BASEL ACCORD AND BASEL NORMS

History of Basel

The Basel Committee was constituted by the Central Bank Governors of the G-10 countries
in 1974. The G-10 Committee consists of members from Belgium, Canada, France, Germany,
Italy, Japan, Luxembourg, The Netherlands, Spain, Sweden, Switzerland, The UK and The US.
These countries are represented by their Central Bank and also by the authority with onus
for the prudent supervision of banking business where this is not the central bank.

The Committee's Secretariat is located at the Bank for International Settlements in Basel,
Switzerland. This committee meets four times in a year. The present Chairman of this
committee is Mr. Nout Wellink(President of The Netherlands Bank). The Secretary General
of the Basel Committee is Mr. Stefan Walter.

This committee on banking supervision provides a forum for regular cooperation on banking
supervisory matters. Its objective is to enhance understanding of key supervisory issues and
quality improvement of banking supervision worldwide. This committee is best known for its
international standards on capital adequacy; the core principles of banking supervision and
the concordat on cross-border banking supervision.

Basel Capital Accord

The Basel Capital Accord (Basel II) guidelines promulgated by the BIS to establish capital
adequacy requirements and supervisory standards for banks to be implemented by 2007
and are structured by three pillars.

The Basel II is designed to facilitate a more comprehensive, sophisticated and risk sensitive
approach for banks to calculate regulatory capital. The proposals will enable banks to align
regulatory requirements more closely with their internal risk measurement and to improve
operational process.

The Committee today consists of central bankers and supervisory regulators from 13
countries.

Basel I Vs. Basel II

Basel I is very simplistic in its approach towards credit risks. It does not distinguish between
collateralized and non-collateralized loans, while Basel II tries to ensure that Basel I are
corrected.

Advantages of Basel-II
It is believed that such an international standard 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. In simple terms, 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.

The basic purpose of this recommendation is to ensure that capital allocation is more risk
sensitive, separating operational risk from credit risk and quantifying both, and attempting
to align economic and regulatory capital more closely to reduce the scope for regulatory
arbitrage.

In a nut-shell, Basel II -

  Provides effective assessment methods.

  Incorporates sensitivity to banks.

  Makes better business standards.

  Reduces losses to the banks.

The above-mentioned advantages of Basel II recommendation are helpful in various ways to

the Indian banking industry: -

  Improving overall efficiency of banking and finance systems.

  Takes global aspect into consideration for more rational decision making, improving the
decision matrix for banks.

  Allowing capital discrimination of the banking system by allocating proper risk weighs to
each asset class.

  Providing range of alternatives to choose from.

  Allowing capital allocation based on ratings of the borrower making capital more risk-
sensitive.

  Providing an incentive for better and more objective risk measurement.

  Encouraging mergers and acquisitions and more collaboration on the part of the banks,
this ultimately leads to proper control over their capital and assets.
The 3-Pillar Approach of Basel II

  Minimum Capital Requirement (Addressing Credit Risk, Operatinal Risk & Market Risk)

  Supervisory Review (Provides Framework for Systematic Risk, Liquidity Risk & Legal Risk)

  Market Discipline & Disclosure (To promote greater stability in the financial system)

Challenges With Indian Banking Industry

  With the feature of additional capital requirements, the overall capital level of the banks
will see an increase. But, the banks that will not be able to make it as per the global system.

  Another biggest challenge is re-structuring the assets of some of the banks would be a
tedious process, since most of the banks have poor asset quality leading to significant
proportion of NPA. This also may lead to Mergers & Acquisitions, which itself would be loss
of capital to entire system.

  The new norms seem to favor the large banks that have better risk management and
measurement expertise, who also have better capital adequacy ratios and geographically
diversified portfolios. The smaller banks are also likely to be hurt by the rise in weightage of
inter-bank loans that will effectively price them out of the market. Thus, banks will have to
re-structure and adopt if they are to survive in the new environment.

  Since improved risk management and measurement is needed, 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 historical bank data that is a tedious and high cost process, as
most Indian banks do not have such a database.

  The technology infrastructure in terms of computerization is still in a nascent stage in

most Indian banks. Computerization of branches, especially for those banks, which have
their network spread out in far-flung areas, will be a daunting task. Penetration of
information technology in banking has been successful in the urban areas, unlike in the rural
areas where it is insignificant.

  Experts say that dearth of risk management expertise in the Asia Pacific region will serve
as a hindrance in laying down guidelines for a basic framework for the new capital accord.

  An integrated risk management concept, which is the need of the hour to align market,
credit and operational risk, will be difficult due to significant disconnect between business,
risk managers and IT across the organizations in their existing set-up.

  Implementation of the Basel II will require huge investments in technology. According to

estimates, Indian banks, especially those with a sizeable branch network, will need to spend
well over $ 50-70 Million on this.

SWOT Analysis (In Indian Banking Context)

Present Scenario in Implementing Basel II in India

The deadline for implementing Basel II, originally set for March 31, 2007, has now been
extended. Foreign banks in India and Indian banks operating abroad had to meet those
norms by March 31, 2008, while all other scheduled commercial banks will have to adhere
to the guidelines by March 31, 2009. But the decision to implement the guidelines remains
unchanged. This is true even though the international exposure of even the major Indian
banks is still limited. Whereas some of the large banks say that they are Basel II compliant
with the presence of all the requirements, which Basel II recommends.

Basel II allows national regulators to specify risk weights different from the internationally
recommended ones for retail exposures. The RBI had, therefore, announced an indicative
set of weights for domestic corporate long-term loans and bonds subject to different ratings
by international rating agencies such as Moody's Investor Services, which are slightly
different from that specified by the Basel Committee.

Most of the Indian banks that have migrated to Basel II have reported a reduction in their
total Capital Adequacy Ratios (CARs) due to the new operational risk-based capital charges.
However, a few banks, those with high exposures to higher rated corporate or to the
regulatory retail portfolio, have reported increased CARs. Given recent changes in
regulatory charges, it is doubted whether this will be sustainable. Banks would find it
increasingly attractive to give out loans to the small business segment that qualify as
regulatory retail, given their higher lending margins and lower risk weights. In contrast, the
increase in risk weight for residential mortgage loans will make this area less attractive.

Conclusion

The Basel Committee on Banking Supervision is a Guideline for Computing Capital for
Incremental Risk. It is a new way of managing risk and asset-liability mis-matches, like asset
securitization, which unlocks resources and spreads risk, are likely to be increasingly used.
This was designed for the big banks in the BCBS member countries, not for smaller or less
developed economies.

The major challenge the country's financial system faces today is to bring informal loans into
the formal financial system. By implementing Basel II norms, our formal banking system can
learn many lessons from money-lenders. Its implementation may involve significant changes
in business model in which potential economic impacts must be carefully monitored.

n a nut-shell, we would like to conclude that keeping in view the cost of compliance for both
banks and supervisors, the regulatory challenge would be to migrate to Basel II in a non-
disruptive manner. We would like to continue the process of interaction with
other countries to learn from their experiences through various international fora. India is
one of the early countries which subjected itself voluntarily to the FSAP of the IMF, and our
system was assessed to be in high compliance with the relevant principles. With the gradual
and purposeful implementation of the banking sector reforms over the past decade, the
Indian banking system has shown significant improvement on various parameters, has
become robust and displayed ample resilience to shocks in the economy. There is,
therefore, ample evidence of the capacity of the Indian banking system to migrate smoothly
to Basel II.