Regulatory Frame work for

banks – BASEL II
S.CLEMENT
 BASEL - GENESIS
• Herstatt Bank, Frankfurt in Germany failed on 26 June
74. Banking license was withdrawn after close of
banking hours. By then DEM payments were received
locally irrevocably. Correspondent bank in N.Y.
suspended payments in New York. Banks which were to
receive $ funds did not get the same.
• Failure of many such banks lead to make regulators
think of uniform regulation of banking sector across the
globe.
 Need for regulation
• Volume of financial flow is on the increase as
compared to trade flows
• International banking- Wide spread net work of
branches across the globe and wide spread risk.
• Different level of supervisory control
• Quality of assets
• Spate of failure of banks
• Integration of market due to globalization effect
 Bank International for
International Settlements (BIS)
• Established in 1930 to promote co operation among
central banks of member countries. Members consist
of central banks of various countries
• Up to 1970-focused on implementing and defending
the Bretton Woods system.
• 197o- 80 – focus on managing cross border capital
flows
• 1988 – Basel I
• 1999- Basel II (Draft guidelines)
 BASEL - Genesis
• Basel committee established in 1974 by
central – bank governors of G 10
countries
• Committee meets regularly four times a
year.
• It has 25 technical working groups and
task forces which also meet regularly
 BASEL - Genesis
• Committee does not possess super
national supervisory authority
• It formulates broad supervisory standards
and guidelines.
• It recommends statements of best
practices
• Recommendations will help countries for
convergence towards common
approaches & standards
• It is widely accepted as international
standard of best practices in banking
 BASEL
• Objectives:
• To close gaps in international supervisory coverage
• No foreign banking establishment should escape
supervision
• Supervision should be adequate
• To arrive at significantly more risk sensitive capital
requirements
• Due regard to supervisory & accounting systems &
Market discipline
• Discretion to adopt standards to different conditions
of national market
 BASEL I
• First BASEL accord was accepted in 1988 and adopted internationally in 1992
• RBI introduced BASEL norms in 1992 in phased manner and all banks were
covered by 1996.
• 1999 – New Capital Adequacy Frame work –BASEL II
• 2004 – BIS brought out BASEL II Accord( International Convergence of
Capital Measurement and Capital Standards – A Revised Frame work)
• RBI issued detailed guidelines on 15.02.05 followed by circular dated 20TH
March, 2006.
• Expected to in in place by March,2008 for
internationally active banks like SBI, BOB, ICICI etc & for others 2009 in India.
* Parallel run already started from April 2006
 Basel –I
• Objectives – ensure adequate level of capital in
the international banking system to with stand
crisis in banking sector.
• Banks to develop business volumes which is
linked to capital. That means, with out capital,
business growth is not possible. Previously, it
was not so i,.e business was not linked to
capital.
• In short , BASEL addresses both Liability and
Asset side of Balance sheet of banks.
 Basel –I
• Parameters to measure and manage risk
via Prudential accounting norms -
• Capital adequacy
• Income recognition
• Asset classification
• Provision
 Capital Adequacy
Capital Funds include
TIER I CAPITAL: This one can absorb losses
without a bank being required to cease
operation. This is Core Capital. Cushion for
unexpected losses.
TIER II CAPITAL: This can absorb losses in the
event of a winding up, and also provides
lesser degree of protection to depositors.
 RBI prescription
• Elements of Tier I capital: The elements of Tier I capital include
• i) Paid-up capital (ordinary shares), statutory reserves, and other disclosed
free reserves, if any;
• ii) Perpetual Non-cumulative Preference Shares (PNCPS) eligible for
inclusion as Tier I capital - subject to laws in force from time to time;
• iii) Innovative Perpetual Debt Instruments (IPDI) eligible for inclusion as Tier
I capital; and
• iv) Capital reserves representing surplus arising out of sale proceeds of
assets.
• Elements of Tier II capital: The elements of Tier II capital include
undisclosed reserves, revaluation reserves, general provisions and loss
reserves, hybrid capital instruments, subordinated debt and investment
reserve account .
• Undisclosed reserves
They can be included in capital, if they represent accumulations of post-tax
profits and are not encumbered by any known liability and should not be
routinely used for absorbing normal loss or operating losses. .
 Capital Adequacy
• Tier I Capital:
• Paid-up Share Capital
• (Common Stock)
• Disclosed Free Reserves
• Statutory Reserve
• Capital Reserves
representing surplus
arising out of sale
proceeds of Assets
• Tier-II Capital:
• Undisclosed Reserves
• Assets Revaluation
Reserves
• Hybrid Capital
Instruments
• General Provisions &
Loss Reserves
• Subordinated Debt
 Capital Adequacy
• Tier I Capital: • Tier II Capital:
• Deductions- • Discounts:
• Equity Investment in • Revaluation Reserves
Subsidiaries with 55% discount
Tier II cannot exceed
• Accumulated Losses if Tier I
any • Discounts:
• Intangible Assets like • Subordinated Debt max.
Deferred Tax Assets 100% of Tier I Capital,
• Goodwill Discounted 20-80% for
remaining maturity
Basel - I (measurement of capital)
• Minimum capital requirements
• Regulatory capital - Capital is measured on the
basis of Risk Weighted Assets (RWA). It is 8%as
per BASEL and 9% in India.
• Classified bank assets in to 4 groups which carried
respective credit risk weights of 0%,,20%,50%, &
100% based on which minimum capital
requirements to be calculated.
• E.g. cash and G-Sec @ 0%,bank borrowings @
20% and loans to others @ 50 – 100%.
RBI- Procedure for computation of CRAR

• 2.4.1. While calculating the aggregate of funded and non-funded

exposure of a borrower for the purpose of assignment of risk weight,
banks may ‘net-off’ against the total outstanding exposure of the
borrower -
• (a) advances collateralised by cash margins or deposits,
• (b) credit balances in current or other accounts which are not
earmarked for specific purposes and free from any lien,
• (c) in respect of any assets where provisions for depreciation or for
bad debts have been made
• (d) claims received from DICGC/ ECGC and kept in a separate
account pending adjustment, and
• (e) subsidies received against advances in respect of Government
sponsored schemes and kept in a separate account.
 Capital adequacy
• Total capital /(Tier 1 + Tier 2)/ Total RWA
= 8%
• For Indian banks , it is 9%.
 RISK Weighted Assets(RWA)
• RWA determined by multiplying the asset
with risk factor
• E.g. loans to a bank Re 100. RWA @
20%. Capital requirement will be 100 X
20% X 8% = Re 1.6.
• Banks to hold capital equal to 8% of R.W.
Assets. In India RBI prescribed CAR of
9%.
 What is retail lending ?
Banks with capital funds of Thresh hold limit

Up to Re 300 crores Re 1 crore

.300 to 500 crores Re 3 crore

500 crores Re 5 crore

 RW % for Assets
ASSET RW %
Cash & bal with RBI 0

CD with other banks 20

Govt.securities 2.5

Loans to corporates etc 100

Staff advances 20

CGF/FD/LIC policy/NSC 0
(with margin)
 RW % for Assets
ASSET RW %
Govt.guaranteed sec of PSU 22.5

Loans to PSU 100

Sub.ord. Bonds of PSU/Bks 102
Commercial real estate 150
Adv.covered by ECGC 50
SSIadv.gua.by CGST 0
SEC.PTC 102.5
Venture capital 150
Other Assets 100
 Risk Weights for Assets
Credit Off- Balance Sheet items
Conversion
factor
100% Financial guarantees, LCs, acceptances (Endorsements), Sale and
Purchase agreement and asset sales with recourse, where credit risk
remains with the Bank.
50% Performance guarantee, L/Cs related to particular transaction, other
commitments (formal stand-by facilities and credit lines- over one
year- if maturity Basel Committee within one year and can be
cancelled at any time- Credit conversion factor – 0)

20% Short term self liquidating trade related contingencies (documentary

credits)
2% Aggregate outstanding foreign exchange contracts of original
maturity-less than one year (for each additional year or part thereof
3%. If original maturity is less than 14 days irrespective of counter
party RWA will be 0%
 Income recognition
• Interest income not to be recognized until
it is realized. Accrual system to actuals.
• One quarter default for recognizing
income
• Either installment or interest or both
• Borrower wise and not Facility wise
• Out of order – applicable to cash
/overdraft a/c
Non performing Assets
1 An asset, including a leased asset, becomes non performing when it ceases
to generate income for the bank.
A non performing asset (NPA) is a loan or an advance where;
i. interest and/ or installment of principal remain overdue for a period of
more than 90 days in respect of a term loan,
ii. the account remains ‘out of order’ as indicated below, in
respect of an Overdraft/Cash Credit (OD/CC),
iii. the bill remains overdue for a period of more than
90 days in the case of bills purchased and discounted,
iv. the installment of principal or interest thereon remains overdue for two
crop seasons for short duration crops,
v. the installment of principal or interest thereon remains overdue for one
crop season for long duration crops,
vi. the amount of liquidity facility remains outstanding for more than 90 days,
in respect of a securitisation transaction undertaken in terms of
guidelines on securitisation dated February 1, 2006.
Banks should, classify an account as NPA only if the interest charged during
any quarter is not serviced fully within 90 days from the end of the quarter.
 Asset classification
• Standard asset – servicing of int. &
principal. Normal risk.
• Sub-Standard – NPA for a period up to 12
months. Asset coverage / net worth of
borrower not enough to cover the loan
• Doubtful asset –age of NPA is more than
12 months.
• Loss Assets – no chance of recovery but
not written off.
 Provisioning norms
• Loss Assts – 100% of out standing amount
• Doubtful Assets –100% of unsecured,20 to 100% ( 1 to
>3 years)
• Substandard Asset -10% on the outstanding amount.
• Standard asset –
a) Agricuture/SME- 0.25%
b) Personal loans, stockmarket, commercial real estate
& Non deposit taking NBFC – 2%
c) Others – 0.40%
 Why BASEL II ?
• One size fit approach to be replaced by a
menu of options for banks to choose
• More risk sensitive to en compass all risks
especially operational risk.
• To bridge the cap between Regulatory &
Economic capital
• BASEL I did not address risk mitigation
techniques such as collateral, guarantees etc
• More emphasis on banks’ internal control and
management
• More disclosure through market discipline
 Basel II: New Capital Adequacy
Framework
• In June 2004, Central Bank governors in the
G-10 countries endorsed the publication of
International Convergence of Capital
Measurement and Capital Standards,
commonly known as Basel II accord.
• The new accord is making capital allocation
of banks more risk-sensitive.
 Objectives of Basel II
• To encourage better and more systematic risk
management practices, especially in the area of credit risk
and to provide improved measure of capital adequacy.
• Introduction of Basel II has given incentives to many of the
best practices banks, to adopt better risk management
techniques and to evaluate their performance relative to
market expectations and relative to competitors.
• The new framework proposes a significant refinement of
regulatory and supervisory practice and encourages
increased attention to risk management practices.
 Minimum Capital Requirements – Pillar 1
Capital: fundamental thing worth having

The
New Basel
Capital Accord
Minimum capital requirements –
Regulatory and Economic capital
Minimum Capital Requirements

Supervisory Review Process

Supervisory review process –

Market Discipline

trancsaction based to risk based

supervision
Market discipline – risk exposure,
migration assets from standard to
NPA etc
Pillar I Pillar II Pillar III
Minimum capital Supervisory review Market discipline
requirement

1. Capital for credit risk 1. Evaluate risk 1.Enhance disclosures

standardized/Internal 2.
ratings based approach
– Foundation/Advanced
2. Capital for mkt.risk –
Standardized method –
maturity / duration 3.
method.
3. Capitla for Opr.risk –
basic 4.
indicator/standardized/a
dvanced measurement
approach.
Ensure soundness & 2.Core disclosures &
integrity of banks’ supplementary
internal process to disclosures
assess the adequacy 3.Period – semi
of capital annual.
Ensure maintenance
of minimum capital
with PCA for short fall.
Prescribe differential
capital , where
necessary i.e. where
internal process is
slack.
 Capital adequacy
• It measures operational risk also as against
regulatory capital which measures only credit
& Market risk.
• Operational is the risk of direct or indirect loss
resulting from inadequate or failed internal
processes, people, & systems or from
external events
• Risk assessment either by standardized or
internal rating based approach
 PILLAR I
• Minimum Capital requirements:
• Credit Risk:
- Standardized approach
- Internal Rating Based Approach
(Foundation IRB/Advanced IRB)
• Operation Risk:
- Basic Indicator Approach
- Standardized approach
- Advanced Measurement Approach
• Market Risk: Market Risk: VaR models for
Trading Book (AFS + HFT) and EaR models for
Banking Book (HTM)
 Pillar 1

Eligible capital
ON-BALANCE-SHEET = 8%
CREDIT RISK
+
Off-balance-sheet credit risk
+
Market risk
+
OPERATIONAL RISK
 Economic Capital
• Economic capital is the capital required
to cover credit, market and operational
risks of a bank
• Economic Capital = Credit Risk Capital
+ market risk capital + operational risk
capital
• The economic capital required to
support the activities of a bank can be
arrived at in a number of ways for
different types of risks faced.
 PILLAR I
• Key Changes:
• Wider spectrum of credit risk weights.
• Greater recognition of collaterals.
• More refined treatment of securitisation.
• Charge for Operational Risk introduced
 Credit Risk
Quantifying Risk
• Standardized Approach
• Foundation Internal Rating Based Approach
• Advanced Internal Rating Based Approach
 All commercial banks in India shall adopt
Standardized Approach (SA) for credit risk to start
with. Banks are required to obtain the prior
approval of the RBI to migrate to the Internal Rating
Based Approach.
 Credit Risk Mitigation
• In order to obtain relief for use of CRM techniques,
proper documentation used in collateralized
transactions must be binding on all parties and
legally enforceable.
• Banks in India can adopt Comprehensive approach,
which allows fuller offset of collateral against
exposures by the value ascribed to the collateral.
• Under this approach, banks which take eligible
financial collateral are allowed to reduce their credit
exposure to a counter party to take account of the
risk mitigating effect.
 Collaterals
• The following collateral instruments are eligible for
recognition in comprehensive approach:
Cash, Gold, Securities issued by Central/ State
Governments, IVPs, KVPs, NSCs, LIC policies, Debt
securities, equities etc.,
• In case of NPAs, other collaterals viz., land and
building, plant and machinery will be recognized for
assigning lesser risk weight of 100%, when
provisions reach 15%, only where the bank is having
clear title and the valuation is not more than 3 years
old and value of machinery not higher than the
depreciated value.
 Risk weights
• Long term ratings of credit rating agencies under
Standardized approach risk weights:
- AAA 20%
- AA 30%
-A 50%
- BBB 100%
- BB & below 150%
- Un rated 100%
 Other Risk Weights
• Exposures to Central Govt.& Inv.in St.Govt 0%
• Exposures guaranteed by State Govt 20%
• Exposures on RBI/DICGC/CGTSI 0%
• Exposures on ECGC 50%
• Staff loans secured by superannuation benefits 20%
• Claims on Multilateral Development Banks 20%
• Claims on Banks (based on CRAR of Bank) 20%-625%
• Claims on Corporates(based on ext.rating) 20%-150%
• Unrated claims in excess of Rs.10 cr 150%
• Claims on Commercial Real Estate 150%
• Consumer credit/personal loans/credit cards 125%
• Claims on restructured/rescheduled a/cs 125%*
• *(till satisfactory performance of one year from the date when
• the first payment of interest/instalment falls due)
 External Credit Assessments
• RBI has identified the following domestic credit
rating agencies for the purposes of risk
weighting the claims for capital adequacy
purposes:
a)Credit Analysis and Research Ltd.,
b)CRISIL Limited
c)FITCH Ratings and
d)ICRA Limited
 External Ratings
• Banks must disclose the names of the credit rating
agencies that They use for the risk weighting of their
assets.
• The rating should be in force and confirmed from the
monthly bulletin of the concerned rating agency. The
rating agency should have reviewed the rating at
least once during the previous 15 months.
• An eligible credit assessment must be publicly
available.
• Even though CC accounts are sanctioned for period
one year or less, these exposures should be reckoned
as long term exposures and accordingly long term
ratings accorded by agencies will be relevant.
• Presently all loans above Re 10 crores will be rated by
outside credit rating agencies under standardized
approach.
 What is operational risk ?
• Operational - risk of direct or indirect loss
resulting from inadequate or failed internal
processes, people, & systems or from
external events. E.g. fraud, forgery,
negligence, system failure etc.
• Risk assessment either by standardized or
internal rating based approach
 OPERATIONAL RISK
• Basel II framework outlines 3 methods for
calculating operational risk capital charge.
- Basic Indicator Approach
- The Standardized Approach
- Advanced Measurement Approach
To begin with banks are required to adopt Basic
Indicator Approach for capital charge under
Operational risk.
• Banks are required to provide 15% of average gross
income of the previous three years for which gross
income is positive.
Standardized Approach for Operational Risk

• Under Standardized approach, Bank’s activities would be

divided into 8 business lines as under:
• Corporate finance, Trading, Retail banking, Commercial
Banking, Payment & settlement, Agency services, Asset
Management and Retail brokerage.
• Under each business line, capital charge is calculated by
multiplying the beta factor assigned to that business line.
Gross income is calculated for each business line and not
for Bank as a whole.
• Under Advanced Measurement Approach, regulatory
capital will equal the risk capital measured by Bank’s
internal risk measurement.
 Measuring operational risk
• Standardized approach – capital charge
against each business to be provided on the
basis of annual average income for 3 years.
• Advanced Measurement Approach –
measured by bank’s internal risk
measurement system using quantitative and
qualitative approach.
 Risk Based Supervision
• Present audit focuses on transaction testing –
accuracy & reliability of records, financial
reports, adherence to legal & regulatory
requirements etc.
• RBS – focus on testing of risk in each
transaction, evaluation of effectiveness risk
management & controls, periodicity of audit,
inherent risks in various activities of institution,
prioritization of audit areas, allocation of audit
resources etc.
• In short, it is a migration form transaction to risk
based audit.
 Pillar II: Supervisory Review
• Banks should have Internal Capital Adequacy Process
(ICAAP).
• Supervisor should verify maintenance of minimum
capital requirements by banks.
• Supervisor would take appropriate action if they are
not satisfied with the Bank’s minimum capital.
• ICAAP should faithfully capture the risks attached in
the bank’s portfolio.
• Supervisor may take early supervisory action by
asking bank to maintain additional capital.
 Pillar III: Market Discipline
• To enable the market to understand the strengths and
weaknesses of the Bank.
• To encourage market discipline by developing a set of
disclosure requirements which allow market participants
to assess key pieces of information on capital, risk
exposure, risk assessment process.
• Providing disclosures that are based on a common
framework is an effective means of informing the market
about a bank’s exposure to those risks and provides a
comprehensive disclosure framework that enhances
comparability.
 Disclosure regime
• Board approved policy for disclosures.
• Financial position and performance.
• Risk management strategies and practices.
• Risk exposures.
• Accounting policies.
• Basic business, management and corporate
governance information.
 Market Discipline- Disclosure
regime
• Transparency & more disclosure
• Calculation of capital adequacy
• Risk exposure to sensitive sectors
• Migration of SA to NPA
• Risk assessment methods
 BENEFITS
• Incentive for improved risk analysis and
pricing of risks.
• Better internal capital management
• Improvement in credit portfolio quality and
better recognition of risk mitigation.
• Control orientation to strategic advantage.
 Current directives of RBI
• RBI issued draft guidelines on implemen-tation of Basel
II in India on 15th Feb 05.
• RBI issued revised draft guidelines on Basel II norms on
20th March 2006.
• As per revised guidelines, all Banks in India having
presence outside India will adopt Standardized
approach for credit risk and Basic Indicator Approach
for operational risk w.e.f. 31.03.08 and all other banks
not later than 31.03.09.
• RBI further stated that banks are required to commence
a parallel run of the revised framework and Boards of
the banks should review the results of parallel run on
quarterly basis.
 Implementation - issues
• Banks by manipulating credit risk measurement,
may reduce CAR. Non deliberate under
estimation also may lead to lower CAR.
• Competition among banks for high quality
loans/customers may exert pressure on interest
spread .
• Burden of approving internal risk models. It will
lead to regulators identifying them selves the
banks they supervise. It will come difficult not to
bail out of a large problem since supervisors have
validated and approved of internal rating system
of bank facing financial crisis.
 Implementation - issues
• Non availability of data over longer time horizon
to measure risk based on historical data.
• Too much disclosure may cause information
over load and may create problem to the
respective bank vis-à-vis competitors.
 Indian perspective
• RBI may enforce to have a uniform credit
rating approach to measure capital
requirement since credit rating is a yard stick
for capital provisioning .
• Technological up gradation involves huge
capital requirement but return may not
match. Smaller banks may suffer.
• Low penetration of credit rating and it has got
to improve.
• Social obligation of public sector banks.
It would be a mistake to conclude
that the only way to succeed in
banking is through ever greater size
and diversity. Indeed better risk
management may be the only truly
necessary element of success in
banking.

Alan Greenspan
Former Chairman, Federal
Reserve
October 5, 2004
 Michael E.O’Neill on SWM (Share
Holder’s Maximization of Wealth)
• The highest potential for increasing
shareholder value is improving the way
allocate capital to businesses,
(including) taking away capital from
businesses that are not achieving return
expectations.
Michael E.O’Neill
CFO, Bank of America
 Peter Drucker on SWM
• “What we generally call profits, the
money left to service equity,
is usually not profits at all. Until a
business returns a profit that is greater
than the cost of capital, it operates at a
loss”.
Peter Drucker
 What is Basel II?
China Banking Regulatory Commission-

“To a large extent we are convinced that

Basel II is more about risk management
than capital regulation, particularly for the
emerging markets”