management thesis on basel 2 norms in india

1An Analytical report to study the impact of Basel II on Indian banking sector with special reference to SBI

CERTIFICATE

This is to certify that the Management Thesis titled AN ANALYTICAL REPORT TO STUDY THE IMPACT OF BASEL II

ON INDIAN BANKING SECTOR WITH SPECIAL REFERENCE TO SBI submitted during Semester IV of the MBA

Program (The Class of 2010) embodies original work done by me.

Signature of the Student

Name (in Capitals) : _______Deepankar Ghosh________________________________________

Enroll Number : __________8NBAH027_____________________________________________

Campus :____Allahabad____________________________________________________

:

ACKNOWLEDGEMENT


Acknowledging debt is not easy to us as we are indebted to many people but firstly towards my father and mother those who have given me opportunity to be in such a professional course.

My acknowledgement debt will be incomplete if I fail to give sincere thanks to my MT Guide Mr. Prateek Jain as without his suggestion the final report would not have materialized of.

I express my profound gratitude to her for making me the fortunate one to get the opportunity to work under her supervision and guidance. The keen interest, co-operation, inspiration, continuous encouragement and motivation provided by him enabled me to complete my research work in time.

I would also take this opportunity to thank the Manager of SBI and bank personnel for given their valuable time and input regarding the topic to furnish it in a complete manner.

Last but not the least I would like to thank all the faculty members and the Principal of INC, Allahabad for their kind cooperation and guidance.

Dipankar.B.Ghosh

Enroll No-8NBAH027

LIST OF TABLES & CHARTS


Table No Content Page No.

1. Pillars of Basel II 15

2. Rating & Risk weights indicated by RBI 16

3. CAR of banks during Global financial turmoil 22

4. CAR of State Bank Group 39

ABBREVIATIONS


AMA - Advanced Measurement Approach

BCBS - Basel Committee on Banking Supervision

BIA - Basic Indicator Approach

BIS – Bank for International Settlements

CDO – Collateralized Debt Obligations

CRAR - Capital to Risk Weighted Assets Ratio

EAD - Exposure at Default

ICAAP - Internal Capital Adequacy Assessment Process

IMA - Internal Measurement Approach

IRB – Internal Ratings Based Approach

LDA - Loss Distribution Approach

LGD - Loss Given Default

MCR - Minimum Capital Requirements

NIBM - National Institute of Bank Management

NPA - Non Performing Assets

PD - Probability of Default

SA - Standardized Approach

SRP - Supervisory Review Process

Var – Value at Risk

SUMMARY


Basel II is basically the second of the Basel Accords, which are recommendations on banking

laws and regulations issued by the Basel 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 banks face. Basel II is believed to 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.

In practice, Basel II attempts to accomplish this by setting up rigorous risk and capital

management requirements designed to ensure that a bank holds capital reserves appropriate to

the risk the bank exposes itself to through its lending and investment practices. The Basel

Committee on Banking Supervision has come up with three pillars namely, minimum capital

requirements, supervisory review process and market discipline, the first one which tries to

ensure that capital allocation is more risk sensitive, the second tries to separate the operational

risk from credit risk, and quantifying both of them, the third attempts to align economic and

regulatory capital more closely to reduce the scope for regulatory arbitrage.

In the current thesis I have done an interview based research to get knowledge of the challenges

faced by the banks during the process of implementing Basel II norms. The interview was done

using an interview protocol prepared in consultation with my guide. The major limitation of the

project has been that the research, suggestions and conclusions have been confined to the banks

in Allahabad.

There are different aspects of the study like change in the quantum and quality of data being

collected for the purpose of rating which had an impact on the manpower requirements of the

banks. The banks which had actually calculated their capital requirements based on internal


capital appraisal methods had their capitals well above the 9% limit set by the central bank. Pro-

cyclicality did not seem to be a major issue with the bankers as they found the counter cyclical

measures of the central bank very effective. With the advent of Basel II the amount available

with the banks for lending has come down and tends to increase again when the advanced credit

measurement approaches are introduced.

INTRODUCTION


In 1988 the Bank for International Settlements’ Basel Committee on Banking Supervision, commonly known as the Basel Committee, imposed the Basel Capital Accord. The Basel Capital Accord introduced a system for implementing a credit risk framework for determining the minimum amount of capital that a bank must hold as a cushion against risks. The Basel Capital Accord was adopted over time not only in member countries, but in virtually all countries operating international banks.

One problem with the original Basel Capital Accord was that it took a "one size fits all" approach, without regard for the actual operational risk incurred by the bank. In 2004, the Basel II Accord was established. The new accord aligns the requirement for capital on hand with the actual risk involved, providing an incentive for banks to improve risk management.

Basel II is the second of the Basel Accords recommended on banking laws and regulations issued by the Basel 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 risk 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. Thus Indian banks require Basel II compliance for the following reasons:-

1) Basel II norms will facilitate introduction of new complex financial products in Indian Banking Sector

2) Indian banks require a more risk sensitive framework. There is improvement in risk management system by Indian banks

3) New rules will provide a range of options for estimating regulatory capital and will reduce gap between regulatory capital & economic capital.

Indian banks today, operate in an environment characterized by progressive deregulation, in-creased global integration and IT usage which have opened up a plethora of domestic and international opportunities for them. In light of this, RBI has enforced mandatory adoption of


Basel II guidelines for Indian banks which are a set of prudential regulatory norms with an almost universal acceptance.

This study explores the impact of Basel II on the Indian banking sector and how it would lead to shifts in lending structure, benefit the larger and sophisticated bank like SBI and enhance the competitiveness of the bank in general, ahead of the opening up of the sector to foreign banks in 2010. It then elaborates on the key challenges that SBI is facing after the implementation of Ba-sel II guidelines, mainly in the areas of infrastructure requirements, development of credit assessment models, and supervisory skills. The study drills deep into the foundations of credit assessment using Internal Ratings method and data requirements for each determinant of credit risk before analyzing the progress of Indian banks on the implementation of these advanced approaches. The concluding section outlines the additional improvements Indian banks would have to register in order to become globally competitive.

DISCUSSION OF PROBLEM


Banks are under increasing pressure to comply with Basel II guidelines. But many are finding that implementation of Basel II is becoming a challenge. Indian banks appear to be uncertain about the actual intent of Basel II guidelines. The main point that all Indian banks and particularly those in the public sector are missing is that Basel II is more about the risk governance structure of a bank and risk calculation is only an intermediate step towards building that structure.

Some of the key issues that require an attention of all sorts are:-

Should banks be looking at the potential business benefits accruable from Basel-II implementation, besides the compliance requirements?

Quantification of the end benefits from Basel compliance – what does the bank stand to gain by ramping up and complying with Basel II?

What is the ideal phase-wise approach to implement Basel-II in the Indian context?

What are the practical problems that banks are certain to face or are currently facing in implementing Basel II?

Is Basel II a technology that can be bought off the shelf or does it involve business process re- engineering or is it merely a new way of calculating a bank's risk profile?

OBJECTIVE OF THE STUDY


During this study, the impact of BASEL II on the Indian banking sector will be analyzed from the view point as follows:-

Need for Basel II?

The analysis on what is Basel II?

The objectives of Basel II

To analyze impact of Basel II on Indian Banks with special reference to State Bank of India.

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

During the study the sub-objectives achieved will be as follows:-

Purpose of setting Capital Standards in banking Sector.

Need for implementing Internal Ratings method for credit assessment

INDUSTRY OVERVIEW


The Indian banking sector has acquired a greater degree of resilience due to the financial reforms implemented in a gradual and sequential manner under the watchful eyes of Reserve Bank of India and Ministry of Finance. This was implemented by a participative process aimed at reduction in statutory pre-emption

.

An assessment of the banking sector performance shows that banks in India have experienced strong balance sheet growth in the post-reform period in an environment of operational flexibility. Improvement in the financial health of banks, reflected in significant improvement in capital adequacy and improved asset quality, is distinctly visible. These significant gains have been achieved even while renewing the goals of social banking by maintaining the wide reach of the banking system and directed credit.

Banks in India have always played a pivotal role in providing a thrust to the development of the country by assisting in the development of the priority sector in India which includes agriculture as well as in the industrial and infrastructural development. Changes in these sectors are essential to boost comprehensive growth and revival of the economy. Thus, in the current challenging times of economic stagnation affecting these sectors, it becomes all the more necessary to provide the much required fiscal support to the banking industry.

The risk aversion which has crept into the domestic banking sector on account of the international banking crisis has created a situation of deep concern and threat for the real economy and all the players in it. Challenges facing the Indian Banking sector this year include: compliance with Basel II norms and competition from foreign banks.

There has been a lackluster demand for credit despite sufficient liquidity in the system and lowering of interest rates by banks, following the phased reductions in cash reserve ratio and policy rates by the Reserve Bank of India. The reduction in PLR required cut in deposit rates as well.

Credit targets of public sector banks had been revised upwards to reflect the needs of the economy, which called for a recapitalization plan for banks to improve their soundness and their ability to withstand sudden shocks—like the ongoing global crisis that has devastated many of top-notch US banks. There is a negative impact on the banking sector due to lending at fixed


ceiling rates to focus sectors. Margins have been hurt as the banking sys-tem has raised a large portion of its liabilities at high rates in the recent past.

With economic slowdown being the major issue at present, the bankers' main concern is to fund growth without facing any hurdles. The obvious choice, according to bankers, which has to be acted upon, is infrastructure funding. Though there has been a revival of economic growth and a pick up in the pace investment cycle, the banking sector expects several positive measures in the near future, so that they can continue to play a vital role in intermediating between the demand and supply of funds.


COMPANY PROFILE

State Bank of India (SBI) is India’s largest commercial bank. SBI has a vast domestic network of

over 9000 branches (approximately 14% of all bank branches) and commands one-fifth of

deposits and loans of all scheduled commercial banks in India.

The State Bank Group includes a network of eight banking subsidiaries and several non-banking

subsidiaries offering merchant banking services, fund management, factoring services, primary

dealership in government securities, credit cards and insurance. The eight banking subsidiaries

are:

State Bank of Bikaner and Jaipur (SBBJ)

State Bank of Hyderabad (SBH)

State Bank of India (SBI)

State Bank of Indore (SBIR)

State Bank of Mysore (SBM)

State Bank of Patiala (SBP)

State Bank of Saurashtra (SBS)

State Bank of Travancore (SBT)

The origins of State Bank of India date back to 1806 when the Bank of Calcutta (later called the

Bank of Bengal) was established. In 1921, the Bank of Bengal and two other Presidency banks

(Bank of Madras and Bank of Bombay) were amalgamated to form the Imperial Bank of India.

In 1955, the controlling interest in the Imperial Bank of India was acquired by the Reserve Bank

of India and the State Bank of India (SBI) came into existence by an act of Parliament as

successor to the Imperial Bank of India.


Today, State Bank of India (SBI) has spread its arms around the world and has a network of

branches spanning all time zones. SBI’s International Banking Group delivers the full range of

cross-border finance solutions through its four wings – the Domestic division, the Foreign

Offices division, the Foreign Department and the International Services division.

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

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

1806 as Bank of Calcutta, it is the oldest commercial bank in the Indian subcontinent. SBI

provides various domestic, international and NRI products and services, through its vast network

in India and overseas.

With an asset base of $126 billion and its reach, it is a regional banking behemoth. The

government nationalized the bank in 1955, with the Reserve Bank of India taking a 60%

ownership stake. In recent years the bank has focused on three priorities, 1), reducing its huge

staff through Golden handshake schemes known as the Voluntary Retirement Scheme, which

saw many of its best and brightest defect to the private sector, 2), computerizing its operations

and 3), changing the attitude of its employees (through an ambitious programme aptly named

'Parivartan' which means change) as a large number of employees are very rude to customers.

http://www.bookrags.com/London_Stock_Exchange

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REVIEW OF LITERATURE

Daniel Tabbush, Head of CLSA Banking Research (2008) in his report stated “Mortgage-loan risk weightings drop from 50% to 35% under Basel II, making them much more profitable in terms of regulatory capital required, while small and medium-sized enterprise (SME) lending can move from 100% to 75%”.

Anand Wadadekar (2008) in his study “Basel Norms & Indian Banking System” revealed that Basel II Norms offers a variety of options in addition to the standard approach to measuring risk. Paves the way for financial institutions to proactively control risk in their own interest and keep capital requirement low.

C.P.Chandrasekhar & Jayati Ghosh(2007) in their study “Basel II and India's banking structure” examined what the guidelines involve, their effects on the banking structure and behavior and some likely outcomes of implementing them.

Rana Kapoor, managing director, YES Bank (the latest entrant to new generation private banks in India), holds “Most (Indian) banks are likely to start with simpler, elementary approaches, just adequate to ensure compliance to Basel II norms and gradually adopt more sophisticated approaches. The continued regulatory challenge will be to migrate to Basel II in a non-disruptive manner”.

P.S. Shenoy, chairman and managing director, Bank of Baroda, believes “Basel II compliance will eventually result in banks acquiring a competitive edge, stating `Banks that move proactively in the broad direction outlined by the Basel Committee will have acquired a definite edge over their competitors when the new accord enters the implementation phase”.


Niall S.K. Booker, chief executive officer, HSBC India and chairman of the IBA Committee on Basel II states “There is the possibility that in international markets access may be easier and costs less for banks adopting a more sophisticated approach….however in a market like India it seems likely that the large domestic players will continue to play a very significant role regardless of the model used”.

Mandira Sharma & Yuko Nikaido (2007) in their study on”Capital Adequacy Regime in India” examined issues and challenges with regard to the implementation of CRAR norms under Basel II regime in India. They also tried to identify limitations, gaps and inadequacies in the Indian banking system which may hamper the realization of the potential benefits of the new regime.

Ernst & Young in their survey in 2008 revealed that Basel II has changed the competitive landscape for banking. Those organizations with better risk systems are expected to benefit at the expense of those which have been slower to absorb change due to increased use of risk transfer instruments. It also concluded that portfolio risk management would become more active, driven by the availability of better and more timely risk information as well as the differential capital requirements resulting from Basel II. This could improve the profitability of some banks relative to others, and encourage the trend towards consolidation in the sector.


RESEARCH METHODOLOGY

RESEARCH DESIGN

The project is carried out, keeping in mind the main objectives of the research.

The research design is the conceptual framework within which the research is conducted. It

contains the blueprint for the collection, measurement and analysis of the data. So research

designs include an online of everything done, from defining the problem in terms of predefined

objectives till the final analysis of data.

METHODOLOGY

In order to get a first hand knowledge of the impact and challenges faced by State Bank

of India while implementing Basel II norms, I found, in consultation with my MT Guide that

“Expert Interview” would be the best way to get an detailed insight and appropriate results on

my thesis. The project has been limited to SBI Bank in Allahabad City, hence I had chosen

expert interview as my research methodology.

DATA COLLECTION

1. Primary data : Primary data is collected from Expert Interview conducted through

systematic & structured set of questions.

2. Secondary data : Secondary data is obtained from Indian Banking Association Journal,

Bank’s Website, and Internet & Articles.


WORK UNDERTAKEN BY ME

The project is basically divided into five phases:-

1. Identify the gaps and research methodology to execute it.

2. Analyze how Indian banks sheltered and resisted themselves from global economic turmoil.

3. Comparative analysis of Capital Adequacy Ratio of banks of different countries during global economic crisis.

4. Study the impact of Basel II on Indian banking sector.

5. Analyze the impact of Basel II on SBI.

DISCUSSION OF IMPLICATION

Since the project deals with impact of Basel II on SBI with an overview of Indian banking sector there are certain issues that require further scope for the research which include:

Growth in Indian banking sector after the implementation of Basel II

Impact of Basel II on other public and private sector banks.

Will the banks able to benefit or suffer their portfolio with Basel II?

Future of Basel II or need to migrate to Basel III

.


RESULTS & ANALYSIS

WHAT IS BASEL I:

Basel I is a framework for calculating ‘Capital to Risk-weighted Asset Ratio’ (CRAR). It defines a bank’s capital as two types: core (or tier I) capital comprising equity capital and disclosed reserves; and supplementary (or tier II) capital comprising items such as undisclosed reserves, evaluation reserves, general provisions/general loan loss reserves, hybrid debt capital instruments and subordinated term debt.

Under Basel I, at least 50 per cent of a bank’s capital base should consist of core capital. In order to calculate CRAR, the bank’s assets should be weighted by five categories of credit risk – 0, 10, 20, 50 and 100 per cent. In 1996, an amendment was made to Basel I to incorporate market risk, in addition to credit risk, in the calculation of CRAR. To measure market risk, banks were given the choice of two options:

a. A standardized approach using a building block methodologyb. An ‘in-house’ approach allowing banks to develop their own proprietary models

to calculate capital charge for market risk by using the notion of Value-at-Risk (VaR).

Adopting the general approach of gradualism, India implemented the Basel I framework with effect from 1992-93 which was, however, spread over 3 years– banks with branches abroad were required to comply fully by end March 1994 and the other banks were required to comply by end March 1996. Further, India responded to the 1996 amendment to the Basel I framework which required banks to maintain capital for market risk exposures, by initially prescribing various surrogate capital charges for these risks between 2000 and 2002.

LOOPHOLES OF BASEL I:

Because of a flat 8% charge for claims on the private sector, banks have an incentive to move high quality assets off the balance sheet (capital arbitrage) through securitization thus reducing the average quality of bank loan portfolio.

It does not take into consideration the operational risks of banks, which become increasingly important with the increase in the complexity of banks.


Also, the 1988 Accord does not sufficiently recognize credit risk mitigation techniques, such as collateral and guarantees.

The regulatory Capital requirement has been in conflict with increasingly sophisticated internal measures of economic Capital.

It was concentrating on only on credit risk

BASEL II

Basel 2 is the new capital accord signed in June 2004 at Bank for International Settlement located at Basel, Switzerland. It is an improvement over Basel 1 which had certain deficiencies which have now been removed. Basel 2 is based on three pillars: capital adequacy, supervisory review and market discipline. It is basically concerned with financial health of the banks worldwide. The focus in Basel 2 is the risk determination and quantification of credit risk, market risk and operational risk faced by banks. Reserve Bank of India has accepted the accord and issued guidelines to ensure compliance with the norms from March 31, 2008.

Basel II is a much more comprehensive framework of banking supervision. It not only deals with CRAR calculation, but has also got provisions for supervisory review and market discipline. Thus, Basel II stands on three pillars:


Pillar 1 spells out the capital requirement of a bank in relation to the credit risk in its portfolio, which is a significant change from the “one size fits all” approach of Basel I. Pillar 1 allows flexibility to banks and supervisors to choose from among the Standardized Approach, Internal Ratings Based Approach, and Securitization Framework methods to calculate the capital requirement for credit risk exposures. Besides, Pillar 1 sets out the allocation of capital for operational risk and market risk in the trading books of banks.

Pillar 2 provides a tool to supervisors to keep checks on the adequacy of capitalization levels of banks and also distinguish among banks on the basis of their risk management systems and profile of capital. Pillar 2 allows discretion to supervisors to (a) link capital to the risk profile of a bank; (b) take appropriate remedial measures if required; and (c) ask banks to maintain capital at a level higher than the regulatory minimum.

Pillar 3 provides a framework for the improvement of banks’ disclosure standards for financial reporting, risk management, asset quality, regulatory sanctions, and the like. The pillar also indicates the remedial measures that regulators can take to keep a check on erring banks and maintain the integrity of the banking system. Further, Pillar 3 allows banks to maintain confidentiality over certain information, disclosure of which could impact competitiveness or breach legal contracts.


Basel II gave a free hand to the RBI to specify different risk weights for retail exposures, in case they think that to be more appropriate. To facilitate a move towards Basel II, the RBI has also come out with an indicative mapping of domestic corporate long term loans and bond credit ratings against corporate ratings by international agencies like Moody’s Investor Services.

Mapping for Corporate Loans and Bond Ratings and risk weights as indicated by the RBI*

Moody’s Ratings ICRA Risk WeightsAaa to Aa LAAA 20%A LAA 50%Baa to Ba LA 100%B LBBB & below 150%Unrated Unrated 100%


OBJECTIVES OF BASEL II

Creating a better linkage between the minimum regulatory capital and risk, enhancing market discipline, supporting a level playing field in an increasingly integrated global financial system, establishing and maintaining a minimum capital cushion sufficient to foster financial stability in periods of adversity and uncertainty, and grounding risk measurement and management in actual data and formal quantitative techniques.

Basel II is the effort to improve risk measurement and management, especially at our largest, most complex organizations. Thus it would be reasonable to infer that the main focus of the new framework (Basel II) is on providing the right incentives to the banks to adopt data-based, quantitative risk management systems to be able to adopt the advanced risk-sensitive approaches of the revised framework, which, in turn, would contribute to systemic and financial stability

CHALLENGES FOR INDIAN BANKS UNDER BASEL II

1) Costly Database Creation and Maintenance Process:

The most obvious impact of BASEL II is the need for improved risk management and measurement. It aims to give impetus to the use of internal rating system by the international banks. More and more banks may have to use internal model developed in house and their impact is uncertain. Most of these models require minimum 5 years bank data which is a tedious and high cost process as most Indian banks do not have such a database.

2) Additional Capital Requirement :

In order to comply with the capital adequacy norms we will see that the overall capital level of the banks will raise a glimpse of which was seen when the RBI raised risk weightages for mortgages and home loans in October 2004. Here there is a worrying aspect that some of the banks will not be able to put up the additional capital to comply with the new regulation and they may be isolated from the global banking system.


3) Large Proportion of NPA's:

A large number of Indian banks have significant proportion of NPA's in their assets. Along with that a large proportion of loans of banks are of poor quality. There is a danger that a large number of banks will not be able to restructure and survive in the new environment. This may lead to forced mergers of many defunct banks with the existing ones and a loss of capital to the banking system as a whole.

4) Low Degree of Corporate Rating Penetration :

India has as few as three established rating agencies and the level of rating penetration is not very significant as, so far, ratings are restricted to issues and not issuers. While Basel II gives some scope to extend the rating of issues to issuers, this would only be an approximation and it would be necessary for the system to move to ratings of issuers. Encouraging ratings of issuers would be a challenge.

5) Cross Border Issues for Foreign Banks:

In India, foreign banks are statutorily required to maintain local capital and the following issues are required to be resolved; validation of the internal models approved by their head offices and home country supervisor adopted by the Indian branches of foreign banks. Date history maintained and used by the bank should be distinct for the Indian branches compared to the global data used by the head office capital for operational risk should be maintained separately for the Indian branches in India


CAPITAL ADEQUACY STANDARD IN INDIA

Capital adequacy is an indicator of the financial health of the banking system. It is measured by the Capital to Risk-weighted Asset Ratio (CRAR), defined as the ratio of a bank’s capital to its total risk-weighted assets. Financial regulators generally impose a capital adequacy norm on their banking and financial systems in order to provide for a buffer to absorb unforeseen losses due to risky investments. A well adhered to capital adequacy regime does play an important role in minimizing the cascading effects of banking and financial sector crises.

India adopted Basel I norms for scheduled commercial banks in April 1992, and its implementation was spread over the next three years. It was stipulated that foreign banks operating in India should achieve a CRAR of 8 per cent by March 1993 while Indian banks with branches abroad should achieve the 8 per cent norm by March 1995. All other banks were to achieve a capital adequacy norm of 4 per cent by March 1993 and the 8 per cent norm by March 1996.

In its mid-term review of Monetary and Credit Policy in October 1998, the Reserve Bank of India (RBI) raised the minimum regulatory CRAR requirement to 9 per cent, and banks were advised to achieve this 9 per cent CRAR level by March 31, 2000.9 Thus, the capital adequacy norm for India’s commercial banks is higher than the internationally accepted level of 8 per cent.

The RBI responded to the market risk amendment of Basel I in 1996 by initially prescribing various surrogate capital charges such as investment fluctuation reserve of 5 per cent of the bank’s portfolio and a 2.5 per cent risk weight on the entire portfolio for these risks between 2000 and 2002. These were later replaced with VaR-based capital charges, as required by the market risk amendments, which became effective from March 2005. India has gone a step ahead of Basel I in that the banks in India are required to maintain capital charges for market risk on their ‘available for sale’ portfolios as well as on their ‘held for trading portfolios’ from March 2006 while Basel I requires market risk charges for trading portfolios only.


FACTS BEHIND INDIAN BANKS RESISTANCE FROM GLOBAL FINANCIAL TURMOIL

The global financial crisis didn’t directly affected India as Indian financial system has sound fundamentals and the Indian Government has put in place, systems and practices to promote a safe, transparent and efficient market to protect market integrity.

This was possible due to classic reports and model given by Mr. Narasimham about the policy framework for the Government of India and the RBI to formulate the structure of India’s banks and financial institutions was based on adequate capitalization, good provisioning norms and well-structured supervision. The Committee also recommended gradual liberalization of the banking sector by adopting measures such as reduction of statutory preemptions, deregulation of interest rates and allowing foreign and domestic private banks to enter the system. Along with these, the Committee also recommended adoption of prudential regulation relating to capital adequacy, income recognition, asset classifications. While the liberalization was aimed at bringing about competition and efficiency into India’s banking system, the prudential regulation was aimed at strengthening the supervisory system, which is important in the process of liberalization.

Government of India and RBI accepted these recommendations and proceeded to implement them. The RBI enforced strict capital adequacy requirements and if any financial institution or bank exceeded the specified limits of exposure to stock markets, it would have to provide more capital. This effectively insulated the banks and financial institutions from volatility of the bourses. Enforcement of the above instructions has paid good dividends. Erosion of capital of the banks and financial institutions has been reduced. These exposure limits, however, deserve to be reviewed from time to time.

The Narasimham Committee endorsed the internationally accepted norms for capital adequacy standards, developed by the Basel Committee on Banking Supervision (BCBS). BCBS initiated Basel I norms in 1988, considered to be the first move towards risk-weighted capital adequacy norms. In 1996 BCBS amended the Basel I norms and in 1999 it initiated a complete revision of the Basel I framework, to be known as Basel II. In pursuance of the Narasimham Committee recommendations, India adopted Basel I norms for commercial banks in 1992, the market risk amendment of Basel I in 1996.

By and large, India has been spared the panic that followed the collapse of banking institutions such as Fortis in Europe, and Merrill Lynch, Lehman Brothers and Washington Mutual in the U.S. Global financial crisis. The turmoil in the international financial markets of advanced economies that started around mid-2007 has exacerbated substantially since August 2008.


This shows that there was no impact of the sub prime episode on the Indian banks & none of the Indian banks or the foreign banks, with whom the discussions had been held, had any direct exposure to the sub-prime markets in the USA or other markets.

However, a few Indian banks had invested in the collateralized debt obligations (CDOs) / bonds which had a few underlying entities with sub-prime exposures. Thus, no direct impact on account of direct exposure to the sub-prime market was in evidence. However a few of these banks did suffer some losses on account of the mark-to-market losses caused by the widening of the credit spreads arising from the sub-prime episode on term liquidity in the market, even though the overnight markets remained stable.

Finally Indian banks’ global exposure was relatively small, with international assets at about 6 per cent of the total assets. Even banks with international operations had less than 11 per cent of their total assets outside India. Moreover 34 percent of our deposits were in government securities and cash with the RBI. The consumer loan to GDP ratio was just 10 percent, whereas this ratio is as high as 100 percent for the US.”


COMPARATIVE ANALYSIS OF CAR OF BANKS DURING GLOBAL FINANCIAL CRISIS

Name of the Bank CAR (%) in 2008Federal Bank of America 22.5

Barclays Bank 21.1J P Morgan Chase Bank 17.7Kotak Mahindra Bank 18.7

Brazil Bank 18.1Indonesian Bank 19.5Singapore Bank 16.1

Hong Kong Bank 15.2Citibank 16.6

UBS Bank 16.7State Bank of India 12.6

HDFC Bank 13.6ICICI Bank 14.0Axis Bank 13.5IDBI Bank 12.0

ING Vyasya Bank 10.2Punjab National Bank 13.0

Bank of Baroda 12.7Indian Overseas Bank 12.0

Allahabad Bank 12.0Union Bank of India 12.0

Bank of India 12.0

From the above table we can clearly demarcate that US, Hong Kong, Brazil, Singapore & Indonesian banks have high capital adequacy ratio as compared to Indian banks who have maintained a steady average of 12 and above but less than 14. Capital adequacy ratios ("CAR") are a measure of the amount of a bank's capital expressed as a percentage of its risk weighted credit exposures. So the risk weightages of these banks were enormous which lead to their downfall during economic turmoil.

The banking sector in India is largely (70%) dominated by the public sector. Partly as a result, India has not witness the kind of crisis of confidence seen in advanced countries because the Indian banking sector is generally cautious and conservatively regulated as compared to foreign banking system where it is freely regulated. Additionally, strict regulation and conservative policies adopted by the Reserve Bank of India have ensured that banks in India are relatively insulated from the travails of their Western counterparts. However, this cannot be advanced as a reason either for continuance of public sector dominance or for resistance to further financial sector reform.


IMPACT OF BASEL II ON INDIAN BANKS

Indian banks are strongly regulated and supervised entities. In particular, weak banks and those banks, which show signs of problems, are subjected to rigorous on-site and off-site supervision and stringent prudential standards. Thus, risks inherent in inter-bank exposures are not comparable to that of the corporates. There is, therefore, a need for a modified treatment for claims on banks. The Basel Committee has provided discretion to national supervisors to assign a lower risk weight to the exposures to the sovereign of incorporation, denominated in domestic currency and funded in that currency.

Basel II is the new regulatory framework within which all banks will have to work. Its aim is to safeguard the stability of the financial sector and one of its aspects is a comprehensive approach to risk. The first phase of the Accord took effect in 2007, and the second phase was implemented in 2008.

The Accord regulates the amount of capital that banks will have to set aside for their loans. In addition, it prescribes that this capital must be a better reflection of the actual credit risks represented by the companies to which the banks lend. Banks can select from three methods of determining the risks and the associated capital requirements; the banks with the most sophisticated risk management will be rewarded with a lower capital requirement relative to their existing capital bases. This is one of the reasons why credit will not necessarily become more expensive. There is also no question of credit crunch; banks' loan portfolios have in fact grown as a proportion of their total assets.

As from 1 January 2007, banks were required to have historical credit information on their lending customers; this information is needed to evaluate their customer’s creditworthiness. Three quarters of companies are currently reported to have insufficient information about the banks' new credit risk criteria.

An increase in the transparency of company accounting and of the information exchanged with banks has intended to result in greater objectivity with regard to the granting of new credit lines. The more favorable the company's risk profile, the better the credit risk rating and the more favorable the bank's terms and conditions will be.


Thus Indian banks have developed:

Credit and Operational Risk Models

Business Models and Surrounding Processes

Skill levels of Operating Personnel

Valid and Integrated Data Backup

With the advent of Basel II, Indian Banks may be required to raise over Rs.1, 70,000 crs additional Capital during the coming 3 years. Basel II has tightened up requirements on the demand side for loans and it is worth giving serious consideration to limit borrowing requirements and to alternative credit products, which can have a considerable impact on a company's balance sheet. Moreover new Framework has helped to reduce Capital Base of Indian Banks by 1% to 2%, except a few Banks. Under Basel II, the banks are little forced to make its loans more expensive, to restrict outstanding credit lines, or to refuse to grant further loans. Also the basic lending criteria are certainly continued to be the competence of the management, the company's ability to repay the loan, and adequate equity.

IMPACT OF BASEL II ON SBI

The impact on SBI can be best studied by analyzing the different types of risk involved with Basel II which is as follows:-

CREDIT RISK

The risk that a borrower or counterparty might not honour its contractual obligations – which is very relevant to operating staff.

There are two approaches for credit risk:

i. Standardized Approach (SA)

ii. Internal Ratings Based (IRB) approach.


In SA, credit risk is measured in a more risk sensitive manner, i.e. by linking credit ratings of credit rating agencies to risk of the assets of the bank. The responsibility of providing the risk-weights corresponding to various assets, under SA, lies with the supervisory authority of a country.

As far as the IRB approach is concerned, banks are allowed to use their internal estimates of credit risk, subject to supervisory approval, to determine the capital charge for a given exposure. This would involve estimation of several parameters such as the probability of default (PD), loss given default (LGD), exposure at default (EAD) and effective maturity (M) corresponding to a particular debt portfolio.

Credit Risk – State Bank of India’s Preparedness

Existing Internal Credit Risk Assessment System refined and extended to cover Advance Accounts of Rs. 25 lacs and above.

Existing Internal Credit Information System is being fine-tuned to meet Basel II requirements, now covering Whole Bank.

Models for implementation of Integrated Risk Management and Operational Risk Management are being implemented.

Consultants are being appointed for Portfolio Credit Risk Modeling Exercise

MARKET RISK

The risk of adverse price movements such as exchange rates, the value of securities, and interest rates - Less relevant to operating staff, more or less centralized at corporate centre.

Market Risk State Bank of India’s Preparedness

Exploring the feasibility of using KVaR+ software for mapping Treasury Operations for market Risk.

Developed adequate hedging mechanisms to absorb the impacts of Market Risk.

Their investment Risk is akin to the Country Risk and thus well protected.


Implementation of Oracle Based ALM Software is in progress, to provide comprehensive ALM data analysis.

Market Risk State Bank of India’s Concerns

During the FY: 2005-06, additional Capital charge of around Rs. 1200 crore has been provided on account of Market Risk on AFS category of Investments.

Securitization Transactions are subjected to stringent treatment thus making them less attractive.

OPERATIONAL RISK

The risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events – Newly introduced & also very relevant to operating staff.

In order to calculate the capital charges for operational risk, three approaches are used: –

1. Basic Indicator Approach (BIA),

2. Standardized Approach (SA) and

3. Advanced Measurement Approaches (AMA)

In the BIA, an estimate of the capital charge for operational risk is provided by averaging over a fixed percentage of positive annual gross income of the bank over the previous three years.

Under SA, at first the bank’s business activities are divided into eight business lines. For each business line, a capital charge is calculated by multiplying the gross income of the business line by a factor. A capital charge for each business line is thus calculated for three consecutive years.

Under AMA, a bank can, subject to supervisory approval, use its own mechanism for determining capital requirement for operational risk.


Operational Risk State Bank of India’s Preparedness

Operational Risk Management Committee, is developing the ORM Policy to assess the losses to:

1) Physical Assets

2) Business and Systems

3) Process Management and Delivery Mechanism.

Business Process Re-engineering Team is in place evaluating the processes and redefining the Systems & Procedures to mitigate incidence of losses on account of processes and Systems.

Operational Risk – SBI’s Concerns

At 12% CAR, the Bank may be required to provide additional capital charge of around Rs. 4500 crore towards Operational Risk.

The Bank has established systems and procedures and hence, may be required to provide lesser capital for Operational Risk under Advanced Approaches.

However, given the current level of MIS and Technical Sophistication, our Bank for the present, may be in a position to adopt Basic Indicator Approach only.

Challenges in Implementation at SBI

Complexities in Systems and Processes involved in Basel II make the implementation process difficult, time consuming and costly.

Availability and mapping of Validated and Auditable Data and Integration of the same to Basel II norms.

Adaptability of Operating Personnel to the New Skills

Internationally active Bank like ours will face problem due to localization of Basel II norms in different Geographical Zones due to Home & Host Country Regulations

An Integrated Risk Governance Structure is set up to facilitate early migration to Basel II.


Separate departments are set up to monitor and manage Credit Risk, Market Risk and Operational Risk.

Risk based Internal Audit has been implemented across the Bank.

An In-house Committee is overseeing the Transition to Basel II.

Main implications of Basel II on SBI

Currently the bank is moderately affected on account of Credit Risk, but adversely affected on account of Operational Risk.

Without any additional Capital support, Basel II would tend to reduce CAR of the bank by around 150 bps.

The Projected CAR tends to slide immediately by around 1.50%, but the negative impact is expected to be neutralized over a period of 5 years

Thus in a nutshell Basel II is basically a Risk Management Exercise which:-

Doesn’t seek to change business models of the Bank.

Requires to fine-tune/update Risk Management practices.

Robust enough to capture all possible Risks the Bank is facing or likely to face.

Initiate adequate and appropriate Risk Mitigation measures through effective Systems and Procedures


FINDINGS

1. Changes have been and will be there in the quantum of data collected due to the new

Basel II norms. This has had an impact on the manpower requirements and the time

availability for the job, which was one of the common problems faced by the banks

during this phase, though some bankers feel it’s just the aggregating of the data available

in various databases. This data collection though is critical for the banks for the purpose

of ratings.

2. While bankers say that there have been privacy and security issues faced during the

collection of data for the purpose of rating but they were not clear on how they had

overcome those issues, most others say that they did not have any issues related to

privacy since the customer is obliged to provide data for the processing of the application

with regards to security issue they were not aware of any security issues faced so far. The

bankers say that industry risk data, business risk data are also available with the banks

which help in the rating process, so data privacy is not a major problem they say.

3. The bank is of the view that with the advent of Basel II there will be better capital

adequacy since they are based on the risks involved unlike the ones in Basel I, where a

single brush approach was adopted without taking any specific risks into consideration.

But it has also been affecting their business in a way; like for instance the underarm

limits for NPAs has been increased from 100% to 150% so there is an impact on the

amount available for lending.

4. Basel II has not affected the short term lending of the banks, the way it was predicted to

affect, but the bankers say that there will be an impact on the pricing of these short term

lending of the banks. The banks have a firm belief that short term lending is a major

weapon in the bank’s armory for the better utilization of the bank’s short term resources.


Further the banks are of the view that the excess liquidity with the banks can be diverted

through into this route.

5. Mostly the bank had their ICAAPs in tune with the regulatory capital requirements set by

the regulatory authorities and IBA. They had used Liquidity risk, Interest risk on banking

book (MVE & Earning Perspective), Credit concentration risk and others to calculate the

ICAAP. Those that had actually calculated ICAAPs had their capitals at well above the

regulatory requirements averaging at around 12%.

6. The interview with manager and officials threw up contradicting views regarding the

number of rating agencies available in the country. Some of them were of the view that in

India there is no much demand for rating of corporate bonds and other instrument, their

argument is that very few organizations which go for ratings, get a good rating, so the

purpose of ratings which is actually to increase the value of the instrument is actually not

working. Some also argue that the situation is opposite where the rating agencies are

behind the banks to rate their instruments.

7. Most of the banker is of the view that it’s difficult to classify the expense incurred as a

capital expenditure or revenue expenditure. There was feeling that there needs to be

proper demarcation of the expenses incurred in order to have better comparability

between the banks. Some of them were already demarcating some expenses as capital

expenditure or revenue expenditure but this has been varying from bank to bank.

8. The question related to pro-cyclicality seemed to be irrelevant as none of the bank felt

that they have been affected or find any reason that they will be affected in the near

future because of this. They were also of the view that their portfolios are well diversified

to handle any such situation.


9. The banker were of the view that the prevalent economic and market conditions are

pointers for consolidation and that the impact of the Basel II norms needs to be

understood by both the banks and its customers. They feel it’s good to wait for the

stabilization period to end rather than to proceed to advanced measurement approaches in

haste. The one exception which I said earlier was eager to proceed to the advanced

approaches as they were confident of handling it.

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

Basel II separate departments have been entrusted with the task of managing Credit Risk,

Market Risk and Operational Risk.

11. Regarding the comparability of the capital standards post Basel II, banks had varying

views some were of the view to wait and watch what happens next, some were of the

view that it definitely achieves the purpose it was set due the basic theme, i.e. the ideas

propounded by Basel II and because it advocates for the international best practices to be

adopted by banks, others were of the view that there needs to be further study regarding

this.


RECOMMENDATIONS

Though data privacy and data security issues have not posed a major problem with the

bank in Allahabad, I feel that this could be an issue in the future considering the issues

the developed countries are facing. Especially with the rise of the out sourcing culture in

India too there could be security issues with regards to data security; hence it’s worth the

regulators give a look at this.

A special forum within the framework of the Indian Bank’s Association to facilitate the

bankers to discuss live issues faced during the implementation of the Basel II. This would

make the transition easy especially for small banks implementing the norms in India.

With regard to the treatment of Basel II implementation expenses incurred by the banks,

the reserve bank could support the banks with proper demarcation of the expenses other

than those provided by the Indian Companies Act, since it was one of the problems faced

by the commercial banks.

The major problem facing the regulators is about the current crisis, it’s not the crisis in

itself that’s the problem but the underlying factor that the countries and banks which

implemented Basel II have faced the most of the heat of the current crisis, so it’s time the

Basel Committee on Banking Supervision revisits the Basel II.

The methods and assumptions used to calculate the ICAAP needs to be made clear,

though ICAAP is totally the banks own calculations there needs to be some regulation

with regards to this since there could be possibility that the banks could use future profits

or other probabilities to set against capital requirements.


Though Basel II has reduced the amount available with the banks for lending it’s for the

good of the banking system as a whole so the strict capital standards.

The number of rating agencies available in India is low compared to the number of

corporate accounts that need to be rated. But first awareness has to be created about the

uses and advantages of external ratings, among the consumers and with provided demand

at the later stage the regulators could authorize more rating agencies.

I feel that the banks would still face problems in capturing the IT systems losses under

the current framework. There needs to be a proper mechanism set in place to measure

future IT systems loss, and the potential monetary losses it could cause, especially since

the Indian banking sector is in a transformational process, upgrading the data bases in IT

systems.

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

Finally, Basel II is fundamentally about better risk management anchored in sound corporate governance. The central bank needs to ensure strong corporate governance practices in the banking industry, the Indian Banking Association needs to conduct regular workshops on corporate governance for the bank’s board members


REFERENCES

ARTICLES:

1. Approach to Basel II (Speech) by Mrs.Shyamala Gopinath.

2. Challenges and implications of Basel II for Asia (Speech) by Dr.Y.V.Reddy

3. Demystifying Basel II (Speech) by Shri V.Leeladhar, Deputy Governor, Reserve Bank of

India

4. Basel II and Credit Risk Management (Speech) Shri V. Leeladhar, Deputy Governor, and

Reserve Bank of India at the program me on Basel II and Credit Risk Management.

5. Regulation and Risk Management: Implementing Basel II (Speech) by Address of Shri V

Leeladhar, Deputy Governor, delivered at the Platinum Jubilee Celebrations of the South

Indian Bank Ltd., Thirussur on 2005

6. India’s Preparedness for Basel II implementation,(Speech) The Special Address delivered

by Shri V. Leeladhar, Deputy Governor, Reserve Bank of India at the Panel Discussion

during “FICCI-IBA Conference on Global Banking : Paradigm Shift.

7. Implementation of Basel II – An Indian perspective(speech) Address by Ms. Kishori J

Udeshi, Deputy Governer, RBI at the Annual International seminar on Policy changes for

financial sector on June 2005


BOOKS :

1. Preeti Phuskele “Basel II Norms- Implications on Business” ISBN: 81-3141-166-9 ICFAI University Press.

2. Nagarajan N “Implications of Basel II for Risk Management and Capital Structure” ISBN: 81-7881-335-1 ICFAI University Press

WEBSITES:

www.bis.org

www.articlesarchive.com

http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=303

www.rbi.org.in/rdocs/Publications/Docs/21113.doc

http://www.iba.org.in/basel_II.asp

http://www.banknetindia.com/index.htm

www.banknet.com/banking/81022.html .

www.epaper.thehindubusinessline.com

www.ficci.com/surveys/II.pdf

http://www.epaper.thehindubusinessline.com/

http://www.banknet.com/banking/81022.html

http://www.banknetindia.com/index.htm

http://www.iba.org.in/basel_II.asp

http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=303

http://www.articlesarchive.com/

http://www.bis.org/


APPENDICES

Interview Protocol

Basel II implementation and challenges faced by Indian banks.

Name of the Bank:

Address of the Branch:

Name and designation of the person in charge:

1. Did/Will Basel II cause changes in the way (intensity, depth etc) that you collect and process data?

If YES: How did it affect your business? How have you overcome it?

Does it impact your business in any way?

If NO: Do you think you will face any problem related to collecting and processing data?

2. Have you so far faced any privacy or security issues with regard to collection of additional data for the purpose of Basel II?

If YES: what was the issue in specific? And how did you tackle it?

If NO: Do you think you would face any such situation in the future?


3. Does your bank have designated people to work exclusively as suggested by RBI on implementing the various stages of the Basel II norms?

If YES... how many?

If NO... didn’t you find the need to employ personnel exclusively for that?

Or was the current staff sufficient enough?

4. Do you think the high rise in the risk weights would increase the cost of borrowings for your consumers?

Comment

5. How much in Percentage terms is your short term lending? Has Basel II discouraged you from such lending?

If YES do you think it is good for the bank in the long term perspective?

If NO so you would say that STL should be continued what is the major reason behind this view of yours?

6. Has the lack of knowledge of employees posed any problems in implementing BASEL II norms in your bank?

If YES: what were the specifics?

If NO: How did you equip the employees?

Did you get any help for the central bank’s side in this regard?


7. What is the current Internal Capital Adequacy Assessment Process (ICAAP) of your bank, how different is it from the regulatory capital requirement?

What are the variables you use to calculate this?

8. Do you have any reservations in classifying the expenses incurred in implementing Basel II?

If YES, How do you think the expenses should be treated?

If NO, So you agree that the additional expenses incurred in technology, resources up gradation need not be treated as Investments right?

----Thank you----


Appendix Table 1: Capital Adequacy Ratio

(As at end-March)

(Per cent)

Sr. No. Name of the Bank

2004-05

2005-06

2006-07

Basel-I 2007-08

Basel-I 2008-

09

Basel-II

2007-08

Basel-II

2008-09

1 2 3 4 5 6 7 8 9 State Bank Group 12.4 12.0 12.3

State Bank of India 12.5 11.9 12.3 13.5 13.0 NA 14.3

State Bank of Bikaner & Jaipur 12.6 12.1 12.9 13.5 13.2 12.5 14.5

State Bank of Hyderabad 11.7 12.1 12.5 12.4 10.6 12.0 11.5

State Bank of Indore 11.6 11.4 11.8 11.3 11.8 11.3 13.5

State Bank of Mysore 12.1 11.4 11.5 12.3 12.4 11.7 13.4

State Bank of Patiala 14.2 13.7 12.4 12.5 11.4 13.6 12.6

State Bank of Travancore 11.1 11.2 11.7 12.7 12.1 13.5 14.0

management thesis on basel 2 norms in india

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