Regulatory Frame work for banks – BASEL II

S.CLEMENT

BASEL - GENESIS• Herstatt Bank, Frankfurt in Germany failed on

26 June 74. Banking license was withdrawn after close of banking hours. By then DEM payments were received locally irrevocably. Correspondent bank in N.Y. suspended payments in New York. Banks which were to receive $ funds did not get the same.

• Failure of many such banks lead to make regulators think of uniform regulation of banking sector across the globe.

Need for regulation

• Volume of financial flow is on the increase as compared to trade flows

• International banking- Wide spread net work of branches across the globe and wide spread risk.

• Different level of supervisory control• Quality of assets• Spate of failure of banks• Integration of market due to globalization effect

Bank International for International Settlements (BIS)

• Established in 1930 to promote co operation among central banks of member countries. Members consist of central banks of various countries

• Up to 1970-focused on implementing and defending the Bretton Woods system.

• 197o- 80 – focus on managing cross border capital flows

• 1988 – Basel I• 1999- Basel II (Draft guidelines)

BASEL - Genesis

• Basel committee established in 1974 by central – bank governors of G 10 countries

• Committee meets regularly four times a year.

• It has 25 technical working groups and task forces which also meet regularly

BASEL - Genesis• Committee does not possess super

national supervisory authority

• It formulates broad supervisory standards and guidelines.

• It recommends statements of best practices

• Recommendations will help countries for convergence towards common approaches & standards

• It is widely accepted as international standard of best practices in banking

BASEL • Objectives:• To close gaps in international supervisory

coverage• No foreign banking establishment should

escape supervision• Supervision should be adequate• To arrive at significantly more risk sensitive

capital requirements• Due regard to supervisory & accounting

systems & Market discipline• Discretion to adopt standards to different

conditions of national market

BASEL I• First BASEL accord was accepted in 1988 and adopted internationally in

1992• RBI introduced BASEL norms in 1992 in phased manner and all banks

were covered by 1996.• 1999 – New Capital Adequacy Frame work –BASEL II• 2004 – BIS brought out BASEL II Accord( International Convergence of

Capital Measurement and Capital Standards – A Revised Frame work)• RBI issued detailed guidelines on 15.02.05 followed by circular dated 20TH

March, 2006.• Expected to in in place by March,2008 for internationally active banks like SBI, BOB, ICICI etc & for others 2009 in

India.* Parallel run already started from April 2006

Basel –I

• Objectives – ensure adequate level of capital in the international banking system to with stand crisis in banking sector.

• Banks to develop business volumes which is linked to capital. That means, with out capital, business growth is not possible. Previously, it was not so i,.e business was not linked to capital.

• In short , BASEL addresses both Liability and Asset side of Balance sheet of banks.

• Parameters to measure and manage risk via Prudential accounting norms -

• Capital adequacy

• Income recognition

• Asset classification

• Provision

Basel –I

Capital Adequacy

Capital Funds include

TIER I CAPITAL: This one can absorb losses without a bank being required to cease operation. This is Core Capital. Cushion for unexpected losses.

TIER II CAPITAL: This can absorb losses in the event of a winding up, and also provides lesser degree of protection to depositors.

RBI prescription • Elements of Tier I capital: The elements of Tier I capital include• i) Paid-up capital (ordinary shares), statutory reserves, and other disclosed

free reserves, if any;• ii) Perpetual Non-cumulative Preference Shares (PNCPS) eligible for

inclusion as Tier I capital - subject to laws in force from time to time;• iii) Innovative Perpetual Debt Instruments (IPDI) eligible for inclusion as Tier

I capital; and• iv) Capital reserves representing surplus arising out of sale proceeds of

assets. • Elements of Tier II capital: The elements of Tier II capital include

undisclosed reserves, revaluation reserves, general provisions and loss reserves, hybrid capital instruments, subordinated debt and investment reserve account .

• Undisclosed reserves They can be included in capital, if they represent accumulations of post-tax

profits and are not encumbered by any known liability and should not be routinely used for absorbing normal loss or operating losses. .

• Tier I Capital:• Paid-up Share Capital• (Common Stock)• Disclosed Free Reserves• Statutory Reserve• Capital Reserves

representing surplus arising out of sale proceeds of Assets

• Tier-II Capital:• Undisclosed

Reserves• Assets Revaluation

Reserves• Hybrid Capital

Instruments• General Provisions

& Loss Reserves• Subordinated Debt

Capital Adequacy

• Tier I Capital:• Deductions-• Equity Investment in

Subsidiaries• Accumulated Losses if

any• Intangible Assets like

Deferred Tax Assets• Goodwill

• Tier II Capital:• Discounts:• Revaluation Reserves

with 55% discountTier II cannot exceed

Tier I

• Discounts:• Subordinated Debt max.

100% of Tier I Capital, Discounted 20-80% for remaining maturity

Capital Adequacy

Basel - I (measurement of capital)

• Minimum capital requirements • Regulatory capital - Capital is measured on the

basis of Risk Weighted Assets (RWA). It is 8%as per BASEL and 9% in India.

• Classified bank assets in to 4 groups which carried respective credit risk weights of 0%,,20%,50%, & 100% based on which minimum capital requirements to be calculated.

• E.g. cash and G-Sec @ 0%,bank borrowings @ 20% and loans to others @ 50 – 100%.

RBI- Procedure for computation of CRAR

• 2.4.1. While calculating the aggregate of funded and non-funded exposure of a borrower for the purpose of assignment of risk weight, banks may ‘net-off’ against the total outstanding exposure of the borrower -

• (a) advances collateralised by cash margins or deposits,• (b) credit balances in current or other accounts which are not

earmarked for specific purposes and free from any lien,• (c) in respect of any assets where provisions for depreciation or for

bad debts have been made • (d) claims received from DICGC/ ECGC and kept in a separate

account pending adjustment, and• (e) subsidies received against  advances in respect of Government

sponsored schemes and kept in a separate  account.

Capital adequacy

• Total capital /(Tier 1 + Tier 2)/ Total RWA = 8%

• For Indian banks , it is 9%.

RISK Weighted Assets(RWA)

• RWA determined by multiplying the asset with risk factor

• E.g. loans to a bank Re 100. RWA @ 20%. Capital requirement will be 100 X 20% X 8% = Re 1.6.

• Banks to hold capital equal to 8% of R.W. Assets. In India RBI prescribed CAR of 9%.

What is retail lending ?

Banks with capital funds of Thresh hold limit

Up to Re 300 crores Re 1 crore

.300 to 500 crores Re 3 crore

500 crores Re 5 crore

RW % for AssetsASSET RW %

Cash & bal with RBI 0

CD with other banks 20

Govt.securities 2.5

Loans to corporates etc 100

Staff advances 20

CGF/FD/LIC policy/NSC (with margin)

0

RW % for AssetsASSET RW %

Govt.guaranteed sec of PSU 22.5

Loans to PSU 100

Sub.ord. Bonds of PSU/Bks

Commercial real estate

102

150

Adv.covered by ECGC 50

SSIadv.gua.by CGST 0

SEC.PTC

Venture capital

102.5

150

Other Assets 100

Risk Weights for AssetsCredit

Conversion factor

Off- Balance Sheet items

100% Financial guarantees, LCs, acceptances (Endorsements), Sale and Purchase agreement and asset sales with recourse, where credit risk remains with the Bank.

50% Performance guarantee, L/Cs related to particular transaction, other commitments (formal stand-by facilities and credit lines- over one year- if maturity Basel Committee within one year and can be cancelled at any time- Credit conversion factor – 0)

20% Short term self liquidating trade related contingencies (documentary credits)

2% Aggregate outstanding foreign exchange contracts of original maturity-less than one year (for each additional year or part thereof 3%. If original maturity is less than 14 days irrespective of counter party RWA will be 0%

Income recognition

• Interest income not to be recognized until it is realized. Accrual system to actuals.

• One quarter default for recognizing income

• Either installment or interest or both

• Borrower wise and not Facility wise

• Out of order – applicable to cash /overdraft a/c

Non performing Assets1 An asset, including a leased asset, becomes non performing when it ceases to generate income for the bank.A non performing asset (NPA) is a loan or an advance where;i. interest and/ or installment of principal remain overdue for a period ofmore than 90 days in respect of a term loan,ii. the account remains ‘out of order’ as indicated below, inrespect of an Overdraft/Cash Credit (OD/CC),iii. the bill remains overdue for a period of more than90 days in the case of bills purchased and discounted,iv. the installment of principal or interest thereon remains overdue for twocrop seasons for short duration crops,v. the installment of principal or interest thereon remains overdue for onecrop season for long duration crops,vi. the amount of liquidity facility remains outstanding for more than 90 days,in respect of a securitisation transaction undertaken in terms ofguidelines on securitisation dated February 1, 2006. Banks should, classify an account as NPA only if the interest charged during any quarter is not serviced fully within 90 days from the end of the quarter.

Asset classification

• Standard asset – servicing of int. & principal. Normal risk.

• Sub-Standard – NPA for a period up to 12 months. Asset coverage / net worth of borrower not enough to cover the loan

• Doubtful asset –age of NPA is more than 12 months.

• Loss Assets – no chance of recovery but not written off.

Provisioning norms• Loss Assts – 100% of out standing amount• Doubtful Assets –100% of unsecured,20 to 100%

( 1 to >3 years)• Substandard Asset -10% on the outstanding

amount.• Standard asset –

a) Agricuture/SME- 0.25%

b) Personal loans, stockmarket, commercial real estate & Non deposit taking NBFC – 2%

c) Others – 0.40%

Why BASEL II ?• One size fit approach to be replaced by a

menu of options for banks to choose• More risk sensitive to en compass all risks

especially operational risk.• To bridge the cap between Regulatory &

Economic capital• BASEL I did not address risk mitigation

techniques such as collateral, guarantees etc

• More emphasis on banks’ internal control and management

• More disclosure through market discipline

Basel II: New Capital Adequacy Framework

• In June 2004, Central Bank governors in the G-10 countries endorsed the publication of International Convergence of Capital Measurement and Capital Standards, commonly known as Basel II accord.

• The new accord is making capital allocation of banks more risk-sensitive.

Objectives of Basel II

• To encourage better and more systematic risk management practices, especially in the area of credit risk and to provide improved measure of capital adequacy.

• Introduction of Basel II has given incentives to many of the best practices banks, to adopt better risk management techniques and to evaluate their performance relative to market expectations and relative to competitors.

• The new framework proposes a significant refinement of regulatory and supervisory practice and encourages increased attention to risk management practices.

The New Basel

Capital Accord

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Minimum capital requirements – Regulatory and Economic capital

Supervisory review process – trancsaction based to risk based supervision

Market discipline – risk exposure, migration assets from standard to NPA etc

Minimum Capital Requirements – Pillar 1

Capital: fundamental thing worth having

Pillar I

Minimum capital requirement

Pillar II

Supervisory review Pillar III

Market discipline

1. Capital for credit risk standardized/Internal ratings based approach – Foundation/Advanced

2. Capital for mkt.risk – Standardized method – maturity / duration method.

3. Capitla for Opr.risk – basic indicator/standardized/advanced measurement approach.

1. Evaluate risk

2. Ensure soundness & integrity of banks’ internal process to assess the adequacy of capital

3. Ensure maintenance of minimum capital with PCA for short fall.

4. Prescribe differential capital , where necessary i.e. where internal process is slack.

1.Enhance disclosures

2.Core disclosures & supplementary disclosures

3.Period – semi annual.

Capital adequacy

• It measures operational risk also as against regulatory capital which measures only credit & Market risk.

• Operational is the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, & systems or from external events

• Risk assessment either by standardized or internal rating based approach

PILLAR I

• Minimum Capital requirements:• Credit Risk: - Standardized approach - Internal Rating Based Approach (Foundation IRB/Advanced IRB)• Operation Risk: - Basic Indicator Approach - Standardized approach - Advanced Measurement Approach• Market Risk: Market Risk: VaR models for

Trading Book (AFS + HFT) and EaR models for Banking Book (HTM)

Eligible capitalON-BALANCE-SHEET

CREDIT RISK+

Off-balance-sheet credit risk+

Market risk+

OPERATIONAL RISK

= 8%

Pillar 1

Economic Capital

• Economic capital is the capital required to cover credit, market and operational risks of a bank

• Economic Capital = Credit Risk Capital + market risk capital + operational risk capital

• The economic capital required to support the activities of a bank can be arrived at in a number of ways for different types of risks faced.

PILLAR I

• Key Changes:

• Wider spectrum of credit risk weights.

• Greater recognition of collaterals.

• More refined treatment of securitisation.

• Charge for Operational Risk introduced

Credit Risk

Quantifying Risk• Standardized Approach• Foundation Internal Rating Based Approach• Advanced Internal Rating Based Approach All commercial banks in India shall adopt

Standardized Approach (SA) for credit risk to start with. Banks are required to obtain the prior approval of the RBI to migrate to the Internal Rating Based Approach.

Credit Risk Mitigation

• In order to obtain relief for use of CRM techniques, proper documentation used in collateralized transactions must be binding on all parties and legally enforceable.

• Banks in India can adopt Comprehensive approach, which allows fuller offset of collateral against exposures by the value ascribed to the collateral.

• Under this approach, banks which take eligible financial collateral are allowed to reduce their credit exposure to a counter party to take account of the risk mitigating effect.

Collaterals

• The following collateral instruments are eligible for recognition in comprehensive approach:

Cash, Gold, Securities issued by Central/ State Governments, IVPs, KVPs, NSCs, LIC policies, Debt securities, equities etc.,

• In case of NPAs, other collaterals viz., land and building, plant and machinery will be recognized for assigning lesser risk weight of 100%, when provisions reach 15%, only where the bank is having clear title and the valuation is not more than 3 years old and value of machinery not higher than the depreciated value.

Risk weights

• Long term ratings of credit rating agencies under Standardized approach risk weights:

- AAA 20% - AA 30% - A 50% - BBB 100% - BB & below 150% - Un rated 100%

Other Risk Weights

• Exposures to Central Govt.& Inv.in St.Govt 0%• Exposures guaranteed by State Govt 20%• Exposures on RBI/DICGC/CGTSI 0%• Exposures on ECGC 50%• Staff loans secured by superannuation benefits 20%• Claims on Multilateral Development Banks 20%• Claims on Banks (based on CRAR of Bank) 20%-625%• Claims on Corporates(based on ext.rating) 20%-150%• Unrated claims in excess of Rs.10 cr 150%• Claims on Commercial Real Estate 150%• Consumer credit/personal loans/credit cards 125%• Claims on restructured/rescheduled a/cs 125%*• *(till satisfactory performance of one year from the date when • the first payment of interest/instalment falls due)

External Credit Assessments

• RBI has identified the following domestic credit rating agencies for the purposes of risk weighting the claims for capital adequacy purposes:

a)Credit Analysis and Research Ltd.,

b)CRISIL Limited

c)FITCH Ratings and

d)ICRA Limited

External Ratings• Banks must disclose the names of the credit rating

agencies that They use for the risk weighting of their assets.

• The rating should be in force and confirmed from the monthly bulletin of the concerned rating agency. The rating agency should have reviewed the rating at least once during the previous 15 months.

• An eligible credit assessment must be publicly available.

• Even though CC accounts are sanctioned for period one year or less, these exposures should be reckoned as long term exposures and accordingly long term ratings accorded by agencies will be relevant.

• Presently all loans above Re 10 crores will be rated by outside credit rating agencies under standardized approach.

What is operational risk ?

• Operational - risk of direct or indirect loss resulting from inadequate or failed internal processes, people, & systems or from external events. E.g. fraud, forgery, negligence, system failure etc.

• Risk assessment either by standardized or internal rating based approach

OPERATIONAL RISK

• Basel II framework outlines 3 methods for calculating operational risk capital charge.

- Basic Indicator Approach - The Standardized Approach - Advanced Measurement Approach To begin with banks are required to adopt Basic

Indicator Approach for capital charge under Operational risk.

• Banks are required to provide 15% of average gross income of the previous three years for which gross income is positive.

Standardized Approach for Operational Risk

• Under Standardized approach, Bank’s activities would be divided into 8 business lines as under:

• Corporate finance, Trading, Retail banking, Commercial Banking, Payment & settlement, Agency services, Asset Management and Retail brokerage.

• Under each business line, capital charge is calculated by multiplying the beta factor assigned to that business line. Gross income is calculated for each business line and not for Bank as a whole.

• Under Advanced Measurement Approach, regulatory capital will equal the risk capital measured by Bank’s internal risk measurement.

• Standardized approach – capital charge against each business to be provided on the basis of annual average income for 3 years.

• Advanced Measurement Approach – measured by bank’s internal risk measurement system using quantitative and qualitative approach.

Measuring operational risk

Risk Based Supervision

• Present audit focuses on transaction testing – accuracy & reliability of records, financial reports, adherence to legal & regulatory requirements etc.

• RBS – focus on testing of risk in each transaction, evaluation of effectiveness risk management & controls, periodicity of audit, inherent risks in various activities of institution, prioritization of audit areas, allocation of audit resources etc.

• In short, it is a migration form transaction to risk based audit.

Pillar II: Supervisory Review

• Banks should have Internal Capital Adequacy Process (ICAAP).

• Supervisor should verify maintenance of minimum capital requirements by banks.

• Supervisor would take appropriate action if they are not satisfied with the Bank’s minimum capital.

• ICAAP should faithfully capture the risks attached in the bank’s portfolio.

• Supervisor may take early supervisory action by asking bank to maintain additional capital.

Pillar III: Market Discipline

• To enable the market to understand the strengths and weaknesses of the Bank.

• To encourage market discipline by developing a set of disclosure requirements which allow market participants to assess key pieces of information on capital, risk exposure, risk assessment process.

• Providing disclosures that are based on a common framework is an effective means of informing the market about a bank’s exposure to those risks and provides a comprehensive disclosure framework that enhances comparability.

Disclosure regime

• Board approved policy for disclosures.

• Financial position and performance.

• Risk management strategies and practices.

• Risk exposures.

• Accounting policies.

• Basic business, management and corporate governance information.

Market Discipline- Disclosure regime

• Transparency & more disclosure

• Calculation of capital adequacy

• Risk exposure to sensitive sectors

• Migration of SA to NPA

• Risk assessment methods

BENEFITS

• Incentive for improved risk analysis and pricing of risks.

• Better internal capital management

• Improvement in credit portfolio quality and better recognition of risk mitigation.

• Control orientation to strategic advantage.

Current directives of RBI

• RBI issued draft guidelines on implemen-tation of Basel II in India on 15th Feb 05.

• RBI issued revised draft guidelines on Basel II norms on 20th March 2006.

• As per revised guidelines, all Banks in India having presence outside India will adopt Standardized approach for credit risk and Basic Indicator Approach for operational risk w.e.f. 31.03.08 and all other banks not later than 31.03.09.

• RBI further stated that banks are required to commence a parallel run of the revised framework and Boards of the banks should review the results of parallel run on quarterly basis.

Implementation - issues

• Banks by manipulating credit risk measurement, may reduce CAR. Non deliberate under estimation also may lead to lower CAR.

• Competition among banks for high quality loans/customers may exert pressure on interest spread .

• Burden of approving internal risk models. It will lead to regulators identifying them selves the banks they supervise. It will come difficult not to bail out of a large problem since supervisors have validated and approved of internal rating system of bank facing financial crisis.

• Non availability of data over longer time horizon to measure risk based on historical data.

• Too much disclosure may cause information over load and may create problem to the respective bank vis-à-vis competitors.

Implementation - issues

Indian perspective

• RBI may enforce to have a uniform credit rating approach to measure capital requirement since credit rating is a yard stick for capital provisioning .

• Technological up gradation involves huge capital requirement but return may not match. Smaller banks may suffer.

• Low penetration of credit rating and it has got to improve.

• Social obligation of public sector banks.

It would be a mistake to conclude that the only way to succeed in banking is through ever greater size and diversity. Indeed better risk management may be the only truly necessary element of success in banking.

Alan Greenspan Former Chairman, Federal Reserve October 5, 2004

Michael E.O’Neill on SWM (Share Holder’s Maximization of Wealth)

• The highest potential for increasing shareholder value is improving the way allocate capital to businesses, (including) taking away capital from businesses that are not achieving return expectations.

Michael E.O’Neill

CFO, Bank of America

Peter Drucker on SWM

• “What we generally call profits, the money left to service equity,

is usually not profits at all. Until a business returns a profit that is greater than the cost of capital, it operates at a loss”.

Peter Drucker

China Banking Regulatory Commission-

“To a large extent we are convinced that Basel II is more about risk management than capital regulation, particularly for the emerging markets”

What is Basel II?