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Banks: Beleaguered Basel II
Nov 28, 2006

Vetted as one of the major reformative milestones in the Indian financial sector, Basel II norms are set to encapsulate the risk management mechanism in the banking sector in 2007. While the RBI had gone a step ahead and mandated a minimum capital adequacy ratio (CAR) of 9% for Indian Banks against the Basel I requirement of 8%, the evolution to Basel II may not be as smooth. Basel I vs. Basel II
The Basel norms provide banks with guidelines to measure the various types of risks they face -credit, market and operational risks, and the capital required to cover these risks.

Credit risk: A bank faces the risk of its borrowers reneging on their liability for timely repayments of loan, interest on loan or meet the other terms of contract. This risk is called credit risk, which varies from borrower to borrower depending on their credit quality.

Market risk: As part of the statutory requirement, Indian banks are required to invest 25% of their net demand and term liabilities in cash, gold, GSecs and other eligible securities to comply with SLR (statutory liquidity ratio) requirements. Such investments are risky because of the change in their market-driven prices. This volatility in the value of a bank's investment portfolio in known as market risk, as it is driven by the market. The change in the value of the portfolio can be due to changes in the interest rates, foreign exchange rates or changes in equity / commodity prices.

Operational risk: The events that are neither due to default by third party nor because of the vagaries of the market are called operational risks and can be attributed to internal systems, processes, people and external factors. While the risk weightage on the capital adequacy ratio for Indian banks (accorded by the RBI) reasonably cover the credit risk, market and operational risks are the ones on which the domestic banks have been lax so far, thus necessitating substantial effort on covering these with the onset of Basel II. Also, Basel II will help in better pricing of the loans in alignment with their actual risks. This will benefit customers (with high credit-worthiness) in terms of bargaining their loan pricing and banks in terms of better credit allocation.

Are Indian Banks prepared for it?

Capital requirement: Basel II norms require vast amount of historical data and advanced techniques and software for calculation of risk measures. This will translate into huge demand for IT and outsourcing services. According to estimates, the cost of implementation of the new norms may range from US$ 10 m to US$ 150 m depending on the size of the bank. Small and medium sized banks will find it difficult to finance high implementation costs of the norms. Infact, most PSU banks have yet to get their entire business under the centralised banking solution (CBS) due to lack of funds.

Benefit skewed towards larger corporates: With better risk measurement practices in place banks’ capital allocation will be skewed towards the rated corporates, which comprise an insignificant proportion of India Inc. Also, the smaller enterprises, being at a disadvantage in size and scale, would attract a risk weight of 100%. During economic downturns, corporate profits and ratings tend to decline and this can lead to banks pulling the plugs on lending to corporates with deteriorating credit ratings, at a time when these companies will be in desperate need of credit.

This calls for…
Independent rating bodies: To facilitate the rating of medium and small corporates, independent rating agencies like CRISIL and ICRA need to develop rating mechanisms suitable to the segment profile that banks can resort to in addition to the internal risk assessment systems so as to accelerate the credit disbursal to the under-privileged corporates. This will also aid banks in providing for adequate risk coverage and diversify their customer base.

Consolidation: There are innumerable small private sector and a couple of PSU banks that are yet to recover from their NPA legacy and need to desperately catch up with their peers in terms of capital adequacy. While on a standalone basis, it would require considerable time span for such banks to edge near Basel II compliance, consolidation of the smaller entities would certainly speed up the process.

While the sanctity of regulator’s intent of bracing up the banking sector with the international best standards is undisputed, what remains to be seen is whether it is able to tide over the execution risks.

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