial reports, integrity, reliability and timeliness of control reports and

adherence to legal and regulatory requirements. The business of Banking has undergone a

sea change and more activities are undertaken by the Banks today. So for internal audit of

Branches, transaction testing in itself will not be sufficient. So there is a need to re-orient

internal audit function and focus on the specific risks on an on-going basis to evaluate the

adequacy and effectiveness of internal control system and risk management procedures

followed in the Banks. So in Risk Based Internal Audit, the role of internal auditors in

mitigating risks gets more emphasis.

BASEL II PILLAR III

THE THIRD PILLAR: MARKET DISCIPLINE

Market discipline imposes strong incentives to banks to conduct their business in a

safe, sound and effective manner. It is proposed to be effected through a series of

disclosure requirements on capital, risk exposure etc. so that market participants can

assess a bank’s capital adequacy. These disclosures should be made at least semiannually

and more frequently if appropriate. Qualitative disclosures such as risk

management objectives and policies, definitions etc. may be published annually.

PURPOSE OF MARKET DISCIPLINE

The purpose of Market discipline (Pillar 3) is to compliment the minimum capital

requirements detailed under Pillar 1 and Pillar 2. The aim is to encourage market

discipline by developing a set of disclosure requirements which will allow market

participants to assess key pieces of information on the scope of application, capital, risk

exposures, risk assessment processes, and hence the capital adequacy of the institution. In

principle, banks’ disclosures should be consistent with how senior management and the

Board of directors assess and manage the risks of the bank. Under Pillar 1, banks use

specified approaches/methodologies for measuring the various risks they face and the

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resulting capital requirements. It is believed that providing disclosures that are based on a

common

RBI GUIDELINES ON MINIMUM CAPITAL REQUIREMENT

With a view to adopting the Basel committee on banking supervision (BCBS) framework

on capital adequacy which takes into account the elements of credit risk in various types

of assets in the balance sheet as well as off- balance sheet business and also to strengthen

the capital base of banks, RBI decided in April 1992 to introduce a risk asset ratio system

for banks (including foreign banks) in India as a capital adequacy measure. Essentially,

under the above system the balance sheet assets, non-funded items and other off-balance

sheet exposures are assigned prescribed risk weights and banks have to maintain

unimpaired minimum capital funds equivalent to the prescribed ratio on the aggregate of

the risk weighted assets and other exposures on an ongoing basis. RBI has issued

guidelines to banks in June 2004 on maintenance of capital charge for market risks on the

lines of ‘Amendment to the capital accord to incorporate market risks’ issued by BCBS in

1996.

The BCBS released the “International convergence of capital measurement and capital

standards: A revised Framework” on June 26, 2004. The revised framework was updated

in November 2005 to include trading activities and the treatment of double defaults

effects and a comprehensive version of the framework was issued in June 2006

incorporating the constituents of capital and the 1996 amendment to the capital accord to

incorporate Marker risk. The revised framework seeks to arrive at significantly more risk-

sensitive approaches to capita; requirements. The Revised frame work provides a range

of options for determining the capital requirements for credit risk and operational risk to

allow banks and supervisors to select approaches that are most appropriate for their

operations and financial markets.

CAPITAL FUNDS

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Banks are required to maintain a minimum capital to Risk-Weighted Assets Ratio

(CRAR) of 9% on an ongoing basis. The RBI will take into account the relevant risk

factors and the internal capital adequacy assessments of each bank to ensure that the

capital held by a bank is commensurate with bank’s overall risk profile. This would

include, among others, the effectiveness of the bank’s overall risk management systems

in identifying, assessing/ measuring, monitoring and managing various risks including

interest rate risk in the banking book, liquidity risk, concentration risk and residual risk.

Accordingly, the RBI will consider prescribing a higher level of minimum capital ratio

for each bank under Pillar 2 framework on the basis of their respective risk profiles and

their risk management systems. Further, in terms of the Pillar 2 requirements of the New

Capital Adequacy Framework, banks are expected to operate at a level well above the

minimum requirement

Banks are encouraged to maintain, at both solo and consolidated level, a Tier 1 CRAR of

at least 6%. Banks which are below this level must achieve this ratio on or before March

31, 2010.

A bank should compute its Tier 1 CRAR and total CRAR in the following manner:

Tier 1 CRAR = Eligible Tier 1 capital funds

Credit Risk RWA* + Market Risk RWA + Operational Risk RWA

RWA*= Risk weighted assets

Total CRAR= Eligible total capital funds

Credit Risk RWA + Market Risk RWA + Operational Risk RWA

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Capital funds are broadly classified as Tier 1 and Tier II capital. Elements of Tier

II capital will be reckoned as capital funds up to a maximum of 100% of Tier I

capital, after making the deductions/ adjustments.

Elements of Tier I capital

For Indian banks, Tier I capital would include the following elements:

Paid up equity capital, statutory reserves, and other disclosed free reserves, if any;

Capital reserve representing surplus arising out of sale proceeds of assets;

Innovative perpetual debt instruments eligible for inclusion in Tier 1 capital,

which comply with the regulatory requirements

Perpetual non cumulative Preference shares (PNCPS), which comply with the

regulatory requirements

Any other type of instrument generally notified by the RBI from time to time foe

inclusion in Tier 1 capital

Limits in eligible Tier 1 capital

The innovative perpetual debt instruments (IPDIs), eligible to be reckoned as Tier

1 capital, will be limited to 15% of total Tier 1 capital as on march 31 of the

previous FY. The above limit will be based on the amount of Tier 1 capital as on

march 31 of the previous year, after deduction of goodwill, DTA and other

intangible assets but before the deduction on investments

The outstanding amount of tier 1 preference shares i.e Perpetual Non-Cumulative

preference shares along with Innovative Tier 1 instruments shall not exceed 40%

of total tier 1 capital at any point of time

Innovative instruments/ PNCPS, in excess of the limit shall be eligible for

inclusion under Tier 2, subject to limits prescribed for tier 2 capital

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Elements of the Tier 2 Capital

Revaluation Reserves

These reserves often serve as a cushion against unexpected losses, but they are less

permanent in nature and cannot be considered as ‘Core Capital’. Revaluation

reserves arise from revaluation of assets that are undervalued on the bank’s books,

typically bank premises. The extent to which the revaluation reserves can be relied

upon as a cushion for unexpected losses depends mainly on the level of certainty

that can be placed on estimates of the market values of the relevant assets, the

subsequent deterioration in values under difficult market conditions or in forced

sale, potential for actual liquidation at those values, tax consequences of

revaluation, etc. Therefore it would be prudent to consider revaluation reserves at

a discount of 55% while determining their value for inclusion in Tier 2 capital.

Such reserves will have to be reflected on the face of the balance sheet as

revaluation reserves.

General Provisions and loss reserves

such reserves, if they are not attributable to the actual diminution in value or

identifiable potential loss in any specific asset and are available to meet

unexpected losses, can be included in Tier 2 capital. Adequate care must be taken

to see that sufficient provisions have been made to meet all known losses and

foreseeable potential losses before considering general provisions and loss

reserves to be part of Tier 2 capital. Banks are allowed to include the General

provisions on Standard Assets, Floating Provisions, Provisions held for country

Exposures, investment Reserve account and excess provisions which arise on

account of sale of NPAs in Tier 2 capital. However, these five items will be

admitted as tier 2 capital up to a maximum of 1.25 % of the total risk-weighted

assets.

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Hybrid debt Capital Instruments

In this category, fall a number of debt capital instruments, which combine

characteristics of equity and certain characteristics of debt. Each has a particular

feature, which can be considered to affect its quality as capital. Where these

instruments have close similarities to equity, in particular when they are able to

support losses on an ongoing basis without triggering liquidation, they may be

included in Tier 2 capital. Banks in India are allowed to recognise funds raised

through debt capital instrument which has a combination of characteristics of both

equity and debt, as Tier 2 capital provided the instrument complies with the

regulatory requirements. Indian banks are also allowed to issue Perpetual

Cumulative Preference Shares (PCPS), Redeemable Non-Cumulative Preference

Shares (RNCPS) and Redeemable Cumulative Preference Shares (RCPS), as

Upper Tier 2 Capital, subject to extant legal provisions as per guidelines.

Subordinated Debt

To be eligible for inclusion in Tier 2 capital, the instrument should be fully paid-

up, unsecured, subordinated to the claims of other creditors, free of restricted

clauses, and should not be redeemable at the initiative of the older or without the

consent of the RBI. They often carry a fixed maturity, and as they approach

maturity, they should be subject to progressive discount, for inclusion in Tier 2

capital. Instruments with an initial maturity of less than 5 years or with a

remaining maturity of one year should be included as part of Tier 2 capital.

Subordinated debt instruments eligible to be reckoned as tier 2 capital.

Innovative Perpetual Debt Instruments (IPDI) and Perpetual Non-Cumulative

Preference Shares (PNCPS)

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IPPDI in excess of 15% of Tier 1 capital may be include in Tier 2 capital, and

PNCPS in excess of the overall ceiling of 40% may be included under Tier 2

capital, subject to the limit prescribed for Tier 2 capital

INDUSTRY PROFILE

INTORDUCTION ABOUT THE INDUSTRY

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:A central bank issues money on behalf of a government, and regulates the money supply

a commercial bank accepts deposits and channels those deposits into lending activities,

either directly or through capital markets. A bank connects customers with capital deficits

to customers with capital surpluses on the world's open financial markets. A savings

bank, also known as a building society in Britain is only allowed to borrow and save from

members of a financial cooperative. Banking in India originated in the last decades of

the 18th century. The first banks were The General Bank of India, which started in 1786,

and Bank of Hindustan, which started in 1790; both are now defunct. The oldest bank in

existence in India is the State Bank of India, which originated in the Bank of Calcutta in

June 1806, which almost immediately became the Bank of Bengal. This was one of the

three presidency banks, the other two being the Bank of Bombay and the Bank of

Madras, all three of which were established under charters from the British East India

Company. For many years the Presidency banks acted as quasi-central banks, as did their

successors. The three banks merged in 1921 to form the Imperial Bank of India, which,

upon India's independence, became the State Bank of India

Banking is generally a highly regulated industry, and government restrictions on financial

activities by banks have varied over time and location. The current set of global bank

capital standards is called Basel II. In some countries such as Germany, banks have

historically owned major stakes in industrial corporations while in other countries such as

the United States banks are prohibited from owning non-financial companies. In Japan,

banks are usually the nexus of a cross-share holding entity known as the keiretsu. In

Iceland banks followed international standards of regulation prior to the 2008 collapse.

Indian banking system is control by an apex banking institution. Its RESERVE BANK

OF INDIA. It is an authorized body which structured down all the banking rules and

regulations in India. It provide many valuable in formations regarding all operation of all

banks working in India. It safeguards the interest of all customers and all banks.

RESERVE BANK dealing directly with individuals and small businesses; business

banking, providing services to mid-market business; corporate banking, directed at large

Page | 37

business entities; private banking, providing wealth management services to high net

worth individuals and families; and investment banking, relating to activities on the

financial markets

HISTORY OF BANKING

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Indian merchants in Calcutta established the Union Bank in 1839, but it failed in 1848 as

a consequence of the economic crisis of 1848-49. The Allahabad Bank, established in

1865 and still functioning today, is the oldest Joint Stock bank in India.(Joint Stock

Bank: A company that issues stock and requires shareholders to be held liable for the

company's debt) It was not the first though. That honor belongs to the Bank of Upper

India, which was established in 1863, and which survived until 1913, when it failed, with

some of its assets and liabilities being transferred to the Alliance Bank of Simla.

When the American Civil War stopped the supply of cotton to Lancashire from the

Confederate States, promoters opened banks to finance trading in Indian cotton. With

large exposure to speculative ventures, most of the banks opened in India during that

period failed. The depositors lost money and lost interest in keeping deposits with banks.

Subsequently, banking in India remained the exclusive domain of Europeans for next

several decades until the beginning of the 20th century.

Foreign banks too started to arrive, particularly in Calcutta, in the 1860s. The Comptoire

d'Escompte de Paris opened a branch in Calcutta in 1860, and another in Bombay in

1862; branches in Madras and Puducherry, then a French colony, followed. HSBC

established itself in Bengal in 1869. Calcutta was the most active trading port in India,

mainly due to the trade of the British Empire, and so became a banking centre.

The first entirely Indian joint stock bank was the Oudh Commercial Bank, established in

1881 in Faizabad. It failed in 1958. The next was the Punjab National Bank, established

in Lahore in 1895, which has survived to the present and is now one of the largest banks

in India.

Around the turn of the 20th Century, the Indian economy was passing through a relative

period of stability. Around five decades had elapsed since the Indian Mutiny, and the

social, industrial and other infrastructure had improved. Indians had established small

banks, most of which served particular ethnic and religious communities.

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The presidency banks dominated banking in India but there were also some exchange

banks and a number of Indian joint stock banks. All these banks operated in different

segments of the economy. The exchange banks, mostly owned by Europeans,

concentrated on financing foreign trade. Indian joint stock banks were generally under

capitalized and lacked the experience and maturity to compete with the presidency and

exchange banks. This segmentation let Lord Curzon to observe, "In respect of banking it

seems we are behind the times. We are like some old fashioned sailing ship, divided by

solid wooden bulkheads into separate and cumbersome compartments."

The period between 1906 and 1911, saw the establishment of banks inspired by the

Swadeshi movement. The Swadeshi movement inspired local businessmen and political

figures to found banks of and for the Indian community. A number of banks established

then have survived to the present such as Bank of India, Corporation Bank, Indian Bank,

n Bank of Baroda, Canara Bank and Central Bank of India.

The fervour of Swadeshi movement lead to establishing of many private banks in

Dakshina Kannada and Udupi district which were unified earlier and known by the name

South Canara ( South Kanara ) district. Four nationalised banks started in this district

and also a leading private sector bank. Hence undivided Dakshina Kannada district is

known as "Cradle of Indian Banking".

During the First World War (1914-1918) through the end of the Second World War

(1939-1945), and two years thereafter until the independence of India were challenging

for Indian banking. The years of the First World War were turbulent, and it took its toll

with banks simply collapsing despite the Indian economy gaining indirect boost due to

war-related economic activities

POST-INDEPENDENCE

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The partition of India in 1947 adversely impacted the economies of Punjab and West

Bengal, paralyzing banking activities for months. India's independence marked the end of

a regime of the Laissez-faire for the Indian banking. The Government of India initiated

measures to play an active role in the economic life of the nation, and the Industrial

Policy Resolution adopted by the government in 1948 envisaged a mixed economy. This

resulted into greater involvement of the state in different segments of the economy

including banking and finance. The major steps to regulate banking included:

The Reserve Bank of India, India's central banking authority, was nationalized on

January 1, 1949 under the terms of the Reserve Bank of India (Transfer to Public

Ownership) Act, 1948 (RBI, 2005b).[Reference www.rbi.org.in]

In 1949, the Banking Regulation Act was enacted which empowered the Reserve

Bank of India (RBI) "to regulate, control, and inspect the banks in India."

The Banking Regulation Act also provided that no new bank or branch of an

existing bank could be opened without a license from the RBI, and no two banks

could have common directors.

NATIONALISATION

Despite the provisions, control and regulations of Reserve Bank of India, banks in India

except the State Bank of India or SBI, continued to be owned and operated by private

persons. By the 1960s, the Indian banking industry had become an important tool to

facilitate the development of the Indian economy. At the same time, it had emerged as a

large employer, and a debate had ensued about the nationalization of the banking

industry. Indira Gandhi, then Prime Minister of India, expressed the intention of the

Government of India in the annual conference of the All India Congress Meeting in a

paper entitled "Stray thoughts on Bank Nationalization." The meeting received the paper

with enthusiasm.

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Thereafter, her move was swift and sudden. The Government of India issued an

ordinance and nationalised the 14 largest commercial banks with effect from the midnight

of July 19, 1969. Jayaprakash Narayan, a national leader of India, described the step as a

"masterstroke of political sagacity." Within two weeks of the issue of the ordinance, the

Parliament passed the Banking Companies (Acquisition and Transfer of Undertaking)

Bill, and it received the presidential approval on 9 August 1969.

A second dose of nationalization of 6 more commercial banks followed in 1980. The

stated reason for the nationalization was to give the government more control of credit

delivery. With the second dose of nationalization, the Government of India controlled

around 91% of the banking business of India. Later on, in the year 1993, the government

merged New Bank of India with Punjab National Bank. It was the only merger between

nationalized banks and resulted in the reduction of the number of nationalised banks from

20 to 19. After this, until the 1990s, the nationalised banks grew at a pace of around 4%,

closer to the average growth rate of the Indian economy.

ORIGIN OF THE WORD

The word bank was borrowed in Middle English from Middle French banque, from Old

Italian banca, from Old High German banc, bank "bench, counter". Benches were used as

desks or exchange counters during the Renaissance by Florentine bankers, who used to

make their transactions atop desks covered by green tablecloths.

The earliest evidence of money-changing activity is depicted on a silver Greek drachm

coin from ancient Hellenic colony Trapezus on the Black Sea, modern Trabzon, c. 350–

325 BC, presented in the British Museum in London. The coin shows a banker's table

(trapeza) laden with coins, a pun on the name of the city. In fact, even today in Modern

Greek the word Trapeza (Τράπεζα) means both a table and a bank.

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DEFINITION

Under English common law, a banker is defined as a person who carries on the business

of banking, which is specified as: conducting current accounts for his customers paying

cheques drawn on him, and collecting cheques for his customers

"Banking business" means the business of receiving money on current or deposit account,

paying and collecting cheques drawn by or paid in by customers, the making of advances

to customers, and includes such other business as the Authority may prescribe for the

purposes of this Act; (Banking Act (Singapore), Section 2, Interpretation).

INDIAN BANKING INDUSTRY

The growth in the Indian Banking Industry has been more qualitative than

quantitative and it is expected to remain the same in the coming years. Based on the

projections made in the "India Vision 2020" prepared by the Planning Commission and

the Draft 10th Plan, the report forecasts that the pace of expansion in the balance-sheets

of banks is likely to decelerate. The total assets of all scheduled commercial banks by

end-March 2010 is estimated at Rs 40,90,000 crores. That will comprise about 65 per

cent of GDP at current market prices as compared to 67 per cent in 2002-03. Bank assets

are expected to grow at an annual composite rate of 13.4 per cent during the rest of the

decade as against the growth rate of 16.7 per cent that existed between 1994-95 and

2002-03. It is expected that there will be large additions to the capital base and reserves

on the liability side.

The Indian Banking Industry can be categorized into non-scheduled banks and scheduled

banks. Scheduled banks constitute of commercial banks and co-operative banks. There

are about 67,000 branches of Scheduled banks spread across India. As far as the present

scenario is concerned the Banking Industry in India is going through a transitional phase.

The Public Sector Banks(PSBs), which are the base of the Banking sector in India

account for more than 78 per cent of the total banking industry assets. Unfortunately they

Page | 43

are burdened with excessive Non Performing assets (NPAs), massive manpower and lack

of modern technology. On the other hand the Private Sector Banks are making

tremendous progress. They are leaders in Internet banking, mobile banking, phone

banking, ATMs. As far as foreign banks are concerned they are likely to succeed in the

Indian Banking Industry.

In the Indian Banking Industry some of the Private Sector Banks operating are IDBI

Bank, ING Vyasa Bank, SBI Commercial and International Bank Ltd, Bank of Rajasthan

Ltd. and banks from the Public Sector include Punjab National bank, Vijaya Bank, UCO

Bank, Oriental Bank, Allahabad Bank among others. ANZ Grindlays Bank, ABN-AMRO

Bank, American Express Bank Ltd, Citibank are some of the foreign banks operating in

the Indian Banking Industry.

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COMPANY PROFILE

PROFILE OF SOUTH INDIAN BANK LTD

The South INDIAN Bank Ltd is one of the leading scheduled commercial banks in India

having their head office at Thrissur, Kerala with a strong focus technology and service

culture. The South Indian Bank Ltd was incorporated on January 25, 1929 in Thrissur,

Kerala. One of the earliest banks in South India, “South Indian Bank” came into being

during the swadeshi movement. The establishment of the bank was the fulfillment of the

dreams of a group of enterprising men who joined together at Thrissur , a major

town(now known as Cultural Capital of Kerala), in the erstwhile state of cochin to

provide for the people a safe, efficient and service oriented repository of savings of the

community on one hand and to free the business community from the clutches of greedy

money lenders on the other by providing need based credit at reasonable rates of interest.

They became a scheduled bank in 1946.With 44 shareholders and paid up capital of

Rs.22000/- the bank started functioning as a private limited company. The south Indian

bank Ltd has its administrative office at Thrissur. They have implemented, Sibertech

which runs on Finacle platform provided by Infosys Technologies Limited. All the

branches in the major cities are covered under this project. The bank delivers their

products and services through a variety of channels ranging from our extensive branch

network, extension counter, ATM centers, Internet banking and mobile banking. The

bank provides a range of retail banking and commercial banking products to their

customers. Their retail banking portfolio include housing loans, auto loans, educational

loans and other personal loans. They offer deposit services like savings, demands and

time deposit to customers. They have technological products like Global debit card, credit

card, anywhere banking facility, mobile banking and internet banking to serve their

customers. They have arrangements to distribute third party products such as Life and

non life insurance products. They also offer various commercial banking products to their

commercial and corporate customers like Term loans, short loans, cash credit, working

capital finance, Export credit, Bill discounting, Letter of credit and guarantees. In

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addition they have specialized products to satisfy the needs of the agriculture sector like

SIB planters choice, which offers to an agriculturist to purchase land and SIB Agriflex

loan for land development. They provide depository services and are depository

participant for land development.

They provide depository services and depository participant for central depository

services (India) limited.

Vision 

To emerge as the most preferred bank in the country in terms of brand, values, principles

with core competence in fostering customer aspirations, to build high quality assets

leveraging on the strong and vibrant technology platform in pursuit of excellence and

customer delight and to become a major contributor to the stable economic growth of the

nation.

Mission 

To provide a secure, agile, dynamic and conducive banking environment to customers

with commitment to values and unshaken confidence, deploying the best technology,

standards, processes and procedures where customer convenience is of significant

importance and to increase the stakeholders’ value..

OBJECTIVES OF SIB:

To establish and carry on the business of banking at the registered office of the

company and at various branches, agencies and offices.

Carrying on the business of accepting deposits of money on current amount or

otherwise subject to withdrawal by cheque, draft or order and carry on the

business of banking in all its branches and departments.

Act as the agent of the government or local authorities or any other persons

carrying on agency business of any discipline other than the business of

management agents.

Page | 46

Contracting for public and private loans and negotiating and issuing the same.

The borrowing , raising or taking up money, the lending or advancing of money

either upon or without security, the drawing, accepting, discounting, buying,

selling, collecting and dealing in Bills of Exchange, promissory notes, coupons

and other instruments and securities the buying selling, dealing in foreign

exchange, dealing in other instruments like share, bonds etc.

Carrying out all such things as are identical or conductive to the promotion or

advancement of the business of the company.

To undertake and carry on all other forms of business as may be permissible for

banking company.

DEPARTMENTAL ANALYSIS

There are various departments functioning in the bank. The bank operates through these

departments. The centre of all activities is the head office situated in Thrissur. Regional

offices coordinate the activities of various branches in each region. Presently SIB has 16

regional offices. The various departments in bank are:

1. Planning and Development Department:

This department provided the entire infrastructure for the bank. They do corporate

planning and make plans for the mobilization and growth of deposits. The department is

maintaining public relation and plans all types of advertisements for banks. Their

function is to make plans for the development of the business of the bank.

2. Premises and maintenance

This department provides all infrastructure services of the bank. They do maintenance of

the buildings of the bank. They fix rent for the buildings. They are also engaged in the

provision of buildings for banking activities and also the provision of furniture and all

other infrastructure facilities.

3. Corporate Finance Management Department:

Page | 47

This department prepares the investment portfolio of the bank. They are undertaking the

profit planning at corporate level. They are having the responsibility of submission of

control returns to RBI. They also undertake the audit functions of the bank.

4. Secretarial Department:

This department conducts all secretarial activities. They conduct board meetings,

publishing of balance sheet etc.

5. Credit Control Department:

This department undertakes the credit functioning of the bank. They also undertake the

monitoring of the loans given. They also ensure the recovery of the loan.

6. Inspection Department:

The inspection activities of the bank are done here. They review and update the systems

and procedures of the bank.

7. Accounts Department:

They keep the various branch accounts and are undertaking the reconciliation of branch

account. They maintain records of provident fund of employees.

8. Vigilance Department:

They undertake all safety measures. They are responsible for the safety activities.

9. Legal Department:

This department deals with the legal aspects of the bank. They mainly deal with the

matters of loan recovery. In case of loan recovery, the branch managers have to inform

the details of the legal department. The department will take immediate and appropriate

decisions and will file the suit if necessary.

10. Integrated Risk Management Department:

Page | 48

This department deals with the management of various risks in banking industry like

credit risk, market risk, operational risk etc. This department makes internal rating for

various accounts and helps in the reduction of risk associated with advances. This

department is also dealing with the calculation of capital adequacy ratio(Basel II)

requirements as per RBI guidelines. IRMD is responsible for setting up the appropriate

risk control mechanism, quantity and monitor risks, the planning and finance sections are

responsible for allocating risk capital to business units, after assessing return and taking

input on risk management departments. CFM department would be responsible for

developing the transfer pricing mechanism.

The risk management department has been established to supervise risk from a Bank

wide perspective, and committees have been formed that includes members of

management to take responsibilities for various forms of risk with the goals of

strengthening risk management and control.

Details of risk governance framework is designed keeping in mind the RBI guideline,

Basel II guidelines such as the requirement of insuring independence of risk management

section, i.e. the role of risk management should not be biased by consideration of profits

or performance evaluation and international good practices.

RISK GOVERNANCE STRUCTURE OF SOUTH INDIAN BANK

Page | 49

Board of Directors

Risk management Committee of Board

Credit Risk Management Committee Market Risk Management CommitteeOperational Risk Management Committee

Asset Liability Management Committee (ALCO)

Chief Risk Officer and General Manager

Credit Risk Management cell

Market Risk Management cell

Operational Risk Management Cell

Asset Liability Management cell Market Risk Cell including mid-office at Treasury, IBD

CREDIT RISK MANAGEMENT POLICY OF SOUTH INDIAN BANK LTD

CREDIT RISK MANAGEMENT:

Risk management can be defined as systematic identification and analysis of various loss

exposures faced by a firm/individual and the best methods of treating the identified loss

exposures consistent with the firm/individuals objectives. Credit risk management as a

process that puts in place systems and procedures enabling a bank to:

> Identify and measure the risk involved in a credit proposition, both at the individual,

transaction and portfolio level.

> Evaluate the impact of exposure on banks balance sheet or profits.

Page | 50

> Asses the capability of this mitigation to hedge or insure risks.

> Design and appropriate risk management strategy to arrest ‘risk migration’ leading to

deterioration in the credit quality.

It helps banks in discriminating loan accounts on the basis of risk characteristics at entry

level besides paying way for timely exit at the portfolio level. In short it helps banks in

minimizing the losses that could emanate from counter party default or concentration risk

at portfolio level. The choice of appropriate strategies for control of credit risk by

individual bank depends on their priorities and risk appetites.

Page | 51

CREDIT RISK MANAGEMENT STRUCTURE

Page | 52

Chief Risk Officer

AGM/CM

Credit Risk Management- Basel II implications, risks warehousing, analytics & validation manager/assistant manager

Credit Risk Assessment Manager/ Assistant Manager

Credit Risk Modelling Manager/ Assistant Manager

RISK MANAGEMENT AND BASEL II AT SOUTH INDIAN BANK

In the present volatile and rapidly changing financial scenario, it is imperative to have

good risk management practices not only to manage risks inherent in the banking

business but also the risks emanating from financial markets as a whole. During the year

the risk management structure of the Bank was further strengthened to enable it to

proactively identify and help in controlling the credit, operational and market risks faced

by the Bank, while maintaining proper trade-off between risk and return thereby

maximizing the shareholder value. The Bank's risk management structure is overseen by

the Board of Directors and appropriate policies to manage various types of risks are

approved by Risk Management Committee of Board (RMC), which provides strategic

guidance while reviewing portfolio behavior. The senior level management committees

like Credit Risk Management Committee (CRMC), Market Risk Management Committee

(MRMC) and Operational Risk Management Committee (ORMC) develop the risk

management policies and vet the risk limits. The Asset Liability Management

Committee, Credit Policy Planning and Intelligence Committee and Investment

Committee ensure adherence to the implementation of the above risk management

policies, and develop Asset Liability Management policy, Credit policy and Investment

policy within the above risk framework. The risk management policies have laid down

risk management processes to identify, measure and mitigate the risks to bring the risks

within the tolerance level. The Bank has already migrated to Basel II during FY 08-09

and assesses the capital adequacy for credit risk under Standardized Approach, market

risk under Standardized Measurement Method and operational risk under Basic Indicator

Approach. To address the issues of Pillar II, the Bank has implemented ICAAP

framework (Internal Capital Adequacy Assessment Process) for integrating capital

planning with budgetary planning and to capture the residual risks which are not

addressed in pillar I like credit concentration risk, interest rate risk in the banking book,

Page | 53

liquidity risk, earnings risk, strategic risk, reputation risk etc. For adhering to market

discipline as laid down in pillar III of Basel II guidelines, the Bank has adopted a

common framework for disclosures. This requires the Bank to disclose its risk exposures,

risk assessment processes and its capital adequacy to the market in a more consistent and

comprehensive manner.

Page | 54

CHAPTER III

RESULTS OF THE ANALYSIS

This chapter is devoted to discuss the results of the analysis in detail:

Calculation of Tier 1 Capital of South Indian Bank for the year 2010-11

TABLE NO: 1

PARTICULARS AMOUNT TOTAL

PAID UP CAPITAL 11300.65 11300.65

FORFEITED SHARES 0

SHARE PREMIUM ACCOUNT 51129.02 51129.02

STATUTORY RESERVE- RESERVE FUND 35841.36

CAPITAL RESERVE 3652.61

GENERAL RESERVE 65728.96

DEVELOPMENT RESERVE 0

CONTIGENCY RESERVE 0

FOREIGN EXCHANGE FLUCTUATION

RESERVE 0

DIVIDENT EQUALIZATION RESERVE 0

TOTAL RESERVE 105222.9

P & L APPROPRIATION 143.84 143.84

TOTAL 167796.4

LESS DEDUCTIONS 2773.41

TIER 1 CAPITAL 165023

(in laks)

Page | 55

Inference: Total Tier 1 capital of SIB is Rs 165023cr. Among that total paid up capital

amounts to be 11300.65. Share premium account shows Rs. 51129.02cr where as various

reserves such as statutory reserve, capital reserve and general reserve show balances

amount to Rs. 105222.9cr. Rs. 143.84cr have been appropriated from the P & L a/c

Calculation of Tier 2 Capital of South Indian Bank for the year 2010-11

TABLE NO: 2

PARTICULARS AMOUNT TOTAL

ASSET REVALUATION RESERVE 6822.97

INVESTMENT FLUCTUATION RESERVE 1557.28

UNDISCLOSED RESERVES

PROVISION FOR STANDARD ASSETS 9144.2

SUBORDINATED TERM DEBT 22600

TOTAL 40124.45

Inference: Total Tier II capital of South Indian Bank amounts to be Rs 40124.45cr.

Various items included in Tier II capital are asset revaluation reserve, investment

fluctuation reserve, provisions for standard assets and subordinated terms debt. More than

50% of the total Tier II capital is contributed by subordinated term debt which amounts to

be Rs 22600cr.

Page | 56

RETURN ON CAPITAL ADEQUACY AS PER BASEL 2 AS ON 31-03-2011

ASSET ITEMS

TABLE NO: 3

CASH AND BALANCES WITH

BANK NET VALUE RW%

RISK ADJUSTED

VALUE

CASH AND RBI 182819.11 0 0

CLAIMS ON BANKS AND

NOTIFIED PFI 61861.5 20% 12372.3

CLAIMS ON FOREIGN BANKS 1932

As per

WN 693.3

TOTAL 13065.6

Inference: According to RBI guide lines on Basel II, cash deposited in RBI attracts no

risk weight where as claims on banks and notified PFIs invite 20% risk weight.

TABLE N0: 4

INVESTMENTS

NET

VALUE RW

RISK

ADJUSTED

VALUE

SLR INVESTMENTS SECURITIES

ISSUED/ (GOI) 605931.15 0% 0

SLR INVESTMENTS

SECURITIES/OTHER APPROVED 1118.74 20% 223.748

ODS-OTHER SECURITIES 0 20% 0

ODS-APPROVED SECURITIES 0 0 0

Page | 57

ODS-SUBORDINATED DEBT 0 100% 0

ODS-SIDBI/NABARD 58545.18 100% 58545.18

ODS-ALL OTHER INVESTMENTS 0 100% 0

RATED – AAA 0 20% 0

AA 0 30% 0

AA 0 50% 0

BBB 0 100% 0

UNRATED 0 100% 0

CERTIFICATE OF DEPOSITS-

BANKS 0 20% 0

EQUITIES 24.5 125% 30.625

TOTAL 58799.553

Inference: Unlike that of Basel I norms, under new accord investments attracts different

risk weight according to the ratings. Investments rated AAA attracts only 20% risk

weight of the value. At same time BBB rated investments and unrated investments

attracts 100% risk weight. If the bank has investments in equities, it has the highest risk

weight of 125%.

TABLE NO: 5

LOANS AND ADVANCES (Performing

assets)

NET

VALUE RW

RISK

ADJUSTEDVALU

E

CLAIMS ON CENTRAL GOVT- FOOD

CREDIT 37702 0% 0

DIRECT LOAN/CREDIT OVERDRAFT

EXPOSURE TO STATE 0 0% 0

Page | 58

CENTRAL GOVT GUARANTEED

ADVANCE 0 0% 0

STATE GOVT GUARANTEED

ADVANCE 67045.39 20% 13409.078

BILLS PURCHASED UNDER OTHER

THAN OWN LC/AC 287391.24 20% 57478.248

BILLS PURCHASED INCLUDING

OWN BANK LC/AC 37701.29 100% 37701.29

DICGC GUARANTEED COVERED

CREDIT 39.05 0% 0

DICGC GUARANTEED UN COVERED

CREDIT 26.04 100% 26.04

ECGC GUARANTEED COVERED

CREDIT 27257.87 20% 5451.574

ECGC GUARANTEED UN COVERED

CREDIT 13300.5 100% 13300.5

HOUSING LOAN 0

LOAN TO VALUE=LESS THAN 75%

SL LESS THAN 30 LAC 87384.84 50% 43692.42

LOAN TO VALUE=LESS THAN 75%

SL GTR THAN 30 LAC 13530.3 75% 10147.725

LOAN TO VALUE GRTE THAN 75% 3173.92 100% 3173.92

HOUSING LOAN ABOVE 75 LAC 2575.08 125% 3218.85

CONSUMER LOAN /AGAINST

SHARES 26502.01 125% 33127.5125

EDUCATIONAL LOANS 6435.2 75% 4826.4

ADVANCE TO ND-SI-NBFC 60476.45 100% 60476.45

ADVANCE TO OWN STAFF

MEMBERS 17896.82 20% 3579.364

Page | 59

RESTUCTURD ADVANCES 41206.28 125% 51507.85

COMMERCIAL REAL ESTATES 12844.32 100% 12844.32

FULLY SECURED LOANS AGAINST

LIP,NSC,IVP,KVP etc. 0 75% 0

GOLD LOAN 109939.91 125% 137424.8875

OTHER REGULATORY RETAIL

PORTFOLIO 425631.42 75% 319223.565

Inference: Under Basel II norms consumer loan (against shares) and housing loans (above

75lac) attracts high risk weight of 125%.Advances which attracts zero weights are those

advances to central and state government (direct loan, overdraft, claims, guaranteed

advance).

TABLE NO: 6

ADVANCES- RATED ITEMS

NET

VALUE RW%

RISK

ADJUSTED

VALUE

AAA 33970.37 20% 6794.074

AA 36795.41 30% 11038.623

PR1 8281.92 30% 2484.576

PR2 8874.27 50% 4437.135

PR4 and Lower 0 150% 0

A 78910.97 50% 39455.485

BBB 66931.32 100% 66931.32

BELOW BB 16508.78 150% 24763.17

ALL OTHER LOANS AND ADVANCES 86761.57 100% 86761.57

Page | 60

Inference: loans and advances to various firms, companies and institutions rated AAA

invites 20% risk weight. Lower rated firms (below BB and PR4) fetch high risk weight of

150%.

ADVANCES TOTAL 1053275.947

NON PERFORMING ADVANCES

TABLE NO: 7

NON PERFORMING ADVANCES

NET

VALUE RW

RISK

ADJUSTED

VALUE

WHERE SPECIFIC PROVISION IS LESS

THAN 20% 5661.39 150% 8492.085

WHERE PROVISION GRTR THAN 20%

LESS THAN 50% 734.66 100% 734.66

WHERE PROVISION GREATER THAN

50% -1749.05 50% 0

NPA ON HL WHERE PROVISION IS LESS

THAN 20% 1128.59 100% 1128.59

NPA ON HL WHERE PROVISION IS

GRTR THAN 20% & LESS THAN 50% 222.41 75% 166.8075

NPA ON HL WHERE PROVISION IS

GREATER THAN 50% 3.5 50% 1.75

TOTAL 10523.8925

TOTAL(TOTAL ADVANCES + TOTAL

NPA) 1063799.84

Page | 61

Inference: from the above table we can generalize that risk weight on NPAs depends on

how much specific provision created for each NPA. Higher the provision lesser the risk

weight.

TABLE: 8

UNAVAILED PORTION OF CREDIT

NET

VALUE RW RAV

STAFF ADVANCE 498.9 20% 99.78

MERCANTILE CREDIT 486.11 75% 364.5825

OTHER ADVANCES 44651.79 100% 44651.79

TOTAL 45116.1525

TOTAL 1249941.72

Inference: other un availed portion of credit includes staff advance, mercantile credit and

other advances which fetch risk weight of 20%, 75% and 100% respectively.

FIRST PILLAR : MINIMUM CAPITAL REQUIREMENT

The first pillar establishes a way to quantify the minimum capital requirements. The main

objective of Pillar I is to align capital the adequacy ratios to the risk sensitivity of the

assets affording a greater flexibility in the computation of banks' individual risk

.

Capital Adequacy Ratio is defined as the amount of regulatory capital to be maintained

by a bank to account for various risks inbuilt in the banking system. The focus of Capital

Adequacy Ratio under Basel I norms was on credit risk and was calculated as follows:

Page | 62

Tier I Capital + Tier II Capital

Capital Adequacy Ratio = -----------------------------------

Risk Weighted Assets

Basel Committee has revised the guidelines in the year June 2001 known as Basel II

Norms.

Capital Adequacy Ratio in New Accord of Basel II:

Capital Adequacy Ratio = Total Capital (Tier I Capital + Tier II Capital)

------------------------------------------------------------------------------

Market Risk(RWA) + Credit Risk (RWA)+Operation Risk(RWA)

*RWA = Risk Weighted Assets

CALCULATION OF CAPITAL ADEQUACY RATIO:

TOTAL CAPITAL:

Total Capital constitutes of Tier I Capital and Tier II Capital less shareholding in other

banks.

Tier I Capital = Ordinary Capital + Retained Earnings& Share Premium - Intangible

assets.

Tier II Capital = Undisclosed Reserves + General Bad Debt Provision+ Revaluation

Reserve+

Subordinate debt+ Redeemable Preference shares

Page | 63

BASEL II REQUIREMENTS ACCORDING TO RBI

TABLE NO: 9

Actual values

Capital to Risk Weighted Ratio

(CRAR)

9%

Tier 1 capital ratio 6%

CAPITAL ADEQUACY COMPUTATION UNDER BASEL 2 AS ON MARCH

2011 IN SOUTH INDIAN BANK

TABLE NO: 10

CAPITAL BASE Rs lacs

CORE (TIER ONE) CAPITAL (CC) 165023.06

SUPPLEMENTRY (TIER TWO) CAPITAL 40124.45

TOTAL CAPITAL (TC) 205147.51

TABLE: 11

RISK WEIGHTED ASSETS Rs lacs

ASSETS (funded-BANKING BOOK) 1249941.72

CONTIGENT CREDIT EXPOSURES 39816.64

FORWARD CONTRACTS/DERIVATIVES EXPOSURES 965.96

RISK WEIGHTED ASSETS FOR OPERATIONAL RISK 113063.69

OPEN POSITION LIMIT - CAPITAL CHARGE 1000

FOREIGN EXCHANGE 0

PRECIOUS METALS 0

TRADING BOOK 59863.9

Page | 64

TOTAL RISK WEIGHTED ASSETS (TRWA) 1464651.91

CRAR (%TC/TRWA) 14.01

CORE CRAR (%CC/TRWA) 11.26704979

CRAR- TIER 2 CAPITAL 2.739521229

Inference: Capital to Risk Weighted Assets Ratio of south Indian bank is very healthy

when compared to the base rate fixed by RBI on recommendations of Basel II. It depicts

the bank has sufficient regulatory capital to cover various kinds of risks.

1 2 3 413

13.5

14

14.5

15

15.5

16

CRAR : QUATERLY INFORMATION OF SIB

CRAR

FIGURE 1

INFERENCE:

Page | 65

Though the CRAR of SIB is exceptionally good, the management should take in to

account that the adequate capital of bank is diminishing throughout the quarters. In the

first quarter of the financial year the CRAR was about 16% and when the year ends it has

reduced to 14%.

CAPITAL TO RISK WEIGHTED ASSEST RATIO OF SIB (PREVIOUS YEARS)

Table No: 12

CRAR

YEAR CRAR

2008-09 17.35%

2009-10 17.86%

2010-11 14.01%

Inference :

It is clear from the above table that the CRAR retained by South Indian Bank is well

above the required rate under Basel II of 9%. During the FY 2010-11 it has reached the

maximum of 17.86%. But it should be noted that capital adequacy ratio of the bank has

come down from 17.86 to 14% this year.

Page | 66

2008-09 2009-10 2010-110.00%2.00%4.00%6.00%8.00%

10.00%12.00%14.00%16.00%18.00%20.00%

CRAR

CRAR

FIGURE 2 CRAR IF SIB

TIER I RATIO

Table No: 13

TIER I RATIO OF SIB

YEAR TIER IRATIO

2008-09 13.93%

2009-10 14.30%

2010-11 11.27%

Inference :

TIER I RATIO of the bank is 13.93 in 2008-09, in 2009-10 it is 14.30. In the present FY

it has reduced to 11.27%. It shows that the performance is far beyond the standard set

under of BASEL II NORMs of 6%.

Page | 67

2008-09 2009-10 2010-110.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

TIER IRATIO

TIER IRATIO

FIGURE: 3

TIER I RATIO

Table No: 14 TOTAL RATIO of SOUTH INDIAN BANK

YEAR CRAR TIER IRATIO TIER II RATIO

2008-09 17.35% 13.93% 3.42%

2009-10 17.86% 14.30% 3.57%

2010-11 14.01% 11.28% 2.74%

Inference :

The CRAR and TIER I RATIO of SIB are maintained according to BASEL II standards.

But in the case of TIER II RATIO.

Page | 68

CRAR TIER IRATIO TIER II RATIO0.00%2.00%4.00%6.00%8.00%

10.00%12.00%14.00%16.00%18.00%20.00%

2008-092009-102010-11

FIGURE 4 TOTAL RATIO of SOUTH INDIAN BANK

PILLAR 2

To address the issues of Pillar II, the Bank has implemented ICAAP framework (Internal

Capital Adequacy Assessment Process) during the year for integrating capital planning

with budgetary planning and to capture the residual risks which are not addressed in pillar

I like credit concentration risk, interest rate risk in the banking book, liquidity risk,

earnings risk, strategic risk, reputation risk etc.

PILLAR 3

For adhering to market discipline as laid down in pillar III of Basel II guidelines, the

Bank has adopted a common framework for disclosures. This requires the Bank to

disclose its risk exposures, risk assessment processes and its capital adequacy to the

market in a more consistent and comprehensive manner.

Page | 69

CAPITAL TO RISK WEIGHTED ASSEST RATIO OF STATE BANK OF INDIA

(PREVIOUS YEARS)

Table No: 14

CRAR

YEAR CRAR

2007-08 13.08

2008-09 14.40

2009-10 13.74

INTERPRETATION

This chart shows the capital to risk weighted asset ratio in STATE BANK OF INDIA is

13.08 during 2007-08 and 14.40 during 2008-09 and 13.74 during 2009-10. It is showing

that CRAR in STATE BANK OF INDIA is way above the CRAR of BASEL II i.e. 9%.

So the bank is adhering to Basel II norms.

2007-08 2008-09 2009-1012

12.5

13

13.5

14

14.5

15

13.08

14.4

13.74

CRAR

CRAR

FIGURE 5

Page | 70

TIER I RATIO

Table No: 16

TIER I RATIO

YEAR TIER IRATIO

2007-08 8.87%

2008-09 9.84%

2009-10 9.62%

Inference

This chart shows the performance of bank regarding the maintenances of Tier I capital.

During the period of 2007-08 the ratio was 8.87% and in next year it increased to 9.84%

and in 2009-10 the ratio has reduced to 9.62%.

2007-08 2008-09 2009-108.28.48.68.8

99.29.49.69.810

8.87

9.849.62

TIER I RATIO

TIER I RATIO

FIGURE No: 6

Page | 71

TOTAL RATIO

Table No: 17 Total Ratio of STATE BANK OF INDIA

YEAR CRAR TIER I RATIO TIER II RATIO

2007-08 13.83% 8.87% 4.21%

2008-09 14.40% 9.84% 4.56%

2009-10 13.74% 9.62% 4.12%

Inference:

The entire ratios showing the performance of STATE BANK OF INDIA as the Capital

Adequacy Ratio is going on in a suitable way during the last three years and also in the

case of Tier I ratio the values are increasing in a normal way according to BASEL II

NORMS

.

CRAR TIER I RATIO TIER II RATIO0

2

4

6

8

10

12

14

16

13.08

8.87

4.21

14.4

9.84

4.56

13.74

9.62

4.12

2007-082008-092009-10

FIGURE: 7

Page | 72

INDIAN BANK

The Capital adequacy ratio of INDIAN BANK for the past three years i.e. for 2007-2008,

2008 -2009,2009-2010 are represented graphically.

CAPITAL TO RISK WEIGTHED ASSET RATIO

Table No : 18

Table showing the CRAR of INDIAN BANK

YEAR CRAR

2007-08 13.05%

2008-09 13.98%

2009-10 12.81%

Inference:

This chart shows the capital to risk weighted asset ratio in INDIAN BANK is 13.05

during 2007-08, 13.98 during 2008-09 and 12.81 during 2009-10. It shows that CRAR in

INDIAN BANK is above the CRAR of BASEL II i.e. 9%. So the performing of bank is

good in its capital adequacy.

2007-08 2008-09 2009-1012

12.513

13.514

14.5

13.05

13.98

12.81

CRAR

Series1

FIGURE No: 8

Page | 73

TIER I RATIO

Table No: 19 TIER I RATIO

YEAR TIER I RATIO

2007-08 10.98%

2008-09 12.09%

2009-10 11.28%

Inference:

This chart shows the performance of bank regarding the maintenance of Tier I ratio of

INDIAN BANK. In this chart it shows that during the period of 2007-08 the ratio is 10.98

and in next year it increase to 12.09 and in 2009-10 the ratio reduces to 11.28. So this

graph saying that the TIER I RATIO retained by the bank is very good according to

BASEL II NORMS.

2007-08 2008-09 2009-1010.4

10.8

11.2

11.6

12

10.98

12.09

11.28

TIER I RATIO

PERCENTAGE

FIGURE No: 9

Page | 74

TOTAL RATIO

Table No: 20

TOTAL RATIO of INDIAN BANK

YEAR CRAR TIER I RATIO TIER II RATIO

2007-08 13.05% 10.98% 2.11%

2008-09 13.98% 12.09% 1.86%

2009-10 12.81% 11.28% 2.66%

Inference:

The entire ratios showing the performance of INDIAN BANK as the Capital Adequacy

Ratio is going on in a suitable way during the last three years and also in the case of Tier

I ratio the values are increasing in a normal way according to BASEL II NORMS

CRAR TIER I RATIO TIER II RATIO0

2

4

6

8

10

12

14

16

13.05

10.98

2.11

13.98

12.09

1.86

12.81

11.28

2.66

2007-082008-092009-10

FIGURE: 10

Page | 75

CANARA BANK

CAPITAL TO RISK WEIGHTED ASSEST RATIO

Table NO: 21

CRAR of CANARA BANK

YEAR CRAR

2007-08 13.45%

2008-09 14.44%

2009-10 13.02%

Inference :

The chart shows the performance of CAPITAL TO RISK WEIGHTED ASSEST RATIO

in Canara bank. It shows that the CRAR in 2007-08 is 13.45 and in 2008-09 it is 14.44%

and in the year of 2009-10 it is 13.02. According to the BASEL II NORMS the standards

set is 9%. And during these consecutive years the Bank performed very well in reaching

the base line.

2007-08 2008-09 2009-1012

12.5

13

13.5

14

14.5

15

13.45

14.44

13.02

CRAR

PERCENTAGE

FIGURE : 11

Page | 76

TIER I RATIO

Table No : 22

Table showing the TIER IRATIO

YEAR TIER IRATIO

2007-08 7.51%

2008-09 9.20%

2009-10 8.27%

Inference:

In this chart the TIER I RATIO is 7.51% in 2007-08 and 9.20 in 2008-09 and 8.27 in

2009-10. So it says that Canara Bank shows an overall good performance in maintaining

Tier I Ratio and it touched base line of BASEL II.

2007-08 2008-09 2009-100123456789

10

7.51

9.28.27

TIER I RATIO

PERCENTAGE

FIGURE NO: 12

Page | 77

TOTAL RATIO

Table No: 23

TOTAL RATIO of CANARA BANK

YEAR CRAR TIER I RATIO TIER II RATIO

2007-08 13.45% 7.50% 6.24%

2008-09 14.44% 9.20% 5.24%

2009-10 13.02% 8.27% 4.75%

INTERPRETATION

This chart shows that the overall performance of CANARA BANK is going on

well as base line set by BASEL Standards.

CRAR TIER I RATIO TIER II RATIO0

2

4

6

8

10

12

14

16

13.45

7.516.24

14.44

9.2

5.24

13.02

8.27

4.75

2007-082008-092009-10

FIGURE: 13

Page | 78

HDFC BANK

CAPITAL TO RISK WEIGHTED ASSEST RATIO

Table No: 24

CRAR of HDFC BANK

YEAR CRAR

2007-08 15.4%

2008-09 18.3%

2009-10 16.3%

Inference:

In this chart the CRAR of HDFC BANK is 15.4 % and in the year of 2008-09 it is 18.3%

and in the tear of 2009-10 it is 16.3%. So the performance of HDFC BANK is good

according to the BASEL II standards.

2007-08 2008-09 2009-1013

14

15

16

17

18

19

15.4

18.3

16.8

CRAR

PERCENTAGE

FIGURE:14

Page | 79

TIER I RATIO

Table No: 25

TIER I RATIO of HDFC BANK

YEAR TIER IRATIO

2007-08 10.6%

2008-09 13.8%

2009-10 12.1%

Inference:

The chart shows that the TIER I RATIO in 2008-09 is 10.6% and in the year of 2008-09

it is 13.8% and in the year of 2009-10 it is 12.1%. TIER I RATIO of HDFC BANK is

better according to BASEL II standards as the base line of Bank is beyond the BASEL II

Standards. It shows the efficiency of Bank in maintaining TIER I RATIO.

2007-08 2008-09 2009-1002468

10121416

10.6

13.812.1

TIER I RATIO

PERCENTAGE

FIGURE: 15

Page | 80

TOTAL RATIO

Table No: 26

TOTAL RATIO of HDFC BANK

YEAR CRAR TIER IRATIO TIER II RATIO

2007-08 15.4% 10.6% 4.8%

2008-09 18.3% 13.8% 4.5%

2009-10 16.3% 12.1% 4.7%

Inference:

Considering all the Ratios of HDFC BANK, bank’s performance is far better than the

standard set by BASEL II NORMS. As the CRAR of BASEL II is 9% and Bank shows a

performance of 15.4%, 18.3% and 16.3% in the last 3 consecutive years.

CRAR TIER I RATIO TIER II RATIO0

2

4

6

8

10

12

14

16

18

20

15.4

10.6

4.8

18.3

13.8

4.5

16.3

12.1

4.7

2007-082008-092009-10

FIGURE: 16

Page | 81

AXIS BANK

CAPITAL TO RISK WEIGHTED ASSEST RATIO

Table No: 27

CRAR of AXIS BANK

YEAR CRAR

2007-08 13.84%

2008-09 16.80%

2009-10 15.80%

Inference

The chart shows the CRAR of AXIS BANK. It shows that during the year of 2007-08 the

ratio is 13.84% and during the year of 2008-09 it is 16.80% and during the year of 2009-

10 the Ratio is 15.80 as against the Basel 2 norm of 9%.

2007-08 2008-09 2009-1002468

1012141618

13.84

16.815.8

CRAR

PERCENTAGE

FIGURE: 17

Page | 82

TIER I RATIO

Table No: 28

TIER I RATIO of AXIS BANK

YEAR TIER I RATIO

2007-08 9.46%

2008-09 11.83%

2009-10 11.18%

Inference:

The chart shows that the TIER I RATIO of AXIS BANK during the year of 2007-08 is

9.46% and during the year of 2008-09 it is 11.83% and during the year of 2009-10 it is

11.18%. It means that TIER I RATIO in 2007-08 is than the standards set by the BASEL

II NORMS but it increases in the next year to 11.83% and in 2009-10 it again increases to

11.18%.

2007-08 2008-09 2009-1002468

101214

9.46

11.83 11.18

TIER I RATIO

PERCENTAGE

FIGURE: 18

Page | 83

TOTAL RATIO

Table No: 29

Table showing the TOTAL RATIO of AXIS BANK

YEAR CRAR TIER IRATIO TIER II RATIO

2007-08 13.84% 9.46% 4.58%

2008-09 16.80% 11.83% 4.97%

2009-10 15.80% 11.18% 4.62%

Inference:

In this chart the Ratios of AXIS BANK are evaluated and it is seeing that the CRAR are

in a good position according to BASEL II NORMS.

CRAR TIER I RATIO TIER II RATIO0

2

4

6

8

10

12

14

16

18

12.84

9.46

4.58

16.8

11.83

4.97

15.8

11.18

4.62

TOTAL RATIO

2007-082008-092009-10

FIGURE: 19

Page | 84

TABLE NO: 30

SIB SBI INDIAN BANK

CANARA HDFC AXIS

Series1 0.166566666666667

0.1399 0.1328 0.136366666666667

0.166666666666667

0.1548

1.00%

3.00%

5.00%

7.00%

9.00%

11.00%

13.00%

15.00%

17.00%

MEAN CRAR FO INDIAN BANKS FOR THE PAST 3 YEARS

MEA

N C

RAR

INFERENCE:

During the past three years among the samples selected HDFC bank has the highest

Capital Adequacy Ratio which is almost double the prescribed rate of 9% under Basel 2

norms

Kerala based private sector bank South Indian bank have the second position.

It is interesting to note that those banks who maintained the highest CRAR were all from

private sector banks. It shows the better risk management implemented in those banks

when compared to public sector banks.

Page | 85

PILLAR II ANALYSIS

SUPERVISORY REVIEW PROCESS

SOUTH INDIAN BANK

The Bank has already migrated to Basel II during FY 08-09 and assesses the

capital adequacy for credit risk under Standardized Approach, market risk under

Standardized Measurement Method and operational risk under Basic Indicator

Approach.

To address the issues of Pillar II, the Bank has implemented ICAAP framework

(Internal Capital Adequacy Assessment Process) during the year for integrating

capital planning with budgetary planning and to capture the residual risks which

are not addressed in pillar I like credit concentration risk, interest rate risk in the

banking book, liquidity risk, earnings risk, strategic risk, reputation risk etc.

For adhering to market discipline as laid down in pillar III of Basel II guidelines,

the Bank has adopted a common framework for disclosures. This requires the

Bank to disclose its risk exposures, risk assessment processes and its capital

adequacy to the market in a more consistent and comprehensive manner.

INFORMATIONS GATHERED FROM PERSONNAL INTERVIEW

An interview schedule has been prepared in order to collect original data regarding the

significance and effectiveness of implementation of Basel II norms in Indian banks with

special reference to South Indian bank. The assistant manager in the Integrated Risk

Management Department of South Indian Bank has been interviewed to collect requisite

information. The resultant information are as follows:

1. The significance of the implementation of Basel II in India is high

Page | 86

2. The significance of the implementation of Basel II in south Indian bank is also

high

3. High priority have been attributed to the implementation of Basel II by the

management of South Indian bank

4. South Indian Bank considers the implementation of Basel II as an opportunity to

improve risk management process

5. The bank sees the use of internal models for risk management and for calculation

of capital requirements

6. The potential problems related to the implementation of Basel II standards is the

personnel training and information system development costs

7. The employees are familiar with basic documents and have solid knowledge

8. Employees are given internal- training within the bank

9. The competency of the employees engaged in the process of risk management is

good

10. 20 employees are engaged in credit risk management process in the bank whereas

5 and 3 employees are engaged in market risk and operational risk management

process.

11. The bank maintains a special team for the implementation of Basel II standards.

12. The existing IT infrastructure in the bank support Basel II requirements.

13. Foundation internal Rating Approach is using for measuring credit risk in the bank

14. Bank is also using internally developed methodology for identifying and

measuring credit risk for your internal needs

15. Standardized measurement approach method is being used by the bank for

measuring market risk

16. Basic indicator approach is being used by for measuring operational risk

17. The bank has formulated the ICAAP with the approval of the board

18. The outcomes of the ICAAP are periodically submitted to the board and RBI.

19. The outcomes of the ICAAP are reviewed by the board on a yearly basis

20. The disclosure practices in the bank expose all types of risks to some extend

Page | 87

CHAPTER IV

FINDINGS CONCLUSION AND SUGGESTIONS

FINDINGS

Project entitled “A study on the adoption of Basel II norms in Indian Banking sector with

special reference to South Indian Bank” probed how South Indian Bank have adopted

various measures in implementing Basel II norms and the current capital requirements of

Indian Banks in conformation to Basel II guidelines. The study begets the following

outputs.

1. Indian banks do well in maintaining required regulatory capital against various

risks.

2. The capital adequacy ratios upholding by Indian banks are higher than the base

ratio of 9% as per the Basel II requirements.

3. All the Indian banks have been migrated to Basel II as per the RBI guidelines

4. Among the samples selected the mean CRAR of Indian Banks for the past 3 years,

Private Banks maintained more regulatory capital when compared to nationalized

banks.

5. Among the samples selected HDFC bank have the highest mean CRAR for the

past 3 years of 16.67 followed by South Indian Bank having 16.66 mean CRAR

for the past 3 years

6. Indian bank has the lowest mean CRAR of 13.28 for the last 3 years

7. South Indian bank has the CRAR of 14.01% for the year 2010/11 which is

exceptionally good when compared to the Basel II requirement of 9%

8. The bank also have Tier I CRAR of 11.267% which is higher than the required

rate of 6%

Page | 88

9. But the CRAR of the bank is diminishing throughout the four quarters. In the first

quarter of the financial year the CRAR was about 16% and when the year ends it

has reduced to 14%.

10. In the previous year CRAR of the bank has touched the all time high of 17.86.

11. The competency of the employees engaged in the process of risk management is

good

12. The existing IT infrastructure in the bank support Basel II requirements.

13. By evaluating the overall performance of these three Nationalized Bank, STATE

BANK OF INDIA maintained more regulatory capital in terms of conformation to

BASEL II Standards than INDIAN BANK and CANARA BANK.

14. By evaluating the overall performance of Private Banks according to BASEL II

norms, all the banks did well especially HDFC and South Indian Bank

15. Investments in government securities, cash with RBI and investments having top

rating attracts less risk weight

16. Investments in equity shares fetch high risk weight

17. Advances which attracts zero weights are those advances to central and state

government (direct loan, overdraft, claims, guaranteed advance

18. Loans and advances to AAA rated institutions fetch lower risk weight compared to

lower rated and unrated companies

CONCLUSION

From the study it has been concluded that Indian banking sector is performing well in the

area of systematic risk management. Basel II norms have been successfully implemented

by all the banks following the RBI guide lines. The risk identification, risk analysis and

risk management process of south Indian bank is exceptionally good.

Page | 89

SUGGESTIONS

Banking industry in India is undergoing aggressive growth. So that banks needs to

maintain adequate regularity capital so as to protect itself from various types of

risk such as credit risk, market risk and operational risk

Basel II norms provide the banks to improve the risk management process. So

banks should follow the Basel II norms strictly.

Apart from stipulated rate of 9% CRAR banks are required to maintain 6% core

CRAR. For this strong equity capital base should be sustained other than external

and sub ordinate debts.

Employees should be given proper training in order to cope up with the changing

stipulations under Basel accord

IT infrastructure in the banks need to be more supportive for the implementation

of Basel II accord

Investment portfolio of the bank should be designed taking into consideration the

risk weight concerted with each and every investment opportunity

Minimize lending loans and advances to lower rated and unrated companies since

they fetch higher risk weights

Page | 90