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					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 Banking license was withdrawn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 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.
                   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.
                Capital Adequacy
•   Tier I Capital:                • Tier-II Capital:
•   Paid-up Share Capital          • Undisclosed
•       (Common Stock)               Reserves
•   Disclosed Free Reserves
                                   • Assets Revaluation
•   Statutory Reserve                Reserves
•   Capital Reserves
    representing surplus           • Hybrid Capital
    arising out of sale proceeds     Instruments
    of Assets                      • General Provisions
                                     & Loss Reserves
                                   • Subordinated Debt
           Capital Adequacy
• Tier I Capital:          • Tier II Capital:
• Deductions-              • Discounts:
• Equity Investment in     • Revaluation Reserves
                             with 55% discount
  Subsidiaries
                             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 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. .
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%.
            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%
          Computation of Risk
           Weighted Assets
S.        Details of Assets      Book    Risk Weight   Risk weighted
No.                              Value       (%)          Assets
 1    Cash & balances with RBI   200         0              0
 2         Bank balances         200         20             40
 3         Investments:
           Government            300         0              0
              Banks               0          20             0
              Others             200        100            200
 4         Advances (net)        2000       100            2000

 5         Other Assets          300        100            300
 6          Total Assets         3200
 7          Total RWAs                                     2540
         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 -
  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%
                       Basel II
• 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
           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
     standardized/Internal     2.   Ensure soundness &       disclosures
     ratings based                  integrity of banks‟      2.Core disclosures &
     approach –                     internal process to      supplementary
     Foundation/Advanced            assess the adequacy      disclosures
2.   Capital for mkt.risk –         of capital               3.Period – semi
     Standardized method –     3.   Ensure maintenance       annual.
     maturity / duration            of minimum capital
     method.                        with PCA for short
3.   Capitla for Opr.risk –         fall.
     basic                     4.   Prescribe differential
     indicator/standardized/        capital , where
     advanced                       necessary i.e. where
     measurement                    internal process is
     approach.                      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              =9% in India
              +
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”

				
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