INTRODUCTION

Risk:
The meaning of ‘Risk’ as per Webster’s comprehensive dictionary is “a
chance of encountering harm or loss, hazard, danger” or “to expose to a chance
of injury or loss”. Thus, something that has potential to cause harm or loss to
one or more planned objectives is called Risk.
The word risk is derived from an Italian word “Risicare” which means “To
Dare”. It is an expression of danger of an adverse deviation in the actual result
from any expected result.
Banks for International Settlement (BIS) has defined it as- “Risk is the threat
that an event or action will adversely affect an organization’s ability to achieve
its objectives and successfully execute its strategies.”

Risk Management:
Risk Management is a planned method of dealing with the potential loss or
damage. It is an ongoing process of risk appraisal through various methods
and tools which continuously Risk management occurs everywhere in the
financial world. It occurs when an investor buys low-risk government bonds
over more risk corporate bonds, when a fund
manager hedges his currency exposure with currency derivatives and when a
bank performs a credit check on an individual before issuing a personal line
of credit. Stockbrokers use financial instruments like options and futures,
and money managers use strategies like portfolio and
investment diversification, in order to mitigate or effectively manage risk.

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  Assess what could go wrong
 Determine which risks are important to deal with
 Implement strategies to deal with those risks

TYPES OF RISKS

When we use the term “Risk”, we all mean financial risk or unexpected
financial loss. If we consider risk in terms of probability or occur frequently,
we measure risk on a scale, with certainty of occurrence at one end and
certainty of non-occurrence at the other end. Risk is the greatest phenomena
where the probability of occurrence or non-occurrence is equal. As per the
Reserve Bank of India guidelines issued in Oct. 1999, there are three major
types of risks encountered by the banks and these are Credit Risk, Market Risk
& Operational Risk. Further after eliciting views of banks on the draft
guidelines on Credit Risk Management and market risk management, the RBI
has issued the final guidelines and advised some of the large PSU banks to
implement so as to gauge the impact. Risk is the potentiality that both the
expected and unexpected events may have an adverse impact on the bank’s
capital or its earnings. The expected loss is to be borne by the borrower and
hence is taken care of by adequately pricing the products through risk
premium and reserves created out of the earnings. It is the amount expected to
be lost due to changes in credit quality resulting in default. Whereas, the
unexpected loss on account of the individual exposure and the whole portfolio
is entirely borne by the bank itself and

hence care should be taken. Thus, the expected losses are covered by
reserves/provisions and the unexpected losses require capital allocation.

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1. CREDIT RISK

In the context of Basel II, the risk that the obligor (borrower or counterparty)
in respect of a particular asset will default in full or in part on the obligation
to the bank in relation to the asset is termed as Credit Risk.
Credit Risk is defined as- “The risk of loss arising from outright default due
to inability or unwillingness of the customer or counter party to meet
commitments in relation to lending, trading, hedging, settlement and other
financial transaction of the customer or counter party to meet commitments”.
Credit Risk is also defined, “as the potential that a borrower or counter party
will fail to meets its obligations in accordance in agreed terms”.

2. MARKET RISK
It is defined as “the possibility of loss caused by changes in the market
variables such as interest rate, foreign exchange rate, equity price and
commodity price”. It is the risk of losses in, various balance sheet positions
arising from movements in market prices.
RBI has defined market risk as the possibility of loss to a bank caused by
changes in the market rates/ prices. RBI Guidance Note focus on the
management of liquidity Risk and Market Risk, further categorized into
interest rate risk, foreign exchange risk, commodity price risk and equity price
risk.
Market risk includes the risk of the degree of volatility of market prices of
bonds, securities, equities, commodities, foreign exchange rate etc., which
will change daily profit and loss over time; it’s the risk of unexpected changes
in prices or rates. It also addresses the issues of Banks ability to meets its
obligation as and when due, in other words, liquidity risk.

3. OPERATIONAL RISK

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Operational risk is the risk associated with the operations of an organization.
It is defined as “risk of loss resulting from inadequate or failed internal
process, people and systems or from external events.”
It includes legal risk. It excludes strategic and reputational risks, as the same
are not quantifiable.
Operational risk includes the risk of loss arising from fraud, system failures,
trading error and many other internal organizational risks as well as risk due
to external events such as fire, flood etc. the losses due to operation risk can
be direct as well as indirect. Direct loss means the financial losses resulting
directly from an incident or an event. E.g. forgery, fraud etc. indirect loss
means the loss incurred due to the impact of an incident.

4. REGULATORY RISK

The owned funds alone are managed by an entity, it is natural that very few
regulators operate and supervise them. However, as banks accept deposit from
public obviously better governance is expected from them. This entails
multiplicity of regulatory controls. Many Banks, having already gone for
public issue, have a greater responsibility and accountability in this regard. As
banks deal with public funds and money, they are subject to various
regulations. The various regulators include Reserve Bank of India (RBI),
Securities Exchange Board of India (SEBI), Department of Company Affairs
(DCA), etc. Moreover, banks should ensure compliance of the applicable
provisions of The Banking Regulation Act, The Companies Act, etc. Thus, all
the banks run the risk of multiple regulatory-risks which inhibits free growth
of business as focus on compliance of too many regulations leave little energy
scope and time for developing new business. Banks should learn the art of
playing their business activities within the regulatory controls.

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5. ENVIRONMENTAL RISK

As the years roll the technological advancement takes place, expectation of

the customers changes and enlarges. With the economic liberalization and
globalization, more national and international players are operating the
financial markets, particularly in the banking field. This provides the platform
for environmental change and exposure of the bank to the environmental risk.
Thus, unless the banks improve their delivery channels, reach customers,
innovate their products that are service oriented; they are exposed to the
environmental risk.

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 BANKING IN INDIA

In the modern sense, originated in the last decades of the 18th century. Among
the first banks were the Bank of Hindustan, which was established in 1770
and liquidated in 1829–32; and the General Bank of India, established in 1786
but failed in 1791.

The largest bank, and the oldest still in existence, is the State Bank of India
(S.B.I). It originated as the Bank of Calcutta in June 1806. In 1809, it was
renamed as the Bank of Bengal. This was one of the three banks funded by a
presidency government, the other two were the Bank of Bombay in 1840 and
the Bank of Madras in 1843. The three banks were merged in 1921 to form
the Imperial Bank of India, which upon India's independence, became the
State Bank of India in 1955. For many years the presidency banks had acted
as quasi-central banks, as did their successors, until the Reserve Bank of India
was established in 1935, under the Reserve Bank of India Act, 1934.

In 1960, the State Banks of India was given control of eight state-associated
banks under the State Bank of India (Subsidiary Banks) Act, 1959. These are
now called its associate banks. In 1969 the Indian government nationalized 14
major private banks, one of the big bank was Bank of India. In 1980, 6 more
private banks were nationalized. These nationalized banks are the majority of
lenders in the Indian economy. They dominate the banking sector because of
their large size and widespread networks.

The Indian banking sector is broadly classified into scheduled banks and non-
scheduled banks. The scheduled banks are those included under the 2nd
Schedule of the Reserve Bank of India Act, 1934. The scheduled banks are
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further classified into: nationalized banks; State Bank of India and its
associates; Regional Rural Banks (RRBs); foreign banks; and other Indian
private sector banks. The term commercial banks refer to both scheduled and
non-scheduled commercial banks regulated under the Banking Regulation
Act, 1949.

Generally banking in India is fairly mature in terms of supply, product range

and reach-even though reach in rural India and to the poor still remains a
challenge. The government has developed initiatives to address this through
the State Bank of India expanding its branch network and through the National
Bank for Agriculture and Rural Development (NABARD) with facilities like
microfinance.

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 The Regulations That Govern Banking In India

The banking system in India is regulated by the Reserve Bank of India (RBI),
through the provisions of the Banking Regulation Act, 1949. Some important
aspects of the regulations which govern banking in this country, as well as
RBI circulars that relate to banking in India, will be dealt with in this article:

Exposure limits

Lending to a single borrower is limited to 15% of the bank’s capital funds (tier
1 and tier 2 capital), which may be extended to 20% in the case of
infrastructure projects. For group borrowers, lending is limited to 30% of the
bank’s capital funds, with an option to extend it to 40% for infrastructure
projects. The lending limits can be extended by a further 5% with the approval
of the bank's board of directors. Lending includes both fund-based and non-
fund-based exposure.

Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)

Banks in India are required to keep a minimum of 4% of their net demand and
time liabilities (NDTL) in the form of cash with the RBI. These currently earn
no interest. The CRR needs to be maintained on a fortnightly basis, while the
daily maintenance needs to be at least 95% of the required reserves. In case of
default on daily maintenance, the penalty is 3% above the bank rate applied
on the number of days of default multiplied by the amount by which the
amount falls short of the prescribed level.

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Over and above the CRR, a minimum of 22% and maximum of 40% of NDTL,
which is known as the SLR, needs to be maintained in the form of gold, cash
or certain approved securities. The excess SLR holdings can be used to borrow
under the Marginal Standing Facility (MSF) on an overnight basis from the
RBI. The interest charged under MSF is higher than the repo rate by 100 bps,
and the amount that can be borrowed is limited to 2% of NDTL. (To learn
more about how interest rates are determined, particularly in the U.S., see:
Who Determines Interest Rates.)

Provisioning

Non-performing assets (NPA) are classified under 3 categories: Substandard,

Doubtful and Loss. An asset becomes non-performing if there have been no
interest or principal payments for more than 90 days in the case of a term loan.
Substandard assets are those assets with NPA status for less than 12 months,
at the end of which they are categorized as doubtful assets. A loss asset is one
for which the bank or auditor expects no repayment or recovery and is
generally written off the books.

For substandard assets, it is required that a provision of 15% of the outstanding

loan amount for secured loans and 25% of the outstanding loan amount for
unsecured loans be made. For doubtful assets, provisioning for the secured
part of the loan varies from 25% of the outstanding loan for NPA’s which have
been in existence for less than one year to 40% for NPA’s in existence between
one and three years to 100% for NPA’s with a duration of more than three
years, while for the unsecured part it is 100%.

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Provisioning is also required on standard assets. Provisioning for agriculture
and small and medium enterprises is 0.25% and for commercial real estate it
is 1% (0.75% for housing), while it is 0.4% for the remaining sectors.
Provisioning for standard assets cannot be deducted from gross NPA’s to
arrive at net NPA’s. Additional provisioning over and above the standard
provisioning is required for loans given to companies that have unhedged
foreign exchange exposure.

Priority sector lending

The priority sector broadly consists of micro and small enterprises, and
initiatives related to agriculture, education, housing and lending to low-
earning or less privileged groups (classified as "weaker sections"). The
lending target of 40% of adjusted net bank credit (ANBC) (outstanding bank
credit minus certain bills and non-SLR bonds) -- or the credit equivalent
amount of off balance sheet exposure (sum of current credit exposure +
potential future credit exposure that is calculated using a credit conversion
factor), whichever is higher -- has been set for domestic commercial banks
and foreign banks with greater than 20 branches, while a target of 32% exists
for foreign banks with less than 20 branches.

The amount that is disbursed as loans to the agriculture sector should either be
the credit equivalent of off balance sheet exposure, or 18% of ANBC --
whichever of the two figures is higher. Of the amount that is loaned to micro-
enterprises and small businesses, 40% should be advanced to those enterprises
with equipment that has a maximum value of 200,000 rupees, and plant and
machinery valued at a maximum of half a million rupees, while 20% of the

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total amount lent is to be advanced to micro-enterprises with plant and
machinery ranging in value from just above 500,000 rupees to a maximum of
a million rupees and equipment with a value above 200,000 rupees but not
more than 250,000 rupees. The total value of loans given to weaker sections
should either be 10% of ANBC or the credit equivalent amount of off balance
sheet exposure, whichever is higher. Weaker sections include specific

castes and tribes that have been assigned that categorization, as well as small
farmers etc. There are no specific targets for foreign banks with less than 20
branches.

The private banks in India until now have been reluctant to directly lend to
farmers and other weaker sections. One of the main reasons is the
disproportionately higher amount of NPA’s from priority sector loans, with
some estimates indicating it to be 60% of the total NPA’s. They achieve their
targets by buying out loans and securitized portfolios from other non-banking
finance corporations (NBFC) and investing in the Rural Infrastructure
Development Fund (RIDF) to meet their quota.

New bank license norms

The new guidelines state that the groups applying for a license should have a
successful track record of at least 10 years and the bank should be operated
through a non-operative financial holding company (NOFHC) wholly owned
by the promoters. The minimum paid-up voting equity capital has to be five
billion rupees, with the NOFHC holding at least 40% of it and gradually
bringing it down to 15% over 12 years. The shares have to be listed within 3
years of the start of the bank’s operations.

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The foreign shareholding is limited to 49% for the first 5 years of its operation,
after which RBI approval would be needed to increase the stake to a maximum
of 74%. The board of the bank should have a majority of independent directors
and it would have to comply with the priority sector lending targets discussed
earlier. The NOFHC and the bank are prohibited from holding any securities
issued by the promoter group and the bank is prohibited from holding any
financial securities held by the NOFHC. The new regulations also stipulate
that 25% of the branches should be opened in previously unbanked rural areas.

Willful defaulters

A willful default takes place when a loan isn’t repaid even though resources
are available, or if the money lent is used for purposes other than the
designated purpose, or if a property secured for a loan is sold off without the
bank's knowledge or approval. In case a company within a group defaults and
the other group companies that have given guarantees fail to honor their
guarantees, the entire group can be termed as a willful defaulter. Willful
defaulters (including the directors) have no access to funding, and criminal
proceedings may be initiated against them. The RBI recently changed the
regulations to include non-group companies under the willful defaulter tag as
well if they fail to honor a guarantee given to another company outside the
group.

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The Bottom Line

The way a country regulates its financial and banking sectors is in some senses
a snapshot of its priorities, its goals, and the type of financial landscape and
society it would like to engineer. In the case of India, the regulations passed
by its reserve bank give us a glimpse into its approaches to financial
governance and shows the degree to which it prioritizes stability within its
banking sector, as well as economic inclusiveness.

Though the regulatory structure of India's banking system seems a bit

conservative, this has to be seen in the context of the relatively under-banked
nature of the country. The excessive capital requirements that have been set
are required to build up trust in the banking sector while the priority lending
targets are needed to provide financial inclusion to those to whom the banking
sector would not generally lend given the high level of NPA’s and small
transaction sizes. Since the private banks, in reality, do not directly lend to the
priority sectors, the public banks have been left with that burden. A case could
also be made for adjusting how the priority sector is defined, in light of the
high priority given to agriculture, even though its share of GDP has been going
down. (For related reading see: India is Eclipsing China's Economy as Bright
Star.)

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Reserve Bank of India

The central bank plays an important role in the monetary and banking structure
of nation. It supervises controls and regulates the activities of the banking
sector. It has been assigned to handle and control the currency and credit of a
country. In older days, the central banks were empowered to issue the currency
notes and bankers to the Union governments. The first central bank in the
world was Risk Banks of Sweden which was established in 1656. The Reserve
Bank of India, the central bank of our country, was established in 1935 under
the aegis of Reserve Bank of India Act, 1934. It was a private shareholders
institution till January 1949, after which it became a state-owned institution
under the Reserve Bank of India Act, 1948. It is the oldest central bank among
the developing countries. As the apex bank, it has been guiding, monitoring,
regulating and promoting the destiny of the Indian financial system.

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Objectives of RBI

It plays a more positive and dynamic role in the development of a country.

The financial muscle of a nation depends upon the soundness of the policies
of the central banking. The objectives of the central banking system are
presented below:

1. The central bank should work for the national interest of the country.

2. The central bank must aim for the stabilization of the mixed economy.

3. It aims at the stabilization of the price level at average prices.

4. Stabilization of the exchange rate is also essential.

5. It should aim for the promotion of economic activities.

Constitution and Management

Reserve Bank of India has been constituted as a corporate body having

perpetual succession and a common seal. Its capital is Rs. 5 crore wholly
owned by the Government of India. The general superintendence and direction
of the affairs and business of the Bank has been vested in the Central Board
of Directors. The Central Government, however, is empowered to give such
directions to the Bank as it may, after consultation with its Governor, consider
necessary in the public interest.

The Central Board of Directors consists of the following:

a) A Governor and not more than four Deputy Governor to be appointed

by the Central Government.

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 b) Four directors to be nominated by the Central Government, one from
each of the four local boards.
c) Ten directors to be nominated by the Central Government.
d) One Government official to be nominated by the Central Government.

Besides the Central Board of Directors, four Local Boards have also been
constituted for each of the four areas specified in the first schedule to the Act.
A Local Board has five members appointed by the Central Government to
represent as far as possible, territorial and economic interests and the interests
of cooperative and indigenous banks. A Local Board advises the Central
Board on matters referred to it by the Central Board and performs such duties
as are delegated to it by the Central Board.

Functions of RBI

The RBI functions are based on the mixed economy. The RBI should maintain
a close and continuous relationship with the Union Government while
implementing the policies. If any differences arise, the government’s decision
will be final. The main functions of the RBI are presented below:

1. Welfare of the public

2. To maintain the financial stability of the country.

3. To execute the financial transactions safely and effectively.

4. To develop the financial infrastructure of the country.

5. To allocate the funds effectively without any partiality.

6. To regulate the overall credit volume for price stability.

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Authorities

The RBI has the full authority in the following aspects:

1. Currency issuing authority

2. Monitoring authority

3. Banker to the Union Government

4. Foreign exchange control authority

5. Promoting authority.

1. Currency Issuing Authority- The RBI has the sole authority to issue the
currency notes and coins. It is the fundamental right of the RBI. The coins
and one-rupee notes are issued by the Government of India and they are
circulated through the RBI. The notes issued by the RBI issues by the RBI will
have legal identity everywhere in India. The RBI issues the notes of the
denomination of RS. 1000, 500, 100, 50, 20 and 10. The RBI has the authority
to circulate and withdraw the currency from circulation. It has also the
authority to exchange notes and coins from one denomination to other
denominations as per the requirement of the public. The currency notes may
be distributed throughout the country through its 15 full pledged offices, 2
branch offices, and more than 4000 currency chests. The currency chests are
maintained by different banks in various locations. The RBI issues currency
notes, based on the availability of balances of gold, bullion, foreign securities,
rupees, coins and permitted bills.

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2. Monitoring Authority- The RBI has the full authority to control all the
aspects of the banking system in India. The RBI is known as the Banker’s
Bank. The banking system in India works according to the guidelines issued
by the RBI. The RBI is the premier banking institute among the commercial
banks. All the commercial banks, foreign banks and cooperative urban banks
in India should obey the rules and regulations which are issued by the RBI
from time to time. The RBI controls the deposits of the commercial banks
through the CRR and the SLRs. Every bank should deposit a certain amount
in the RBI. The commercial banks have the power to borrow the money from
the RBI when they are in need of finance. Hence it is known as the lender of
the last resort. The RBI has the authority to control the credit supply in the
economy or monetary systems of the nation.

3. Banker to the Union Government- Generally in any country all over the
world the Central bank dominates the banking sector. It advises the
government on monetary policies. The RBI is the bankers to the Union
Government and also to the state governments in the country. It provides a
wide range of banking services to the government. It also transfers the funds,
collects the receipts and makes the payment on behalf of the Government. It
also manages the public debts. The Government will not pay any remuneration
or brokerage to the RBI for rendering the financial services. Any deficit or
surplus in the Central Government account with the RBI will be adjusted by
creation or cancellation of the treasury bills. The treasury bills are known as
the Adhoc Treasury bills.

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4. Foreign Exchange Regulation Authority- The RBI’s another major
function is to control the foreign exchange reserves position from time to time.
It maintains the stability of the external value of the rupee through its domestic
policies and forex market. The RBI has the full authority to regulate the market
as discussed below:

· To monitor the foreign exchange control.

· To prescribe the exchange rate system.

· To maintain a better relation between rupee and other currencies.

· To interact with the foreign counterparts.

· To manage the foreign exchange reserves.

It administers the FERA, 1973. It is replaced by the FEMA which would be

consistent with full capital account convertibility with policies of the Central
Government.

The RBI administers the control through the authorized forex dealers. The RBI
is the custodian of the country’s foreign exchange reserves. The foreign
exchange is precious and it takes the responsibility of the better utilization.

5.Promoting Authority:

The RBI’s function is to look after the welfare of the financial system. It
renders the promotion services to strengthen the country’s banking and
financial structure. It helps in mobilizing the savings and diverting them
towards the productive channel. Thus, the economic development can be
achieved. After the nationalization of the commercial banks, the RBI has taken

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a number of series of actions in various sectors such as agriculture sector,
industrial sector, lead bank scheme and cooperative sector.

4.3 Commercial Banks

Amongst the banking institutions in the organized sector, commercial banks

are the oldest institutions, some of them having their genesis in the nineteenth
century. Initially, they were set up in large numbers, mostly as corporate
bodies with shareholdings by private individuals. In the sixties of the twentieth
century, a large number of weaker and smaller banks were merged with other
banks. As a consequence, a stronger banking system emerged in the country.
Subsequently, there has been a drift towards state ownership and control.
Today 27 banks constitute strong public sector in Indian commercial banking.
Commercial banks operating in India fall under different sub-categories on the
basis of their ownership and control over management.

Public Sector Banks

Public sector in Indian banking emerged to its present position in three stages.
First, the conversion of the then existing Imperial Bank of India into the State
Bank of India in 1955, followed by the taking over of the seven state
associated banks as its subsidiary banks, second the nationalization of 14
major commercial banks on July 19, 1969 and last, the nationalization of 6
more commercial banks on April 15, 1980. Thus 27 banks constitute the
Public sector in Indian Commercial Banking.

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Private Sector Banks

After the nationalization of major banks in the private sector in 1969 and 1980,
no new bank could be set up in India for about two decades, though there was
no legal bar to that effect. The Narasimham Committee on Financial Sector
Reforms recommended the establishment of new banks in India. Reserve Bank
of India,

thereafter, issued guidelines for the setting up of new private sector banks in
India in January 1993.

These guidelines aim at ensuring that the new banks are financially viable
and technologically up-to-date from the start. They have to function in a
professional manner, so as to improve the image of commercial banking
system and to win the confidence of the public.

In January 2001 Reserve Bank of India issued new rules for the licensing of
new banks in the private sector. The salient features are as follows:

1. A new bank may be started with a capital of Rs. 200 crores. The net
worth is to be raised to Rs. 300 crores in three years.

2. The promoter’s minimum holding in the capital shall be 40 per cent with
a lock-in-period of 5 years. Excess holding over 40 per cent will have to be
diluted within a year.

3. Non-resident Indians can pick up 40 per cent equity share in the new
bank. Any foreign bank or finance company may join as technical
collaborators or as co-promoter, but their equity participation will be restricted
to 20 per cent, which will be within the ceiling of 40 per cent allowed to Non
–resident Indians.

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4. Corporates have been allowed to invest up to meet existing priority
sector norms and prudential norms and also to open 25 % of their branches in
rural and semi-urban areas. Preference will be given to promoters with
expertise in financing priority areas and rural and agro based industries.

5. Non-banking finance companies may convert themselves into banks if

their net worth is Rs. 200 crores, capital adequacy ratio is 12%, non-
performing assets below 5% and possess triple A credit rating.

In addition to the above guidelines, the new banks are governed by the
provisions of the Reserve Bank of India Act, the Banking Regulation Act and
other relevant statutes.

4.4 Local Area Bank

In 1996, Government decided to allow new local area banks with the twin
objectives of Providing an institutional mechanism for promoting rural and
semi-urban savings, and For providing credit for viable, economic activities
in the local areas.

Such banks can be established as public limited companies in the private

sector and can be promoted by individuals, companies, trusts and societies.
The minimum paid up capital of such banks would be Rs. 5 crore with
promoter’s contribution at least Rs. 2 crore. They are to be set up in district

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towns and the area of their operations would be limited to a maximum of 3
geographically contiguous districts. At present, five Local Area Banks are
functional, one each in Punjab, Gujrat, Maharashtra and two in Andhra
Pradesh.

4.5 Foreign Bank

Foreign Commercial Banks are the branches in India of the joint stock banks
incorporated abroad. Their number has increased to forty as on 31 st March,
2002. These banks, besides financing the foreign trade of the country,
undertake normal banking business in the country as well.

Licensing of Foreign Bank: In order to operate in India, the foreign banks have
to obtain a license from the Reserve Bank of India. For granting this license,
the following factors are considered:

1. Financial soundness of the bank.

2. International and home country rating.

3. Economic and political relations between home country and India.

4. The bank should be under consolidated supervision of the home country

regulator.

5. The minimum capital requirement is US $ 25 million spread over three

branches - $ 10 million each for the first and second branch and $5 million for
the third branch.

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6. Both branches and ATMs require licenses and these are given by the
RBI in conformity with WTO’s commitments.

Function of Foreign Banks: The main business of foreign banks is the

financing of India’s foreign trade which they can handle most efficiently with
their vast resources. Recently, they have made substantial inroads in internal
trade including deposits, advances, discounting of bills, mutual funds, ATMs
and credit cards. A large part of their credit is extended to large enterprises
and MNCs located mostly in the tier one cities- mainly the metros, though
some banks are now foraying in the rural sector as well. Technology used by
these banks has been a major driver of

change in the Indian banking industry. A highly trained and efficient

workforce and the huge pool of capital resources at the disposal of these banks
have created tremendous goodwill and prestige of foreign banks in India.

Apart from their main businesses, foreign banks are also instrumental in
shaping the attitudes, perceptions and policies of foreign governments,
corporates and other clients towards India, especially in the following areas:

1. Bringing together foreign institutional investors and Indian companies.

2. Organizing joint ventures.

3. Structuring and syndicating project finance for telecommunication, power

and mining sectors.

4. Providing a thrust to trade finance through securitization of export loan.

5. Introducing new technology in data management and information

systems.

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Performance: Foreign banks are not subject to the stringent norms regarding
opening of rural branches, priority sector lending or bound by the social
philosophy of Indian banks. These factors combined with the financial,
technical and human resources of the foreign banks have ensured a healthy
growth of these banks in India.

4.6 Co-operative Banks

Besides the commercial banks, there exist in India another set of banking
institutions called co-operative credit institutions. These have been in
existence in India since long. They undertake the business of banking both in
urban and rural areas on the principle of co-operation. They have served a
useful role in spreading the banking habit throughout the country. Yet, their
financial position is not sound and a majority of co-operative banks has yet to
achieve financial viability on a sustainable basis.

The cooperative banks have been set up under the various Co-operative
Societies Acts enacted by the State Governments. Hence the State
Governments regulate these banks. In 1966, need was felt to regulate their
activities to ensure their soundness and to protect the interests of depositors.
Consequently, certain provisions of the Banking Regulation Act 1949 were
made applicable to co-operative banks as well. These banks have thus fallen
under dual control viz., that of the State Govt. and that of the Reserve Bank of

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India which exercises control over them so far as their banking operations are
concerned.

Features of Cooperative banks

· These banks are government sponsored government supported and

government subsidized financial agencies in India.

· Unlike commercial banks which focus on profits, cooperative banks are

organized and managed on principles of cooperation, self help and mutual
help. They function on a “no profit, no loss” basis.

· They perform all the main banking functions but their range of services
is narrower than that of commercial banks.

· Some of them are scheduled banks but most are unscheduled banks.

· They have a federal structure of three-tier linkages and vertical

integration.

· Cooperative banks are financial intermediaries only, particularly

because a significant amount of their borrowings is from the RBI, NABARD,
the central and state governments and cooperative apex institutions.

· There has been a shift of cooperative banks from the rural to the urban
areas as the urban and non-agricultural business of these banks has grown over
the years.

Weaknesses: Cooperative banks suffer from too much dependence on RBI,

NABARD and the government.

26
· They are subject to too much officialization and politicization. Both the
quality of loans assets and their recovery are poor. The primary agricultural
cooperative societies- a vital link in the cooperative credit system- are small
in size, very week and many of them are dormant.

· The cooperative banks suffer from existence of multiple regulation and

control authorities.

· Many urban cooperative banks have failed or are in the process of

liquidation.

· Cooperative banks have increasingly been facing competition from

commercial banks, LIC, UTI and small savings organizations.

4.7 Regional Rural Banks

Regional Rural Banks are relatively new banking institutions which

supplement the efforts of the cooperative and commercial banks in catering to
the credit requirements of the rural sector. These banks have been set up in
India since October 1975, under the Regional Rural Banks Act, 1976. At
present there are 196 RRBs functioning in 484 districts. The distinctive feature
of a Regional Rural Bank is that though it is a separate body corporate with
perpetual succession and a common seal. It is very closely linked with the
commercial bank which sponsors the proposal to establish it and is called the
sponsor bank. The central government establishes a RRB, at the request of the
sponsor bank and specifies the local limits within which it shall establish its
branches and agencies.

27
Business of a Regional Rural Bank

A Regional rural bank carries on the normal banking business i.e., the business
of banking as defined in section 5(b) of the Banking Regulation Act, 1949 and
engages in one or more forms of businesses specified in Section 6 (1) of that
Act. A Regional rural bank may in particular, undertake the following types
of businesses, namely:

1. The granting of loans and advances, particularly to small and marginal

farmers and agricultural laborers, and to cooperative societies for agricultural
operations or for other connected purposes, and

2. The granting of loans and advances, particularly to artisans, small

entrepreneurs and persons of small means engaged in trade, commerce or
industry or other productive activities within the notified areas of a rural bank.

Regional Rural Banks are thus primarily meant to cater to the needs of the
poor and small borrower in the countryside.

Capital

The authorized capital of a RRB shall be Rs. 5 crores which may increase or
reduced (not below Rs. 25 lakh) by the Central Government in consultation
with NABARD and the sponsor bank. The issued capital shall not be less than
Rs. 25 lakhs. Of the issued capital, the Central Government shall subscribe
fifty percent, the sponsor bank thirty five percent and the concerned State
Government fifteen percent.

28
The shares of the Rural Banks shall be deemed to be included in the securities
enumerated in Section 20 of the Indian Trusts Act, 1882 and shall also be
deemed to be approved securities for the purpose of the Banking Regulation
Act 1949.

Management

Each Rural Bank is managed by a Board of Directors. The general

superintendence, direction and management of the affairs and business vest in
the Board. In discharging its functions, the Board of Directors acts on business
principles and shall have due regard to public interests. A regional rural bank
is guided by the directions, issued by the Central Government in regard to
matters of policy involving public interest.

4.8 Annual Report

An annual report is a reflection of the company’s philosophy, policies,

achievements and shortcomings. The annual report gives general information
regarding the name(s) of the chairman/MD, chief executive officer and all the
directors, the bankers and auditors of the company, registered office, date,
time and venue of the annual general meeting. An annual report comprises
two parts.

29
Part I: It includes

Ø Notice of the meeting of the shareholders.

Ø Directors’ Report: The chairman of the company presents the Director’s

report which usually highlights the company’s achievements in the given
macro and micro-environment, new initiatives/ products/ technology, etc.
proposed to be used, constraints if any faced by the company, future plans for
modernization, diversification, etc.

Ø The company’s philosophy that describes how the company does business,
is delineated in a separate section.

Ø Social responsibility report: It has initiatives for environment conservation

and corporate social responsibility. Since banks do not manufacture goods,
therefore, treatment of effluents is not relevant. However, most banks do
conduct a number of social outreach programmes for education, training etc.
for the poor and underprivileged sectors of the society.

Ø Corporate Governance report: Corporate Governance deals with conducting

the affairs of the organization with integrity, transparency and commitment to
principles of good governance. It has to be certified that all mandatory
requirements as stipulated by Securities and Exchange Board of India (SEBI)
have been complied with.

Ø Declaration of dividend (if any) is provided.

Ø Retirement, reappointment of existing directors or appointment of new

directors.

30
Ø For the sake of uniformity and transparency in reporting, banks are also
supposed to give details of their non-performing assets (NPA). NPAs are those
assets which have remained unpaid for a period of ninety days. They are
further categorized as sub-standard, doubtful and loss.

Part II: The second part of the report deals with performance highlights of
the organization.

Ø It includes a balance sheet, a profit and loss account, cash flow statement
and other statements and explanatory material that are an integral part of the
financial statements.

Ø An auditors’ report certifying that the financial statements together present

a true and fair view of the company’s affairs, and are in compliance with
existing accounting standards, applicable laws and regulations.

31
4.9 Balance Sheet of a Commercial Bank

One of the best ways to learn about the business of banking is through a
perusal of a typical bank’s balance sheet. Balance sheet of a commercial bank
is a statement of its assets and liabilities at a particular point of time. It throws
light on the financial health or otherwise of the bank.

Another way of viewing a balance sheet is as a statement of the sources and

uses of bank funds. Banks obtain funds in the form of deposits (fixed, savings
and current) by borrowing from other banks (RBI, commercial banks, etc.)
and by obtaining equity funds from the owners (i.e. the shareholders of the
bank) through the capital account. All these constitute the liabilities of the
bank. Banks use these funds to grant loans, invest in securities, purchase
equipment and hold cash items such as currency and deposits in other banks.
All these are the assets of the bank.

According to section 29 of the Banking Regulation Act, 1949, at the

expiration of each calendar year (or at the expiration of a period of twelve
months ending with such date as the Central Government may, by notification
in the official gazette, specify in this behalf), every banking company
incorporated in India, in respect of all business transacted through its branches
in India, in respect of all business transacted through its branches in India,
shall prepare with reference to that year or period, as the case may be, a
balance sheet and profit and loss account as on the last working day of the year
or the period, as the case may be, in the forms set out in the third schedule or
as near thereto as circumstances admit.

32
 The balance sheet and profit and loss account shall be signed:

in the case of a banking company incorporated in India, by the manager or the

principal officer of the company. Where there are more than three directors of
the company, by at least three are more than three directors. Where there are
not more than three directors, by all the directors, and

in the case of a banking company incorporated outside India by the manager

or agent of the principal office of the company in India.

Audit

The balance sheet and profit and loss account prepared in accordance with
section 29 shall be audited by a person duly qualified under any law for the
time being in force to be an auditor of companies.

Where the Reserve Bank is of opinion that audit is necessary in the interest
of the public or the banking company or its depositors, it may, at any time
order a special audit of the banking company’s accounts, for any such
transaction or class of transactions or for some specific period or periods as it
deems necessary. The RBI may through its order either appoint a person duly
qualified under any law for the time being in force to be an auditor of
companies or direct the auditor of companies or direct the auditor of the
banking company himself to conduct such special audit.

Submission of Returns

The accounts and balance sheet referred to in sanction 29 together with the
auditor’s report shall be published in the prescribed manner, and three copies

33
thereof shall be furnished as returns to the Reserve Bank within three months
from the end of the period to which they refer.

A banking company which furnishes its accounts and balance sheet in

accordance with the provisions of section 31 shall send three copies of such
accounts, balance sheet and the auditor’s report to the registrar.

It is mandatory for all banking companies incorporated outside India that

before the first Monday in August of any year in which it has carried on
business, it must display a copy of its last audited Balance Sheet and profit
and Loss Account prepared under section 29, in a conspicuous place in its
principal office and every branch office in India. These should be kept on
display until they are replaced by a copy of the subsequent Balance Sheet and
profit and Loss Account.

Items of the Balance Sheet of a Bank

The balance sheet of a commercial bank like any other balance sheet
comprises two sides; conventionally the left side shows liabilities and capital,
while the right side shows assets. A bank’s assets are indications of what the
bank owns or the claims that the bank has on external entities: individuals,
firms, governments, etc. A bank’s liabilities are indications of what the bank
owes as claims which are held by external entities of the bank. The net worth
or capital is calculated by subtracting total liabilities from total assets.

34
Assets-Liabilities = Net worth

Or

Assets= Liabilities+ Net worth

Liabilities and Assets of a Bank

Many institutions offer financial services. It is the taking of deposits and

granting of loans that single out a bank from other financial institutions.
Deposits are liabilities for banks, which must be managed if the bank is to
maximize profits. Likewise, they need to manage the assets created by
lending. The liabilities and assets of a bank explained below:

Liabilities of a Bank

Liabilities of a commercial bank are claims on the bank. They represent the
amounts which are due from the bank to its shareholders, depositors, etc. Bank
liabilities are the funds that banks obtain and the debts they incur, primarily to
make loans and purchase securities. The major components of the liabilities
of a bank are as follows:

1. Capital: Capital and reserves what the customer regards as an asset, the
same bank deposit is a liability for the bank as the customer gains claims over
them. The paid up share capital implies the liability of the bank to its

35
shareholders. It is the amount actually received by the bank out of the total
subscribed capital. Adequate share capital is considered as a source of strength
for the bank as it provides confidence to the depositors about the solvency of
the bank.

2. Reserve Fund: Reserves are created out of the undistributed profits

which are retained over a period of years by the bank. Creation of reserve fund
is a statutory requirement in most of the countries of the world. Reserve
requirements limit the portion of the bank’s funds that it can use to give loans
and purchase securities. Banks build up reserves to strengthen their financial
position and also to meet unforeseen liabilities or unexpected losses. Reserve
fund, together with capital

represents the capital structure or net worth of the bank. Net worth is a residual
term that is calculated by subtracting total liabilities from total assets.

3. Deposits: Deposits constitute the major sources of funds for banks.

What the customer regards as an asset, the same bank deposit is a liability for
the bank as the customer gains claim over them. Banks get funds from
investment and these are indirectly the source of its income. Banks keep a
certain percentage of its time and demand deposits in cash and after meeting
the liquidity requirement, they lend the remaining amount on interest. Indian
banks accept two main types of deposits, demand deposits and term deposits.
Demand deposits, as the name suggests, are repayable on particular period.
The prosperity, growth and goodwill of the bank depend upon the amount of
these deposits. Fixed deposits have specific maturity and so can be used by
banks to earn income. Demand deposits can be further subdivided into current

36
and savings. Current deposits are chequeable accounts with no restriction on
the number of withdrawals. It is possible to obtain clean on secured overdraft
on these accounts. Saving deposits are more liquid than fixed deposits as
money can be withdrawn when needed, though some banks restrict the number
of withdrawals per-month or per-quarter.

4. Borrowing from Other Sources: In case of need, banks can borrow from
the Reserve Bank of India, other commercial banks, development banks, non-
bank financial intermediaries like LIC, UTI, GIC, etc. Secured loans are
obtained on the basis of some recognized, securities whereas unsecured loans
are out of its reserve funds lying with the central bank.

5. Other Liabilities: Other liabilities include bills payable, bills sent for
collection, acceptance, endorsement, etc. The amounts of all such bills are
shown on the liability side of the balance sheet.

6. Contingent Liability: Contingent liabilities are those liabilities which

may arise in future but cannot be determined accurately, e.g. guarantee given
on behalf of others, outstanding forward exchange contracts, etc. These are
shown on the liability side as a rough estimate.

7. Profit or loss: Profit is unallocated surplus or retained earnings of the

year after paying tax and dividends to shareholders. As shareholders have
claim over the bank’s profit, it is shown as a liability. In case of loss, the figure
will be shown on the assets side.

37
Assets of a Bank

Like all other business firms banks also strive for profit. Commercial banks
use their funds primarily to purchase income earning assets, mainly loans and
investments. These assets are shown in the balance sheet of the bank in
decreasing order of the liquidity. The major assets of the bank include:

1. Cash: Cash in hand and cash balances with the Reserve Bank of India
are the most liquid assets of a bank. Cash assets provide bank funds to meet
the withdrawals of deposits and to accommodate new loan demand.
Maintaining of cash reserve ratio with RBI is a statutory requirement for the
banks.

2. Money at Call and Short Notice: This is the money lent by the banks to
other banks, bill brokers, discount houses and other financial institutions for a
very short period of time varying from 1 to 14 days. When these funds are
repayable on demand without prior notice, it is called money at call. On the
other hand, if some prior notice is required, it is known as money at short
notice. In the balance sheet, both are shown as a single item on the asset side.
Banks charge very low rate of interest on these. If the cash position continues
to remain comfortable, these loans may be renewed day after day.

3. Loans and Advances: Loans and advances are the bank’s earning assets.
The interests earned from these assets generate the bulk of commercial bank
revenues. Loans may be demand loans or term loans which may be repayable
is single or in many installments. Advances are usually made in the form of
cash credit and overdraft.

38
4. Investments: Commercial banks use funds for investment in various
types of securities like the gilt edged securities of the central and state
government as well as shares and debentures of corporate undertakings. The
securities issued by government are safe from the risk of default though they
are subject to risk from change in rate of interest. These securities include
treasury bills, treasury deposit certificates, etc. The long-term investments
have the greatest profitability.

5. Bills Receivable: Bills receivable and other credit instruments accepted

by the commercial banks on behalf of their customers are also shown on the
asset side of the balance sheet. The reason is that the bank has a claim on the
payee, on whose behalf it has accepted the bills. Thus, the same amount
appears on assets as well as liabilities sides of the balance sheet of the bank.

6. Other Assets: These include the physical assets of a bank like the bank
premises, furniture, computers, machine equipment, etc. These also include
the collaterals which the bank has repossessed from the borrowers in default.

39
 LITRATURE REVIEW

Risk Management and Risk based Supervision in Banks has been the subject
of study of many Agencies and Researchers and Academicians. There is a
treasure of literature available on the subject. A careful selection of relevant
material was a formidable task before the Researcher. Efforts have been made
to scan the literature highly relevant to the Context. The main sources of
literature have been the Website of the Reserve Bank of India, the website of
the Basle Committee on Banking Supervision and the websites of several
major Banks both in India and abroad. The publications of Academicians
engaged in the Risk Management and Central Banking Supervision sphere
also throws valuable insights in to the area. The occasional Research papers
published by Reserve Bank, the speeches of the Governor and the

Deputy Governors of the Reserve Bank of India, the Publications of the

Reserve Bank of India, the Indian Banks Association have proved quite
relevant to the study.

TOPIC NAME- The Essentials of Risk Management

Crouhy, Gala, Marick

They have summarized the core principles of Enterprise wide Risk

Management. As per the authors Risk Management culture should percolate
from the Board Level to the lowest level employee. Firms will be required to
make significant investment necessary to comply with the latest best practices
in the new generation of Risk Regulation and Management. Corporate
Governance regulation with the advent of Sarbanes-Oxley Act in US and

40
several other legislations in various countries also provide the framework for
sound Risk Management structures. Hitherto,

Enterprise wide Risk Management existed only for name sake. Generally,
firms did not institute a truly integrated set of Risk measures, methodologies
or Risk Management Architecture. The ensuing decades will usher in a new
set of Risk Management tools encompassing all the activities of a Corporation.
The integrated Risk

Management infrastructure would cover areas like Corporate Compliance,

Corporate Governance, Capital Management etc. Areas like business risk,
reputation risk and strategic risk also will be

incorporated in the overall Risk Architecture more formally. As always it will

be the Banks and the Financial Services firms which will lead the way in this
evolutionary process. The compliance requirements of Basel II and III
accords will also oblige Banks and Financial institutions to put in place robust
Risk Management methodologies.

The authors felt that it is generally felt that Risk Management concerns largely
with activities within the firm. However, during the next decade Governments
in different countries would desire to have innovatively drawn Risk
Management system for the whole country. The authors draw reference to the
suggestions of Nobel Laureate Robert Merton who suggested that a country
with exposure to a few concentrated industries should be obliged to diversify
its excessive exposures by arranging appropriate swaps with other countries
with similar problems. Risk Management offers many other potential macro
applications to improve the management of their social security measures etc.
They draw references to the spread of Risk Management Education
worldwide.

41
 TOPIC NAME - International banking regulation

Carl Felsenfeld outlined the patterns of international Banking regulation and

the sources of governing law. He reviewed the present practices and evolving
changes in the field of control systems and regulatory environment. The book
dealt a wide area of regulatory aspects of Banking in the United States,
regulation of international Banking, international Bank services and
international monetary exchange. The work attempted in depth analysis of all
aspects of Bank Regulation and Supervision. Money Laundering has been of
serious concern worldwide. Its risk has wide ramifications. Money
Laundering has led to the fall of Banks like BCCI in the past. In this context
the book on Anti-Money Laundering: International Practice and Policies by
John Broome Published by Sweet and Maxwell (August 2005) reviews the
developments in the area of Money Laundering. The author explains with
reference to case studies the possible effects of Money Laundering. The book
gives a comprehensive account of the existing rules and practices and suggests
several improvements to make the control systems and oversight more
failsafe.

42
 TOPIC NAME- Measuring bank risk

Hannan and Hanweck

He felt that the insolvency for Banks become true when current losses exhaust
capital completely. It also occurs when the return on assets (ROA) is less than
the negative capital asset ratio. The probability of insolvency is explained in
terms of an equation p, 1/(2(Z2). The help of Z-statistics is commonly
employed by Academicians in computing probabilities. Daniele Nouy
elaborates the Basel Core Principles for effective Banking Supervision, its
innovativeness, content and the challenges of quality implementation. Core
Principles are a set of supervisory guidelines aimed at providing a general
framework for effective Banking supervision in all countries. They are
innovative in the way that they were developed by a mixed drafting group and
they were comprehensive in coverage, providing a checklist of the principal
features of a well-designed supervisory system. The core Principles specify
preconditions for effective banking supervision characteristics of an effective
supervisory body, need for credit risk management and elaborates on Principle
22 dealing with supervisory powers.

Dearth of skilled human resources, poor financial strength of supervisor and

consequent inability to retain talented staff, inadequate autonomy and the need
for greater understanding of modern risk management techniques are
identified as the main difficulties in quality implementation. The critical
elements of infrastructure, legal framework that supports sound banking
supervision and a credit culture that supports lending practices are the essence
of a strong banking system. Widespread failures have occurred during a
period of increased vulnerability that can be traced back to some regime
change induced by policy or by external conditions.

43
 TOPIC NAME - Risk – banks and government

Patrick Honohan

He explains the use of budgetary funds to help restructure a large failed

Bank/Banking system and the various consequences associated with it. The
article discusses how instruments can best be designed to restore Bank capital,
liquidity and incentives. It considers how recapitalization can be modelled to
ensure right incentives for new operators/managers to operate in a prudent
manner ensuring good subsequent performance It discusses how
Government’s budget and the interest of the tax payer can be protected and
suggest that monetary policy should respond to the recapitalization rather
determine its design.

The author proposes the following four distinct policy tools to achieve four
distinct goals-injecting assets, adjusting capital claims on the Banks,
rebalancing the govt’s own debt management and managing monetary policy
instruments to maintain stability. The author also assessed the effect of bank
recapitalization for budget and debt management and implications for
monetary policy and macro-economic environment in his article.

The Basel Committee on Banking Supervision, which came into existence in

1974, volunteered to develop a framework for sou0nd banking practices
internationally. In 1988 the full set of recommendations was documented and
given to the Central banks of the countries for implementation to suit their
national systems. This is called the Basel Capital Accord or Basel I Accord. It
provided level playing field by stipulating the amount of capital that needs to
be maintained by internationally active banks.

44
Basel II Accord: Banking has changed dramatically since the Basel I
document of 1988. Advances in risk management and the increasing
complexity of financial activities / instruments (like options, hybrid securities
etc.) prompted international supervisors to review the appropriateness of
regulatory capital standards under Basel I. To meet this requirement, the Basel
I accord was amended and refined, which came out as the Basel II accord.

The new proposal is based on three mutually reinforcing pillars that allow
banks and supervisors to evaluate properly the various risks that banks have
to face and realign regulatory capital more closely with underlying risks. Each
of these three pillars has risk mitigation as its central board. The new risk
sensitive approach seeks to strengthen the safety and soundness of the industry
by focusing on:

● Risk based capital (Pillar 1)

● Risk based supervision (Pillar 2)

● Risk disclosure to enforce market discipline (Pillar 3)

45
 OBJECTIVES OF THE STUDY

 To findout the significant factors that have an impact on Risk

management.
 To analyse the various aspects of risk management.
 To understand the challenges and impact of Implementing Basel norms.

46
 RESEARCH METHODOLOGY

 Research Question.
 To find out the impact on the risk management on Private and
public sector banks in India.

 Data collection
 Secondary information collected from internet, Manuals,
Journals, Audit/Annual reports.
 https://www.rbi.org.in/
 http://www.sebi.gov.in/

 Research Design.
 Qualitative Research.

47
 DATA ANALYSIS

The Basel III framework builds on and enhances the regulatory framework set
out under Basel II and Basel 2.5.

• Basel II: Basel II, which improved the measurement of credit risk and
included capture of operational risk, was released in 2004 and was due to be
implemented from year-end 2006. The Framework consists of three pillars:
Pillar 1 contains the minimum capital requirements; Pillar 2 sets out the
supervisory review process; and Pillar 3 corresponds to market discipline.

• Basel 2.5: Basel 2.5, agreed in July 2009, enhanced the measurements of
risks related to securitization and trading book exposures. Basel 2.5 was due
to be implemented no later than 31 December 2011.

• Basel III: In December 2010, the Committee released Basel III, which set
higher levels for capital requirements and introduced a new global liquidity
framework. Committee members agreed to implement Basel III from 1
January 2013, subject to transitional and phase-in arrangements.

• G-SIB framework: In July 2013, the Committee published the framework on

the assessment methodology for global systemic importance and the
magnitude of additional loss absorbency that global systemically important
banks (G-SIBs) should have. The requirements will be introduced on 1
January 2016 and become fully effective on 1 January 2019. To enable their
timely implementation, national jurisdictions agreed to implement by 1
January 2014 the official regulations/legislations that establish the reporting
and disclosure requirements.

48
• D-SIB framework: In October 2012, the Basel Committee issued a set of
principles on the assessment methodology and the higher loss absorbency
requirement for domestic systemically important banks (D-SIBs). Given that
the D-SIB framework complements the G-SIB framework, the Committee
believes it would be appropriate if banks identified as D-SIBs by their national
authorities are required by those authorities to comply with the principles in
line with the phase-in arrangements for the G-SIB framework, i.e. from
January 2016.

• Liquidity coverage ratio: In January 2013, the Basel Committee issued the
revised liquidity coverage ratio (LCR). The LCR underpins the short-term
resilience of a bank’s liquidity risk profile. The LCR will be introduced on 1
January 2015 and will be subject to a transitional arrangement before reaching
full implementation on 1 January 2019.

In September 2013, the Committee issued the final framework for margin
requirements for non-centrally cleared derivatives, which will be phased in
over a four-year period, beginning in December 2015 with the largest, most
active and most systemically important derivatives market participants. In
December 2013, the Committee issued the final standard for the treatment of
banks’ investments in the equity of funds that are held in the banking book,
which will take effect from 1 January 2017. In April 2014, the Committee
issued the final standard for the capital treatment of bank exposures to central
counterparties, which will come into effect on 1 January 2017. Also in April
2014, the Committee issued the final standard that sets out a supervisory
framework for measuring and controlling large exposures, which will take
effect from 1 January 2019. In January 2014, the Committee issued final
requirements for banks’ LCR-related disclosures. Banks will be required to
comply with them from the date of the first reporting period after 1 January
2015.

49
• Leverage ratio: In January 2014, the Basel Committee issued the Basel III
leverage ratio framework and disclosure requirements following endorsement
by its governing body, the Group of Central Bank Governors and Heads of
Supervision (GHOS). Implementation of the leverage ratio requirements has
begun with bank-level reporting to national supervisors of the leverage ratio
and its components, and will proceed with public disclosure starting on 1
January 2015.

• Net stable funding ratio: In January 2014, the Basel Committee issued
proposed revisions to the Basel framework’s net stable funding ratio (NSFR).
In line with the timeline specified in the 2010 publication of the liquidity risk
framework, it remains the Committee’s intention that the NSFR, including any
revisions, will become a minimum standard by 1 January 2018.

Methodology

The following classification is used for the adoption status of Basel regulatory
rules:

1. Draft regulation not published: no draft law, regulation or other official

document has been made public to detail the planned content of the domestic
regulatory rules. This status includes cases where a jurisdiction has
communicated high-level information about its implementation plans but not
detailed rules.

50
2. Draft regulation published: a draft law, regulation or other official document
is already publicly available, for example, for public consultation or legislative
deliberations. The content of the document has to be specific enough to be
implemented when adopted.

3. Final rule published: the domestic legal or regulatory framework has been

finalized and approved but is still not applicable to banks.

4. Final rule in force: the domestic legal and regulatory framework is already
applied to banks. In order to support and supplement the status reported,
summary information about the next steps and the adoption plans being
considered are also provided for each jurisdiction. In addition to the status
classification, a color code is used to indicate the adoption status of each
jurisdiction. The color code is used for those Basel components for which the
agreed adoption deadline has passed.

51
The reforms target:

Bank-level, or micro-prudential regulation, which will help raise the resilience

of individual banking institutions to periods of stress o Macro-prudential,
system wide risks that can build up across the banking sector as well as the
pro-cyclical amplification of these risks over time
These two approaches to supervision are complementary as greater resilience
at the individual bank level reduces the risk of system-wide shocks. The
Committee's package of reforms will increase the minimum common equity
requirement from 2% to 4.5%. In addition, banks will be required to hold a
capital conservation buffer of 2.5% to withstand future periods of stress
bringing the total common equity requirements to 7%. This reinforces the
stronger definition of capital and the higher capital requirements for trading,
derivative and securitization activities to be introduced at the end of
2012.Banks and around 100 basis points for private banks. Additionally,
banks would be required to maintain liquidity coverage ratio and net stable
funding ratio of above 100%.

The Basel-III norms come at a time when banks are under pressure to set aside
funds for a potential increase in bad loans. For every 1% increase in gross
NPA's (Nonperforming-assets), the banking system may require additional
Rs.25000 crore.

Movement of Capital requirement and triggers under various scenarios

o Core Capital: Equity component of a bank's capital (5.5% in all scenarios) o

Capital conservation buffer: Capital set aside for off balance-sheet
transactions (2.5% in all scenarios) o Counter cyclical buffer: Extra capital to
cushion shocks (1% in 'High Credit Growth Scenario'; 2.5% in 'Higher Credit

52
Growth Scenario'; 1.5% in 'Stress Situation, Higher credit Growth Continues
Scenario')

Criticism

Think tanks such as the World Pensions Council have argued that Basel III
merely builds on and further expands the existing Basel II regulatory base
without fundamentally questioning its core tenets, notably the ever-growing
reliance on standardized assessments of "credit risk" marketed by two private
sector agencies- Moody's and S&P, thus using public policy to strengthen anti-
competitive duopolistic practices. The conflicted and unreliable credit ratings
of these agencies is generally seen as a major contributor to the US housing
bubble. Academics have criticized Basel III for continuing to allow large
banks to calculate credit risk using internal models and for setting overall
minimum capital requirements too low. Opaque treatment of all derivatives
contracts is also criticized. While institutions have many legitimate
("hedging", "insurance") risk reduction reasons to deal in derivatives, the
Basel III accords:

 treat insurance buyers and sellers equally even though sellers take on
more concentrated risks (literally purchasing them) which they are then
expected to offset correctly without regulation

 do not require organizations to investigate correlations of all internal

risks they own

 do not tax or charge institutions for the systematic or aggressive

externalization or conflicted marketing of risk - other than requiring an
orderly unravelling of derivatives in a crisis and stricter record keeping

Since derivatives present major unknowns in a crisis these are seen as major
failings by some critics causing several to claim that the "too big to fail" status
53
remains with respect to major derivatives dealers who aggressively took on
risk of an event they did not believe would happen - but did. As Basel III does
not absolutely require extreme scenarios that management flatly rejects to be
included in stress testing this remains a vulnerability. Standardized external
auditing and modelling is an issue proposed to be addressed in Basel 4
however.

A few critics argue that capitalization regulation is inherently fruitless due to

these and similar problems and - despite an opposite ideological view of
regulation - agree that "too big to fail" persists.

Basel III has been criticized similarly for its paper burden and risk inhibition
by banks, organized in the Institute of International Finance, an international
association of global banks based in Washington, D.C., who argue that it
would "hurt" both their business and overall economic growth. Basel III was
also criticized as negatively affecting the stability of the financial system by
increasing incentives of banks to game the regulatory framework. The
American Bankers Association, community banks organized in the
Independent Community Bankers of America, and some of the most liberal
Democrats in the U.S. Congress, including the entire Maryland congressional
delegation with Democratic Senators Ben Cardin and Barbara Mikulski and
Representatives Chris Van Hollen and Elijah Cummings, voiced opposition to
Basel III in their comments to the Federal Deposit Insurance Corporation,
saying that the Basel III proposals, if implemented, would hurt small banks by
increasing "their capital holdings dramatically on mortgage and small business
loans".

Professor Robert Reich has argued that Basel III did not go far enough to
regulate banks as inadequate regulation was a cause of the financial crisis. On
6 January 2013 the global banking sector won a significant easing of Basel III

54
Rules, when the Basel Committee on Banking Supervision extended not only
the implementation schedule to 2019, but broadened the definition of liquid
assets.

Key milestones

Capital requirements

Date Milestone: Capital requirement

2014 Minimum capital requirements: Start of the gradual phasing-in of

the higher minimum capital requirements.

2015 Minimum capital requirements: Higher minimum capital

requirements are fully implemented.

2016 Conservation buffer: Start of the gradual phasing-in of the

conservation buffer.

2019 Conservation buffer: The conservation buffer is fully

implemented.

55
 Leverage ratio

Date Milestone: Leverage ratio

2011 Supervisory monitoring: Developing templates to track the leverage ratio

and the underlying components.

2013 Parallel run I: The leverage ratio and its components will be tracked by
supervisors but not disclosed and not mandatory.

2015 Parallel run II: The leverage ratio and its components will be tracked and
disclosed but not mandatory.

2017 Final adjustments: Based on the results of the parallel run period, any final
adjustments to the leverage ratio.

2018 Mandatory requirement: The leverage ratio will become a mandatory part
of Basel III requirements.

Emergence of Basel III

Basel II indeed had its share of criticism. To begin with, the Basel Committee
declared that the committee’s recommendations were for G-10 member states.
This leaves out emerging economies, and actually implied potential
unfavorable impact on these economies. To begin with, the scope of
responsibilities for regulators (in emerging economies) may be too much for
them to handle. Central banks might not be stringent enough in regulating
private banks, thus letting them raise their risk exposure – defeating the entire
purpose.

56
Banks in emerging economies were at a disadvantage in terms of receiving
loans from global banks. This was so because rating agencies might either be
unaffordable, or prone to assigning lower ratings anyway to such banks. The
consequence here was that global banks would need to maintain more capital
for a loan to an emerging market bank.
The inclusion of internal risk measurements when calculating the capital
reserves of bank gives rise to another drawback. Since risk weights are
fundamentally a factor of expected economic performance, banks would call
back credit prior to and during recessionary times, and pump in credit in
favorable periods or recovery periods. This effectively means that recessions
would be made worse, and growth periods could be accompanied by even
higher inflation. The issues surrounding Basel II together contributed to the
emergence of the Basel III accord. The essence of Basel III revolves around
two sets of compliance:

i. Capital
ii. Liquidity

While good quality of capital will ensure stable long term sustenance,
compliance with liquidity covers will increase ability to withstand short term
economic and financial stress.
Liquidity Rules
One of the objectives of Basel III accord is to strengthen the liquidity profile
of the banking industry. This is because despite having adequate capital levels,
banks still experienced difficulties in the recent financial crisis. Hence, two
standards of liquidity were introduced.

Liquidity Coverage Ratio (LCR)

LCR was introduced with the objective of promoting efficacy of short term
liquidity risk profile of the banks. This is ensured by making sufficient

57
investment in short term unencumbered high quality liquid assets, which can
be quickly and easily converted into cash, such that it enables the Rating
agencies assign ‘credit ratings’, which capture the borrower’s ability to repay
debt, and the interest it bears, on time. Moody’s, S&P and Fitch Ratings are
the three most prominent rating agencies.
19 financial institution to withstand sustained financial stress for 30 days
period. It is assumed, within 30 days, the management of the bank shall take
corrective actions to deal with the adverse situation.
𝐿𝐶𝑅 =
𝑆𝑡𝑜𝑐𝑘 𝑜𝑓 ℎ𝑖𝑔ℎ 𝑞𝑢𝑎𝑙𝑖𝑡𝑦 𝑙𝑖𝑞𝑢𝑖𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 𝑇𝑜𝑡𝑎𝑙 𝑛𝑒𝑡 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠 𝑜𝑣𝑒𝑟 𝑡ℎ𝑒
𝑛𝑒𝑥𝑡 30 𝑐𝑎𝑙𝑒𝑛𝑑𝑎𝑟 𝑑𝑎𝑦𝑠
The explanations of stock of high quality liquid assets and total net cash
outflows over the next 30 calendar days are given in Annex 1.
Net Stable Funding Ratio (NSFR)
Long term stability of financial liquidity risk profile is an important objective
to be achieved. The Net Stable Funding Ratio incentivizes banks to obtain
financing through stable sources on an ongoing basis. More specifically, the
standard requires that a minimum quantum of stable and risk less liabilities
are utilized to acquire long term assets. The objective is to deter reliance on
short term means of finance, especially during favorable market periods.
𝑁𝑆𝐹𝑅 =
𝐴𝑚𝑜𝑢𝑛𝑡 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑜𝑓 𝑠𝑡𝑎𝑏𝑙𝑒 𝑓𝑢𝑛𝑑𝑖𝑛𝑔 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑠𝑡𝑎𝑏𝑙𝑒
𝑓𝑢𝑛𝑑𝑖𝑛𝑔

58
Capital Rules
These rules have been updated to continue to ensure that banking institutions
maintain a sound and stable capital base. Enhancement of risk coverage is the
objective of Basel III accords and the same is achieved by introduction of
capital conservation buffer and countercyclical buffer.
Capital Conservation Buffer
The intention behind the capital conservation buffer is to make certain that
banks accumulate capital buffers in times of low financial stress. Such a buffer
is handy when banks are hit by losses, and aims to prevent violations of
minimum capital requirements. When the buffer is 20 utilized (say, in a period
of financial stress), banks need to recreate it by pruning their discretionary
distribution of earnings. Banks facing reduced capital buffers must certainly
not signal their financial strength by way of distributing earnings. The other
option available here is to raise fresh capital from the private sector.
Basel II incorporates a capital conservation buffer of 2.5 percent above the
minimum capital requirement. This buffer is built out of Common Equity Tier
1 (CETI)11, only after the 6 percent Tier 1 and 8 percent total capital
requirements have been fulfilled. While the bank’s operations remain
unaffected when its capital falls short of the 2.5 percent threshold, the accord
enforces constraints on distribution of earnings.

59
Countercyclical Buffer

The underlying premise of the countercyclical buffer is that capital

requirements in the banking sector must take into consideration the
macroeconomic environment in which banks operate. When a financial
downswing succeeds a period of excess credit growth, banks incur huge
losses. This can create massive disorder in the banking sector. Banks must
thus arm themselves with capital buffers in times of rapidly-growing financial
stress. Modes of distributing earnings would basically include “dividends and
share buybacks, discretionary payments on other Tier 1 capital instruments
and discretionary bonus payments to staff” as per the Basel III accord (2011
Revision). CETI refers to equity capital and reserves, but excludes all
preference shares. It is part of Tier 1 capital. The countercyclical buffer will
be enacted by national authorities, when they believe that the excess credit
growth potentially implies a threat of financial distress. The buffer for
internationally-active banks is computed as a weighted average of the buffers
for all jurisdictions where the bank bears a credit exposure. Considering the
fact that credit cycles are generally not highly correlated across jurisdictions,
such banks would need to maintain a small buffer (quite frequently) in most
circumstances.
Banks would be subject to a countercyclical buffer between zero and 2.5
percent of their total risk-weighted assets. The countercyclical buffer
mandated for a bank “will extend the size of the capital conservation buffer”,
as per the accord. Further, banks failing to maintain the required
countercyclical buffer would face restrictions on distributions. Also, banks
should mandatorily calculate (and disclose) their countercyclical buffer
requirements with minimally the same frequency as their minimum capital
requirements. Table 6 below captures the calibration of the capital framework

60
in Basel III in terms of the minimum capital requirements and the respective
buffers.
Leverage Ratio
A critical characteristic of the 2007-08 financial crisis was the overuse of on-
and off-balance sheet leverage in the banking sector. On the other hand, banks
portrayed healthy risk based capital ratios. However, when banks had no
choice but to reduce leverage in the worst part of the crisis, a vicious circle
was created. Off-balance sheet leverage, also known as incognito leverage,
refers to a financing activity, asset or debt, which does not appear on the
entity’s balance sheet. The leverage ratio was incorporated in order to have a
non-risk based metric in addition to the risk based capital requirements in
place. Of course, the primary intentions were thus to throttle the tendency of
excessive leverage and strengthen risk based requirements.
The occurrence of financial crisis of 2008 highlighted the failure of Basel II
norms to contain the widespread shock. This led to more stringent definition
of capital and capital requirements. Besides, liquidity standards were
introduced to ensure stable source of short term (30 days) and medium term
funding (one year) of the bank of its assets. Thus, the liquidity coverage ratio
and net stable funding ratio made its way into the refined Basel III accord.

61
 FINDINGS

 Credit risk is generally well contained, but there are still problems
associated with loan classification, loan loss provisioning, and the
absence of consolidated accounts.
 Market risk and Operational risk are clear challenge, as they are
relatively new to the areas that were not well developed under the
original Basel Capital Accord.
 The new regulations will allow banks to introduce substantial
improvements in their overall risk management capabilities, improving
risk based performance measurement, capital allocation as portfolio
management techniques.

 Future complexity is expected because banks diversify their operations.

It is expected that banks will diversify their operations to generate
additional income sources, particularly fee-based income i.e. non-
interest income, to improve returns.

 Basel II leads to increase in Data collection and maintenance of privacy

and security in various issues.

 The banks that would prefer to adopt the Standard Approach should try
to adopt Advanced Approach.

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RECOMMENDATION

 A workshop should be planned to produce a road map to Basel II

Compliance.

 Training and additional assistance to make it easier for the banking

system to comply with new guidelines on market and operational risk.

 Data Privacy and security needs more attention

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 CONCLUSION

Implementation of Basel II has been described as a long journey rather than a

destination by itself. Undoubtedly, it would require commitment of substantial
capital and human resources on the part of both banks and the supervisors.
RBI has decided to follow a consultative process while implementing Basel II
norms and move in a gradual, sequential and co-ordinate manner. For this
purpose, dialogue has already been initiated with the stakeholders. As
envisaged by the Basel Committee, the accounting profession too, will make
a positive contribution in this respect to make Indian banking system still
stronger.

The Basel-III will lead to much safer financial system and will reduce chances
of banking crisis. Indian banking system is integrated with the global banking
system and deviation from the global banking standards will prevent foreign
banks from entering into the Indian economy. Also, with greater integration
with the global banks, India needs to mitigate the risk thus associated with the
global financial system by applying Basel-III practices.

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 REFERENCE

 https://www.rbi.org.in/
 http://www.sebi.gov.in/
 Reports.
 News Paper.

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