DissertationProject On

SubmittedinpartialfulfilmentfortheawardofthedegreeofMasterof BusinessAdministration(M.B.A)Finance20072009

Under the guidance of:

Dr. Shashi Srivastava, Lecturer, Faculty of Management Studies, Banaras Hindu University

VARANASI-221005 INDIA

Submitted by:
Nidhi Suhasaria M.B.A. (2007-09) Enrollment No. 281690 Exam Roll No. - 07M01015

FACULTY OF MANAGEMENT STUDIES BANARAS HINDU UNIVERSITY

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 Declaration
I, Nidhi Suhasaria, hereby declare that this dissertation and the work described in it is my own work, and are carried out in accordance with the regulations of the Banaras Hindu University. The work is original except, where indicated by special references and citations in the text and no part of the dissertation has been submitted for any other degree.

(Nidhi Suhasaria)

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Acknowledgement
I would like to take this opportunity to thank all the people who contributed to the successful completion of my dissertation. First of all, I extend my heartfelt gratitude for our honourable Dean Sir, Prof. Deepak Burman for providing an opportunity to undertake this project. I am also thankful to Prof. A.K. Agarwal, Faculty of Management Studies, BHU, for his permission to undertake this dissertation work. I would like to show my indebtness towards my supervisor, Dr. Shashi Srivastava, for her constant guidance and encouragement right from the beginning. Her advice, inspirations, enthusiasm and suggestions have been invaluable in shaping this dissertation and in providing me with all the support required in completing this task. I owe my special thanks to the librarians of Faculty of Management Studies, BHU for constantly extending their help in successful completion of the project. I would also be grateful for the tremendous support and love of my parents and other family members for their love, blessings and encouragement to successfully complete this work. Last but not the least, my great appreciation goes to all the participants for their valuable time for filling the questionnaires, and their coordination and co-operation in the research part of this project.

(Nidhi Suhasaria)

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Tableofcontents
Particulars
Executive summary Dissertation outline Chapter1: Introduction 1.1: Basel Committee 1.2: Introduction to Basel I 1.3: Introduction to Basel II 1.4: Overview of Indian Banking sector 1.5: Indias journey with Basel norms Chapter 2: Literature Review 2.1: FICCI 2.2: CRISIL and IBA 2.3: FITCH Chapter 3: Research Methodology 3.1: Research objectives 3.2: Scope of study 3.3: Research plan 3.3: Research design 3.4: Data collection design 3.5: Sample design 3.6: Data analysis 3.6: Research limitation Chapter 4: Comparative study of Basel I and Basel II 4.1: Similarities 4.2: Differences Chapter 5:Analysis-Impact study of Basel II- Qualitative and Quantitative 5.1: Analysis of primary data 5.2: Analysis of impact on Indian banks- secondary data 5.3: Further analysis of CRAR 5.4: Hypothetical study on credit risk 5.5: Study of operational risk 5.3: Analysis of Challenges imposed on Indian banks Chapter 6: Findings and Interpretations 6.1. Primary data findings 6.2. Secondary data findings Chapter 7: Suggestions Chapter 8: Conclusions Chapter 9: References Chapter 10: Annexure

Page number
5 7 8 10 12 18 31 34 49 50 52 52 56 57 57 57 58 58 59 60 61 62 63 63 66 67 78 94 98 100 102 108 109 109 111 114 117 120
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Executivesummary
The BASEL II accord from the Bank of International Settlements attempts to put in place sound frameworks of measuring and quantifying the risks associated with banking operations. This paper seeks to showcase the comparative analysis of both the accords and the changes that will emerge as a result of Indian banks adopting the Basel norms. India implemented the Basel II norms from March 2008. It is thus worthwhile to take a look at the current scenario and examine the challenges and long term implications of moving towards the new regime. This research elaborates Indias journey with Basel norms and discusses several related issues and challenges. In doing so it provides an interesting account of Indias experience with Basel I and a perspective to the several issues in relation to Basel II. In this paper I present an analytical review of the capital adequacy regime and the present state of capital to risk-weighted asset ratio (CRAR) of the banking sector in India vis--vis the Basel framework. In the regime of Basel I, Indian banking system performed reasonably well, with an average CRAR of about 12 per cent, which is higher than the internationally accepted level of 8 per cent as well as Indias own minimum regulatory requirement of 9 per cent. With the implementation of the revised capital adequacy norms from March 2008, several issues have emerged. The paper tries to identify limitations, gaps and inadequacies in the Indian banking system which may hamper the realization of the potential benefits of the new regime. Objective of the study: The various objectives areTo have an insight about the Basel Accord: Basel I and Basel II. To comparatively analyse both the Accords. To determine the impact of Basel II on the Indian banking sector. To evaluate the implications of Basel II on Indian banking sector and suggest remedial measures. Scope of study: This dissertation covers research over two periods- Post Basel I and post Basel II period in India. The study has been made around three sectors of banks- Public sector banks, Private sector banks and foreign banks. The specific banks in each category are-

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Public sector banks State bank of India Bank of Baroda Private sector banks ICICI HDFC Foreign banks Barclays bank Citibank Approach: Both primary data and secondary data has been used. Impact: The Risk Management scenario will strengthen owing to the liberalization, regulation and integration with global markets. Management of risks will be carried out proactively and quality of credit will improve, leading to a stronger financial sector.The calculation of risk will be done by sophisticated credit scoring models. The management information systems (MIS) will be put in place and the level of efficiencies will increase more than proportionately. Risk based pricing will be used for all credit facilities extended by banks. The treasury departments of banks are poised to benefit from the BASEL II accord as would be showcased in the paper. The future will see a structural change in the banking sector marked by consolidation and a shake-out within the sector. The smaller banks would not have sufficient resources to withstand the intense competition of the sector. Banks would evolve to be a complete and pure financial services provider, catering to all the financial needs of the economy. Flow of capital will increase and setting up of bases in foreign countries will become common place. Suggestions: Certain suggestions included in the report are as follows. Professional risk management courses can be initiated by the academic councils in order to tap the intellectual capital of the country. The risk weighting system needs to be revised so as to give higher weight to unrated agency as against underrated agency. Such a step will discourage the present attitude of low creditworthy borrowers to remain unrated. The scheme of solicited ratings can be replaced by unsolicited ratings. In order to meet the increased credit requirement by public sector banks, government can consider further dilution of its stake to 33%. Centarlised ratings based approach can be employed for uniform ratings.

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Dissertationoutline
This section is a synopsis to provide the reader with a brief understanding of how the entire research is structured, the various chapters incorporated in this study, the content of these chapters and their contribution towards the research objective. 1. Chapter 1 provides a brief review of the Basel committee, Basel I and Basel II. Emergence, structure, objectives and evaluation of both the accords is done at length. It discusses the structure of Indian banking sector to understand the initiatives taken in India to implement both the Basel accords. This chapter forms the basis for basic understanding of the Basel framework. It forms the basis of the comparative analysis of both the accords and in determining the impact of Basel II on Indian banks. 2. Chapter 2 is on Literature review. It provides a synoptic view of research conducted by various institutional bodies on the above topic. 3. Chapter 3 is on research methodology and includes a description of the approach that has been used in the research work. The research design has been detailed out. It covers the data collection based on the sample size, the primary and the secondary sources used for collecting data. 4. Chapter 4 provides an exhaustive comparative analysis of both the accords. It includes both the similarities and differences between both the Accords- Basel I and Basel II. 5. Chapter 5 states the impact of Basel II on the Indian banking sector. Both qualitative and quantitative approaches used to determine the impacts are covered in this chapter. Analysis of both primary and secondary data is included. This chapter includes all the analytical tools used by the researcher. 6. Chapter 6 consolidates the results of the research. It also includes valuable inferences made by the researcher. 7. Chapter 7 presents the recommendations of the researcher on the impact study of Basel II. 8. Chapter 8 consists of the concluding remarks. 9. The last two chapters outline the valuable readings used by the researcher for the project and also the questionnaire as annexure.

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INTRODUCTION
1.1Introduction. 1.2BaselCommittee. 1.3BaselIAccord. 1.4BaselIIAccord. 1.5Indianbankingsector. 1.6IndiasjourneywithBaselnorms. InitiativeswithBaselInorm. InitiativeswithBaselIInorm.

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Introduction
Banking industry is the backbone of any country's economy; the sounder it is, the better the performance of the financial markets and the economy as a whole. A sound and evolved banking system is a prime requirement to support the hectic and enhanced levels of domestic and international economic activities in the country. Banking industry is susceptible to various types of risks which at times tend to be so severe that they take entire firm down with them. Thus the risk management role of helping identify, evaluate, monitor, manage and control or mitigate these risks has become a crucial role in modern-day banking. The quality of a bank's risk management has become one of the key determinants of a success of a bank. It is the overall capital which makes financial systems stable. In general, expected losses are to be covered by earnings and provision and unexpected losses have to be met by capital. Financial regulators therefore impose a capital adequacy norm on their banking and financial systems in order to provide for a buffer to absorb unforeseen losses due to risky investments. Capital adequacy standards form an integral part of prudential banking sector regulation and an indicator of the financial health of the banking system. It is measured by the Capital to Risk-weighted Asset Ratio (CRAR), defined as the ratio of a banks capital to its total risk-weighted assets A well adhered to capital adequacy regime does play an important role in minimizing the cascading effects of banking and financial sector crises. Capital standards all over the world are converging at the behest of the Basel Committee on Banking Supervision towards the so called Basel II norms. The size of this regulatory capital was determined by Based Accord (Basel I) earlier and now by Basel II Framework. Basel Committee on Banking Supervision (BCBS) is responsible to frame these rules. Evolution of Basel Committee Initiatives:

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Baselcommittee
The Basel Committee on Banking Supervision is an institution created by the central bank Governors of the Group of Ten nations. It was created in 1974 after the messy 1974 liquidation of the Cologne-based Bank Herstatt, and meets regularly four times a year. Its membership is composed of senior representatives of bank supervisory authorities and central banks from the G-10 countries (Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States), and representatives from Luxembourg and Spain. The Committee usually meets at the Bank for International Settlements (BIS) in Basel, Switzerland, where its 12 member permanent Secretariat is located. The Committee is often referred to as the BIS Committee after its meeting location. However, the BIS and the Basel Committee remain two distinct entities. The Bank for International Settlements (BIS) is an international organization which fosters international monetary and financial cooperation and serves as a bank for central banks. It was originally formed by the Hague Agreements of 20 January, 1930, to administer the transaction of monies according to the Treaty of Versailles. It sponsors the Basel Committee. The BIS is located in Basel, Switzerland, and has representative offices in Mexico City and Hong Kong. Member banks include the Bank of Canada, the Federal Reserve Bank and the European Central Bank. The present Chairman of the Committee is Nout Wellink, President of the Netherlands Bank, who succeeded Jaime Caruana of the Bank of Spain on 1 July 2006. Stefan Walter is the Secretary General of the Basel Committee. The Basel Committee is guided by two overarching principles: no banking system should operate unsupervised, and supervision of banks must be adequate. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. Its focus is on initiatives designed to: a) Define roles of regulators in cross-jurisdictional situations; b) Ensure that international banks or bank holding companies do not escape comprehensive supervision by a home regulatory authority; c) Promote uniform capital requirements so banks from different countries may compete with one another on a level playing field. The Basel Committee formulates broad supervisory standards and guidelines and recommends statements of best practice in banking supervision in the expectation that member authorities and

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other nations' authorities will take steps to implement them through their own national systems, whether in statutory form or otherwise. Organisation of the committee: The Committee's work is organised under four main sub-committees:

Baselcommitteeon BankingSupervision Chair:NoutWellink International Liasion Group Chair: Giovanni Carosio

Accord Implementation Group Chair:Jose MariaRoldan

Policy Development Group Chair:Stefan Walter

Accounting TaskForce Chair:Sylvie Matherat

Figure: Organisation Chart of Basel committee

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BaselIAccord
During the 1970s and 80s, some international banks were able to skirt regulatory authorities by exploiting the inherent geographical limits of national banking legislation. Moreover, internationally active banks also encouraged a regulatory race to the bottom, where they would relocate to countries with less strict regulations. Thus the Basel committee after six years of deliberation in July 1988 came to a final agreement: The International Convergence of Capital Measurements and Capital Standards, known informally as Basel I. Basel I is a framework for calculating Capital to Risk weighted Asset Ratio (CRAR). Scope: 1. Basel I mainly meant to harmonise the regulatory and capital adequacy standards of developed countries. Since Basel I gives considerable regulatory leeway to state central banks, views domestic currency and debt as the most reliable and favorable financial instruments, sees FDIC-style depositor insurance as risk-abating, and uses a maximum level of risk to calculate its capital requirements that is only appropriate for developed economies, its implementation could create a false sense of security within an emerging economys financial sector while creating new, less obvious risks for its banks. 2. It only concentrates on credit risk. 3. It only proposes minimum capital requirements for internationally active banks. Objectives: The Basel Capital Accord of 1988 (Basel I) had as its major objectives the strengthening of the international banking system, by promoting convergence of national capital standards, with a view to ironing out competitive inequalities among banks across countries. Basel I was formed to serve the following purpose: 1. 2. 3. 4. Make regulatory capital more sensitive to risk. Factor off-balance sheet exposures into the assessment of capital adequacy. Minimize disincentives to holding liquid, low-risk assets. Achieve greater international consistency in evaluating capital adequacy.

Structure: The Basel I Accord divides itself into four pillars. 1. Pillar 1- The Constituents of Capital: It defines what types of on-hand capital are counted as a banks reserves and how much of each type of reserve capital a bank can hold. Capital reserve is divided into two tiers. Tier 1 Capital consist of only two types of fundsdisclosed cash reserves and other capital paid for by the sale of bank equity, i.e. stock and preferred
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shares. Tier 2 Capital includes reserves created to cover potential loan losses, holdings of subordinated debt, hybrid debt/equity instrument holdings, and potential gains from the sale of assets purchased through the sale of bank stock. To follow the Basel Accord, banks must hold the same quantity (in dollar terms) of Tier 1 and Tier 2 capital. 2. Pillar 2- Risk weighting: It creates a comprehensive system to risk weight a banks assets by categorizing them into five risk categories. The categories are as follows: Category Riskless Weight 0% Class of assets Cash held by bank, Sovereign debt in domestic currency, all OECD debt and claims on OECD central government. Multilateral development bank debt, bank debt created by banks incorporated in the OECD, non-OECD bank debt with a maturity of less than one year, cash items in collection, and loans guaranteed by OECD public sector entities. Residential mortgages A banks claims on the private sector, non-OECD bank debt with a maturity of more than one year, claims on non-OECD dollar-denominated debt or Eurobonds, equity assets held by the bank, and all other assets. Variable 0%,10%, Claims on domestic public sector entities. 20%,50%

Low Risk

20%

Moderate Risk High Risk

50% 100%

3. Pillar 3- A Target Standard Ratio: It unites the first and second pillars of the Basel I Accord. It sets a universal standard whereby 8% of a banks risk-weighted assets must be covered by Tier 1 and Tier 2 capital reserves. Moreover, Tier 1 capital must cover 4% of a banks risk-weighted assets. This ratio is seen as minimally adequate to protect against credit risk in deposit insurance-backed international banks in all Basel Committee member states. 4. Pillar 4- Transitional and Implementing Agreements: It sets the stage for the implementation of the Basel Accords. Each countrys central bank has to create strong surveillance and enforcement mechanisms to ensure the Basel Accords are followed, and transition weights are given so that Basel Committee banks can adapt over a four-year period to the standards of the accord.

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Introduction of Market risk amendment: In 1996, an amendment was made to Basel I to incorporate market risk, in addition to credit risk, in the calculation of CRAR. It went into effect in 1998. To measure market risk, banks were given the choice of two options: 1. A standardized approach using a building block methodology 2. An in-house approach allowing banks to develop their own proprietary models to calculate capital charge for market risk by using the notion of Value-at-Risk (VaR). Tier III capital was introduced in the capital structure of the bank, which was characterized by subordinate debt as in Tier II capital, except for original maturity of at least 2 years, lock in clause, limitation of Tier III capital to 250% of Tier I capital and substitution of unused Tier I for Tier III up to 250% limit. Market risk capital requirements were set equal to the greater of: The previous days VaR, or The average VaR over the previous sixty business days, multiplied by a factor of at least 3. These approaches, however, calculated the capital charges for market risk and not the riskweighted asset. Therefore, this measure of capital charges would have to be multiplied by a factor 12.5 (reciprocal of 8 per cent, the minimum regulatory capital adequacy ratio) and then added to the risk-weighted assets computed for credit risk. In the calculation of CRAR, the numerator will be the sum of the banks tier I and tier II capital (tier II capital should be limited to a maximum of 100 per cent of tier I capital), plus a tier III capital (which comprised of short term sub ordinate debt) introduced in the 1996 amendment to support market risk. In short, the proposed amendment required that banks hold capital such that:

Implementation: With the exception of Japan (which, due to the severity of its banking crisis in the late 1980s, could not immediately adopt Basel Is recommendations), all Basel Committee members implemented Basel Is recommendationsincluding the 8% capital adequacy targetby the end of 1992. Japan later harmonized its policies with those if Basel I in 1996.

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Though it was mainly meant for developed countries, its simplicity encouraged over 100 countries across the world to not only adopt the Basel I framework but also apply it across the entire banking segment without restricting it to the internationally active banks. The reasons for the unquestioned acceptance of the Basel I norms by advanced as well as less developed countries, lay largely in the fact that it arrived on the scene precisely when most countries were seriously contemplating comprehensive financial sector reforms. In India too, the Narasimham Committee Reports I and II saw in the Accord a convenient peg, whereby to hang the entire agenda for the envisaged reforms in the banking sector. The Accord has been successful in achieving 2 principal aims: firstly, it ensured an adequate level of capital and at the same time stabilized the international banking system. Secondly, it created a level playing field in competitive terms for international bank Strengths The various advantages of Basel I was as follows: 1. Relatively simple structure 2. Comparability of banks capital positions across countries 3. Risk based capital: Regulatory capital ratios was adjusted by banks based on the RiskBased Capital (RBC) framework, which was designed not only for items on balance sheet but also for items off balance sheet, such as letter of credits and derivatives. Development of sophisticated mathematical simulation methods in order to determine potential future exposure of off-balance-sheet instruments. 4. Substantially increased the capital ratios of internationally active banks: RBC disciplined banks to continuously revise their capital ratios 1 in order to keep pace with the market environment changes. It required banks to hold capital requirements above minimum levels, in order to create a cushion against insolvency. 5. Competitive equity: An important feature of Basel I made it mandatory for banks to hold higher percentages of equity capital per loan than per government security. As loans are riskier than securities, these new capital regulations are thought to have improved the link between bank risk and bank capital. As the equity capital is considered to be more costly than deposits, it made lending relatively more expensive than purchasing securities, which provided an incentive for banks to shift their portfolios away from loans.

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Criticism The inherent weakness of Basel I was: 1. Broad-brush risk weighting structure: The risk weighting structure was not aligned with actual risks faced by banking organizations. There was no discrimination between different levels of risk. Due to this banks added more risk on their loan books through- securitization (cherry picking method) and through swapping of long term non OECD bank debt with short run non OECD bank debt. This created opportunities for regulatory capital arbitrage (retaining risky assets, removing lower risk assets). Banks were able to lower their risk-based capital requirements significantly without actually reducing the material credit risk embedded in their banking portfolios. 2. Perceived omissions: Because Basel I covers only credit and market risk and only targets G10 countries, Basel I is seen as too narrow in its scope to ensure adequate financial stability in the international financial system. Also, Basel Is omission of market discipline is seen to limit the accords ability to influence countries and banks to follow its guidelines. It failed to recognise other risks such as operational risk by focusing strictly on financial risk. 3. The way in which Basel I was publicized and implemented by banking authorities: The inability of G-10 authorities to translate Basel Is recommendations properly into laymans terms and the strong desire to enact its terms quickly caused regulators to over-generalize and oversell the terms of Basel I to the G-10s public. This, in turn, created the misguided view that Basel I was the primary and last accord a country needed to implement to achieve banking sector stability. 4. Application to emerging markets: Although Basel I was never intended to be implemented in emerging market economies, its application to these economies under the pressure of the international business and policy communities created foreseen and unforeseen distortions within the banking sectors of industrializing economies. Firstly, in countries subject to high currency fluctuation and sovereign default risks, the Basel I accords actually made loan books riskier by encouraging the movement of both bank and sovereign debt holdings from OECD sources to higher-yielding domestic sources. Next, FDIC-style deposit insurance, combined with lax regulation on what assets fall under Basel Is risk weightings, caused emerging market regulators to underestimate the credit default risks of a banks assets. Again because emerging market sovereign debt is seen as less risky than private debt, Basel I had created a scenario where the private sector is squeezed out of many banks emerging market lending portfolios. Finally, the lack of deep and liquid capital markets in emerging markets make capital adequacy ratios less reliable in emerging economies. 5. Limited recognition to credit risk mitigation: Even with a growth in credit derivatives as a risk management tool during the past few years, the 1988 Accord does not recognise offsets in the banking book through credit risk mitigation techniques
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6. Lack of risk sensitivity: Under Basel I, capital requirements are only moderately related to a banks risk taking. For example, an on-balance sheet loan generally faces a higher capital requirement that an off-balance sheet exposure to the same borrower. This lack of risk sensitivity under the current Accord creates a problem in economic decision making. It also obstructs effective supervision. Its static approach made it inadaptable to new banking activities and risk management techniques. 7. Its non legal status, the limited geographical coverage, failure to do enough to the level playing field, the risk of contributing to global or regional credit crunches and the danger of bleeding complacency among the regulatory fraternity are other causes of its failure.

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BaselIIaccord
Also known as A Revised Framework on International Convergence of Capital Measurement and Capital Standards, Basel II is the second of the Basel Accords recommended on banking laws and regulations issued by the Basel Committee on Banking Supervision. The Basel Committee first released the proposal to replace the 1988 Accord with a more risk sensitive framework in June 1999, on which more than 200 comments were received. Reflecting on those comments the Committee presented a more concrete proposal in January 2001 seeking more comments from interested parties. The third consultative paper was released in April 2003. Furthermore the Committee conducted three quantitative impact studies to assess the impact of the new proposals. Thereafter, the final version of the New Accord titled the International Convergence of Capital Measurement and Capital Standards: a Revised Framework, more commonly referred to as Basel II was published on June 26, 2004 and was endorsed by the G10 governors + 3 countries, European Union (EU) and in Singapore. Again it underwent two revisions one in September and another in November of 2005before a final agreement was agreed upon in July 2006. Basel-II approach aims to correct most of the deficiencies that Basel-I had suffered from. The new standards are more risk sensitive to business type and assets classes. This approach is multidimensional and focuses on all the operations of the bank. Objectives: The fundamental objective of Basel II approach is to further strengthen the soundness and stability of the international banking system while maintaining sufficient consistency that capital adequacy regulation will not be a significant source of competitive inequality among internationally active banks. Basel II aims to encourage the use of modern risk management techniques; and to encourage banks to ensure that their risk management capabilities are commensurate with the risks of their business. It aims to serve the following purpose: Structure: The structure of Basel II rests on a set of three "mutually reinforcing" pillars, namely, (i) capital requirements, (ii) supervisory review and (iii) market discipline.

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Fi igure: The th hree pillars o Basel II of 1. Mini imum regul latory capit (Pillar 1 This is a revised an extensive framewor for tal 1): nd rk maint taining regu ulatory capit (capital a tal adequacy sta andards), wh here CRAR is calculate by ed incor rporating cre edit, market and operat t tional risks. It also spe . ecifies the m methodology for y assign ning risk we eights on the basis of cre risk and operational risk. e edit Capit Adequacy Ratio signifies the amo tal y ount of regu ulatory capita to be main al ntained by a bank to acc count for va arious risks i inherent in t banking system. Reg the gulatory cap pital is defin as ned the m minimum cap pital banks a required to hold by th regulator, i.e. "The a are he amount of ca apital a ban must ha nk ave". It is th summatio of Tier I and Tier II capital. T basic ca he on The apital requi irement for banks under Basel II is 8 which can be express as: b 8% n sed

Figure Formula fo capital to r weighted assets e: or risk 19|P a g e

The three different types of risk incorporated are: a. Credit risk: The risk that a counterparty will not settle an obligation for full value, either when due or at any time thereafter. b. Operational risk: The risk of loss resulting from inadequate or failed internal processes people and systems or from external events. The major factors for operational risk aremanagement, people, system, technology, transaction, control, loan portfolio, reputation, environmental and legal factors. c. Market risk: The risk of losses in on- and off-balance-sheet positions arising from movements in market prices. Capital charge for market risks include: Capital Charge for interest rate risk. Capital Charge for equity risk. Capital Charge for foreign exchange risk. 2. Supervisory review (Pillar 2): Pillar 2 deals with the regulatory response to the first pillar. It is intended to ensure that banks have adequate capital to support all the risks in their business determined both by pillar 1 and by supervisory evaluation of risks not explicitly captured in pillar 1. It provides a tool to supervisors to keep checks on the adequacy of capitalisation levels of banks and also distinguish among banks on the basis of their risk management systems and profile of capital. It requires the banks to develop an Internal Capital Adequacy Assessment Process (ICAAP) which should encompass their whole risk universe by addressing all those risks which are either not fully captured or not at all captured under the other two Pillars (residual risks: systemic risk, strategic risk, reputation risk, liquidity risk and legal risk) and assign an appropriate amount of capital, internally, for all such risks, commensurate with their risk profile and control environment. Pillar 2 introduces two critical risk management concepts: the use of economic capital, and the enhancement of corporate governance, encapsulated in the following four principles: 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. The key elements of this rigorous process are: Board and senior management attention; Sound capital assessment; Comprehensive assessment of risks; Monitoring and reporting; and Internal control review. Supervisors should review and evaluate banks internal capital adequacy assessment and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. This could be achieved through:
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On-site examinations or inspections; Off-site review; Discussions with bank management; Review of work done by external auditors; and Periodic reporting. 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. 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. 3. Market discipline (Pillar 3): It is intended to complement the first two pillars. This pillar encourages market discipline by developing a set of disclosure requirements on quarterly basis for financial reporting, risk management and its exposure, asset quality, regulatory sanctions, and the like, to ensure that market participants can better understand banks' risk profiles and the adequacy of their capital positions. It would be applicable to all banks using the IRB approach of Basel II. The pillar also indicates the remedial measures that regulators can take to keep a check on erring banks and maintain the integrity of the banking system. Further, it allows banks to maintain confidentiality over certain information, disclosure of which could impact competitiveness or breach legal contracts.

The disclosure recommendations and requirements are as follows:

Capital structure: It includes: a. Amount of Tier 1, Tier 2 and Tier 3 capital if held, b. Accounting policies especially with respect to valuation of assets and liabilities and income recognition, c. Components of capital and terms and main features of capital instruments, d. Reserves set aside for credit and potential losses, e. Conditions that may help in analysing strength of banks capital like maturity level of seniority, step up provisions. Risk exposures: Qualitative and Quantitative information needs to be disclosed in a manner which facilitates objective assessment of the nature and magnitude of the risk exposures run by the bank.

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Capital adequacy: It includes disclosure of risk based capital ratios calculated in accordance with the prescribed methodology and qualitative disclosure about the internal processes used for evaluating capital adequacy. Implementation plans: Implementation of the Basel II Framework continues to move forward around the globe. A significant number of countries and banks already implemented the standardised and foundation approaches as of the beginning of the year 2007. In many other jurisdictions, the necessary infrastructure (legislation, regulation, supervisory guidance, etc) to implement the Framework is either in place or in process, which will allow a growing number of countries to proceed with implementation of Basel IIs advanced approaches in coming years. It was expected that banks and supervisors of G-10 would implement it by beginning 2007, after a transition time of 30 months. A survey by Financial Stability Institute (FSI) of the Bank for International Settlement in 2006 revealed that 95 countries, including India intended to adopt Basel II, in some form or the other, by 2015. (Cornford, 10) Strengths: Basel II provides the methodology for transforming banks into vibrant and stable entities in the globally competitive and dynamic financial markets. The main incentives for adoption of Basel II are1. Greater risk sensitivity: Under Basel II, banks which have larger risk exposures will have to set apart more capital to meet the unexpected losses that go with it. 2. Provides effective assessment methods- It recognizes developments in risk measurement and risk management techniques employed in the banking sector and accommodates them within the framework. It points towards RAPM (Risk Adjusted Performance Management) methodology and RORAC (Return on Risk Adjusted Capital). 3. It more closely aligns economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.

Criticisms: The various criticisms on the adoption of Basel II norms are: 1. Credit risk concerns: Under the standardized approach, un-rated corporate borrowers attract less risk weight (100 per cent) than the lowest rated borrower (150 per cent) giving incentives to high-risk borrowers to remain un-rated. Another argument against Basel II is
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that it does not resort to full credit risk modeling; it fails to take into account portfolio effects of risk mitigation through diversification. A loan portfolio spread between rich countries, emerging economies and developing countries has a lower level of risk than one focused exclusively on just one of these sectors, but Basel II falls short of recognising the diversification benefits of full credit risk models. 2. Pro- cyclicality- In simple terms, pro-cyclicality means that banks governed by Basel II (capital tied to risks) will loosen credit in `good times (when risk perceptions are low) and restrict it when times are bad (when risks rise again). With the addition of internal risk measurements in the calculation of a banks capital reserves, Basel II may cause banks to function in a way that is pro cyclical to the business cycle. Because risk weights are based on expectations of future economic performance, banks will tend to withdraw credit in times before and during a recession and extend additional credit once a recovery is underway. Although this method protects banks against additional economic risk, it is well known in the financial community that economic forecasters tend to exaggerate their predictions during periods of growth and recession alike. Therefore, the expectations-based movement of credit will tend to amplify recessions and perhaps spur inflation during periods of high economic growth. It means that the operation of Basel II will lead to a more pronounced business cycle. 3. Demerits for emerging markets banks: It runs the risk of materially reducing the incentive for larger internationally active banks to expand their operations in emerging market economies. a. Lack of skilled work force: Because of the high technicality in Basel II and the inclusion of internal mechanisms in the measurement of risk, regulators will be forced to hire and hold highly skilled employees through the medium and long term. Many emerging market regulatory agencies lack such skilled professionals and they also do not have the budget to add costly high-skilled workers to their ranks. b. Reduced lending to emerging market banks: This is due to three factors. Firstly, because only larger firms can afford to hire rating agencies to asses their debt, it is likely that many banks in emerging markets will not have their debt rated by Moodys, S&P, or Fitch. Therefore, global banks will be lest apt to loan to emerging market banks because such loans will have to be matched with larger capital reserve requirements than those made to larger, rated banks. Secondly, even if an emerging market bank is able to afford the services of an international rating agency, experience has shown that the uncertainty surrounding differences in accounting practices and banking regulations causes rating agencies to assign unduly unfavorable bond ratings to banks in industrializing states.
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This, along with withdrawal of uniform risk weight of 0% on sovereign claims may result in overall reduction in lending by internationally active banks in developing countries and increase their cost of borrowing. 4. Regulatory arbitrage- Dangers of asymmetry in financial intermediation: A likely scenario, which might arise post-Basel II implementation, is the asymmetry in regulatory regime amongst the competing broad segments of the financial sector viz., banking, securities and insurance sectors. While the commercial banking sector is expected to migrate to the Basel II regimen soon, the other segments are not likely to be subjected to the same or similar discipline unless they are a part of a banking group, where Basel II regime would apply indirectly through the parent bank. The Joint Forum has taken some initiatives in this direction, which may have to be pursued further to achieve parity in the level of regulatory burden across the three sectors, which compete amongst themselves for the business of financial intermediation. Approaches for calculating risks under Pillar 1: 1. Credit risk: The various approaches for credit risk are the Standardized Approach (SA) and the Internal Ratings Based (IRB) approach.

A. Standardised approach : In this approach, the bank allocates a risk weight to each of its assets and off-balance sheet positions on the basis of the credit ratings given by external credit assessment institutions (primarily rating agencies). The capital charge is equal to 8% of the asset value. The different classifications of risk assets under Basel II are sovereigns, corporate, banks, securities firms, multilateral development banks, non-central government public sector enterprises, and retail. The

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responsibility of providing the risk-weights corresponding to various assets lies with the supervisory authority of a country. The risk weighted assets is calculated using the following formula: Risk Weighted Assets (RWA) = Loan Equivalent * Risk Weight Credit risk mitigation: Credit risk mitigants can be used by banks under this approach for capital reduction based on the market risk of the collateral instrument or the threshold external credit rating of recognised guarantors. Basel II Framework allows a wide range of credit risk mitigants to be recognized for calculating regulatory capital and few of these are: Collateralised Transactions On-balance sheet netting - confined to loans / advances and deposits where banks have legally enforceable netting arrangements Guarantees BCBS has provided an example of how risk weights can be linked with the credit ratings. Sovereign claims are discounted according to the credit rating assigned to a sovereigns debt by an authorized rating institution. Claims on non central government public sector entities will be risk weighted at national discretion. For bank debt, authorities can choose between two risk weighting options. In the first option, authorities can risk-weight this type of debt at one step less favorable than the debt of the banks sovereign government. Risk is capped at 100% if the sovereigns rating is below BB+ or unrated. The second option bases the risk weighting on the external credit assessment of the bank itself with claims on unrated banks being weighted at 50%. Under this option, a preferential risk weight that is one category more favourable may be applied to claims with an original maturity of 3 months or less, subject to a floor of 20%. This treatment is available to both rated and unrated banks except to banks risk weighted at 150%. Corporate debt is weighted in the same manner as bank debt, except the 100% category is extended to include all debt that is rated between BBB+ and BB-.

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Option 1 = Risk weights based on risk weight of the country. Option 2a = Risk weight based on assessment of individual bank. Option 2b = Risk weight based on assessment of individual banks with claims of original maturity of less than 6 months. Asset category Retail portfolio (subject to qualifying criteria) Claims secured by residential property Non-performing assets: If specific provision is less than 20% If specific provision is more than 20% 150% 100% Risk weight 75% 35%

Recognition of ECAI: It is the responsibility of the national supervisors to determine whether the external credit assessment institution meets the following criteria- Objectivity, Independence, International access, Disclosure, Resources and Credibility. B. Internal rating Based (IRB) approach: In this approach, a bank uses its internal ratings, subject to supervisory approval, to measure the borrowers creditworthiness and the results obtained are translated into estimates of a potential future loss, which forms the basis of minimum capital requirements. Under this approach, banks will be required to classify banking book exposures into the six broad classes of assets which underlie different credit risk characteristics corporate, bank, sovereign, retail, project finance, and equity. The IRB Approach is based on the measurement of unexpected loss (UL) and expected loss (EL) derived from four key variables:

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Probability of default (PD): This measures the likelihood that the borrower will default over a given time horizon. Loss given default (LGD): This measures the proportion of the exposure that will be lost if a default occurs. Exposure at default (EAD): This measures the amount of the facility that is likely to be drawn in the event of a default and Effective maturity (M): This measures the remaining economic maturity of the exposure. Requirement of minimum capital is defined as the summation of Expected Loss and Unexpected Loss. Here the formulas used are: Loan Equivalent: The value of the loan that has been given to the customer adjusted for certain risk mitigants. Risk weight: Risk Weight (PD, LGD, EAD, M) = 12.5 * EAD * K (PD, LGD, M) K is the Capital per unit of credit exposure and is the product of: K (PD, LGD, M) = Default Risk Capital (PD, LGD) * Maturity Factor (PD, M) The IRB Approach has been further subdivided into Foundation Approach and Advanced Approach. In Foundation Approach, a bank would internally estimate the PD and the regulator would provide the other three variables, whereas in Advanced Approach, the bank would be expected to provide the other three variables as well. The implementation of IRB approach is subject to explicit approval of the regulator who would have the discretion to allow the bank concerned to use its internal credit rating systems for assessing credit risk. Banks would have to satisfy the regulator about the adequacy and robustness of their risk management systems and internal rating process, and of their competency in estimating the key variables. The IRB Approach is more risk sensitive as compared with the Standardised Approach and would benefit banks with improved risk management systems, strengthening their risk assessment processes. By forcing banks to scale up their risk-weighted reserves by 6% if they use the standardized approach, the Basel Committee offers banks the possibility of lower reserve holdingsand thus higher profitabilityif they adopt these internal approaches. C. Securitization framework: Banks must apply the securitization framework for determining regulatory capital requirement on exposure arising from securitization. Banks that apply the standardized approach to credit risk for the underlying exposure must use the standardized approach under the securitization

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framework. Similarly, banks that have received approval to use IRB approach for the type of underlying exposure must use the IRB approach for the securitization. 2. Operational risk: Under Basel II, operational risk can be measured using three methods: Basic Indicator Approach; Standardised Approach; and Advanced Measurement Approach. A. Basic indicator approach: Under this approach, the capital charge for operational risk is linked to a single parameter, that is, the banks gross annual revenue. The capital charge is calculated as an average of the previous three years of a fixed percentage (defined as alpha; set at 15% by the Basel committee) of positive gross annual income, ignoring years in which income was either zero or negative. B. Standardised approach: This approach is a variant of the Basic Indicator Approach. Here, the activities of the bank are divided into eight business lines: namely corporate finance; trading & sales; retail banking; commercial banking; payment and settlement; agency services; asset management and retail brokerage. Within each business lines, a fixed percentage multiplier (specified as beta; varies from 12% for retail brokerage to 18% for corporate finance) is specified by Basel II. As shown in the diagram, less operationally risky business linessuch as retail bankinghave lower reserve targets, while more variable and risky business linessuch as corporate financehave higher targets. The capital charge for each business line is calculated by multiplying the beta for each business line with its annual gross income. The total capital charge for the bank is the three-year average of the summation of the capital charge across each business line. The negative capital charges for a business line can offset a positive capital charge from another business line in a year, but not across years. Business Line Corporate finance Trading and sales Retail banking Commercial banking Payment and Settlement Agency services Asset management Retail brokerage Beta Factor 18% 18% 12% 15% 18% 15% 12% 12%

Source: Basel II Accord, 2006 Revision

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C. Advanced Measurement Approach: Under this approach, the capital charge will be the risk measure generated by the banks internal operational risk measurement system that uses both quantitative and qualitative criteria- internal loss data; external loss data; scenario analysis; business environment & internal control factors. The bank would need to satisfy the regulator, that its Board and senior management has an active oversight on operational risk management framework, the operational risk management systems are sound and is implemented with integrity; and that it has resources in the use of the approach in the major business lines as well as control and audit functions. 3. Market risk: There are two approaches for calculating it: Standard approach and Banks Internal Risk Management Models. In its evaluation of market risk, Basel II makes a clear distinction between fixed income and other products such as equity, commodity, and foreign exchange vehicles and also separates the two principal risks that contribute to overall market risk: interest rate and volatility risk. A. Fixed assets: Value at risk method: Here, banks can develop their own calculations to determine the reserves needed to protect against interest rate and volatility risk for fixed income assets on a position-by-position basis. VaR summarizes the likely loss in value of a portfolio over a given time period with specified probability. Historical simulation, Model building approach, Montey carlo simulation are some of the VaR techniques. Again, regulators must approve of such an action. Non VaR method: Under this method there are two separate risk protection methodologies. For interest rate risk, reserve recommendations are tied to the maturity of the asset. The following table provides an overview of the risk weights assigned to each asset given its maturity. Time to maturity 1 month or Less 6 months or Less 1 year or Less 4 years or Less 8 years or Less 16 years or Less 20 years or Less Over 20 years Risk weighting 0.00% 0.70% 1.25% 2.25% 3.75% 5.25% 7.50% 12.50%

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To guard against the volatility risk of fixed income assets, Basel II recommends risk weightings tied to the credit risk ratings given to underlying bank assets as illustrated in the table below. Credit ratings of fixed income instruments Risk weights AAA to AA0% A to BBB 0.25% BB+ to B8% Below B12% Unrated 8% For the final calculation of the total amount of reserves needed to protect against market risk for fixed income instruments, the value of each fixed income asset is multiplied against both risk weightings and then summed alongside all other fixed income assets. B. Other class of assets: Basel IIs risk weightings for all other market-based assets such as stocks, commodities, currencies, and hybrid instrumentsis based on a second, separate group of methodologies. The Simplified Approach: It uses systems similar to the bucket approaches used in non-VAR fixed income reserve calculations. This method divides assets by type, maturity, volatility, and origin, and assigns a risk weights along a spectrum of values, from 2.25% for the least risky assets to 100% for the most risky assets. Scenario Analysis: Under this method risk weights are allocated according to the possible scenarios assets may face in each countrys markets. This approach, while much more complex than the Simplified Approach, is much less conservative and therefore more profitable for a bank. The Internal Model Approach (IMA): Along the lines of the VAR and IRB approaches, this methodology group encourages banks to develop their own internal models to calculate a stock, currency, or commoditys market risk on a case-by-case basis. On average, the IMA is seen to be the most complex, least conservative, and most profitable of the approaches toward market risk modeling.

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Indianbankingsector
Structure: Indian banking is a patchwork of public sector banks, new private and old private banks, regional banks, development banks and cooperative banks. As on 31st March 2008, there were 174 commercial banks- 4 non scheduled commercial banks and 170 scheduled commercial banks, out of which 91 Regional Rural Banks, 28 public sector banks, 23 private sector banks, 28 foreign banks and 69 scheduled cooperative banks. The 28 public sector banks, which includes IDBI and India's biggest financial institution, the State Bank of India, and its eight subsidiaries, together with banks nationalised in 1969 and 1980, still account for three-quarters of the sector's assets. Thus, in India there is the dominance of Government ownership coupled with significant private shareholding in the public sector banks which in turn continue to have a dominant share in the total banking system. The private sector banks especially the new ones are world class. Cooperative banks pose a challenge because of the multiplicity of regulatory and supervisory authorities. There are also Regional Rural Banks with links to their parent commercial banks. Foreign bank branches operate profitably in India and by and large the regulatory standards for all these banks are uniform. Indias perspective on banking reforms: The banking system over the last two decades has seen extraordinary changes in the banking and financial systems all over the world. The 1990s have seen such an alarming situation when banks had poor bottom line, poor CAR and huge NPA. It is pertinent to mention that many banks incurred huge losses and major banks had marginal profits. At this juncture came the Narismham Committee reports; Phase I in 1991 and Phase II in 19997, which systematically prescribed financial sector reforms and amalgamated Basel I accord along with it. In its report submitted to the Government of India in December 1991, the Narasimhan Committee on Financial System suggested several reform measures like gradual liberalization of the banking sector and also adoption of prudential norms for Indian financial system. While the liberalization was aimed at bringing about competition and efficiency into Indias banking system, the prudential regulation was aimed at strengthening the supervisory system, which is important in the process of liberalization. The Narasimhan Committee also endorsed the internationally accepted norms for capital adequacy standards, developed by the Basel Committee on Banking Supervision (BCBS). In pursuance of the Narasimhan Committee recommendations, India adopted Basel I norms for commercial banks in 1992, the market risk amendment of Basel I in 1996 and implemented the revised norms, the Basel II, from March 2008. After the commencement of the banking sector

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reforms in the early 1990s, the Reserve Bank of India (RBI) has been consistently upgrading the Indian banking sector by adopting international best practices. The two broad phases of regulation relevant to Indian banks are as follows: First Phase Introduction of Prudential norms Reduction in statutory Pre-emptions Deregulation of interest rates Entry of private sector banks Public sector banks allowed to access capital market Recapitalization of some banks Strengthening of recovery process Strengthening of supervisory framework Setting up of Board for Financial Supervision Strengthening of corporate governance practices Second phase Fine-tuning of Prudential Norms Capital Charge for Market Risk Introduced Consolidated accounting and supervision Adherence to all Core Principles for Effective Banking Supervision. Risk Based Approach Introduced on a pilot basis Prompt Corrective Action Thus, there has been a paradigm shift from balance sheet to off balance sheet intermediation, from capital adequacy to capital efficiency and transition from banking to financial services. The rules for the Indian banking game have been changing and moving towards a convergence with international norms and standards. Though in the Indian banking sector there is a robust dialogue between the Regulator- RBI and the banks, the traditional paternalistic approach by the RBI for every issue has left the Indian banks in an awkward position when competing with the global banks which have developed over the years on a strong engine backed by self driven initiatives. Thus, the challenge here is to make up for the lack of self learned lessons with learnings from the mistake already made- not just by International banks but across financial institutions.

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Risk management scenario in future: Risk management activities will be more pronounced in future banking because of liberalization, deregulation and global integration of financial markets. This would be adding depth and dimension to the banking risks. As the risks are correlated, exposure to one risk may lead to another risk, therefore management of risks in a proactive, efficient & integrated manner will be the strength of the successful banks. The standardized approach would be implemented by 31st March 2008, and the forward-looking banks would be in the process of placing their MIS for the collection of data required for the calculation of Probability of Default (PD), Exposure at Default (EAD) and Loss Given Default (LGD). The banks are expected to have at a minimum PD data for five years and LGD and EAD data for seven years. Presently most Indian banks do not possess the data required for the calculation of their LGDs. Also the personnel skills, the IT infrastructure and MIS at the banks need to be upgraded substantially if the banks want to migrate to the IRB Approach.

Although many banks are working towards the IRB Approach, RBI will allow only a few banks to implement and follow the IRB Approach by the year 2015. Indian banks would be moving upward on the strategic continuum of risk scoring models as can be seen in the above diagram.

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IndiaJourneywithBaselnorms
Why adoption of Basel norms by India? Certain reasons which manifests why Indian Banks require Basel II compliance are:The voluntary adoption of Basel norms is due to financial liberalization. Basel II norms will facilitate introduction of new complex financial products in Indian Banking Sector. Indian banks require a more risk sensitive framework. Basel II provides an incentive for better and more objective risk measurement which will improve the overall risk management system of Indian banks. Improving overall efficiency of banking and finance systems. Takes global aspect into consideration for more rational decision making, improving the decision matrix for banks. To take advantage of all other benefits of Basel II. Lastly, its adoption is the result of pressure from the Bretton Woods institutions, which function as a de facto international regulatory power monitoring implementation of a set of best practice standards for financial institutions across the world. The World Bank and the IMF are seen as enforcing compliance with these guidelines by introducing them in the conditions that developing countries are required to meet in order to qualify for financing from these institutions or as part of the standards used in IMF Article IV surveillance. Mechanisms have also been put in place to encourage their introduction, govern their use and monitor compliance. The key instrument is the Report on the Observance of Standards and Codes, prepared by the IMF as a part of Article IV consultations or through Financial Sector Assessment Programmes conducted jointly by the IMF and the World Bank. (Kregel 2006)

First step:
Reserve Banks association with the Basel Committee on Banking Supervision (BCBS) the owner of the Basel II framework - dates back to 1997 as India was among the 16 non-member countries that were consulted in the drafting of the Basel Core Principles. Reserve Bank of India became a member of the Core Principles Liaison Group in 1998 and subsequently became a
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member of the Core Principles Working Group on Capital. Within the Working Group, RBI has been actively participating in the deliberations on the Basel II framework and had the privilege to lead a group of six major non-G-10 supervisors which presented a proposal on a simplified approach for Basel II to the Committee. Basel I: Initiatives taken by RBI for the implementation of Basel I: 1. The Basel I framework was implemented in India with effect from 1992-93(i.e. April 1992) which was, however, spread over 3 years banks with branches abroad were required to comply fully by end March 1994 and the other banks were required to comply by end March 1996. 2. In April 1992, RBI introduced a risk weighted assets ratio system for banks (including foreign banks) in India as capital adequacy norms. 3. Further, India responded to the 1996 amendment to the Basel I framework which required banks to maintain capital for market risk exposures, by initially prescribing various surrogate capital charges such as investment fluctuation reserve of 5 per cent of the banks portfolio and a 2.5 per cent risk weight on the entire portfolio for these risks between 2000 and 2002. 4. These were replaced with the VaR based capital charges as required under the Basel I framework in June 2004, which become fully effective from March 2005.

Approach: 1. Change in the definition of capital: Capital was defined into two tiersTier 1 of the capital comprised of the followinga. Paid up capital, b. Statutory reserves, c. Other disclosed free reserves, d. Capital reserves representing surplus arising out of sale proceeds of assets, Equity investment in subsidiaries, intangible assets and losses in the current period and those brought forward from previous periods, would be deducted from Tier 1 capital. Tier 2 of the capital would consist of the followinga. Undisclosed reserves and cumulative perpetual preference shares, b. Revaluation of reserves, c. General provisions and loss reserves,
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d. Hybrid debt capital instruments, e. Subordinated debt. 2. Revision of discounting norms for tier 2 Capital: Uniform discounting norms were devised for calculating all scheduled commercial banks capital adequacy ratio on account of revaluation reserves and subordinated debt instruments. The revaluation of fixed assets done by banks for capital adequacy purpose was to be discounted by nearly 55% as against 25% earlier. For subordinated debt instrumentsRemaining maturity period Less than 1 year Less than 2 years but more than 1 year Less than 3 years but more than 2 years Less than 4 years but more than 3 years Between 4 years to less than 5 years Discount rate 100% 80% 60% 40% 20%

3. Assignment of risk weights: The balance sheet assets, non funded items and other off balance sheet exposures were assigned weight according to prescribed risk. Funded risk assets of percentage weight Categories of assets Risk weight Cash, balances with RBI, balances with other banks, money at call and short term 0% notice and investments in Government and other trustee securities. Claims (funded or non funded) on commercial banks 20% Other investments 100% Investments in subordinated debt instruments or bonds issued by Banks or Financial 20% institutions for Tier 2 Capital Loans guaranteed by Government of India, banks, loans to staff members 0% Loans guaranteed by State Governments 100% Others 100% Advances guaranteed by DICGC or ECGC 50% Rediscounting of discounted bills accepted by banks or loans due from banks or bills 20% negotiated under LCs of other banks Premises 100% Other assets 100%

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4. Deadline for minimum capital adequacy ratio: For Indian banks having branches abroad, the risk weighted assets ratio of 8% was to be achieved as early as possible and in any case by 31st March, 1995. Other banks were to achieve capital adequacy norms of 4% by 31st March, 1993 (Tier 1 Capital should not be less than 50% of total capital) and the 8% norm in full by 31st March, 1996. Foreign banks were to achieve the norm of 8% by 31st March, 1993. 5. Raising the minimum limit of capital adequacy ratio: In its mid-term review of Monetary and Credit Policy in October 1998, the Reserve Bank of India (RBI) raised the minimum regulatory CRAR requirement to 9 per cent, and banks were advised to achieve this 9 per cent CRAR level by March 31, 2000. Thus, the capital adequacy norm for Indias commercial banks is higher than the internationally accepted level of 8 per cent.
6. Prudential guidelines: In an effort to implement and monitor prudential norms in the area of

credit, the Central Bank of the country came out with comprehensive guidelines in the areas like pre condition of effective banking and supervision, licensing and structure, prudential regulations and requirements, liquidity risk management and methods of ongoing banking supervision. 7. Market risk: India has gone a step ahead of Basel I in that the banks in India are required to maintain capital charges for market risk on their available for sale portfolios as well as on their held for trading portfolios from March 2006 while Basel I requires market risk charges for trading portfolios only. Summary of Basel I implementation: In India, the Basel I recommendations on the minimum regulatory capital requirement was accepted and a timetable was prescribed for banks to exceed the minimum capital requirement prescribed by the Basel Committee. Today, banks in India take pride in indicating in their balance sheets the extent to which they exceed the minimum Capital Adequacy Requirement (CAR). Banks in India also adopted the asset classification and provisioning norms prescribed by the Basel Committee and as directed by the Reserve Bank of India. The general belief now is that the commercial banks' balance sheets are comparable with most of the banks in the developing world and many in the developed world too Introduction of Basel I coincided with the initiation of financial reforms in India in the early 1990s. The prudential norms set out by Basel I came as a timely solution to the ills affecting the Indian banks, particularly the public sector banks (PSBs) after two decades of nationalization. Public sector banks despite the differences in their strengths and weaknesses were able to switch over to the international standards without much hiccups.

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Initially when the reforms were introduced, there were mergers and closure of overseas branches of various weak banks. But after few years of implementation, the same banks in question posted impressive profits year after year, opened new overseas branches and acquired other banks. Evidently, it is this successful switchover that has made the country eager to adopt the Basel II framework as well. The ratio for tier 1 capital (equity and retained earnings), was set to be at least 4.5%. In practice, the average total ratio for the top ten private sector banks is in excess of 11% and for the top ten public sector banks, more than 12%. The tier 1 ratio is 7.9% and 7.6%, respectively. A couple of smaller public sector banks dropped below the 9% level in India's financial year ended March 31, 2002, but action was taken by the RBI to ensure that this situation was quickly remedied. More recently, a couple of smaller private banks have faced similar difficulties. However, the Indian banks became fully compliant with Basel I Accord in March 2005.

Basel II: The Indian banking sector is robust and significantly resilient to shocks. There is ample evidence of the capacity of the Indian banking system to migrate smoothly to Basel II norms. As per normal practice in regard to all changes in financial sector, and with a view to ensuring a particularly smooth migration to Basel II, a flexible, consultative and participative approach has been adopted for both - designing and implementing Basel II. The policy approach to Basel II in India is to conform to best international standards and in the process emphasis is on harmonization with the international best practices. RBI has adopted a calibrated approach for a phased implementation of Basel II so as to secure a non-disruptive migration to the new framework. RBI will implement Basel II in India after taking into account the experience of the more advanced G7 nations. Initially it should be restricted to the more efficient banks to take stock of the intricacies and problems and help in a more full-fledged transition towards implementation of Basel-II. A Steering Committee comprising of representatives from fourteen select private sector banks, public sector banks and foreign banks, the Indian Banks Association and the Reserve Bank of India was constituted to ensure smooth migration to Basel II framework. The Steering Committee has examined various issues of the Basel II framework and made its recommendations to the Reserve Bank for consideration. A clear distinction is made between Indian banks and foreign banks for Basel II compliance. That would enable the domestic banks to learn and capture the experience of the foreign banks in Basel II implementation. The very fact that RBI decided to postpone the target migration date
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from 31st March,2007 to 31st March, 2008 shows that RBI would prefer a slow and steady implementation of the Basel framework to a hasty dash. Initiatives taken by RBI for the implementation of Basel II: The various initiatives taken by RBI are as follows: 1. RBI had announced in its annual policy statement in May 2004 that banks in India should examine in depth the options available under Basel II and draw a road-map by end-December 2004 for migration to Basel II and review the progress at quarterly intervals. 2. RBI organized a two-day seminar in July 2004 mainly to sensitise the Chief Executive Officers of banks to the opportunities and challenges emerging from the Basel II norms. 3. In August 2004 all banks were asked to undertake a self-assessment of the various risk management systems in place, with specific reference to the three major risks covered under the Basel II and initiate necessary remedial measures to update the systems to match up to the minimum standards prescribed under the New Framework. 4. Banks were advised by the Reserve Bank of India (RBI) to formulate and operationalise an internal capital adequacy assessment process in alignment with business plan and performance budgeting system to address risks not captured under Pillar I (minimum capital requirement), including interest rate risk in the banking book, credit concentration risk, liquidity risk and reputation risk. This, together with adoption of Risk Based Supervision would aid in factoring the Pillar II requirements under Basel II. 5. In February 2005, RBI issued the first draft guidelines on Basel II implementations in which an initial target date for Basel II compliance was set for March 2007 for all commercial banks (roughly 90 banks), excluding Local Area Banks (LABs) and Regional Rural Banks (RRBs). This deadline was, however, postponed to March 2008 for internationally active banks and March 2009 for domestic commercial banks in RBIs mid-year policy announcement of October 30, 2006. 6. The methodology for computing the capital requirement under the Basic Indicator Approach has been explained to banks by RBI in its draft guidelines in February 2005. 7. RBI issued a Guidance Note on operational risk management in November 2005, which serves as a benchmark to establish a scientific operational risk management framework. 8. Risk Based Supervision (RBS) in 23 banks has been introduced on a pilot basis to ensure that banks have suitable risk management framework oriented towards their requirements dictated
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by the size and complexity of business, risk philosophy, market perceptions and the expected level of capital. 9. In order to meet additional capital requirements of banks, RBI has issued policy guidelines enabling issuance of several instruments by the banks viz., innovative perpetual debt instruments, perpetual non-cumulative preference shares, redeemable cumulative preference shares and hybrid debt instruments so as to enhance their capital raising options. 10. The final RBI guidelines on Basel II implementation were released on April 27, 2007. 11. Regulation was to be restricted largely to the supervisory functions and disclosure norms incorporated in Pillars II and III of the Basel II guidelines. 12. The RBI had asked the banks in May 2006 to begin conducting parallel runs, as per the draft guidelines, so as to familiarise them with the requirements of the new framework. During the period of parallel run, the banks are required to compute, parallely, on an on going basis, their capital adequacy ratio both under Basel I norms, currently applicable, as well as the Basel II guidelines to be applicable in future. This analysis, along with several other prescribed assessments, is to be placed before the Boards of the banks every quarter and is also transmitted to the RBI. These reports received in the RBI indicate that implementation of Basel II in the banks is in the process of getting stabilised. 13. Enhancing the area of disclosures (Pillar III), so as to have greater transparency of the financial position and risk profile of banks. 14. Improving the level of corporate governance standards in banks. 15. Building capacity of RBI for ensuring its ability for identifying and permitting eligible banks to adopt IRB / Advanced Measurement approaches.

Approach: 1. A three track approach: In India, at present, there is a three track approach for Basel compliance the commercial banks are Basel I compliant with respect to credit and market risks; the urban cooperative banks maintain capital for credit risk as per Basel I and market risk through surrogate charges; and the rural banks have capital adequacy norms that are not on par with the Basel norms (Leeladhar 2006, Reddy 2006). The three track approach is justified by the necessity to maintain varying degree of stringency across different types of banks in India reflecting different levels of operational complexity and risk appetite. The

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three track approach is also justified in order to ensure greater financial inclusion and for an efficient credit delivery mechanism (Reddy 2006). Consequently, the Indian banking sector will have a major segment of systemic importance on a Basel II framework, a portion of the minor segment partly on Basel I framework, and the smallest segment on a non-Basel framework. 2. Options for calculating risks: Banks in India will initially adopt Standardised Approach for credit risk and Basic Indicator Approach for operational risk and Standardised Duration approach for calculating capital charge under market risk. RBI has provided the specifics of these approaches in its guidelines. After adequate skills are developed, both by banks and RBI, some banks may be allowed to migrate towards more sophisticated approaches like IRB. Since, the standardised approach might not suit the needs of the smaller banks; RBI has suggested a simplified standardised approach for those banks that are not internationally active. Even at India's largest banks it is assumed that the RBI will not sanction the more sophisticated risk measurement techniques for at least a further two years after the new rules come into effect, and probably then only for a couple of banks. The prime considerations while deciding on the likely approach included the cost of implementation and the cost of compliance. Along side the implementation of Basel II, India banks will also have to apply the provisions of the market risk amendment, which was added to Basel I in 1996, but not introduced in India at the time. 3. Definition of bank capital: Elements of Tier 1 Capital a) Paid-up equity capital, Statutory Reserves, and other disclosed free reserves, if any; b) Capital reserves representing surplus arising out of sale proceeds of assets; c) Innovative perpetual debt instruments eligible for inclusion in Tier 1 Capital which comply with regulatory requirements (limited to 15% of total Tier 1 Capital and excess will be eligible for inclusion under Tier 2 Capital, subject to limits prescribed for Tier 2 Capital). Elements of Tier 2 Capital (should not exceed 100% of Tier 1 Capital) a) b) c) d) Revaluation Reserves General Provisions and Loss Reserves Hybrid debt capital instruments Subordinated Debt
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Following deductions are allowed to be made from capital while calculating eligible capital: a) Intangible assets and losses in current period and those brought forward from previous periods should be deducted from Tier 1 Capital, b) Deferred Tax Asset, c) Gain-on-sale arising at time of securitisation of standard assets. 4. Revised CRAR: Under the revised regime of Basel II, Indian banks will be required to maintain a minimum CRAR of 9 per cent on an ongoing basis. Further, banks are encouraged to achieve a tier I CRAR of at least 6 per cent by March 2010. In order to ensure a smooth transition to Basel II, RBI has advised the banks to have a parallel run of the revised norms along with the currently applicable norms. 5. Two stage implementation: A two-stage implementation of the guidelines is envisaged to provide adequate lead time to the banking system. Accordingly, the foreign banks operating in India and the Indian banks (like ICICI, SBI) having operational presence outside India are required to migrate to the Standardised Approach for credit risk and the Basic Indicator Approach for operational risk with effect from March 31, 2008. All other Scheduled commercial banks are encouraged to migrate to these approaches under Basel II in alignment with them, but, in any case, not later than March 31, 2009. It has been a conscious decision to begin with the simpler approaches available under the framework. As regards the market risk, the banks will continue to follow the Standardised-Duration Method, already adopted under the Basel I framework, under Basel II also. The central bank explained that its decision to provide banks with more time to put in place appropriate systems so as to ensure full compliance with Basel II had been made after taking into account the state of preparedness of the banking system. 6. Areas of national discretion: Sovereign State Government guaranteed exposures risk weighted at 20% instead of 0% ECAs not recognised for risk weighting purpose Claims on domestic PSEs treated as corporates Claims on banks Option 1, risk weight one category less than sovereign Scheduled Commercial banks at 20%, others at 100% Risk weight on claims secured by residential properties RBI stipulation at 75% instead of 35% Banks to use only solicited ratings

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7. Retail exposures: RBI will evaluate periodically the risk weights assigned to retail and other sensitive areas. 8. Mapping of ratings: RBI undertook the process of identifying the eligible ECAIs. An internal working group examines the eligibility criteria and mapping process. 9. Credit risk mitigants: Basel II recognizes a wide range of collaterals (e.g. Cash margins, Bank deposits, Gold- benchmark 99.99% purity), state government securities, central government securities, NSC, IVP and KVP. 10. Assignment of risk weights for calculating credit risk: Tables 1 and 2 below present the RBIs scheme of risk-weights for different categories of assets to be considered for credit risk under Standardised Approach of Basel II. For claims in Indian rupees, RBIs guidelines provide risk-weights for direct and guarantee exposures of the Central and State governments, exposures to apex bodies such as RBI, Deposit Insurance and Credit Guarantee Corporation (DICGC), Credit Guarantee Fund Trust for Small Industries (CGTSI) and Export Credit Guarantee Corporation (ECGC), exposures to scheduled commercial banks and other banks, and exposures to corporate with various credit ratings. Apart from these, RBI guidelines also deal with claims in retail portfolios, claims secured by residential property and claims secured by commercial real estate. RBI has also set extensive guidelines on to how to deal with Non-Performing Assets (NPAs) in calculating risk-weighted assets. As far as claims on foreign currency are concerned, RBI has retained the indicative guidelines of Basel Committee, and provided risk weights in accordance with the credit ratings of external credit rating agencies. Risk weights on off balance sheet items are calculated as sum of risk-weighted amount of market related and non-market related off-balance sheet items. It includes instruments like swaps, forward rate agreements, interest rate futures, foreign exchange contracts.

Table: RBIs Risk-weights for SA of Basel II: Claims on Foreign Entities

Source: RBI
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Table: RBI's Risk-weights for SA of Basel II: Claims on Indian Entities

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11. Parallel run implementation strategy: Under the "parallel run" approach, banks are expected to calculate CRAR based on both Basel I and Basel II, but will keep higher of the two as per timeframe shown in Exhibit 3. For example, by 2009-10, banks will adopt CRAR which is higher of two: that calculated through Basel II and 90% of that of Basel I. Under parallel run, banks are expected to do the following: a) Banks should apply prudential guidelines on capital adequacy - on an ongoing basis and compute their Capital to Risk Weighted Assets Ratio (CRAR) under both the guidelines. b) Analysis of CRAR to be submitted to Board on a bimonthly basis till December 2006; monthly thereafter. c) Analysis under both guidelines should be reported quarterly to the board. d) A copy of quarterly report should be submitted to RBI, one each to Department of Banking Supervision and Department of Banking Operations. e) To smoothen the process of implementation RBI has taken adequate measures to safeguard interests of Indian banks. To make more capital available to banks, RBI has enabled banks to issue several instruments like innovative perpetual debt instruments, perpetual noncumulative preference shares and hybrid debt instruments. f) Board approved policy on CRM techniques & collateral management, disclosures, ICAAP & MIS. g) Mechanisms for validating CRAR position

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Figure: Implementation Approach, Minimum Capital Subjected to Prudential Floor

12. Disclosure requirements: The requirements include both qualitative disclosures and quantitative disclosures in respect of scope of application, capital structure, capital adequacy, risk exposure and assessment, credit risk and its mitigation, securitization, market risk, operational risk, interest rate risk etc. It also includes terms of issue of innovative capital instruments in Indian rupee and foreign currency for Tier 1 capital, terms of issue of Tier 2 capital instruments in Indian rupees and foreign currency, issue of subordinated debt for raising lower Tier 2 capital, compliance with reserve requirements, reporting requirements, etc. The Reserve Bank of India may consider imposing a penalty, including financial penalty, in case of non-compliance with the prescribed disclosure requirements. 13. Scope and frequency of disclosures: Banks should provide all Pillar 3 disclosures, both qualitative and quantitative, as at the end March each year along with the annual financial statements. With a view to enhance the ease of access to the Pillar 3 disclosures, banks may make their annual disclosures both in their annual reports as well as their respective web sites. Banks with capital funds of Rs.100 crore or more should make interim disclosures on the quantitative aspects, on a stand alone basis, on their respective websites as at end September each year. Qualitative disclosures that provide a general summary of a banks risk

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management objectives and policies, reporting system and definitions may be published only on an annual basis. In recognition of the increased risk sensitivity of the Revised Framework and the general trend towards more frequent reporting in capital markets, all banks with capital funds of Rs.500 crore or more, and their significant bank subsidiaries, must disclose their Tier 1 capital, total capital, total required capital and Tier 1 ratio and total capital adequacy ratio, on a quarterly basis on their respective websites. The disclosure on the websites should be made in a web page titled Basel II Disclosures and the link to this page should be prominently provided on the home page of the banks website. Each of these disclosures pertaining to a financial year should be available on the websites until disclosure of the third subsequent annual (March end) disclosure is made.

Specific issues for implementation: Pillar 1 implementationImplementation of the simplified approaches also requires preparation on the part of the banks, banking regulators and the rating agencies. Banks have to gather data relating to the rated exposures in order to risk-weight them accordingly and track the ratings migrations of these exposures. The rating agencies have to demonstrate that they adhere, on an ongoing basis, to the six parameters laid down under Basel II for their recognition, viz., Objectivity, Independence, International Access/Transparency, Disclosure, Resources and Credibility. The rating agencies have also to develop frameworks for assigning Issuer Rating instead of the Issue Rating that they have carried out so far. Pillar 2 implementationImplementing the ICAAP under the Pillar 2 of the framework would perhaps be the biggest challenge for the banks in India as it requires a comprehensive risk modelling infrastructure to capture all the risks that are not covered under the other two Pillars of the framework. The validation of the internal models of the banks by the supervisors would also be an arduous task. Reserve Bank of India has moved towards Risk Based Supervision (RBS) on a pilot basis in place of the previous method of Annual financial Supervision of the Banks. For taking up RBS, Banks have been advised by RBI to adopt Risk Based Internal Audit. The risk based supervision (RBS) framework evaluates the risk profile of the banks through an analysis of 12 risk factors viz, eight business risks and four control risks. The eight business risks relate to: Capital, Credit Risk, Market Risk, Earnings, Liquidity Risk, Business Strategy and Environment Risk, Operational Risk and Group Risk. The control risks relate to Internal Controls Risk, Organisation risk, Management Risk and Compliance Risk. The RBS framework is currently undergoing
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further refinement. The RBS methodology can be used as a starting point for the implementation of pillar 2 proposals in India. Pillar 3 implementationThere is still a militant inhibition among Indian banks on disclosures, calling for the sharing of information, including details of willful defaulters. Markets in India lack adequate depth and width which would qualify them as efficient markets. Pillar 3 disclosures are not required to be audited by an external auditor. But the disclosures should be subjected to adequate validation i.e. e. it must be consistent with the audited statements. The Reserve Bank will consider future modifications to the Market Discipline disclosures as necessary in light of its ongoing monitoring of this area and industry developments.

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LITERATURE REVIEW

2.1FICCI. 2.2CRISILandIBA. 2.3FITCH.

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LiteratureReview
1. FICCI
FICCI has conducted a survey to analyze the state of preparedness of commercial banks (which includes Public sector banks, Private banks and foreign banks) in implementation of Basel II norms. The survey questionnaire covered some of the most important aspects related to Implementation of Basel II. Based upon the data collated, some of the important findings of the survey are enumerated as below: 1. General state of preparedness: a. 87 percent of the respondents were confident of meeting the deadline of implementing the Basel II norms by 31st March 2007. These banks have already prepared the detailed Implementation Roadmap as been instructed by Reserve Bank of India. 80 per cent of these banks faced Data Collection as the biggest challenge in preparing the Basel II roadmap. They also expressed that they require an ongoing support from the regulatory authorities in this regard. b. 77 percent of respondent banks are still in the process of putting in place a robust Management Information System (MIS) in order to comply with the requirements of Pillar III Market Discipline of the new norms. 2. Capital requirement: a. 54 percent of the banks are technologically equipped to face the future challenges being posed by the Basel II norms. These banks have already put in place the core banking solutions. Also enough attention has been focused upon networking the banks. b. All the respondent banks already have 70-90 % level of computerization in their bank. However 60 percent of these banks are of an opinion that lower level of computerization would not hinder their progress in implementing these norms. Perhaps this is because banks feel that lower level of the computerization in the rural areas is not likely to effect the implementation of Basel II norms because the bulk of banks operations are in urban areas, which already have 100% computerization. c. 87 percent of respondent banks have already estimated the incremental capital required for this purpose in their organization. 27 per cent banks expect their capital requirements to increase by 1-2 % while 20 per cent banks expect their capital requirements to increase by more than 3 % during the implementation stage of Basel II norms.

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d. All the respondents believe that there are sufficient resources available for raising the higher amount of capital needed for this purpose. 62 percent of banks would prefer to raise the requisite capital by a combination of Tier I and Tier II. To a question on the need of further regulatory relaxations, 50% of the respondent banks voiced that IFR (Investment Fluctuation Reserve) surplus and the Hybrid capital should be considered in Tier I. Some of the other relaxations desired by the banks were treatment of Investment Allowance Reserve as Tier I since it is created from post tax profits and Foreign currency translation reserve as Tier II capital. e. 80 percent of respondent banks expect that there would be an increase in their capital adequacy requirements in their organization as a result of these norms while the rest expect the same to fall as they expect their Capital adequacy ratio to improve. f. 62 percent of the respondent banks believe that there is a high degree of relationship between the size of the banks and associated risk. Since the complexity of the new framework may be out of reach for many smaller banks, majority of the respondents agree to the fact that this would trigger off a need for consolidation in Indian banking system.

3. Impact on credit: a. 87 percent of the respondent banks quoted that increased capital requirements imposed by the Basel accord will not make their banks more risk averse towards credit dispensation. Merely 13% felt that implementation of Basel II could have an adverse impact on banks lending to commercial sector. Small and Medium enterprises and Farm and rural sectors are likely to be the most affected sectors.

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4. Expectation from the regulator: a. 87% of the respondents were completely satisfied with the support given by the RBI in respect to Basel II implementation. However some of them felt that there should be consistency in implementation of these norms in terms of timing and approach. Further there should be greater consultation with internationally active banks that face significant cross-border implementation challenges. b. To a question on comfort level with the stricter disclosure requirements under the Basel II norms, 50 percent of respondents expressed that they were completely comfortable with these requirements, whereas rest felt that they were comfortable to some extent. c. Operational risk measurement is one of the new planks of the Basel II accord. 73 percent of respondents quoted that capital allocation to operational risk will not be counter productive. They instead believe that explicit charge on operational risk will direct more focus on it, which will further enhance operational risk management and operational efficiency for the banks. Also such an allocation would create a cushion for the claims or losses on this account. However the remaining felt that in the Indian context, capital requirements are too high as the Indian banks, unlike their foreign counterparts are not much involved in speculative activities such as derivatives. Hence the capital requirement for operational risk should be lower for the Indian Banks than what is specified in Basel II Accord.

2. CRISIL and IBA: According to a survey by the Indian Banking Association and CRISIL Limited, most Indian banks have internal rating models for large corporates but not for all types of borrowing entities. The survey indicated varying degrees of preparedness in the area of risk management among different banks. Foreign banks led in the area of internal rating methods as almost all of those surveyed had such policies, compared to a minority of public sector banks, and just over half of private banks. Speaking at a seminar, 'Risk management in banks in the changing environment', D Ravishankar, director, CRISIL, said that operational risk is a developing area, and a majority of banks have a long way to go. When it comes to measuring and managing market risk, adoption is very limited. Integrated risk management frameworks are far more common in foreign banks than Indian ones.

3. FITCH: 1. The larger Indian banks with an international presence (along with the associate banks of the State Bank of India) adopted the standardised approach for credit risk and the basic indicator approach for operational risk under the Basel II framework on 31 March 2008. These 18
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banks accounted for about 65% of total assets in the Indian banking system at endMarch 2008. The foreign bank branches too have migrated to the standardised and basic indicator approaches for the purpose of local regulatory reporting of their Indian operations. The rest of the commercial banking system (32 banks, accounting for around 25% of total assets) will migrate on 31 March 2009. 2. The results so far have been mixed. While most of the Indian banks that migrated to Basel II reported a reduction in the total capital adequacy ratio (CAR) by about 80bp, primarily on account of operational risk, a few banks reported a capital relief. The savings appear to be on account of higher exposure to betterrated corporates as well as savings on the regulatory retail portfolio, though their sustainability remains to be seen in view of the increased risk weights on the unrated corporate loan portfolio that became applicable after 31 March. 3. National ratings (which are unique to a country, unlike foreign currency ratings which are internationally comparable) assigned by external credit rating agencies (such as Fitch Ratings) are used for risk weighting under the standardised approach for calculating credit risk of corporate loans. Fitch expects this to encourage rating penetration in India, which has traditionally been low and limited only to the larger corporates. Banks are increasingly having their loan portfolios rated as the risk weighting for unrated corporate exposures in excess of INR500m (about USD12m) increased to 150% from April 2008. This limit for unrated corporate exposures will further reduce to INR100m (slightly over USD2m) from April 2009. While the corporate loan portfolios of Indian banks are somewhat concentrated (for example, the top 100 loans could account for about 40% to 50% of the corporate credit portfolio), the increased risk weighting for the unrated portfolio could increase a banks capital requirement by more than 35bp (assuming there are no external ratings yet for most of the corporate credits outside the top 100 list). Foreign currency exposures to corporates are riskweighted on the basis of foreign currency ratings; if they are unrated, the 150% risk weight would apply based on the size of the exposure (as in local currency loans). 4. The differential risk weighting on different asset classes under Basel II could help guide the proportion and direction of bank lending, such as lending to higherrated corporates or hedging exposures to smallscale industries with permitted collaterals and guarantees. Risk weight on residential mortgage loans is based on the loan/value ratio (LTV); this could dissuade aggressive lending policies, as risk weight would increase from 50% or 75% to 100% for LTVs above 75%. 5. The use of national ratings for risk weighting corporate exposures could result in a capital saving of about 100bp of the corporate loan portfolio, but could make it difficult to compare capital adequacy ratios of Indian banks with those in other countries. Also, exposure to the Indian sovereign is risk weighted at 0% even if it is denominated in foreign currency, which
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would otherwise have been risk weighted at 100%, given Indias Foreign Currency Long Term Issuer Default Rating (BBB). 6. While banks are integrating risks like (credit concentration risk, liquidity risk, reputation risk, interest rate risk) into their risk management systems, the internal capital planning process in most large banks appears to increase the CAR threshold by about 200bp to 300bp higher than the regulatory minimum ratio of 9%. This is important, as some of these risks are significant for Indian banks. 7. Basel II encourages banks to develop and use better risk management techniques for monitoring and managing their risks. Some of the larger government and new private banks that have developed systems and processes are arguably better prepared to migrate to the internal ratings based approach for credit risk and the standardised approach or the advanced measurement approach for operational risk. Banks have been building up databases to help validate the internal models, though it may need several years of testing before the regulator is comfortable with these models. Ultimately, the use of an internal ratings based approach would help bridge the lack of global comparability thrown up by the use of national ratings. 8. Impact on Risk weighted assets: The impact of Basel II is primarily through the additional capital charge on operational risk. The overall impact of the credit risk has generally been mildly negative, wherein the additional capital charge for corporate credit and residential mortgages has been compensated by the relief on the regulatory retail portfolio. a. Operational risk is the largest contributor to the capital increase at about 6575bp. b. The impact on the corporate portfolio will play out in stages over the next 12 months. The immediate effect is neutral to positive, as additional capital is used only on the undrawn exposures that were earlier not considered under Basel I. The full impact would be felt during the current year (FY09) and the next, when the additional charge for the unrated portfolio is applied. c. Residential mortgages have been neutral (for government banks) to negative (for private banks with higher ticket size and LTV). d. The regulatory retail portfolio (defined later in the report) releases about 40 50bp of capital.

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The above chart demonstrates the capital consumption on a typical portfolio of an Indian bank. While the capital charge for market risk and other assets does not change under Basel II, capital requirements increase for residential mortgage and operational risk, while regulatory retail provides capital relief. In the case of corporates, capital requirements increase for undrawn limits and lower rated corporates (BB+(ind) and below) while banks benefit from higher rated corporates (A(ind) and above). Also, additional capital requirement arises from higher risk weights on unrated claims on corporates in excess of INR500m from April 2008. A few banks have declared substantial capital relief for credit risk in FY08, offsetting most of the additional capital required for operational risk. The relief is either due to higher regulatory retail portfolio or exposure to higher rated corporates. Capital requirements for the corporate portfolio would, however, increase due to the effect of the additional charge for the unrated corporates. Fitch estimates the cumulative impact on the total CAR in April 2009 (when the unrated threshold moves to INR100m) at about 35bp of additional charge.

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 RESEARCH METHODOLOGY
3.1Researchobjective. 3.2Scopeofstudy. 3.3Researchplan. 3.4Researchdesign. 3.5DataCollectionTechniques. 3.6SampleDesign. 3.7DataAnalysis. 3.8Limitationsofstudy.

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Researchmethodology
Research objective: Objective of a research work defines the driving force for a research action. It is the focal point around which the whole action revolves. This dissertation was undertaken to fulfill the following objectives: To have an insight about the Basel Accord: Basel I and Basel II. To comparatively analyse both the Accords. To determine the impact of Basel II on the Indian banking sector. To evaluate the implications of Basel II on Indian banking sector and suggest remedial measures.

Scope of study: Scope of any project defines the boundary within which the research work was undertaken. This dissertation covers research over two periods- Post Basel I and post Basel II period in India. The study has been made around three sectors of banks- Public sector banks, Private sector banks and foreign banks. The specific banks in each category arePublic sector banks State bank of India Bank of Baroda Private sector banks ICICI HDFC Foreign banks Barclays bank Citibank

Research plan: A systematic and planned move to accomplish the research objective is always appreciable in conducting a resourceful research work. My dissertation was also accomplished in a syatematic way. The flowchart of my research plan was as follows:
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Insight about the Basel Accord: Basel Committee, Basel I and Basel II.

The measures of RBI for phased implementation of Basel Accords were studied. . Comparative analysis of both the Accords was done on theoretical aspects.

Level of preparedness of Indian banks for Basel II was studied which helped in determining the impact of the Accord on the banks.

Primary and secondary research was conducted with regard to the impact study.

Analysis of the research findings was done, which led to certain conclusions and recommendations.

Research Design: A research design lays the foundation for conducting the project and ensures that the research plan is conducted efficiently and effectively. This research has been carried out to explore the literature review on the Basel framework and also as to how it has an impact on the Indian banking system. Both primary and secondary research was used. The research design was an analytical research design. Data collection design: Primary data and secondary data were used to present a balanced argument that compares and contrasts theoretical considerations with what respondents had to say. The data collection was primarily done through communication- responses to questionnaire via email. The contacts and database of the bank managers were found by visiting the websites of different banks and also through personal references. The risk managers of 6 different banks were requested to answer the questionnaire via e-mails. Secondary data was collected through publications of RBI on Indian Banking sector like Report on currency and finance, Trend and progress of banking and annual reports of the above mentioned banks.

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Da collection design ata

Primary da ata

Seconda data ary Re eport on Curr rency and Fi inance

Qu uestionairre Survey S

Report o Trend and on d progr ress- RBI

Annual reports of selec banks ct

Fig gure: Techn niques of dat collection ta n Type of data collect ted:

1. Prim mary data - Questionnai method: Q ire The prim mary research was condu h ucted in form of questio m onnaires circ culated via e emails amon ngst 6 different banks in In ndia. The q questionnaire comprised of two dif e d fferent types of questions in s nature i.e open ende and close ended quest e. ed tions. The fo ormat of the questionnai drafted he ire elped in a com mprehensive analysis of the impac of Basel II on the I f ct Indian bank king system. The questions were relate to variou aspects of risk manag s ed us f gement syste and also views on f em o future changes i the regula in atory require ements. 2. Secondary data ry as d nk rnational Se ettlement w website and RBI Secondar data wa collected from Ban of Inter publication- Report on Trend a Progress in Banking, Report o currency and finance and and s on e reports of sel banks (S BOB, IC lect SBI, CICI, HDFC Barclays b C, bank and Cit tibank). Annual r Design: Sample D a) Populatio Schedule commerc banks in India ) on: ed cial b) Sampling frame: Ba ) g anks which h have implem mented Basel II. c) Sampling Unit: Indi ) g ividual Bank ks d) Sample si ) ize: 6

e) Instrume ) ent: Questio onnaire f) Sampling technique: Non proba ) g ability sampl ling techniqu ue Convenien Samplin nce ng

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Criteria for selection of sample and determining its size: The sample size for this research was decided in order to cover various sectors of banking in India like two each from private sector banks, foreign banks and public sector banks. The reason to take such a sample size was to include all the sectors of banking in India with the help of which it would have been easier to understand how Basel II will have an impact on each sector. However, the sample size of this research is small as this is something very confidential for a bank to disclose. The respondents for the questionnaire were at the management level of the risk management department of the banks. As there is not many research in this particular topic and no academic journals for secondary data available it was very important to target right sort of people in the bank with right position who would be able to answer the questions correctly as well as with the right kind of knowledge.

Data Analysis: The analysis and conclusions of the study are based on both the existing literature reviewed and research work done. The data collected were analysed with the help of Pictorial analysis- Bar charts and pie charts, Likert scale analysis- Summated analysis, Trend analysis, SWOT analysis.

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Limitationsofthestudy
In order to present a true and valid picture about the topic it is essential to include and disclose the limitations of this research study. The various limitations were 1. There were very few academic journals available online regarding my research. My main source of information was mainly the RBI websites and the Bank for International Settlements website. 2. There was a major problem faced in getting the bank managers to fill up the questionnaires as it was regarding the confidentiality of their bank. Not many managers were comfortable or willing in filling up the questionnaire and provide information regarding impact of Basel II on their banks. Again since it was March end, they were very much packed with their schedule. 3. Not all information was available on my sample study. At certain instances, I was not able to find information on all banks included in my scope of study. 4. Financial and time constraint was also a limitation. 5. The analysis of project was based on observations and interpretation on the basis of sample survey. Hence they could be slightly biased due to my inability to extract all possible facts despite all efforts. 6. Being a student I undertake this project as a learning experience. I have made many mistakes and then learned from them. I have tried my best to be as authentic and as accurate as possible in the research analysis taking the help of my project mentor on relevant primary and secondary data.

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Comparative studyofBaselI andBaselII
4.1.SimilaritiesbetweenBaselIandBaselII 4.2.DifferencesbetweenBaselIandBaselII

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ComparativestudyofBaselIandBaselII
Similarities between Basel I and Basel II: The various common features between the two Basel norms are as follows: 1. The general requirement for banks to hold total capital equivalent to their risk-weighted assets is at least 8%; 2. The treatment of market risk is based on the basic structure of the 1996 Market Risk Amendment whereby banks uses internal models to determine the capital requirements ; and 3. Common definition of eligible capital- the regulatory capital i.e. its division into Tier 1 and Tier 2 capital and the rules limiting its composition is same under both the Accord.

Differences between Basel I and Basel II: Serial no. 1. Basis Focus Basel I Limited focus. It mainly concentrated on the total amount of bank capital, which reduces the risk of banks insolvency and also the potential cost of a banks failure for depositors. Basel II Focus on all operational aspects of bank. It intends to improve safety and soundness in the financial system by placing more emphasis on banks own internal control and management, the supervisory review process, and market discipline. Align more closely to business model- Flexibile, menu of approaches, incentives for better risk management; granularity in the valuation of assets and type of businesses and in the risk profiles of their systems and operations Complex but a more comprehensive and risk sensitive structure. It identifies credit, operational and market risks. It also includes provision for residual risks faced by banks. Charge for credit, operational and market risk. Basel II uses the differential risk
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2.

Model

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.

3.

Structure

Broad brush structure.

4.

Nature risks identified Capital charge Basis

of It identifies only credit and market risks.

5. 6.

Charge for credit risk of Risk weights are prescribed for

7.

8.

9.

10.

11.

Internal simulation model that incorporates the estimates of the frequency of operational losses and severity of operational losses, supplemented with qualitative adjustment factors. Based on a scaled value at risk, Enhanced requirementsto Methodology with Internal define policies and procedures for calculating calculated simulation model or standardised for what is allowed in trading market risk method. book, to model specific risk, for stress test as a part of internal risk capital calculation. None Guidelines on the supervisory Supervisory review of bank capital adequacy review
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risk different loan assets essentially on the basis of security available after classifying the assets as standard or non-standard on the basis of payment record. Basel I did not draw a distinction for the purpose of capital allocation between loan assets based on the intrinsic risk in lending to individual counterparties. Security in the form of tangible assets and/or guarantees from governments/banks is the sole distinguishing factor. E.g. it does not distinguish the risk characteristics between- 1 year loan and 5 year loan; collateralized and non collateralized loans; loan to large corporate and small scale unit. 100% risk weight for all Difference in the impact for corporate exposures and hence the capital requirement will be capital for comparatively larger. corporate exposures. Formula based calculation, using a simplistic categorization of Methodology for calculating obligor types, (Corporations: 100% risk and government: 0% Credit risk risk) without considering the actual credit risk profile of the customers. None Methodology for calculating operational risk defining weights

factor in loans made to different types of businesses, entities, markets, geographies, and so on, and allowing banks to have different levels of minimum capital taking into account intrinsic riskiness of the exposure. Risk weights are to be developed by rating provided by an external credit assessment institution like a rating agency that meets strict standards or by relying on Internal Rating Based (IRB) approaches where the banks provide the inputs for the risk weights.

Risk weight based on ratings assigned by external credit assessment institutions and hence the capital requirement will be lower. Formula based calculation, utilizing the internal risk parameters determined by individual banks. Separate formulas for wholesale and retail customers.

12.

Market discipline

None

13.

14.

Scope of Limited power regulators power Difference in risk buckets

are being added Concept of market discipline introduced through improved disclosure rules. Regulatory power has been greatly enhanced. Shown in the table below

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Analysis
5.1. Analysisofprimarydata
FactorsleadingtoshifttoBaselIIframework. MostchallengingpillarofBaselIIvizavizimplementation. Preparednessforadvancedapproaches. Concernsofcreditriskmanagement. Concernsforoperationalriskmanagement. Needofnewskills. Thirdpartiesinvolvement. ChangesinCRARandTier1Capital. Impactondifferenttypesofbank.s

5.2. AnalysisofSecondarydataImpactstudyonvariousparameters
Loanpricing,Portfoliocompositionandlendingprocess. Borrowers. Cost. Structureofbankingindustryconsolidation. Bankmargin. Businessmodel. Technologicaladvancementscomputerisation. Thirdparties. Capital.

5.3. ChallengesinimplementingBaselII 5.4. SWOTanalysisonIndianbanks

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Analy A ysisof fprim maryd data

1. Facto leading to the imple ors ementation of Basel II norms. This que estion was asked to the respondents in order to find out th factors th consider to s o he hey red adopt Ba asel II. Also it will he to know that wheth the bank and their employees have o, elp her ks actually u understood the importan of Basel Accord or n t nce not. 1.Facto orsthatmad deyourban nkshiftto BaselIInorms: Portfolio omanageme ent capabilit ties Riskbas sedpricing Creditlo ossreduction n Regulato orycapitalre elief

Factorst F thatmad deyourbank shifttoBaselIInorm ms

6 6

Result t:
All respondents s said that regulatory capital relief and improved portfolio ement was a major facto for the or manage shift. 4 out of 6 res spondents feel that an importa factor fo consideri Basel ant or ing II was risk based pricing. Again a s majorit 5 out of 6 believed r ty, reduction in cred loss as another i dit s important factor.

Interp pretation:
Portf foliomanagem mentcapabilitie es Riskb basedpricing Credi itlossreductio on Regulatorycapitalr relief

igure: Facto responsi ors ible for Basel II Fi imple ementation

Hence, it can be concluded t that there are var rious aspects or factors p s present in Basel I which attr II racts bank to adopt it. o Moreov ver, the bank manager knows, r can di ifferentiate and unders stand the factors which will benefit be l ecause of which they will b applying Basel II. be ore, shortly all Therefo it can be said that s the ban will ado Basel II as it will nks opt play an import tant role in the develop pment of the banking ind e dustry.

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2. The m challen most nging pillar of Basel II implement r tation This que estion was asked to find out that wh d hich of the aspect of Basel II was considered more challengi by banks to impleme Though all the pilla require so ing s ent. h ars ome new ad djustments, it was t considere imperativ to know that out of the three w ed ve which aspect banks wou find the most t uld difficult.

2.Whichofthefollow wingpillaris sagreater eunderBase elII? challenge Pillar1

W Whichofthefollo f owingpi illar is sagreat terchallengeunder BaselII I?

0

Pillar2 Pillar3

Result:

All the respondents invariably agreed to s y Pillar 2 as the gre eatest challenge while implementing Basel II.

Interpre etation:
6

Since Pil 2 requires the banks to have an llar s

Pilar r1 Pillar2 Pillar3

internal control syst tem for ass sessment of f risks, ban are find nks ding difficult in setting ty the stand dards.

Greatest ch hallenge in B Basel II imp plementation n Figure: G

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3. Preparedness of banks: This question was asked to know the preparedness of Indian banks to shift to advanced approaches of calculating risk weighted assets. RBI initiated the implementation framework for Basel II with simplest approaches under the various risks. Hence it was considered necessary to know about the transition plans of select banks on advanced models as these models require a lot of preliminary infrastructure and its implementation would make the banks more risk sensitive. Implementation steps Credit rating models Progress towards operational risk standardised approach Credit risk technology support Consolidation of disclosures Completed - C 3 4 2 6 Progress - P 2 2 4 0 Not started- N 0 0 0 0

3.Foreachofthefollowingstepsinimplementationprogram,writeC completed,PProgress,N Notstarted: Creditratingmodels Progresstowardsoperationalriskstandardisedapproach Creditrisktechnologysupport Consolidationofdisclosures

Result:
In all the banks requirements for Pillar 3 implementation is almost completed. Majority of banks 4 out of 6 have prepared themselves for standardised approach of operational risk. 3 out of 6 banks have completed the design of risk models while 2 are in progress. 4 out of 6 banks are still building their credit risk technology infrastructure. Remaining 2 have completely designed their models. Respondents were of the view that the framework is almost completed, although the models are not yet fully calibrated.

Interpretation:
Since banks were earlier also complying with disclosure requirements, consolidation of all relevant disclosures under pillar 3 was not a major issue. Even preparedness for operational risk is also impressive. However designing of credit risk models and developing required infrastructure is still in progress due to lack of availability of data and poor technological infrastructure. Collection of data is also a mammoth task. Again poor coordination among different banks on information regarding customer profile is also resulting in the delay of completion of these processes.

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4. Concerns regarding credit risk management Credit risk is considered as an important parameter under Pillar 1 for calculating CRAR. Hence a question was framed to analyse the various issues faced by them in implementing the credit risk management model. Rate the concerns for credit risk management that you face: (1-Easy, 5-Most challenging) Concerns Data gathering for IRB model development Methodology for IRB development Integration of credit risk into business processes Meeting local regulatory guidance on loan grading/ internal ratings Implementing risk based pricing 1 0 0 0 0 0 2 0 0 0 0 0 3 0 3 5 5 4 4 1 2 1 1 2 5 5 0 0 0 0 Summated scores (4 X1) + (5 X5) = 29 (3 X3) + (4 X2)= 21 (3 X5) + (4 X1) = 19 (3 X5) + (4 x1) = 19 (3 X4) + (4 X2) = 20

4. Ratetheconcernsforcreditriskmanagementthatyouface:(1easy,5mostchallenging) DatagatheringforIRBmodeldevelopment MethodologyforIRBdevelopment Integrationofcreditriskintobusinessprocesses Meetinglocalregulatoryguidanceonloangrading/internalratings Implementingriskbasedpricing

Result:
The summated scores in the above table reflect the challenging nature of these concerns. The highest score that could have been received was 30. A comparative analysis of the scores shows that Data gathering for IRB model development is the most challenging aspect of credit risk management followed by methodology development for IRB model. Risk based pricing is also one of the important issues.

Interpretation:
The data collection and development of IRB model is considered to be the most challenging due to lack of historical data, poor technology infrastructure, lack of effective coordination among different banks and the like. Due to lack of adequate information on various parameters, implementation of risk based pricing is also a bit difficult.

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5. Operational risk management Operational risk is a new parameter included under Pillar 1 for calculating CRAR. This question was framed to analyse the various issues faced by them in implementing the operational risk management model. Various researchers opine that this risk would be the single most factor which will have a far reaching impact on the various aspects of banks. Thus to have an empirical study of the challenging issues in its implementation, this question was asked.
Rate the concerns for operational risk management that you face: (1-Easy, 5-Most challenging)

Concerns Identification of key risk indicators Quantification of operational risk Lack of internal and external data Implementation of loss data collection

1 1 0 0 0

2 5 0 3 0

3 0 0 0 5

4 0 4 3 1

5 0 2 0 0

Summated scores (1 X1) + (2 X5) = 11 (4 X4) + (5 X2) = 22 (2 x3) + (4 X3) = 18 (3 X5) + (4 X1) = 19

5. Ratetheconcernsforoperationalriskmanagementthatyouface:(1easy,5mostchallenging)
Identificationofkeyriskindicators Quantificationofoperationalrisk Lackofinternalandexternaldata Implementationoflossdatacollection

Result:
The summated scores in the above table reflect the nature of these concerns. The highest score that could have been received was 30. A comparative analysis of the scores shows that Quantification of operational risk is the most challenging aspect of operational risk management followed by Implementation of loss data collection. Lack of internal and external data is also one of the important issues.

Interpretation:
Since this risk has been incorporated for the first time, and Basel II framework does not provide detailed outline on this aspect banks are finding it challenging to quantify this risk. Again just like in credit risk, lack of data for operational risk is also one of the major impediments.

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6. Requi irements of new skills f impleme for entation of B Basel II Having t right pe the ersonnel is v very important for the successful implementat tion of Basel II. Adequate trained staff is cen ely ntral to a ro obust superv visory infras structure an the succe nd essful implemen ntation of Basel II. An hence th question was frame to unders B nd his ed stand the hu uman resource needs of ban under Basel II. nks
6. Does i implementat tion of Base II require el newskills s:

Ye es No N

Doesim mplemen ntationo of BaselIIrequirenewskil lls

0

Result:
All the r respondents invariably a agreed that the succe essful imple ementation o Basel II of requires n skills. new

Interpre etation:
6

Yes

No

Figur Requirem re: ment of new skills for B w Basel II

In India for implem a menting the advanced e approach of Basel II, there is a need for hes both ban and super nk rvisory pers sonnel with the quan ntitative ex xpertise and skills to d understan banks r nd rating system models ms, and cap pital asses ssment stra ategies in advance of Basel II implementa ation. Even for the simpler ap pproaches, skills are required at both bank and superv k visory level reas of cred risk miti dit igation and in the ar operation risk as w as capita adequacy nal well al assessme under Pil 2. ent llar

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7.Option to fulfill the requirem ns t ment for req quisite skills s. The requ uirement for new skills can be met by various ways like training of existing sta or r t s aff hiring of new staffs. Inorder to k f know the like elihood of th options, th question was asked t the he his to ents. responde 7. Ifyes,how wwillyoufu ulfillyourreq quirement fortheseskills? By t training pro ogrammes By h hiring new employees with the s requ uisite skills Ifyes,h howwilly youfulfi ill Both h

yourrequ y uiremen ntforthe ese skills

1 0

Result:
The feedba ack that w was received by the d respondents was a mix and match. 5 out of 6 s said that the new skills were requir and so e red both the options were t be used- new staffs to as well as tr raining to ex xisting staff, while the , remaining 1 thought tha new skills could be at taught to th existing s he staff. Of the mainly ese managers from new private banks and foreign ban nks were w willing to hire new employees whereas ma anagers from the old m private ban wanted t train thei existing nks to ir staff. Nation banks we willing to do both. nal ere o

Bytrainingprog B grammes Byhiringnewe B employeeswith htherequisite eskills Both B

Interpreta ation:
The private sector and foreign se e d ector have more mone and can afford hi ey n iring new employees. The new staffs were required e mainly fo or advanc ced approa ach and Operational risk. On the other h l hand local banks prefe erred training their old e g employees to the new rules rath than hi w her iring new employees because ove erall it is le costly. ess ver National banks howev follow both the w ees where ways. They hire new employe required and train them where possi d ible.

re: g rement of ne skills ew Figur Fulfilling the requir

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8. Assist tance of thir parties fo validatio of Basel f rd or on framework. This ques stion was asked in the qu uestionnaire to find out a to whethe the banks in India took the e as er k help of ex xternal parti in validat ies ting their Ba II risk fr asel ramework. 8. 8 Which of the follow f wing parties help is s
used in valid u dation of Basel II fram mework?

RBI Rating agency g

Third dparties sfor validati ingtheb baselII fra amewor rk

0 6 6

Audit and cons tors sultants Other rs

Result: R
All A the bank managers agreed to the fact that e th required a third pa hey d arty to valid date their Basel II framework. All res B spondents considered a the abov third par all ve rties help in nevitable.

Interpretati I tion:
6

RBI Ratin ngagency Audit torsandconsu ultants Othe ers

ure: nce hird parties s Figu Assistan of the th

Thus it is c T clear from the answer by the r re espondents t that they do understand that it is not n possible for them to implement Basel II o with w its own existing ban nking system A third m. party is a mu so that it can help the bank to p ust e get g its standa up to the internation level. ard nal RBI R was ma ainly conside ered as a th hird party si ince it is the central ban of India. Auditors e nk an consultan are given importance because nd nts n e it is believed that they have requis skills t d site an thus the can do t work fa nd ey the aster and more professionally. m

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9. Chan in the cu nge urrent CRA . AR This question was as sked to know the percep w ptions of Ba anks on furth increase in the regul her latory requirem of CRAR Since the are the on who wil b directly im ment R. ey nes be mapcted, the views on such eir n measure is very impo ortant. 9. Shouldthe . ecurrent9% %CRARbera aisedby RBI? Yes No Why.............................................................. W ... .................... .................... .................... ..........

Shouldthecurre ent9% CRARbe eraisedbyRBI

0

Result: R

All A the respon ndents refus to the op sed ption of ra aising the current CR RAR level. They . be elieved that the curren 9% CRA was t nt AR su ufficient and no further increase sho d ould be made by RBI. m

In nterpretati ion:
Su uch a resp ponse can be attribu uted to fo ollowing two factors: o

Yes

No

Current mar C rket scenar rio: The rai ising of CRAR will le to difficu C ead ulties in the present sc cenario wh here liquidi ity is a serious co onstraint in f financial sys stem. Current CRA levels of banks: Mo C AR oreover In ndian Banks are largely over capital lized in te erms of the risks that th are expo hey osed to. The present average C T CRAR for Indian ba anking secto is 12%. or

Fi igure: Chan in the cu nge urrent CRAR R

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10. Chan in the pe nge ercentage o tier 1 capi of ital Tier 1 Ca apital refers to the core c capital. Presntly it is 6% of the CRA Increase in its percen % AR. ntage will mak the sector more stable and strong. ke e .This questio was asked to know th perceptio of on he ons Banks on further increase in the percentage r n requirement ofTier 1 cap t pital. Since they are the ones who wil b directly im be mapcted, the views on such measu is very im eir n ure mportant. 10.Shou uldtheperce entageshare eofTierI capitalb beraised? Yes No

In ncreasei inthepe ercentag geof Tier1Cap Ti pital

0

Why .

Result:
All the respondents invariably agreed to s y the fact that the c t current share of tier 1 e capital n need not be r raised.

Interpr retation:
The una animous ag greement to no further increase in Tier 1 ca e apital can be attributed e to the c current mark condition It would ket n. be diffi icult for Banks to raise Tier 1 capital in the curre market c ent conditions. easier to r raise Tier II capital It is e currently. And therefore bank prefer to ks increased meet their capital al. requirements with tier 2 capita

Yes

No

Fig gure: Chang in %shar of tier 1 C ge re Capital

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11. Impa on differ act rent types of banks Analysis of various parameters o secondary data reveale varying d p of ed degree of imp of Basel II pact on differe banks. Hence to vali ent H idate the find ding this que estion was as sked. 11. Will Basel II have varying degree of g ttypesofbanks? impactondifferent
Yes No

BaselII Iwillhav vevaryin ng degreeof d fimpact tondiffe erent ty ypesofB Banks

0

Result t:
All the respondent invariably agreed to e ts y the fact that Basel II implemen t ntation will have di iffering impa on differe banks. act ent

Interp pretation:
It can b inferred t be that due to changes in the op perational a and structur ral aspect, Basel II implem mentation w will have varying degree of impact. On one hand g n public sector bank have lar ks rge capital base su upported by governmen holdings, nt their op perations are not as effic e cient as that of its counterparts While on the other s. n hand pr rivate sector face dearth of capital rs h but they are profes ssionally ma anaged and their op perations are efficient. W e While both these banks lack in modern tec n chnologies, n over them. foreign banks have an edge o The ch hallenge face by them is that the ed regulati ions for them beco ome more stringen and due to operations in various nt o s countries, they h have to dea with a al plethora of issues.

Yes

No N

Figure: Varying imp on ban pact nks

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ImpactonIndianbanks
One of the key issues, which will emerge from the Basel II Accord, is "a need to establish a clear accountability for data quality and ownership. The capital calculations for credit and operations risk will be completely dependent on the quality of data." - Price Waterhouse Coopers The Basel II implementation will affect the Indian banks in various ways. It will significantly affect the competitive landscape, with increased competition in retail lending, and shake-outs in corporate lending, involve high costs on IT infrastructure, have an effect on loan pricing, possibly alter the current business model of banks or give rise to consolidations. In effect, it will involve a lot of trade offs for the banks and the banking sector as a whole. Banks see substantial benefit from more economically rational allocation of capital and more robust risk-based pricing as a result of Basel II. The financial health of the Indian banking system has improved significantly with the implementation of Basel II.

1. Impact on Loan Pricing, Portfolio Composition and the Lending Process as a Whole: Loan pricing- Risk based pricing: Basel II requires the capital requirement for each bank to be more closely tailored to various risks run by each bank. Risk-based Pricing is the technique of charging different interest rates from two different customers on the same type of loans, depending on the risk attributed to each of them. Under this method credit scores are calculated for individuals, taking into consideration various factors which are assumed to represent the individuals willingness and capacity to repay the loan installments. As the banks would be in the process of moving toward the IRB Approach they would be armed with the knowledge of the risks associated with the various types of exposures. This knowledge would help the banks in passing on the charge arising from higher credit risk to the customers. Risk-Based Pricing would be the norm of the banking industry in another ten years. Portfolio composition: Loans will be granted to only good borrowers. The more risky borrowers will have difficulty in finding banks that are willing to lend to them. This would result in reduced Non Performing Assets for the banking sector as a whole resulting in better solvency of the Indian banking system. The risk appetite of the entire banking sector shall decrease with the shift to Basel II. Lending process: Since the pricing of the loans will be based on the risks assessment and will be done only after proper and thorough screening of the borrower, the efficiency of the entire lending process would improve.
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NPA lev of 6 sele banks (2 from each category) fo last 13 y vel ect for years incorpo orating both post h Basel I (1996- 2006) and post Basel II (2007 2008) pe ) 7 eriod has been taken. Th analysis o the he of following graph rev g veals that the NPA leve have sho els own a dram matic improv vement acros all ss banks. H However in case of few banks, it h increased from its p c has d previous yea like in IC ars CICI, Barclays etc. This ca be attribut to their in an ted nternational exposure af ffected by su ubprime crisi is.

Bank kofBaro oda

10 0 8 6 4 2 0 1996 199 1998 199 2000 200 2002 200 2004 200 2006 200 2008 97 99 01 03 05 07 8.15 53 7.5 6.6 .7 7. 6.95 77 6.7 5.68

81 4.8

4.95 2.8 82 0.87 .6 0. 0.47

Stateb bankofI India

8 6 4 2 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 200 2006 200 2008 7 9 1 05 07 6.61 7.3 6.07 8 7.18 6.41 6.0 03 5.64 49 4.4 3.45 65 2.6 1.87 1.56 1.78

ICICI
6 5 4 3 2 1 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 200 2006 200 2008 7 9 1 05 07 0 1.73 3 1.14 8 2.88 19 2.1 1.53 0.72 2.21 2.3 34 1.0 02 1.55 5.48 5.2 21

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HDFC
1.18 1.2 2 1 0.8 8 0.6 6 0.4 4 0.2 2 0 1.1

0.34 0 0

0.45

0.5

0.37 0.16

0.44 0.24

0.43

0.47

1996 199 1998 199 2000 200 2002 200 2004 200 2006 200 2008 97 99 01 03 05 07

Barc claysban nk
12 2 10 0 8 6 4 2 0 11.45

5. .1 35 3.3 0 0 0

6.06

0.42

1996 199 1998 199 2000 200 2002 200 2004 200 2006 200 2008 97 99 01 03 05 07

Citibank C
2.5 2 1.5 1 0.5 0 0.5 1996 199 1998 199 2000 200 2002 20 97 99 01 003 2004 20 005 2006 20 007 2008 0.08 0.6 63 0.57 1.05 .71 0. 0.4 1.17 1.4 1 0.95 1.02 1 1.23 08 2.0

Source: R Report on Tren and progr in banking nd ress

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2. Impact on borrowers: Efficient borrower

Impact of Basel II
Risky borrower

Lower rates; Favourable terms; Large amounts. Higher rates; Less favourable terms; Lesser amounts.

Figure: Borrower wise impact of Basel II

Due to greater differentiation in pricing, stronger borrowers will be benefited from less than 100% risk-weighting while weaker borrowers will potentially have a risk-weighting of 150% or more. Borrowers might find that the bank wants to increase the cost of its borrowing if the banks credit assessment means that the borrowers risk-weighting is more than 100%. The bulk of the borrowers in India fall under the speculative grade. The speculative-grade borrowers will suffer from a dramatic rise in debt costs and heightened cyclicality of global bank credit as a result of Basel II. The more efficient borrowers will have easier and larger access to funds while the more risky borrowers will find it tough to garner funds at favorable rates. In the extreme case, some borrowers will find no banks that are willing to lend to them. Example: There are two companies from the same sector - one with a high credit rating say AAA and other with a lower rating say BBB. Even a 2% interest rate differential can transform into a huge competitive advantage for the AAA rated borrower. Further with increased competitiveness in the sector, the quality of services to the customers will be improved as the focus will be more on service based business model rather than on cost based.

3. Impact on cost: Though the extensive data requirements, up gradation of technical infrastructure, increased level of capital requirement, capacity building and human resource development translates into very high implementation cost, the Reserve Banks initiative to migrate to Basel II at the basic level has considerably reduced the Basel II compliance costs for the Indian system. The elementary approaches which have been identified for the Indian banking system are very similar to the Basel I methodology. For instance, a. There is no change in the methodology for computing capital charge for market risks between Basel I and Basel II;
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b. T computa The ation of capit charge fo operationa risk under the BIA is very simple and tal or al r s e will w not invol any comp lve pliance cost; ; c. T computation of capit charge fo credit risk will involv compilatio of inform The tal or k ve on mation in a marginal more gra n lly anular level, which is ex , xpected to b achieved with a sligh rebe ht or rientation of the existing MIS. f g Further, the expend diture incurr by bank to impro their ris managem red ks ove sk ment system IT ms, infrastruc cture, core banking sol lutions, corp porate gover rnance, risk models etc should no be k c. ot included as Basel II compliance costs, since these are e e expenses which a bank w would incur even in the nor rmal course of business to improve t their efficien ncies. The abov arguments are consist with the informal fe ve tent e eedback rece eived from banks that the do ey not see B Basel II implementation as a costly propositio (Shyamala Gopinath, May 12, 2006). y on. Thus it can be safely said that im y mplementatio of the elem on mentary leve of Basel II leads to a very els marginal increase in the cost o regulatory compliance. An analy l n of y ytical study of the oper rating expenses of the Indi banks sh s ian hows a marg ginal decrea in the ra of opera ase atio ating expens to ses total asse ets. The follo owing graphs studies the trend of op e perating expe enses as per rcentage of total assets a across six banks for a perio of 13 year covering b s od rs both post Ba I and po Basel II period. From the asel ost m graphs it can be conc cluded that f public se for ector banks, while there was a reduc ction in oper rating expenses ratio, for private and fo s foreign bank the trend i ks increased. It can be attri t ibuted to the fact e that PSU have comp Us paratively la arge asset ba For priva and forei banks th subprime crisis ase. ate ign he is a maj impact as these ba jor anks had an internation exposure However it can als be n nal e. r, so conclude that the im ed mplementati of Basel framework does not in ion l k nvolve too m much of spe ecific costs. Ba II is not a costly prop asel position for Indian bank ks.

BankofBa aroda
3 2.5 2 1.5 1 0.5 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2.53 2.37 2.34 2.54 2.31 2.22 2.2 2.16 2.12 2.09 2.1 1.78 3 1.63

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Stat teBanko ofIndia

3.5 3 2.5 2 1.5 1 0.5 0

3.09

2.94

2.63

2.61

2.68

2.79 2.4 2.13

1 2.71 2.08

2.41 1

2.22

1.99 9

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 8

ICICI
2.5 2 1.5 1 0.5 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 8 2.37 2.27 1.76 1.19 1.27 0.6 1.69 1.88 2.05 1.97 1.9 1.94 4 2.04

HDFC C
3 2.5 2 1.5 1 0.5 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 8

2.79 2.32 2.22 2.04 1.46 1.98 1.76 1.95 1.91 1 2.11 2.3

2.65

1 2.81

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Ba arclaysb bank
7 6 5 4 3 2 1 0 1996 1997 1 1998 1999 2000 2001 2002 2003 2004 4 2005 2006 2007 200 08 3.43 3.71 3.6 3.67 2.81 1.87 1.94 4.1 4 3.24 2.27 76 2.7 6.52 5.35

CitiBan nk
4 3 2 1 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

3.82 3.28

3.83

3.53

3.88 3.09

3.52

3.32

3.41

3.62

3.36 2.79 2.6

Sourc Report on Trend and p ce: progress in b banking

act ation in the sector: 4. Impa on structure- Lead to consolida The i implementat tion of Basel II is likely to provide momentum for mergers and acquisi y s itions in th Indian ba he anking indu ustry. As m more and mo banks m ore move toward the adva ds anced appro oaches, the gap between the strong and weak banks will increase fur g n g rther, making the weak banks po ker otential takeo over targets. The trend in the India banking i an industry sug ggests that t industry is moving f the from a large number of small playe towards a small nu e f ers umber of lar players. The various reasons for the consolidation in the industryrge s r e eased Comp petition: fro foreign as well as domestic b om banks after d deregulation and n a. Incre libera alization of the Indian b t banking indu ustry. It wou be very d uld difficult for smaller ban to nks corre ectly price th loans a they wo heir and ould lose ou on custom ut mers with lo probabili of ow ity defau to larger banks, who would offe them low interest r ult o er wer rates and the would en up ey nd with customers with high pro w obability of default, whi would be offered hig ich e gher interest rates
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by the larger banks. The only way the banks would be able to survive would be by growing in size, and mergers and acquisition would be the preferred path to growth. This trend has already started as can be seen by the spurt of mergers that have taken place during recent times (Times Bank and HDFC Bank (2000-01), ICICI Bank with Bank of Madura(2002) and subsequently with ICICI Ltd.(2002), Benares State Bank and Bank of Baroda (2003), Global Trust Bank with Oriental bank of Commerce (2005).) b. Capital requirement: Mergers and acquisitions in the sector are expected to gather steam voluntarily because banks are required to scale up capital base to take care of market, credit and operational risks, as envisaged in the stringent Basel-II norms. In the present market scenario, the banks might find it difficult to raise funds through the capital markets for servicing the capital adequacy requirements. The maximum level of dilution allowed of government's stake is 51% in PSB which might cap their capital market funding. Besides this the guideline to bring down single holding in the banks to 10 per cent will also aid the consolidation as through mergers the shareholding can be brought down. c. Banks on Basel I norms: Basel I banks will become likely takeover targets for Basel II banks that believe they can deploy Basel I bank capital more efficiently. As Basel I banks are left with more riskier assets, lower credit ratings and higher costs of liabilities, they will find it more difficult to compete for the higher quality assets. With implementation of Basel II, Basel I banks will be considered as second tier institutions by the market, the rating agencies, and sophisticated customers such as government and institutional borrowers and thus they would prefer to be merged. d. To go global: Indian banking industry is on a look out for expanding their operations to the overseas countries. Hence to have the size advantage, there is a need for consolidation in the banking industry today in order to compete for a piece of the pie in the international markets. e. To attain the benefits of IRB Approach like lower capital adequacy requirements, better image, etc., the banks would require investment in its risk management models as well as information systems. It could be difficult for a small sized bank to undertake these investments. Again lower capital levels that large bank obtains under Basel II will result in more acquisitions by the larger banks seeking to lever capital efficiencies. The following table shows the trend of mergers in the Indian banking sector for the past 18 years. It reflects that implementation of Basel II has increased the momentum of mergers and consolidation of Indian banks.

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Year

Number of bank mergers 1 0 0 1 0 1 0 2 0 3 1 0 3 0 2 2 3 5

1990- 91 1991- 92 1992- 93 1993- 94 1994- 95 1995- 96 1996- 97 1997- 98 1998- 99 1999- 2000 2000- 01 2001- 02 2002- 03 2003- 04 2004- 05 2005- 06 2006- 07 2007- 08

Private sector banks 0 1 0 0 8 2 1 0 0 0 0 1 0 1 1 1 0 0

New banks set up Foreign banks Public sector banks 2 0 0 0 4 4 8 4 8 1 0 4 1 1 0 0 1 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 1 0 0 0

Source: RBI- Report on currency and finance 2007 2008

5. Impact on bank margin: Implementation of Basel II will increase the margins for the more efficient banks resulting from savings on account of reduced capital requirement and probable increase in business while the lesser efficient players would find the going tough, as they will be required to provide a higher level of capital and this will be reflected on their margins. The new framework could also intensify the competition for the best clients with high credit ratings, which attract lower capital charge. This could put pressure on the margins of the bank. The banks would, therefore, need to streamline and reorient their client acquisition and retention strategy. The following graph shows the trend of spread (net interest margin) for the select 6 banks over a period of 13 years. It reflects that though the margin has been thinning, but for efficient banks it has increased after Basel II implementation. With the implementation of Basel framework, the margins though decreased have been consistent throughout. It is believed that with increase in efficiencies due to Basel II framework, the margins will show a comparative rise. The thinning margin also portrays the changing universal nature of the banks. And it also signifies that the business model of banks have to be service based rather than cost based.

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Ban nkofBar roda

4 3 2 1 0 1992 1993 1994 1995 19 1997 199 1999 2000 2001 2002 20 2004 2005 2006 2007 2008 996 98 003 2.92 2.76 2.99 3.68 3.59 3 3.21 2.9 3.01 2.85 3.06 91 2.75 2.65 2 15 3.02 3.1 2.84 2.64 2.18

State ebankof fIndia

4 3 2 1 0 1992 1993 1994 1995 199 1997 1998 1999 2000 20 2002 2003 2004 2005 20 2007 2008 1 96 001 3 006 3.63 2.95 2.61 28 3.25 3.2 3.43 3.01 2.72 2.65 2.61 2.61 2.65 2.74 5 3.17 3.03 3 2.83 36 2.3

ICICI
4 3 2 1 0 1995 1996 1997 1998 1999 2000 2001 200 2003 200 2005 200 2007 200 6 8 02 04 06 08 1.44 2.7 7 2.2 23 1.7 1.5 54 57 0.5 2.05 1.33 .5 1. 1.69 1.67 1.93 .83 1. 3.68

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HDFC
5 4 3 2 1 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 6 8 0 2 4 6 8 0.23 1 4.41 4.11 5 3.65 4.07 3.38 2.6 6 3.24 5 2.65 2.73 3.16 6 3.46 3.46 6 3.93

Ba arclaysbank
8 6 4 2.23 2 0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2 1 8 2001 2002 20 2004 2005 2006 2007 2008 003 5 6.94 5.72 4.83 .16 4. 8 2.78 3.58 2.37 1.54 0.94 0.83 1.67 1.65 2 2.13 2.32 7.08

Citibank k
6 5 4 3 2 1 0 1992 1993 1994 1995 1996 1997 1998 1 1 6 1999 2000 20 2002 2003 2004 2005 2006 2007 20 001 3 008 3.25 5.08 4. .39 4.72 3.91 1 4.75 4.39 3.44 4.55 3.97 3.76 3.76 4.58 4.36 4.29 4.53 4.05 4

Source: R Report on tre and prog end gress in ban nking

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6. Impact on business model: A business model typically looks at the way the business is run in terms of: The marget segment, The delivery channels, The product/ service range, The revenue drivers and The supporting infrastructure. Viewed from the above perspective, the folowing table indiates the shift that has been taking place in the Indian banking scene: Basis Previous decade (1990- 2000) Public sector New generation banks banks All segments Segmentation retail corporates Current decade (2000 onwards) Public sector New generation banks banks

Marget segment

for All segments but Retail corporates and increasing and Small and differentiation medium sized entities

Delivery channels Product/ Service range Revenue drivers Supporting infrastructure

Brick and mortar Brick and mortar Brick and mortar Brick and mortar branches branches; ATMs branches; ATMs; branches; ATMs; internet banking internet banking Traditional products Interest income Internal to bank Both traditional Both traditional Innovative and new products and new products products Interest income Internal outsourcing Fee based and Fee based and Interest income Interest income and Internal outsourcing and Internal increased outsourcing and

Table: Changing face of Indian banking business model

Low Moderate

Basel

Risk level

II

High

Unacceptable Returns

Acceptable

Figure: Effect on business model

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With the advent of Basel II, banks with a risk appetite, i.e. high risk - high return lending strategy or lending without proper appraisal merely to generate additional business will find the going tough. Business models, which take disproportionately high risks, will not survive. Banks will need to differentiate based on the services provided rather than the customer segment catered to (low risk/high risk). The business models, which should survive, will be where moderate level of risk for the banks is backed by adequate returns. 7. Need of advanced technology: Basel II incorporates much of the latest technology in the financial arena for managing risk and allocating capital to cover risk. Thus, banks would be required to adopt superior technology and information systems which aid them in better data collection, support high quality data and provide scope for detailed technical analysis. Technology in Indian banks has increased remarkably, but it hasnt been leveraged to the maximum extent essential to achieve and maintain high service and efficiency standards. And therefore initially the standardised approach under Basel II is implemented. The banks often do not have the data or systems to adopt the advanced internal ratings based (A-IRB) method, or even the intermediate, foundation internal ratings based (F-IRB) method.In India, private sector banks that are already investing in technology face teething problems that include appointing a final internal authority, who will be building and maintaining this solution. In case of public sector banks, majority of them lack data due to late computerisation. 8. Computerization: Now a necessity In the advanced approaches under Pillar 1, capital requirements are based on banks' own measures of risks. This requires comprehensive data collection and analysis, for which banks need to have in place a well developed modular and flexible risk management system to upgrade their capability to assess and quantify their risk exposure and allot their capital accordingly. Thus in the long run all the banks will have to get their risk management systems computerized. Data of public sector banks reveal that most of the banks have fully computerised their control systems and many of them have also implemented core banking solutions. This shows the heightened preparations for adoption of complex methods under Pillar 1. Computerisation in Public Sector Banks as on March 31, 2008 Serial Name of the bank Branches under Branches Fully Branches number core banking already fully computerised partially solution computerised branches computerised (A) (B) (A + B) Bank of Baroda 60.4 39.9 100.0 1 State bank of India 92.2 7.8 100.0 2
Source: RBI- Trend and Progress on Banking 2007- 2008 90|P a g e

9. Involvement of External and Internal Auditors: Since RBI can involve third parties, such a external auditors, internal auditors and consultants to assist it in carrying out some of the duties under Basel II, a suitably developed national accounting and auditing standards and framework, which are in line with the best international practices is required. With the implementation of the new framework, internal auditors may become increasingly involved in various processes, including validation and of the accuracy of the data inputs, review of activities performed by credit functions and assessment of a banks capital assessment process. Though ICAI is internationally recognized, the eligibility criteria for auditors have to be more stringent in the face of negligence shown by them in various cases. 10. Impact on capital: Basel II compliant banks can achieve better capital efficiency as identification, measurement and management of credit, market and operational risks have a direct bearing on regulatory capital relief. The proposed capital framework will have a positive affect on the Indian banking sector. In the long-term, it will encourage banks to become more risk sensitive, leading to an improvement in their risk management systems. On current indications, implementation of Basel II will require more capital for banks in India due to the fact that operational risk is not captured under Basel I, and the capital charge for market risk was not prescribed until recently. The cushion available in the system, which at present has a Capital to Risk Assets Ratio (CRAR) of over 12 per cent, provides for some comfort but the banks have been provided various avenues (like innovative perpetual debt instruments, perpetual non-cumulative preference shares, redeemable cumulative preference shares and hybrid debt instruments) by RBI for meeting the capital requirements under Basel II. According to CRISIL, the banks' adoption of Basel II will reduce the sector's capital adequacy by 1.6 percentage points (i.e. the CRAR for the sector would have been 11.3% rather than 12.9 %). This is a function of a 0.7% gain on credit risk, and declines of 1.2% and 1.1% on market risk and operational risk, respectively. A separate study by ICRA estimates that Indian banks will need additional capital of Rs. 120 billion ($2.8 billion) to meet the Basel II operational risk capital requirement alone. The following graph shows the CRAR position of select banks for post Basel I and Basel II period. It can be seen that the CRAR position throughout the period has been much above the minimum requirement 8% and also the regulatory requirement of 9%. For Indian banks the current CRAR averages around 12%. This indicates a healthy and sound state of the industry. Again with Basel II framework their had been an improvement in the capital required for credit risk as a result of which for many banks CRAR improved in March, 2008.

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Ban nkofBaroda
14 4 12 2 10 0 8 6 4 2 0 11.19 11 1.8 12.05 13.3 1 12.1 12.8 11.32 12.65 13.91 12.61 13.65 5 11.8 12.9 91

1996

199 97

1998

19 999

2000

2001 2

2002

2003

2004

2005

2006

2007

2008 8

State ebankof fIndia

16 14 12 10 8 6 4 2 0 14.58 11.6 12.17 2.51 12 11.49 12.79 13.35 1 13.5 13.53 64 12.45 11.88 12.34 12.6

1996

199 97

1998

19 999

2000

2001 2

2002

2003

2004

2005

2006

2007

2008

ICICI
19.64 20 15 10 5 0 1996 199 97 1998 19 999 2000 2001 2 2002 2003 2004 2005 2006 2007 2008 17.52 13.04 13.48 11.06 11.57 11.44 1 11.1 11.66 11.62 5 13.35 92 14.9 11.69

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HDFC
25 20 15 10 5 0 1996 199 97 1998 19 999 2000 2 2001 2002 2003 2004 2005 2006 6 2007 200 08 13.92 11 1.86 12.09 1 11.09 13.93 11.12 10.36 11.78 11.41 13.08 13.6 23.53 .25 22.

Ba arclaysb bank
70 60 50 40 30 20 10 0 1996 199 97 1998 19 999 2000 2001 2002 2003 2004 4 2005 2006 2007 2008 2 9.56 11. .62 14.52 12.9 1 17.75 26.97 45.68 37.1 16 2.92 20.85 22 13.68 21.11 2 6 63.56

Citiban nk
12 2 10 0 8 6 4 2 0 1996 19 997 1998 1999 1 2000 2001 2002 2003 200 04 2005 20 006 2007 10.1 9.46 9 10 8.61 10.62 11.24 11.04 11.3 11. .11 10.78 11.33 11.06

12

2008 2

Report on tre and prog end gress in ban nking Source: R

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FurtheranalysisofCRAR
Trend study of distribution of CRAR The following table provides yearly frequency distribution of different bank groups by their CRAR levels for the period 1996-2006. As shown in the table, by the end of March 1997, all but 2 nationalised banks and 4 private banks were short of meeting the capital adequacy norm. The SBI group and the foreign banks had achieved the minimum regulatory norm by March 1997. Although a few banks were having negative CRAR during 2000-02, all banks achieved the minimum regulatory level by 2006. As shown in Table, majority of the banks in all bank categories have achieved a CRAR level of more than 10 per cent by March 2006, indicating good financial health of the banking industry, in terms of capital adequacy norms, over the recent years. Table: Distribution of Indian banks by CRAR (1996-2006) (Unit: Nos.)

Note: 1) MRR is Minimum Regulatory Requirement (8% till 1998-99, 9% thereafter); 2) - indicates nil, * indicates negative Source: RBI, Reports on Trend and Progress of Banking in India, (various issues) 94|P a g e

Trend study of average CRAR level The average level of CRAR for the Indian banking groups for the period 1999-2006 is presented in the following table. As shown by this table, the average CRAR level for the banking industry has stood consistently between 11 and 12 per cent during 1999-2006, which is much higher than the current minimum regulatory requirement of 9 per cent and the international minimum requirement of 8 per cent. As seen from the table, overall CRAR for the banking system has marginally declined since 2005. Between 2004 and 2005, the overall CRAR declined by 0.1 percentage points and between 2005 and 2006, this decline was by 0.5 percentage points. Bank group wise, between 2004 and 2005, old private banks recorded the highest decline of 1.2 percentage points in CRAR followed by a 1 percentage point fall for SBI group and the foreign bank group each. The new Private Banks recorded a rise of 1.9 percentage points in CRAR and the nationalised banks recorded a rise of 0.1 percentage points. The net result was a marginal decline in CRAR for the banking system as a whole. This decline can be attributed to the increase in total risk-weighted assets relative to the capital, for the first time since March 2000. The increase in risk-weighted assets was due to a higher growth in the loan portfolio of banks and higher risk weights made applicable for housing loans, the most rapidly increasing component of retail loans for banks. Following a similar pattern, CRAR levels for all but one banking group recorded a decline between 2005 and 2006. The highest decline of 1 percentage point was observed for foreign banks, followed by a decline by 0.8 percentage points for nationalised and old private banks, of 0.7 percentage points for other public sector bank (IDBI being the sole member of this group) and a decline by 0.5 percentage points for the SBI group. During this period new private banks showed a rise of 0.5 percentage point in CRAR. The resultant change in CRAR for the banking system as a whole was a decline of 0.5 percentage points. This overall decline in CRAR could be attributed to three factors (i) higher growth in loan portfolio of banks as compared to investment in government securities, (ii) increase in risk weights for personal loans, real estate and capital market exposure, and (iii) application of VaR-based capital charge for market risk for investment held under held for trade and available for sale portfolios. Notwithstanding the overall decline in CRAR recorded successively for the last two years, the CRAR level remains at a satisfactory level of 12.3 per cent at the end of March 2006. As far as the individual banking groups are concerned, IDBI bank (the sole member of the group other public sector banks) had the highest CRAR at 14.8 per cent at the end of March 2006, followed by the foreign banks with a CRAR level of 13 per cent, the new domestic private banks with 12.6 per cent and the nationalised banks at 12.4 per cent at the same period. At the end of March 2006, the SBI group has an average CRAR of 11.9 per cent and the old domestic private banks have an average CRAR of 11.7 per cent.

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Table: Average CRAR level of Indian banking groups

(Unit: %)

Source: RBI, Report on Trend and Progress of Banking in India, 2005-06

Reported CRAR of select banks under two regimes: The following table shows a comparative study of CRAR requirement for certain banks under the two regimes. It can be concluded that the select banks will report a decrease in their CRAR requirement. However there can be other banks like Indian bank, Punjab national bank which will have an increase. However the actual CRAR is much above the stipulated level of CRAR. Bank Bank of Baroda State bank of India ICICI Source: Annual reports FY 2007 Basel I 11.8 12.34 11.69 Basel I 12.94 13.47 14.92 FY 2008 Basel II 12.91 12.64 13.97 Difference .03 0.83 .95

International comparison
The following table provides a comparative picture of the capital adequacy ratios of different countries vis--vis Indias. As shown by this table, CRAR of Indian banking system compares well with many emerging countries such as Korea, Malaysia and South Africa. Countries such as Brazil, Indonesia, Hong Kong, Singapore and Thailand have higher CRAR level than India in 2005 while Japan, Taiwan, the United States and the neighbouring countries of Bangladesh and Sri Lanka have lower CRAR levels than India. In 2005, Chinas banking system had a CRAR level of less than 8 per cent. According to the official website of the Chinese Government, 74 per cent of Chinas total banking asset could meet the 8 per cent level in 2006, compared with 0.56
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per cent in 2003 when only eight banks complied. Thus, when compared with China, India is at a much better position with respect to capital adequacy.

Table: CRAR level in select countries (unit: %)

Source: Central Bank websites

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AhypotheticalstudyoftheimpactofBasel IIcreditrisk
A typical bank portfolio has an exposure to retail loans, mortgage loans, personal/credit card loans, corporate loans, cash credit, working capital demand loans, corporate bonds and commercial papers. Typically, a banks corporate loan portfolio including cash credit and working capital demand loans has mostly unrated exposures. External ratings are used more in the investment portfolio, for investing in debentures, bonds, and commercial paper (typically A1+/A1), lowering the proportion of unrated exposures. For illustration, I have considered a bank with exposures to these loans segments and applied the current and new risk weights (under Basel II). The share of- exposures, corporate loans and bonds, cash credit and commercial paper are all assumptions. The exposures and risk weight calculations for the hypothetical bank in the illustration is as follows: Bank portfolio Personal/credit card loans Mortgage Other retail loans Corporate Loans Cash Credit & Demand Loans Corporate Bonds Corporate CPs Total Working notes: Long term ratings LAAA LAA LA LBBB & below Unrated Total Share 2.00% 12.00% 8.00% 28.00% 40.00% 9.00% 1.00% 100.00% Current risk Current risk weight weighted assets 125% 2.50% 75% 100% 100% 100% 100% 100% 9.00% 8.00% 28.00% 40.00% 9.00% 1.00% 97.50% Basel II risk weights 75% 100% 75% 100.90% 100.00% 72.70% 20.60% Basel II risk weighted assets 1.50% 12.00% 6.00% 28.25% 40.00% 6.54% 0.21% 94.50% Basel II risk weighted assets (Corporate bonds) 5.20% 8.00% 10.00% 4.50% 45.00% 72.70%
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Basel II risk weights 20% 50% 100% 150% 100%

Corporate loans distribution 2.00% 5.00% 15.00% 10.00% 68.00% 100.00%

Basel II risk Corporate weighted assets bond (Corporate loans) distribution 0.40% 26.00% 2.50% 16.00% 15.00% 10.00% 15.00% 3.00% 68.00% 100.90% 45.00% 100.00%

Short term ratings A1+/A1 A2+/A2 A3+/A3 A4+/A4 A5 Unrated Total

Basel Cash credit Basel II risk II risk and short term weighted assets weights demand loans (Cash credit and short term loans) 20% 50% 100% 150% 150% 100% 0% 0% 0% 0% 0% 0% 100% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 100.00%

Short term investments (Commercial paper) 98% 2% 0% 0% 0% 0% 100%

Basel II risk weighted assets (Commercial paper) 19.60% 1.00% 0.00% 0.00% 0.00% 0.00% 20.60%

Result: The risk weights under Basel II are marginally lower at 94.50% vis--vis the 97.50% under Basel I. Thus, implementation of Basel II would result in a marginally lower credit risk weights and a marginal release in regulatory capital needed for credit risk. Thus for most banks, Basel II would result in reduction in regulatory credit risk weights. However, if the banks were to significantly increase their retail exposures or get external ratings for the short-term exposures (cash credit, overdraft and working capital demand loans), the credit risk weights could decline significantly.

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Impactofoperationalrisk
A. Capital requirement for the industryTable: Estimation of operational risk capital Year Annual gross income Capital required (Amount in Rs. crores) Capital charge

2005- 2006 2006- 2007 2007- 2008 2005- 2006 2006- 2007 2007- 2008 2005- 2006 2006- 2007 2007- 2008 2005- 2006 2006- 2007 2007- 2008 2005- 2006
20062007 20072008

All scheduled commercial banks 1.15,047 17257 1,32,296 19844 1,60,886 24133 Public sector banks 79,275 11891 85,910 12887 97,038 14556 Old private sector banks 5,482 822 5,987 898 6,839 1026 New Private sector banks 17.839 2676 23,036 3455 32,665 4900 Foreign banks 12,285 1843 17,365 2605 24,592 3689

14588

13111

915

3677

2712

From the above table it can be analysed that the total requirement of the commercial banks would be Rs. 14500 crores. The major chunk will be required by the public sector banks followed by new generation private sector banks. Further, given the asset growth witnessed in the past and the expected growth trends, the capital charge requirement for operational risk would grow 15-20% annually over the next three years. B. Effect on Tier 1 capital percentageFrom the following table it can be concluded that the percentage for Tier 1 Capital would reduce with the provision for operational risk capital. It will significantly reduce for public sector banks followed by private sector. Thus banks will have extra capital.

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Name of the bank

Annual gross income 2006 2007

9261

2008
5962

Operational Tangible risk capital net worth (A) (B)

976.25 11044 3528.2 49033

A/B = C

Current Estimated Tier I Tier I capital Capital (D) D*(1- C)

7.63 8.48 6.96% 7.87%

Bank of 4302 Baroda

0.8839641 0.07195562

23025 21823 25716 State bank of India 8890 ICICI 3669 HDFC Barclays 272 Bank 12566 4985 284 4034 16115 7511 869 6099

1878.55 46820 808.25 11497 71.25 4865 661.7 9351

0.04012281 0.07030095 0.01464543 0.07076249

11.32 10.3 20.81 11.24

10.87% 9.58% 20.51% 10.44%

Citibank 3101

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ChallengesinimplementingBaselII
The various challenges faced by Indian banks while implementing Basel II are as follows: 1. RBI risk-weighing scheme: The RBIs scheme of risk-weighing reveals certain shortcomings. First, RBIs scheme provides much less risk weights to exposures to scheduled commercial banks than exposures to other banks/financial institutions. To be more precise, exposure to scheduled commercial banks with current regulatory level of CRAR will attract a risk weight of 20 % while exposure to non-scheduled banks/financial institutions with same level of CRAR will attract 100 % risk-weight. This is discriminatory not only against non-scheduled banks of sound financial health, but also against cooperative banks and micro-finance institutions that cater to a large number of urban and rural poor in India. Second, RBIs scheme encourages borrowers to remain unrated rather than rated below a certain level. A rating of B- and below will have a higher risk-weight of 150 %, while an unrated entity will have a risk-weight of 100 %. 2. Issues on credit rating industry: As the Standardised approach of credit risk is dependent on linking risk weights to the credit ratings of an external rating agency, credit ratings are being institutionalized into the regulatory framework of banking supervision. This raises four important issues that need to be looked into. These are the quality of credit rating in India, the level of penetration of credit rating, lack of issuer ratings in India and last but not the least, the effect of the credit rating scheme on Small and Medium Enterprises (SMEs) and Small Scale Industry (SSI) lending. a. Status of credit rating in India- The credit rating industry in India presently consists of four agencies: Credit Rating Information Services of India Limited (CRISIL), Investment Information and Credit Rating Agency of India (ICRA), Credit Analysis & Research Limited (CARE) and Fitch India. Basel guidelines entrust the national banking supervisors with the responsibility to identify credit rating agencies for assessing borrowers. RBI has recognized all four credit rating agencies as eligible for the purposes of risk-weighting banks claims for capital adequacy. Further, the following international rating agencies are recognized for risk weighing claims on foreign entities: Fitch, Moodys and Standard & Poors. Further, RBI has recommended the use of only solicited ratings. b. Credit rating quality- While RBI has recognized all four credit rating agencies as eligible for the purpose of capital adequacy norm; one is faced with the lack of objective assessment of the quality of these agencies. The few available studies indicate poor track record of the
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credit rating quality in India. Various rated issues at the time of default were placed in the investment grade by rating agencies. Further ratings published often do not reflect the financial ratios of the rated entity. In addition to this, RBIs recommendation for use of only solicited ratings causes some concern, owing to the problem of moral hazard. In India all ratings are solicited, i.e. all ratings are paid for by the rated entity. This creates a conflict of interest on the part of the rating agency since it is dependent on the fees of the rated entity for its business. Thus, credit rating industry in India is driven mostly by the rated entities. Under the present system, issuers of bond/debt instruments may go to any number of agencies for a rating of their bonds/debt instruments and have the right to accept or reject the rating. Further, the rating cannot be published unless accepted by the issuer. c. Low penetration of credit rating: The second important issue in Indias credit rating industry is the low penetration of credit rating in India. A study in 2006 revealed that out of 79,640 borrowers enjoying fund-based working capital facilities from banks, only 42300 were rated by major agencies. The legitimacy brought about by Basel II for credit ratings of borrowers will definitely increase the penetration of the industry. However, until such time, most loans will be given 100% risk weightage (since an unrated claim gets 100% weightage); thus leading to no significant improvement of Basel II over Basel I. d. Issuer ratings: Though ICRA and CARE have launched issuer ratings for corporations, municipal bodies and the State government bodies, presently credit rating in India is restricted to issues (the instruments) rather than to issuers. Ratings to issuers become important as the loans by corporate bodies and SMEs are to be weighted as per their ratings. Until such efforts pick up rapidly, issuers will be assigned 100% weightage, leading to no improvement in the risk-sensitive calculation of the loans. e. Effects on SMEs and SSI lending: Besides agriculture and other social sectors, Small Scale Industry is treated as a priority lending sector by RBI. SSI accounts for nearly 95 % of industrial units in India, 40 % of the total industrial production, 35 % of the total export and 7 % of GDP of India. In spite of its importance on Indian economy, SSI receives only about 10 % of bank credit. As banking reforms have progressed, credit to SSI has fallen. The SSI sector in India is out of the reach of the credit rating industry. Under the proposed Basel II norms, banks will be discouraged to lend to SSI that is not rated because a loan to unrated entity will attract 100 % risk-weight. Thus, bank lending to this sector may further go down. To promote credit rating of SMEs including SSI, the Government of India had launched SMEs Rating Agency (SMERA), a joint Small Industries Development Bank of India
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(SIDBI), Dun and Bradstreet Information Services India (D&B), Credit Information Bureau India Limited (CIBIL) and 16 major banks in India in September 2005. Apart from SMERA, other rating agencies have also launched SMEs rating. As an incentive to get credit rating, Government of India currently provides a subsidy of 75% of the rating fees to SMEs who get a rating. While introduction of credit rating for the SMEs (including SSIs) may, in the long run, improve the accounting practices of the SSI, there is also a possibility that SMEs will continue to rely on the existing system of informal credit as formal credit is likely to become more expensive due to the credit rating requirement of Basel II. The preference of banks for government securities and the increased risk-aversion of banks following the adoption of Basel II would adversely affect credit to agriculture and small scale industries. 3. Pro cyclical effect of credit ratings: The risk-sensitive approaches will have pro-cyclical effects that will aggravate the booms and busts and thereby affect the real economy. The capital requirements will drop at the peak of economic cycles and increase at the bottom of cycles when capital can be more scarce and expensive. Credit rating agencies upgrade sovereigns in times of sound market conditions and downgrade in turbulent times. Bank and corporate ratings in India are linked to their sovereign ratings. In times of crisis, when the need for credit may be imperative, credit flow may diminish due to downgrading of the sovereign (and therefore the bank and corporate) ratings by external rating agencies, leading to banking crisis, in addition to the currency/balance of payments crisis, what Kaminsky and Reinhart (1999) call twin crises. This may have severe impact on macro economic stability. However, prudent risk management policies and Pillars II and III would help in overall stability. 4. Costly Database Creation and Maintenance Process: Implementation of the advanced approaches like the IRB for credit risk and AMA for operational risk require a huge amount of data for model building and validation. Data on losses due to operational risk are currently non-existent. Collection of data is very tedious and high cost process as most Indian banks do not have such a database. Due to a late start in computerization, most Indian banks lack reliable data, robust data capture, cleansing and management practices, and this serves as the single largest limitation in adopting the accord. Moreover, to get rid of the common tradition of individuals maintaining paper work is another daunting task. 5. Lack of technical manpower: Because of the high technicality in Basel II and the inclusion of internal mechanisms in the measurement of risk, RBI requires highly skilled employees through the medium and long term. Unfortunately, the educational institutions needed to train
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such employees are at infancy in India, and RBI does not have the budget to add costly highskilled workers to their ranks. 6. Regulatory arbitrage- Dangers of asymmetry in financial intermediation: With regard to Indian context, the three-track theme to Basel II implementation, might give rise to scope for regulatory arbitrage within the banking system. But it would have no major concern on account of the relatively insignificant size of the non Basel II entities and their relevance from the systemic perspective. 7. Social dimensions: RBI has to ensure that the implementation of Basel II does not constrain the non-Basel II entities from discharging their respective specified roles in the national economies viz., achieving greater financial inclusion, playing a developmental role, and acting as conduits for credit delivery to the neglected sectors. 8. Cross Border Issues for Foreign Banks: In India, foreign banks are statutorily required to maintain local capital and hence, the following issues are required to be resolved. The first issue is whether the Basel-II internal models approved by a foreign bank's head office and home country supervisor would need to be validated again by the RBI. The second is whether the data history maintained and used by the bank should be distinct for the Indian branches compared to the global data used by the head office. The third is whether capital for operational risk should be maintained separately for the Indian branches in India or whether it should be maintained abroad at head office. The fourth is whether banks can be mandated by Indian supervisors to maintain capital irrespective of the approaches adopted by a foreign bank's head office. 9. Unfavorable impact on small and medium sized banks: To raise the additional capital for maintaining the Capital adequacy requirements the small and medium sized banks will surely face a lot of problems. The new norms seem to favor the large banks that have better risk management and measurement expertise. PSUs and large banks can easily tap the capital market; can get assistance from the government- infuse funds in the form of recapitalisation and can use their internal resources. The new framework also calls for revamping the entire MIS structure and allocation of banks resources. The smaller banks are also likely to be hurt by the rise in weightage of inter-bank loans that will effectively price them out of the market. Thus small banks facing dearth of financial resources, intellectual capital and skills will have to restructure and adopt if they are to survive in the new environment. 10. Communication gap: An integrated risk management concept, which is the need of the hour to align market, credit and operational risk, will be difficult due to significant disconnect between business, risk managers and IT across the organisations in their existing set up.

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11. Disclosure Regime: Pillar 3 purports to enforce market discipline through stricter disclosure requirement. While admitting that such disclosure may be useful for supervisory authorities and rating agencies the expertise and ability of the general public to comprehend and interpret disclosed information is open to question. Moreover, too much disclosure may cause information overload and may even damage financial position of bank. 12. Lack of knowledge about softwares methodology: Today banks are relying upon software vendors for assessment of risk associated with borrowers. This softwares does not provide a detailed account of the methodology. E.g. Bank of Baroda uses RAM software provided by CRISIL for assessment of borrower account having value more than Rs. 5 crore. This software provides various options for calculating various risks but it evaluates them completely on its own without even letting the user know about its methodology. 13. Adoption of IRB model by select banks: In the event of some banks adopting IRB Approach, while other banks adopt Standardised Approach, the following profiles may emerge: Banks adopting IRB Approach will be much more risk sensitive than the banks on Standardised Approach, since even a small change in degree of risk might translate into a large impact on additional capital requirement for the IRB banks. Hence IRB banks could avoid assuming high risk exposures. Since banks adopting Standardised Approach are not equally risk sensitive and since the relative capital requirement would be less for the same exposure, the banks on Standardised Approach could be inclined to assume exposures to high risk clients, which were not financed by IRB banks. As a result, high risk assets could flow towards banks on Standardised Approach which need to maintain lower capital on these assets than the banks on IRB Approach. Similarly, low risk assets would tend to get concentrated with IRB banks which need to maintain lower capital on these assets than the Standardised Approach banks. Hence, system as a whole may maintain lower capital than warranted. Due to concentration of higher risks, Standardised Approach banks can become vulnerable at times of economic downturns.

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SWOTAnalysisofIndianbanks
The SWOT analysis of Indian banks with reference to Basel II is as follows: 1. Strengths: a. Aggression towards development of the existing standards by banks. b. Strong regulatory impact by central bank to all the banks for implementation. c. Presence of intellectual capital to face the change in implementation with good quality. The system to train them has to be established. 2. Weakness: a. Poor technology infrastructure b. Ineffective risk measures c. Presence of more number of smaller banks that would likely to be impacted adversely. 3. Opportunities: a. Increasing risk management expertise. b. Need significant connection among business, credit and risk management and information technology. c. Advancement of technologies d. Strong asset base would help in bigger growth. 4. Threats: a. Inability to meet the additional capital requirements b. Loss of capital to the entire banking system due to mergers and acquisitions. c. Huge investments in technology

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 Findings

5.1Primarydata.

5.2Secondarydata.

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Findings
The analysis of various parameters revealed a series of findings. The findings of the research have been grouped into two categories on the basis of the nature of data used- Primary data findings and secondary data findings. Primary data findings: 1. Banks consider better risk management system, portfolio management systems and risk based pricing as major factors for implementation of Basel norms. 2. Pillar 2 implementation under Basel II is considered a major challenge. 3. In most of the banks, process for transition to improved approaches for calculating operating risk and requirements of market disclosure has been completed. While steps for transition to advanced credit risk methodology is still in progress. 4. Data collection for advanced credit models is a challenge due to lack of availability of data. 5. Quantification of operational risk is considered as the most challenging task in operational risk management. 6. Implementation of Basel norms requires new skills which Indian banks are trying to meet by training existing staff and hiring new technical employees. Hiring is a preferred option for new generation banks and foreign banks. 7. Assistance of RBI, rating agencies and auditors is used in validation of Basel risk framework. 8. The Basel framework has varying degree of impact on different types of banks. The public sector banks will be least affected, followed by foreign banks, old private sector banks and maximum impact on new generation banks. Secondary data findings: 1. Risk based pricing method is used for pricing the loans. The lending process has become very efficient and the level of NPAs in the banks studied has decreased over the years. 2. The Basel II framework will benefit efficient and high rated borrowers. Less creditworthy borrowers will find garnering of funds difficult under Basel II regime.

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3. Basel II is not a costly proposition for Indian banks. 4. Implementation of Basel II framework has resulted in mergers and will further increase the scenario of consolidation in the sector. Basel II will favour big players more than as compared to small players. 5. The bank margin has narrowed. However efficient players will have an edge over others. 6. Implementation of Basel framework warrants technological advancements. In most of the banks computerisation has been completed or is in process. However the Indian banks will face challenge on this front. 7. The higher capital charges i.e. above the 8% minimum mandated by RBI provide 99.9% degree of protection for the credit loss distribution to the banks under Standardised or Internal Ratings Based approach. Indian banks have an average of 12% CRAR which shoes the high buffer they are having. 8. In India there is the scheme of solicited credit ratings which has its own disadvantage. 9. Many banks are working towards the intermediate F-IRB approach. They are implementing internal rating systems, so that they will have enough rating history data, and loss-givendefault history. There are only about three banks that fall into this category, even loosely defined: the State Bank of India, Bank of Baroda, and Indian Bank (all public sector banks). Certain private banks like HDFC, ICICI etc are also doing this. 10. Public sector banks are likely to face capital problems as the government shareholding is approaching the minimum level of 51%. 11. The various systems of the banks affected by Basel II are not properly coordinated. 12. Implementation of IRB approached might reduce the overall capital requirement of the sector.

In a nutshell, it can be said that Basel II will have its impacts on the whole economy- whether it be banking sector, IT industry, BPO industry or credit rating industry. The impact of Basel II framework will be more apparent in the following years as its implementation gathers momentum.

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 Suggestions

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Suggestions
1. Third parties: Stringent minimum qualifying criteria for rating agencies and auditors can be imposed. Parties assisting in validation of Basel framework may be required to have a dedicated financial services or banking division that is properly researched and have proven ability to respond to training and upgrades required of its own staff to complete the tasks adequately. 2. Consolidation: To ensure smooth merger of PSU banks, the government needs to carry out a host of regulatory and legislative changes including amendments in Income Tax Act and Banking Companies Act. 3. Capital requirement: To solve the need of increased capital a relaxation can be given by allowing dilution level up to at least 33% of stake of government or providing other avenues for raising capital under Tier 1. 4. Educational incentive: More innovative professional courses designed on risk management viz- a viz Basel framework can be initiated by academic councils to meet the increased requirement of trained professionals. 5. A linear rise in risk weightings along the spectrum of higher probability of default can be implemented rather than an exponential rise because an exponential rise would sharply increase the costs of borrowing for low rated sovereigns, banks and corporates to the extent that they would be effectively cut off from international bank lending. 6. A Centralized Rating Based (CRB) approach can be implemented where the RBI dictates a rating scale and banks to have to rate borrowers according to that centralized scale. The great benefit of the approach is that the RBI would be able to monitor and control banks' ratings and hence monitor and control their capital sufficiency in relation to risk much more effectively. 7. Other supporting measures like volume limit and debt equity ratio can be used as they are very transparent and are not based on complex models. Further they calculate the only element that is relevant in a crisis, and that is the size of the buffer that a bank needs to absorb losses. 8. The difference between an unrated and an underrated borrower has to re evaluated as the current classification provides incentive to less creditworthy borrower to remain unrated.
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9. Risk buckets can be further classified so as to avoid the regulatory distortions associated with jumps between buckets. 10. Increase in the CRAR and the percentage of Tier 1 capital can be postponed till the situation of the capital market improves. 11. The scheme of solicited ratings can be replaced by unsolicited ratings.

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Conclusion

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Conclusion
This project was all about the difference between Basel I and Basel II, features of Basel II and how will its implementation impact the Indian banking system. It also highlighted the challenges which the Indian Banking System has to face by incorporating Basel II. Basel I and Basel II: While summarizing, one very important fact to assess is the achievements and limitations of each Basel Accord. The first Basel Accord, Basel I, was a groundbreaking accord in its time, and did much to promote regulatory harmony and the growth of international banking across the borders of the G-10 and the world alike. On the other hand, its limited scope and rather general language gave banks excessive leeway in their interpretation of its rules, which resulted in holding of improper risks and unduly low capital reserves. In order to overcome the drawbacks of Basel I the Basel II came about which brought a new dimension to the banking sector of the world. Basel II, on the other hand, extended the breath and precision of Basel I, bringing in factors such as market and operational risk, market-based discipline and surveillance, and regulatory mandates. It brought about an improvement in the risk sensitivity, the capital management allocation and portfolio management centre stage. But then its very complex. From an Indian perspective, it appears that Basel II compliance may be a challenge in the short term but it will certainly prove to be an opportunity in the long term. Despite of its criticisms, it's a one step forward in achieving integration of & uniformity across global banking industry. Challenges: Under the Basel II guidelines, the credit rating agencies will play a prominent role in determining regulatory risk capital. The main concerns are the unsatisfactory performance of the credit rating industry in India, the low credit rating penetration and the high costs of credit rating especially for SMEs. Further, the increased requirement of tier I capital, the high cost of implementation and the requirement of extensive data and software for implementation of Basel II will, in my view, pose a major challenge in Indias migration towards Basel II regime. If these issues are not tackled up front, then the end result would be no different from the current Basel I norms, albeit at higher cost. Despite these challenges, in a globalizing financial system, India will not be able to do away with the recent international developments such as Basel II. Impact: In the long run, adherence to Basel II by Indian banks will result in improved accounting, risk management and supervisory principles that are in line with internationally accepted best practices and will also benefit several other sectors of Indian economy, such as the credit rating industry, the IT industry and the BPO industry. Implementation of Basel II will greatly improve the banks operational stability. It will have its impact on loan pricing, borrowers,
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cost, structure of sector, technological developments and capital requirement etc.The post Basel II era will belong to the banks who manage their risks effectively A Basel II compliant banking system will further enhance the image of India in the League of Nations. The country rating of India will surely improve, and consequently facilitate a higher capital inflow in the country. This will tremendously help India to move on the higher growth trajectory in the coming decades. With respect to the current regime of capital standards, the Basel I, Indias banking industry is performing reasonably well, with an average CRAR of about 12 per cent, which is not only higher than the internationally acceptable level of 8 per cent, but also higher than Indias own regulatory requirement of 9 per cent. Therefore, meeting the Basel II requirements for the immediate future should not be an issue. However, going forward, meeting the capital requirements would be a major challenge, especially for public sector banks. In a nut-shell, I would like to conclude that keeping in view the far reaching impact for Indian banking sector; the regulatory challenge would be to migrate to Basel II in a non-disruptive manner. However, work is apparently already underway on Basel III, at least in a preliminary sense. The goals of Basel III are to refine the definition of bank capital, quantify further classes of risk and to further improve the sensitivity of the risk measures.

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 References

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References
Demystifying Basel II Address by Shri V. Leeladhar on September 26, 2006 at the FICCIIBA Conference on 'Global Banking: Paradigm Shift', Mumbai. Challenges and implications of Basel II for Asia - Speech by Dr. Y.V. Reddy, Governor, Reserve Bank of India at Asian Development Bank's 39th Annual Meeting in Hyderabad on May 3, 2006 Approach to Basel II - Speech by Shyamala Gopinath, Deputy Governor, RBI at the IBA briefing session at Bangalore on May 12, 2006. Implementation of Basel II: An Indian Perspective- Kishori J. Udeshi; Deputy Governor; Reserve Bank of India V Leeladhar: Indias preparedness for Basel II implementation during the FICCI-IBA Conference on Global Banking: Paradigm Shift, Mumbai, 13 September 2007. Basel II A Challenge and an Opportunity to Indian Banking: Are we ready for it?- FICCI Basel II Framework and India: Compliance V/s Opportunity- Indian Banks Association. Will the proposed new basel capital accord have a net negative effect on developing countries? - Stephany Griffith-Jones, Stephen Spratt, IDS: (economic commission for Latin America and the Caribbean (ECLAC); United Nations Development Programme (UNDP)) International Convergence of Capital Measurement and Capital Standards: A Revised Framework (Comprehensive Version: June 2006) Studies in Money, Finance and Banking By Manoranjan Sharma : Capital structure of Banks viz a viz Basel II: Shifting paradigms N Kantha Kumar : Linkhttp://books.google.co.in/books?hl=en&lr=&id=9y1F6OmRQl4C&oi=fnd&pg=PA1&d q=comparative+study+of+Basel+I+%26+II+impact+on+Indian+banks&ots=sHovFNpo6&sig=JHaDWDng81zwwtC0yWsQjdtAdcM#PPA1,M1

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INDIAN COUNCIL FOR RESEARCH ON INTERNATIONAL ECONOMIC RELATIONS- Working paper 196: Capital Adequacy Regime in India: An Overview- By Mandira Sarma, Yuko Nikaido; July 2007. Global risk regulator- Newsletter Jan 2008: Other measures needed to supplement Basel IIZURICH. ICRA rating feature March 2005 Basel Accord II- Impact on Indian banks Basel I, Basel II, and Emerging Markets: A Nontechnical Analysis- Bryan J. Balin

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 Annexure
Questionnaireforbankmanagerson implementationofBaselII

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Questionnaire
QuestionnaireforbankmanagersdealingwithimplementationofBaselII ThisstudyispurelyforacademicpurposeasapartofMBA,FMSBHUdissertationwork. TheobjectiveisTostudytheimpactofBaselIIonIndianbanks. Theinformationcollectedthroughthisquestionnairewillbekeptconfidential.
1. FactorsthatmadeyourbankshifttoBaselIInorms: Portfoliomanagementcapabilities Riskbasedpricing Creditlossreduction Regulatorycapitalrelief 2. WhichofthefollowingpillarisagreaterchallengeunderBaselII? Pillar1 Pillar2 Pillar3 3. Foreachofthefollowingstepsinimplementationprogram,writeCcompleted,PProgress, NNotstarted: Creditratingmodels Progresstowardsoperationalriskstandardisedapproach Creditrisktechnologysupport Consolidationofdisclosures 4. Ratetheconcernsforcreditriskmanagementthatyouface:(1easy,5mostchallenging) DatagatheringforIRBmodeldevelopment MethodologyforIRBdevelopment Integrationofcreditriskintobusinessprocesses Meetinglocalregulatoryguidanceonloangrading/internalratings Implementingriskbasedpricing 5. Ratetheconcernsforoperationalriskmanagementthatyouface:(1easy,5mostchallenging)

Identificationofkeyriskindicators Quantificationofoperationalrisk Lackofinternalandexternaldata Implementationoflossdatacollection 6. DoesimplementationofBaselIIrequirenewskills? YesNo

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 7. Ifyes,howwillyoufulfillyourrequirementfortheseskills? Bytrainingprogrammes Byhiringnewemployeeswiththerequisiteskills Both 8. WhichofthefollowingpartieshelpisusedinvalidationofBaselIIframework? RBI Ratingagency InternalAuditors,externalauditors,externalconsultants Others,pleasespecify. 9. Shouldthecurrent9%CRARberaisedbyRBI? Yes No Why?....................................................................................................................................................... ................................................................................................................................................................. .......................................................................................................................................................... 10. ShouldthepercentageshareofTierIcapitalberaised? Yes No Why?....................................................................................................................................................... ................................................................................................................................................................. .............................................................................................................................................................. 11. WillBaselIIhavevaryingdegreeofimpactondifferenttypesofbanks? Yes No Thanks for your cooperation

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