FINANCIAL MARKETS AND INSTITUTIONS

BASEL II

NEW BASEL CAPITAL ACCORD

The New Basel Capital Accord, often referred to as the Basel II Accord or simply Basel II, was approved by the Basel Committee on Banking Supervision of Bank for International Settlements in June 2004.

The Origin
Basel was an attempt to reduce the number of bank failures by tying a bank's capital adequacy ratio to the risk of the loans it makes. For instance, there is less chance of a loan to the government going bad than a loan to, say, an Internet business. So the bank would not have to hold as much capital in reserve against the first loan as against the second. The first attempt to do this worldwide was by the Basel committee for international banking supervision in 1988. However, its system of judging the relative risk of different loans was crude. For instance, it penalized banks no more for making loans to a fly-by-night software company in Thailand than to Microsoft; no more for loans to South Korea, bailed out by the IMF in 1998, than to Switzerland. In 1998, "Basel 2" was proposed, using much more sophisticated risk classifications. However, controversy over these new classifications, and the cost to banks of administering the new approach, led to the introduction of Basel 2 being delayed until (at least) 2005. Over the past 20 years, there have been several examples of banking crises that have threatened wider systemic damage. Instances of Mexico (1982), the other Latin American debt crises of the 1980s, Mexico again in 1994 and 1995, and then the east Asias debt problems of 1997 and 1998, Russia in 1998 and Brazil in 1999 are all sad reminders of how banking sector weaknesses can result in huge economic losses involving sometimes massive costs of banking sector restructuring. Actually, the Basel Capital Accord (Basel I) of 1988 was evolved by the Basel Committee2 to prevent major bank failures. It primarily comprised principles for able risk management, capital adequacy, sound supervision and regulation, and transparency of operations. It introduced for the first time an internationally accepted definition of bank capital and prescribed a minimum acceptable level of capital for banks. This framework was progressively introduced not only in member countries but also in the more than 100 other countries that have active global banks. The reason for its unquestioned acceptance by advanced as well as less developed countries, lay largely in the fact that it arrived on the scene precisely when many countries were reforming their financial sectors [Nachane 2003]. India was no exception to this. The Narasimham Committee Reports I and II had heavily relied on Basel I for their entire agenda for the banking sector reforms in India. However, the banking industry world over has undergone a major transformation since Basel I was implemented in 1988. Two specific changes the expanded use of securitisation and derivatives in secondary markets and vastly improved risk management systems had significant implications for Basel I. For banks that operate on a global scale in virtually allfinancial markets, Basel I has become outdated. In recognition of these trends, the Basel Committee proposed a new Capital Adequacy framework (Basel II) in June 1999,

Which recommends more risk-sensitive minimum capital requirements for banking organizations. The new framework was widely debated and discussed by regulators of different countries and members of the banking industry before the Basel Committee endorsed its final document on June 26, 2004. The new framework will be available for implementation in member jurisdictions as of year-end 2006. The most advanced approaches to risk measurement will be available for implementation as of yearend 2007. The G-10 governors and supervisors have encouraged authorities in other jurisdictions to consider the readiness of their supervisory structures for the Basel II framework and recommended that they proceed at their own pace, based on their own priorities.

Salient features of Basel II

PILLAR-1 MINIMUM CAPITAL REQUIREMENT Pillar-1 envisages capital requirement for credit risk, market risk and operational risk. Detailed guidelines are given for each risk category and within each risk category, there are different approaches. 1) Credit risk: this is the most important category as maximum capital requirement will come from this category. There are three approaches as under: a) Standardized Approach: All banks in India have to follow this approach. It envisages different risk weights for different exposures based of the rating given by any of the approved "External Credit Assessment Institutions (ECAIs)". The following four rating agencies have been approved by RBI for domestic exposure: CARE, CRISIL, FITCH, and ICRA. For external exposure, the following three agencies have been approved: FITCH, Moody's and Standard & Poor's. Further, rating should be `solicited rating' by the borrowers. b) Internal Rating-based Approach (foundation): This requires the banks to have robust internal rating system. It is necessary that such internal rating system is independent of business units, which take credit decisions. It requires at least 3-5 years data for calculation of Probability of Default (PD). c) Internal Rating-based Approach (advanced): It requires five years data for computing PD, seven years data for computing Loss Given Default (LGD). The above ratings are applicable to corporate exposure, i.e., exposure above Rs. 5 cr; and exposure of less than Rs. 5 cr is classified as retail exposure. For retail exposure, risk weights have been prescribed under the RBI policy. 2) Operational risk: This involves three approaches. a) Basic Indicator Approach: Computation of capital requirement under this approach is very simple and not data-intensive. It is 15% of gross average income, positive for the last three years. b) The Standardized Approach (TSA): This should not be confused with the standardized approach under credit risk. To arrive at capital requirement under this approach, gross

income has to be mapped to various business lines. Thereafter, depending upon the `beta' factors provided by the RBI, capital charge has to be calculated. c) Advance Management Approach (AMA): Under this approach, capital charge is based on average `loss' due to operational risk in the last five years plus expected loss during the next year. 3) Market risk: This involves two approaches: a) Standard Duration Approach: This approach is now followed by all banks. Capital charge under this method is calculated on the basis of duration of investment. b) Model Approach: This is an advanced approach. It is based on internal risk management models developed by bank. Banks in India are not yet ready for this approach. In the initial stage, all banks are required to follow Standardized Approach in Credit Risk, Basic Indicator Approach in Operational Risk, and Standard Duration Approach in Market Risk. Migration to higher approaches will require RBI permission. Higher approaches are more risk sensitive and may reduce capital requirement for banks following sound risk management policies. Pillar 2: SUPERVISORY REVIEW Under this pillar, the banks are required to establish a robust risk management system. Such a system is subject to supervisory review. If the regulator is not satisfied with the risk profile of the bank and its risk management system, it has the right to prescribe higher capital requirement. Moreover, the banks are required to prepare Internal Capital Adequacy Assessment Procedure (ICAAP) policy, which should be duly approved by its Board. This policy should capture risk categories other than those covered under Pillar-1, i.e., legal risk, concentration risk, reputation risk, etc. Capital requirement under ICAAP policy will be over and above regulatory capital requirement. Under Pillar-2, the banks are expected to put in place stress testing policy duly approved by the Board and also carry out stress testing and scenario testing. Independent validation of rating of credit exposures based on internal rating models is also an important part of Pillar-2. Under operational risk, the banks may put in place a risk management system based on self-assessment of operational risk by branches and preparation of a risk mitigation plan based on such self-assessment. Pillar-3 MARKET DISCIPLINE Pillar-3 relates to periodical disclosures to regulator, Board of the Bank and market about various parameters which indicate the risk profile of the bank. The banks are required to put such disclosures on its websites. Such disclosures ensure market discipline. All the three pillars under Basel II will ensure a sound banking system, which can stand the risk inherent in market economy, Should be in place.

BASEL I and BASEL II

As stated earlier, advances in risk management practices, technology banking markets have made the simple approach f Basel I less meaningful for many organizations. For example, Basel I sets capital requirements based on broad classes of exposures and does not distinguish between relative degrees of creditworthiness among individual borrowers. According to the BIS Paper (2004), the Basel II framework s more reflective of the underlying risks in banking and provides stronger incentives for improved risk management. It builds on the basic structure of the Basel I for setting capital requirements and improves the capital frameworks sensitivity to the risks that banks actually face. This is deemed to be achieved in part by aligning capital requirements more closely to the risk of credit loss and by introducing a new capital charge for risk exposures caused by operational failures. To accomplish the goal of adequate capitalization of banks, the Basel II framework has introduced three pillars that reinforce ach other and enhance the quality of banks control processes. Under Pillar 1, the Basel II improves capital adequacy for banks by requiring higher levels of capital for high credit-risk borrowers and vice versa. Here, three options are available for banks to choose an appropriate approach for credit risk assessment. Under the standardized approach to credit risk, the relatively less sophisticated banks are supposed to use the ratings given by external credit rating agencies to assess the credit quality of their borrowers for regulatory capital purposes. Banks that possess sophisticated risk measurement systems may with the approval of their supervisors, select from one of two internal ratings based(IRB) approaches (the foundation and advanced models)to credit risk. Under these options, banks rely partly on their own measures of borrowers credit risk to determine their capital requirements, subject to strict data, validation, and operational requirements. Under the Foundation IRB Approach, the banks can use default probabilities for credit risk based on their own internal risk calculations. However, the Advanced IRB Approach also lets them supply key variables such as loss given default and other risk measures.3 In addition to the credit and market risk covered by the Basel I framework, Basel II establishes an explicit capital charge for a banks exposure to operational risks, i e, the risk of losses caused by failures in systems, processes or staff or that caused by external events, such as natural disasters. Similar to the range of options provided for assessing credit risk exposures, banks will choose one of the three options for measuring operational risks exposures. These are the Basic Indicators Approach that employs a single proxy for the entire bank such as trading volumes, the Business Line Approach that uses the Committee imposed capital ratios for different business lines (such as retail banking, corporate financial services, payment and settlement, etc) and the Advanced Measurement Approach that uses a banks own loss data within a supervisory specified Framework. Pillar 2 is represented by the effective supervisory review of Pillar 1, whereby bank supervisors are expected to evaluate the activities and risk profiles of individual banks in order to determine whether those banks have provided adequate Capital under Pillar 1 and suggest ways to set right the discrepancies, if any. Pillar 3 is represented by the market discipline to ensure prudent management by banks by enhancing

the degree of transparency in banks public reporting. It sets out the public disclosures that banks must undertake to make adequacy of theicapitalisation more transparent. Keeping in mind the growing complexities of banking operations, the Basel II framework covers not just banks but also securities firms, asset managers, insurance companies, etc, with any involvement in banking, fund or asset management, securitisation, long-term equity holdings, etc. The qualitative difference between Basel Basel II and I summarized in Table 1. While everybody accepts the significant potential of Basel I framework in improving risk management practices, there are some caveats, especially for its implementation in emerging economies. This was originally designed in the context of internationally active banks in G-10 jurisdictions, which are already largely in compliance with Basel I and the Basel Core Principles (BCP). But Basel II, at this stage may not be the priority objective in Banking Supervision for many developing countries with less advanced banking systems. The implementation of Basel II would require both banks and supervisors to invest large resources in upgrading their technology and human resources to meet the minimum standards. This may distract the attention of supervisors from supervision to implementations sues [Nachane 2003]. As per the International Monetary Funds (IMF) Staff Noteon Basel II (2004), there are many serious gaps in the baseline compliance of several developing countries with respect to BCP.The baseline compliance reflects a system fully or largely compliant with the BCP, which incorporates Basel I as the capital adequacy standard. In the course of 71 assessments conducted by the IMF as part of its Financial Sector Assessment Programme exposures, banks will choose one of the three options for measuring operational risks exposures. These are the Basic Indicators Approach that employs a single proxy for the entire bank such as trading volumes, the Business Line Approach that uses the committee imposed capital ratios for different business lines (such as retail banking, corporate financial services, payment and settlement, etc) and the Advanced Measurement Approach that uses a banks own loss data within a supervisory specified framework. Pillar 2 is represented by the effective supervisory review of Pillar 1, whereby bank supervisors are expected to evaluate the activities and risk profiles of individual banks in order to determine whether those banks have provided adequate capital under Pillar 1 and suggest ways to set right the discrepancies, if any. Pillar 3 is represented by the market discipline to ensure prudent management by banks by enhancing the degree of transparency in banks public reporting. It sets out the public disclosures that banks must undertake to make adequacy of their capitalization more transparent. Keeping in mind the growing complexities of banking operations, the Basel II framework covers not just banks but also securities firms, asset managers, insurance companies, etc, with any involvement in banking, fund or asset management, securitisation, long-term equity holdings, etc. The qualitative difference between Basel Basel II and I summarized in Table 1.

Advantages of Basel II
Though every bank has to invest lot of time, manpower and energy in the implementation of Basel II, it is worth doing so. It helps the banks to assess the risks associated with the business effectively; more so, it facilitates the banks to produce quantified and more realistic measure of the risks. Thus, Basel II enables the banks to handle business with more confidence and make better business decisions. Banks in the process of implementation of the new Accord can enhance their risk management systems and methods, which in turn will reduce the losses associated with the risks taken by the banks. As banks migrate to advanced approaches, the requirement of capital will come down depending upon the risk profile. Proper risk differentiation in credit risk assessment in Basel II facilitates banks to maintain capital as per the intrinsic risk of the counter party, instead of "one size fits all". Hence we say that it is more risk sensitive; it recognizes developments in risk measurement and risk management techniques employed in the banking sector and accommodates them within the framework;

it aligns regulatory capital closer to economic capital.

Opportunities for India

The Basel II norms are in line for implementation by the year 2008 Though not mandatory for all countries to follow this regime, many including India are likely to adopt it. And the plausible advantages that this would have in store for India would be both banking as well as non-banking. Banking Opportunities With second highest growth rate in the world and huge scientific and general work force, India is now well recognized as one of the fast emerging nations in the world. A sound and evolved banking system would thus be a prime requirement to support the hectic and enhanced levels of domestic and international economic activities in the country. Though India is credited with a very strong banking system, in comparison to many peer group countries, still some better risk practices by Indian banks are required. A majority of Indian banks are either at nascent or at a very low level of competence in Credit, Market and Operational risk measurement and management system. They are lagging behind in use of modern risk methodologies and tools in comparison to their western counterparts. Economic reforms, higher market dynamics and large-scale globalization demand a robust risk management system in the Indian banks. As suggested by the recent Global Trust bank fiasco the current level of risk based supervision and market disclosures are also not very satisfactory in the Indian banking system. Basel II gives an opportunity and a framework for improvement to the Indian banks. 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. Non-Banking Opportunities The major advantage of Basel II to India is going to be in the area of services predominantly IT and manpower. The banks all over the world will have to make huge investments in order to be the Basel II compliant. These investments will be mainly in the areas of information technology systems (software tools, database management, Business Intelligence, hardware), training etc. to create risk infrastructure to address the three compliance pillars of the Basel II. Here is the opportunity for consultancy and IT companies in India and abroad. Indian IT companies with an established reputation of system implementation and service support can and must use this opportunity to enhance their business from the financial services domain. A broad understanding among WTO countries on GATS (General Agreement on Trade and Services) should help in the movement of cheaper Indian service personnel across the globe. IT/ITES industry in banking and financial services sector can enhance the present level of revenue from both on

and off site services related to Basel II compliance. Some of the Indian IT majors like I flex, Infosys and Wipro are believed to be, in the advanced stage of preparation in terms of product and services, to embark upon the business opportunities provided by Basel II

Basel II and Emerging Economies

While everybody accepts the significant potential of Basel II framework in improving risk management practices, there are some caveats especially for its implementation in emergingeconomies. Basel II framework was originally designed in the context of internationally active banks in G-10 jurisdictions, which are already largely in compliance with Basel I and the Basel Core Principles (BCP). But Basel II, at this stage may not be the priority objective in Banking Supervision for many developing countries with less advanced banking systems. The implementation of Basel II would require both banks and supervisors to invest large resources in upgrading their technology and human resources to meet the minimum standards. This may distract the attention of supervisors from supervision to implementation issues [Nachane 2003]. As per the International Monetary Funds (IMF) Staff Noteon Basel II (2004), there are many serious gaps in the baseline compliance of several developing countries with respect to BCP.The baseline compliance reflects a system fully or largely compliant with the BCP, which incorporates Basel I as the capital adequacy standard. In the course of 71 assessments conducted by the IMF as part of its Financial Sector Assessment Programmecovering 12 advanced, 15 transition, and 44 developing countries the IMF staff has noted many deficiencies in the area of risk management, consolidated supervision, and corrective action for undercapitalized institutions all of which are crucial for the proper implementation of Basel II. Table 2 aptly reflects the gravity of the non-compliance problem for developing countries. Table 2 reveals that about half the developing countries were assessed as noncompliant by the IMF, with BCP 6 dealing with capital regulation, BCP 11 dealing with country risk, BCP 22dealing with formal powers of supervisors for corrective action, and BCP 20 dealing with consolidated supervision. More than two-thirds of developing countries were non-compliant withBCPs 12 and 13 dealing with market and other risk management, while over one-third did not comply with BCP 8 dealing with loan evaluation and provisioning, and BCP 21 dealing with accounting and information requirements. This critically brings out the difficulties involved in implementing Basel II consistently across developed and developing countries within the specified period of time.

TABLE 2

Another major argument pertaining to the effect of Basel II on emerging economies relates to the adoption of IRB system under Basel II. The adoption of IRB system is not just costly but also discriminates against smaller banks. There is also a possibility of heightened cyclically of global bank credit under this system. In brief, the idea runs like this. In a business downturn, a banks capital base is likely to be eroded by loan losses. As a result of this, its existing non-defaulted borrowers will also be downgraded by the relevant credit risk models, forcing the bank to hold more capital against its current loan portfolio. To the extent that it is difficult for the bank to raise fresh external capital in bad times, it will be forced to cut back on its lending activity, thereby contributing to the worsening of the initial downturn. Thus, Basel II is likely to exacerbate cyclical fluctuations a price too high for emerging economies once they adopt the advanced IRB system Recent empirical research [Stephany Griffith-Jones et al 2004] shows that Basel II would quite significantly overestimate the risk of international bank lending to developing countries, leading to a sharp rise in the cost of bank borrowings by these countries as well as a fall in their capital inflows. This is likely to damage the growth potential of emerging economies. There is also growing concern that Basel II norms may go against the interests of small enterprises, infrastructure projects, etc, whichrequire a more liberal approach to bank credit. It is feared that adoption of elaborate and cumbersome regulations such as BaselII may adversely affect the risk appetite of banks in developing countries and attainment of sound banking could be at the cost of growth. In the initial years of implementation, internationally active banks of developed world are likely to adopt the IRB approach for risk management and hence will be more risksensitive. Banks from developing countries will be more dependent on approach to begin with and hence will not be highly risk sensitive. This means banks from the less developed countries will be more inclined to assume exposures to high risk clients. This is likely to

increase the vulnerability of banks in the less developed countries to economic downturns. Thus, instead of creating a level playing field between banks of different financial strengths, the Basel II framework will introduce more unevenness in some respects.

Challenges in switching over to the new capital Accord

Risk management systems: Implementation of the new framework will require substantial resources and commitment on the part of both banks and supervisors. Implementation of the new Accord is expected to have far-reaching implications for banks. The complexity of the new Accord demands substantial enhancement of capabilities to capture the benefits of the Accord. Banks are required to make enormous improvements in the areas of policies, organizational structure, MIS, tools of analysis, processes, specialized training of staff, etc. Capital adequacy assessment process: Planning for adequate capital and assessment of quantification of risk to be covered by the capital are the two sides of the risk management process under Pillar-1 of Basel Accord. It is likely that Capital Adequacy Assessment Process (CAAP) will pose challenges to many banks, as banks manage risk on an individual basis and do not have procedures for integrating these risks into an overall assessment of capital adequacy. Presently, capital adequacy ratio of a bank is more of computation than the result of a planning process. Though banks may plan for their capital for the next one or two years, planning for the risk arising out of the business profile of the banks in the future is seldom done. Banks need to plan for the risks that they may take in the future and the capital required to cover these risks. This type of planning requires proper integration of the business plan for the next few years with the capital adequacy plan. Technological upgradation: There has been a rapid evolution of risk measurement tools and methodologies in the last few years. However, a great amount of learning has to take place as banks are not fully prepared for the effective utilization of these tools and methodologies. The pace at which the sophistication of the risk management technology increases is much greater than the speed at which the knowledge of risk management team and others involved in the decision processes in the banking industry is updated. In these conditions, relying on the risk measurement software as a `black box' may be highly dangerous for a bank's asset management, capital, earnings and reputation. Risk management software can prove to be a double-edged weapon: both useful and dangerous. The business sense and practical wisdom of a manager who is a traditional financial analyst can often prevail over the most sophisticated technologies that are not properly understood and utilized. They are highly effective tools, but nevertheless they are just tools. Human know-how and decision-making are required for their proper utilization. The risk managers have to have a complete understanding of the methodologies, concepts and logic used in the software before using them in decision-making processes. The risk managers have to evaluate the different risk management software available in the market in terms of their capabilities, contribution and more so their suitability to the organization,

matching with the capabilities of the organization to derive benefit and the level of sophistication in risk management desired by the management. A highly priced product, whatever may be its capabilities, will prove to be costly and undesirable to the bank at a later stage if not evaluated properly before it is bought. But do banks have at present technical capability and competence to evaluate these complex software products? Data requirement and data management: Banks need to implement substantial changes to their internal systems to prepare for appropriate data collection and revised reporting requirements. These changes may require systems integration, modification and introduction of new software. Banks need to Assessthe capabilities of their present systems and review the necessary system changes required and implement a framework to suit the data requirements, building in flexibility to expand their data range. The requirement of substantial data and the need for integration of the process of collection and management of data with the technology and the technology comfort to be derived by the people dealing with the data also pose challenges. Building risk culture - a top down approach: The creation and development of a genuine risk culture throughout a bank is the foundation of a sound risk management system. Risk should not simply be measured but also understood. Well laid down risk management systems and capital adequacy assessment processes evolve from the institutionalization of risk culture. The risk culture should be made to percolate down the levels in the organization (Top-Down Approach) and the operational line managers who actually contract risks in the form of business should be driven by the risk culture of the organization in all their decision-making processes. In short, the decision-makers should understand the importance of risk management and practice the same in their decisions. The process of inculcation of risk culture has to be equally reflected in the work of each employee, type of technology used, business acquired and capital utilized. The organizational structure, delegation of authority and reporting lines should be conducive for percolation of risk culture. Management issues: Business opportunities, coupled with the demand for more diverse and highly sophisticated products on the one hand, and shareholders' expectations, corporate governance and regulatory prescriptions on the other hand, have triggered the need for a well-integrated and sophisticated risk management system to be put in place, and as a result, resources are allocated worldwide in the banking industry for building a risk management system with more and more focus on risk quantification. But the increase in the sophistication of risk management systems and processes and the high cost for introduction of the sophisticated methods and processes have bottlenecks for speedier implementation of the sophisticated methods of risk management in the banking industry. Risk management education: The managers should understand both the theory and practice of risk. To reach such an understanding undoubtedly involves a continuous learning process in the new technologies. The learning processes and the zeal for learning have not been much evident in the line managers and are limited to the risk management group at the apex level. Inducting a continuous learning process in the line managers and educating them in risk management is a task to be addressed on priority by the banks for

the smooth adoption of the risk management principles and practices and Basel II recommendations across the bank. Emphasis on Pillar-2 and Pillar-3: Most banks have either focused their Basel II activities on Pillar-1, leaving aside the equally important aspects of Pillar-2 and Pillar-3, or are just in the very early stages of implementation. Some of the key requirements for Pillar2 include setting up a supervisory structure for assessing reliability, validity and soundness of risk management process, establishing a system to assess the effectiveness of implementation of the measures spelt out in Pillar-2, ongoing refinement of rating model performance and model validation efforts for across asset classes, back testing and stress testing of model, demonstrating that risk information is used in all key credit-related processes, such as credit pricing and credit limit management. Reorienting CAAP based on the risk profile of the bank as a whole is another challenge that the banks face in Pillar-2. Disclosure of the financial information of a bank enables the market participants to assess the bank's activities and the risks inherent in those activities. Under Pillar-3, reliability of the disclosed information should be assured by sound internal control and risk management systems and subject to external and internal audit. Evaluation of each piece of information as to its correctness and completeness and the risk of the error in its disclosure is a difficult issue to be tackled by the banks

Implementing the minimum approaches of Basel II

In India, we have 88 commercial banks, which account for about 82% (total assets) of the financial sector; over 2000 cooperative banks, which account for about 5%; and 133 Regional Rural Banks, which account for about 3%. The policy approach to Basel II in India is such that external perception about India conforming to best international standards remains positive. Taking into account the size, complexity of operations, relevance to the financial sector, need to ensure greater financial inclusion and the need for having an efficient delivery mechanism, the capital adequacy norms applicable to these entities have been maintained at varying levels of stringency. On the first track, the commercial banks in India will start implementing Basel II with effect from March 31, 2008. They will initially adopt the Standardised Approach for credit risk and the Basic Indicator Approach for operational risk. After adequate skills are developed, both by the banks and also by the supervisors, some banks may be allowed to migrate to the Internal Rating Based (IRBA) Approach and Advanced Measurement Approach (AMA). The cooperative banks, on the second track, are required to maintain capital for credit risk as per Basel I framework and through surrogates for market risk; the Regional Rural Bank,on the third track, have a minimum capital requirement which is, however, not on par with the Basel I framework. Consequently, we 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 rules. Further, we are approaching Basel II as a means to achieve an end the goal being vastly improved risk management systems in the Indian banking sector. Even though the commercial banks will be adopting the simpler options available under the Basel II

framework, the supervisory focus will be primarily on enhancing the quality of risk management systems in these banks. The implementation schedule of the new Accord and the choice of the different approaches to compute risk is decided by each country. The Reserve Bank of India (RBI) has decided that all foreign banks operating in India and Indian banks having presence outside India have to implement Basel II with effect from March 31, 2008. All other Commercial Banks (excluding Local Area Banks and Regional Rural Banks) are encouraged to migrate to Basel II Accord not later than March 31, 2009. Banks adopting Basel II as per the timeline prescribed have to implement Standardized Approach for credit risk and Basic Indicator Approach for operational risk, while continuing to apply Standardized Duration Approach for capital requirements under market risk. RBI does not permit any of the banks to implement advanced approaches now. As and when banks put in place robust risk management systems and develop the necessary skills to implement advanced approaches and the supervisor also puts in methods to effectively oversee the implementation of advanced approaches, permission may be given by RBI to banks to migrate to advanced approaches. Standardized approach for credit risk Rating penetration: All exposures to sovereigns, banks and corporates need to be rated by an External Credit Assessment Institution (ECAI) to take advantage of the risk differentiation, but only a few exposures taken by the banks are rated by ECAIs. Low rating penetration may pose challenges in implementation of standardized approach, particularly in respect of corporate claims. India has four established rating agencies. In three of them, leading international credit rating agencies are stakeholders and also extend technical support. However, the level of rating penetration is not very significant and this problem needs to be addressed in implementing standardized approach for credit risk. Data collection: Capital computation under standardized approach for credit risk involves mainly collection of amount-wise, rating-wise, asset class-wise details of exposures and application of credit risk mitigation. The collection of the host of details, borrower-wise, from the various branches of the banks is the most important challenge that the banks may face in implementing the standardized approach, in comparison to the existing methodology of collecting details of assets block-wise (government, banks, staff, advance against deposits, approved securities, residential mortgages, etc). Though the Indian banks may not gain much from the credit risk mitigation (as CRM is restricted to eligible financial collaterals only, which banks in India may not have sizably), as a process of capital computation, the same has to be captured. Loan-wise capturing of the details of credit risk mitigants and applying haircuts borrower-wise is a difficult exercise to be done manually and the same has to be done through application software. Basic Indicator Approach (BIA) for operational risk Computation of capital for operational risk under the basic indicator approach may not require any additional systems to be put in place, as it is based on calculation from the

items in the P&L account. However, implementation of advanced approaches and compliance with "Sound Practices for the Management and Supervision of Operational Risk" issued by the Basel Committee on Banking Supervision (BCBS) in February 2003 will pose challenges to the banks, as banks are neither equipped nor having the expertise at present to put in place a sound Operational Risk Management (ORM) framework that will meet the standards of Basel II. Challenges in implementing advanced approaches Implementations of the advanced approaches under Basel II pose a huge challenge to the banks to substantially upgrade their existing MIS, risk management systems and technical skills of staff. The issues get complicated considerably with each step towards migration to the advanced Internal Ratings Based (IRB) approach for credit risk and advanced approach for operational risk. The major challenge is in regard to data collection. High quality data are critical for estimation of risk inputs and formulating effective internal risk assessments, and banks will have to focus considerable resources in areas such as designing and structuring internal rating systems, validating the internal rating, and ensuring the continued availability and integrity of credit data. Extensive and prescriptive data history requirements as well as the complexity of the data components required to carry out the capital calculation process under advanced approaches render the exercise complicated and highly technical, involving huge cost. In the area of operational risk, banks need to prioritize risk control among different business lines. This would require banks to build up a robust Management Information Systems (MIS) for such scenario analysis. The availability of very little data on operational risk internally, difficulties in capturing them and non-availability of any pooled data make advanced approach for operational risk difficult to be implemented. Implementation issues for the supervisor Under advanced approaches, banks have to capture reliable estimates of the different risk inputs: Probability of Default (PD), Loss Given Default (LGD) and Exposure at Default (EAD) for credit risk, and Probability of Event (PE) and Loss Given Event (LGE) for operational risk. The estimates of risk inputs and the models used by the banks for arriving at the estimates require continuous validation by the supervisor, and the supervisor has to provide the inputs required for risk assessment to ensure consistency in the output across the banks. All these call for a high degree of sophistication in supervisory skills, besides ensuring the availability of information at supervisory levels for validation or for providing inputs.

Impact of Basel II
Improved Risk Management & Capital Adequacy

One aspect that the staunchest critics of Basel II agree to is the fact that it will tighten the risk management process, improve capital adequacy and strengthen the banking system. Curtailment of Credit to Infrastructure Projects and priority sector The norms require a higher weightage for project finance, curtailing credit to these very crucial sector. The long-term impacts for this could be disastrous. Preference for Mortgage Credit to Consumer Credit Lower Risk Weights to Mortgage credit would accentuate bankers preference towards it vis--vis consumer credit. This trend has been observed in many countries with the growth of Mortgage credit outstripping growth of consumer credit. Basel II would further accentuate the situation impacting Industrial growth rate and consumers. Basel II: Advantage Big Banks It would be far easier for the larger banks to implement the norms, raising their quality of risk-management and capital adequacy. This combined with the higher cost of capital for smaller players would queer the pitch in favour of the former. The larger banks would also have a distinct advantage in raising capital in equity markets. Emerging Market Banks can turn this challenge into an advantage by active implementation and expanding their horizons outside the country. IT spending: Advantage Indian IT companies On the flipside, Indian IT companies, which have considerable expertise in the BFSI segment, stand to gain. Major Indian IT companies such as I-flex and Infosys already have the products, which could help them develop an edge over their rivals from the developed countries. Consolidation in the banking Industries The Inadequacy of Tier I Capital would hasten the process of consolidation within the banking Industry. The RBI has recently capped the stake of single enterprises in banks at 5%. This coupled with high government holdings in PSU banks and the unwillingness of politicians to disinvest could lead to a crisis situation. Implementation cost of Basel II is very high and would dent the Tier II capital, worsening the situations. The recent glut of bank IPOs have been a response to the CAR norms of the RBI and across the Emerging economies similar scenarios will be re-enacted.

Non-implementation could impact Sovereign rating Non-implementation of Basel II & a weak banking system would impact the sovereign rating further worsening the situations for banks & the governments which borrow capital from advanced countries.

CONCLUSION
The financial world changes all the time and those who supervise and regulate the financial world have to be prepared to change too. So we do not have any doubt that soon after Basel II is in place, we will begin to hear about Basel III. Basel II is much better than Basel I. But, it does not mean that it is good enough. There are some very serious shortcomings and has so many loose ends. Basel II is more risk sensitive than Basel I but it is NOT really risk sensitive. We do have a new risk, operational risk, but Reputational risk is not an operational risk Systemic risk (disruption at a firm or a market segment causes difficulties to other firms or market segments) is not an operational risk Strategic risk (the risk of losses or reduced earnings due to failures in implementing strategy) is not an operational risk

The logic behind Basel II: Capital requirements should increase for banks that hold risky assets and decrease significantly for banks that hold safer portfolios What is really happening: Basel II has become an international competition for consultants: How to help banks allocate less capital. Basel II creates incentives for banks to move risky assets to unregulated parts of the holding company. Banks take advantage of the opportunity to transfer risk to investors - use securitization.

REFERENCES
Bailey, R (2005), Basel II and Development Countries: Understanding the Implications, London School of Economics Working Paper No. 05-71.

Basel Committee on Banking Supervision (1988), International Convergence of Capital Measurement and Capital Standards, available at www.bis.org Basel Committee on Banking Supervision (1996), Amendment to the Capital Accord to incorporate market risks available at www.bis.org Basel Committee on Banking Supervision (2006), International Convergence of Capital Measurement and Capital Standards: A Revised Framework, available at www.bis.org Ghosh, S. and D.M. Nachane (2003), Are Basel Capital Standards Pro-cyclical? Some Empirical Evidence from India, Economic and Political Weekly, 38(8), pp. 777- 783 McKinnon, R.I. (1973), Money and Capital in Economic Development, Washington D.C, Brookings Institutions. Reserve Bank of India (2007a), Revised Draft Guidelines for Implementation of the New Capital Adequacy Framework, RBI Circular DBOD No. BP.1151/21.06.001/2006 07 Reserve Bank of India (2007b), Guidelines for Implementation of the New Capital Adequacy Framework, RBI Circular DBOD. No. BP. BC. 90 / 20.06.001/ 2006- 07 Emerging Markets Instability: Do Sovereign Ratings Affect Country Risk and Stock Returns?By Graciela Kaminsky George Washington University and Sergio Schmukler * World Bank February 28, 2001 How to prevent the Basel Capital accord from harming developing countries - Professor stephanie Jones Institute of Development Studies presented at WADMO conference 2003 Implementation of the new basel capital accord in emerging market economies problems and alternatives marusa mrak september 2003 Implementation of Basel II: An Indian Perspective Kishori J. Udeshi Deputy Governor Reserve Bank of India World Bank Conference A Capital Accord for Emerging Economies? Andrew Powell1 Universidad Torcuato Di Tella andVisiting Research Fellow, World Bank (Financial Sector Strategy and Policy FSP) ICFAI monthly magazine Analyst October 2007