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India - Basel II, Regulatory Capital Under the Standardised Approach
RiskCenter.com (August 4, 2004)

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Location: Mumbai
Author: Shekar A.
Date: Wednesday, August 4, 2004
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One of the principal goals of Basel Accord II is to instill good risk management practices in banks, which will ensure exercise of prudence and sound judgment while assuming business risks. The accord aims to achieve this by aligning banks' capital obligations with various categories of risks taken and arising from their operations.

A great deal of work has been done by Bank For International Settlements ( BIS ) in putting together this Accord. BIS has provided uniform risk assessment frameworks for the global banking community, with which the banks will be able to measure risks and provide the required regulatory capital to meet unexpected losses.

BIS has also armed the national supervisors with considerable discretion to meet country specific operating requirements, for implementing the Accord. This is a truly mind boggling exercise, given the diversity in banking practices across the globe and geographical peculiarities. The aim is to make the bankers, the regulators and the customers more "risk sensitive".

Many central banks, commercial banks, rating agencies and risk management associations have raised issues on various aspects of the Accord. While the current accord is quite comprehensive and has considered more risks, which were hitherto left out, it has not been able to alleviate all the apprehensions of all the banks completely. After all, Accord cannot be expected to be the panacea for the global banking system.

Reserve Bank Of India (RBI) is one of the active banks among the non G-10 countries in this exercise. It was a member in various committees at various stages and has also committed to the implementation of Basel II to achieve convergence of Indian banking practices with international standards and practices.

A significant number of banks in the developed countries are opting for Internal-Rating Based method of credit risk measurement, while their counter parts in the developing countries (including India), by and large, follow The Standardised Approach. In this article, an attempt is made to point out some of the issues in ascertaining regulatory capital obligations arising out of following The Standardised Approach.

The broad guidelines governing risk weighting of various types of exposures- consequently, the regulatory capital associated with them- are as follows:

  • a) Claims on Sovereigns, PSEs, Banks, Security Firms and Corporates - Based on ratings by the Export Credit Agencies( ECA) / External Credit Assessment Institutions (ECAI). The unrated exposures will attract 100% risk weighting.
  • b) Retail Portfolios - Risk weighted at 75%.
  • c) Claims secured by residential property - Risk weighted at 35%.
  • d) Past due loans - Risk weighted at 100% / 150%, based on the level of provisioning.

BIS , perhaps with the objective of achieving uniformity in the risk assessment methodologies, has aligned risk weighting with the risk ratings assigned by ECA /ECAI, for exposures enlisted in (a) above. As regards the rest, a portfolio approach has been advocated.

In the emerging markets, the rating culture is not as well pronounced as in the developed markets for a variety of reasons. Most of the ratings are issue specific. It is also not uncommon, in these markets, for banks to consider external ratings as an additional input in risk assessment, rather than as the sole risk indicator. Majority of the borrowers under category (a) would be unrated, attracting 100% risk weighting for regulatory capital purposes. The Accord, for capital purposes, recognizes only the external credit ratings, to the total exclusion of internal rating systems of the banks. In other words, the intrinsic credit quality of the borrowers is irrelevant for regulatory capital purposes, if the borrowers are not rated by ECAI/ECA .

The question arises, from regulatory capital perspective, as to how can risk profile differentiators be incorporated in the system to encourage healthy risk management practices. How does a bank differentiate risks among its unrated borrowers in its lending portfolio? How can depositors, investors, regulators compare the relative risk profiles in the lending portfolios of banks? How do we provide incentives to banks to be more risk conscious, one of the core objectives, the Basel Accord is hoping to achieve?

This is an area where the national regulators of the respective countries can play a vital role. National Supervisors in these countries should design and devise country-specific operating methodologies to address this requirement.

The methodology may have two components - 1. Uniform Credit Rating System, 2. Graded Regulatory Capital obligation, linked to Credit Ratings.

As credit rating is the yardstick for capital provisioning, it is imperative that the banks follow a uniform credit rating system for ascertaining the credit quality of the borrowers. National Supervisors of the respective countries may develop rating systems, which should be used by the banks for calculating their regulatory capital obligations.

Alternatively, the National Supervisors may stipulate a set of risk parameters, which would have to be built-in in the rating systems of the banks operating in those countries. The supervisors may also stipulate a graded regulatory capital requirement linked to the credit rating of the borrowers. For example, in a scenario of, say, 7 credit risk grades (with 1 signifying low risk and 7 high risk), risk weighting for grades 1 to 3 might be 100%, which would increase with deterioration in the risk.

This approach will ensure that the banks are obliged to provide capital in relation to the risk they assume, which is calculated as per a uniform formula. This approach does not aim to curtail the operating flexibility of the banks, but to bring about uniformity in calculating capital obligations and to reward banks following healthy banking practices. This will also ensure that a strong sense of risk sensitivity is ingrained in the banking system.

Is it feasible? In this context, it is worthwhile, pointing out the practice followed by Indian banking system for assessing the working capital requirements of the borrowers. Till a few years ago, all the banks operating in India, perforce, had to follow a particular method prescribed by the RBI for ascertaining the working capital requirements of the borrowers. RBI could enforce this with a fair degree of success.

Hence, RBI should first "feel" the need to have a uniform approach for ascertaining the regulatory capital obligation. If it fells the need, it has the experience and expertise to successfully implement a uniform system.

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Article Printed From RiskCenter.com

 

 

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