INTERNATIONAL BANKING REGULATION

Manjunath H. Mannapur M.A-II

Why International Banking Regulation?

When banking systems weakened in the number of industrial countries in 1980s, there was a large pressure on developed countries to regulate banks. This was brought in the form of regulating the banks thus reducing the likelihood of individual failures that could spread the adverse effects across national boundaries and also because banks in different countries would not benefit from any competitive advantages due to subsidies from their governments, such as lower capital ratios in an environment of implicit or explicit deposit insurance or other government support.

 This regulation reflects the limited market discipline on banks in most countries because of the existence of actual or speculative government guarantees. Also, the greater difficulty in monitoring banks in non-home jurisdictions by both private stakeholders and government regulators. This is particularly true if the regulations differ significantly across jurisdictions. The international regulations would resemble domestic prudential regulations, but taken into account any differences in institutional and legal structures in different countries that, in particular, impact the quality of regulatory supervision and private market discipline.

History of Basel committee

The Basel Committee on Banking Supervision (BCBS) was established as the Committee on Banking Regulations and Supervisory Practices by the central-bank Governors of the Group of Ten countries at the end of 1974 in the aftermath of serious disturbances in international currency and banking markets.

The meeting took place in February 1975 and usually it meets four times a year.
Chairman: Stefan Ingves, Governor of Sveriges Riksbank. Secretary General :Wayne Byres, supported by a staff of 17 members.

Basel committee members

Countries Institutions represented

Argentina
Australia Belgium Brazil Canada China France India Sweden

Central bank of Argentina

Reserve Bank of Australia Australian Prudential Regulation Authority National Bank of Belgium Banking, Finance and Insurance Commission Central Bank of Brazil Bank of Canada Office of the Superintendent of Financial Institutions Peoples Bank of China China Banking Regulatory Commission Bank of France Banking Commission Reserve Bank of India Sveriges Riksbank Finansinspecktionen

Indonesia Italy Japan Korea Luxembourg Mexico Netherlands

Bank of Indonesia Bank of Italy Bank of Japan Financial services agency Bank of korea Financial supervisory service Surveillance commission for the financial sector Bank of mexico Comision Nacional Bancaria Y De Valores The Netherlands bank

Russia
Saudi Arabia Singapore South Africa

Central bank of the Russian federation

Saudi Arabian monetary agency Monetary authority of Singapore South African reserve bank

Germany

Deutsche bundesbank German financial supervisory authority(BAFin)

Hong Kong SAR Spain Switzerland Turkey

Hong Kong Monetary Authority Bank of Spain Swiss National Bank Swiss Federal Banking Commission Central Bank of The Republic of Turkey Banking Regulation and Supervision Agency Bank of England Financial Services Authority Board of Governors of the Federal Reserve System Federal Reserve Bank of New York Office of the Comptroller of the Currency Federal Deposit Insurance Corporation Office of Thrift Supervision

United Kingdom United states

The Standards Implementation Group(SIG)

a) Operational Risk Subgroup - addresses issues related to Advanced Measurement Approach for Operational Risk.

b) Task Force on Colleges - develops guidance on the Basel Committee's work on supervisory colleges. c) Task Force on Remuneration - promotes the adoption of sound remuneration practices.

d) Standards Monitoring Procedures Task Force - develops procedures to achieve greater effectiveness and consistency in standards monitoring and implementation.

The Policy Development Group(PDG)

Risk Management and Modeling Group - point of contact with the industry on the latest advances in risk measurement and management. Research Task Force - facilitates economists from member institutions to discuss research on financial stability in consultation with the academic sector. Trading Book Group - reviews how risks in the trading book should be captured by regulatory capital. Working Group on Liquidity - works on global standards for liquidity risk management and regulation.

 Definition of Capital Subgroup - reviews eligible capital instruments. Capital Monitoring Group - co-ordinates the expertise of national supervisor in monitoring capital requirements. Cross-border Bank Resolution Group - compares the national policies, legal frameworks and the allocation of responsibilities for the resolution of banks with significant cross-border operations.

The Accounting Task Force(ATF)

Ensures that accounting and auditing standards help promote sound risk management thereby maintaining the safety and soundness of the banking system. Audit subgroup - explores key audit issues and co-ordinates with other bodies to promote standards

Functions
The Committee provides a forum for regular cooperation on banking supervisory matters. Over recent years, it has developed increasingly into a standard-setting body on all aspects of banking supervision.

Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide.
This committee formulates broad supervisory standards and guidelines, recommends statements of best practice in banking supervision in the expectation that member authorities and other nations' authorities will take steps to implement them by directly committees recommendations or through their own national laws and regulations

 Also its regulations are not compulsory to be followed. It seeks to fulfill its objective in three principal ways: by exchanging information on national supervisory arrangements; by improving the effectiveness of techniques for supervising international banking business and by setting minimum supervisory standards in areas where they are considered desirable.

Basel Accords
The Committee encourages convergence towards common approaches and common standards without attempting detailed management of member countries supervisory techniques. The BCBS proposed three agreements or accords (on the recommendations on banking regulations) BASEL I, BASEL II, BASEL III. The committee normally meets in Basel, Switzerland at the Bank for International Settlements (secretariat).

Basel I
In 1988, The first round i.e. Basel I was created. Also known as 1988 Basel Accord. But was later on adopted by banks of G10 countries by end of 1992. Focused on credit risk. They were subsequently amended in 1996 (effective January 1, 1998) to accommodate market risk alongside credit risk.

 Assets of banks were classified and grouped in five categories according to how risky they are.

The five categories are risk weights of 0%, 10%, 20%, 50% and upto 100%.

 All banks with international transactions are required to hold capital upto 8% under the risk weights. This framework has been progressively introduced in member countries of G-10. Most other countries over 100, have also adopted the principles prescribed under Basel I. The efficiency with which they are enforced varies, even within nations of the Group of Ten.

Basel II
Basel II is the second of the Basel Accords which are recommendations on banking laws and regulations issued by the BCBS. Initially published in June 2004, was planned to create an international standard for banking regulators to control how much capital banks need to put aside to guard against the types of financial and operational risks banks face. Advocates of Basel II believed that such an international standard could help protect the international financial system from the types of problems that might arise when a major bank or a series of banks collapse.

 This was achieved by setting up risk and capital management requirements designed to ensure that a bank has adequate capital for the risk the bank exposes itself to through its lending and investment practices. i.e. 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.

Basel II was not successfully implemented because of global financial crisis that hit during 2008.

 Basel II requires to hold 2% of common equity of risk weighted assets Basel II uses a three Pillars concept Minimum capital requirements (addressing risk)[Pillar i] Supervisory review [Pillar ii] Market discipline [Pillar iii]

Pillar i
Deals with maintenance of minimum capital which is calculated for three major components of risk that a bank faces: credit risk, operational risk, and market risk. Banks can choose from
Operational risk Basic Indicator Approach (BIA) Standardized approach(STA) Advanced Measurement Approach

Credit risk Standardized approach Foundation Internal Rating Based Approach(IRBA) Advanced IRBA

Market risk VaR (Value at Risk) approach

 Credit risk is an investors risk of loss arising from a borrower who does not make payments as promised (also called as default risk or counterparty risk).

Operational risk arises from execution of companys business operations or functions, focuses on risk arising from the people, systems and process through which a company operates. Included risks such as fraud risks, legal risk, physical or environmental risk, etc.
Market risk means the value of a portfolio (either an investment portfolio or trading portfolio) will decrease due to change in value of market risk factors, the four standard market risk factors are: stock prices, interest rates, forex rates and commodity prices.

 Standardized approach: In this credit assessments was done external agency for less sophisticated banks, more sophisticated banks used internal rating based approach (IRB),
In IRB, banks were generally encouraged to improve their internal risk management process.

Overall the credit risk = Exposure at default X Probability of default X Loss given at default.

where; Probability of default

Exposure at default
Loss given default

Likelihood that customers will default in the next 12 months. Expected amount of exposure at the point of default. Likely financial loss associated with the default.

Banks can use their internal estimates of borrower credit worthiness to assess credit risk.

Pillar ii
Deals with supervisory review: where early supervision is encouraged by giving them tools to measure risks of banks. Supervisors should review & evaluate banks assessments and strategies for calculating capital requirements. Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold more than the required capital level and are expected to intervene when capital falls below the required levels. This pillar also involves a set of principles to promote cooperation and information exchange among supervisors or regulators.

Pillar iii
This Pillar complements the minimum capital requirements (Pillar i) and supervisory review process (Pillar ii) by developing a transparency which will allow the market participants to determine the capital adequacy of an institution. The aim of Pillar iii is to allow market discipline to operate by requiring institutions to disclose details on the scope of application, capital, risk exposures, risk assessment processes and the capital adequacy of the institution. It must be consistent with how the senior management including the board assess and manage the risks of the institution.

 When market participants have a sufficient understanding of a banks activities and the controls it has in place to manage its exposures, they are better able to distinguish between banking organizations so that they can reward those that manage their risks carefully and penalise those that do not. Banks are forced to make disclosures twice a year about capital structure, risk exposures and capital adequacy except qualitative disclosures providing a summary of the general risk management objectives and policies which can be made annually.

Institutions are also required to create a formal policy on what will be disclosed, controls around them along with the legalization and frequency of these disclosures.

Basel III
It was developed in response to the deficiencies in financial regulation during late 2000s financial crises. Implementation expected by the end of 2012. Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage. When using Basel II, where mortgage-backed securities, credit default swaps and other instruments had AAA ratings which were not properly supervised or regulated by official agencies which proved to be bad credit risks. Basel III will require banks to hold 4.5% of common equity of risk weighted assets.

Also introduces additional capital buffer . Mandatory capital conversion buffers of 2.5%. Discretionary countercyclical buffer, allowing national regulators to require up to range of 0% to 2.5% of capital during periods of high credit growth.

It also introduces minimum 3% leverage ratio and two required liquidity ratios.
The Liquidity Coverage Ratio requires a bank to hold sufficient highquality liquid assets to cover its total net cash flows over 30 days. The Net Stable Funding Ratio requires the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.

International Banking Regulation and India

Indian banking has continually upgraded from the system of on-site Annual Appraisal of the banks by the RBI followed in the 1970s

to the system of Annual Financial Review during the 1980s,

then on to the Annual Financial Inspection of stand-alone banks during the 1990s and further on to the consolidated supervision of financial conglomerates so as to address the supervisory concerns on a group-wide basis.

 The Off-site Monitoring & Surveillance (OSMOS) of the banking system was also introduced in 1995 as a part of the supervisory strategy of ongoing supervision of the banks, so as to supplement the periodical full-scope onsite bank examinations.

The supervisory rating models CAMELS {i.e. Capital adequacy, Asset quality, Management, Earnings, Liquidity & System and control} based on crucial prudential parameters, were also developed by the RBI to provide a summary view of the overall health of the banks.

 The Prompt Corrective Action (PCA) Framework was put in place to enable timely intervention in case of any incipient stress in a bank.

The RBI has introduced risk-based supervision of the banks so as to move away from transaction audit and to enable the modulation of the supervisory efforts in tune with the risk profile of the banks and to achieve optimal deployment of the scarce supervisory resources.

 Also, the Board for Financial Supervision, constituted in 1994 under the Chairmanship of the Governor, RBI led the transformation in the regulatory and supervisory apparatus of the banking system.

Limit on Inter-bank Exposures to reduce the ill-effects of inter-bank exposures, in March 2007,RBI limited a banks inter-bank liabilities (IBL) to twice its net worth.

A higher IBL limit up to 300 per cent of the net worth was allowed for banks whose CRAR was at least 25 % more than the minimum CRAR (nine per cent) i.e., 11.25 %.

 Regulation of NBFCs: The systemic significance of non-banking financial institutions and hence, the need for their regulation, wherein the RBI Act was amended to bring the non-banking financial institutions within the regulatory domain of the Reserve Bank. Implementation of Basel II Advanced Approaches: RBI have announced a timetable for the gradual and calibrated adoption of advanced approaches of the Basel II Accord by the banks in India. The challenges include the absence of long-enough history of economic/business cycles. Also, using past data may not be appropriate in cases where the sector has undergone structural transformation.

 Another issue with regard to adoption of the advanced approaches is the possibility that the risk weights assigned to employment-intensive retail and SME sectors may increase in certain circumstances, which may obstruct the credit flow to these sectors or make it costlier. Thus there is a need to develop an appropriate risk mitigants for the borrowers of these sectors on the basis of which lower risk weights could be assigned in order to ensure continued flow of credit to them. Credit Rating: There is an urgent need to ensure accuracy and reliability of credit ratings assigned by the rating agencies. The RBI has recently completed a detailed process of review of the accredited credit ratings agencies for their continued accreditation under Basel II.

 RBI is liaisoning with Securities Exchange Board of India (SEBI) with regard to credit ratings agencies adherence to the IOSCO (International Organisation of Securities Commission) Code of Conduct Fundamentals. The issue of strengthening the regulation of credit ratings agencies is under the consideration of the HLCCFM (High Level Co-ordination Committee on Financial and Capital Markets ). Risk Management Capabilities (HR and IT Issues): In the future, banks would need to upgrade their infrastructure, including human resources, to face the growing complexity of risk management. Apart from traditional risks such as credit risk, market risk and operational risk, new genre of risks including reputation risk, liquidity risk, counterparty credit risk, and model risk have emerged on the horizon, management of which obviously requires skills of a higher order. These issues are engaging the attention of the stakeholders of the Indian banking industry.

References'
History of the Basel Committee and its Membership (August 2009) (www.bis.org/bcbs/history.pdf). The Evolution of Banking Regulation in India A Retrospect on Some Aspects (http://rbidocs.rbi.org.in/rdocs/Speeches/PDFs/81434.pdf). INTERNATIONAL BANKING REGULATION, Maximilian J.B. Hall and George G. Kaufman (www.luc.edu/faculty/.../InternationalBankingRegulation7-12-02.doc). Fact sheet - Basel Committee on Banking Supervision. INDIAN PERSPECTIVE ON BANKING REGULATION.pdf, address by Mrs. Usha Thorat, Deputy Governor, Reserve Bank of India, at the International Conference on Financial Sector Regulation and Reforms in Asian Emerging Markets on February 8, 2010. http://www.investopedia.com/