Basel frame work impact on the banks

In addition to the work on capital standards, particular supervisory questions which the Committee has addressed include the supervision of bank’s foreign exchange positions, the management of banks international lending (i.e. country risk ), the management of bank’s off –balance –sheet exposures, the prevention of criminal use of the banking system, the supervision of large exposures, risk management  guidelines for derivatives and the management of interest rate risk . Supervisors may decide to apply a 150% or higher risk weight reflecting the higher risks associated with other assets.  In the case of credit risk, it prescribes differential risk weights within each category of exposure. Credit risk could be reduced by adoption of credit risk mitigation techniques. However introduction of operational risk factor is likely to increase the capital requirement. Improved risk assessment ensures greater discipline and better information for investors in order to comprehend the bank’s risk pastures and act rationally. From 1997 onwards, Basel Committee has  taken initiative to address the rigidities in 1988 Capital Accord by evolving a comprehensive and risk- sensitive  New Basel Capital Accord. The Minimum Capital Requirements are composed of three fundamental elements: a definition of regulatory capital, risk weighted assets and the minimum ratio of capital to risk weighted assets.

 

IMPACT ON THE BANK

At the outset it is clarified that the proposed New Accord is yet in its formative/ evolutionary stage – it has been floated as a Consultative Document and the accord is not yet finalised or even fully crystallised. Many sections/ parts of the proposed Accord have scope for additional inputs/ further refinement. Further, there are also a number of areas where options are to be exercised at the supervisory level. There are also other areas where options could be exercised at individual bank level. This three-fold fluidity at the level of the Committee, the Supervisor and the Bank will render premature, any attempt at this stage to quantify the impact. It may be added that until the Committee views are firmed up, the supervisory (RBI) options can not be delineated; similarly until the supervisory options are exercised, the options available to the Bank can not be examined properly.

AREAS NOT FINALISED BY THE COMMITTEE:-    

    It is still exploring the possibility of using the country risk rating assigned to sovereigns by Export Credit Agencies(ECAs) as against using the ratings of  External Credit Assessment Institutions(ECAIs)
    The risk weights for retail portfolio have not yet been finalised.

    The proposals on the IRB approach for retail, project finance and equity exposures are yet be finalised.

    The proposals related to operational risk are still in a formative stage.

AREAS REQUIRING THE EXERCISE OF OPTIONS AT THE SUPERVISORY LEVEL :-

    Recognition of eligible ECAIs (External Credit Assessment Institutions) / ECAs (Export Credit Agencies) and discretion for assigning lower risk weights for specific exposures.

    Normally banks may use only solicited ratings, Supervisors may allow them to use unsolicited ratings.

    Claims on PSEs may be treated as claims on the Sovereigns.

    Risk weight may be increased depending upon the overall default experience of the Supervisor.

    Supervisors may decide to apply a 150% or higher risk weight reflecting the higher risks associated with other assets.

IMPACT ON CAPITAL REQUIREMENT :-

Within the above constraints, we give below our opinion which is limited to the likely direction(increase/ decrease) of change and does not extend to the magnitude thereof.

    The new accord will be extended on a consolidated basis to holding companies of banking groups. Further, individual banks within the group should also be capitalised on a stand-alone basis. Thus we will need to provide for adequate capital at all of our subsidiary companies. This could lead to additional demands on capital requirements, to compensate for deficit capital, if any, in the group.

    In the case of credit risk, it prescribes differential risk weights within each category of exposure. It is difficult to crystallise  the impact as it could move both ways. For instance, under the existing accord, all corporates get risk weighted at 100% whereas under the new accord, some may get a weightage of 20% or 50% while others may get a weightage of 150%.

    Credit risk could be reduced by adoption of credit risk mitigation techniques. It may have an effect of reduced capital requirement.

    In the case of market risks, there is no change from the existing accord. However, as it has not been implemented in India so far, there could be an additional capital requirement when RBI introduces it.

    In the case of operational risks, the consultative document states that the work is still in a developmental stage. While it is expected that the operational risk would constitute approx. 20% of the overall capital requirements under the new framework, the impact can not be assessed till further crystallisation of the committee’s views. However introduction of operational risk factor is likely to increase the capital requirement.
5.    CONCLUSION

In the light of the above, our Bank needs to have a definite agenda encompassing the following: -

    There is an urgent need to realise that adoption of advanced risk management practice is absolutely essential in its own right. New risk management models do have the potential to support rational, efficient, reliable internal control system and choices about risks. Pre-requisite for such applications require advanced IT infrastructure, robust MIS and necessary human expertise.

    Effectiveness of IRB approach and compliance with its spirit will be contingent on efficient internal audit and loan review system.

    While the efficacy of proper risk management will optimise yield on their funds, higher return on funds will facilitate ploughing back of profits into capital. Due to high cost of capital and subdued market sentiments, this is the only way left for banks to raise their capital adequacy.

    Improved risk assessment ensures greater discipline and better information for investors in order to comprehend the bank’s risk pastures and act rationally. It has to be borne in mind that improved market discipline does not necessarily amount to uniformly harsher treatment of banks by the market. On the contrary, it recognises the strengths of banks and weeds out weak links in a transparent manner.    

Calculating operational risk capital charges

OPERATIONAL RISK
Operational risk is defined as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events.

There are three methods for calculating operational risk capital charges –
(I)    The Basic Indicator Approach  (II)  The standardised approach and
(III) The Advanced measurement Approach.

A – The Basic Indicator Approach

Banks have to hold capital for operational risk equal to the fixed percentage (Alpha) of average annual gross income over the previous three years.

        K BIA    =    GI  
Where
K BIA = the capital charge under the Basic Indicator Approach
GI      = average annual gross income over the previous three years.
     =  fixed percentage
B – The Standardised Approach

Bank’s activities are divided into 8 business lines: corporate finance, trading and sales, retail banking, commercial banking, payment and settlement, agency services, asset management and retail brokerage. Within each business line, there is a specified broad indicator that reflects the amount of operational risk. The capital charge for each business line is calculated by multiplying gross income by a factor (denoted beta) assigned to that business line. In case, however, any significant revenue earning activity of a bank cannot be approximately categorised under any of the above lines, then that emerging / new activity may be classified under the one to which the highest beta factor is attached, indicating high risk.

C – The Advanced Measurement Approach

Under the AMA, the regulatory capital requirement will equal the risk

measure generated by the bank’s internal operational risk

measurement system using the quantitative and qualitative criteria subject to supervisory approval.

MARKET RISK (Trading Book Issues)

A trading book consists of positions in financial instruments and commodities held either with trading intent or in order to hedge other elements of the trading book.  Valuation of positions in the trading book include systems and control, valuation methodologies and valuation adjustments.

The Second Pillar – Supervisory Revision Process

It includes principles of supervisory review, supervisory transparency and accountability and risk management guidance with respect to banking risks, including guidance pertaining to the treatment of interest rate risk in the banking book.

The supervision review process is intended not only to ensure that banks have adequate capital to support all the risks in their business, but also to encourage banks to develop and use better risk management techniques in monitoring and managing their risks.
There are three main areas that might be particularly suited to treatment under Pillar 2.

i)    Risks considered under Pillar 1 that are not fully captured by the Pillar 1 process (e.g. the proposed Operational risk in Pillar 1 may not adequately cover all the specific risks of any given institution).

ii)    Those factors not taken into account by the Pillar 1 process e.g. interest rate risk

iii)    Factor external to the bank e.g. business cycle effects.

The Committee has identified four key principles of supervisory review: -

I)    Bank should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.

II)    Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.

III)    Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.

IV)    Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

The Third Pillar – Market Discipline

It contains disclosure recommendations and requirements for banks. Core disclosures are those which convey vital information for all institutions and are important to the basic operation of market discipline.  Supplementary disclosures are important for some, but not all, institutions depending on the nature of their risk exposures, capital adequacy and methods adopted to calculate the capital requirement.

3.    COMMENTS OF RBI

RBI appreciates the Basel Committee’s efforts in evolving the New Accord containing proposals that are comprehensive in coverage.When implemented, they would go a long way in making the capital allocation more risk-sensitive and use of supervisory oversight with market discipline would reinforce the supervisory framework and ensure financial stability.  However, the complexity and sophistication of the proposals restricts its universal application in emerging markets, where the banks continue to be the major segment in financial intermediation and would be facing considerable challenges in adopting all the proposals.

The New Accord would involve shift in direct supervisory focus away to the implementation issues.  Further, banks and the supervisors would be required to invest large resources in upgrading their technology and human resources to meet the minimum standards.  The increasing reliance on external rating agencies in the regulatory process would undermine the initiatives of banks in enhancing their risk management policies and practices and internal control systems.  The minimum standards set are complex and beyond the reach of many banks.

It is therefore essential that the Basel Committee should evolve a simplified standardised approach, which could be adopted uniformly by all banks that are not internationally active.  Further, the transitional arrangement proposed in the New Accord may not be sufficient for their banks.  National supervisors may, therefore, be given discretion to decide on the time frame for implementing the Accord and applying it to various banks in their jurisdiction depending upon the scale and complexity of their operations.

Some of the key responses of the RBI are as under :-

    External rating agencies should not be assigned the direct responsibility for risk rating of banking assets primarily in view of enormous subjective element involved in the rating process and lack of transparency and uniformity in risk assessment.

    As an alternative to external rating, supervisor-validated internal rating systems, developed by credit institutions themselves could be accepted as a standard tool for risk assessment.

    Risk weighting of the banks should be delinked from that of the sovereign in which they are incorporated.

    A range of risk weight baskets could be devised to better reflect the default probabilities of corporates at different rating levels.

    Regarding credit risk models, major hurdles principally concern data availability and model validation. Model based approach could be adopted only when the banks develop sufficient expertise and database to estimate the capital.  (Words used : 1067)

Basel framework on capital adequacy

1.    INTRODUCTION

The Basel Committee 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 first meeting took place in February, 1975 and meetings have been held regularly three or four times a year  since.
The Committee’s  members come from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Sweden, Switzerland , U. K. & U.S.A. The committee does not possess any formal transnational supervisory authority. Rather, it formulates broad supervisory standards &  guidelines  and recommends statements of best practices in the expectation that individual  authorities will take steps to implement those which are best suited to their own national systems.
The Committee reports to the Committee of Central Bank Governors of the group of ten Countries, which meets at the Bank for International Settlements (BIS) and seeks the Governor’s endorsement and commitment for its major initiatives.
The topic to which most of the Committee’s time has been devoted in recent years is capital adequacy. A Capital measurement system was released to the Banks in July 1988. However, it was not intended to be static but to evolve over time. In November 1991, it was amended to give clarification of general provisions  which could be included in capital. In April 1995, it issued an amendment to recognise the effects of bilateral netting of bank’s credit exposure in derivative products. Another
task has been to refine the frame work to address risks other than credit risk, which was the focus of the 1988 accord. In January 1996, the market risks arising from bank’s open positions were incorporated.

In addition to the work on capital standards, particular supervisory questions which the Committee has addressed include the supervision of bank’s foreign exchange positions, the management of banks international lending (i.e. country risk ), the management of bank’s off –balance –sheet exposures, the prevention of criminal use of the banking system, the supervision of large exposures, risk management  guidelines for derivatives and the management of interest rate risk . Other topics currently being addressed include the supervision of financial conglomerates, risk management issues relating to reporting, disclosure and accounting. In 1997, the Committee has also preferred a set of “ Core Principles for Effective Banking Supervision”
The Committee’s Secretariat is provided by the BIS in Basle, where nearly all the committee’s meetings take place. From 1997 onwards, Basel Committee has  taken initiative to address the rigidities in 1988 Capital Accord by evolving a comprehensive and risk- sensitive  New Basel Capital Accord. In June 1999, it issued a paper on New Capital adequacy framework and a second revision in January 2001. The paper is open for discussion and comments till March 2002 and it is expected that the final accord will come into effect by 2005. The new proposals, once finalised, will replace the 1988 capital adequacy framework. The New Accord provides a range of options for providing capital, which would facilitate banks with varying degrees of sophistication to adopt appropriate methods with supervisory validations.

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2.    SALIENT FEATURES OF NEW BASLE CAPITAL ACCORD

Due to the rapid transformation of the financial market since the 1988 accord, a situation has arisen where regulatory capital alone may not be a good indicator of the financial condition of banks. It is therefore essential that the capital, which supervisors mandate the institutions to hold, should be adequate to cover the risks to which the institutions are exposed. The new framework is based on three pillars. The three pillar approach will suitably enhance the role of supervisors on the one hand and the ‘market’ on the other, in ensuring that the regulated entities maintain adequate capital at all times with reference to their risk profile. 

The First Pillar – Minimum Capital Requirements

The Minimum Capital Requirements are composed of three fundamental elements: a definition of regulatory capital, risk weighted assets and the minimum ratio of capital to risk weighted assets. While the definition of regulatory capital remains unchanged, there are considerable refinements in the risk weights as also in the calculation of the ratio.
Under the new accord, the denominator of the minimum capital ratio will consist of three parts: the sum of all risk weighted assets for credit risk, plus 12.5 times( reciprocal of 8% minimum risk-based capital ratio) the sum of the capital charges for market risk and the operational risk. The multiplicatory factor of 12.5 has been introduced in order to enable banks to create a numerical link between the calculation of capital requirement for credit risk, where the capital is based on the risk weighted assets and the capital requirement for operational and market risks, where instead capital charge itself is calculated directly.
Regulatory Capital
------------------------                     = Desired Capital Ratio
Risk weighted        12.5(Market + Operational)
Asset for Credit        Risk        Risk
Risk
The regulatory requirements cover three types of risks, viz, credit, market and operational risk. To improve risk sensitivity, the committee is proposing a range of options for addressing credit and operational risks. The committee has decided to treat interest rate risk in the banking book under Pillar II.

Credit Risk

The Committee proposes to permit banks a choice between measuring credit risk in a standardised  manner or use their internal rating systems.

A – The Standardised Approach

The Committee has modified the treatment of banks’ exposures to Sovereigns, Banks and Corporate by providing more than one risk bucket under each category of exposure. For example, for corporate lending, the existing Accord provides only one risk bucket of 100% but the New Accord will provide four categories ( 20%, 50%, 100% & 150%).
In determining risk weights, banks may use assessment by External Credit Assessment Institutions(ECAIs)/ Export Credit Agencies(ECAs) recognised by the national supervisor. The committee is examining the capital treatment of credit risk mitigation techniques e.g. collateral, credit derivatives or netting agreements.

B – The Internal Rating Based Approach

Bank would be required to categorise assets in the six broad classes – Corporate, banks, sovereigns, retail, project finance and equity.  Further, on the basis of a specified and distinct  set of rating criteria, loans would have 6-9 borrower grades.  The bank’s assessment of capital adequacy would be linked with the internal ratings.