Bharat S Raut & Co.

Basel II A New Global Banking Paradigm

20 February 2004

Risk management has emerged as a key area of focus for banks in recent times especially due to Basel II accord

Corporate

Bank

Sovereign

Retail

Project Finance

Equity

Internal Process

Credit Risk

Interest Rate in
banking and trading books

People

Operational Risk

Types of Risks

Market Risk

Foreign Exchange
Equity

External Factors

Information Risk

Commodity

Systems Risk

Security and Integrity Risk

Bharat S Raut & Co.

The Basel Committee recommendations urge banks to adopt more risk sensitive approaches to Risk Management
Old Accord One size Fits All New Accord Portfolio of approaches

Broad Brush

More Risk Sensitive

The new Basel Accord is based on Three Pillars

Minimum Capital

Supervisory Review

Market Discipline

Advanced methods for capital allocation Capital charge for operational risk

Focus on internal capabilities Supervisors to review banks internal assessment and strategies

Focus on disclosure

and has proposed a challenging implementation deadline of 2006 for internationally active banks
Bharat S Raut & Co.

Overview of the New Basel Capital Accord

Pillar 1 Minimum capital requirements Market risk Unchanged from existing Basel Accord Credit risk
Significant change from existing Basel

Pillar 2 Supervisory Review

Banks should have a process for

Pillar 3 Market Discipline

Market discipline reinforces efforts to

assessing their overall capital adequacy and strategy for maintaining capital levels
Supervisors should review and

promote safety and soundness in banks

Core disclosures (basic information)

Accord
Three different approaches to the

evaluate banks internal capital adequacy assessment and strategies

Supervisors should expect banks to

and supplementary disclosures to make market discipline more effective

calculation of minimum capital requirements

Capital incentives to move to more

sophisticated credit risk management approaches based on internal ratings

Sophisticated approaches have

operate above the minimum capital ratios and should have the ability to require banks to hold capital in excess of the minimum (cf. trigger / target ratios in UK)
Supervisors should seek to intervene

systems / controls and data collection requirements Operational risk

Not covered in existing Basel Accord Three different approaches to the

at an early stage to prevent capital falling below minimum levels

calculation of minimum capital requirements

Adoption of each approach subject to

compliance with defined qualifying criteria

Bharat S Raut & Co.

Basel II intends to a simulate a convergence of regulatory driven risk management towards economic driven risk management
Does not take Asset quality into account

Regulatory Capital : Capital that banks are required to hold by their regulator (RBI)

To maintain Capital Adequacy Ratio = Capital/ Risk Weighted Assets >= 9%

The amount of capital a bank must have

Economic Capital : Capital that a prudent bank would choose to hold - to balance safety with return on equity The amount of capital a bank should have

Capital depends on the risk profile of the banks portfolio

Bharat S Raut & Co.

Basel II regime is expected to enable Banks to reduce their regulatory capital by using advanced advanced risk management approaches

Current
Equity load

Future
Equity load

Traditionalists

Traditionalists Traditionalists Large midfield Market leader Large midfield Tendency Market leader Regulatory capital for Credit risks Regulatory capital only for Credit risks Quality of Risk Management Regulatory capital for operative risks Regulatory capital for Credit risks & Operative risks

Quality of Risk Management

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Operational risk is inherent to banking business and not received adequate attention in past
Banking

Retail Banking Retail Deposits & Lending Private Banking Card Services

Commercial Banking Project Finance

Payment and Settlement Payments and Collections Funds Transfer Clearing and Settlement

Treasury (Trading & Sales) Sales Market Making Proprietary Positions Treasury

ACTIVITY

Trade Finance Working Capital Finance Advisory Services

Operation Risk
categories

Internal Fraud

External Fraud

Employment Practices & Workplace Safety

Clients, Products & Business Practices

Physical Damage to Assets

Business Disruption and System Failures

Execution, Delivery & Process Management

Bharat S Raut & Co.

Designing and implementing action plans for operational risk management could be in many forms, depending on the banks needs . . . Basel accord requires Sound Practices for Management and Supervision of

operational Risk

Establish a structured risk management framework for the bank Redesign process and approach Strengthen existing controls, policies and procedures Invest in staff training Automate processes

Acceptance of risk as cost of doing business

Transfer risk through subcontracting Contingency plan - Insurance Create risk awareness culture

based on a cost-benefit assessment

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Strategic implications on Banking sector

Capital requirements Capital release: Prime mortgages High quality corporate lending High quality liquidity portfolios Collaterised & hedged exposures Capital absorption: Leveraged finance Specialised lending Small business Commitments & pipeline Opportunities to use surplus capital Wider market Significant barriers to entry as a bank Increased competition for low risk customers Disclosure under Pillar III Peer group pressure will lead to adoption of more advanced approaches Risk Transfer:
- Outside Basel regulated banking system

Products Focus on key products / those with best return on regulatory capital Impact of differing capital treatment and return transparency will impact product design Increased risk based product pricing for those on sophisticated credit risk approaches Those with less sophisticated risk approaches may be priced out of the market

Basel II

Customers Increased transparency of account profitability Risk-differentiated customer management through: - Winners: - Losers:
- Prime mortgage customers - Well rated entities - Small & medium sized businesses - Higher credit risk individuals

e.g. insurance industry

Bharat S Raut & Co.

Challenges in Basel II implementation

Constituent

Challenges
Interpret new regulations and understand effects on business Secure and maintain board and senior management sponsorship Face new expectations from regulators, rating agencies, and customers Need to consider whether to target certain customers/products or eliminate others

Banks

Customers

Face new costs resulting from need to provide lenders with new, timely information Use key performance indicators to monitor performance Face request for better collateralization Manage rating process

Regulators

Need well-trained, educated professionals to fill roles. Create regulation that reflects the linkages among risks Provide incentives for banks to evaluate risks through stress-testing and scenario

analysis

Rating Agencies

Seek to improve reputation (national agencies) Maintain high quality of ratings

Financial institutions out of Basel IIs scope

Interpret new regulations and understand effects on business and risk management Demonstrate quality as Basel II emerges as a best practice standard

Bharat S Raut & Co.

Phased approach to migration to Basel II implementation

Phase 1
ASSESS AND PLAN

Phase 2
DESIGN AND IMPLEMENT

Phase 3
USE TEST AND APPROVAL

Phase 4
MONITOR AND CONTROL

ORGANIZATION

Corporate Governance/ Risk Management

Basel II Implementation Approach

Basel II implementation Master Plan

Use Test and Approval

Basel II Roll-Out Plan

Impact Analysis

PROCESSES

Gap Analysis

Operational Risk Market and Other Risks Capital Planning Disclosure

(including linkage to IFRS)

METHODS

DATA

SYSTEMS

Supervisory Review Process

BASEL II PROJECT MANAGEMENT

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Monitor and Control

Credit Risk

Bharat S Raut & Co.