Basel II and Financial StabilityBasel II and Financial StabilityImplementing the Revised FrameworkImplementing the Revised Framework

in Indiain India

ByByDr. Janak RajDr. Janak Raj

AdviserAdviserReserve Bank of IndiaReserve Bank of India

Bali, IndonesiaBali, IndonesiaSeptember 22, 2006September 22, 2006

Structure of Indian Financial SystemStructure of Indian Financial System

•• Financial InstitutionsFinancial InstitutionsBanks and other Financial InstitutionsBanks and other Financial Institutions

Insurance CompaniesInsurance CompaniesMutual FundsMutual Funds

•• Capital marketCapital market

Financial Institutions Regulated by RBI

5 %5 %21062106Limited and retail bankingLimited and retail bankingCoCo--operative operative BanksBanks

3 %3 %196196--Rural and agriculture financingRural and agriculture financing--Retail banking Retail banking

Regional Rural Regional Rural BanksBanks

2 %2 %875875--No No chequablechequable depositsdeposits--Leasing, hire purchase, loan & Leasing, hire purchase, loan & investment investment

NonNon--banking banking financial financial companiescompanies

8 %8 %88--No depositsNo deposits--LongLong--term / project financingterm / project financing

Financial Financial InstitutionsInstitutions

82%82%8989Full range of banking Full range of banking Commercial Commercial BanksBanks

Market Market shareshare

NumberNumberBusinessBusinessCategoryCategory

Major Financial Sector Reforms in IndiaMajor Financial Sector Reforms in India

•• First PhaseFirst Phase–– Prudential normsPrudential norms–– Reduction in statutory PreReduction in statutory Pre--emptionsemptions–– Deregulation of interest ratesDeregulation of interest rates–– Entry of private sector banksEntry of private sector banks–– Public sector banks allowed to access capital marketPublic sector banks allowed to access capital market–– Recapitalization of some banksRecapitalization of some banks–– Strengthening of recovery processStrengthening of recovery process–– Strengthening of supervisory frameworkStrengthening of supervisory framework–– Setting up of Board for Financial SupervisionSetting up of Board for Financial Supervision–– Strengthening of corporate governance practicesStrengthening of corporate governance practices

Major Financial Sector Reforms in IndiaMajor Financial Sector Reforms in India

•• Second PhaseSecond Phase–– FineFine--tuning of Prudential Norms tuning of Prudential Norms –– Capital Charge for Market Risk IntroducedCapital Charge for Market Risk Introduced–– Consolidated accounting and supervisionConsolidated accounting and supervision–– Adherence to all Core Principles for Effective Adherence to all Core Principles for Effective

Banking Supervision.Banking Supervision.–– Risk Based Approach Risk Based Approach –– Introduced on a pilot basisIntroduced on a pilot basis–– Prompt Corrective Action Prompt Corrective Action

Impact of ReformsImpact of Reforms-- Soundness ParametersSoundness Parameters

12.812.82.02.05.25.20.90.92.92.92.22.20404--0505

12.912.92.92.97.27.21.11.12.92.92.22.20303--0404

12.712.74.44.48.88.81.01.02.82.82.22.20202--0303

12.012.05.55.510.410.40.80.82.62.62.22.20101--0202

10.410.48.18.115.715.70.70.73.23.22.92.99696--9797

CRARCRARNNPA/NNPA/Net AdvNet Adv

GNPA/GNPA/GAGA

Net Net Profit/TAProfit/TA

SpreadSpread//TATA

Operating Operating

Exp./TAExp./TAYearYear

Improvement in CRAR and Asset Quality Improvement in CRAR and Asset Quality

02468

101214

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Gross NPAs* Net NPAs* CRAR* as ratio of advances

Implementing Basel II: Issues Faced Implementing Basel II: Issues Faced (Contd.)(Contd.)

•• GeneralGeneral–– Complex Framework Complex Framework –– High Level of Human Resource skillsHigh Level of Human Resource skills–– Accurate and wellAccurate and well--classified Historical Dataclassified Historical Data–– Entails Heavy CostsEntails Heavy Costs

Implementing Basel II: Issues Faced Implementing Basel II: Issues Faced ((Contd.)Contd.)

•• Specific to India Specific to India (contd.)(contd.)

–– Diverse Banking SystemDiverse Banking System•• Nature of operationsNature of operations•• Some banks internationally active, others notSome banks internationally active, others not•• Mix of small and big banks Mix of small and big banks •• Mix of very strong and not so strong banksMix of very strong and not so strong banks•• Diverse patterns of ownershipDiverse patterns of ownership•• Different levels of technology applicationDifferent levels of technology application•• Different levels of human resource capabilitiesDifferent levels of human resource capabilities

Implementing Basel II: Issues Faced Implementing Basel II: Issues Faced

•• Specific to India Specific to India

–– Extensive Branch NetworkExtensive Branch Network–– Most Banks lack a Robust Credit Rating FrameworkMost Banks lack a Robust Credit Rating Framework–– Insufficiently Developed Legal Framework Relating Insufficiently Developed Legal Framework Relating

to Enforcement of Collateralto Enforcement of Collateral

Implementation of Basel IIImplementation of Basel II-- Indian Approach Indian Approach (contd.)(contd.)

•• Commercial banks to adopt Basel II from March 2007Commercial banks to adopt Basel II from March 2007•• SA for credit risk and BIA for operational risk SA for credit risk and BIA for operational risk •• India adopting a three track approachIndia adopting a three track approach

–– Commercial Banks to adopt Basel II frameworkCommercial Banks to adopt Basel II framework–– Cooperative Banks to adopt Basel ICooperative Banks to adopt Basel I–– Regional Rural Banks to adhere to minimum capital Regional Rural Banks to adhere to minimum capital

requirementrequirement

•• Scope of ApplicationScope of Application-- Solo as well as Consolidated Solo as well as Consolidated BasisBasis

How Are We Preparing to Implement Basel II?How Are We Preparing to Implement Basel II?

•• Consultative ApproachConsultative Approach–– Formation of a Steering Committee Formation of a Steering Committee –– 14 banks, 14 banks,

Indian BanksIndian Banks’’ Association and RBI Association and RBI –– SubSub--groups of Steering Committee formed to address groups of Steering Committee formed to address

specific issues relating to:specific issues relating to:•• National discretionNational discretion•• Mapping of ratingsMapping of ratings•• Retail exposuresRetail exposures•• Credit risk mitigation,Credit risk mitigation,•• Pillar 3 aspectsPillar 3 aspects•• Issues relating to ICAAP of banksIssues relating to ICAAP of banks•• Issues relating to operational risk managementIssues relating to operational risk management

How Are We Preparing to Implement Basel II?How Are We Preparing to Implement Basel II?

•• Steps taken by the Reserve BankSteps taken by the Reserve Bank

–– Banks advised in May 2004: Banks advised in May 2004: a) to examine options under the Revised Framework a) to examine options under the Revised Framework

and lay a roadand lay a road--map by endmap by end--December 2004 for December 2004 for migrationmigration

b) to review the progress on the timeb) to review the progress on the time--line at quarterly line at quarterly intervalsintervals

-- TwoTwo--day Seminar with CEOs of Banksday Seminar with CEOs of Banks-- In August 2004 banks advised to make a selfIn August 2004 banks advised to make a self--

assessment of their risk management systemsassessment of their risk management systems

How Are We Preparing to Implement Basel II?How Are We Preparing to Implement Basel II?

•• Steps taken by the Reserve BankSteps taken by the Reserve Bank

–– In August 2004 banks were required to formulate and In August 2004 banks were required to formulate and operationalise CAAP as required under Pillar 2.operationalise CAAP as required under Pillar 2.

–– Risk Based Supervision introduced on a pilot basis. Risk Based Supervision introduced on a pilot basis. –– Strengthened the disclosures requirements for Strengthened the disclosures requirements for

enhanced transparencyenhanced transparency–– Strengthened the level of corporate governance Strengthened the level of corporate governance

standards in banksstandards in banks

How Are We Preparing to Implement Basel II?How Are We Preparing to Implement Basel II?

•• Steps taken by Reserve BankSteps taken by Reserve Bank

–– Draft prudential guidelines on implementation of Draft prudential guidelines on implementation of Revised Framework issued in February 2005Revised Framework issued in February 2005

–– Guidance Note on Management of Operational Risk Guidance Note on Management of Operational Risk issued in October 2005issued in October 2005

How Are We Preparing to Implement Basel II?How Are We Preparing to Implement Basel II?

•• Areas of National DiscretionAreas of National Discretion–– Sovereign Sovereign –– State Government guaranteed exposures risk State Government guaranteed exposures risk

weighted at 20% instead of 0% weighted at 20% instead of 0% –– ECAsECAs not recognised for risk weighting purpose not recognised for risk weighting purpose –– Claims on domestic Claims on domestic PSEsPSEs treated as corporates treated as corporates –– Claims on banks Claims on banks –– Option 1, risk weight one category less than Option 1, risk weight one category less than

sovereign sovereign –– Scheduled Commercial banks at 20%, others at Scheduled Commercial banks at 20%, others at 100% 100%

–– Risk weight on claims secured by residential properties Risk weight on claims secured by residential properties –– RBI RBI stipulation at 75% instead of 35% stipulation at 75% instead of 35%

How Are We Preparing to Implement Basel II?How Are We Preparing to Implement Basel II?

•• Areas of National DiscretionAreas of National Discretion–– Use of unsolicited ratings Use of unsolicited ratings –– banks to use only solicited banks to use only solicited

ratings ratings •• RBI to evaluate periodically risk weights assigned to retail RBI to evaluate periodically risk weights assigned to retail

and other sensitive sectors and other sensitive sectors •• External Credit Assessment InstitutionsExternal Credit Assessment Institutions

–– RBI undertook processes for identifying eligible ECAIsRBI undertook processes for identifying eligible ECAIs–– An Internal Working Group examined the eligibility An Internal Working Group examined the eligibility

criteria & mapping processcriteria & mapping process

How Are We Preparing to Implement Basel II?How Are We Preparing to Implement Basel II?

•• Parallel runParallel run–– Banks advised in February 2005 to start parallel run Banks advised in February 2005 to start parallel run

from April 1, 2006from April 1, 2006–– Banks to apply prudential guidelines both under Basel Banks to apply prudential guidelines both under Basel

I & II I & II –– Analysis of CRAR to be submitted to Board on a biAnalysis of CRAR to be submitted to Board on a bi--

monthly basis till December 2006; monthly thereaftermonthly basis till December 2006; monthly thereafter•• Other requirements during parallel runOther requirements during parallel run

–– Board approved policy on CRM techniques & Board approved policy on CRM techniques & collateral management, disclosures, ICAAP & MIScollateral management, disclosures, ICAAP & MIS

–– Mechanisms for validating CRAR positionMechanisms for validating CRAR position

How Are We Preparing to Implement Basel II?How Are We Preparing to Implement Basel II?

•• Fifth Quantitative Impact Study by BCBSFifth Quantitative Impact Study by BCBS

–– 11 Indian Banks with 50% market share Participated11 Indian Banks with 50% market share Participated

–– Impact on CRAR Impact on CRAR –– 1 %1 %

Implementation of Basel II : Future ChallengesImplementation of Basel II : Future Challenges

•• Issues at Bank Level Issues at Bank Level –– Higher capital requirementsHigher capital requirements–– Capacity buildingCapacity building–– Improved IT architecture / MISImproved IT architecture / MIS–– Improvements in governance standards and oversightImprovements in governance standards and oversight–– Data issuesData issues–– Validating economic capitalValidating economic capital

Implementation of Basel II : Future ChallengesImplementation of Basel II : Future Challenges

•• Issues at Regulator LevelIssues at Regulator Level

–– Capacity building Capacity building –– Rating penetration Rating penetration –– Issue Issue vsvs IssuerIssuer–– Refine & upgrade financial information monitoring Refine & upgrade financial information monitoring –– Data warehousing Data warehousing

Thank YouThank You