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Indian Financial SystemBasel Committee on banking supervision

Submitted to

Mrs. Ridhi Bhatia

Group- 7

Saurav pal

Saurabh Kirti

Sri Krishan Rana

Shruti Kale

Shalini Singh

Sunil Yadav

Sukhwant Singh

Shikha Singh

SECTION- K4/21/2011



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Table of contents

Sno. Particulars

1 Introduction

2 The 1988 Basel Accord

3 Two tiered capital

4 Value at risk

5 The new accord Basel 2

6 Criticism of basel 27 Indian Banks; Impact of basel 2

8 Basel 3

9 Implication for India

10 Conclusion



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INTRODUCTION

FORMATION OF BASEL COMMITTEE ON BANKING SUPERVISION (BCBS)

On 26th June 1974, a number of banks had released Deutschmarks to Bank Herstatt inFrankfurt in exchange for dollar payments that were to be delivered in New York.Due to differences in time zones, there was a lag in dollar payments to counter-partybanks during which Bank Herstatt was liquidated by German regulators, i.e. beforethe dollar payments could be affected.

The Herstatt accident prompted the G-10 countries (the G-10 is today 13 countries:Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Spain,Sweden, Switzerland, United Kingdom and United States) to form, towards the end of 1974, the Basel Committee on Banking Supervision (BCBS), under the auspices of the Bank for International Settlements (BIS), comprising of Central Bank Governorsfrom the participating countries. The present Chairman of the Committee is Mr NoutWellink, President of the Netherlands Bank.The Committee encourages contacts and cooperation among its members and otherbanking supervisory authorities. It circulates to supervisors throughout the world bothpublished and unpublished papers providing guidance on banking supervisorymatters. Contacts have been further strengthened by an International Conference of Banking Supervisors (ICBS) which takes place every two years.The Committee's Secretariat is located at the Bank for International Settlements inBasel, Switzerland, and is staffed mainly by professional supervisors on temporarysecondment from member institutions. In addition to undertaking the secretarial work

for the Committee and its many expert sub-committees, it stands ready to give adviceto supervisory authorities in all countries. Mr Stefan Walter is the Secretary Generalof the Basel Committee.



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THE 1988 BASEL ACCORD (BASEL I)

From 1965 to 1981 there were about eight bank failures (or bankruptcies) in theUnited States. Bank failures were particularly prominent during the '80s, a time whichis usually referred to as the "savings and loan crisis." Banks throughout the world

were lending extensively, while countries' external indebtedness was growing at anunsustainable rate.

As a result, the potential for the bankruptcy of the major international banks becausegrew as a result of low security. In order to prevent this risk, the Basel Committee onBanking Supervision, comprised of central banks and supervisory authorities of 10countries, met in 1987 in Basel, Switzerland.

The committee drafted a first document to set up an international 'minimum' amountof capital that banks should hold. This minimum is a percentage of the total capital of a bank, which is also called the minimum risk-based capital adequacy. In 1988, the

Basel I Capital Accord (agreement) was created.

The Purpose of Basel I

In 1988, the Basel I Capital Accord was created. The general purpose was to:

1. Strengthen the stability of international banking system.

2. Set up a fair and a consistent international banking system in order to decreasecompetitive inequality among international banks.

The basic achievement of Basel I have been to define bank capital and the so-calledbank capital adequacy ratio. In order to set up a minimum risk-based capital adequacyapplying to all banks and governments in the world, a general definition of capital wasrequired. Indeed, before this international agreement, there was no single definition of bank capital. The first step of the agreement was thus to define it.

What Does Capital Adequacy Ratio - CAR Mean?It is a measure of a bank's capital. It is expressed as a percentage of a bank's risk weighted credit exposures.

Also known as "Capital to Risk Weighted Assets Ratio (CRAR)", this ratio is used toprotect depositors and promote the stability and efficiency of financial systems aroundthe world.

Two types of capital are measured: tier one capital, which can absorb losses without abank being required to cease trading, and tier two capital, which can absorb losses inthe event of a winding-up and so provides a lesser degree of protection to depositors.



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Credit Risk is most simply defined as the potential of a bank borrower or counter-party to fail to meet its obligations in accordance with agreed terms. For most banks,loans are the largest and most obvious source of credit risk. It the risk weighted asset(RWA) of the bank, which are banks assets weighted in relation to their relative creditrisk levels. According to Basel I, the total capital should represent at least 8% of the

bank's credit risk (RWA).

Two-Tiered Capital

Basil I define capital based on two tiers:

1. Tier 1 (Core Capital): Tier 1 capital includes stock issues (or share holder’s equity)and declared reserves, such as loan loss reserves set aside to cushion future losses orfor smoothing out income variations.

2. Tier 2 (Supplementary Capital): Tier 2 capital includes all other capital such asgains on investment assets, long-term debt with maturity greater than five years andhidden reserves (i.e. excess allowance for losses on loans and leases). However, short-term unsecured debts (or debts without guarantees), are not included in the definitionof capital.

Bank assets were classified into five risk buckets i.e. grouped under five categoriesaccording to credit risk carrying risk weights of zero, ten, twenty, fifty and onehundred per cent. Assets were to be classified into one of these risk buckets based onthe parameters of counter-party (sovereign, banks, public sector enterprises or others),collateral (e.g. mortgages of residential property) and maturity. Generally,

government debt was categorised at zero per cent, bank debt at twenty per cent, andother debt at one hundred per cent. 100%.

Let's take a look at some calculations related to RWA and capital requirement. Figure1 displays predefined category of on-balance sheet exposures, such as vulnerability toloss from an unexpected event, weighted according to four relative risk categories.

Figure 1: Basel's Classification of risk weights assets

As shown in Figure 2, there is an unsecured loan of $1,000 to a non-bank, whichrequires a risk weight of 100%. The RWA is therefore calculated as RWA=$1,000 ×100%=$1,000. By using Formula 2, a minimum 8% capital requirement gives 8% ×

RWA=8% ×$1,000=$80. In other words, the total capital holding of the firm must be$80 related to the unsecured loan of $1,000..



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Market risk includes general market risk and specific risk. The general market risk refers to changes in the market values due to large market movements. Specific risk refers to changes in the value of an individual asset due to factors related to the issuerof the security. There are four types of economic variables that generate market risk.These are interest rates, foreign exchanges, equities and commodities. The market risk can be calculated in two different manners: either with the standardized Basel model

or with internal value at risk (VaR) models of the banks. These internal models canonly be used by the largest banks that satisfy qualitative and quantitative standardsimposed by the Basel agreement. Moreover, the 1996 revision also adds thepossibility of a third tier for the total capital, which includes short-term unsecureddebts. This is at the discretion of the central banks.



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Value at Risk (VAR)

VAR is a method of assessing risk that uses standard statistical techniques andprovides users with a summary measure of market risk. For instance, a bank might saythat the daily VAR of its trading portfolio is rupees 20 million at the 99 per centconfidence level. In simple words, there is only one chance in 100, under normalmarket conditions, for a loss greater than rupees 20 million to occur. This singlenumber summarizes the bank's exposure to market risk as well as the probability (oneper cent, in this case) of it being exceeded. Shareholders and managers can thendecide whether they feel comfortable at this level of risk. If not, the process that led tothe computation of VAR can be used to decide where to trim risk.Now the definition; `VAR summarizes the predicted maximum loss (or worst loss)over a target horizon within a given confidence interval’. Target horizon means the

period till which the portfolio is held. Ideally, the holding period should correspond to

the longest period needed for orderly (as opposed to a fire sale’) portfolio liquidation.

Pitfalls of Basel I

Basel I Capital Accord has been criticized on several grounds. The main criticismsinclude the following:

Limited differentiation of credit risk

There are four broad risk weightings (0%, 20%, 50% and 100%), as shown inFigure1, based on an 8% minimum capital ratio.

Static measure of default risk

The assumption that a minimum 8% capital ratio is sufficient to protect banks fromfailure does not take into account the changing nature of default risk.No recognition of term-structure of credit risk the capital charges are set at the samelevel regardless of the maturity of a credit exposure.

Simplified calculation of potential future counterparty risk the current capitalrequirements ignore the different level of risks associated with different currenciesand macroeconomic risk. In other words, it assumes a common market to all actors,

which is not true in reality.

Lack of recognition of portfolio diversification effects

In reality, the sum of individual risk exposures is not the same as the risk reductionthrough portfolio diversification. Therefore, summing all risks might provide incorrect

judgment of risk. A remedy would be to create an internal credit risk model - forexample, one similar to the model as developed by the bank to calculate market risk.This remark is also valid for all other weaknesses.These listed criticisms have led to the creation of a new Basel Capital Accord, knownas Basel II, which added operational risk and also defined new calculations of credit



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risk. Operational risk is the risk of loss arising from human error or managementfailure. Basel II Capital Accord was implemented in 2007.

Conclusion

The Basel I Capital Accord aimed to assess capital in relation to credit risk, or the risk

that a loss will occur if a party does not fulfil its obligations. It launched the trendtoward increasing risk modelling research; however, its over-simplified calculations,and classifications have simultaneously called for its disappearance, paving the wayfor the Basel II Capital Accord and further agreements as the symbol of thecontinuous refinement of risk and capital. Nevertheless, Basel I, as the firstinternational instrument assessing the importance of risk in relation to capital, willremain a milestone in the finance and banking history.

THE NEW ACCORD (BASEL 2)

In June 1999 BCBS issued a proposal for a New Capital Adequacy Framework toreplace the 1988 Accord. The proposed capital framework consists of three pillars:

minimum capital requirements, which seek to refine the standardised rules setforth in the 1988 Accord;

supervisory review of an institution's internal assessment process and capitaladequacy; and

Effective use of disclosure to strengthen market discipline as a complement tosupervisory efforts.



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The accord has been finalized recently on 11th May 2004 and the final draft isexpected by the end of June 2004. For banks adopting advanced approaches formeasuring credit and operational risk the deadline has been shifted to 2008, whereasfor those opting for basic approaches it is retained at 2006.

THE NEED FOR BASEL II

The 1988 Basel I Accord has very limited risk sensitivity and lacks risk differentiation(broad brush structure) for measuring credit risk. For example, all corporations carrythe same risk weight of 100 per cent. It also gave rise to a significant gap between theregulatory measurement of the risk of a given transaction and its actual economic risk.The most troubling side effect of the gap between regulatory and actual economic risk has been the distortion of financial decision-making, including large amounts of regulatory arbitrage, or investments made on the basis of regulatory constraints rather

than genuine economic opportunities. The strict rule based approach of the 1988accord has also been criticised for its `one size fits all’ prescription. In addition, it

lacked proper recognition of credit risk mitigants such as credit derivatives,securitisation, and collaterals.

PILLAR I: Minimum Capital Requirements

Credit Risk

Three alternate approaches for measurement of credit risk have been proposed. Theseare:• Standardised

• Internal Ratings Based (IRB) Foundation

• Internal Ratings Based (IRB) Advanced



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The standardised approach is similar to the current accord in that banks are required toslot their credit exposures into supervisory categories based on observablecharacteristics of the exposures (e.g. whether the exposure is a corporate loan or aresidential mortgage loan). The standardised approach establishes fixed risk weightscorresponding to each supervisory category and makes use of external credit

assessments to enhance risk sensitivity compared to the current accord. The risk weights for sovereign, inter-bank, and corporate exposures are differentiated based onexternal credit assessments. An important innovation of the standardised approach isthe requirement that loans considered `past due’ be risk weighted at 150 per cent

unless, a threshold amount of specific provisions has already been set aside by thebank against that loan.

The IRB approach uses banks’ internal assessments of key risk drivers as primary

inputs to the capital calculation. The risk weights and resultant capital charges aredetermined through the combination of quantitative inputs provided by banks andformulae specified by the Committee. The IRB calculation of risk weighted assets for

exposures to sovereigns, banks, or corporate entities relies on the following fourparameters:

Probability of default (PD), which measures the likelihood that the borrowerwill default over a given time horizon.

Loss given default (LGD), which measures the proportion of the exposure thatwill be lost if a default occurs.

Exposure at default (EAD), which for loan commitment measures the amountof the facility that is likely to be drawn in the event of a default.

Maturity (M), which measures the remaining economic maturity of theexposure.

The differences between foundation and advanced IRB approaches are captured in thetable below based on who provides the inputs on the various parameters:



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Operational Risk

Within the Basel II framework, operational risk is defined as the risk of lossesresulting from inadequate or failed internal processes, people and systems, orexternal events. Operational risk identification and measurement is still in an

evolutionary stage as compared to the maturity that market and credit risk measurements have achieved.

PILLAR 2: Supervisory Review Process

Pillar 2 introduces two critical risk management concepts: the use of economiccapital, and the enhancement of corporate governance, encapsulated in the followingfour principles:

Principle 1: Banks should have a process for assessing their overall capitaladequacy in relation to their risk profile and a strategy for maintaining theircapital levels.

Principle 2: Supervisors should review and evaluate banks’ internal capital

adequacy assessments and strategies, as well as their ability to monitor andensure their compliance with regulatory capital ratios. Supervisors should takeappropriate supervisory action if they are not satisfied with the result of thisprocess. This could be achieved through:

o on-site examinations or inspections;o off-site review;o discussions with bank management;o review of work done by external auditors; ando periodic reporting.

Principle 3: Supervisors should expect banks to operate above the minimumregulatory capital ratios and should have the ability to require banks to holdcapital in excess of the minimum.

Principle 4: Supervisors should seek to intervene at an early stage to preventcapital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

Prescriptions under Pillar 2 seek to address the residual risks not adequately coveredunder Pillar 1, such as concentration risk, interest rate risk in banking book, businessrisk and strategic risk. `Stress testing’ is recommended to capture event risk. Pillar 2

also seeks to ensure that internal risk management process in the banks is robustenough.



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PILLAR 3: MARKET DISCIPLINE

The focus of Pillar 3 on market discipline is designed to complement the minimumcapital requirements (Pillar 1) and the supervisory review process (Pillar 2). With this,the Basel Committee seeks to enable market participants to assess key information

about a bank’s risk profile and level of capitalization— thereby encouraging marketdiscipline through increased disclosure. Public disclosure assumes greater importancein helping banks and supervisors to manage risk and improve stability under the newprovisions which place reliance on internal methodologies providing banks withgreater discretion in determining their capital needs.

Criticism of Basel II

Pro-cyclicality:In simple terms, pro-cyclicality means that banks governed by Basel II (capital tied torisks) will loosen credit in `good times’ (when risk perceptions are low) and restrict it

when times are bad (when risks rise again). If most banks act in this fashion, havingadopted the accord, they would accentuate the crisis in bad times, jeopardizingstability.

Fearsome complexity

The US Comptroller of Currency, John D. Hawke Jr., considers CP3 (ConsultativePaper 3) published by Basel Committee as having `mind-numbing complexity’. `Can

anyone reasonably assume that a mandate of the complexity of Basel II will beapplied with equal forcefulness across such a broad spectrum of supervisory regimes,’

asks Hawke.The meek answer from BCBS is that the complexity of the new accord results fromthe complexity it seeks to address. `This (Basel II implementation) is a task of extreme complexity involving the intersection of computer science, mathematics andfinance,’ says Dr. Ron Dembo, founding chairman of Algorithmics Inc., a Toronto-based company specializing in financial risk management software.

Heavy Implementation Costs:

Data monitor estimates that financial institutions worldwide will spend close to US$ 4billion over two years on upgrading databases and other systems in order to complywith Basel II. The moot questions for banks are `what benefits will accrue from thisinvestment?’ and `how long will the pay back period be?’



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Credit Risk ConcernsUsing 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 that it does not resort to full credit risk

modelling--it fails to take into account portfolio effects of risk mitigation throughdiversification.

Indian Banks: Impact of Basel II Implementation

07 August 2008: Fitch Ratings has commented that the renewed focus on risk broughtby the Basel II guidelines has been timely, given the current credit environment that isturning increasingly challenging. The release of capital in a few of the businesssegments, including the regulatory retail portfolio, however, reduces the cushionavailable to banks to withstand the current downturn in the credit cycle, particularly inconsumer loans.

In a special report entitled "Indian Banks: Impact of Basel II Implementation", Fitchdiscusses the business impact of the new Basel II guidelines on the capital ratios of the Indian banking system. The report highlights some of the modifications exercisedby the Indian regulator (making comparisons to the document published by the BaselCommittee on Banking Supervision), including the zero risk weights for directexposures to both the central and state governments and higher risk weights onresidential mortgage loans. "The use of national ratings for risk weighting corporateexposures could result in capital savings of about 100bp of the corporate loan

portfolio of Indian banks, but makes it difficult to compare their capital adequacyratios with banks in other countries," commented Ananda Bhoumik, Senior Directorwith Fitch's Financial Institutions team in Mumbai.

While most of the Indian banks that migrated to Basel II in FY08 reported a reductionin their total capital adequacy ratios (CARs) on account of a capital charge onoperational risk (65-75bp), a few banks actually reported capital relief on account of higher exposures to better rated corporates or savings on the regulatory retail portfolio(including the small business segment). However, following the imposition of anadditional charge for the unrated corporate portfolio that became applicable on 1 April2008, Fitch believes that the sustainability of the capital relief remains to be seen,

since the additional capital charge on account of the higher risk weight for unratedcorporate loan portfolio could be up to 30-40bp.

In the report, Fitch also discusses how Basel II regulations may influence theproportion and direction of bank lending. This is because banks would find itincreasingly attractive to give out loans to the small business segment that qualify asregulatory retail, given their higher lending margins and lower risk weights; althoughthe agency notes that the small manufacturing segment has traditionally been mostvulnerable to delinquencies during an economic slowdown. Also, the increase in risk weight for residential mortgage loans where the loan to value (LTV) exceeds 75%could dissuade aggressive lending policies by some banks.



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In a recent guideline, the Reserve Bank of India has required banks to develop anInternal Capital Adequacy Assessment Process to address risks not captured under thefirst pillar (minimum capital requirement). While banks are integrating these into theirrisk management systems, the internal capital planning process appears to throw upthe CAR threshold by about 200bp to 300bp higher than the regulatory minimum ratio

of 9%. Additionally, Indian banks have also been working on internal risk models inpreparation of the Internal Risk Based approach for credit risk, although it may take afew years before these are ready for validation.

After being postponed by a year to allow greater preparation, the standardisedapproach on credit risk and the basic indicator approach for operational risk wereimplemented on 31 March 2008 by Indian banks having international operations.

BASEL III

Basel III is a set of international banking regulations developed by the Bank forInternational Settlements in order to promote stability in the international financialsystem. The purpose of Basel III is to reduce the ability of banks to damage theeconomy by taking on excess risk. Problems with the original accord became evidentduring the subprime crisis in 2007.

Basel III and the Banks

With that in mind, banks must hold more capital against their assets, therebydecreasing the size of their balance sheets and their ability to leverage themselves.While these regulations were under discussion prior to the financial crisis, theirnecessity is magnified as more recent events occur.The Basel III regulations contain several important changes for banks' capitalstructures. First of all, the minimum amount of equity, as a percentage of assets, willincrease from 2% to 4.5%. There is also an additional 2.5% "buffer" required,bringing the total equity requirement to 7%. This buffer can be used during times of financial stress, but banks doing so will face constraints on their ability to paydividends and otherwise deploy capital. Banks will have until 2019 to implement

these changes, giving them plenty of time to do so and preventing a sudden "lendingfreeze" as banks scramble to improve their balance sheets.It is possible that banks will be less profitable in the future due in part to theseregulations. The 7% equity requirement is a minimum and it is likely that many bankswill strive to maintain a somewhat higher figure in order to give themselves a cushion.If financial institutions are perceived as being safer, the cost of capital to banks wouldactually decrease. Banks that are more stable will be able to issue debt at a lower cost.At the same time, the stock market might assign a higher P/E multiple to banks thathave a less risky capital structure.



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Basel III and Financial Stability

Basel III is not a panacea, and will not single-handedly restore stability to thefinancial system and prevent future financial crisis. However, in combination withother measures, these regulations are likely to help produce a more stable financial

system. In turn, greater financial stability will help produce steady economic growth,with less risk for crisis fueled recessions such as that experienced following the globalfinancial crisis of 2008-2009.While banking regulations may help reduce the possibility of future financial crises, itmay also restrain future economic growth. This is because bank lending and theprovision of credit are among the primary drivers of economic activity in the moderneconomy. Therefore, any regulations designed to restrain the provision of credit arelikely to hinder economic growth, at least to some degree. Nevertheless, following theevents of the financial crisis, many regulators, financial market participants andordinary individuals are willing to accept slightly slower economic growth for thepossibility of greater stability and a decreased likelihood of a repeat of the events of 2008 and 2009

Basel III and Investors

As with any regulations, the ultimate impact of Basel III will depend upon how it isimplemented in the future. Furthermore, the movements of international financialmarkets are dependent upon a wide variety of factors, with financial regulation beinga large component. Nevertheless, it is possible to generalize about some of thepossible impacts of Basel III for investors.

It is likely that increased bank regulation will ultimately be a positive for bond marketinvestors. That is because higher capital requirements will ultimately make bondsissued by banks safer investments. At the same time, greater financial system stabilitywill provide a safer backdrop for bond investors, even if the economy grows at aslightly weaker pace as a result. The impact on currency markets is less clear; butincreased international financial stability will allow participants in these markets tofocus upon other factors while perhaps eventually giving less focus to the relativestability of each country's banking system.Finally, the effect of Basel III on stock markets is uncertain. If investors valueenhanced financial stability more than the possibility of slightly higher growth fueledby credit, stock prices are likely to benefit from Basel III (all else being equal).

Furthermore, greater macroeconomic stability will allow investors to focus more onindividual company or industry research while having to worry less about theeconomic backdrop or the possibility of broad-based financial collapse.



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Implication for India

Reserve Bank of India (RBI) does not see higher capital requirements under theproposed Basel III norms hitting Indian banks significantly.“Indian banks are not likely to be significantly impacted by the proposed new capital

rules. As on June 30, 2010, the aggregate capital to risk weighted assets ratio of theIndian banking system stood at 13.4%, of which Tier I capital constituted 9.3%.Although the Basel III norms are yet to be calibrated, it is unlikely that they will behigher than the above figures,” Duvvuri Subbarao, governor, RBI, said at a

conference on Tuesday.As such, we do not expect our banking system to be significantly stretched in meetingthe proposed new capital rules both in terms of the overall capital requirement and thequality of capital, Subbarao said.The Basel Committee on Banking Supervision, under the Basel III rules, proposes thatbanks hold more and better quality capital, besides having more liquid assets.The norms will also limit banks’ leverage and make it mandatory for them to build up

capital buffers in good times that can be utilised in periods of stress.“Indian banks already make most of the deductions from capital now b eing proposedunder Basel III. Moreover, our banks do not have re-securitisation exposures and theirtrading books are small. However, there may be some negative impact arising fromshifting some deductions from Tier I and Tier II capital to common equity, ” said

Subbarao.“The major challenge for banks in India, in implementing liquidity standards, is to

develop the capability to collect the relevant data accurately and granularly, and toformulate and predict the liquidity stress scenarios with reasonable accuracy andconsistent with their own situation,” he said.

Tier-I capital (equity capital and disclosed reserves) can absorb losses without a bank being required to cease trading and Tier-II capital (undisclosed reserves, general lossreserves and subordinate term debts) can absorb losses in the event of a winding-upand so provides a lesser degree of protection to depositors.Bankers seem to be comfortable with the proposed Basel III norms. Rana Kapoor,founder/managing director & CEO, Yes Bank, said the migration to Basel III works inthe bank’s favour because external ratings are actually helping it reduce the core Tier

I burden. “In fact, every time we get external ratings, in almost 75% of the cases, we

are releasing capital. And secondly we do not have any exclusion capital — forinstance we do not have any large investments sitting on our book,” he said at the

sidelines of the conference.

Conclusion

These regulations should result in a somewhat safer financial system, while perhapsrestraining future economic growth to a small degree. For investors, the impact islikely to be diverse, but should result in safer markets for bond investors and perhapsgreater stability for stock market investors. An understanding of Basel III regulationswill allow investors to better analyse the financial sector going forward, while alsoassisting them in formulating macroeconomic opinions on the stability of theinternational financial system and the global economy.

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