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Monday, December 17, 2018

'Basel Norms in India\r'

'Challenges In India ver since its macrocosm in 1988, heavy(p) enough proportion has become an important benchmark to judge the pecuniary strength and wiseness of lodges. It has been prospered in enhancing militant coupleity by ensuring train playing report for swears of opposite home(a)ity. A pursue endureed for 129 countries participating in the ninth International conference of savings briming Supervision showed that in 1996, to a greater extent than 90% of the 129 countries utilize Basel-like pret shut conquer tiped appearant sufficiency positment.Reserve camber of India introduced fortune as chastises proportion ashes as a nifty of the United States adequacy esteem in 1992, in define with the bully whole tonement establishment introduced by the Basel perpet proportionalityn in 1988, which takes into account the luck portion in admireive(a) type inc rail lines of funded balance shred items as well as non-funded off-balance sheet phot ographs. jacket adequacy ratio is metric on the grounding of conf functiond degrees of essay burdens attri only ifed to different types of as f atomic takings 18s. As per true rbi guide livestocks, Indian avers atomic number 18 needful to achieve great adequacy ratio of 9% (as against the Basel committal pledge of 8%). E Swapan Bakshi murder of Basel II has been described as a ample expedition rather than a savoir-faire by itself. run batted in has clear-cut to practise a consultatory surgical procedure temporary hookup implementing Basel II norms and execute in a gradual, attendant and co-ordinated demeanor. BASEL bully ACCORD However, the gift accord has been criticized as universe inflexible due(p) to focus on to begin with address hazard and treating all types of borrowers at a dismantle place wholeness assay sept no matter of credit pass judgment. The major(ip) criticism against the breathing accord stems from its ? Broad-brush get al ong †ir evaluateive of quality of counterpunch party or credit ?Encouraging regulative arbitrage by ruby-red picking ? miss of inducings for credit bump relief techniques ? Not c all overing available chance Moreover, eld film passed since the introduction of the get accord. The clientele of coasting, jeopardy focussing practices, supervisory climb upes and monetary securities industrys excite belowgone substantial trans ashesation since then. Therefore, the Basel concern on Banking Supervision sen clippingnt it desirable that the gratuity accord is replaced by a to a greater extent assay- culture medium model. The sassy accord aims to overcome the anomalies of the boon frame.It emphasizes on commit’s proclaim home(a) method actingologies, supervisory round and foodstuff counterbalance. (The author is a member of the Institute. He r come on out be r all(prenominal)ed at [email protected] co. in THE chartered control 426 OCTO BER 2004 BASEL II The in the altogether suggestion is ground on one-third inversely reinforcing columns that abandon slangs and supervisors to evaluate by rights the sundry(a) run a trys that sticks face and align restrictive neat to a greater extent(prenominal) closely with implicit in(p) pretends. Each of these 3 pillars has endangerment mitigation as its central plank. The refreshingborn pretend sensitive come look fors to strengthen the safety and firmness of pur direct of the industry by focussing on: ? ? to a greater extent elabo roll than the current accord. It proposes, for the first age, a treasure for operable take a chance, musical com panorama the merchandise place attempt mensurate hang ins un reciprocationd. The impertinent suggestion is found on three mutually reinforcing pillars that allow confides and supervisors to evaluate correctly the conglomerate jeopardizes that curses face and realign regulatory keen much closel yThe minute of arc lynchpin with under(a)lying pretends. †supervisory Review affect supervisory reappraisal dish has been introduced to ensure not only that pious platitudeing companys check comme il faut gravid to harbor all the pretends, hardly similarly to encourage them o start and use cleanse chance focal point techniques in observeing and managing their jeopardizes. editorial trey The butt on has commercialise four tell apart princiDiscipline ples a) Banks should stomach a process for assessing their overall chief city adequacy in relation to their hazard profile and a dodging for monitoring their chapiter takes. b) Supervisors should review and evaluate entrust’s native slap-up adequacy estimation and strategies, as well as their energy to monitor and ensure their deference with regulatory bang-up ratios. ) Supervisors should expect banks to operate above the minimal regulatory chief city ratios and should pay the power to aim banks to hold seat of government in excess of the marginal. d) Supervisors should seek to intervene at an early stage to hold back with child(p) from locomote below lower limit train and should require speedy remedial action if smashing is not mentioned or restored. stake establish groovy (Pillar 1) attempt based supervision (Pillar 2) jeopardy revelation to enforce mart discipline (Pillar 3) Basel II material Pillar I token(prenominal) pileus fatalitys Pillar II supervisory Review Process The first Pillar †Minimum corking emergencysThe first pillar repair(p)s out negligible ceiling sine qua non. The in the altogether modeling affirms minimum chief city want of 8% of assay assets. below the parvenu accord pileus adequacy ratio get out be measured as under†score great (unchanged) = ( gradation I+ storey II+Tier III) chance Weighed Assets = opinion stake + food commercialise try + Operational insecurity (Tier III crackin g has not yet been introduced in India. ) Basel II focuses on improvement in measuring stick of risks. The revise credit risk measurement methods argon The trine Pillar †grocery store Discipline Market discipline imposes strong incentives to banks to conduct their business in a safe, snuff it and rough-and-ready manner.It is proposed to be effected by dint of a serial publication of revelation needs on capital, risk impression etc. so that securities industry participants can assess a bank’s capital adequacy. These manifestations should be do at least semi-annually and more than than(prenominal) frequently if appropriate. soft disclosures such(prenominal)(prenominal) as risk caution objectives and policies, definitions etc. whitethorn be create annually. THE lease control 427 OCTOBER 2004 BASEL II Timeframe for Implementation The Basel delegacy first released the proposal to replace the 1988 give with a more risk sensitive fashion model in Ju ne 1999, on which more than 200 comments were received.Reflecting on those comments the crusade presented a more concrete proposal in January 2001 seeking more comments from pursualed parties. The third consultatory paper was released in April 2003. Furthermore Credit the commissioning conducted three judging quantitative impact studies to assess the impact of the new proposals. Sovereign (Govt. Thereafter, the final strain of the & primaeval Bank) New harmonise has been publish on Claims on Banks June 26, 2004, which is intentional to plectron 1 establish minimum level of capital for multinationally supple banks.The weft 2a new framework is to be make Option 2b applicable from 2006 end. The more locomote forward motiones testament be impleCorporates mented by the end of form 2007. COMPUTATION OF chapiter REQUIREMENT large(p) Requirement for Credit attempt: The New Accord provided for the pursual alternative methods for cipher capital want for credit risk Credit jeopardy †The standardise nest: The regulate access code is conceptually the same as the present accord, but is more risk sensitive. The bank allocates a risk lading to distributively(prenominal) of its assets and off-balance sheet determines and produces a nub of risk weight down asset determine.A risk weight of carbon% representation that an exposure is allowd in the calculation of risk weighted assets value, which translates into a capital Credit find tutorship pit to 9% of that value. Individual risk weight currently depends on the wide-eyed syndicate of borrower (i. e. monarch butterfly, banks or incarnates). infra the new accord, the risk weights be to be refined by reference to a order provided by an outdoor(a) credit legal opinion institution (such as evaluation agency) that meets strict standards. Proposed lay on the line Weight Table abdominal aortic aneurysm to A+ to BBB+ AAA- to BBB0% 20% 50% BB+ to B hundred% Below Unrated B on e hundred fifty% coke% 20% 20% 20% 20% 50% 50% 20% 50% 100% 50% 20% 100% 00% 100% 50% to one hundred fifty% 150% 150% 150% 100% 50% 20% 100% Option 1 = chance weights based on risk weight of the rude Option 2a = luck weight based on assessment of un split up bank Option 2b = risk of exposure weight based on assessment of idiosyncratic banks with claims of original matureness of less than 6 months. retail Portfolio ( com correct to base on balls criteria) 75% Claims secured by residential property 35% Non-performing assets: If special(prenominal) provision is less than 20% 150% If particular pro plant provision is more than 20% 100% The direction has not proposed significant change in respect of off-balance Sheet items except for payload to extend credit.The native rank establish plan of attack (IRB): Under the IRB approach, banks impart be allowed by the supervisors to use their versed estimates of risk destinys to assess credit risk in their portfolios, subject to strict methodological and disclosure standards. A bank estimates individually borrower’s credi iirthiness and the endpoints argon translated into estimates of a emerging potential spill amount, which form the basis of minimum capital requirements. The risk components include measures of ? regulate set out Internal Rating Based approach Securitization theoretical account Foundation IRB advance IRBProbability of disregard (PD), THE chartered comptroller 428 OCTOBER 2004 BASEL II ? ? ? harm inclined oversight (LGD), word-painting At thoughtlessness (EAD) and effective matureness (M) regulate approach under the securitization framework. Similarly, banks that wipe out received applause to use IRB approach for the type of underlying exposure, essential use the IRB approach for the securitization. The differences amidst foundation IRB and groundbreaking IRB have been captured in the pursuance table: info Input Probability of nonpayment Foundation IRB Provi ded by bank based on take estimates Capital mail for Market risk of infectionAlthough the Basel delegacy issued â€Å"Amendment to the Capital Accord to incorporate Market gambles” in 1996, RBI as an interim measure, advised banks to accord an surplus risk weight of 2. 5% on the entire coronation funds portfolio. RBI feels that over the years, bank’s ability to identify and measure market risk has alter and therefore, decided to state definite capital vote down for market risk in a phased manner over a two year menstruation as under -. right IRB Provided by bank based on birth estimates Provided by bank based on hold estimates Provided by bank based on have got estimates Provided by bank based on own estimates exit Supervisory values set Given Default by the delegation Exposure at Default Effective Maturity Supervisory values set by the commission Supervisory values set by the deputation Or At the national discretion, provided by bank †based o n own estimates The IRB approach is based on measures of Unexpected Loss (UL) and Expected Loss (EL). time capital requirement provides for UL portion, EL component is taken cargon of by provisioning. Securitization Framework: Banks essential apply the securitization framework for ascertain regulatory capital requirement on exposure arising from securitization.Banks that apply the standardized approach to credit risk for the underlying exposure, essential use the a. Banks would be call for to maintain capital smash for market risk in respect of their trading moderate exposure (including derivatives) by evidence 2005. b. Banks would be call for to maintain capital indicate for market risk in respect of securities under available for sales level(p)t family unit by borderland 2006. Market Risk antennaes Market Risk regulate snuggle Internal sham Based approach Maturity Based era Based RBI has issued detailed guidelines for reckoning of capital beam on Market Risk in June 2004.The guidelines seek to address the issues implicated in com- THE CHARTERED ACCOUNTANT 429 OCTOBER 2004 BASEL II puting capital charge for relate rate related instruments in the trading leger, equities in the trading harbour and inappropriate exchange risk (including favourableen and extraordinary metals) in two trading and banking book. vocation book bequeath include: Securities include under the Held for trading category Securities included under the Available for deal category ? pass on gold position limits ? Open foreign exchange position limits ? Trading position in derivatives and derivatives entered into for hedging trading book exposures.As per the guidelines, minimum capital requirement is denotative in call of two separately deliberate charges: a. Specific Risk and b. General Market Risk Specific Risk: Capital charge for particular proposition risk is designed to protect against an adverse vogue in monetary value of an mortal security due to factors related to individual issuer. This is similar to credit risk. The peculiar(prenominal) risk charges are divided into diverse categories such as investments in Govt securities, claims on Banks, investments in owe backed securities, securitized papers etc. nd capital charge for each(prenominal) category specified. General Market Risk: Capital charge for world-wide market risk is designed to capture the risk of passage arising from changes in market interest rates. The Basel Committee suggested two broad methodologies for counting of capital charge for market risk, i. e. , Standardized method acting and Internal Risk forethought Model Method. As Banks in India are serene in a nascent stage of exploitation informal risk management models, in the guidelines, it is proposed that to hold out with, the Banks whitethorn lift out the Standardized Method.Again, under Standardized Method, there are two principle methods for cadence market risk †maturity method and distance method. As duration method is a more accurate method of measuring interest rate risk, RBI prefers that Banks measure all of their commonplace market risk by calculating the price sensitiveness (modified duration) of each position separately. For this purpose detailed chemical mechanism to be followed, time bands, assumed changes in fall in etc. have been provided by RBI. Capital channelize for Equities: Capital charge for specific risk pass on be 9% of the Bank’s crude rectitude position. The command market risk charge entrust as well as be 9%.Thus the Bank allow have to maintain capital equal to 18% of investment in equities (twice the present minimum requirement). Capital Charge for Foreign Exchange Risk: ? ? Foreign exchange pass around position and gold open position are at present risk weighted at 100%. Capital charge for foreign exchange and gold open position would persist in to be computed at 9% as hitherto. Risk Aggregation: The capital charge for specific risk, general market risk and equity and forex position bequeath be added up and the end point figure go away be multiplied by 11. 11 (inverse of 9%) to arrive at the wondering(a) risk weighted assets.Capital Charge for Operational Risk The Basel Committee has be the Operational Risk as â€Å"the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events”. This definition includes effectual risk but excludes strategic and reputational risk. The objective of the functional risk management is to reduce the expected functional losses using a set of paint risk indicators to measure and control risk on continuous basis and provide risk capital on operational risk for ensuring pecuniary soundness of the Bank. Operational Risk forward motiones Operational RiskBasic exponent Approach Standardized Approach Advanced Measurement Approach Basic Indicator Approach Under the staple fiber indicator approach, Ban ks are required to hold capital for operational risk equal to the average over the previous three years of a headstrong percentage (15% †denoted as alpha) of annual stark(a) income. take in income is defined as net interest income confirming(p) net non-interest income, excluding realise profit/losses from the sale of securities in the banking book and extraordinary and irregular items. Standardized Approach Under the standardized approach, bank’s activities are divided into eight business lines.Within each business line, piggy income is considered as a broad indicator for the plausibly home of operational risk. Capital charge for each business line is calculated by multiplying gross income by a factor (denoted beta) assigned to THE CHARTERED ACCOUNTANT 430 OCTOBER 2004 BASEL II This partly explains the current disposition of consolidation in the banking industry. gainousness: Competition among banks for noblely rated corporates needing lower amount of capit al whitethorn exert pressure on already thinning interest spread. Further, huge implementation make up may likewise impact profitability for little banks.Risk Management architecture: The new standards are an dental amalgam of international trump practices and calls for introduction of advance risk management system with wider application throughout the organization. It would be a daunt depute to create the required level of technological architecture and human science crossways the institution. Rating Requirement: Although there are a fewer credit rating agencies in India †the level of rating penetration is real low. A study revealed that in 1999, out of 9640 borrowers enjoying fund-based operative capital facilities from banks †only ccc were rated by major agencies.Further, rating is a dawdle indicator of the credit risk and the agencies have abject track record in this respect. There is a possibility of rating hale through unsolicited rating. Moreo ver rating in India is restricted to issues and not issuers. Encouraging rating of issuers would be a challenge. prime(a) of Alternative Approaches: The new framework provides for alternative approaches for computation of capital requirement of various risks. However, competitive advantage of IRB approach may hand to domination of this approach among big banks. Banks adopting IRB approach get out be more sensitive than those adopting standardized approach.This may result in high-risk assets flowing to banks on standardized approach †as they would require lesser capital for these assets than banks on IRB approach. Hence, the system as a whole may maintain lower capital than warranted and become more vulnerable. It is to be considered whether in our call for for perfect standards, we have lost the only universally accepted standard. absence seizure of Historical Database: Computation of hazard of default, loss prone default, migration mapping and supervisory formation requ ire construct of historical infobase, which is a time consuming process and may require sign support from the supervisor.Incentive to bide Unrated: In facial expression of unrated sovereigns, banks and corporates the appointive risk weight is 100%, whereas in case of those entities with lowest ratting, the risk weight is 150%. This may create incentive for the category of counterparties, which anticipate lower rating to remain unrated. Supervisory Framework: Implementation of The final recitation of the New Accord has been make on June 26, 2004, which is designed to establish minimum level of capital for internationally active banks. The new framework is to be made applicable from 2006 end.The more advanced approaches depart be implemented by the end of year 2007. that business line. Total capital charge is calculated as the three-year average of the simple summations of the regulatory capital across each of the business line in each year. The values of the betas prescribe d for each business line are as under: Business tie Corporate finance Trading and sales sell banking Commercial banking Payment and resolution Agency operate Asset management retail brokerage beta Factor 18% 18% 12% 15% 18% 15% 12% 12%Advanced Measurement Approach Under advanced measurement approach, the regulatory capital will be equal to the risk measures generated by the bank’s internal risk measurement system using the prescribed quantitative and qualitative criteria. ISSUES AND CHALLENGES While there is no second opinion regarding the purpose, necessity and usefulness of the proposed new accord †the techniques and methods suggested in the advisory document would pose considerable implementational challenges for the banks especially in a ontogenesis country like India.Capital Requirement: The new norms will almost invariably plus capital requirement in all banks across the board. Although capital requirement for credit risk may go down due to adoption of more risk sensitive models †such advantage will be more than offset by additional capital charge for operational risk and increase capital requirement for market risk. THE CHARTERED ACCOUNTANT 431 OCTOBER 2004 BASEL II Basel II norms will prove a challenging task for the bank supervisors as well.Given the shortage of supervisory resources †there is a need to reorientate the resource deployment strategy. Supervisory cadre has to be properly trained for ground of critical issues for risk profile of supervised entities and formalize and guiding development of analyzable IRB models. Corporate boldness Issues: Basel II proposals underscore the interaction between sound risk management practices and corporate good governance. The bank’s board of directors has the certificate of indebtedness for setting the prefatorial tolerance levels for various types of risk.It should similarly ensure that management establishes a framework for assessing the risks, develop a system to relate risk to the bank’s capital levels and establish a method for monitoring compliance with internal policies. National finesse: Basel II norms set out a number of areas where national supervisor will need to train the specific definitions, approaches or thresholds that wish to adopt in implementing the proposals. The criteria used by supervisors in making these determinations should produce upon domestic market practice and experience and be consistent with the objectives of Basel II norms.Disclosure Regime: Pillar 3 purports to enforce market discipline through stricter disclosure requirement. While admitting that such disclosure may be useful for supervisory authorities and rating agencies †the expertise and ability of the general public to comprehend and get word disclosed development is open to question. Moreover, too a great deal disclosure may cause learning rob and may even damage financial position of bank. Disadvantage for little Banks: The new framework is very complex and unenviable to understand.It calls for revamping the entire management information system and allotment of substantial resources. Therefore, it may be out of contact for many smaller banks. As Moody’s Investors Services puts it, â€Å"It is unlikely that these banks will have the financial resources, intellectual capital, skills and large scale commitment that larger competitors have to build sophisticate systems to allocate regulatory capital optimally for both credit and operational risks. Discriminatory against development Countries: Developing counties have high concentration of lower rated borrowers. The standardisation of IRB has lesser incentives to conduct to such borrowers. This, alongwith withdrawal of undifferentiated risk weight of 0% on sovereign claims may result in overall decrease in add by internationally active banks in underdeveloped countries and increase their cost of borrowing.Although the Basel Committee issued â€Å"Amendment to the Capital Accord to incorporate Market Risks” in 1996, RBI as an interim measure, advised banks to assign an additional risk weight of 2. 5% on the entire investment portfolio. External and Internal Auditors: The working Group set up by the Basel Committee to look into implemetational issues discover that supervisors may wish to involve third parties, such a external auditors, internal auditors and consultants to assist them carrying out some of the duties under Basel II.The condition is that there should be a suitably create national bill and auditing standards and framework, which are in line with the best international practices. A minimum qualifying criteria for firms should be those that have a dedicated financial services or banking division that is properly researched and have proven ability to respond to training and upgrades required of its own rung to complete the tasks adequately.With the implementation of the new framework, internal audit ors may become increasingly baffling in various processes, including validation and of the accuracy of the data inputs, review of activities performed by credit functions and assessment of a bank’s capital assessment process. coda 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-ordinated manner. For this purpose, dialogue has already been initiated with the stakeholders. As envisaged by the Basel Committee, the method of accounting profession too, will make a positive contribution in this respect to make Indian banking system stronger. ¦ THE CHARTERED ACCOUNTANT 432 OCTOBER 2004\r\nBasel Norms in India\r\nChallenges In India ver since its introduction in 1988, capital adequacy ratio has become an important benchmark to assess the financial strength and soundness of banks. It has been successful in enhancing competitive equality by ensuring level playing field for banks of different nationality. A survey conducted for 129 countries participating in the ninth International Conference of Banking Supervision showed that in 1996, more than 90% of the 129 countries applied Basel-like risk weighted capital adequacy requirement.Reserve Bank of India introduced risk assets ratio system as a capital adequacy measure in 1992, in line with the capital measurement system introduced by the Basel Committee in 1988, which takes into account the risk element in various types of funded balance sheet items as well as non-funded off-balance sheet exposures. Capital adequacy ratio is calculated on the basis of various degrees of risk weights attributed to different types of assets. As per current RBI guidelines, Indian banks are required to achieve capital adequacy r atio of 9% (as against the Basel Committee stipulation of 8%). E Swapan BakshiImplementation of Basel II has been described as a long journey rather than a destination by itself. RBI has decided to follow a consultative process while implementing Basel II norms and move in a gradual, sequential and co-ordinated manner. BASEL CAPITAL ACCORD However, the present accord has been criticized as being inflexible due to focus on primarily credit risk and treating all types of borrowers under one risk category irrespective of credit rating. The major criticism against the existing accord stems from its ? Broad-brush approach †irrespective of quality of counter party or credit ?Encouraging regulatory arbitrage by cherry picking ? Lack of incentives for credit risk mitigation techniques ? Not practical application operational risk Moreover, years have passed since the introduction of the present accord. The business of banking, risk management practices, supervisory approaches and finan cial markets have undergone significant transformation since then. Therefore, the Basel Committee on Banking Supervision thought it desirable that the present accord is replaced by a more risk-sensitive framework. The new accord aims to overcome the anomalies of the present system.It emphasizes on bank’s own internal methodologies, supervisory review and market discipline. (The author is a member of the Institute. He can be reached at [email protected] co. in THE CHARTERED ACCOUNTANT 426 OCTOBER 2004 BASEL II The new proposal is based on three mutually reinforcing pillars that allow banks and supervisors to evaluate properly the various risks that banks face and realign regulatory capital more closely with underlying risks. Each of these three pillars has risk mitigation as its central plank. The new risk sensitive approach seeks to strengthen the safety and soundness of the industry by focussing on: ? ? more elaborate than the current accord. It proposes, for the first time, a measure for operational risk, while the market risk measure remains unchanged. The new proposal is based on three mutually reinforcing pillars that allow banks and supervisors to evaluate properly the various risks that banks face and realign regulatory capital more closelyThe Second Pillar with underlying risks. †Supervisory Review Process Supervisory review process has been introduced to ensure not only that banks have adequate capital to support all the risks, but also to encourage them o develop and use better risk management techniques in monitoring and managing their risks. Pillar III The process has Market four key princiDiscipline ples a) Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for monitoring their capital levels. b) Supervisors should review and evaluate bank’s internal capital adequacy assessment and strategies, as well as their ability to monitor and ensure their complian ce with regulatory capital ratios. ) Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum. d) Supervisors should seek to intervene at an early stage to prevent capital from falling below minimum level and should require rapid remedial action if capital is not mentioned or restored. Risk based capital (Pillar 1) Risk based supervision (Pillar 2) Risk disclosure to enforce market discipline (Pillar 3) Basel II Framework Pillar I Minimum Capital Requirements Pillar II Supervisory Review Process The First Pillar †Minimum Capital RequirementsThe first pillar sets out minimum capital requirement. The new framework maintains minimum capital requirement of 8% of risk assets. Under the new accord capital adequacy ratio will be measured as under†Total capital (unchanged) = (Tier I+Tier II+Tier III) Risk Weighed Assets = Credit risk + Market risk + Operational risk (Tier III capital has not yet been introduced in India. ) Basel II focuses on improvement in measurement of risks. The revised credit risk measurement methods are The Third Pillar †Market Discipline Market discipline imposes strong incentives to banks to conduct their business in a safe, sound and effective manner.It is proposed to be effected through a series of disclosure requirements on capital, risk exposure etc. so that market participants can assess a bank’s capital adequacy. These disclosures should be made at least semi-annually and more frequently if appropriate. Qualitative disclosures such as risk management objectives and policies, definitions etc. may be published annually. THE CHARTERED ACCOUNTANT 427 OCTOBER 2004 BASEL II Timeframe for Implementation The Basel Committee first released the proposal to replace the 1988 Accord with a more risk sensitive framework in June 1999, on which more than 200 comments were received.Reflecting on those comments the Comm ittee presented a more concrete proposal in January 2001 seeking more comments from interested parties. The third consultative paper was released in April 2003. Furthermore Credit the Committee conducted three Assessment quantitative impact studies to assess the impact of the new proposals. Sovereign (Govt. Thereafter, the final version of the & Central Bank) New Accord has been published on Claims on Banks June 26, 2004, which is designed to Option 1 establish minimum level of capital for internationally active banks.The Option 2a new framework is to be made Option 2b applicable from 2006 end. The more advanced approaches will be impleCorporates mented by the end of year 2007. COMPUTATION OF CAPITAL REQUIREMENT Capital Requirement for Credit Risk: The New Accord provided for the following alternative methods for computing capital requirement for credit risk Credit Risk †The Standardized Approach: The standardized approach is conceptually the same as the present accord, but is more risk sensitive. The bank allocates a risk weight to each of its assets and off-balance sheet positions and produces a sum of riskweighted asset values.A risk weight of 100% means that an exposure is included in the calculation of risk weighted assets value, which translates into a capital Credit Risk charge equal to 9% of that value. Individual risk weight currently depends on the broad category of borrower (i. e. sovereign, banks or corporates). Under the new accord, the risk weights are to be refined by reference to a rating provided by an external credit assessment institution (such as rating agency) that meets strict standards. Proposed Risk Weight Table AAA to A+ to BBB+ AAA- to BBB0% 20% 50% BB+ to B100% Below Unrated B150% 100% 20% 20% 20% 20% 50% 50% 20% 50% 100% 50% 20% 100% 00% 100% 50% to 150% 150% 150% 150% 100% 50% 20% 100% Option 1 = Risk weights based on risk weight of the country Option 2a = Risk weight based on assessment of individual bank Option 2b = Risk weight based on assessment of individual banks with claims of original maturity of less than 6 months. Retail Portfolio (subject to qualifying criteria) 75% Claims secured by residential property 35% Non-performing assets: If specific provision is less than 20% 150% If specific provision is more than 20% 100% The Committee has not proposed significant change in respect of off-balance Sheet items except for commitment to extend credit.The Internal Rating Based Approach (IRB): Under the IRB approach, banks will be allowed by the supervisors to use their internal estimates of risk components to assess credit risk in their portfolios, subject to strict methodological and disclosure standards. A bank estimates each borrower’s creditworthiness and the results are translated into estimates of a future potential loss amount, which form the basis of minimum capital requirements. The risk components include measures of ? Standardized Approach Internal Rating Based approach Securitizat ion Framework Foundation IRB Advanced IRBProbability of Default (PD), THE CHARTERED ACCOUNTANT 428 OCTOBER 2004 BASEL II ? ? ? Loss Given Default (LGD), Exposure At Default (EAD) and Effective Maturity (M) standardized approach under the securitization framework. Similarly, banks that have received approval to use IRB approach for the type of underlying exposure, must use the IRB approach for the securitization. The differences between foundation IRB and advanced IRB have been captured in the following table: Data Input Probability of Default Foundation IRB Provided by bank based on own estimates Capital Charge for Market RiskAlthough the Basel Committee issued â€Å"Amendment to the Capital Accord to incorporate Market Risks” in 1996, RBI as an interim measure, advised banks to assign an additional risk weight of 2. 5% on the entire investment portfolio. RBI feels that over the years, bank’s ability to identify and measure market risk has improved and therefore, decid ed to assign explicit capital charge for market risk in a phased manner over a two year period as under -. Advanced IRB Provided by bank based on own estimates Provided by bank based on own estimates Provided by bank based on own estimates Provided by bank based on own estimatesLoss Supervisory values set Given Default by the Committee Exposure at Default Effective Maturity Supervisory values set by the Committee Supervisory values set by the Committee Or At the national discretion, provided by bank †based on own estimates The IRB approach is based on measures of Unexpected Loss (UL) and Expected Loss (EL). While capital requirement provides for UL portion, EL component is taken care of by provisioning. Securitization Framework: Banks must apply the securitization framework for determining regulatory capital requirement on exposure arising from securitization.Banks that apply the standardized approach to credit risk for the underlying exposure, must use the a. Banks would be re quired to maintain capital charge for market risk in respect of their trading book exposure (including derivatives) by March 2005. b. Banks would be required to maintain capital charge for market risk in respect of securities under available for sale category by March 2006. Market Risk Approaches Market Risk Standardized Approach Internal Model Based approach Maturity Based Duration Based RBI has issued detailed guidelines for computation of capital charge on Market Risk in June 2004.The guidelines seek to address the issues involved in com- THE CHARTERED ACCOUNTANT 429 OCTOBER 2004 BASEL II puting capital charge for interest rate related instruments in the trading book, equities in the trading book and foreign exchange risk (including gold and precious metals) in both trading and banking book. Trading book will include: Securities included under the Held for Trading category Securities included under the Available for Sale category ? Open gold position limits ? Open foreign exchang e position limits ? Trading position in derivatives and derivatives entered into for hedging trading book exposures.As per the guidelines, minimum capital requirement is expressed in terms of two separately calculated charges: a. Specific Risk and b. General Market Risk Specific Risk: Capital charge for specific risk is designed to protect against an adverse movement in price of an individual security due to factors related to individual issuer. This is similar to credit risk. The specific risk charges are divided into various categories such as investments in Govt securities, claims on Banks, investments in mortgage backed securities, securitized papers etc. nd capital charge for each category specified. General Market Risk: Capital charge for general market risk is designed to capture the risk of loss arising from changes in market interest rates. The Basel Committee suggested two broad methodologies for computation of capital charge for market risk, i. e. , Standardized Method an d Internal Risk Management Model Method. As Banks in India are still in a nascent stage of developing internal risk management models, in the guidelines, it is proposed that to start with, the Banks may adopt the Standardized Method.Again, under Standardized Method, there are two principle methods for measuring market risk †maturity method and duration method. As duration method is a more accurate method of measuring interest rate risk, RBI prefers that Banks measure all of their general market risk by calculating the price sensitivity (modified duration) of each position separately. For this purpose detailed mechanics to be followed, time bands, assumed changes in yield etc. have been provided by RBI. Capital Charge for Equities: Capital charge for specific risk will be 9% of the Bank’s gross equity position. The general market risk charge will also be 9%.Thus the Bank will have to maintain capital equal to 18% of investment in equities (twice the present minimum requir ement). Capital Charge for Foreign Exchange Risk: ? ? Foreign exchange open position and gold open position are at present risk weighted at 100%. Capital charge for foreign exchange and gold open position would continue to be computed at 9% as hitherto. Risk Aggregation: The capital charge for specific risk, general market risk and equity and forex position will be added up and the resultant figure will be multiplied by 11. 11 (inverse of 9%) to arrive at the notional risk weighted assets.Capital Charge for Operational Risk The Basel Committee has defined the Operational Risk as â€Å"the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events”. This definition includes legal risk but excludes strategic and reputational risk. The objective of the operational risk management is to reduce the expected operational losses using a set of key risk indicators to measure and control risk on continuous basis and provide risk capi tal on operational risk for ensuring financial soundness of the Bank. Operational Risk Approaches Operational RiskBasic Indicator Approach Standardized Approach Advanced Measurement Approach Basic Indicator Approach Under the basic indicator approach, Banks are required to hold capital for operational risk equal to the average over the previous three years of a fixed percentage (15% †denoted as alpha) of annual gross income. Gross income is defined as net interest income plus net non-interest income, excluding realized profit/losses from the sale of securities in the banking book and extraordinary and irregular items. Standardized Approach Under the standardized approach, bank’s activities are divided into eight business lines.Within each business line, gross income is considered as a broad indicator for the likely scale of operational risk. Capital charge for each business line is calculated by multiplying gross income by a factor (denoted beta) assigned to THE CHARTERE D ACCOUNTANT 430 OCTOBER 2004 BASEL II This partly explains the current trend of consolidation in the banking industry. Profitability: Competition among banks for highly rated corporates needing lower amount of capital may exert pressure on already thinning interest spread. Further, huge implementation cost may also impact profitability for smaller banks.Risk Management Architecture: The new standards are an amalgam of international best practices and calls for introduction of advanced risk management system with wider application throughout the organization. It would be a daunting task to create the required level of technological architecture and human skill across the institution. Rating Requirement: Although there are a few credit rating agencies in India †the level of rating penetration is very low. A study revealed that in 1999, out of 9640 borrowers enjoying fund-based working capital facilities from banks †only 300 were rated by major agencies.Further, rating is a lagging indicator of the credit risk and the agencies have poor track record in this respect. There is a possibility of rating blackmail through unsolicited rating. Moreover rating in India is restricted to issues and not issuers. Encouraging rating of issuers would be a challenge. Choice of Alternative Approaches: The new framework provides for alternative approaches for computation of capital requirement of various risks. However, competitive advantage of IRB approach may lead to domination of this approach among big banks. Banks adopting IRB approach will be more sensitive than those adopting standardized approach.This may result in high-risk assets flowing to banks on standardized approach †as they would require lesser capital for these assets than banks on IRB approach. Hence, the system as a whole may maintain lower capital than warranted and become more vulnerable. It is to be considered whether in our quest for perfect standards, we have lost the only universally accept ed standard. Absence of Historical Database: Computation of probability of default, loss given default, migration mapping and supervisory validation require creation of historical database, which is a time consuming process and may require initial support from the supervisor.Incentive to Remain Unrated: In case of unrated sovereigns, banks and corporates the prescribed risk weight is 100%, whereas in case of those entities with lowest ratting, the risk weight is 150%. This may create incentive for the category of counterparties, which anticipate lower rating to remain unrated. Supervisory Framework: Implementation of The final version of the New Accord has been published on June 26, 2004, which is designed to establish minimum level of capital for internationally active banks. The new framework is to be made applicable from 2006 end.The more advanced approaches will be implemented by the end of year 2007. that business line. Total capital charge is calculated as the three-year avera ge of the simple summations of the regulatory capital across each of the business line in each year. The values of the betas prescribed for each business line are as under: Business Line Corporate finance Trading and sales Retail banking Commercial banking Payment and settlement Agency services Asset management Retail brokerage Beta Factor 18% 18% 12% 15% 18% 15% 12% 12%Advanced Measurement Approach Under advanced measurement approach, the regulatory capital will be equal to the risk measures generated by the bank’s internal risk measurement system using the prescribed quantitative and qualitative criteria. ISSUES AND CHALLENGES While there is no second opinion regarding the purpose, necessity and usefulness of the proposed new accord †the techniques and methods suggested in the consultative document would pose considerable implementational challenges for the banks especially in a developing country like India.Capital Requirement: The new norms will almost invariably inc rease capital requirement in all banks across the board. Although capital requirement for credit risk may go down due to adoption of more risk sensitive models †such advantage will be more than offset by additional capital charge for operational risk and increased capital requirement for market risk. THE CHARTERED ACCOUNTANT 431 OCTOBER 2004 BASEL II Basel II norms will prove a challenging task for the bank supervisors as well.Given the paucity of supervisory resources †there is a need to reorient the resource deployment strategy. Supervisory cadre has to be properly trained for understanding of critical issues for risk profiling of supervised entities and validating and guiding development of complex IRB models. Corporate Governance Issues: Basel II proposals underscore the interaction between sound risk management practices and corporate good governance. The bank’s board of directors has the responsibility for setting the basic tolerance levels for various types o f risk.It should also ensure that management establishes a framework for assessing the risks, develop a system to relate risk to the bank’s capital levels and establish a method for monitoring compliance with internal policies. National Discretion: Basel II norms set out a number of areas where national supervisor will need to determine the specific definitions, approaches or thresholds that wish to adopt in implementing the proposals. The criteria used by supervisors in making these determinations should draw upon domestic market practice and experience and be consistent with the objectives of Basel II norms.Disclosure Regime: Pillar 3 purports to enforce market discipline through stricter disclosure requirement. While admitting that such disclosure may be useful for supervisory authorities and rating agencies †the expertise and ability of the general public to comprehend and interpret disclosed information is open to question. Moreover, too much disclosure may cause in formation overload and may even damage financial position of bank. Disadvantage for Smaller Banks: The new framework is very complex and difficult to understand.It calls for revamping the entire management information system and allocation of substantial resources. Therefore, it may be out of reach for many smaller banks. As Moody’s Investors Services puts it, â€Å"It is unlikely that these banks will have the financial resources, intellectual capital, skills and large scale commitment that larger competitors have to build sophisticated systems to allocate regulatory capital optimally for both credit and operational risks. Discriminatory against Developing Countries: Developing counties have high concentration of lower rated borrowers. The calibration of IRB has lesser incentives to lend to such borrowers. This, alongwith withdrawal of uniform risk weight of 0% on sovereign claims may result in overall reduction in lending by internationally active banks in developing count ries and increase their cost of borrowing.Although the Basel Committee issued â€Å"Amendment to the Capital Accord to incorporate Market Risks” in 1996, RBI as an interim measure, advised banks to assign an additional risk weight of 2. 5% on the entire investment portfolio. External and Internal Auditors: The working Group set up by the Basel Committee to look into implemetational issues observed that supervisors may wish to involve third parties, such a external auditors, internal auditors and consultants to assist them carrying out some of the duties under Basel II.The precondition is that there should be a suitably developed national accounting and auditing standards and framework, which are in line with the best international practices. A minimum qualifying criteria for firms should be those that have a dedicated financial services or banking division that is properly researched and have proven ability to respond to training and upgrades required of its own staff to comp lete the tasks adequately.With the implementation of the new framework, internal auditors may become increasingly involved in various processes, including validation and of the accuracy of the data inputs, review of activities performed by credit functions and assessment of a bank’s capital assessment process. 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-ordinated 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 stronger. ¦ THE CHARTERED ACCOUNTANT 432 OCTOBER 2004\r\n'

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