Basel Norms and Indian Banking Scenario

1. Basel Norms and Indian Banking Scenario

2. “Banking in modern economy is all about risk” Banks need to manage risk profitably. Each activity they undertake involves risk and therefore they need to have robust risk management framework, so that they can pool risk, diversify exposure and manage risk in a manner that make them unique. “More effective the risk mgmt. framework of the institution, more successful the institution in long run”

3. Moreover, Globalization and increased integration of financial markets across the globe is aggravating the complexity of risk faced by banks. This has promoted regulators and supervisors of banking system to form standardized, cross jurisdictional banking regulations. Banking regulation framework in most of the developed countries is based on document known as “Basel Accord”

4. BACKGROUND • Basel Committee was established by the central bank governors of group of 10 countries in 1974 in the aftermath of series of disturbances in international currency and banking matters following the failure of Fraklin National Bank in New York and Herstatt Bank in West Germany, which left many of these banks’ counterparties in the foreign exchange market with significant loss.

5. BACKGROUND • Both these events demonstrated that the failure of even a moderately sized bank could have implications that went far beyond their national boundaries and the competence of national supervisory authorities. This resulted in the 1987 Basel Committee guidelines for the measurement and assessment of the capital adequacy of banks operating internationally

6. Journey of Basel Norms

7. Basel Norms in India

8. BASEL I

9. The Basel Committee published a set of universal capital requirements for banks in 1988 which is known as Basel accord or Basel I. It was a brief set of simple rules with the aim of ensuring financial stability and soundness in the international banking system

10. The main purpose of the Basel Capital Accord was to ensure that the regulators utilize particular standards while assessing capital adequacy . Under Basel I Minimum Capital Adequacy Ratio was set at 8%. These capital standards have been framed not only to strengthen the International banking system but also the national banking system thereby ironing out competitive inequalities among banks across the countries

11. KEY FEATURES OF BASEL I

13. Capital Adequacy Ratio • Capital Adequacy Ratio • = Tier 1+ Tier 2 Capital /Risk Weighted Assets • This ratio ensures that bank can absorb a reasonable amount of loss • It determines capacity of bank in terms of meeting the time liabilities and risks • The banks’ capital act as a ‘cushion’ for future unforeseeable losses and risks

14. CRITICISM OF BASEL I

16. A Three Pillar Approach BASEL II

17. BASEL II • Basel Committee proposed an improved version in 1999 which provides for better alignment of regulatory capital with underlying risk and also addresses the risk arising from financial innovation thereby contributing to enhanced risk management and control.

18. This sophisticated and superior framework was formally endorsed by central bank governors and heads of banking supervisory authorities of various countries on June 26, 2004 under the name “International Convergence of Capital Measurement and Capital Standards” popularly known as “Basel II” or New Basel Capital Accord

19. KEY FEATURES OF BASEL II

21. STRUCTURE OF BASEL II

22. BASEL II stands on three pillars which constitutes its structure each of which reinforces other. These three pillars enable bank regulators and supervisors to evaluate properly various risks faced by banks and to realign regulatory capital more closely with underlying risk

23. FIRST PILLAR: The Minimum Capital Requirement The first pillar deals with maintenance of regulatory capital i.e minimum capital required by banks as per their risk profile with reference to credit risk, operational risk and market risk . It sets out Capital Adequacy Ratio of 8%. The Capital Adequacy Ratio is ratio of bank’s capital to its risk weighted assets. Capital Adequacy Ratio (CAR)= Total Capital Risk Weighted Assets • Risk Weighted Assets = Credit risk + Operational risk + Market risk • Total Capital = Tier I + Tier II Capital • Tier I Capital = Ordinary Capital + Retained Earnings& Share Premium – Intangible Assets • Tier II Capital = Undisclosed reserves + General bad debt Provision + Revaluation Reserve + Subordinate debt + Redeemable Preference Shares

24. Types of Risks covered under First Pillar

26. Second Pillar: Supervisory Review Process • Pillar II of new capital framework recognizes the necessity of exercising effective supervisory review of banks internal assessment of their overall risk to ensure that bank management is exercising sound judgment and has set aside adequate capital for these risks.

27. Third Pillar: Market Discipline • Third pillar of BASEL II accord is aimed at bringing more transparency in banks and improve public reporting. • It involves the public disclosure which banks must make in their annual reports and on their websites to enable the better understanding of bank’s risk profile and their capital positions.

28. The three pillars provide a kind of “triple protection” by encompassing three complementary approaches that work together towards ensuring the capital adequacy of institutions. The smooth interaction between these three pillars is necessary for Basel II framework to work effectively and efficiently.

29. SHORTCOMINGS OF BASEL II

31. BASEL NORMS IMPLEMENTATION IN INDIA

32. Reserve Bank of India has adopted a gradual approach towards convergence to international standards. So, it took prompt initiative to respond to Basel Accord and RBI became one of the signatory to it. The Narsimahan committee on financial system endorsed the internationally accepted norms for capital adequacy standards, developed by BCBS and thereby India adopted Basel I norms for scheduled commercial banks in April 1992, and market risk amendment of Basel I in 1996

33. Basel II in India Keeping in view its goal to have consistency and harmony with international standards, Basel II was adopted by India and RBI directed that Indian banks having foreign branches and foreign banks operating in India should migrate to Basel II norms from March 31, 2008 and all other commercial banks, excluding local area banks and regional rural banks, were required by RBI to adopt Basel II norms not later than March 31, 2009. Indian banks had met Basel-II norms by March 2009 with simplified approaches and presently are migrating towards advanced approaches.

34. RBI Initiatives for Basel Norms (I & II) Implementation RBI has raised minimum CAR to 9% in the year 2000 which is higher than threshold limit of 8% set by BCBS RBI had stated that Tier I capital of banks should be at least 6 per cent. Banks below this level were required to achieve this ratio on or before March 31, 2010 at both solo and consolidated level Further, the Government of India has stated that public sector banks must have a capital cushion with a CAR of at least 12%, higher than the threshold of 9% by RBI Capital Adequacy Ratio

35. RBI Initiatives for Basel Norms Implementation RBI in 2005-06 required banks to compute capital requirements for credit risk exposures under Standardized approach on the basis of ratings assigned to these exposures by external credit assessment institutions (ECAI). Credit rating agencies in Indiaare CARE, CRISIL , Fitch India, Brickworks and ICRA. Banks are also allowed to use the credit ratings of international rating agencies for the purpose of risk weighing their claims for capital adequacy purposes where specified i.e. Fitch, Moody’s and Standard & Poor’s Credit Rating

36. RBI Initiatives for Basel Norms Implementation Reserve Bank had advised banks to build up Investment Fluctuation Reserve (IFR) of a minimum of 5% of investment portfolio The Reserve bank of India had issued guidance notes on Credit risk management, operational risk management and other risk dimensions For sound risk management, RBI has suggested the use of tools such as stress testing, scenario analysis, gap analysis and disaster management Risk Management

37. RBI Initiatives for Basel Norms Implementation Approaches Recommended All Scheduled Commercial banks in India firstly adopted the Standardized Approach for credit risk and Basic Indicator Approach for operational risk After development of adequate skills, both in banks and at supervisory levels, RBI allowed the banks to migrate to the Internal Ratings Based (IRB) Approach. Timeframe for Implementation of Advanced Approaches

38. Due to inadequacy of Basel II in the wake of the worst economic crisis of recent times, there have been widespread calls for better regulation and supervision of the international financial system. This had led regulators from around the world to reach an agreement on new banking rules aimed at preventing another financial crisis. The Committee has agreed on new norms for banks' capital adequacy standards (Basel III).

39. BASEL III

40. On 16 December 2010, the Basel Committee on Banking Supervision (Basel Committee) published many of the Basel III rules with the objective of reducing the probability and severity of future crisis. This development is the result of an unprecedented process of coordination across 27 countries. Compared to Basel II, it was also achieved in record time, less than two years. These set out the details of the new global capital and liquidity standards for banks developed by the Basel Committee.

41. KEY FEATURES OF BASEL III

42. Minimum capital requirements: Minimum Tier 1 capital as a percentage of risk-weighted assets will be raised from 4% to 6% and proportion of equity to 4.5%. Minimum total capital (including both Tier 1 and Tier 2 capital) as a percentage of risk-weighted assets will remain notionally the same at 8% • Capital conservation buffer: In good times, a capital conservation buffer of 2.5% of common equity Tier 1 will be held on top of the minimum capital requirements, bringing the total common equity capital requirements to 7%. In times of stress, banks can draw on the buffer provided that, if they do so, earnings distributions such as bonuses and dividends are limited. • Countercyclical capital buffer: This additional buffer of up to 2.5% of common equity Tier 1 or other fully loss-absorbing capital will have to be built up in periods of rapid credit growth to address systematic risk. • Additional requirements for systemically important financial institutions: Systemically important financial institutions could be subject to additional requirements reflecting the greater risks to financial stability that their failure would present. • Leverage ratio: A leverage ratio of Tier 1 capital to total exposures (including on-balance sheet and off-balance sheet items) will be introduced to address concerns about leverage in the financial system .A minimum ratio of 3% will be tested.

44. Basel III in India • RBI, in line with its tradition, has been a bit conservative compared with its international counterparts, by front-loading the compliance deadline for Basel-III • Implementation of Basel-III in India is proposed to begin on January 1, 2013 and it is proposed to be fully implemented by March 31, 2017, compared to the January 1, 2019 deadline proposed by the Basel Committee.

45. RBI Draft Guidelines on Basel III • Proposed minimum Tier-I capital of 7 per cent of Risk Weighted Assets (RWAs) • Common equity ratio of at least 5.5 per cent, and a minimum total capital Adequacy Ratio of at least 9 per cent • Additional capital conservation buffer (CCB) is in the form of common equity will be phased in, culminating in an additional 2.5 per cent. Hence, the total capital requirements would be 11.5 per cent of Risk Weighted Assets

46. The Reserve Bank of India (RBI) has proposed stricter norms for Indian banks as part of a plan to migrate to the Basel-III global regulatory framework to create a healthier banking system. The central bank has suggested enhancing minimum capital standards, the creation of a capital cushion and better risk coverage mechanisms for domestic lenders. • The impact of the new norms (Basel III) on the Indian banking system is expected to be marginal. Most of the Indian banks complied (as on March 31, 2010) with Tier 1 capital ratio of 6 per cent, which banks have to achieve in 2015 (based on Basel III).

47. CHALLENGES AHEAD

48. Though Basel III offers myriad benefits to banks in terms of improved business processes and effective risk management, yet smooth transition to new framework requires deeper understanding of its complex structure, techniques and methods.

49. CHALLENGES