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Banking: Basel II calling…

May 4, 2007

With a view to adopting the Basel Committee framework on capital adequacy (which takes into account the elements of credit risk in various types of assets) and also to strengthen the capital base of banks, the Reserve Bank of India (RBI) decided to introduce a risk weighted asset ratio system for banks in India as a capital adequacy measure in April 1992. Essentially, under the above system, the balance sheet and off-balance sheet exposures are assigned prescribed risk weights and banks have to maintain unimpaired minimum capital funds equivalent to the prescribed ratio on the aggregate of the risk weighted assets, on an ongoing basis. The revised Basel framework seeks to arrive at significantly more risk-sensitive approaches to capital requirements. It provides a range of options (by way of ratings) for determining the capital requirements for credit risk and operational risk to allow banks to select approaches that are most appropriate for their operations and financial markets. As per the final Basel II guidelines recently recommended by the RBI, the foreign banks operating in India and Indian banks having operational presence outside India should migrate to the Basel II norms with effect from March 31, 2008. All other commercial banks have been encouraged to migrate to these approaches not later than March 31, 2009.

The specifics...
With a view to ensuring smooth transition to the revised norms, banks have been advised to have a parallel run of the same on a quarterly basis. This means that banks should apply both the approaches of prudential guidelines on capital adequacy - erstwhile as well as the revised ones - and compute their CAR under both the guidelines until they achieve Basel II compliance. While the minimum CAR to be maintained is retained at 9%, the sub-limit for Tier I CAR has been pegged at 6%.

A bank needs to compute its Tier 1 CAR and Total CAR in the following manner:
Tier 1 CAR =

Eligible Tier 1 capital funds
----------------------------------------------------------------------------------

Credit Risk RWA* + Market Risk RWA + Operational Risk RWA
*RWA = Risk weighted Assets

where eligible Tier 1 capital funds includes paid-up equity capital, statutory and capital reserves, and innovative perpetual debt instruments eligible for inclusion in Tier 1 capital.

Total CAR =

Eligible total capital funds
----------------------------------------------------------------------------------
Credit Risk RWA + Market Risk RWA + Operational Risk RWA

where eligible total capital funds includes Tier 1 capital as well as debt.

Ratings assumes prominence
The importance of credit rating is more than evident in the revised Basel norms, wherein unrated entities are accorded the same risk weight as those with the worst ratings. The RBI has withheld the right to increase the standard risk weight for unrated claims where a higher risk weight is warranted by the overall default experience. To begin with, for FY09, all fresh sanctions in respect of unrated claims on corporates in excess of Rs 500 m will attract a risk weight of 150% and for FY10, fresh sanctions of unrated claims on corporates in excess of Rs 100 m will attract a risk weight of 150%.

Rating Risk weight
CARE CRISIL FITCH ICRA
PR1+ P1+ F1+ A1+ 20%
PR1+ P1+ F1+ A1+ 30%
PR2 P2 F2 A2 50%
PR3 P3 F3 A3 100%
Unrated Unrated Unrated Unrated 100%

Collateral assumes significance
Lending against collateral has assumed importance in the revised norms with emphasis upon the loan to value (LTV) ratio (ratio of home loan to the value of the underlying property). Loan to value (LTV) ratio upto 75% attract risk weights of 50% and 75% for loans upto Rs 2 m and above Rs 2 m respectively. LTV ratio of more than 75% will attract a risk weight of 100%. At the same time, non-collateral loans such as personal loans and credit card receivables will attract a higher risk weight of 125% or more as warranted by the external rating (or the lack of it) of the counterparty.

The way ahead...
Indian banks are estimated to need more than Rs 500 bn (source: RBI) in the current financial year to meet capital adequacy requirements under Basel II norms. Banks having a capital adequacy ratio between 9% and 10% may encounter a problem in adhering to the norms unless they go for fresh capital, as the implementation of the revised norms is expected to reduce the capital adequacy by 1% to 1.5% (for most banks), primarily on account of additional capital requirement to provide for operational risks. The extension of deadline by the RBI has given public sector banks the much-needed time to get their house in order before implementation of the Basel II norms. They are now much more confident of keeping their date, with plans to raise funds and use technology for management of data - crucial under the new regime.

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