Adoption of Basel II Norms:

Are Indian Banks Ready?

What is Basel II?

Basel II is the second of the Basel Accords recommended on banking laws and regulations issued
by theBasel Committee on Banking Supervision. The purpose of Basel II is to create an international
standard that banking regulators can use when creating regulations about how much capital banks
need to put aside to guard against the types of financial and operational risks (these terms are
explained in later sections) banks face. These international standards can help protect the international
financial system from the types of problems that might arise should a major bank or a series of banks
collapse. 

Basel II insists on setting up rigorous risk and capital management requirements designed to ensure
that a bank holds capital reserves appropriate to the risk The underlying assumption behind these rules
is that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs
to hold to safeguard its solvency and overall economic stability. It will also oblige banks to enhance
disclosures.

Advantages of Basel II over Basel I

Basel 1 Proposed new Accord or Basel II
Focus on a single risk measure, More emphasis on banks' own internal 
primarily on credit risk. Doesn't methodologies, supervisory review,
cover operation risk and market discipline
One size fits all Flexibility, menu of approaches,
incentives for better risk management
Broad structure More risk sensitivity
Uses arbitrary risk categories & Risk weights linked to external ratings
risk weights assigned by ECAI or IRB by bank

Capital Adequacy Requirements 

Capital adequacy requirements on the banks not only protect investors, but also safeguard them
against possibility of failure of a big-bank. It also strengthens market discipline. In Basel I Capital
adequacy is given as a single number that was the ratio of a banks capital to its assets. The key
requirement was that tier-I capital was at least 8% of assets

Three pillars of Basel II

Types of risks according to Basel II

Credit Risk Operational Risk

Market Risk
The risk of losses in on- and The risk that a counterparty (Internal controls & Corporate
off-balance-sheet positions will not settle an obligation for governance):
arising from movements in full value, either when due or
market prices.  at any time thereafter.  The risk of loss resulting from
inadequate or failed internal
Main factors contributing to In exchange for-value systems, processes people and systems
market risk are: equity, the risk is generally defined to or from external events
interest rate, foreign include replacement risk and
exchange, and commodity risk. principal risk.
The total market risk is the
aggregation of all risk factors.

Why Indian Banks need Basel II or new accord

India had adopted Basel I guidelines in 1999. Subsequently, based on the recommendations of
Steering Committee established in February 2005 for the purpose, the RBI had issued draft guidelines
for implementing a New Capital Adequacy Framework, in line with Basel II.

The deadline for implementing Basel II, originally set for March 31, 2007, has now been extended.
Foreign banks in India and Indian banks operating abroad will have to adhere to the guidelines by
March 31, 2009. But the decision to implement the guidelines remains unchanged.

Apart from the above mentioned advantages of Basel II vis-à-vis Basel 1, there are certain reasons
which manifests why Indian Banks require Basel II compliance:-

 Basel II norms will facilitate introduction of new complex financial products in Indian Banking
Sector
 Indian banks require a more risk sensitive framework. There is improvement in risk
management system by Indian banks
 New rules will provide a range of options for estimating regulatory capital and will reduce gap
between regulatory capital & economic capital

Adoption of BASEL II Norms: Are the Indian Banks Ready?

1. Base II Pillar I Preparedness

RBI has advised the banks to use Standardised Approach for measuring Credit Risk (risk ratings are
assigned by credit assessment institutions like Moody's) and Basic Indicator Approach for assessing
Operational Risk. Since the loans and advances portfolios of India banks largely covers un-rated
entities that are assigned a risk weight of 100 per cent, the impact of the lower risk weights assigned
to higher rated corporate would not be significant.

The other major impact will be in the area of short-term assets. Under Basel II norms RBI in its capital
adequacy guidelines has provided for lower risk weights for short-term asset exposures. The Indian
banks have large short-term portfolio (cash and working capital loans). This lower risk weight can be
leveraged by the Indian banks

The Indian banking sector will require an additional capital of Rs

5,68,744 crores in the next 5 years to maintain the Capital Adequacy
Ratio at 12% according to the Basel II norms. Major share is of Public
Sector

Hence Basel II in spite of its stringent rules for Capital adequacy provides opportunity for the Indian
banks to significantly reduce their credit risk weights and reduce the required regulatory capital

To raise the additional capital for maintaining the Capital adequacy requirements the small and
medium sized banks will surely face a lot of problems. The advantages that the PSBs and the large
private banks have are:

 The banks can use the capital market to meet the capital requirements and can go for a public
issue or can use private placement to garner the capital
 PSBs are helped by the state and central government which can infuse their funds in the form of
recapitalization to fulfill the capital adequacy
 Significant proportion will be met by internal resources of the banks, like growth in reserves and
surplus through efficient operations in the coming years.

Small and medium sized banks in the country may also have to incur enormous costs to acquire the
required technology as well as to train staff in terms of the risk management activities.  They also need
technological upgradation and access to information like historical data etc. 

2. Base II pillar II preparedness

Pillar II requirements are also demanding on the supervisor i.e. RBI to emphasize the following areas
of development:

 Skill development both at RBI level and the banks level

 Proper framework for the supervisory role
 Administer and enforce minimum capital requirements from bank even higher than the Basel II
specified level based on the risk management skills of the bank.
 Preparing the banks for the IRB method and facilitate them to develop their risk management
systems
 Validating and upgrading the Indian banks IRB model and help them develop the required IT
 architecture and upgrade its MIS systems

3. Basel II Pillar III preparedness

Pillar III according to Basel II Accord demands comprehensive disclosure requirements from the banks.
For such comprehensive disclosure the IT structure must be in place for the supporting data collection
and for generating MIS which is compatible with Pillar III requirements

For this a data roadmap must be developed. IT structure required must be defined with technology
architecture with focus on

 Scalability
 Availability
 Security
 Generation of MIS

Possible dynamics in the Indian Banking Sector

In all the regards the big banks (read PSB and large private banks) will have the marked advantage
over the small and medium sized banks. This might lead to considerable level of consolidation in the
Indian Banking Industry. In the present market scenario, the banks might find it difficult to raise funds
through the capital markets to raise funds for servicing the capital adequacy requirements. The
maximum level of dilution allowed of government's stake is 51% in PSB which might cap their capital
market funding. The nationalized banks can access the market up to the level of Rs5, 171 crores still
maintaining the government's stake. To solve this there needs to be a relaxation in the allowed dilution
level up to atleast 33%.

An area of relaxation is in the case of private banks which are allowed to access capital from foreign
sources up to 74% with no single entity allowed to have an FDI of above 10%. This is leading to
foreign firms having substantial stake in Indian private banks

Hence, regarding the opening of Indian banking sector to foreign banks RBI is going for a measured
and synchronized manner with the maturity of the Indian Banking sector in terms of size and risk
management. It is taking a measured approach instead of directly opening the gates for the foreign
banks.

References

1. ICRA -  www.icraratings.com

2. Master Circular – Prudential Guidelines on Capital Adequacy and Market Discipline –

Implementation of the New Capital Adequacy Framework (NCAF) – by Reserve Bank of India

3.  BASEL II ACCORD: IMPACT ON INDIAN BANKS BY ICRA

4. Master Circular – Prudential Guidelines on Capital Adequacy and Market

5. Discipline – Implementation of the New Capital Adequacy Framework (NCAF) by RBI

6. Basel Committee on Banking Supervision International Convergence of Capital Measurement

and Capital Standards A Revised Framework Comprehensive Version

7. Risk Management and Capital Adequacy by  Reto R. Gallati