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BASEL II Accord Introduction Amidst globalization, Banking System in India has attained vital importance. Day by day there has been increasing banking complexities in banking transactions, capital requirements, liquidity, credit and risks associated with them. The World Trade Organisation (WTO), of which India is a member nation, required the countries like India to get their banking systems at par with the global standards in terms of financial health, safety and transparency, by implementing the Basel II Norms. BASEL Committee: The Basel Committee on Banking Supervision provides a forum for regular co-operation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. It seeks to do so by exchanging information on national supervisory issues, approaches and techniques, with a view to promoting common understanding. The Committee's Secretariat is located at the Bank for International Settlements (BIS) in Basel, Switzerland. Why Basel II? The main incentives for adoption of Basel II are - it is more risk sensitive; it recognizes developments in risk measurement and risk management techniques employed in the banking sector and accommodates them within the framework; it aligns regulatory capital closer to economic capital. These elements of Basel II take the regulatory framework closer to the business models employed in banks. Further, the Basel I framework can be seen as a "one size fits all" model which measures risk broadly and it is necessary for the regulator to discriminate among banks on the basis of their risk profiles. Need for such norms The first accord by the name ―Basel Accord I‖ was established in 1988 and was implemented by 1992. It was the very first attempt to introduce the concept of minimum standards of capital adequacy. Then the second accord by the name ―Basel Accord II‖ was established in 1999 with a final directive in 2003 for implementation by 2006 as ―Basel II Norms‖. Basel III is still in the evolution stage and is expected to be implemented gradually. Features of BASEL II Norms: Basel II Norms are considered as the reformed & refined form of Basel I Accord. The Basel II Norms primarily stress on 3 factors, viz. Capital Adequacy, Supervisory Review and Market discipline. The Basel Committee calls these factors as the Three Pillars to manage risks. Pillar I: Capital Adequacy Requirements Under the Basel II Norms, banks should maintain a minimum capital adequacy requirement of 8% of risk assets. For India, the Reserve Bank of India has mandated maintaining of 9% minimum capital adequacy requirement. This requirement is popularly called as Capital Adequacy Ratio (CAR) or Capital to Risk Weighted Assets Ratio (CRAR). Bank capital plays a very important role in the safety and soundness of individual banks and the banking system. Basel committee for bank supervision (BCBS) has prescribed a set of norms for the capital requirement of banks in 1988 known as Basel Accord I. These norms ensure that capital should be adequate to absorb unexpected losses or risks involved. All the countries establish their own guidelines for risk based capital norms known as Capital adequacy norms. The focus of Capital adequacy ratio under Basel I norms was on credit risk and was calculated as follows: Capital adequacy ratio = Tier I capital + Tier II capital / Risk weighted assets* *Risk weighted assets - Fund Based: Risk weighted assets mean fund based assets such as cash, loans, investments and other assets. Degrees of credit risk expressed as % / weights have been assigned by RBI to each such assets. Non-fund (Off-balance sheet) Items: The credit risk exposure attached to off-balance sheet items has to be first calculated by multiplying the face amount of each of the off-balance sheet items by the credit conversion factor. This will then have to be again multiplied by the relevant weightage. The focus of Capital adequacy ratio under Basel II norms is on credit risk/market risk and operational risk and is calculated as follows: Capital adequacy ratio = Total Capital* (Tier I capital + Tier II capital) / market Risk + credit risk + Operation risk *Total capital constitutes of Tier I Capital and Tier II Capital less shareholding in other banks. Tier I Capital = Ordinary capital + Retained earnings & share premium - Intangible assets. Tier II Capital = Undisclosed reserves + General bad debt provision + revaluation reserve + Subordinate debt + Redeemable preference shares Tier I Capital should at no point of time be less than 50.00% of the total capital. This implies that Tier II cannot be more than 50.00% of the total capital. Minimum Requirement of Capital adequacy ratio (CAR): Capital adequacy norm – 8.00% Scheduled commercial banks CAR- 9.00% New private sector banks CAR - 10.00% Banks undertaking insurance business CAR – 10.00% Local area banks CAR =15.00% Pillar I of Basel II norms provide banks with guidelines to measure the various types of risks they face — credit, market and operational risks — and the capital required to cover these risks. Nature of Definition of risk Mitigation of risk risk Credit risk Default by borrower Mitigated by rating process (Internal/External) Market risk Volatility in banks Value at risk (VAR) is used to measure the portfolio due to changes inmarket risk. VAR summarises the likely loss in market factors value of a portfolio over a given time period with specified probability. Operational Risk arising out of banks Various methods are followed to measure and Risk inefficient internal allocate capital for operational risk (Advance processes / systems / measurement approach is most widely used). manpower etc. Pillar II: Supervisory Review Banks majorly encounter three types of risks, viz. Credit risk Operational risk Market risk Basel II Norms under this Pillar wants to ensure that not only banks have adequate capital to support all the risks, but also to encourage them to develop and use better risk management techniques in monitoring and managing their risks. The process has four key principles: a) Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for monitoring their capital levels. b) Supervisors should review and evaluate bank's internal capital adequacy assessment and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. c) 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. d) Supervisors should seek to intervene at an early stage to prevent capital from falling below minimum level and should require rapid remedial action if capital is not mentioned or restored. Pillar III: Market Discipline: Market discipline imposes banks to conduct their banking business in a safe, sound and effective manner. Mandatory disclosure requirements on capital, risk exposure (semiannually or more frequently, if appropriate) are required to be made so that market participants can assess a bank's capital adequacy. Qualitative disclosures such as risk management objectives and policies, definitions etc. may be also published. Conclusion Basel II Norms offers a variety of options in addition to the standard approach to measuring risk. Paves the way for financial institutions to proactively control risk in their own interest and keep capital requirement low. Requires strategizing risk management for the entire enterprise, building huge data warehouses, crunching numbers and performing complex calculations and poses great challenges of compliance for banks and financial institutions. Advantages of BASEL II Basel II norms will facilitate introduction of new complex financial products in Indian Banking Sector Indian banks require a more risk sensitive framework. There is improvement in risk management system by Indian banks New rules will provide a range of options for estimating regulatory capital and will reduce gap between regulatory capital & economic capital. Difference between BASEL I and BASEL II BASEL II takes into consideration Operational risk unlike BASEL I BASEL I used arbitrary risk categories and risk weights whereas BASEL II uses rationalized risk weights and risk categories linked to external rating. BASEL I prescribed Capital requirements for banks only unlike BASEL II which has added 2 more features Supervisory review process and Market discipline. BASEL II and role of auditors Chartered Accountants, contribute to the country’s financial system as bank managers, financial executives, analysts, internal and external auditors, and advisers. Their role in strengthening the internal control and transparency of banking organizations is a major one that RBI, as banking supervisor, is increasingly recognizing in its risk-focused examination policies, capital adequacy approaches, and disclosure initiatives. Currently the auditors of the bank are required to provide a certification on the capital adequacy ratio computation. Implementation of Basel II is not impacting this certification process from an auditor’s perspective, other than the computation mechanism has changed considerably. Hence it is apparent for the auditor, to understand more comprehensively the approach and mechanism adopted by the bank, and accordingly certify the computation. Chartered Accountants can provide a substantial role in ensuring compliance with the Basel II norms. The role would be primarily restricted to the Pillar I and would mainly involve: • Feasibility study and benchmarks as to the best approach to be adopted by the banks in order to monitor the Credit Risk, Operational Risk and Market Risk. • Validation of benchmarks adopted by the management and interpretation of benchmarks and stratification of major issues in the light of the industry knowledge and regulatory insight (e.g., issues expected to be subject to heavier regulatory scrutiny). • Diagnostic/gap analysis prior to implementation of Basel II. • Periodic checks to ensure that the bank is on track. • System Review for Market Risk Management. Some of the banks would prefer to avail services of Chartered Accountants as their external auditors to review the quality of internal controls and systems, and assess the scope and adequacy of internal audit function. Role of branch auditors The statutory central auditors should primarily look into the capital adequacy computation as part of their attest function. As per requirements set by the RBI, the statutory central auditors are required to certify the capital adequacy computation. The underlying requirements from the auditor’s perspective have not changed. It is only the computation methodology that has changed due to the change in parameters as defined in Basel II. Having said, Basel II is not only about capital adequacy but is all about creating a robust risk management structure. In case of credit risk management the underlying computation for Basel II is based on credit ratings, which primarily is driven centrally and passed onto branches such that branches follow head office instructions in its entirety. This way the bank branch auditors check only the computation process and test check the source rather than getting into the credit rating process. Similarly, for operational risk computation the simplified approach currently approved by the RBI requires computation based on gross revenues of the bank as a whole and not dependent on branch revenues. The branch auditors can assess any issues relating to completeness and correctness of the data, which is used to compute the underlying risks emanating from credit, market and operational risk. It is finally the pyramid approach whereby all the data from branches will get consolidated at head office. The statutory central auditors may choose to test check certain source data and also verify the basis considered at the head office. The statutory central auditors may review the work done by internal auditors, as may be stipulated by the management or the regulators. The Basel Accord does provide specific areas where internal auditors play a role.
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