Monday, March 23, 2009

Basel II Norms – A Revised Framework

Basel II framework, refers to a set of document named “International Convergence of Capital Measurement and Capital Standard: A Revised Framework” released by the Basel Committee on Banking Supervision (BCBS) on June 26th 2004 and added more in November 2005.No doubt, the Basel I framework played a key role in raising capital levels across the banking system over the late 1980’s and 1990’s. But in the wake of present crisis,Dr Nant Wellink (President of Netherlands central bank and chairmen, BCBS) emphasized on its failure to deliver on the four objectives: -

I. To develop a more meaningful link between bank’s on and off balance sheet risk exposures and the capital supporting them.
II. To beef up the links between sound regulatory capital and risk based supervision, as a way to foster strong risk management practices at banks.
III. To enhance market disciplines through better information about banks risk profiles, risk management techniques and capital.
IV. The Basel committee endeavored to develop framework that was adaptive to rapid financial innovations.

Further he laid out how the implementation of the Basel II framework would provide an opportunity for banks and supervisors to strengthen the banking system against financial and economic shock.
Key Areas Of Importance: -
I. Basel II delivers great risk differentiation. Banks that move from prime to sub prime mortgage lending or that move from traditional or corporate lending to leveraged lending would see a hike in their capital, commensurate with the changing business strategy and risk profile. Under Basel I all such exposures receive the same charge.
II. Off balance sheet contractual exposures to structural investment vehicle (SIV) and conduits would be brought into the field and subject to regulatory capital, whatever the accounting treatment.
III. There will be much more risk sensitive treatment for secrutisation exposures.
IV. Banks will have to develop more rigorous approaches to measures and manage their operational risk exposures and whole commensurate capital.
V. Banks will have to develop more rigorous methodologies for capturing counter party credit exposures including a wrong way risk. It capitalizes on the modern means of risk management and efforts to establish and improve risk-responsive linkage between the banks operation and their capital requirements.

In modern banking sector where the transactions are increasingly becoming complex and techno specific,so,improving regulatory mechanism is an utmost need especially to deal with international banking. Basel II norms posses all the qualities that a modern global banking system needs to share. Some desirable approaches of Basel II norms are –
I. Create attention to data planning for insures meeting of evolving compliance requirements
II. It is an evolution and there is more to come
III. Pr pressure continues to propel activities
IV. Built in flexibility is mandatory for future proofing compliance initiatives of banks
V. Transparency will be the norm
VI. Modular yet integrated in an enterprise – wide approach is the only long term solution
VII. More investment will be made

It has based on the pertinent pillars which overt its aim more closely: -

I. Pillars Ist : - Deals with the maintenance of regulatory capital circulated for the major components of risk. Risk weights were linked to the external ratings by accrediated rating agencies of some of these assets. Finally, banks were allowed to develop their own internal rating of different asset and risk weight them based on these ratings.
II. Pilllar II nd : -Concerned with supervision by national regulators for ensuring comprehensive assessment of the risks and capital adequacy for their banking institutions. It provides a framework for dealing with all the other risk a bank may such as systematic risk, liquidity risk, pension risk, concentration risk, strategic risk, legal risk, reputation risk etc which are represented under the tune of residual risk. It gives bank a power to review their management system.
III. Pillar III rd: - Provides norms for disclosure by banks of key information regarding their risk exposure and capital positions and aims to improving market discipline. This designed to allow the market to have a better picture of the overall risk position of the bank and to allow the counter parties of the bank to price and deal appropriately.

Effects Of Implementation

I. Basel II allows national regulators to specify risk weights different from the internationally recommended ones for retail exposures.
II. Varying risk weights assigned by the agencies like Fitch, moody, ICRA etc.
III. In the case of retail exposures, the RBI has gone with the lower 75% risk weight prescribed under Basel II norms, as against the currently applicable risk weight125% and 100% for personal/credit card lone and other retail loans respectively. The Indian banks can get enormous benefit to deal with its un-rated high risk loans and other investments like Commercial Papers presenrly carrying 100% risk weight.
IV. The RBI’s draft capital adequacy guidelines provide for lower risk heights for short term exposures, if these are rated.
V. Its enabled Indian banks to significantly reduce their credit risk weight and their required regulatory capital. If they suitably adjust their portfolio by lending to rated strong corporate, will increase their retail lending and provide mortgage loans under high margins.

But the same is not applicable on operational risk. The Basic Indicator Approaches (BIA) specifies that banks should hold capital charge for operational risk equal to the average of the 15% of annual positive gross income over the past three years. Excluding one year when the gross income was negative. Gross income is summed as net interest and non interest income.
Basel II and India’s Banking Structure: -
In their column MACROSCAN (Business Line 2007), Jayati Ghosh and C.P. Chandrashekhar visualized some potential change in the Indian Banking System after its adaptation with Basel II norms. Some key points of their observations are: -

I. Developed countries are at a completely different level of development of their economies and of the extent of deepening financial intimidation as compared to the developing countries.
II. In principles the adoption of the core principles for effective bank supervision issued by the Basel Committee on Banking Supervision (BCBS) is voluntary. India like many other emerging countries adopted the Basel-I guidelines and has now decided to implement Basel II. India has adopted Basel-I guidelines in 1999. Subsequently, based on the recommendations of a steering committee established in Feb 2005 for the purpose the RBI has issued draft guidelines for implementing a new Capital Adequacy Framework (CAF) in line of Basel-II.
III. Regulatory capital is defined in terms “tiers of capital” that are characterized by different degrees of liquidity and capacity to absorb losses. The highest tier I, consists principally of the equity and recorded reserves of the bank assets to be risk weighted.
IV. Initially set for march 31,2007 deadline later extended for foreign operation of banks to March 31,2008 (overall Indian Overseas Banking) while all other Schedule commercial banks (SCB) will have to adhere to the guidelines by March 31,2009.

RBI had taken a view that only Indian Banks that get 20% of their business from abroad need to follow the Basel Norms. In 2003,SBI’s international operations contributed just about 6% of its business.
Difficult Aspects of Basel-II: -

I. Differing cultures, varying structural models, complexities of public policy and existing regulation.
II. Foreign pressure impacts adversely on priority sector lending. A match up attitude on profit may grow further.
III. Following the reforms; the credit-deposit ratio of commercial banks as a whole declined substantially from 60.4% in 1990-91 to 55.9% in 2003-04.
IV. Deregulation, which takes the form of both easing the entry of domestic and foreign players as well as the disinvestments of equity in Public Sector Banks (PSB) forces a change in banking practices.
V. Even the earlier implementation of Basel-I was not proven positive for credit delivery. This would worsen after Basel-II. The preferences of banks for government securities and the increased risk aversion of banks following the adoption of Basel-II would adversely affect credit allocation to priority sector.
VI. Priority sector lending as a proportion of net bank credit after reaching the target of 40% in 1991 had been keep falling short of target till 1996. It has subsequently been in excess of the target and stood at 44% in 2004, because having inclusion of funds provided to RRB by their sponsoring banks that were eligible to be treated as priority sector advances.
VII. Small Scale Industries (SSI) finance is a major problem; which fall from 17.3% of the net banking credit from PSB in 1999-2000 to 7% in 2003-04.
VIII. Basel II norms would introduce pro-cyclical elements in developing economies.

So, the Basel-II norms will effect dubiously on Indian banking system, but that does not mean its disqualification on policy matters, because its consists some very effective tools for Indian banking. Banking sector has a lot to gain in near future from Basel-II norms implementation...

Atul Kumar Thakur
New Delhi
March 23rd 2009


  1. Dear Atul-I just checked your blog-It is quite seriuos and analytical.All the best-N Madhavan,Associate editor(Hindushtan Times),05/3/2009

  2. Dear Atul,
    Thanks for your intrest.I just took a quick glance at your blog.I am afraid I did not have the time or the immediate need to go through in detail,but I appreciate the fact that you are analysing serious issues.On Basel II,I am not too informed but I think the Bank of International Settlements at Basel itself shoud have a good website.There is a nice magazine called Microfinance Insights and I will try to send you some links for it.Best-N Madhavan,Associate editor(Hindustan Times),05/3/09