180
The Analysis of Basel Norms and Implementation KLE SOCEITY’s INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH, VIDYANAGAR, HUBLI. MASTERS OF BUSINESS ADMINISTRATION ( Recognised and Affiliated to Karnataka University Dharwad) Project on “The Analysis of Basel Norms and its implementation” Undertaken At State Bank of India, KLE’s Institute of Manageent Studies of Research MBA IV Sem 1

Final PRoj Basel

Embed Size (px)

Citation preview

Page 1: Final PRoj Basel

The Analysis of Basel Norms and Implementation

KLE SOCEITY’s

INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH,

VIDYANAGAR, HUBLI.

MASTERS OF BUSINESS ADMINISTRATION( Recognised and Affiliated to Karnataka University Dharwad)

Project on“The Analysis of Basel Norms and its implementation”

Undertaken AtState Bank of India,

Main Branch,Dharwad

Internal Guide Company GuideProf: Prashanth.C Mr.Subramanya Faculty Chief ManagerKLE’s IMSR State Bank of India

KLE’s Institute of Manageent Studies of Research MBA IV Sem 1

Page 2: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Hubli Dharwad

DECLARATION

I, Miss Shveta.R.Chikkamath hereby declare that the project for MCP

title

“ The Study of Basel Norms and its implementation” at State Bank of

India, Main Branch Dharwad submitted in fulfillment of the

requirement for the degree of “ Master of Business Administration” by

Karnataka University Dharwad, is correct and by my own effort and is

submitted elsewhere for the award of any degree.

Date:

Place: ( Shveta.R.Chikkamath)

KLE’s Institute of Manageent Studies of Research MBA IV Sem 2

Page 3: Final PRoj Basel

The Analysis of Basel Norms and Implementation

ACKNOWLEDGEMENT

All my efforts will be meaningless, if I don’t express my sincere gratitude to the

authorities, who rendered their support and guided me more than what I had expected

from them, while carrying out my project. First and foremost I extend my heartfelt

gratitude to our State Bank of India, Chief Manager Dharwad for giving me an

opportunity to undertake my project in this prestigious bank.

I express my sincere gratitude to Sir R.S. Prakash, Faculty Training Centre SBI and also

Sir, Prasad Faculty Training Centre State Bank of India for their valuable support.

I also express my gratefulness to Miss Shailaja. M.S Chief Manager, SBI Zonal Office.

I also thank all SBI staff for supporting me in one or the other way.

Dr.M.M.Bagali, I/c Director KLE’s Institute of Management Studies and Research for

his encouragement in carrying out the project.

I extend gratefulness to Prof Prashanth. C my institute guide his guidance.

Lastly, I’m immensely grateful to my family and friends who have directly or indirectly

Strived hard from commencement to completion of my project.

\

KLE’s Institute of Manageent Studies of Research MBA IV Sem 3

Page 4: Final PRoj Basel

The Analysis of Basel Norms and Implementation

TABLE OF CONTENTS

S.NO INDEX Page No

1. EXECUTIVE SUMMARY 6-9

2. INDUSRTY PROFILE 11-26

3 COMPANY PROFILE 28-33

4 The Analysis of Basel Norms and Implementation

6 Background of Basel Accord 35-51

7 BASEL I 53-57

8 LOOPHOLES OF BASEL I 58

9 OBJECTIVES OF BASEL II 62-64

10 BASEL II GUIDELINES 65-66

11 BASEL II FRAMEWORK 67-68

12 CATEGORIES OF RISK 69-86

13 CHALLENGES FOR INDIAN BANKING UNDER

BASEL II

87-90

14 CHALLENGES FOR SBI 91

15 MIGRATION TO BASEL BY SBI 92-93

16 IMPACT OF BASEL NORMS ON INDIAN BANKS 94-98

17 IMPACT OF BASEL NORMS ON SBI 99

18 RELATION BETWEEN BASEL I & BASEL II 100

19 CONCLUSIONS 101

20 FINDINGS 102

21 SUGGESTIONS & LIMITATIONS 103

22 BIBLIOGRAPHY 105

KLE’s Institute of Manageent Studies of Research MBA IV Sem 4

Page 5: Final PRoj Basel

The Analysis of Basel Norms and Implementation

EXECUTIVE SUMMARY

In 1988 the Bank for International Settlements’ Basel Committee on Banking

Supervision, commonly known as the Basel Committee, imposed the Basel

Capital Accord. The Basel Capital Accord introduced a system for

implementing a credit risk framework for determining the minimum amount of

capital that a bank must hold as a cushion against risks. The Basel Capital

Accord was adopted over time not only in member countries, but in virtually all

countries operating international banks.

One problem with the original Basel Capital Accord was that it took a "one size

fits all" approach, without regard for the actual operational risk incurred by the

KLE’s Institute of Manageent Studies of Research MBA IV Sem 5

Page 6: Final PRoj Basel

The Analysis of Basel Norms and Implementation

bank. In 2004, the Basel II Accord was established. The new accord aligns the

requirement for capital on hand with the actual risk involved, providing an

incentive for banks to improve risk management.

Managing Risk

Operational risk is a broad term that applies to various types of risk, the most

crucial of which involve a breakdown in either internal controls or corporate

governance. Other areas that introduce operational risks are information

technology and catastrophes such as fires, floods or earthquakes. These

operational risks can lead to significant financial losses for the bank.

If not properly mitigated and managed, these risks can introduce opportunities

for loss. It may be direct fraud or error, or it could be a bank representative or

officer exceeding their authority and conducting illegal or unethical

transactions. If the proper framework is in place, these operational risks are

reduced and the bank can be considered to be more secure under the Basel II

guidelines.

 

OBJECTIVES OF THE PROJECT

The analysis of what is basel 1 and why was it implemented

To trace the loopholes of Basel I

The analysis what is Basel II

The objectives of Basel II

The analysis of credit risk, market risk and operational risks are quantified.

To analyse the challenges in implementing Basel II in State Bank of India.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 6

Page 7: Final PRoj Basel

The Analysis of Basel Norms and Implementation

To analyse impact of Basel II on Indian Banks with special reference to State

Bank of India

Sources of Data

Primary Data:

Most of the data was extracted from Bank, State Bank of India Zonal Office, State Bank

of India Training Centre. Discussion with Bank’s Employees, Circulars,

Documents and soft copies.

Secondary Data

Indian Banking Association Journal and Bank Website.

Significance of the Study

“ The project report helps in understanding how important the risk management is

Banking Sector”.

FINDINGS

It was observed that while undertaking a project none of the SBI employees

knows about Basel II.

The Bank is going to raise additional capital of by way of equity shares through

IPO to support additional capital requirement for implementing Basel II

KLE’s Institute of Manageent Studies of Research MBA IV Sem 7

Page 8: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Earlier there were no separate departments for managing risks, but after

implementing Basel II separate departments to have been entrusted with the task

of managing Credit Risk, Market Risk and Operational Risk.

Skilled operational personnel is required for State Bank of India.

Basel II tends to reduce Capital Base of Indian Banks by 1% to 2%, except a few

Banks

Complexities in Systems and Processes involved in Basel II make the

implementation process difficult, time consuming and costly.

Standardised Approach is adopted by bank to assess Credit Risk in which external

Credit rating Agencies are involved, this is due bank’s internal rating system is

not full proof system which is not approved by RBI.

CONCLUSIONS

Basel II will improve risk management exercise in Banks.

State Bank of India will get international standard for adopting Basel II.

All the areas of risks have been taken care.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 8

Page 9: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Some additional Capital is required.

SUGGESTIONS

Bank has to train all its employees so that everybody can understand about Basel

Accord.

It has to recruit operationally skilled personnel in order to implement Basel

accord.

Bank has to develop a full proof internal credit rating system so that it can go for

Advanced approach in assessing credit risk

INDUSRTY PROFILE

KLE’s Institute of Manageent Studies of Research MBA IV Sem 9

Page 10: Final PRoj Basel

The Analysis of Basel Norms and Implementation

BANKING INDUSTRY OVERVIEW

History:

Banking in India has its origin as carry as the Vedic period. It is believed that the

transition from money lending to banking must have occurred even before Manu, the

great Hindu jurist, who has devoted a section of his work to deposits and advances and

laid down rules relating to the interest. During the mogal period, the indigenous bankers

KLE’s Institute of Manageent Studies of Research MBA IV Sem 10

Page 11: Final PRoj Basel

The Analysis of Basel Norms and Implementation

played a very important role in lending money and financing foreign trade and

commerce. During the days of East India Company, it was to turn of the agency houses

top carry on the banking business. The general bank of India was the first joint stock

bank to be established in the year 1786.The others which followed were the Bank of

Hindustan and the Bengal Bank. The Bank of Hindustan is reported to have continued till

1906, while the other two failed in the meantime. In the first half of the 19 th Century the

East India Company established three banks; The Bank of Bengal in 1809, The Bank of

Bombay in 1840 and The Bank of Madras in 1843.These three banks also known as

presidency banks and were independent units and functioned well. These three banks

were amalgamated in 1920 and The Imperial Bank of India was established on the 27 th

Jan 1921, with the passing of the SBI Act in 1955, the undertaking of The Imperial Bank

of India was taken over by the newly constituted SBI. The Reserve Bank which is the

Central Bank was created in 1935 by passing of RBI Act 1934, in the wake of swadeshi

movement, a number of banks with Indian Management were established in the country

namely Punjab National Bank Ltd, Bank of India Ltd, Canara Bank Ltd, Indian Bank Ltd,

The Bank of Baroda Ltd, The Central Bank of India Ltd .On July 19 th 1969, 14 Major

Banks of the country were nationalized and in 15 th April 1980 six more commercial

private sector banks were also taken over by the government. The Indian Banking

industry, which is governed by the Banking Regulation Act of India 1949, can be broadly

classified into two major categories, non-scheduled banks and scheduled banks.

Scheduled Banks comprise commercial banks and the co-operative banks.

The first phase of financial reforms resulted in the nationalization of 14 major

banks in 1969 and resulted in a shift from class banking to mass banking. This in turn

resulted in the significant growth in the geographical coverage of banks. Every bank had

to earmark a min percentage of their loan portfolio to sectors identified as “priority

sectors” the manufacturing sector also grew during the 1970’s in protected environments

and the banking sector was a critical source. The next wave of reforms saw the

KLE’s Institute of Manageent Studies of Research MBA IV Sem 11

Page 12: Final PRoj Basel

The Analysis of Basel Norms and Implementation

nationalization of 6 more commercial banks in 1980 since then the number of scheduled

commercial banks increased four- fold and the number of bank branches increased to

eight fold.

After the second phase of financial sector reforms and liberalization of the sector

in the early nineties. The PSB’s found it extremely difficult to complete with the new

private sector banks and the foreign banks. The new private sector first made their

appearance after the guidelines permitting them were issued in January 1993.

This is how the Banking Industry grew.

The Indian Banking System:

Banking in our country is already witnessing the sea changes as the banking

sector seeks new technology and its applications. The best port is that the benefits are

beginning to reach the masses. Earlier this domain was the preserve of very few

organizations. Foreign banks with heavy investments in technology started giving some

“Out of the world” customer services. But, such services were available only to selected

few- the very large account holders. Then came the liberalization and with it a multitude

of private banks, a large segment of the urban population now requires minimal time and

space for its banking needs.

Automated teller machines or popularly known as ATM are the three alphabets

that have changed the concept of banking like nothing before. Instead of tellers handling

your own cash, today there are efficient machines that don’t talk but just dispense cash.

Under the Reserve Bank of India Act 1934, banks are classified as scheduled banks and

non-scheduled banks. The scheduled banks are those, which are entered in the Second

Schedule of RBI Act, 1934. Such banks are those, which have paid- up capital and

reserves of an aggregate value of not less then Rs.5 lacs and which satisfy RBI that their

KLE’s Institute of Manageent Studies of Research MBA IV Sem 12

Page 13: Final PRoj Basel

The Analysis of Basel Norms and Implementation

affairs are carried out in the interest of their depositors. All commercial banks Indian and

Foreign, regional rural banks and state co-operative banks are Scheduled banks. Non

Scheduled banks are those, which have not been included in the Second Schedule of the

RBI Act, 1934.

The organized banking system in India can be broadly classified into three

categories: (i) Commercial Banks (ii) Regional Rural Banks and (iii) Co-operative banks.

The Reserve Bank of India is the supreme monetary and banking authority in the country

and has the responsibility to control the banking system in the country. It keeps the

reserves of all commercial banks and hence is known as the “Reserve Bank”.

Current scenario:-

Currently (2007), the overall banking in India is considered as fairly mature in terms of

supply, product range and reach - even though reach in rural India still remains a

challenge for the private sector and foreign banks. Even in terms of quality of assets and

capital adequacy, Indian banks are considered to have clean, strong and transparent

balance sheets - as compared to other banks in comparable economies in its region. The

Reserve Bank of India is an autonomous body, with minimal pressure from the

Government.

With the growth in the Indian economy expected to be strong for quite some time

especially in its services sector, the demand for banking services especially retail

banking, mortgages and investment services are expected to be strong. Mergers &

Acquisitions., takeovers, are much more in action in India.

One of the classical economic functions of the banking industry that has remained

virtually unchanged over the centuries is lending. On the one hand, competition has had

KLE’s Institute of Manageent Studies of Research MBA IV Sem 13

Page 14: Final PRoj Basel

The Analysis of Basel Norms and Implementation

considerable adverse impact on the margins, which lenders have enjoyed, but on the other

hand technology has to some extent reduced the cost of delivery of various products and

services.

Bank is a financial institution that borrows money from the public and lends

money to the public for productive purposes. The Indian Banking Regulation Act of 1949

defines the term Banking Company as "Any company which transacts banking business

in India" and the term banking as "Accepting for the purpose of lending all investment

of deposits, of money from the public, repayable on demand or otherwise and

withdrawal by cheque, draft or otherwise".

Banks play important role in economic development of a country, like:

o Bank mobilise the small savings of the people and make them available

for productive purposes.

Promotes the habit of savings among the people thereby offering attractive

rates of

interest on their deposits

o Provides safety and security to the surplus money of the depositors and as

well provides a convenient and economical method of payment.

Banks provide convenient means of transfer of fund from one place to another.

Helps the movement of capital from regions where it is not very useful to regions

where it can be more useful.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 14

Page 15: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Banks advances exposure in trade and commerce, industry and agriculture by

knowing their financial requirements and prospects.

Bank acts as an intermediary between the depositors and the investors. Bank also acts

as mediator between exporter and importer who does foreign trades.

Thus Indian banking has come from a long way from being a sleepy business

institution to a highly pro-active and dynamic entity. This transformation has been

largely brought about by the large dose of liberalization and economic reforms that

allowed banks to explore new business opportunities rather than generating revenues

from conventional streams (i.e. borrowing and lending). The banking in India is highly

fragmented with 30 banking units contributing to almost 50% of deposits and 60% of

advances.

The Structure of Indian Banking:

The Indian banking industry has Reserve Bank of India as its Regulatory Authority. This is a mix of the Public sector, Private sector, Co-operative banks and foreign banks. The private sector banks are again split into old banks and new banks.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 15

Reserve Bank of India[Central Bank]

Scheduled Banks

Scheduled Co-operative BanksScheduled

Commercial Banks

Foreign Banks

RegionalRural Banks

Page 16: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Chart Showing Three Different Sectors of Banks

i) Public Sector Banks

ii) Private Sector Banks

KLE’s Institute of Manageent Studies of Research MBA IV Sem 16

Public Sector Banks

Nationalized Banks

SBI & its Associates

Private Sector Banks

Old Private Sector Banks

Scheduled Urban Co-Operative

Banks

Scheduled State Co-Operative Banks

New Private Sector Banks

Page 17: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Public Sector Banks

SBI and Nationalized Regional Rural

SUBSIDIARIES Banks Banks

SBI and subsidiaries

This group comprises of the State Bank of India and its seven subsidiaries viz.,

State Bank of Patiala, State Bank of Hyderabad, State Bank of Travancore, State Bank of

Bikaner and Jaipur, State Bank of Mysore, State Bank of Saurashtra, State Bank of India

State Bank of India (SBI) is the largest bank in India. If one measures by the

number of branch offices and employees, SBI is the largest bank in the world.

Established in 1806as Bank of Bengal it is the oldest commercial bank in the Indian

subcontinent. SBI provides various domestic, international and NRI products and

services, through its vast network in India and overseas. With an asset base of $126

billion and its reach, it is a regional banking behemoth. The government nationalized the

bank in1955, with the Reserve bank of India taking a 60% ownership stake. In recent

years the bank has focused on two priorities, 1), reducing its huge staff through Golden

handshakeschemes known as the Voluntary Retirement Scheme, which saw many of its

best and brightest defect to the private sector, and 2), computerizing its operations.

The State Bank of India traces its roots to the first decade of19th century, when the Bank

of culcutta, later renamed theBank of bengal, was established on 2 jun 1806. The

government amalgamatted Bank of Bengal and two other Presidency banks, namely, the

KLE’s Institute of Manageent Studies of Research MBA IV Sem 17

Page 18: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Bank of Bombay and the bank of Madras, and named the reorganized banking entity the

Imperial Bank of India. All these Presidency banks were incorporated ascompanies, and

were the result of theroyal charters. The Imperial Bank of India continued to remain a

joint stock company. Until the establishment of a central bank in India the Imperial Bank

and its early predecessors served as the nation's central bank printing currency.

The State Bank of India Act 1955, enacted by the parliament of India, authorized the

Reserve Bank of India, which is the central Banking Organisationof India, to acquire a

controlling interest in the Imperial Bank of India, which was renamed the State Bank of

India on30th April 1955.

In recent years, the bank has sought to expand its overseas operations by buying foreign

banks. It is the only Indian bank to feature in the top 100 world banks in the Fortune

Global 500 rating and various other rankings. According to the Forbes 2000 listing it tops

all Indian companies.

Nationalized banks

This group consists of private sector banks that were nationalized. The

Government of India nationalized 14 private banks in 1969 and another 6 in the year

1980. In early 1993, there were 28 nationalized banks i.e., SBI and its 7 subsidiaries plus

20 nationalized banks. In 1993, the loss making new bank of India was merged with

profit making Punjab National Bank. Hence, now only 27 nationalized banks exist in

India.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 18

Page 19: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Regional Rural banks

These were established by the RBI in the year 1975 of banking commission. It

was established to operates exclusively in rural areas to provide credit and other facilities

to small and marginal farmers, agricultural labourers, artisans and small entrepreneurs.

Private Sector Banks

Private Sector Banks

Old private New private

Sector Banks Sector Banks

Old Private Sector Banks

This group consists of the banks that were establishes by the privy sectors,

committee organizations or by group of professionals for the cause of economic

betterment in their operations. Initially, their operations were concentrated in a few

regional areas. However, their branches slowly spread throughout the nation as they

grow.

New private Sector Banks

These banks were started as profit orient companies after the RBI opened the

banking sector to the private sector. These banks are mostly technology driven and better

managed than other banks.

Foreign banks

These are the banks that were registered outside India and had originated in a

foreign country. The major participants of  the Indian financial system are the

KLE’s Institute of Manageent Studies of Research MBA IV Sem 19

Page 20: Final PRoj Basel

The Analysis of Basel Norms and Implementation

commercial banks, the financial institutions (FIs), encompassing term-lending

institutions, investment institutions, specialized financial institutions and the state-level

development banks, Non-Bank Financial Companies (NBFCs) and other market

intermediaries such as the stock brokers and money-lenders. The commercial banks and

certain variants of NBFCs are among the oldest of the market participants. The FIs, on

the other hand, are relatively new entities in the financial market place.

IMPORTANCE OF BANKING SECTOR IN A GROWING ECONOMY

In the recent times when the service industry is attaining greater importance

compared to manufacturing industry, banking has evolved as a prime sector providing

financial services to growing needs of the economy.

Banking industry has undergone a paradigm shift from providing ordinary

banking services in the past to providing such complicated and crucial services like,

merchant banking, housing finance, bill discounting etc. This sector has become more

active with the entry of new players like private and foreign banks. It has also evolved as

a prime builder of the economy by understanding the needs of the same and encouraging

the development by way of giving loans, providing infrastructure facilities and financing

activities for the promotion of entrepreneurs and other business establishments.

For a fast developing economy like ours, presence of a sound financial system to

mobilize and allocate savings of the public towards productive activities is necessary.

Commercial banks play a crucial role in this regard.

The Banking sector in recent years has incorporated new products in their

businesses, which are helpful for growth. The banks have started to provide fee-based

services like, treasury operations, managing derivatives, options and futures, acting as

bankers to the industry during the public offering, providing consultancy services, acting

KLE’s Institute of Manageent Studies of Research MBA IV Sem 20

Page 21: Final PRoj Basel

The Analysis of Basel Norms and Implementation

as an intermediary between two-business entities etc.At the same time, the banks are

reaching out to other end of customer requirements like, insurance premium payment, tax

payment etc. It has changed itself from transaction type of banking into relationship

banking, where you find friendly and quick service suited to your needs. This is possible

with understanding the customer needs their value to the bank, etc. This is possible with

the help of well organized staff, computer based network for speedy transactions,

products like credit card, debit card, health card, ATM etc. These are the present trend of

services. The customers at present ask for convenience of banking transactions, like 24

hours banking, where they want to utilize the services whenever there is a need. The

relationship banking plays a major and important role in growth, because the customers

now have enough number of opportunities, and they choose according to their

satisfaction of responses and recognition they get. So the banks have to play cautiously,

else they may lose out the place in the market due to competition, where slightest of

opportunities are captured fast.

Another major role played by banks is in transnational business, transactions and

networking. Many leading Indian banks have spread out their network to other countries,

which help in currency transfer and earn exchange over it.

These banks play a major role in commercial import and export business, between parties

of two countries. This foreign presence also helps in bringing in the international

standards of operations and ideas. The liberalization policy of 1991 has allowed many

foreign banks to enter the Indian market and establish their business. This has helped

large amount of foreign capital inflow & increase our Foreign exchange reserve.

Another emerging change happening all over the banking industry is

consolidation through mergers and acquisitions. This helps the banks in strengthening

their empire and expanding their network of business in terms of volume and

effectiveness.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 21

Page 22: Final PRoj Basel

The Analysis of Basel Norms and Implementation

EMERGING SCENARIO IN THE BANKING SECTOR

The Indian banking system has passed through three distinct phases from the time

of inception. The first was being the era of character banking, where you were recognized

as a credible depositor or borrower of the system. This era come to an end in the sixties.

The second phase was the social banking. Nowhere in the democratic developed world,

was banking or the service industry nationalized. But this was practiced in India. Those

were the days when bankers has no clue whatsoever as to how to determine the scale of

finance to industry. The third era of banking which is in existence today is called the era

of Prudential Banking. The main focus of this phase is on prudential norms accepted

internationally.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 22

Page 23: Final PRoj Basel

The Analysis of Basel Norms and Implementation

SBI Group-

The Bank of Bengal, which later became the State Bank of India. State Bank of

India with its seven associate banks commands the largest banking resources in India.

Nationalisation-

The next significant milestone in Indian Banking happened in late 1960s when the

then Indira Gandhi government nationalized on 19th July 1949, 14 major commercial

Indian banks followed by nationalisation of 6 more commercial Indian banks in 1980.

The stated reason for the nationalisation was more control of credit delivery. After

this, until 1990s, the nationalised banks grew at a leisurely pace of around 4% also called

as the Hindu growth of the Indian economy.

After the amalgamation of New Bank of India with Punjab National Bank,

currently there are 19 nationalised banks in India

Liberalization -

In the early 1990’s the then Narasimha rao government embarked a policy of

liberalization and gave licences to a small number of private banks, which came to be

known as New generation tech-savvy banks, which included banks like ICICI and HDFC.

This move along with the rapid growth of the economy of India, kick started the banking

sector in India, which has seen rapid growth with strong contribution from all the sectors

of banks, namely Government banks, Private Banks and Foreign banks. However there

KLE’s Institute of Manageent Studies of Research MBA IV Sem 23

Page 24: Final PRoj Basel

The Analysis of Basel Norms and Implementation

had been a few hiccups for these new banks with many either being taken over like

Global Trust Bank while others like Centurion Bank have found the going tough.

The next stage for the Indian Banking has been set up with the proposed relaxation in

the norms for Foreign Direct Investment, where all Foreign Investors in Banks may be

given voting rights which could exceed the present cap of 10%, at pesent it has gone up

to 49% with some restrictions.

The new policy shook the Banking sector in India completely. Bankers, till this

time, were used to the 4-6-4 method (Borrow at 4%;Lend at 6%;Go home at 4) of

functioning. The new wave ushered in a modern outlook and tech-savvy methods of

working for traditional banks.All this led to the retail boom in India. People not just

demanded more from their banks but also received more.

CURRENT SCENARIO-

Currently (2007), overall, banking in India is considered as fairly mature in terms of

supply, product range and reach-even though reach in rural India still remains a challenge

for the private sector and foreign banks. Even in terms of quality of assets and capital

adequacy, Indian banks are considered to have clean, strong and transparent balance

sheets-as compared to other banks in comparable economies in its region. The Reserve

Bank of India is an autonomous body, with minimal pressure from the government. The

stated policy of the Bank on the Indian Rupee is to manage volatility-without any stated

exchange rate-and this has mostly been true.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 24

Page 25: Final PRoj Basel

The Analysis of Basel Norms and Implementation

With the growth in the Indian economy expected to be strong for quite some time-

especially in its services sector, the demand for banking services-especially retail

banking, mortgages and investment services are expected to be strong. M&As, takeovers,

asset sales and much more action (as it is unravelling in China) will happen on this front

in India.

The next stage for the Indian Banking has been set up with the proposed relaxation in the

norms for Foreign Direct Investment, where all Foreign Investors in Banks may be given

voting rights which could exceed the present cap of 10%, at pesent it has gone up to 49%

with some restrictions.

The new policy shook the Banking sector in India completely. Bankers, till this

time, were used to the 4-6-4 method (Borrow at 4%;Lend at 6%;Go home at 4) of

functioning. The new wave ushered in a modern outlook and tech-savvy methods of

working for traditional banks.All this led to the retail boom in India. People not just

demanded more from their banks but also received more.

In March 2006, the Reserve Bank of India allowed Warburg Pincus to increase its

stake in Kotak Mahindra Bank (a private sector bank) to 10%. This is the first time an

investor has been allowed to hold more than 5% in a private sector bank since the RBI

announced norms in 2005 that any stake exceeding 5% in the private sector banks would

need to be vetted by them.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 25

Page 26: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Currently, India has 88 scheduled commercial banks (SCBs) - 28 public sector banks

(that is with the Government of India holding a stake), 29 private banks (these do not

have government stake; they may be publicly listed and traded on stock exchanges) and

31 foreign banks. They have a combined network of over 53,000 branches and 17,000

ATMs. According to a report by ICRA Limited, a rating agency, the public sector banks

hold over 75 percent of total assets of the banking industry, with the private and foreign

banks holding 18.2% and 6.5% respectively.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 26

Page 27: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Banking in India

1 Central Bank Reserve Bank of India

2 Nationalised Banks

State Bank of India, Allahabad Bank, Andhra Bank,

Bank of Baroda, Bank of India, Bank of

Maharastra,Canara Bank, Central Bank of India,

Corporation Bank, Dena Bank, Indian Bank, Indian

overseas Bank,Oriental Bank of Commerce, Punjab and

Sind Bank, Punjab National Bank, Syndicate Bank,

Union Bank of India, United Bank of India, UCO

Bank,and Vijaya Bank.

3 Private Banks

Bank of Rajastan, Bharath overseas Bank, Catholic

Syrian Bank, Centurion Bank of Punjab, City Union

Bank, Development Credit Bank, Dhanalaxmi Bank,

Federal Bank, Ganesh Bank of Kurundwad, HDFC

Bank, ICICI Bank, IDBI, IndusInd Bank, ING Vysya

Bank, Jammu and Kashmir Bank, Karnataka Bank

Limited, Karur Vysya Bank, Kotek Mahindra Bank,

Lakshmivilas Bank, Lord Krishna Bank, Nainitak Bank,

Ratnakar Bank,Sangli Bank, SBI Commercial and

International Bank, South Indian Bank, Tamil Nadu

Merchantile Bank Ltd., United Western Bank, UTI

KLE’s Institute of Manageent Studies of Research MBA IV Sem 27

Page 28: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Bank, YES Bank.

COMPANY PROFILE

KLE’s Institute of Manageent Studies of Research MBA IV Sem 28

Page 29: Final PRoj Basel

The Analysis of Basel Norms and Implementation

STATE BANK OF INDIA

Not only many financial institution in the world today can claim the antiquity and

majesty of the State Bank Of India founded nearly two centuries ago with primarily intent

of imparting stability to the money market, the bank from its inception mobilized funds

for supporting both the public credit of the companies governments in the three

presidencies of British India and the private credit of the European and India merchants

from about 1860s when the Indian economy book a significant leap forward under the

impulse of quickened world communications and ingenious method of industrial and

agricultural production the Bank became intimately in valued in the financing of

practically and mining activity of the Sub- Continent Although large European and Indian

merchants and manufacturers were undoubtedly thee principal beneficiaries, the small

man never ignored loans as low as Rs.100 were disbursed in agricultural districts against

glad ornaments. Added to these the bank till the creation of the Reserve Bank in 1935

carried out numerous Central – Banking functions.

Adaptation world and the needs of the hour has been one of the strengths of the Bank,

In the post depression exe. For instance – when business opportunities become extremely

restricted, rules laid down in the book of instructions were relined to ensure that good

business did not go post. Yet seldom did the bank contravenes its value as depart from

sound banking principles to retain as expand its business. An innovative array of office,

KLE’s Institute of Manageent Studies of Research MBA IV Sem 29

Page 30: Final PRoj Basel

The Analysis of Basel Norms and Implementation

unknown to the world then, was devised in the form of branches, sub branches, treasury

pay office, pay office, sub pay office and out students to exploit the opportunities of an

expanding economy. New business strategy was also evaded way back in 1937 to render

the best banking service through prompt and courteous attention to customers.

A highly efficient and experienced management functioning in a well defined

organizational structure did not take long to place the bank an executed pedestal in the

areas of business, profitability, internal discipline and above all credibility A impeccable

financial status consistent maintenance of the lofty traditions if banking an observation of

a high standard of integrity in its operations helped the bank gain a pre- eminent status.

No wonders the administration for the bank was universal as key functionaries of India

successive finance minister of independent India Resource Bank of governors and

representatives of chamber of commercial showered economics on it.

Modern day management techniques were also very much evident in the good old

days years before corporate governance had become a puzzled the banks bound

functioned with a high degree of responsibility and concerns for the shareholders. An

unbroken records of profits and a fairly high rate of profit and fairly high rate of dividend

all through ensured satisfaction, prudential management and asset liability management

not only protected the interests of the Bank but also ensured that the obligations to

customers were not met.

The traditions of the past continued to be upheld even to this day as the State Bank

years itself to meet the emerging challenges of the millennium.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 30

Page 31: Final PRoj Basel

The Analysis of Basel Norms and Implementation

ABOUT LOGO

KLE’s Institute of Manageent Studies of Research MBA IV Sem 31

Page 32: Final PRoj Basel

The Analysis of Basel Norms and Implementation

THE PLACE TO SHARE THE NEWS ...……

SHARE THE VIEWS ……

Togetherness is the theme of this corporate loge of SBI where the world of banking

services meet the ever changing customers needs and establishes a link that is like a

circle, it indicates complete services towards customers. The logo also denotes a bank

that it has prepared to do anything to go to any lengths, for customers.

The blue pointer represent the philosophy of the bank that is always looking for the

growth and newer, more challenging, more promising direction. The key hole indicates

safety and security.

MISSION, VISION AND VALUES

MISSION STATEMENT:

To retain the Bank’s position as premiere Indian Financial Service Group, with world

class standards and significant global committed to excellence in customer, shareholder

and employee satisfaction and to play a leading role in expanding and diversifying

financial service sectors while containing emphasis on its development banking rule.

VISION STATEMENT:

KLE’s Institute of Manageent Studies of Research MBA IV Sem 32

Page 33: Final PRoj Basel

The Analysis of Basel Norms and Implementation

¨ Premier Indian Financial Service Group with prospective world-class

Standards of efficiency and professionalism and institutional values.

¨ Retain its position in the country as pioneers in Development banking.

¨ Maximize the shareholders value through high-sustained earnings per

Share.

¨ An institution with cultural mutual care and commitment, satisfying and

Good work environment and continues learning opportunities.

VALUES:

¨ Excellence in customer service

¨ Profit orientation

¨ Belonging commitment to Bank

¨ Fairness in all dealings and relations

¨ Risk taking and innovative

¨ Team playing

¨ Learning and renewal

¨ Integrity

¨ Transparency and Discipline in policies and systems.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 33

Page 34: Final PRoj Basel

The Analysis of Basel Norms and Implementation

ORGANISATION STRUCTURE

MANAGING DIRECTOR

G. M G.M G. M G.M G.M

(Operations) (C&B) (F&S) (I) & CVO (P&D)

KLE’s Institute of Manageent Studies of Research MBA IV Sem

CHIEF GENERAL MANAGER

34

Page 35: Final PRoj Basel

The Analysis of Basel Norms and Implementation

zonal officers

Functional Heads

THE ANALYSIS OF BASEL NORMS AND ITS

IMPLEMENTATION

KLE’s Institute of Manageent Studies of Research MBA IV Sem 35

Page 36: Final PRoj Basel

The Analysis of Basel Norms and Implementation

BACKGROUND OF BASEL ACCORD

The initiatives taken by the Basel Committee in addressing the rigidities in the 1988

Capital Accord by evolving a comprehensive and risk-sensitive New Basel Capital

Accord (the New Accord) are timely. The range of options for providing capital would

facilitate banks with varying degrees of sophistication to adopt appropriate method with

supervisory validation. Further, the emphasis laid on the role of supervisory review

process and market discipline, as essential complements to minimum capital

requirements would go a long way in enhancing the efficacy of supervision.

Reserve Bank’s association with the Basel Committee on Banking Supervision (BCBS) –

the owner of the Basel II framework- dates back to 1997 as India was among the 16 non-

member countries that were consulted in the drafting of the Basel Core Principles.

Reserve Bank of India became a member of the Core Principles Liaison Group in 1998

and subsequently became a member of the Core Principles Working Group on Capital.

Within the Working Group, RBI has been actively participating in the deliberations on

the Basel II framework and had the privilege to lead a group of six major non-G-10

KLE’s Institute of Manageent Studies of Research MBA IV Sem 36

Page 37: Final PRoj Basel

The Analysis of Basel Norms and Implementation

supervisors which presented a proposal on a simplified approach for Basel II to the

Committee.

Approach to reforms

With the commencement of the banking sector reforms in the early 1990s, the RBI has

been consistently upgrading the Indian banking sector by adopting international best

practices. The approach to reforms is one of having clarity about the destination, deciding

on the sequence and modulating the pace of reforms to suit Indian conditions. This has

helped us in moving ahead with the reforms in a purposeful but non-disruptive manner.

Basel I

The progress made by the Indian banking system with regard to Basel I implementation

before we discuss Basel II implementation. Adopting our general approach of

gradualism, we implemented the Basel I framework with effect from 1992-93 which was,

however, spread over 3 years– banks with branches abroad were required to comply fully

by end March 1994 and the other banks were required to comply by end March 1996.

Further, India responded to the 1996 amendment to the Basel I framework which required

banks to maintain capital for market risk exposures, by initially prescribing various

surrogate capital charges for these risks between 2000 and 2002. These were replaced

with the capital charges as required under the BaselI framework in June 2004, which

become fully effective from March2005. With the successful implementation of banking

sector reforms over the past decade, the Indian banking system has shown substantial

improvement on various parameters. It has become robust and displayed significant

resilience to shocks. There is ample evidence of the capacity of the Indian banking

KLE’s Institute of Manageent Studies of Research MBA IV Sem 37

Page 38: Final PRoj Basel

The Analysis of Basel Norms and Implementation

system to migrate smoothly to Basel II norms.

RBI recognises that several of the concerns expressed and recommendations made by

India and other emerging markets on the first consultative document have been taken into

account and addressed in the second consultative document. Particularly, the proposals to

do away with the sovereign floor in assigning risk weights and subscription to IMF’s

Special Data Dissemination Standards (SDDS) and Core Principles for Effective Banking

Supervision for preferential risk weighting, greater use of Export Credit Agencies

(ECAs), additional risk weight bucket of 50% in respect of claims on corporates,

simplified internal rating based approach, etc., reflect the Committee’s endeavour in

evolving a consensual framework which could be adapted by all countries including

emerging markets.

In this context, the Basel Committee’s concerns for the constraints which are faced by

the emerging markets and greater outreach by involving non G-10 countries in the

standards setting exercise would lead to greater appreciation for the New Accord.

However, some of the issues in the context of emerging markets are still to be addressed.

RBI feels that the complexity and sophistication of the proposals restricts its universal

application in emerging markets, where the banks continue to be the major segment in

financial intermediation and would be facing considerable challenges in adopting all the

proposals. The New Accord would involve shift in direct supervisory focus away to the

implementation issues. Further, banks and the supervisors would be required to invest

large resources in upgrading their technology and human resources to meet the minimum

standards. The increasing reliance on external rating agencies in the regulatory process

would undermine the initiatives of banks in enhancing their risk management policies and

practices and internal control systems. The minimum standards set even for the Internal

Rating Based (IRB) foundation approach are complex and beyond the reach of many

banks. Further, while the Basel Committee desires neither to produce a net increase nor a

KLE’s Institute of Manageent Studies of Research MBA IV Sem 38

Page 39: Final PRoj Basel

The Analysis of Basel Norms and Implementation

net decrease in minimum regulatory capital, it is felt that the current proposals are going

to result in significant increase in the capital charge for banks, especially in emerging

markets. The emerging markets with their low technical skills, structural rigidities and

less robust legal system, etc. would face serious implementation challenges. RBI,

therefore, feels that the spirit of flexibility, universal applicability and discretion to

national supervisors, consistent with the macro economic conditions specific to emerging

markets ought to be preserved while finalizing the New Accord.

Scope of Application

RBI agrees with the Committee’s view that the focus of the New Accord may be

primarily on internationally active banks, which would be followed by adherence by all

significant banks after a certain period of time. The basic philosophy of the New Accord

being to achieve competitive equality and financial stability and the Committee’s

pronouncement that the underlying principles are generally suitable to all types of banks

around the globe, the New Accord, like the 1988 Accord, should be applied, generally to

all banks. However, RBI shares the views of Mr. Laurence H. Meyer, Member of the

Board of Governors of the Federal Reserve System that ‘it is not at all obvious that the

proposed standardised approach fits the needs of smaller banking organization engaged

primarily in traditional banking activities… but I question whether the added

implementation burdens are cost-effective for traditional banking organizations,

especially since neither the current nor the proposed capital frameworks yet address what

is perhaps the most critical risk factor for smaller banks – geographic and sectoral

concentrations of credit risk’1.

It is, therefore, suggested that a simplified standardised approach, based on internal

rating systems of banks may be evolved and applied to banks, which are not

internationally active. Under this approach, standardised risk weights in the range of 0%

to 150% on the basis of internal ratings of banks, could be assigned, subject to mapping

KLE’s Institute of Manageent Studies of Research MBA IV Sem 39

Page 40: Final PRoj Basel

The Analysis of Basel Norms and Implementation

of such ratings with the benchmark Probability of Default (PD) estimated by the

supervisor on the basis of pooled data from select banks. As a precursor, however,

internal rating systems of banks need to be substantially upgraded and strengthened,

keeping in view the best practices and the standards prescribed by the Basel Committee

for IRB approach.

Recognising, however, the fact that even the simplified approach is likely to be more

extensive and complex than the 1988 Accord, the New Accord may be applied, in

phases, at the discretion of national supervisors to banks on the basis of the complexity,

scale of operation, etc. Each national supervisor may, however, be required to publicly

announce a schedule for implementation of the New Accord and the status of

implementation may be evaluated under the proposed framework for exchange of

information amongst member countries.

RBI, therefore, agrees with the view that the New Accord should initially be applied to

all internationally active banks. Further, a simplified standardised approach, as suggested

above, may be evolved for other banks and that national supervisors should have

discretion to implement the New Accord, in a phased manner.

As the main objective of the New Accord is to ensure competitive equality and

providing a reasonable degree of consistency in application, it is necessary that all

supervisors, across the world should have a common definition of internationally active

and significant banks. Basel Committee may, therefore, define what constitute

internationally active and significant banks.

In this regard, RBI is of the view that all banks with cross-border business exceeding

15% of their total business may be defined as internationally active banks. Significant

banks may be defined as those banks with complex structures and whose market share in

the total assets of the domestic banking system exceeds 1%. In the event of no consensus

KLE’s Institute of Manageent Studies of Research MBA IV Sem 40

Page 41: Final PRoj Basel

The Analysis of Basel Norms and Implementation

evolving on a uniform definition, national supervisors should have discretion to define

what constitutes an internationally active and a significant bank. Each national supervisor

may, however, be required to announce the criteria adopted for defining internationally

active and significant banks in its jurisdiction through the Basel Committee. The criteria,

when endorsed, should be accepted by supervisors in other jurisdictions and by

international agencies.

Cross-holding of Capital

RBI, while appreciating the Committee’s proposal that reciprocal cross-holdings of bank

capital artificially designed to inflate capital position of banks should be deducted, feels

that cross-holdings of equity and other regulatory investments also need to be moderated

to preserve the integrity of the financial system and minimise the adverse effect of

systemic risk and contagion.

RBI is, therefore, of the view that the Basel Committee may consider prescribing a

material limit (10% of the total capital) upto which cross-holdings of capital and other

regulatory investments could be permitted and any excess investments above the limit

would be deducted from total capital.

4.3 Claims on Sovereigns

4.3.1 RBI reiterates its earlier views that it will not be proper to link the risk weights

assigned to claims on sovereigns on the basis of assessments of External Credit

Assessment Institutions (ECAIs), as their credibility and past record lack empirical

evidence. In the recent past, the credit rating agencies had resorted to sudden and rapid

downgrading of certain countries, which experienced financial crises that exacerbated the

tendency of financial institutions to risk for exit.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 41

Page 42: Final PRoj Basel

The Analysis of Basel Norms and Implementation

RBI, therefore, reiterates that the ECAIs should not be assigned the direct responsibility

for risk assessment of banking book assets. This also applies to the assessments of Export

Credit Agencies (ECAs) as their independence and judgment are also subject to the same

limitations as those of the rating agencies.

4.3.2 The Committee’s proposal that the assessments of ECAs are recognized only if they

publish their risk scores and subscribe to the OECD 1999 country risk assessment

methodology is appreciated. However, the OECD methodology and ECAs’ country risk

classifications are still confidential. Further, their insight into the local conditions and

issues specific to emerging markets is also not comprehensive.

RBI, therefore, feels that such of the ECAs that disclose publicly their risk scores, rating

process and procedure and subscribe to the publicly disclosed OECD methodology and

qualify for use by national supervisors should only be eligible for use in assigning

preferential risk weights.

Claims on Banks

The flexibility to provide uniform risk weight i.e. one category less favourable than that

assigned to claims on sovereign to all the banks (under first option) militates the basic

philosophy of aligning capital adequacy assessment more closely with the key elements

of risk. The mere location may not necessarily be a good indicator of a bank’s

creditworthiness. This proposal provides competitive advantage to banks with weak

financials by virtue of their having been incorporated in better-rated countries.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 42

Page 43: Final PRoj Basel

The Analysis of Basel Norms and Implementation

RBI, therefore, reiterates its earlier view that the risk weighting of banks should be de-

linked from that of the credit rating of sovereigns in which they are incorporated. Instead,

preferential risk weights should be assigned on the basis of their underlying strength and

creditworthiness.

4.4.2 Banks are strongly regulated and supervised entities. In particular, weak banks and

those banks, which show signs of problems, are subjected to rigorous on-site and off-site

supervision and stringent prudential standards. Thus, risks inherent in inter-bank

exposures are not comparable to that of the corporates. There is, therefore, a need for a

modified treatment for claims on banks. The Basel Committee has provided discretion to

national supervisors to assign a lower risk weight to the exposures to the sovereign of

incorporation, denominated in domestic currency and funded in that currency. A similar

flexibility should be provided in respect of claims on banks as well.

RBI, therefore, feels that on the lines of discretion provided in the case of claims on

sovereigns, the national supervisors may be given discretion to assign lower risk weight

(one category less favourable than the risk weight to claims on sovereign), subject to a

floor of 20% to claims on all banks, which are denominated in domestic currency and

funded in that currency.

The proposal to assign preferential risk weight to short-term claims may lead to

regulatory arbitrage through roll-overs, concentration of short-term borrowings and

serious asset-liability mismatches, which could trigger systemic crisis and contagion in

the domestic inter-bank market. It would also be very difficult to monitor and control the

rollovers of short-term claims, given the high volume of transactions in the inter-bank

market.

RBI, therefore, feels that preferential risk weights should not be linked to the maturity of

the claims.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 43

Page 44: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Claims on Corporates

RBI appreciates the Committee’s efforts in evolving a range of risk-sensitive options for

assessing capital for credit risk. However, the reliance on ECAIs under the standardised

approach for assigning preferential risk weights may not be a better option. First, the

credibility of the rating agencies is at stake and there is no system of accountability for

sharp deterioration in the credit quality of rated entities immediately after assigning a

rating. Secondly, their access to information, especially in the absence of transparency

and good corporate governance principles is severely restricted. Whereas, banks are privy

to customer information and are less exposed to customer-related informational

asymmetry. Thirdly, the population of rated entities, even in the advanced countries, and

especially in the emerging markets, which have exposure to the banking system, is very

few in number. Fourthly, the use of external credit rating agencies in the regulatory

process may act as a disincentive for the banks to improve their credit risk management

systems.

It is appreciated that the expanded role envisioned for IRB approach provides positive

incentives to banks in improving their credit risk management techniques. However, the

adoption of the IRB approach, even under the foundation approach requires considerable

investments in IT / human resources and rigorous supervisory oversights. Thus, most of

the banks may not be able to adopt, even in advanced markets, the IRB foundation

approach.

RBI, therefore, feels that adoption of the IRB approach, as envisaged, may be possible

only for internationally active banks within the time frame and transition period proposed

by the Committee. For other banks, as an alternative, it is proposed that a simplified

standardised approach to assign preferential risk weights based on internal ratings of

banks may be evolved, subject to complying with the minimum standards prescribed by

the Basel Committee for IRB approach. Under this approach, standardised risk weights,

KLE’s Institute of Manageent Studies of Research MBA IV Sem 44

Page 45: Final PRoj Basel

The Analysis of Basel Norms and Implementation

instead of the continuous function of PD, Loss Given Default (LGD) and Exposure at

Default (EAD), in the range of 20% to 150% could be assigned, subject to mapping of

these ratings based on the robustness of the rating systems and the benchmark PD

estimated by the supervisor on the basis of pooled data from select banks.

This approach could be extended to a greater number of counterparties such as unrated

borrowers in the small/retail sector and will encourage banks to refine their credit risk

assessment and monitoring process, which would facilitate better management of their

loan books. This will also avoid the use of ECAIs in the regulatory process and reduce

the burden of additional cost on this count. Also, the scarce supervisory resources will be

optimally utilised for validating the banks’ internal rating systems rather than for

approving ECAIs. This would also avoid conflict of jurisdiction over rating agencies.

RBI, therefore, proposes that while internationally active banks may be required to follow

the IRB approach, a simplified standardised approach may be evolved for other banks,

whereby standardised risk weights in the range of 20% to 150% could be assigned on the

basis of internal ratings of banks.

Higher-risk Categories

The Committee’s proposals to assign 150% risk weight on unsecured portion of any

asset that is past due for more than 90 days, net of specific provisions, would adversely

affect the capital position of banks, especially those incorporated in emerging markets.

Normally, banks take some time in initiating the legal process after recognising

impairment. Further, there are well-established norms for recognition of and full

provision for any known loan losses. Collaterals also back such loans. Thus, the proposal

KLE’s Institute of Manageent Studies of Research MBA IV Sem 45

Page 46: Final PRoj Basel

The Analysis of Basel Norms and Implementation

to assign 150% risk weight even after recognising, in full, diminution in the value of

impaired loans would lead to pre-emption of scarce capital which does not reflect the

historical loan loss experiences. In India, the adoption of the proposal alone would

increase the risk-weighted assets of the banking system by USD 3.2 bio, entailing a drop

in the existing CRAR by 31 bps. as on March 31, 2000.

The 90-day norm also makes the regulatory capital extremely pro-cyclical. While during

the boom period there would be low accretion to NPAs leading to lower provisioning

requirements and higher capital adequacy ratio, during the recessionary phase, temporary

cash flow problems accentuate the pace of accretion to NPAs and hence the need for

higher provisioning requirements leading to lower capital adequacy ratio.

Lending by banks especially in the emerging markets is basically for productive

purposes and are adequately collateralised by various types of assets. The proposal to

reckon only the eligible collaterals for the secured portion of assets, which are past due

for more than 90 days, is too restrictive. National supervisors should have discretion to

recognise a wider range of collaterals for reckoning the secured portion of the assets.

RBI, therefore, feels that assets that are overdue over 90 days need not be placed under a

separate higher-risk category

External Credit Assessments

RBI appreciates the Committee’s endeavour in addressing most of the deficiencies

inherent in the first document regarding the use of ECAIs. The operative details about

implementation considerations viz. mapping process, multiple assessments, issuer versus

KLE’s Institute of Manageent Studies of Research MBA IV Sem 46

Page 47: Final PRoj Basel

The Analysis of Basel Norms and Implementation

issue assessment, etc. would go a long way in addressing the supervisory concerns

expressed by many regulators including RBI. However, the proposal to use unsolicited

ratings in the same way as solicited ratings would undermine the efficacy of using

external assessments for regulatory purposes. The unsolicited ratings are generally

superficial. The use of such ratings for assigning preferential risk weights would

undermine the basic philosophy of the New Accord. It may also lead to the potential for

trade off between competition and quality in the rating industry.

RBI is of the view that preferential risk weights should be assigned only on the basis of

solicited ratings.

Internal Rating Based Approach

RBI appreciates the Basel Committee’s proposal to offer a range of options of increasing

sophistication for providing explicit capital charge for credit risk. RBI recognises the

inherent attractiveness of the IRB foundation approach, which will result in better

internal credit risk management and may have the potential to be used in the supervision

of banks.

However, the minimum requirements stipulated even under the IRB foundation

approach are difficult to be enforced, especially in the emerging markets. Most of the

banks do not have robust rating systems and historical data on PDs, nor do the

supervisory authorities maintain time series data for estimating LGD. The transition

period of three years proposed in the New Accord may, therefore, not be adequate for

building database on various parameters. It is pertinent to quote Mr. Laurence H. Meyer

that ‘despite the importance of evaluating a borrower’s probability of default, banks have

been surprisingly slow, it seems, to distinguish among acceptable credit risk levels in

their pricing and in their own assessments of capital adequacy… Last fall, the Basel

Committee conducted an initial survey of large internationally active banks in order to

KLE’s Institute of Manageent Studies of Research MBA IV Sem 47

Page 48: Final PRoj Basel

The Analysis of Basel Norms and Implementation

estimate the quantitative effects of the proposal on their capital requirements. The

Committee was disappointed in the modest number of banks worldwide that could

provide meaningful distributions of credit quality, even for their corporate portfolios’2.

RBI, therefore, suggests that a simplified standardised approach as indicated in para

above might be evolved and applied to banks that are not internationally active.

It is well recognised that the proposal to assign banking book exposures into six broad

classes of exposures with different underlying credit risk characteristics - corporates,

sovereigns, banks, retail, project finance and equity under IRB approach would better

discriminate the likely pattern of portfolio losses. However, a common framework for

definition of these loan portfolio segments, without recognising the institutional

framework, value of accounts, geographical spread, etc., may pose severe implementation

problems to banks in emerging markets.

RBI, therefore, feels that national supervisors may have discretion and flexibility in

defining the exposure classes, viz. corporate, retail, sovereign, project finance, etc.

Operational Risk

In the context of increasing globalization, enhanced use of technology, product

innovations and growing complexity in operations, RBI agrees, in principle, with the

Committee’s proposal to assign explicit capital charge for operational risk. RBI also

acknowledges that the range of approaches of increasing sophistication - basic indicator,

standardised and internal measurement - would set the basic framework for estimating

capital for operational risk. Given the sophistication and database required for

standardised and internal measurement approaches, most of the banks, especially those

domiciled in emerging markets would be adopting the basic indicator approach.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 48

Page 49: Final PRoj Basel

The Analysis of Basel Norms and Implementation

However, the current provisional estimate of around 30% of gross income, which as per

Committee’s estimate works out to 20% of the current capital requirement as per the

1988 Accord, is expected to impose significant burden on the capital requirement of

banks. Further, it also does not reflect the risk profile of various banks, operating under

various levels of sophistication, markets, etc. It is observed that the fixed percentage has

been prescribed on the basis of economic capital set by only 6 international banks for

operational risk. As the magnitude of operational risk depends on complexity of

operations, absorption of technology, value of transactions, legal / supervisory

framework, internal control systems, etc., a uniform rate may not reflect the degree of

operational risk. The Committee may consider undertaking studies on operational risk

with particular reference to observed rate of losses, correlation between credit and market

risks and operational risk, etc.

RBI, therefore, feels that until a scientific method to measure the operational risk across

countries is evolved, the Basel Committee may consider prescribing a lower capital

charge of 15% of the gross income or 10% of the current capital requirement to align

capital to the underlying risk profile. National supervisors may, however, be given

discretion to prescribe higher capital charge towards operational risk in case of banks,

which may be considered as ‘outliers’.

Trading Book Issues

The Basel Committee has indicated that the changes made in the trading book are

consistent with the changes in the banking book capital requirements under the

standardised approach. However, the Committee’s proposal to provide explicit capital

charge on the basis of ratings is not consistent with the banking book capital requirements

as discussed hereunder. Under the standardised approach, discretion has been provided to

assign a lower risk weight to banks’ exposure to the sovereign of incorporation

denominated in domestic currency and funded in that currency. A similar discretion

KLE’s Institute of Manageent Studies of Research MBA IV Sem 49

Page 50: Final PRoj Basel

The Analysis of Basel Norms and Implementation

should be provided for specific risk capital charge for trading book to avoid regulatory

arbitrage.

Further, the graduated specific risk charge for qualifying securities has not been

consistent with preferential risk weights proposed in the banking book, as these have

been differentiated only on the basis of maturity rather than linking the capital charge to

the rating of the instruments. Further, the uniform capital charge of 8% to other category

does not reflect and compare with the risk weight of 150% or higher being proposed for

claims on sovereigns, banks and corporates that are rated below B-. Unless, the capital

charge or risk weights are uniform both in the trading and banking books, the New

Accord may lead to banks going for regulatory arbitrage.

RBI, therefore, feels that the capital charge for specific risk in the banking and trading

books should be consistent to avoid regulatory arbitrages.

Market Discipline – Third Pillar

RBI shares the Committee’s view that too much information could blur the key signals to

the market and agrees with the proposal to make a clear distinction between core and

supplementary disclosures. Further, the proposals to mandate frequent disclosures on

information, subject to rapid time decay, would facilitate market participants in taking

informed decisions.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 50

Page 51: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Transitional Arrangements

The Committee has provided a three year transition period beginning from the date of

implementation for applying full sub-consolidation. Similarly, a three-year transition

period has been provided for the foundation IRB approach, during which period, the

requirements could be relaxed, although supervisors would be expected to ensure that

implementation of IRB approach is done by banks in a sound manner.

While RBI feels that the above transition period would be sufficient for the

internationally active banks, other banks may need more transition period even for

implementing the suggested simplified standardised approach.

RBI, therefore, feels that national supervisors may be given discretion to implement the

New Accord, in a phased manner by banks, which are not internationally active and are

engaged predominantly in traditional banking.

. General Issues

Impact on Capital under Standardised Approach

Under the standardised approach, the Committee desires neither to produce a net

increase nor a net decrease, on an average, in minimum regulatory capital, even after

accounting for 20% explicit capital charge for operational risk. The Committee’s views

are apparently based on the assumption that capital discharge would be available on

assigning preferential risk weights to claims on sovereigns, banks and corporates, on the

basis of external assessments and recognition of more collaterals under credit risk

mitigation techniques.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 51

Page 52: Final PRoj Basel

The Analysis of Basel Norms and Implementation

However, RBI feels that the adoption of the New Accord would definitely enhance the

minimum regulatory capital, especially for banks domiciled in emerging markets on

account of the following:

i. All claims on sovereign (OECD or non-OECD) in India are currently assigned a

uniform risk weight of 0%. The discretion to assign a lower risk weight would

henceforth be available to claims on sovereign (or Central Bank) of incorporation,

denominated in domestic currency and funded in that currency. Other sovereigns

are required to be assigned risk weight in the range of 0% to 150% on the basis of

e20%. The 20% risk weight would henceforth be converted as a floor. Most of the

ii. banks are also not rated and therefore would have to be assigned a risk weight of

50%;

iii. The population of rated corporates is very few in number and most of them would

have to be risk weighted at 100%. The benefit of lower risk weight of 20% and

50% would therefore be available only to very few corporates;

iv. Unsecured portion of any asset which is past due over 90 days, net of specific

provisions, would have to be assigned a risk weight of 150%, which proposal

alone would increase the risk-weighted assets of the banking system by USD 3.2

bio, entailing a drop in the existing CRAR by 31 bps. as on March 31, 2000;

v. Claims on certain high-risk exposures viz. venture capital and private equity, at

national discretion, are also required to be assigned a higher risk weight of 150%;

vi. The deduction of significant investments in commercial entities; and

vii. Explicit capital charge, constituting 20% of the current capital requirement for

operational risk.

The benefit of credit risk mitigation techniques also may not be available as most of the

banks in emerging markets are not in a position to comply with the preconditions

stipulated by the Basel Committee.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 52

Page 53: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Thus, unless suitably modified, the adoption of the New Accord in its present format

would result in significant increase in the capital charge for banks, especially in emerging

markets.

Areas of Further Consultation

Some of the proposals contained in the New Accord warrant further consultation and the

Committee itself has indicated that the work was in progress in specific areas viz. IRB

approach, risk mitigation techniques, capital for operational risk, etc. As the objective of

the New Accord is to evolve a consensual framework that could be adopted uniformly by

all countries including emerging markets, the Committee may hold further consultations

on these areas.

Conclusion

RBI appreciates the committee’s efforts in evolving the New Accord containing

proposals that are comprehensive in coverage. When implemented, these would go a long

way in making the capital allocation more risk-sensitive and use of supervisory oversight

with market discipline would reinforce the supervisory framework and ensure financial

stability. However, the complexity and sophistication of the proposals restricts its

universal application in emerging markets, where the banks continue to be the major

segment in financial intermediation and would be facing considerable challenges in

adopting all the proposals. Like the 1988 Capital Accord, the New Accord should also

preserve the spirit of simplicity and flexibility to ensure universal applicability including

emerging markets.

viii. The New Accord would involve shift in direct supervisory focus away to the

implementation issues. Further, banks and the supervisors would be required to

invest large resources in upgrading their technology and human resources to meet

the minimum standards. The increasing reliance on external rating agencies in the

KLE’s Institute of Manageent Studies of Research MBA IV Sem 53

Page 54: Final PRoj Basel

The Analysis of Basel Norms and Implementation

regulatory process would undermine the initiatives of banks in enhancing their

risk external assessments;

Similarly, the claims on all banks are also assigned a uniform risk weight of management

policies and practices and internal control systems. The minimum standards set even for

the IRB foundation approach are complex and beyond the reach of many banks.

It is, therefore, essential that the Basel Committee should evolve a simplified

standardised approach, which could be adopted uniformly by all banks that are not

internationally active. Further, the transitional arrangements proposed in the New Accord

may not be sufficient for these banks. National supervisors may, therefore, be given

discretion to decide on the timeframe for implementing the Accord and applying it to

various banks in their jurisdiction depending upon the scale and complexity of their

operations.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 54

Page 55: Final PRoj Basel

The Analysis of Basel Norms and Implementation

BASEL I

KLE’s Institute of Manageent Studies of Research MBA IV Sem 55

Page 56: Final PRoj Basel

The Analysis of Basel Norms and Implementation

BASEL I

Basel I is the term which refers to a round of deliberations by central bankers from

around the world, and in 1988, the Basel Committee (BCBS) in Basel, Switzerland,

published a set of minimal capital requirements for banks. This is also known as the 1988

Basel Accord, and was enforced by law in the Group of Ten (G-10) countries in 1992,

with Japanese banks permitted an extended transition period. Basel I is now widely

viewed as outmoded, and a more comprehensive set of guidelines, known as Basel II are

in the process of implementation by several countries.

Background

The Committee was formed in response to the messy liquidation of a Cologne-based

bank in 1974. On 26 June 1974, a number of banks had released Deutschmark to the

Bank Herstatt in exchange for dollar payments deliverable in New York. On account of

differences in the time zones, there was a lag in the dollar payment to the counter-party

banks, and during this gap, and before the dollar payments could be effected in New

York, the Bank Herstatt was liquidated by German regulators.

This incident prompted the G-10 nations to form towards the end of 1974, the Basel

Committee on Banking Supervision, under the auspices of the Bank of International

Settlements (BIS) located in Basel, Switzerland.

Capital Adequacy Ratio - Basle Accord 1988

KLE’s Institute of Manageent Studies of Research MBA IV Sem 56

Page 57: Final PRoj Basel

The Analysis of Basel Norms and Implementation

The growing concern of commercial banks regarding international competitiveness and

capital ratios led to the Basle Capital Accord 1988. The accord sets down the agreement

among the G-10 central banks to apply common minimum capital standards to their

banking industries, to be achieved by year end 1992. The standards are almost entirely

addressed to credit risk, the main risk incurred by banks. The document consists of two

main sections, which cover

a. the definition of capital and

b. the structure of risk weights.

Based on the Basle norms, the RBI also issued similar capital adequacy norms for the

Indian banks. According to these guidelines, the banks will have to identify their Tier-I

and Tier-II capital and assign risk weights to the assets. Having done this they will have

to assess the Capital to Risk Weighted Assets Ratio (CRAR). The minimum CRAR

which the Indian banks are required to meet is set at 9 percent.

Tier-I Capital

Paid-up capital

Statutory Reserves

Disclosed free reserves

Capital reserves representing surplus arising out of sale proceeds of assets

Equity investments in subsidiaries, intangible assets and losses in the current period and

those brought forward from previous periods, will be deducted from Tier I capital.

Tier-II Capital

Undisclosed Reserves and Cumulative Perpetual Preference Shares

KLE’s Institute of Manageent Studies of Research MBA IV Sem 57

Page 58: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Revaluation Reserves

General Provisions and Loss Reserves

Background of the Basel Accord of 1988

The major impetus for the 1988 Basel Capital Accord was the concern of the Governors

of the G10 central banks that the capital of the world's major banks had become

dangerously low after persistent erosion through competition. Capital is necessary for

banks as a cushion against losses and it provides an incentive for the owners of the

business to manage it in a prudent manner.

The Existing Framework

The 1988 Accord requires internationally active banks in the G10 countries to hold

capital equal to at least 8% of a basket of assets measured in different ways according to

their riskiness. The definition of capital is set (broadly) in two tiers, Tier 1 being

shareholders' equity and retained earnings and Tier 2 being additional internal and

external resources available to the bank. The bank has to hold at least half of its measured

capital in Tier 1 form.

A portfolio approach is taken to the measure of risk, with assets classified into four

buckets (0%, 20%, 50% and 100%) according to the debtor category. This means that

some assets (essentially bank holdings of government assets such as Treasury Bills and

bonds) have no capital requirement, while claims on banks have a 20% weight, which

KLE’s Institute of Manageent Studies of Research MBA IV Sem 58

Page 59: Final PRoj Basel

The Analysis of Basel Norms and Implementation

translates into a capital charge of 1.6% of the value of the claim. However, virtually all

claims on the non-bank private sector receive the standard 8% capital requirement.

There is also a scale of charges for off-balance sheet exposures through guarantees,

commitments, forward claims, etc. This is the only complex section of the 1988 Accord

and requires a two-step approach whereby banks convert their off-balance-sheet positions

into a credit equivalent amount through a scale of conversion factors, which then are

weighted according to the counterparty's risk weighting.

The 1988 Accord has been supplemented a number of times, with most changes dealing

with the treatment of off-balance-sheet activities. A significant amendment was enacted

in 1996, when the Committee introduced a measure whereby trading positions in bonds,

equities, foreign exchange and commodities were removed from the credit risk

framework and given explicit capital charges related to the bank's open position in each

instrument.

Impact of the 1988 Accord

The two principal purposes of the Accord were to ensure an adequate level of capital in

the international banking system and to create a "more level playing field" in competitive

terms so that banks could no longer build business volume without adequate capital

backing. These two objectives have been achieved. The merits of the Accord were widely

recognised and during the 1990s the Accord became an accepted world standard, with

well over 100 countries applying the Basel framework to their banking system. However,

there also have been some less positive features. The regulatory capital requirement has

been in conflict with increasingly sophisticated internal measures of economic capital.

The simple bucket approach with a flat 8% charge for claims on the private sector has

given banks an incentive to move high quality assets off the balance sheet, thus reducing

the average quality of bank loan portfolios. In addition, the 1988 Accord does not

KLE’s Institute of Manageent Studies of Research MBA IV Sem 59

Page 60: Final PRoj Basel

The Analysis of Basel Norms and Implementation

sufficiently recognise credit risk mitigation techniques, such as collateral and guarantees.

These are the principal reasons why the Basel Committee decided to propose a more risk-

sensitive framework in June 1999.

Loopholes of Basel I Accord

After ten years of implementation and taking into consideration the rapid

technological, financial and institutional changes happened during the period

many weaknesses started appearing in Basel I accord.

Because of a flat 8% charge for claims on the private sector, banks have an

incentive to move high quality assets off the balance sheet (capital arbitrage)

through securitization. Thus, reducing the average quality of bank loan portfolio

It does not take into consideration the operational risks of banks, which become

increasingly important with the increase in the complexity of banks.

Also, the 1988 Accord does not sufficiently recognize credit risk mitigation

techniques, such as collateral and guarantees.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 60

Page 61: Final PRoj Basel

The Analysis of Basel Norms and Implementation

The regulatory Capital requirement has been in conflict with increasingly

sophisticated internal measures of economic Capital

It was concentrating on only on credit risk.

Why Basel II

Basel I is less Risk Sensitive

(More broad brush approach)

Basel II is more Risk Sensitive

(Granular capturing of Risk Profile)

It has been a long way from Basel introduced in 1988 to the present Basel II in

2006.

The measures envisaged in Basel II are intended to identify and measure the Risk

Profile of the Exposures and help Banks to initiate appropriate Risk Mitigation

Measures.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 61

Page 62: Final PRoj Basel

The Analysis of Basel Norms and Implementation

What is Basel II

Basel 2 is the new capital accord signed in June 2004 at Bank for International Settlement

located at Basel, Switzerland. It is an improvement over Basel 1 which had certain

deficiencies which have now been removed. Basel 2 is based on three pillars: capital

adequacy, supervisory review and market discipline. It is basically concerned with

financial health of the banks worldwide. The focus in Basel 2 is the risk determination

and quantification of credit risk, market risk and operational risk faced by banks. Reserve

Bank of India has accepted the accord and issued guidelines to ensure compliance with

the norms by March 31, 2008. Other scheduled commercial banks are required to

implement Basel 2 by March 31, 2009

• Is Basel II –

A Risk Management Exercise ? (or)

KLE’s Institute of Manageent Studies of Research MBA IV Sem 62

Page 63: Final PRoj Basel

The Analysis of Basel Norms and Implementation

A Capital Management Exercise ?

Basel II is basically a Risk Management Exercise

Doesn’t seek to change business models of the Bank.

But requires to fine-tune/update Risk Management practices.

Robust enough to capture all possible Risks the Bank is facing or likely to

face.

Initiate adequate and appropriate Risk Mitigation measures through effective

Systems and Procedures

KLE’s Institute of Manageent Studies of Research MBA IV Sem 63

Page 64: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Objectives of the New Basel Accord

Broadly speaking, the objectives of Basel II are to encourage better and more

systematic risk management practices, especially in the area of credit risk, and to provide

improved measures of capital adequacy for the benefit of supervisors and the marketplace

more generally. At the outset of the process of developing the new Accord, the Basel

Committee developed the so-called three pillars approach to capital adequacy involving

(1)minimum capital requirements,

(2) supervisory review of internal bank assessments of capital relative to risk, and

(3) increased public disclosure of risk and capital information sufficient to provide

meaningful market discipline. Although the Committee’s proposals have evolved

considerably over the past several years, these fundamental objectives and the three-pillar

approach have held constant.

It is hardly necessary to emphasize the importance of banks and banking systems to

financial and economic stability. The ability of a sound and well-capitalized banking

system to help cushion an economy from unforeseen shocks is well known, as are the

KLE’s Institute of Manageent Studies of Research MBA IV Sem 64

Page 65: Final PRoj Basel

The Analysis of Basel Norms and Implementation

negative consequences of a banking system that itself becomes a source of weakness and

instability. A critical potential weakness of financial markets is that risks are in many

cases under-estimated and not fully recognized until too late, with a concomitant

potential for excessive consequences once they have been fully realized. This is why the

Basel Committee’s efforts to promote greater recognition of risks and more systematic

attention to them are vitally important.

The essence of Basel II is a focus on risk differentiation and the need for enhanced

approaches to assessing credit risk. Some critics have argued that it is preferable to

downplay differences in risk, and indeed forbearance can sometimes appear the most

expedient strategy.

But experience has also shown that this will not work as an overall approach because

ignoring risks inevitably leads to larger problems down the road. Thus, one of the key

messages of Basel II is that bankers, supervisors, and other market participants must

become better attuned to risk and better able to act on those risk assessments at the

appropriate time. Bank supervisors must get better at addressing issues pre-emptively

rather than in crisis mode.

Significant attention to risk management is one of the primary mechanisms available to

help banks and supervisors do that. Basel II seeks to provide incentives for greater

awareness of differences in risk through more risk-sensitive minimum capital

requirements. The Pillar 1 capital requirements will, by necessity, be imperfect measures

of risk as any rules-based framework will be. The objective of the proposals is to increase

KLE’s Institute of Manageent Studies of Research MBA IV Sem 65

Page 66: Final PRoj Basel

The Analysis of Basel Norms and Implementation

the emphasis on assessments of credit and operational risk throughout financial

institutions and across markets.

Perhaps even more important in the long run is the second pillar of the new Accord.

Pillar 2 requires banks to systematically assess risk relative to capital within their

organization. The review of these internal assessments by supervisors should provide

discipline on bank management to take the process seriously and will help supervisors to

continually enhance their understanding of risk at the institutions. The third pillar of

Basel II provides another set of necessary checks and balances by seeking to promote

market discipline through enhanced transparency. Greater disclosure of key elements of

risk and capital will provide important information to counterparties and investors who

need such information to have an informed view of a bank’s profile.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 66

Page 67: Final PRoj Basel

The Analysis of Basel Norms and Implementation

BASEL II GUIDELINES

Basel II Committee set up by Bank for International Settlements (BIS) released

the first version of Basel II in June 2006.

A Comprehensive Version, incorporating amendments to relating to Market

Risks, Trading Activities and the Treatment of Double Default Effects, was

released in June 2006.

Basel II Guidelines in Indian context were finalized by RBI, after due

deliberations and brain-storming by select 14-member Committee of Banks from

Public Sector and Private Sector.

Our Bank is also a member and headed the Sub-Committee on ‘National

Discretion’.

RBI released Basel II Final Guidelines vide their notification dated

27.04.2007.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 67

Page 68: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Effective Date

Foreign banks operating in India and Indian banks having operational presence

outside India should adopt Standardised Approach (SA) for credit risk and Basic

Indicator Approach (BIA) for operational risk for computing their capital requirements

under the Revised Framework with effect from March 31, 2008. All other commercial

banks (excluding Local Area Banks and Regional Rural Banks) are encouraged to

migrate to these approaches under the Revised Framework in alignment with them

but in any case not later than March 31, 2009. These banks shall continue to apply

the Standardised Duration Approach (SDA) for computing capital requirement for

market risks under the Revised Framework.

Parallel run

With a view to ensuring smooth transition to the Revised Framework and with a

view to providing opportunity to banks to streamline their systems and strategies,

banks were advised to have a parallel run of the revised Framework. A copy of the

quarterly reports to the Board of Directors may be continued to be submitted to the

Reserve Bank of India – one each to the Department of Banking Supervision, Central

Office and the Department of Banking Operations and Development, Central Office.

Migration to other approaches under the Revised Framework

KLE’s Institute of Manageent Studies of Research MBA IV Sem 68

Page 69: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Banks are required to obtain the prior approval of the Reserve Bank to migrate to

the Internal Rating Based Approach (IRBA) for credit risk and the Standardised

Approach (TSA) or the Advanced Measurement Approach (AMA) for operational risk

for computing regulatory capital requirements. A separate communication in this

regard will be issued to banks at a later date, specifying the pre-requisites and

procedure for approaching the Reserve Bank for seeking its prior approval for such

migration

BASEL II FRAMEWORK

KLE’s Institute of Manageent Studies of Research MBA IV Sem 69

THREE PILLARS OF BASEL II

MinimumCapital Requirement

SupervisoryReviewProcess

Market Discipline

Page 70: Final PRoj Basel

The Analysis of Basel Norms and Implementation

1 The first Pillar:

Minimum capital requirement

The definition of capital in Basel 2 will not modify and that the minimum ratios of capital

to risk-weighted assets including operational and market risks will remain 8% for total

capital. Tier 2 capital will continue to be limited to 100% of Tier 1 capital. The main

changes will come from the inclusion of the operational risk and the approaches to measure

the different kinds of risks.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 70

Credit Risk

StandardisedApproach

IRBA

Market Risk

Standardised DurationApproach Internals

Model Approach

Basic IndicatorApproach

Operational Risk

Basic IndicatorApproach

StandardisedApproach

Advanced MeasurementApproach

Page 71: Final PRoj Basel

The Analysis of Basel Norms and Implementation

While there were no changes in the approaches to measure the market risk there were

fundamental changes in the approaches to measure the credit risk, which we will discuss

in section 3. Regarding the operational risk it is introduced for the first time in this

accord.

In the standardized approach to credit risk, exposures to various types of counter

parties, e.g. sovereigns, banks and corporates, will be assigned risk weights based on

assessments by external credit assessment institutions. To make the approach more risk

KLE’s Institute of Manageent Studies of Research MBA IV Sem

Approaches to Measure Market Risk1.Standardised Approach2.Internal Model Approach

71

Approaches to measure credit Risk1.Standardised Approach2.IRBA

Approaches to measure operational risk1.Basic Indicator Approach2. Standardised Approach 3.IMA

Risk-Based Capital Ratio= Capital _____________________________________________

Credit Risk + Market Risk+Operational Risk

Capital Unchanged

Page 72: Final PRoj Basel

The Analysis of Basel Norms and Implementation

sensitive an additional risk bucket (50%) for corporate exposures will be included.

Further, certain categories of assets have been identified for the higher risk bucket

(150%).

The “foundation” approach to internal ratings incorporates in the capital

calculation the banks’ own estimates of the probability of default associated with the

obligor, subject to adherence to rigorous minimum supervisory requirements. Estimates

of additional risk factors to calculate the risk weights would be derived through the

application of standardized supervisory rules. In the “advance” IRB approach, banks that

meet even more rigorous minimum requirements will be able to use a broader set of

internal risk measures for individual exposures.

The Second Pillar:

Supervisory Review Process

In Basel 1 the risk weight were fixed and the implementation of the accord was straight

forward. In Basel 2 the bank can choose from a menu of approaches to measure the credit,

market and operational risks. This process of choosing the approach requires the review of

the availability of the minimum requirements to implement the approach. In addition to that,

in IRB approaches the risk weight is computed from inputs from the bank (like the

KLE’s Institute of Manageent Studies of Research MBA IV Sem 72

Page 73: Final PRoj Basel

The Analysis of Basel Norms and Implementation

probability of default). It is necessary in this case to make sure that the bank inputs are

measured or estimated in an accurate and robust manner. Basel

committee suggests four principles to govern the review process:

Principle 1: Banks should have a process for assessing their overall capital in relation to

their risk profile and a strategy for maintaining their capital levels.

Principle 2: Supervisors should review and evaluate banks’ internal capital adequacy

assessments and strategies, as well as their ability to monitor and ensure their compliance

with regulatory capital ratios. Supervisors should take appropriate supervisory action if

they are not satisfied with the results of this process.

Principle 3: 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.

Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from

falling below the minimum levels required to support the risk characteristics of a

particular bank and should require rapid remedial action if capital is not maintained or

restored.

The Third Pillar:

Market Discipline

The third pillar in Basel 2 aims to bolster market discipline through enhanced disclosure

by banks. Effective disclosure is essential to ensure that market participants can better

KLE’s Institute of Manageent Studies of Research MBA IV Sem 73

Page 74: Final PRoj Basel

The Analysis of Basel Norms and Implementation

understand banks’ risk profiles and the adequacy of their capital positions. The new

framework sets out disclosure requirements and recommendations in several areas,

including the way a bank calculates its capital adequacy and its risk assessment methods.

The core set of disclosure recommendations applies to all banks, with more detailed

requirements for supervisory recognition of internal methodologies for credit risk,

mitigation techniques and asset securitization.

The Risk Categories of Bank

Credit risk

The risk that a borrower or counterparty might not honour its contractual obligations -

Very relevant to operating staff.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 74

Page 75: Final PRoj Basel

The Analysis of Basel Norms and Implementation

The Standardized approach for credit risk

The standardized approach is conceptually the same as the present Accord, but it

is more risk sensitive. The bank allocates a risk-weight to each of its assets and offbalance-

sheet positions and produces a sum of risk-weighted asset values. A risk weight

of 100% means that an exposure is included in the calculation of risk weighted assets at

10 its full value, which translates into a capital charge equal to 8% of that value. Similarly, a

risk weigh of 20% results in a capital charges of 1.6%. Because of its simplicity it is

expected that it will be used by a large number of banks around the globe for calculating

minimum capital requirements.

Under Basel 1 individual risk weights depend on the board category of borrower

(i.e. sovereigns, banks or corporates). Under Basel 2 the risk weights are to be refined by

reference to a rating provided by an external credit assessment institution (such as a

rating agency) that meets strict standards. For example, for corporate lending, the

existing Accord provides only one risk weigh category of 100% but the new Accord will

provide four categories (20%, 50%, 100% and 150%)3. The following table illustrates

the relation between the risk weights and credit assessment for corporate lending.

Credit

Assessment

AAA to AA- A+ to A- BBB+ to BB- Below BB- Unrated

Risk Weights 20% 50% 100% 150% 100%

Banks’ exposures to the lowest rated corporates are captured in the 150% risk-weight

KLE’s Institute of Manageent Studies of Research MBA IV Sem 75

Page 76: Final PRoj Basel

The Analysis of Basel Norms and Implementation

category. 150% risk-weight can be assigned for example to unsecured portions of assets

that are past due for more than 90 days, net of specific provisions. Similar frameworks

for sovereigns and banks credit risk weighs will be applied.

For bank’s exposures to sovereigns4, the Basel 2 proposes the use of published

credit scores of export credit agencies (ECA) and developed a method for mapping such

ratings to the standardized risk buckets.

In a suggested simple form for the foundation method one can use for corporate risk

weight of 100% if the external credit assessment will not be available. 4 The term

“sovereigns” includes sovereign governments; central banks and public sector entities

treated as sovereign governments by the nations supervisor.

Operational requirements for the standardized approach

In the standardized approach, national supervisors will not allow banks to assign

risk weight based on external assessments in a mechanical fashion. Rather, supervisors

and banks are responsible for evaluating the methodologies used by external credit

assessment institutions (ECAI) and the quality of the ratings produced. The supervisors

will use the following six criteria in recognizing ECAIs as outlined by Basel committee:

Objectivity. The methodology for assigning credit assessments must be

rigorous, systematic, and subject to some form of validation based on historical

experience. Moreover, assessments must be subject to ongoing review and

responsive to changes in financial condition. Before being recognized by

supervisors, an assessment methodology for each market segment, including

rigorous back testing, must have been established for at least one year and

preferably three.

Independence: An ECAI should be independent and should not be subject to

KLE’s Institute of Manageent Studies of Research MBA IV Sem 76

Page 77: Final PRoj Basel

The Analysis of Basel Norms and Implementation

political or economic pressures that may influence the rating.

International access/Transparency: The individual assessments should be

available to both domestic and foreign institutions with legitimate interests and at

equivalent terms. In addition, the general methodology used by the ECAI should

be publicly available.

Disclosure: An ECAI should disclose the following information: its

assessment methodologies, including the definition of default, the time horizon

and the meaning of each rating; the actual default rates experienced in each

assessment category; and the transitions of the assessments, e.g. the likelihood of

AAA rating becoming AA over time.

Resources : An ECAI should have sufficient resources to carry out high quality

credit assessments.

Credibility: To some extent, credibility is derived from the criteria above. In

addition, the reliance on an ECAI’s external credit assessments by independent

parties (investors, insurers, trading partners) is evidence of the credibility of the

assessments of an ECAI.

Banks may elect to use a subset of the ECAI assessments deemed eligible by their

national supervisor, though the assessments must be applied consistently for both risk

weighting and risk management purposes. The requirement is intended to limit the

potential for external credit assessments to be used in a manner that results in reduced

capital requirements but is inconsistent with sound risk management practices.

Basel 2 address also practical considerations, such as the use of multiple external credit

assessments, issuer versus issue assessments, short-term versus long-term assessments

KLE’s Institute of Manageent Studies of Research MBA IV Sem 77

Page 78: Final PRoj Basel

The Analysis of Basel Norms and Implementation

and unsolicited assessments.

Internal ratings-based approach (IRB)

The IRB approach provides a similar treatment for corporate, bank and sovereign

exposures, and a separate framework for retail, project finance and equity exposures. For

each exposure class, the treatment is based on three main elements: risk components,

where a bank may use either its own or standardized supervisory estimates; a risk-weight

function which converts the risk components into risk weight to be used by banks in

calculating risk-weighted assets; and a set of minimum requirements that a bank must

meet to be eligible for IRB treatment.

Credit Risk – State Bank of India’s Preparedness

Existing Internal Credit Risk Assessment System refined and extended to cover

Advance Accounts of Rs. 25 lacs and above.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 78

Page 79: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Existing Internal Credit Information System is being fine-tuned to meet Basel II

requirements, now covering Whole Bank.

Models for implementation of Integrated Risk Management and Operational Risk

Management are being implemented.

Consultants are being appointed for Portfolio Credit Risk Modelling Exercise

Credit Risk–Corporate & Retail Classification

Fund based + Non Fund based Limits < or = Rs. 5 crs and/or Turnover <Rs. 50

crs are classified as Retail Exposures and are assigned 75% RW.

Fund based + Non Fund based Limits > Rs. 5 crs and/or Turnover = or >Rs. 50

crs are classified as Corporate Exposures and assigned RWs as per Rating.

Sovereigns, MDBs, Banks, Public Sector Entities, Primary Dealers, Banks and

Staff Residential Housing Loans are outside the scope of Retail and Corporate

classification.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 79

Page 80: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Specified categories like Commercial Real Estate, Venture Capital, Capital

Market Exposures, Personal Loans and exposures to Non-Deposit taking

Systematically Important NBFCs (Asset size of over Rs.100 crs) are outside the

scope of Retail and Corporate classification.

CREDIT RISK ASSET NETTING

KLE’s Institute of Manageent Studies of Research MBA IV Sem 80

Page 81: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Asset Netting means reducing value of eligible Collaterals from Outstanding to

arrive at the Net Exposure amount.

Basel II recognizes only Financial Collaterals and Gold for Asset Netting.

To be eligible for Asset Netting, lien on Collaterals is to be marked and legal

certainty is to be met.

Banker’s General Lien is not permitted (which is available in Basel I scenario).

For Asset Netting, value of Basel II collaterals is considered account-wise and not

in aggregate. i.eThe additional collateral available for a particular Exposure

cannot be used for Asset Netting of other Exposures, unless charge is extended.

All Advances including Staff loans are eligible for Asset Netting, if Basel II

collaterals are available

Market Risk

KLE’s Institute of Manageent Studies of Research MBA IV Sem 81

Page 82: Final PRoj Basel

The Analysis of Basel Norms and Implementation

- The risk of adverse price movements such as exchange rates, the value of

securities, and interest rates - Less relevant to operating staff, more or less

centralised @ Corporate centre

Although the Basel Committee issued “Amendment to the Capital Accord to incorporate

Market Risks” in1996, RBI as an interim measure, advised banks to assign an additional

risk weight of 2.5% on the entire investment portfolio. RBI feels that over the years,

bank’s ability to identify and measure market risk has improved and therefore, decided to

assign explicit capital charge for market risk in a phased manner over a two year period

as under -.

a. Banks would be required to maintain capital charge for market risk in respect of

their trading book exposure (including derivatives) by March 2005.

b. Banks would be required to maintain capital charge for market risk in respect of

securities under available for sale category by March 2006 puting capital charge for

interest rate related instruments in the trading book, equities in the trading book

and foreign exchange risk (including gold and precious metals) in both trading and

banking book. Trading book will include:

◆ Securities included under the Held for Trading category

◆ Securities included under the Available for Sale category

◆ Open gold position limits

◆ Open foreign exchange position limits

◆ Trading position in derivatives and derivatives

entered into for hedging trading book exposures.

As per the guidelines, minimum capital requirement

is expressed in terms of two separately calculated charges:

KLE’s Institute of Manageent Studies of Research MBA IV Sem 82

Page 83: Final PRoj Basel

The Analysis of Basel Norms and Implementation

a. Specific Risk and

b. General Market Risk

Specific Risk: Capital charge for specific risk is

designed to protect against an adverse movement in price

of an individual security due to factors related to individual

issuer. This is similar to credit risk. The specific risk

charges are divided into various categories such as investments

in Govt securities, claims on Banks, investments in mortgage backed securities,

securitized papers etc. and capital charge for each category specified.

General Market Risk: Capital charge for general market risk is designed to capture the

risk of loss arising from changes in market interest rates. The Basel Committee suggested

two broad methodologies for computation of capital charge for market risk, i.e.,

Standardized Method and Internal Risk Management Model Method. As Banks in India

are still in a nascent stage of developing internal risk management models, in the

guidelines, it is proposed that to start with, the Banks may adopt the Standardized

Method. Again, under Standardized Method, there are two principle methods for

measuring market risk – maturity method and duration method. As duration method is a

more accurate method of measuring interest rate risk, RBI prefers that Banks measure all

of their general market risk by calculating the price sensitivity (modified

duration) of each position separately. For this purpose detailed mechanics to be followed,

time bands, assumed changes in yield etc. have been provided by RBI.

Market Risk State Bank of India’s Preparedness

KLE’s Institute of Manageent Studies of Research MBA IV Sem 83

Page 84: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Exploring the feasibility of using KVaR+ software for mapping Treasury

Operations for Market Risk.

Developed adequate hedging mechanisms to absorb the impacts of Market Risk.

Our Investment Risk is akin to the Country Risk and thus well protected.

Implementation of Oracle Based ALM Software is in progress, to provide

comprehensive ALM data analysis.

Market Risk State Bank of India’s Concerns

During the FY: 2005-06, additional Capital charge of around Rs. 1200 crores has

been provided on account of Market Risk on AFS category of Investments.

Securitization Transactions are subjected to stringent treatment thus making them

less attractive.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 84

Page 85: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Operational Risk

The risk of loss resulting from inadequate or failed internal processes, people, and

systems, or from external events – Newly introduced & also very relevant to operating

staff

Capital Charge for Operational Risk

The Basel Committee has defined the Operational Risk as “the risk of loss resulting from

inadequate or failed internal processes, people and systems or from external events”.

This definition includes legal risk but excludes strategic and reputational risk. The

objective of the operational risk management is to reduce the expected operational losses

using a set of key risk indicators to measure and control risk on continuous basis and

provide risk capital on operational risk for ensuring financial soundness of the Bank.

Basic Indicator Approach

Under the basic indicator approach, Banks are required to hold capital for operational risk

equal to the average over the previous three years of a fixed percentage (15% - denoted as

alpha) of annual gross income. Gross income is defined as net interest income plus net

non-interest income, excluding realized profit/losses from the sale of securities in the

banking book and extraordinary and irregular items.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 85

Page 86: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Standardized Approach

Under the standardized approach, bank’s activities are divided into eight business lines.

Within each business line, gross income is considered as a broad indicator for the likely

scale of operational risk. Capital charge for each business line is calculated by

multiplying gross income by a factor (denoted beta) assigned to that business line. Total

capital charge is calculated as the three-year average of the simple summations of the

regulatory capital across each of the business line in each year. The values of the betas

prescribed for each business line are as under:

Business Line Beta Factor

Corporate Finance 18%

Trading and sales 18%

Retail banking 12%

Commercial banking 15%

Payment and Settlement 18%

Agency Sevices 15%

Asset Management 12%

Retail Brokerage 12%

KLE’s Institute of Manageent Studies of Research MBA IV Sem 86

Page 87: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Advanced Measurement Approach

Under advanced measurement approach, the regulatory capital will be equal to the risk

measures generated by the bank’s internal risk measurement system using the

prescribed quantitative and qualitative criteria.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 87

Page 88: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Operational Risk State Bank Of India’s Preparedness

Operational Risk Management Committee, is developing the ORM Policy to assess

the losses to:

i) Physical Assets ii) Business and Systems iii) Process Management and

Delivery Mechanism.

Business Process Re-engineering Team is in place evaluating the processes

and redefining the Systems & Procedures to mitigate incidence of losses on

account of Processes and Systems.

Operational Risk - Our Concerns

At 12% CAR, the Bank may be required to provide additional capital charge of

around Rs. 4500 crores towards Operational Risk.

The Bank has established systems and procedures and hence, may be required to

provide lesser capital for Operational Risk under Advanced Approaches .

However, given the current level of MIS and Technical Sophistication, our Bank

for the present, may be in a position to adopt Basic Indicator Approach only.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 88

Page 89: Final PRoj Basel

The Analysis of Basel Norms and Implementation

MIS – State Bank of India’s Preparedness

Moving towards Core Banking Solutions, which will help byrobust MIS and mapping

of Historical Data.

CBS Data Structure is being fine-tuned to factor-in data needs for CAR compilation.

Data Warehouse is being setup to store and retrieve Historical Data.

In-house teams from BI (MIS) and IT-SS Depts. are developing solutions for Auto-

generation of CAR B II on CBS and BankMaster branches respectively.

MIS and others – State Bank of India Concerns

Quality of data inputted by the branches is found wanting.

Developing of robust MIS to facilitate mapping of valid auditable historical data.

Transition requires huge investments in Technical Up-gradation, for mapping of

validated auditable historical data etc

.

Adverse balances in Agency Clearing A/c leads to additional RWs.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 89

Page 90: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Adverse comments by the Statutory Auditors

CHALLENGES FOR INDIAN BANKING SYSTEM UNDER

BASEL II

A feature, somewhat unique to the Indian financial system is the diversity of its

composition. We have the dominance of Government ownership coupled with significant

private shareholding in the public sector banks and we also have cooperative banks,

Regional Rural Banks and Foreign bank branches. By and large the regulatory standards

for all these banks are uniform.

Costly Database Creation and Maintenance Process:

The most obvious impact of BASEL II is the need for improved risk management and

measurement. It aims to give impetus to the use of internal rating system by the

international banks. More and more banks may have to use internal model developed in

house and their impact is uncertain. Most of these models require minimum 5 years bank

data which is a tedious and high cost process as most Indian banks do not have such a

database

Additional Capital Requirement:

In order to comply with the capital adequacy norms we will see that the overall capital

level of the banks will raise a glimpse of which was seen when the RBI raised risk

weightages for mortgages and home loans in October 2004. Here there is a worrying

aspect that some of the banks will not be able to put up the additional capital to comply

with the new regulation and they may be isolated from the global banking system.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 90

Page 91: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Large Proportion of NPA's:

A large number of Indian banks have significant proportion of NPA's in their assets.

Along with that a large proportion of loans of banks are of poor quality. There is a danger

that a large number of banks will not be able to restructure and survive in the new

environment. This may lead to forced mergers of many defunct banks with the existing

ones and a loss of capital to the banking system as a whole

Low Degree of Corporate Rating Penetration:

India has as few as three established rating agencies and the level of rating penetration is

not very significant as, so far, ratings are restricted to issues and not issuers. While Basel

II gives some scope to extend the rating of issues to issuers, this would only be an

approximation and it would be necessary for the system to move to ratings of issuers.

Encouraging ratings of issuers would be a challenge.

Cross Border Issues for Foreign Banks:

In India, foreign banks are statutorily required to maintain local capital and the following

issues are required to be resolved;

Validation of the internal models approved by their head offices and home country

supervisor adopted by the Indian branches of foreign banks.

Date history maintained and used by the bank should be distinct for the Indian branches

KLE’s Institute of Manageent Studies of Research MBA IV Sem 91

Page 92: Final PRoj Basel

The Analysis of Basel Norms and Implementation

compared to the global data used by the head office capital for operational risk should be

maintained separately for the Indian branches in India

NOT WHEN BUT HOW?

The important decision for India is not whether to stay on Basel I or move to Basel II, but

of which of the many alternatives on offer, should be adopted. Given the lack of rating

penetration, the Standardized Approach yields little in linking capital to risk while the

IRB approach looks complex to implement and difficult to monitor. In the event of some

banks adopting IRB Approach, while other banks adopt Standardised Approach, banks

adopting IRB Approach will be much more risk sensitive than the banks on Standardised

Approach, since even a small change in degree of risk might translate into a large impact

on additional capital requirement for the IRB banks.

For banks adopting Standardised Approach the relative capital requirement would be less

for the same exposure and would be inclined to assume exposures to high risk clients,

which were not financed by IRB banks. As a result, high risk assets could flow towards

banks on Standardised Approach which need to maintain lower capital on these assets.

Similarly, low risk assets would tend to get concentrated with IRB banks which need to

maintain lower capital on these assets. Hence, system as a whole may maintain lower

capital than warranted.

Keeping in view the above complications we suggest as a transitional tool, a Centralized

Rating Based(CRB) approach where the RBI dictates a rating scale and asks banks to rate

KLE’s Institute of Manageent Studies of Research MBA IV Sem 92

Page 93: Final PRoj Basel

The Analysis of Basel Norms and Implementation

borrowers according to that centralized scale. The great benefit of the approach is that the

RBI would be able to monitor and control banks' ratings and hence monitor and control

their capital sufficiency in relation to risk much more effectively. These kinds of

comparisons combined with simple procedures for spotting outliers and keeping a track

of the different banks' ratings of the main borrowers from the financial system will be

extremely valuable tools for a RBI.

Finally the CRB approach should be used as a precursor to IRB. Once the CRB approach

is working the RBI could then work with banks to approve their own rating scales and

rating methodology using the basic CRB approach as a reference tool.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 93

Page 94: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Challenges in Implementation in SBI

Complexities in Systems and Processes involved in Basel II make the

implementation process difficult, time consuming and costly.

Availability and mapping of Validated and Auditable Data and Integration of the

same to Basel II norms.

Adaptability of Operating Personnel to the New Skills

.

Internationally active Bank like ours will face problem due to localization of

Basel II norms in different Geographical Zones due to Home & Host Country

Regulations

KLE’s Institute of Manageent Studies of Research MBA IV Sem 94

Page 95: Final PRoj Basel

The Analysis of Basel Norms and Implementation

MIGRATION TO BASEL II BY SBI TIME LINES

Our Bank has to migrate to Basel II Framework by 31.03.2008, both at the Solo

and at the Consolidated Level.

The Board of Directors directed that Bank complete all Basel II related activities

and equip itself to migrate by 30.09.2007.

The time-line set by the Board is highly demanding and requires conscious and

concerted efforts by all of us.

Bank has to conduct Parallel Run of all Basel II related activities.

Compilation of CAR B II is one of the important activities of Parallel Run.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 95

Page 96: Final PRoj Basel

The Analysis of Basel Norms and Implementation

MIGRATION TO BASEL II -MONITORING

An Integrated Risk Governance Structure is set up to facilitate early migration to

Basel II.

Separate departments are set up to monitor and manage Credit Risk, Market Risk

and Operational Risk.

Risk based Internal Audit has been implemented across the Bank.

An In-house Committee is overseeing the Transition to Basel II.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 96

Page 97: Final PRoj Basel

The Analysis of Basel Norms and Implementation

THE IMPACT OF BASEL NORMS

Basel II is the new regulatory framework within which all banks will have to work. Its

aim is to safeguard the stability of the financial sector and one of its aspects is a

comprehensive approach to risk.

The first phase of the Accord will take effect in 2007, and the second phase will be

implemented in 2008.

The Accord regulates the amount of capital that banks will have to set aside for their

loans. In addition, it prescribes that this capital must be a better reflection of the actual

credit risks represented by the companies to which the banks lend. Banks can select from

three methods of determining the risks and the associated capital requirements; the banks

with the most sophisticated risk management will be rewarded with a lower capital

requirement relative to their existing capital bases. This is one of the reasons why credit

will not necessarily become more expensive. There is also no question of credit crunch;

banks' loan portfolios have in fact grown as a proportion of their total assets.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 97

Page 98: Final PRoj Basel

The Analysis of Basel Norms and Implementation

As from 1 January 2007, banks will be required to have historical credit information on

their lending customers; this information is needed to evaluate their customers'

creditworthiness. Three quarters of companies are currently reported to have insufficient

information about the banks' new credit risk criteria.

An increase in the transparency of company accounting and of the information exchanged

with banks is intended to result in greater objectivity with regard to the granting of new

credit lines. The more favourable the company's risk profile, the better the credit risk

rating and the more favourable the bank's terms and conditions will be.

Creditworthiness a management priority

The banks' credit risk assessment will be repeated during the term of the financing; this

seems to be paving the way for a greater role for companies' accountants. Systematic

analysis of a company's creditworthiness is a useful part of medium-term planning.

A company's creditworthiness must be a management priority. Efficient debtor

management, good payment history, and up-to-date financial reporting will help to boost

credit ratings.

Banks use both quantitative and qualitative criteria to assess credit risk. The quantitative

factors are gearing, liquidity, profitability, debt repayment capacity, and security. The

qualitative factors are the quality and the expertise of the management, the market

environment, and the legal form of the business. They use many different information

sources, ranging from balance sheets and profit and loss accounts, to business plans and

tax returns, but also meetings with the management.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 98

Page 99: Final PRoj Basel

The Analysis of Basel Norms and Implementation

A company that does not score well in a bank's credit risk assessment may face

difficulties in the future. Under Basel II, the bank would then be forced to make its loans

more expensive, to restrict outstanding credit lines, or to refuse to grant further loans.

In order to improve their credit risk assessment or rating, companies have the option of

making greater use of off-balance sheet finance, such as leasing or factoring. Another

option is to raise private equity.

Undercapitalisation is a mortgage on the future

Under Basel II the basic lending criteria will certainly continue to be the competence of

the management, the company's ability to repay the loan, and adequate equity.

Companies demonstrate their ability to repay debt using credible business plans and

historical cash flows. Under Basel II, the cash flows that companies are able to

demonstrate will become more important.

Companies must also demonstrate their inherent profitability and the managers of many

SMEs and medium-sized corporates will certainly have to address this issue. Benefits in

kind and the segregation of corporate and personal assets must be properly organised. In

this way, the business can organise its activities at the level of a management company,

thereby increasing the transparency of the operating company.

Basel II will also have a major impact on equity, as the penalties for undercapitalisation

will increase. Undercapitalisation is generally tax-driven and under a /historically high

tax burden in many countries, overcapitalisation has become synonymous with an

KLE’s Institute of Manageent Studies of Research MBA IV Sem 99

Page 100: Final PRoj Basel

The Analysis of Basel Norms and Implementation

expensive price tag. Too many companies have excessively high gearing. In Europe, for

instance, bank loans account for 22% of financing, compared with 12% in the UK, and

4% in the US.

Undercapitalisation constitutes a mortgage on the future; this situation needs to change.

Profit retention and capital injections have become fiscally more attractive in recent years

and personal equity needs to be used more extensively to finance businesses.

The new lending relationship: six recommendations

What precautions can a company take in order to avoid a poor credit risk assessment?

The European Commission has put forward six recommendations, which are the basic

rules governing lending relationships in the new Basel II environment.

The collection of information and credit rating systems vary from bank to bank. One

recommendation is that companies should obtain information at the outset on the type of

documentation that the bank issues, on its approach to credit assessment, on the

information that it will require, and on whether it will disclose the results of its credit

assessment.

The company must develop the discipline to present complete, unambiguous information

to the bank within the agreed time period.

Each bank has different credit terms. The factors that affect these terms are, in

descending order of importance: the credit risk assessment, security (in the form of cash,

KLE’s Institute of Manageent Studies of Research MBA IV Sem 100

Page 101: Final PRoj Basel

The Analysis of Basel Norms and Implementation

property, securities, receivables, stocks, etc.), the term of the loan, special clauses

(maximum gearing, minimum liquidity, debt to equity ratio, etc.), the relationship with

the customer, the volume of loans (borrowers can generally secure better terms by raising

a number of loans from the same bank).

An active credit rating system requires companies' managements to be vigilant; they need

to monitor the quantitative and qualitative factors that change their companies' risk

profiles.

A company's position will be monitored from a distance throughout the term of a credit

by the bank. Disappointing figures, the expiry of supplier credit, a negative cash flow, or

fluctuating accounting ratios can result in a breach in its loan terms and all represent

alarm signals. In particular, companies should make their banks aware of the real

financial situation in the market environment.

Finally, the company can use other types of finance, including innovative products.

Measures to reduce borrowing requirements

In summary, Basel II tightens up requirements on the demand side for loans and it is

worth giving serious consideration to measures to limit borrowing requirements and to

alternative credit products, which can have a considerable impact on a company's balance

sheet.

Companies can reduce their borrowing requirements by using leasing, factoring, and/or

efficiency gains. All three are reflected on the asset side of the balance sheet. Leasing

affects capital employed, factoring affects debtors, and efficiency gains affect the assets

that can be converted into cash within one year. Efficiency gains lie primarily in lower

KLE’s Institute of Manageent Studies of Research MBA IV Sem 101

Page 102: Final PRoj Basel

The Analysis of Basel Norms and Implementation

stocks and/or real productivity gains.

Use of alternative forms of finance is growing. These include private equity, mezzanine

structures, and even financial incentives, such as government subsidies. These are shown

as liabilities on the balance sheet. Private equity affects the company's capital base,

mezzanine finance affects borrowings and the capital base, and subsidies affect

borrowings.

Mezzanine finance is funding using hybrid debt and equity, and is expected to become

increasingly widely used. By 2007, all European banks will be offering this type of

finance.

IMPACT OF BASEL NORMS ON INDIAN BANKS

Banks will have to develop:

o Credit and Operational Risk Models

o Business Models and Surrounding Processes

o Skill levels of Operating Personnel

o Valid and Integrated Data Backup

o

Advanced Measurement Methods require at least 5 years Auditable and

Reconcilable Data

New Framework tends to reduce Capital Base of Indian Banks by 1% to 2%,

except a few Banks.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 102

Page 103: Final PRoj Basel

The Analysis of Basel Norms and Implementation

With the advent of Basel II, Indian Banks may be required to raise over Rs.

1,70,000 crs additional Capital during the coming 3 years.

IMPACT OF BASEL NORM on SBI

Our Bank is moderately affected on account of Credit Risk, but adversely affected

on account of Operational Risk.

Without any additional Capital support, Basel II would tend to reduce CAR of the

Bank by around 150 bps.

The Projected CAR tends to slide immediately by around 1.50%, but the negative

impact is expected to be neutralized over a period of 5 years

KLE’s Institute of Manageent Studies of Research MBA IV Sem 103

Page 104: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Rationale for a new Accord or Comparison Between Both The Accords

The Existing Accord ( Basel I) The Proposed Accord ( Basel II)

For on a single risk measure More emphasis own bank’s internal

methodologies, supervisory review and

market discipline

KLE’s Institute of Manageent Studies of Research MBA IV Sem 104

Page 105: Final PRoj Basel

The Analysis of Basel Norms and Implementation

One size fits for all Flexibility, menu of approaches, incentives

for better risk management

Broad Brush Approach More risk sensitivity

CONCLUSIONS

Basel II is an international Accord which is implemented India by all the internationally

active banks this will change the entire banking scenario. The norm is very complex and

it is recently implemented due to which entire data could not be collected.

Basel II will improve risk management exercise in Banks.

State Bank of India will get international standard for adopting Basel II.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 105

Page 106: Final PRoj Basel

The Analysis of Basel Norms and Implementation

All the areas of risks have been taken care.

Some additional Capital is required.

FINDINGS

It was observed that while undertaking a project none of the SBI employees

knows about Basel II.

The Bank is going to raise additional capital of by way of equity shares through

IPO to support additional capital requirement for implementing Basel II

KLE’s Institute of Manageent Studies of Research MBA IV Sem 106

Page 107: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Earlier there were no separate departments for managing risks, but after

implementing Basel II separate departments to have been entrusted with the task

of managing Credit Risk, Market Risk and Operational Risk.

Skilled operational personnel is required for State Bank of India.

Basel II tends to reduce Capital Base of Indian Banks by 1% to 2%, except a few

Banks

Complexities in Systems and Processes involved in Basel II make the

implementation process difficult, time consuming and costly.

Standardised Approach is adopted by bank to assess Credit Risk in which external

Credtit rating Agencies are involved, this is due bank’s internal rating system is

not full proof system which is not approved by RBI.

SUGGESTIONS

Bank has to train all its employees so that everybody can understand about Basel

Accord.

It has to recruit operationally skilled personnel in order to implement Basel

accord.

KLE’s Institute of Manageent Studies of Research MBA IV Sem 107

Page 108: Final PRoj Basel

The Analysis of Basel Norms and Implementation

Bank has to develop a full proof internal credit rating system so that it can go for

Advanced approach in assessing credit risk

LIMITATIONS

The time stipulated for the project was limited

Some confidential information was not revealed by the bank.

Some employees were not co-operative

BIBLIOGRAPHY

Indian Nanking Association Journal

www.bis.com

Bank’ Magazines

KLE’s Institute of Manageent Studies of Research MBA IV Sem 108