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Effects of Basel II Implementation on Indian Banking System Bank of Baroda

1. INTRODUCTION

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COMPANY INTRODUCTION

The founder, Maharaja Sayajirao Gaekwad had an uncanny foresight into the future
of trade and enterprising in his country. On 20th July 1908, under the Companies Act of 1897,
and with a paid up capital of Rs 10 Lakh started the legend that has now translated into a
strong, trustworthy financial body, THE BANK OF BARODA.

Bank of Baroda is a leading 100 years old Public Sector Bank in India with modern and
contemporary personality, offering banking products and services to industrial and
commercial, retail and agricultural customers across the country. Between 1913 and 1917, as
many as 87 banks failed in India. Bank of Baroda survived the crisis, mainly due to its honest
and prudent leadership. This financial integrity, business prudence, caution and an abiding care
and concern for the hard earned savings of hard working people, were to become the central
philosophy around which business decisions would be effected.

The bank has a strong domestic presence through 2,884 branches across the country.
The Overseas business operations extend across 25 countries through 72 branches/offices. The
bank provides Financial Services to over 36.5 million customers globally.

The bank has an uninterrupted record in profit-making and dividend payment over the
years and has pioneered in many Customer-centric initiatives. It is the first PSB to receive
Corporate Governance Rating (CAGR – 2).

Bank of Baroda’s share is listed on BSE and NSE and in ‘Future and Options’ segment
also. BOB is a part of BSE 100, BSE 200 and BSE 500 Indexes. The Net worth of Bank of
Baroda was Rs. 11,387.19 crore as on 31st March, 2009 and the no. of shares was 364.27
million.

Global Business was up by 30% (Y-o-Y) to Rs. 3,36,383 crore out of which domestic
business rose by 26.0% (Y-o-Y) to Rs. 2,60,692 crore as on 31st March, 2009. Global Deposits
was up by 26.6% (Y-o-Y) to Rs. 1,92,397 crore out of which domestic deposits rose by 23.6%
(Y-o-Y) to Rs. 1,51,409 crore as on 31st March, 2009. Global Advances was up by 34.9% (Y-
o-Y) to Rs. 1,43,986 out of which domestic advances rose by 29.3% to Rs. 1,09,283 crore as
on 31st March, 2009.

The Capital Adequacy Ratio as per BASEL II was 14.05% for the year ended 31 st
March, 2009.

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BRANCH AND DEPARTMENT INTRODUCTION

Sir. P. M. Road Branch of Bank of Baroda is situated in Laxmi Insurance Building, Sir.
P.M. Road in the Fort area. The Branch is named on the road where it is situated. It also has
another premises at Sheel chambers.

Sir. P. M. Road branch was started its operations on 10th August, 1958. The branch has
a huge customer base. The bank has a huge customer base including the corporate as well as
the retail customers. The branch is headed and is under total control of Mr. D. P. Srivastava,
Asst. General Manager.

Many departments work in tandem for the smooth functioning of this branch. A special
foreign exchange department has been set up in this branch so as to facilitate the customers
with easy transactions of foreign currencies.

The branch is one of the major contributors in terms of business in Mumbai Metro
South region of Bank of Baroda. The total business for the year ended march, 2009 is Rs.
2497.29 crore.

The Loans and Advances Department is headed by Chief Manager and is ably
supported by a Senior Manager and a Manager. The department contributed Rs. 1399.48 crore
in the annual business of the branch for the year ended 31st March, 2009. The major work
handled by the loans and advances department is of accepting loan applications and
forwarding it to the SME loan factory and keeping a track of these activities as well as
reviewing the advances that have been already distributed. Other than SME loans are
processed at branch level and forwarded to the respective authorities. Overall monitoring of all
advances accounts are done and facilities of different advances are reviewed at regular
intervals for their credibility.

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2. LITERATURE REVIEW

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RISK

There are many definitions of risk depending on the specific application and situational
contexts. In general, every risk (indicator) is proportional to the expected losses, which can be
caused by a risky event, and to the probability of this event. Risk can be defined as the
variability in the expected earnings of a company. Therefore, differentiation of risk definitions
depends on the losses context, their assessment and measurement, as well as when the losses
are clear and variable, for example in the case of a human life, the Risk Assessment is focused
on the probability of the event, event frequency and its circumstances.

Engineering Definition of Risk:

Financial Definition of Risk:

It is “the chance that an investment’s actual return will be different than expected. This
includes the possibility of losing some or all of the original investment. It is usually measured
by calculating the standard deviations of the historical returns or average returns of a specific
investment”.

Risk in finance is defined as a general method to assess risk as an expected after-the-


fact level of regret. Such methods have been successful in limiting interest rate risk in financial
markets. Financial markets are proving ground for general methods of risk assessment. A
fundamental idea in finance is the relationship between risk and return. The greater the amount
of risk that an investor is willing to take, the greater the potential return he will get. The reason
for this is that investors need to be compensated for taking an additional risk.

TYPES OF RISKS

Credit Risk:

The risk of loss of principal or loss of a financial reward stemming from a borrower's
failure to repay a loan or otherwise meets a contractual obligation. Credit risk arises whenever
a borrower is expecting to use future cash flows to pay a current debt. Investors are
compensated for assuming credit risk by way of interest payments from the borrower or issuer
of a debt obligation. Credit risk is closely tied to the potential return of an investment, the most
notable being that the yields on bonds correlate strongly to their perceived credit risk.

The higher the perceived credit risk, the higher the rate of interest that investors will
demand for lending their capital. Credit risks are calculated based on the borrowers' overall
ability to repay. This calculation includes the borrowers' collateral assets, revenue-generating
ability and taxing authority (such as for government and municipal bonds).

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Operational Risk:

A form of risk that summarizes the risks a company or firm undertakes when it
attempts to operate within a given field or industry. Operational risk is the risk that is not
inherent in financial, systematic or market-wide risk. It is the risk remaining after determining
financing and systematic risk, and includes risks resulting from breakdowns in internal
procedures, people and systems.

Operational risk can be summarized as human risk; it is the risk of business operations
failing due to human error. Operational risk will change from industry to industry, and is an
important consideration to make when looking at potential investment decisions. Industries
with lower human interaction are likely to have lower operational risk.

Interest Rate Risk:

The risk that an investment's value will change due to a change in the absolute level of
interest rates, in the spread between two rates, in the shape of the yield curve or in any other
interest rate relationship. Such changes usually affect securities inversely and can be reduced
by diversifying (investing in fixed-income securities with different durations) or hedging (e.g.
through an interest rate swap).

Interest rate risk affects the value of bonds more directly than stocks, and it is a major
risk to all bondholders. As interest rates rise, bond prices fall and vice versa. The rationale is
that as interest rates increase, the opportunity cost of holding a bond decreases since investors
are able to realize greater yields by switching to other investments that reflect the higher
interest rate. For example, a 5% bond is worth more if interest rates decrease since the
bondholder receives a fixed rate of return relative to the market, which is offering a lower rate
of return as a result of the decrease in rates.

Market Risk:

A bank’s investment portfolio is impacted by the fluctuation in prices of securities.


Even in respect of sovereign exposure there will be change in market price because of interest
rate movements. When the prices of securities are marked to market, a bank may incur loss if
the prices have declined. Change in interest rates, foreign exchange rates and prices of equity,
corporate debt instruments and commodities may involve market risk for the bank.
Mismatches in interest rates on assets and liabilities may also entail risk for the bank. The
investment portfolio has to be divided into the trading book and the banking book. While the

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trading book has to be valued on a daily basis on mark to market basis, for the
banking book, there should be frequent assessment of shock absorption
capacity of the portfolio to interest rate movements.

Liquidity Risk:

Liquidity risk is considered to be major risk in the bank. It is the risk of loss arising due
to adverse changes in the cash flow on transactions. It can be defined in different ways, such
as, extreme liquidity, the safety caution provided by the portfolio of liquid asset, or the ability
to raise fund at normal cost.

Liquidity risk is the normal outcome of standard transaction. These transactions tend to
generate a maturity gap between assets and liabilities. Often, bank collect short term resources
and lend long term. Given this gap between maturity, there exists always a liquidity risk and a
cost of liquidity.

Foreign Exchange Risk:

The risk of an investment's value changing due to changes in currency exchange rates
or the risk that an investor will have to close out a long or short position in a foreign currency
at a loss due to an adverse movement in exchange rates. It is also known as "currency risk" or
"exchange-rate risk".

This risk usually affects businesses that export and/or import, but it can also affect
investors making international investments. For example, if money must be converted to
another currency to make a certain investment, then any changes in the currency exchange
rate will cause that investment's value to either decrease or increase when the investment is
sold and converted back into the original currency.

Settlement Risk:

Settlement risk is the risk that a counterparty does not deliver a security or its value in
cash as per agreement when the security was traded after the other counterparty or

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counterparties have already delivered security or cash value as per the trade
agreement.

Reputation Risk:

Reputation risk is the current and prospective impact on earnings and capital arising
from negative public opinion. This affects the institution’s ability to establish new
relationships or services or continue servicing existing relationships. This risk may expose the
institution to litigation, financial loss, or a decline in its customer base. Reputation risk
exposure is present throughout the organization and includes the responsibility to exercise an
abundance of caution in dealing with its customers and the community.

Systemic Risk:

Systemic risk is the risk of collapse of an entire financial system or entire market, as
opposed to risk associated with any one individual entity, group or component of a system. It
can be defined as "financial system instability, potentially catastrophic, caused or exacerbated
by idiosyncratic events or conditions in financial intermediaries". It refers to the risks imposed
by inter linkages and interdependencies in a system or market, where the failure of a single
entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or
bring down the entire system or market. It is also sometimes erroneously referred to as
"systematic risk".

RISK MANAGEMENT

Risk management is the process of identifying risk, assigning appropriate values,


identifying threats to those assets, measuring or assessing risk and then developing strategies
to manage the risk. In risk management the following steps are taken to minimize the risk.

Step 1: Identification of assets at Risk

The first step in the Risk management process is to identify the assets in support of
critical business operations. The assets could fall under different groups, which are physically
tangible and conceptual assets.

Step 2: Valuation of Assets

The assets so identified and grouped in the previous step are to be valued and
categorised into different classes, such as critical and essential.

Step 3: Identifying the threats

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Threats can be defined as anything that contributes to the interruption


or destruction of any service/product. Various threats can be grouped into
environmental, internal and external threats.

Step 4: Risk Assessment

The process of Risk Assessment includes not only assessment as to the provability of
occurrence but also the assessment as to the potential severity of loss, if risk materialises. This
will assist in determining the appropriate risk mitigation strategy, the residual risk and
investment required to mitigate the risk.

Step 5: Developing Strategies for Risk Management

Once risks have been identified and assessed, the strategies to manage the risk fall into
one or more of these four categories:

1. Risk Avoidance: Not doing an activity that involves risk and losing out on the potential
gain that accepting risk might have provided.

2. Risk Mitigation: Implementing controls to protect infrastructure and to reduce the


severity of the loss.

3. Risk Reduction/Acceptance: Formally acknowledge that the risk exists and monitoring
it. In some cases it may not be possible to take immediate action to avoid/mitigate the
risk. All risks that are not avoided or transferred are retained by default.

4. Risk Transfer: Causing another party to accept the risk i.e. sharing risk with partners or
insurance coverage.

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3. OBJECTIVE OF THE
PROJECT

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OBJECTIVE OF THE PROJECT

The objective of the project is to study BASEL II, a norm of Banking Supervision, and
its effects on the Indian Banking System.

Basel II is a type of recommendations on banking laws and regulations issued by the


Basel Committee on Banking Supervision that was initially published in June 2004. The
objective of Basel II is to create an international standard that banking regulators can use when
creating regulations about how much capital banks need to put aside to guard against the types
of financial and operational risks banks face.

The Reserve Bank of India (RBI) has ensured the implementation of BASEL II Accord
which has been accepted by over 100 nations, including India. BASEL II Accord has mainly
emphasized on the maintenance of Capital Adequacy Ratio (CAR) for managing Credit,
Market and Operational risks which has become mandatory now.

BASEL II Accord is primarily based on three pillars:

Pillar 1: Minimum Capital Requirements

Pillar 2: Supervisory Review Process

Pillar 3: Market Discipline and Disclosure

Indian Banks complied with BASEL I norms until BASEL II norms were introduced.
Basel II insists on setting up rigorous risk and capital management requirements designed to
ensure that a bank holds capital reserves appropriate to the risk. The underlying assumption
behind these rules is that the greater risk to which the bank is exposed, the greater the amount
of capital the bank needs to hold to safeguard its solvency and overall economic stability. It
will also oblige banks to enhance disclosures.

The Implementation of BASEL II in Indian Banks has prompted the banks to take
necessary measures so as to comply with these stringent norms. BASEL II has had many
positive as well as negative effects on the Indian Banking System. This project tries to
encapsulate these effects in brief.

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4. BANKS

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INTRODUCTION:

A bank is a financial institution licensed by a government. The name


bank derives from the Italian word banco meaning "desk/bench", used during
the Renaissance by Florentine bankers, who used to make their transactions above a desk
covered by a green tablecloth.

A bank is a financial institution where an individual can deposit money. Banks provide
a system for easily transferring money from one person or business to another. Using banks
and the many services they offer saves an incredible amount of time, and ensures that the
funds of micro as well as macroeconomic agents "pass hands" in a legal and structured
manner.

The definition of a bank varies from country to country. Banking Regulation Act of
India, 1949 defines Banking as "accepting, for the purpose of lending or investment of
deposits of money from the public, repayable on demand or otherwise and withdraw able by
cheques, draft, and order or otherwise".

Bank regulations are a form of government regulation which subject banks to certain
requirements, restrictions and guidelines.

Functions of a Bank

Functioning of a Bank is among the more complicated of corporate operations. Since


Banking involves dealing directly with money, governments in most countries regulate this
sector rather stringently. In India, the regulation traditionally has been very strict and in the
opinion of certain quarters, responsible for the present condition of banks, where NPAs are of
a very high order. The process of financial reforms, which started in 1991, has cleared the
cobwebs somewhat but a lot remains to be done. The multiplicity of policy and regulations that
a Bank has to work with makes its operations even more complicated, sometimes bordering on
illogical. This section attempts to give an overview of the functions in as simple manner as
possible. Viewed solely from the point of view of the customers,

Banks essentially perform the following functions:

1. Accepting Deposits from public/others (Deposits)

2. Lending money to public (Loans)

3. Transferring money from one place to another (Remittances)

4. Credit Creation

5. Acting as trustees

6. Keeping valuables in safe custody

7. Investment Decisions and analysis

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8. Government business

9. Other types of lending and transactions

In addition to providing a safe custodian of money, banks also loan money to


businesses and consumers. A large portion of a bank's business is lending. How do banks get
the money they loan? The money comes from depositors who intend to save a portion of their
wealth. Banks acting as intermediaries use these deposits as loans to prospective borrowers.
The objective of commercial banks like any other organization is profit maximisation. This
profit generally originates from the interest differential between borrowers and lenders. In the
present day, however, the banking operation has extended much beyond simple lending
exercise. So there are other different channels of profit ensuing from other investment
programmes as well. However, it should be mentioned in this context that the entire deposit
held by a bank cannot be given as loans as the Central Bank retains a portion of this money in
the form of cash-reserve for unforeseen circumstances.

Other Services Offered by Banks Include:

• Credit Cards

• Debit Cards

• Personal Loans

• Home and Car Loans

• Business Loans

• Mutual Funds

• Safe Deposit Boxes

• Trust Services

• Signature Guarantees

• Issuance of guarantees on behalf of customers

• Establishment of Letter of credit on behalf of Customer

… and many other investment services.

Types of Banks

Different types of banks specialize in different lines of business. Banks come with a
variety of names, and one bank can function as several different types of banks. Some of the
most common types of banks are:

Central Bank:

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A central bank, reserve bank, or monetary authority is the entity responsible


for the monetary policy of a country or of a group of member states. Its
primary responsibility is to maintain the stability of the national currency and
money supply, but more active duties include controlling subsidized-loan
interest rates, and acting as a lender of last resort to the banking sector during times of
financial crisis (private banks often being integral to the national financial system). It may also
have supervisory powers, to ensure that banks and other financial institutions do not behave
recklessly or fraudulently.

Commercial Bank:

A Commercial Bank performs all kinds of banking functions such as accepting deposits,
advancing loans, credit creation & agency functions. They generally advance short term loans
to their customers; in some cases they may give medium term loans also.

Commercial banks handle banking needs for large and small businesses, including:

• Basic accounts such as savings and checking


• Lending money for real and capital purchases
• Lines of credit
• Letters of credit
• Lockbox services
• Payment and transaction processing
• Foreign exchange

Commercial banks often function as retail banks as well, serving individuals along with
businesses.

Retail Bank:

A retail bank is a bank that works with consumers, otherwise known as 'retail customers'.

Retail banks provide basic banking services to the general public, including:

• Checking and savings accounts


• CDs
• Safe deposit boxes
• Mortgages and second mortgages
• Auto loans
• Unsecured and revolving loans such as credit cards

Retail banks are the banks you most often see in cities on crowded intersections, the ones you
probably use for your personal checking account. In addition to helping consumers, retail
banks often serve businesses as well - so they can also serve as commercial banks.

Investment Banks:

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Investment banks help organizations use investment markets.

For example, when a company wants to raise money by issuing stocks or


bonds, an investment bank helps them through the process. Investment banks
also consult on mergers and acquisitions, among other things.

Investment banks primarily work in the investment markets and do not take customer deposits.
However, some large investment banks also serve as commercial banks or retail banks.

Industrial Banks:

Ordinarily, the industrial banks perform three main functions: Firstly, Acceptance of Long
term deposits: Since the industrial bank give long term loans, they cannot accept short term
deposits from the public. Secondly, Meeting the credit requirements of companies: Firstly the
industries require to purchase land to erect buildings and purchase heavy machinery. Secondly
the industries require short term loans to buy raw materials & to make payment of wages to
workers. Thirdly it does some Other Functions - The industrial banks tender advice to big
industrial firms regarding the sale & purchase of shares & debentures

Agricultural Banks:

As the commercial & the industrial Banks are not in a position to meet the credit requirements
of agriculture, there arises the need for setting up special types of banks to finance agriculture.
Firstly, the farmers require short term loans to buy seeds, fertilizers, ploughs and other inputs.
Secondly, the farmers require long term loans to purchase land, to effect permanent
improvements on the land to buy equipment & to provide for irrigation works.

Foreign Exchange Banks:

Their main function is to make international payments through the purchase and sale of
exchange bills. As is well known, the exporters of a country prefer to receive the payment for
their exports in their own currency. Hence there arises the problem of converting the currency
of one country into the currency of another. The foreign exchange banks try to solve this
problem. These banks specialize in financing foreign trade.

Indigenous Banks:

According to the Indian Enquiry Committee, “Indigenous banker is a person or a firm which
accepts deposits, transacts business in hundies and advances loans etc.”

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5. BANKING SECTOR IN INDIA

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HISTORY OF INDIAN BANKING

The first bank in India, though conservative, was established in 1786.


From 1786 till today, the journey of Indian Banking System can be segregated
into three distinct phases. They are as mentioned below:

• Early phase from 1786 to 1969 of Indian Banks

• Nationalisation of Indian Banks and up to 1991 prior to Indian banking Sector reforms

• New phase of Indian Banking System with the advent of Indian Financial And banking
Sector reforms after 1991.

Phase I

The General Bank of India was set up in the year 1786. Next came Bank of Hindustan
and Bengal Bank. The East India Company established Bank of Bengal (1809), Bank of
Bombay (1840) and Bank of Madras (1843) as independent units and called it Presidency
Banks. These three banks were amalgamated in 1920 and Imperial Bank of India was
established which started as private shareholders banks, mostly Europeans shareholders.

In 1865 Allahabad Bank was established and first time exclusively by Indians, Punjab
National Bank Ltd. was set up in 1894 with headquarters at Lahore. Between 1906 and 1913,
Bank of India, Central Bank of India, Bank of Baroda, Canara Bank, Indian Bank, and Bank of
Mysore were set up. Reserve Bank of India came in 1935.

During the first phase the growth was very slow and banks also experienced periodic
failures between 1913 and 1948. There were approximately 1100 banks, mostly small. To
streamline the functioning and activities of commercial banks, the Government of India came
up with The Banking Companies Act, 1949 which was later changed to Banking Regulation
Act 1949 as per amending Act of 1965 (Act No. 23 of 1965). Reserve Bank of India was
vested with extensive powers for the supervision of banking in India as the Central Banking
Authority.

During those day’s public had less confidence in the banks. As an aftermath deposit
mobilisation was slow. Abreast of it the savings bank facility provided by the Postal
department was comparatively safer. Moreover, funds were largely given to traders.

Phase II

Government took major steps in this Indian Banking Sector Reform after
independence. In 1955, it nationalised Imperial Bank of India with extensive banking facilities
on a large scale especially in rural and semi-urban areas. It formed State Bank of India to act
as the principal agent of RBI and to handle banking transactions of the Union and State
Governments all over the country.

Seven banks forming subsidiary of State Bank of India was nationalised in 1960 on
19th July, 1969, major process of nationalisation was carried out. It was the effort of the then

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Prime Minister of India, Mrs. Indira Gandhi 14 major commercial banks in the
country were nationalised.

Second phase of nationalisation Indian Banking Sector Reform was


carried out in 1980 with seven more banks. This step brought 80% of the banking segment in
India under Government ownership.

The following are the steps taken by the Government of India to Regulate Banking
Institutions in the Country:
• 1949 : Enactment of Banking Regulation Act.
• 1955 : Nationalisation of State Bank of India.
• 1959 : Nationalisation of SBI subsidiaries.
• 1961 : Insurance cover extended to deposits.
• 1969 : Nationalisation of 14 major banks.
• 1971 : Creation of credit guarantee corporation.
• 1975 : Creation of regional rural banks.
• 1980 : Nationalisation of seven banks with deposits over 200 core.

After the nationalisation of banks, the branches of the public sector bank India rose to
approximately 800% in deposits and advances took a huge jump by 11,000%. Banking in the
sunshine of Government ownership gave the public implicit faith and immense confidence
about the sustainability of these institutions.

Phase III

This phase has introduced many more products and facilities in the banking sector in its
reforms measure. In 1991, under the chairmanship of M Narasimham, a committee was set up
by his name which worked for the liberalisation of banking practices.

The country is flooded with foreign banks and their ATM stations. Efforts are being put to
give a satisfactory service to customers. Phone banking and net banking is introduced. The
entire system became more convenient and swift. Time is given more importance than money.

The financial system of India has shown a great deal of resilience. It is sheltered from any
crisis triggered by any external macroeconomics shock. This is all due to a flexible exchange
rate regime, the foreign reserves are high, the capital account is not yet fully convertible, and
banks and their customers have limited foreign exchange exposure.

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Banking Sector in India

Central Bank:

The Reserve Bank of India is the Central Bank that is fully owned by the
Government. It is governed by a central board (headed by a Governor) appointed by the
Central Government. It issues guidelines for the functioning of all banks operating within the
country.

The main objectives for the establishment of the Central Bank were as follows:

• To manage the monetary and credit system of the country.

• To stabilizes internal and external value of rupee.

• For balanced and systematic development of banking in the country.

• For the development of organized in the money market in the country.

• For proper arrangement of Agriculture Finance.

• For proper arrangement of Industrial Finance.

• To establish monetary relations with other countries of the world & international
financial institutions.

• For proper management of public debts.

• For centralization of cash reserves of commercial banks.

• To maintain balance between the demand and supply of currency.

Public Sector Banks:

a. State Bank of India and its associate banks called the State Bank Group

b. 20 nationalized banks

c. Regional rural banks mainly sponsored by public sector banks

Some of the Public Sector Banks in India are:

• Allahabad Bank
• Andhra Bank
• Bank of Baroda
• Bank of India
• Bank of Maharashtra
• Canara Bank
• Central Bank of India
• Corporation Bank

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• Dena Bank
• Indian Bank
• Oriental Bank of Commerce
• Punjab National Bank
• Syndicate Bank
• UCO Bank
• Union Bank of India
• United Bank of India
• Vijaya Bank

List of State Bank of India and its subsidiary Public Sector Banks:

• State Bank of Bikaner & Jaipur


• State Bank of Hyderabad
• State Bank of Indore
• State Bank of Mysore
• State Bank of Saurastra
• State Bank of Travancore

Private Sector Banks:

a. Old generation private banks

b. New generation private banks

c. Foreign banks operating in India

d. Scheduled co-operative banks

e. Non-scheduled banks

Co-operative Sector:

The co-operative sector is very much useful for rural people. The co-operative banking sector
is divided into the following categories.

a. State co-operative Banks

b. Central co-operative banks

c. Primary Agriculture Credit Societies

Development Banks/Financial Institutions:

The Industrial Finance Corporation of India (IFCI),

Industrial Development Bank of India (IDBI),

Industrial Credit and Investment Corporation of India (ICICI) Bank,

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Industrial Investment Bank of India (IIBI),

Shipping Credit and Investment Corporation of India (SCICI) Ltd,

National Bank for Agricultural and Rural Development (NABARD),

Export-Import Bank of India,

National Housing Bank,

Small Industries Bank of India (SIDBI)

6. ROLE OF BANKS
IN ECONOMY

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Role of Banks in Economy

Banks create money in the economy by making loans. The amount of money that banks
can lend is directly affected by the reserve requirement set by the Central Bank (RBI). The
reserve requirement is currently 3 percent to 10 percent of a bank's total deposits. This amount
can be held either in cash on hand or in the bank's reserve account with the Fed. To see how
this affects the economy, think about it like this. When a bank gets a deposit of $100, assuming
a reserve requirement of 10 percent, the bank can then lend out $90. That $90 goes back into
the economy, purchasing goods or services, and usually ends up deposited in another bank.
That bank can then lend out $81 of that $90 deposit, and that $81 goes into the economy to
purchase goods or services and ultimately is deposited into another bank that proceeds to lend
out a percentage of it.

In this way, money grows and flows throughout the community in a much greater
amount than physically exists. That $100 makes a much larger ripple in the economy than you
may realize!

A proper financial sector is of special importance for the economic growth of


developing and underdeveloped countries. The commercial banking sector which forms one of
the backbones of the financial sector should be well organized and efficient for the growth
dynamics of a growing economy. No underdeveloped country can progress without first
setting up a sound system of commercial banking.

The importance of a sound system of commercial banking for a developing country


may be depicted as follows:

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Effects of Basel II Implementation on Indian Banking System Bank of Baroda

Capital Formation:

The rate of saving is generally low in an underdeveloped economy due


to the existence of deep-rooted poverty among the people. Even the potential
savings of the country cannot be realized due to lack of adequate banking facilities in the
country. To mobilize dormant savings and to make them available to the entrepreneurs for
productive purposes, the development of a sound system of commercial banking is essential
for a developing economy.

Monetization:

An underdeveloped economy is characterized by the existence of a large non


monetized sector, particularly, in the backward and inaccessible areas of the country. The
existence of this non monetized sector is a hindrance in the economic development of the
country. The banks, by opening branches in rural and backward areas, can promote the process
of monetization in the economy.

Innovations:

Innovations are an essential prerequisite for economic progress. These innovations are
mostly financed by bank credit in the developed countries. But the entrepreneurs in
underdeveloped countries cannot bring about these innovations for lack of bank credit in an
adequate measure. The banks should, therefore, pay special attention to the financing of
business innovations by providing adequate and cheap credit to entrepreneurs.

Finance for Priority Sectors:

The commercial banks in underdeveloped countries generally hesitate in extending


financial accommodation to such sectors as agriculture and small scale industries, on account
of the risks involved there in. They mostly extend credit to trade and commerce where the risk
involved is far less. But for the development of these countries it is essential that the banks
take risk in extending credit facilities to the priority sectors, such as agriculture and small scale
industries.

Provision for Medium and Long term Finance:

The commercial banks in underdeveloped countries invariably give loans and advances
for a short period of time. They generally hesitate to extend medium and long term loans to
businessmen. As is well known, the new businesses need medium and long term loans for their
proper establishment. The commercial banks should, therefore, change their policies in favour
of granting medium and long term accommodation to business and industry.

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Cheap Money Policy:

The commercial banks in an underdeveloped economy should follow


cheap money policy to stimulate economic activity or to meet the threat of
business recession. In fact , cheap money policy is the only policy which can help promote the
economic growth of an underdeveloped country . It is heartening to note that recently the
commercial banks have reduced their lending interest rates considerably.

Need for a Sound Banking System:

A sound system of commercial banking is an essential prerequisite for the economic


development of a backward country.

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7. BASEL

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BASEL COMMITTEE

The Basel Committee on Banking Supervision (BCBS) was formed


in response to the messy liquidation of a Cologne-based bank in 1974. On 26
June 1974, a number of banks had released Deutsche Mark (German Mark) to the Bank
Herstatt in exchange for dollar payments deliverable in New York. On account of differences
in the time zones, there was a lag in the dollar payment to the counter-party banks, and during
this gap, and before the dollar payments could be effected in New York, the Bank Herstatt was
liquidated by German regulators.

This incident prompted the G-10 nations to form towards the end of 1974, the Basel
Committee on Banking Supervision, under the auspices of the Bank of International
Settlements (BIS) located in Basel, Switzerland.

The Committee was established to facilitate information sharing and cooperation


among bank regulators in major countries. The Basel Committee was constituted by the
Central Bank Governors of the G-10 countries. The G-10 Committee consists of members
from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, The Netherlands, Spain,
Sweden, Switzerland, The UK and The US. These countries are represented by their Central
Bank and also by the authority with onus for the prudent supervision of banking business
where this is not the central bank.

The Committee's Secretariat is located at the Bank for International Settlements in


Basel, Switzerland. This committee meets four times in a year. The present Chairman of this
committee is Mr. Nout Wellink (President of The Netherlands Bank). The Secretary General
of the Basel Committee is Mr. Stefan Walter.

This committee on banking supervision provides a forum for regular cooperation on


banking supervisory matters. Its objective is to enhance understanding of key supervisory
issues and quality improvement of banking supervision worldwide. This committee is best
known for its international standards on capital adequacy; the core principles of banking
supervision and the concordat on cross-border banking supervision.

The committee's efforts over the last three decades have made Basel synonymous with
the best practices and standards in banking regulation and supervision. Perhaps the most far-
reaching of these initiatives was the laying down of minimum capital standards in 1988,
known as the Basel Capital Accord, to ensure a level playing field in terms of capital required
to be maintained by internationally active banks. The fact that Basel Committee’s capital
standards were implemented by more than 100 countries points to their near universal
acceptance. The Basel Committee does not possess any formal supranational supervisory
authority and its conclusions do not have any legal or binding force. It merely formulates
broad-based supervisory principles or strategies. However, it recommends statements of best
practice, keeping in mind that individual authorities will undertake steps to implement them
through detailed arrangements in a way that suits them best.

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BASEL I

In 1988, the BASEL Committee on Banking Supervision introduced


global standards for regulating the capital adequacy of banks.

Basel I, that is, the 1988 Basel Accord, primarily focused on credit risk. Assets of
banks were classified and grouped in five categories according to credit risk, carrying risk
weights of zero (for example home country sovereign debt), ten, twenty, fifty, and up to one
hundred percent (this category has, as an example, most corporate debt). Banks with
international presence are required to hold capital equal to 8 % of the risk-weighted assets.

Since 1988, this framework has been progressively introduced in member countries of
G-10, currently comprising 13 countries, namely, Belgium, Canada, France, Germany, Italy,
Japan, Luxemburg, Netherlands, Spain, Sweden, Switzerland, United Kingdom and the United
States of America.

Most other countries, currently numbering over 100, have also adopted, at least in
name, the principles prescribed under Basel I. The efficiency with which they are enforced
varies, even within nations of the Group of Ten.

The original accord, was quite simple and adopted a straight-forward ‘one size fits all
approach’ that does not distinguish between the differing risk profiles and risk management
standards across banks.

TRANSITION FROM BASEL I TO BASEL II

Basel I concentrated on credit risk alone being the biggest risk a bank assumes and
arising out of its lending/investment operations. It prescribed risk weights for different loan
assets essentially on the basis of security available after classifying the assets as standard or
non-standard on the basis of payment record. Basel I did not draw a distinction for the purpose
of capital allocation between loan assets based on the intrinsic risk in lending to individual
counterparties. Security in the form of tangible assets and/or guarantees from
governments/banks is the sole distinguishing factor. Credit extended on secured basis to a
small-scale unit and to a large corporate was put in the same category in so far as minimum
capital requirement was concerned. The higher probability of default in respect of a loan to,
say, a proprietorship compared to the large professionally managed corporate did not get
reflected in the capital requirement.

Basel II addresses this issue by factoring in the differential risk factor in loans made to
different types of businesses, entities, markets, geographies, and so on, and allowing banks to
have different levels of minimum capital taking into account intrinsic riskiness of the
exposure. Three methods, increasing in sophistication, for assessing credit risks have been
recommended for adoption. Assets are to be risk weighted based on a rational approach
cleared in advance by the regulator and then aggregated to arrive at the minimum capital
requirement. Higher the risk, higher the weightage, and more the capital allocation required. In

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the proposed scheme of things, weak credits can carry a weightage of up to


150 per cent.

The objective of the recommendation of Basel II on credit risk is that


banks should be more risk-sensitive than hitherto in their lending/investment activity and
derive the benefit from lesser capital engagement for high quality credit risks. In addition to
credit risk, Basel II recognizes the operational risks arising out of the day-to-day running of
banks in the form of service quality shortcomings, non-adherence to policy and procedures,
staff malfeasances, and so on, the capital charge for which is linked to operational income
through a multiplier to be given by the regulator based on its assessment of the quality of
banks operational instructions, style of functioning, control of top management and audit
quality.

BASEL II TO INDIA

The Basel I recommendations on minimum capital requirement were accepted by most


countries for adoption by the banks operating within their boundaries. In India, too, a
Minimum Required Capital (MRC) was accepted and a timetable prescribed for banks to
exceed the minimum capital requirement prescribed by the Basel Committee. Today, banks in
India take pride in indicating in their balance sheets the extent to which they exceed the
minimum Capital Adequacy Requirement (CAR). Banks in India also adopted the asset
classification and provisioning norms prescribed by the Basel Committee and as directed by
the Reserve Bank of India. The general belief now is that the commercial banks' balance sheets
are comparable with most of the banks in the developing world and many in the developed
world too.

Though not mandatory for non Basel II countries including India, majority of them are
also going to implement Basel II. Some great opportunities for India are coming out of Basel II
implementation. These opportunities can be classified in two categories - Banking and Non -
Banking. 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. Goldman
Sachs and many other research reports have predicted a robust growth of Indian economy in
the coming decades. A sound and evolved banking system would 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. The majority
of Indian banks are either nascent or at a very low level of competence in all, Credit, Market
and Operational risk measurement and management system. They are lagging behind in the
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. The current level of Risk Based Supervision
and Market disclosures are also not very satisfactory in the Indian Banking system. This is
more evident from the recent problems in one well-known private sector bank and in some co-

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operative banks. 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.

The explanation why countries such as India are eager to adopt the new framework
perhaps lies in the Basel II authors' contention that "by motivating banks to upgrade and
improve their risk management systems, business models, capital strategies and disclosure
standards, the Basel II framework should improve their overall efficiency and resilience."
Even Basel I was originally meant for internationally active banks in the G-10 countries but it
was soon accepted universally as a benchmark measure of a bank's solvency and was,
subsequently, adopted in some form by more than 100 countries.

Introduction of Basel I coincided with the initiation of financial reforms in India in the
early 1990s. The prudential norms set out by Basel I came as a timely solution to the ills
affecting the Indian banks, particularly the public sector banks (PSBs) after two decades of
nationalization. That these banks despite the differences in their strengths and weaknesses
could switch over to the international standards without much hiccups has surprised many a
critic.

There was so much talk of weak banks, merger of banks, and closure of overseas
branches and so on when the reforms began. But the same banks in question are now posting
impressive profits year after year, opening new overseas branches and are even looking for
banks to take over. Evidently, it is this successful switchover that has made the country eager
to adopt the Basel II framework as well.

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8. BASEL II

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BASEL II

Basel II is the second of the Basel Accords, which are


recommendations on banking laws and regulations issued by the Basel
Committee on Banking Supervision. The purpose of Basel II, which was initially published
in June 2004, is to create an international standard that banking regulators can use when
creating regulations about how much capital banks need to put aside to guard against the types
of financial and operational risks banks face. Advocates of Basel II believe that such an
international standard can help protect the international financial system from the types of
problems that might arise should a major bank or a series of banks collapse.

In practice, Basel II attempts to accomplish this by setting up rigorous risk and capital
management requirements designed to ensure that a bank holds capital reserves appropriate to
the risk the bank exposes itself to through its lending and investment practices. Generally
speaking, these rules mean that the greater risk to which the bank is exposed, the greater the
amount of capital the bank needs to hold to safeguard its solvency and overall economic
stability.

The efforts of the Basel Committee on Banking Supervision to revise the standards
governing the capital adequacy of internationally active banks achieved a critical milestone in
the publication of an agreed text in June 2004. In November 2005, the Committee issued an
updated version of the revised Framework incorporating the additional guidance set forth in
the Committee's paper The Application of Basel II to Trading Activities and the Treatment of
Double Default Effects (July 2005).

On 4 July 2006, the Committee issued a comprehensive version of the Basel II


Framework. Solely as a matter of convenience to readers, this comprehensive document is a
compilation of the June 2004 Basel II Framework, the elements of the 1988 Accord that were
not revised during the Basel II process, the 1996 Amendment to the Capital Accord to
Incorporate Market Risks, and the 2005 paper on the Application of Basel II to Trading
Activities and the Treatment of Double Default Effects. No new elements have been
introduced in this compilation.

On 16th January, 2009, the Basel Committee announced a series of proposals to


enhance the Basel II framework.

The final version aims at:

1. Ensuring that capital allocation is more risk sensitive;


2. Separating operational risk from credit risk, and quantifying both;
3. Guidelines for computing capital for incremental risk;
4. Attempting to align economic and regulatory capital more closely to reduce the scope
for regulatory arbitrage.

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SCOPE OF BASEL II IN BANKS

• To the greatest extent possible, all banking and other relevant financial
activities (Both regulated and unregulated) conducted within a group
containing an internationally active bank will be captured through consolidation. Thus,
majority-owned or –controlled banking entities, securities entities (where subject to
broadly similar regulation or where securities activities are deemed banking activities)
and other financial entities should generally be fully consolidated.
• Supervisors will assess the appropriateness of recognising in consolidated capital the
minority interests that arise from the consolidation of less than wholly owned banking,
securities or other financial entities. Supervisors will adjust the amount of such
minority interests that may be included in capital in the event the capital from such
minority interests is not readily available to other group entities.
• There may be instances where it is not feasible or desirable to consolidate certain
securities or other regulated financial entities. This would be only in cases where such
holdings are acquired through debt previously contracted and held on a temporary
basis, are subject to different regulation, or where non-consolidation for regulatory
capital purposes is otherwise required by law. In such cases, it is imperative for the
bank supervisor to obtain sufficient information from supervisors responsible for such
entities.
• If any majority-owned securities and other financial subsidiaries are not consolidated
for capital purposes, all equity and other regulatory capital investments in those entities
attributable to the group will be deducted, and the assets and liabilities, as well as third-
party capital investments in the subsidiary will be removed from the bank’s balance
sheet.
• Supervisors will ensure that the entity that is not consolidated and for which the capital
investment is deducted meets regulatory capital requirements. Supervisors will monitor
actions taken by the subsidiary to correct any capital shortfall and, if it is not corrected
in a timely manner, the shortfall will also be deducted from the parent bank’s capital.
• Significant minority investments in banking, securities and other financial entities,
where control does not exist, will be excluded from the banking group’s capital by
deduction of the equity and other regulatory investments. Alternatively, such
investments might be, under certain conditions, consolidated on a pro rata basis. For
example, pro rata consolidation may be appropriate for joint ventures or where the
supervisor is satisfied that the parent is legally or de facto expected to support the
entity on a proportionate basis only and the other significant shareholders have the
means and the willingness to proportionately support it. The threshold above which
minority investments will be deemed significant and be thus either deducted or
consolidated on a pro-rata basis is to be determined by national accounting and/or
regulatory practices.
• The Committee reaffirms the view set out in the 1988 Accord that reciprocal
crossholdings of bank capital artificially designed to inflate the capital position of
banks will be deducted for capital adequacy purposes.

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BASEL II - THE THREE PILLARS

While Basel I framework was confined to the prescription of only


minimum capital requirements for banks, the Basel II framework expands this
approach not only to capture certain additional risks in the minimum capital ratio but also
includes two additional areas, viz. Supervisory Review Process and Market Discipline through
increased disclosure requirements for banks. Thus, Basel II framework rests on the following
three mutually- reinforcing pillars:

Pillar 1: Minimum Capital Requirements — prescribes a risk-sensitive calculation of


capital requirements that, for the first time, explicitly includes operational risk along with
market and credit risk.

Pillar 2: Supervisory Review Process — envisages the establishment of suitable risk


management systems in banks and their review by the supervisory authority.

Pillar 3: Market Discipline and Disclosures — seeks to achieve increased


transparency through expanded disclosure requirements for banks.

PILLAR 1: MINIMUM CAPITAL REQUIREMENTS

Pillar 1 offers distinct options for computing capital requirements for "Credit Risk",
"Operational Risk" and "Market Risk".

Credit Risk:

Pillar 1 stipulates the following options for assigning capital to meet credit risk:
1. Standardised Approach
2. Internal Rating Based (IRB) Approach
3. Advanced IRB Approach.

1. Standardised Approach:

Banks may use external credit ratings by institutions recognized for the purpose by the
central bank for determining the risk weight. Exposure on sovereigns and their central banks
could vary from zero percent to 150 percent depending on credit assessment from ‘AAA’ to
below B- . Similarly, exposure on public sector entities, multilateral development banks, other
banks, securities firms and corporates also may have risk weights from 20 percent to 150
percent. Exposure on retail portfolio may carry risk weight of 75 percent.
While Basel II stipulates minimum capital requirement of 8 percent on risk weighted
assets, India has prescribed 9 percent. Under Basel II exposure on a corporate with ‘AAA’
rating will have a risk weight of only 20 percent. This implies that for Rs. 100 crore exposure
on a ‘AAA’ rated corporate the capital adequacy will be only Rs.1.8 crore (100 x 20% x 9%)
compared to the earlier requirement of Rs. 9 crore. However, claims on a corporate with below

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Effects of Basel II Implementation on Indian Banking System Bank of Baroda

BB- rating will carry a risk weight of 150 percent and the capital requirement
will be Rs.13.50 crore (100 x 150% x 9%). Thus, a bank with a credit portfolio
with superior rating may be able to save capital while banks having lower
rated credit exposure will have to mobilize more capital. Risk weights can go
beyond 150 percent in respect of exposures with low rating. For example, securitisation
tranches with rating between BB+ and BB- may carry risk weight of 350 percent. In order to
adopt standardized approach, banks will have to encourage their corporate customers to go in
for ‘obligor (borrower) rating’ and get themselves rated. The central bank has to accredit
External Credit Assessment Institutions (ECAI) who satisfies defined criteria of objectivity,
independence, international access, transparency, disclosure, resources and credibility.

2. Internal Ratings Based (IRB) Approach:

It is also called Foundation Internal ratings Based Approach. Banks, which have
developed reliable Management Information System (MIS) and have received the approval of
the central bank, can use the IRB approach to measure credit risk on their own. The bank
should have reliable data on Probability of Default (PD), Loss Given Default (LGD), Exposure
at Default (EAD) and effective Maturity (M) to make use of IRB approach. Minimum
requirements to adopt the IRB approach are:

1. Bank’s overall Credit Risk management practices must be consistent with the sound
practice guidelines issued by the Basel committee and the National Supervisor.
2. Rating dimensions to include both Borrower Rating and Facility Rating and has to
be applied to all asset classes.
3. The Rating Structure adopted need to have minimum 7 grades of performing
borrowers and a minimum 1 Grade of non-performing borrowers and Enough
grades to avoid undue concentrations of borrowers in particular grades.
4. Criteria of Rating Systems to be documented and have the ability to differentiate
risk, predictive and discriminatory power.
5. Assessment Horizon for PD estimation to be 1 year.
6. Use of models to be coupled with the use of human judgement and oversight.
7. Rating Assignment and Rating Confirmation to be independent.
8. The PD to be a long run average over an entire economic cycle (at least 5 years)
9. Banks should have confidence in the robustness of PD estimates and the underlying
statistical analysis.
10. Data collection and IT systems to improve the predictive power of rating systems
and PD estimates.
11. Validation of internal Rating systems/ Models by the Supervisor.
12. Streamlining use of credit risk mitigants and ensuring legal certainty of executed
documents.

3. Advanced Internal Rating Based (IRB) Approach:

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Under foundation approach banks provide more of their own estimates


of Probability of Default (PD) and rely on supervisory estimates for other risk
components. In the case of advanced approach banks provide more of their
own estimate of Loss Given Default (LGD), Exposure at Default (EAD) and
effective Maturity (M), subject to meeting minimum stipulated standards.

Market Risk:

A bank’s investment portfolio is impacted by the fluctuation in prices of securities.


Even in respect of sovereign exposure there will be change in market price because of interest
rate movements. When the prices of securities are marked to market, a bank may incur loss if
the prices have declined. Change in interest rates, foreign exchange rates and prices of equity,
corporate debt instruments and commodities may involve market risk for the bank.
Mismatches in interest rates on assets and liabilities may also entail risk for the bank. The
investment portfolio has to be divided into the trading book and the banking book. While the
trading book has to be valued on a daily basis on mark to market basis, for the banking book,
there should be frequent assessment of shock absorption capacity of the portfolio to interest
rate movements.
The approaches for Market risk are Standardised Approach and Internal Model Based
Approach.

Operational Risk:

A bank also encounters risks other than on account of default by a third party or
adverse market rate movements. These risks can be attributed to failed internal systems,
processes, people and external events. Mistakes committed because of weak internal systems
may lead to losses. Frauds may be committed on the bank by some customers, outsiders and
even by employees. If a proper KYC system is not in place, a bank may be exposed to loss of
money and reputation in a punitive action by the regulators. To minimize operational risks
Know your Employee (KYE) principles are also to be observed before employees are
entrusted with sensitive assignments.
The approaches for Operational Risk are Basic Indicator Approach, Standardised
Approach and Advanced Measurement Approach.

Pillar 1 envisages that banks assess credit risk, market risk and operational risk and
provide for adequate capital to cover the risks.
PILLAR 2: SUPERVISORY REVIEW PROCESS

Compliance of requirements under Pillar 1 and providing adequate capital alone may
not be enough to prevent bank failures and to protect the interests of depositors. Therefore,
under Pillar 2 which deals with key principles of supervisory review, risk management
guidance and supervisory transparency and accountability with respect to banking risks,
including guidance relating to the treatment of interest rate risk in the banking book, credit risk
(stress testing, definition of default, residual risk and credit concentration risk), operational

A.I.M.S. 36
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risk, enhanced cross border communication and co-operation and


securitisation, supervisors are expected to evaluate how well banks are
assessing their capital needs relative to their risks and to intervene where
appropriate. This interaction is intended to foster an active dialogue between
banks and supervisors so that when deficiencies are identified, prompt and decisive action can
be taken to reduce risk or restore capital. Supervisors may focus more intensely on banks with
risk profiles or operational experience, which warrants such attention.

There are the following four main areas to be treated under Pillar 2:

1. Risks considered under Pillar 1 that are not fully captured by Pillar 1 process (e.g
credit concentration risk);
2. Those factors not taken into account by Pillar 1 process (e.g. interest rate risk in the
banking book, business and strategic risk).
3. Factors external to the bank (e.g. business cycle effects).
4. Assessment of compliance with minimum standards and disclosure requirements of
the more advanced methods under Pillar 1.

Supervisors have to ensure that these requirements are being met both as qualifying
criteria and on a continuing basis.

The four key principles of supervisory review are:

Principle 1:

Banks should have a process for assessing their overall capital adequacy in relation to
their risk profile and a strategy for maintaining their capital levels.

The five main features of a rigorous process are as follows:

1. Board and senior management oversight;


2. Sound capital assessment;
3. Comprehensive assessment of risks;
4. Monitoring and reporting; and
5. Internal control review.

Principle 2:

Supervisors should review and evaluate banks’ internal capital adequacy assessments
and strategies, as well as their ability to monitor and ensure their compliance with regulatory
capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied
with the result of this process.

Principle 3:

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Effects of Basel II Implementation on Indian Banking System Bank of Baroda

Supervisors should expect banks to operate above the minimum


regulatory capital ratios and should have the ability to require banks to hold
capital in excess of the minimum.

Principle 4:

Supervisors should seek to intervene at an early stage to prevent capital 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.

Reserve Bank of India has implemented the risk-based supervision and has made a
good beginning in implementation of the guidelines under Pillar 2. Internal inspections of
banks in India are also tuned more towards risk-based audit.

PILLAR 3: MARKET DISCIPLINE AND DISCLOSURES

Disclosure requirements are stipulated for banks to encourage market discipline. This
will help the market participants to assess the information on capital, risk exposures, risk
assessment processes and capital adequacy of the bank. Such disclosures are more important in
the case of banks, which are permitted to rely on internal methodologies giving them more
discretion in assessing capital requirements. Market discipline supplements regulation as
sharing of information facilitates assessment of the bank by others including investors,
analysts, customers, other banks and rating agencies. It also leads to good corporate
governance.

Supervisors can stipulate the minimum disclosures to be made by banks. Banks can
also have Board approved policies on disclosure. A transparent organization may create more
confidence in the investors, customers and counter parties with whom the bank has dealings. It
would also be easier for such banks to attract more capital.

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IMPLEMENTATION OF BASEL II NORMS IN INDIA

Basel I Framework was introduced in India in 1988. RBI mandated that


all commercial banks in India (excluding Local Area Banks and Regional
Rural Banks) should adopt Standardised Approach (SA) for credit risk, Basic Indicator
Approach (BIA) for operational risk and Standardised Duration Approach (SDA) for
computing capital requirement for market risks under Basel II. Foreign Banks in India and
Indian Banks having foreign operational presence migrated to above selected approaches with
effect from March 31, 2008. All other commercial banks (except LABs and RRBs) have
migrated to these approaches under revised framework not from March 31, 2009. However,
the RBI has adopted a gradual approach to Basel II implementation, which stipulates a
"prudential floor" for minimum capital. Under this "parallel run" approach, banks are
expected to calculate CRAR based on both Basel I and Basel II, but will keep higher of the
two as per timeframe shown in Exhibit 3. For example, by 2009-10, banks will adopt CRAR
which is higher of two: that calculated through Basel II and 90% of that of Basel I.

Implementation Approach, Minimum Capital Subjected to Prudential Floor

Under parallel run, banks are expected to do the following: -

• Banks should apply prudential guidelines on capital adequacy - on an ongoing basis


and compute their Capital to Risk Weighted Assets Ratio (CRAR) under both the
guidelines.
• Analysis under both guidelines should be reported quarterly to the board.
• A copy of quarterly report should be submitted to RBI, one each to Department of
Banking Supervision and Department of Banking Operations.
• To make the process of implementation smoother RBI has taken adequate measures to
safeguard interests of Indian banks. To make more capital available to banks, RBI has
enabled banks to issue several instruments like innovative perpetual debt instruments,
perpetual non-cumulative preference shares and hybrid debt instruments.

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9. EFFECTS OF BASEL II
IMPLEMENTATION

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SWOT ANALYSIS OF THE BANKING SECTOR W.R.T. BASEL II

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THE EFFECTS

TYPES OF RISKS INVOLVED / COVERAGE OF RISKS

The principal solecism in the Basel I proposal was that it dealt with credit risk only.
Other types of risks faced by a bank like market risk and operational risks were not dealt with
at all. Hence there was an inadequate estimation of the overall risks faced by a bank under
Basel I. This could result in under-capitalization of the banking sector as a whole and could
give rise to systemic risk and bank crises in the long run. Basel II tries to address this systemic
risk and other forms of risks like credit risk, operational risk and market-risk.

Risks Handled By Basel-II Norms

SYSTEMIC RISK:

Systemic Risk is the risk of collapse of an entire financial system or entire market, as
opposed to risk associated with any one individual entity, group or component of a system. It
can be defined as "financial system instability, potentially catastrophic, caused or exacerbated
by idiosyncratic events or conditions in financial intermediaries". It refers to the risks imposed
by interlinkages and interdependencies in a system or market, where the failure of a single
entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or
bring down the entire system or market. It is also sometimes erroneously referred to as
"Systematic Risk".
The easiest way to understand systemic risk is to consider a bank run which has a
cascading effect on other banks which are owed money by the first bank in trouble, causing a
cascading failure. As depositors sense the ripple effects of default, and liquidity concerns
cascade through money markets, a panic can spread through a market, creating many sellers
but few buyers. These interlinkages and the potential "clustering" of bank runs are the issues
which policy makers consider when addressing the issue of protecting a system against
systemic risk. Governments and market monitoring institutions (such as the RBI) often try to
put policies and rules in place to safeguard the interests of the market as a whole, as all the
trading participants in financial markets are entangled in a web of dependencies arising from

A.I.M.S. 42
Effects of Basel II Implementation on Indian Banking System Bank of Baroda

their interlinkages and often policy makers are concerned to protect the
resiliency of the system, rather than any one individual in that system.
Sometimes "picking winners" and protecting favoured individual participants
in a system can engender moral hazard in a system and weaken the resilience
of the system as a whole.

CREDIT RISK:

Credit risk is the risk of loss due to a debtor's non-payment of a loan or other line of
credit (either the principal or interest or both).
In simple terms credit risk can be defined as the risk that customers default, or rather
fail to comply with their obligation to service debt. Credit risk can also be stated as the risk of
a decline in the credit standing of counterparty. Such a decline in the value of the debt does not
connote default, but implies that the probability of default increases. Credit risk is of enormous
importance since the default of a small number of important customers can generate huge
losses, which can lead to insolvency. It is important to note that the various market
transactions also generate credit risk. The loss in the event of default depends upon the value
of the instruments and their liquidity.

APPROACH TO CREDIT RISK

Basel I did not differentiate the quality of credit exposures. The risk weight accorded to
a triple-A rated corporate and a retail loan was similar although the risk associated with the
exposures varied substantially.
The BASEL II Accord offers three distinct approaches for arriving at the capital
requirements arising out of Credit Risk. Some of the key comparative features of these
approaches are mentioned below.

INTERNAL INTERNAL
STANDARDIZED RATING BASED RATING BASED
CRITERION
APPROACH (FOUNDATION) (ADVANCED)
APPROACH APPROACH
Rating External Internal Internal
Calibrated on the
Function provided by Function provided by
Risk Weight basis of ratings by
Basel Committee Basel Committee
Basel Committee
Implicitly provided
by the BASEL Provided by Bank Provided by Bank
Probability of committee through based on its own based on its own
Default the risk weights internal estimates internal estimates
which are based on
External ratings
Provided by Bank
Supervisory values Supervisory values based on its own
Exposure at Default
provided by Basel provided by Basel internal estimates

A.I.M.S. 43
Effects of Basel II Implementation on Indian Banking System Bank of Baroda

Implicitly provided Implicitly provided


Loss Given Default by Basel on external by Basel on external Provided by Bank
estimates estimates based on its own
internal estimates

To be computed as
per guidelines given
Maturity: The by the BASEL Provided by Bank
remaining economic Committee Or At based on its own
Implicit recognition
maturity of the national discretion, internal estimates
exposure provided by bank
based on own
estimates
All in the
Defined by Regulator
Standardized
and includes
Approach plus All types of
Financial Collaterals,
Receivables for Collaterals if Bank
Risk Mitigation Guarantees, Credit
goods and services, can prove by internal
Derivatives Netting
Other physical estimation.
(on and off balance
securities subject to
sheet) and Real estate
criteria.

OPERATIONAL RISK:

An operational risk is a risk arising from execution of a company's business functions.


As such, it is a very broad concept including e.g. fraud risks, legal risks, physical or
environmental risks, etc. The term operational risk is most commonly found in risk
management programs of financial institutions that must organize their risk management
program according to Basel II. In many cases, credit and market risks are handled through a
company's financial department, whereas operational risk management is perhaps coordinated
centrally but most commonly implemented in different operational units (e.g. the IT
department takes care of information risks, the HR department takes care of personnel risks,
etc)

More specifically, Basel II defines operational risk as the risk of loss resulting from
inadequate or failed internal processes, people and systems, or from external events. Although
the risks apply to any organisation in business, this particular way of framing risk management
is of particular relevance to the banking regime where regulators are responsible for
establishing safeguards to protect against systemic failure of the banking system and the
economy.

A.I.M.S. 44
Effects of Basel II Implementation on Indian Banking System Bank of Baroda

APPROACH OF OPERATIONAL RISK:

The treatment given under different approaches for operational risk is as follows:

ADVANCED
APPROACH BASIC INDICATOR STANDARDIZED
MEASUREMENT
• Gross income • Capital charge
per regulatory equals internally
line as generated
indicator measures based
• Average of • Depending on on, Internal &
Gross Income business line External loss
for 3 years as 12, 15 or 18% data, Scenario
Calculation of
indicator of the analysis,
Capital Charge
• Capital charge indicator as Business
equals 15 % of Capital charge environment and
the indicator • Total capital internal control
charge equals factors
sum of charge • Recognition of
per business risk mitigation
line (upto 20 %)
Same as Standardized
• Active plus
• No specific involvement • Measurement
criteria of Board of integrated into
• Compliance Directors and day-to-day risk
with the Basel Senior management
Committee’s Management • Review of
“Sound • Existence of management and
Qualifying practices for OpRisk measurement
Criteria the Management processes by
Management Function internal/external
and • Sound OpRisk auditor
Supervision of Management • Numerous
Operational System quantitative
Risk” • Systematic standards – in
recommended tracking of particular 3-5
loss data years of historic
data

MARKET RISK:

A.I.M.S. 45
Effects of Basel II Implementation on Indian Banking System Bank of Baroda

Market risk is the risk that the value of an investment will decrease
due to moves in market factors.
In the simplest terms, market risk can be defined as the risk of adverse
deviations of the mark-to-market value of the trading portfolio during the
period that is required to liquidate the transactions. Existence of market risk can be for any
period of time. Earnings for the market portfolio are the Profits and Losses (P&L) arising from
transactions. The assessment of market risk is based on the instability of market parameters
such as interest rates, stock exchange indexes, exchange rates. The instability is measured by
market volatilities. With the help of volatilities of market parameters and sensitiveness of
instruments, the changes in market value can be quantified.
The components of market risk can be divided into several dimensions. One dimension
is the liquidity risk that forms an important component in all markets where the low volume of
transactions makes it difficult to find counterparty. Another dimension is the presence of
volatility risk arising from the fluctuations over time of the instability of the market
parameters.

APPROACH TO MARKET RISK

The standardized approach which specifies the standards in five categories:

1. Interest Rate risk

2. Equity Position Risk

3. Foreign Exchange risk

4. Commodities Risk

5. Options risk

The second approach to deal in the market risk is based on the internal assessments of the
banks. The bank needs to consider following five elements in calculating the internal model
based risk structure.

1. General criteria, where the approval from the supervisory authority of the bank is
mandatory.
2. Qualitative standards regarding the maintenance of the Risk management unit
3. Specification of Market Risk Factors
4. Quantitative standards
5. Stress testing to identify the events that could impact the banks.
6. External Validation by External auditors and Supervisory authorities

ROLE OF CREDIT RATING AGENCIES

A.I.M.S. 46
Effects of Basel II Implementation on Indian Banking System Bank of Baroda

A Credit Rating Agency (CRA) is a company that assigns credit


ratings for issuers of certain types of debt obligations as well as the debt
instruments themselves. In some cases, the servicers of the underlying debt are
also given ratings. In most cases, the issuers of securities are companies,
special purpose entities, state and local governments, non-profit organizations, or national
governments issuing debt-like securities (i.e., bonds) that can be traded on a secondary market.
A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its
ability to pay back a loan), and affects the interest rate applied to the particular security being
issued.

Banks will have to depend on the Credit rating Agencies to rate their borrowers. The
RBI decided that banks may use the ratings of the following domestic credit rating agencies
for the purposes of risk weighting their claims for capital adequacy purposes: a) Credit
Analysis and Research Ltd. b) CRISIL Ltd. c) FITCH Ltd. and d) ICRA Ltd. Banks may use
the ratings of the following international credit rating agencies for the purposes of risk
weighting their claims for capital adequacy purposes a) Fitch; b) Moody's; and c) Standard &
Poor's.

Banks should use the chosen credit rating agencies and their ratings consistently for
each type of claim, for both risk weighting and risk management purposes. Banks will not be
allowed to "cherry pick" the assessments provided by different credit rating agencies.

Banks must disclose the names of the credit rating agencies that they use for the risk
weighting of their assets, the risk weights associated with the particular rating grades as
determined by RBI for each eligible credit rating agency as well as the aggregated risk
weighted assets.

Let us take the example of Bank of Baroda (BOB) who is in MoU with CRISIL for
rating purpose to understand how a rating system works.

BOB – CRISIL MODEL CREDIT RATING METHODOLOGY

The CRISIL Rating Model for Commercial Advances is based on two dimensional
methodology, specified under Basel II Accord requirements. The credit risk rating process as
per CRISIL Rating Models involves three types of ratings for each credit facility viz.
1. Obligor (Borrower) Rating – for credit worthiness indicating the Probability
of Default (PD),
2. Facility Rating – representing the Loss Given Default (LGD) and
3. Composite Rating – which is indicative of the Expected Loss (EL)

1. OBLIGOR (BORROWER) RATING:


The obligor rating is indicative of credit worthiness of an obligor or the
Probability of Default (PD) and it is based on the assessment of past and projected cash
flows of the company.

A.I.M.S. 47
Effects of Basel II Implementation on Indian Banking System Bank of Baroda

For assessment of an obligor, the rating structure consists of


evaluation by way of four modules viz. i) Industry Risk, ii) Business
risk, iii) Financial Risk and iv) Management Risk.

Industry Risk: The assessment of this module which is external to the borrower and is
done by assessment of Industry related macroeconomic parameters like demand supply
gap / capacity utilisation level / financial ratios like ROCE / OPM etc. applicable to the
specific industry and having different risk weights.
Business Risk: The assessment of this module is based on internal working of the
borrower and relates to parameters such as after sales service, distribution set up,
capacity utilisation etc. The parameters which are only relevant to a particular industry
are selected for scoring having different risk weights.
Financial Risk: The assessment of this module is based on internal working of the
borrower and relates to parameters such as past and project financials. The CMA based
data input sheet is uploaded into the software and the same allows computation of
financial rating automatically based on the computation of financial ratios like Net
Profit Margin, Current Ratio, DSCR, Interest Coverage etc.
Management Risk: The assessment of this module is based on internal working of
borrower’s management and relates to parameters such as past repayment record,
quality of information submitted, group support etc.

Obligor (Borrower) Rating Grades: Depending upon the model used, the rating grades
ranging from BOB-1 to BOB-10 or BOB-3 to BOB-10 or BOB-6 to BOB-10 are
generated.

NATURE GRADE
MODEL DESCRIPTION
OF GRADE NO.
For Borrowers under
Large Corporate
(Mfg./Services), Banks,
NBFCs, Broker
categories and BOB-1 to
A I to X
Infrastructure projects BOB-10
having operations phase
or
expansion/diversification
projects categories
For Borrowers under
SME (Mfg./ Services)
BOB-3 to
B and existing and new III to X
BOB-10
borrowers under Trader
category
C Green Field project BOB-6 to VI to X
borrowers with project BOB-10
under Large Corporate

A.I.M.S. 48
Effects of Basel II Implementation on Indian Banking System Bank of Baroda

(Mfg. /Services), SME


(Mfg. / Services and
Infrastructure
(Power/Port
/Road/Telecom) Build
Phase categories.

BOB-1 indicates Investment Grade Highest Safety whereas BOB-10 indicates Default.

2. FACILITY RATING:
Facility Rating involves assessment of the security coverage for a given facility
and indicates the Loss Given Default (LGD) for a particular facility. Facilities
proposed/ sanctioned to a company are assessed separately under this dimension of
rating.
Facility Rating Grades:
GRADE NO. NATURE OF GRADE DESCRIPTION
I FR-1 Highest Safety
II FR-2 Higher Safety
III FR-3 High Safety
IV FR-4 Adequate Safety
V FR-5 Reasonable Safety
VI FR-6 Moderate Safety
VII FR-7 Low Safety
Lowest Safety/Clean
VIII FR-8 Loans/Totally
Unsecured

3. COMPOSITE RATING:
The Composite rating – which is the matrix or the combination of PD and LGD,
indicates the Expected Loss in case the facility is defaulted. The Composite rating is
worked out automatically by the software based on the matrix of Obligor (Borrower)
Grade (BOB rating) and Facility Rating (FR).

Composite Rating Grades:


GRADE NO. NATURE OF GRADE DESCRIPTION
I CR-1 Minimum (Lowest)

A.I.M.S. 49
Effects of Basel II Implementation on Indian Banking System Bank of Baroda

Expected
Loss
Lower
II CR-2 Expected
Loss
III CR-3 Low Expected Loss
IV CR-4 Reasonable Expected Loss
Adequate Coverable
V CR-5
Expected Loss
VI CR-6 Moderate Expected Loss
VII CR-7 Extra Expected Loss
VIII CR-8 High Probability of Loss
IX CR-9 Higher Probability of Loss
X CR-10 Highest Expected Loss

CUT – OFF GRADE FOR ACCEPTANCE:

Bank of Baroda has accepted BOB-6 as the cut-off point for the acceptance of an
borrower based on Obligor (Borrower) rating.
For Borrowers of Type A: The acceptance grade can be any grade from BOB-1 to BOB-6.
BOB-6 having the score ranges of above 4.25 to 5.00 out of total 10.00 for these categories of
borrowers.
For Borrowers of Type B: The acceptance grade can be any grade from BOB-3 to BOB-6.
BOB-6 having the score ranges of above 5.00 to 5.75 out of total 10.00 for these categories of
borrowers.
For Borrowers of Type C with new projects: These borrowers are initially rated under the
project risk rating assigned grades from BOBPR-1 to BOBPR-5 and subsequently converted to
common obligor rating grade from BOB-6 to BOB-10 automatically. BOBPR-1 under project
rating is the only investment grade being equivalent to Obligor rating scale of BOB-6.

PRICING:

The Composite Rating represents the Expected Loss. This loss has to be recovered
from the borrower by the way of risk premium over the BPLR. For the purpose of fixing the
Rate of Interest the mapping of existing rating grades with the CRISIL Rating Models is done.

RATE OF
INTEREST(ROI)
FOR
DEFINITION OF
NATURE OF BORROWERS TO
GRADE NO. COMPOSITE
GRADE BE MAPPED
GRADES
WITH EXISTING
RATINGS AS
UNDER
Minimum(Lowest)
I CR-1 AAA
Expected Loss
II CR-2 Lower Expected Loss AA

A.I.M.S. 50
Effects of Basel II Implementation on Indian Banking System Bank of Baroda

A/
III CR-3 Low Expected Loss
BBB
Reasonable Expected BB
IV CR-4
Loss
Adequate Coverable
V CR-5 B
Expected Loss
Moderate Expected
VI CR-6 C
Loss
VII CR-7 Extra Expected Loss C
High Probability of
VIII CR-8 D
Loss
Higher Probability of
IX CR-9 D
Loss
Highest Expected
X CR-10 D
Loss

CHANGES IN CAR:

Indian banking companies were required to ensure full implementation of Basel


II guidelines by March 31, 2009. The process of implementing Basel II norms in India is being
carried out in phases. Phase I has been carried out for foreign banks operating in India and
Indian banks having operational presence outside India with effect from March 31,2008.

In phase II, all other scheduled commercial banks (except Local Area Banks and
RRBs) will have to adhere to Basel II guidelines by March 31, 2009. With Basel II norms
coming into force in 2009, maintaining adequate capital reserves is a priority for banks.

Basel II mandates Capital to Risk Weighted Assets Ratio (CRAR) of 8% and Tier I
capital of 6%. The RBI has stated that Indian banks must have a CRAR of minimum 9%,
effective March 31, 2009. All private sector banks are already in compliance with the Basel II
guidelines as regards their CRAR as well as Tier I capital. Further, the Government of India
has stated that public sector banks must have a capital cushion with a CRAR of at least 12%,
higher than the threshold of 9% prescribed by the RBI.

CAPITAL ADEQUACY RATIO (CAR):

Capital Adequacy Ratio (CAR) is also known as Capital to Risk Weighted Assets
Ratio which indicates a bank's risk-taking ability. The RBI uses CRAR to track whether a
bank is meeting its statutory capital requirements and is capable of absorbing a reasonable
amount of loss.

Under BASEL I,

A.I.M.S. 51
Effects of Basel II Implementation on Indian Banking System Bank of Baroda

Under BASEL II,

Where
RWA = Risk Weighted Asset

Capital funds are broadly classified as Tier 1 and Tier 2 capital. Two types of capital
are measured: Tier one capital, which absorbs losses without a bank being required to cease
trading, and Tier two capital, which absorbs losses in the event of winding-up and so provides
a lesser degree of protection to depositors.

Tier I Capital (core capital) is the most reliable form of capital. The major
components of Tier I capital are paid up equity share capital and disclosed reserves viz.
statutory reserves, general reserves, capital reserves (other than revaluation reserves) and any
other type of instrument notified by the RBI as and when for inclusion in Tier I capital.
Examples of Tier 1 capital are common stock, preferred stock that is irredeemable and non-
cumulative, and retained earnings.

Tier II Capital (supplementary capital) is a measure of a bank’s financial strength


with regard to the second most reliable forms of financial capital. It consists mainly of
undisclosed reserves, revaluation reserves, general provisions, subordinated debt, and hybrid
instruments. This capital is less permanent in nature.

Risk Weighted Assets is a measure of the amount of a bank’s assets, adjusted for risk.
The nature of a bank's business means it is usual for almost all of a bank’s assets will consist
of loans to customers. Comparing the amount of capital a bank has with the amount of its
assets gives a measure of how able the bank is to absorb losses. If its capital is 10% of its
assets, then it can lose 10% of its assets without becoming insolvent.

The main use of risk weighted assets is to calculate tier 1 and tier 2 capital adequacy
ratios. Risk weighting adjusts the value of an asset for risk, simply by multiplying it be a factor
that reflects its risk. Low risk assets are multiplied by a low number, high risk assets by 100%.

DOMESTIC
BB &
RATING AAA AA A BBB Unrated
AGENCIES Below
RISK
20 % 30 % 50 % 100 % 150 % 100 %
WEIGHT
Risk Weights as per Various Rating Agencies

The higher the CAR, the stronger is the security and safety against bankruptcy and
lower is the risk of financial crisis.

A.I.M.S. 52
Effects of Basel II Implementation on Indian Banking System Bank of Baroda

Majority of Scheduled Commercial Banks (SCBs) in India have


reported a CAR of more than 12 % as prescribed in BASEL II. The average
CAR for the SCBs improved dramatically from just 2% in 1997 to 13.08% on
March 31, 2008. As per the RBI report, the Indian Banking system needs to
increase its capital base from the present level of Rs. 2,96,191 crore to Rs. 8,64,935 crore by
March, 2012.

The CRAR of the Bank of Baroda is summarized as under.

DATE BASEL I BASEL II

31.03.2008 12.91 % 12.94 %

31.03.2009 12.88 % 14.05 %

In order to meet the ever increasing capital needs, (which is expected to be around 65
per cent more than the present level of capital base) keeping pace with the Basel II accord,
Indian banking system may have to resort to the strategy of entering into both domestic as well
as international capital market and enlarge its portfolio in these markets. However, Public
Sector Banks (PSBs) may have to face difficulties in raising capital from the capital market
since the government holding in such banks cannot be reduced below 51 per cent and that is
why many industry experts are in support of reducing such government control in state-owned
banks to around 33 per cent.

RISK BASED SUPERVISION

The Risk Based Supervision (RBS) approach aims at overall efficiency and
effectiveness of the supervisory process, optimizing supervisory resources. RBI has developed
risk profile document for undertaking risk assessment exercise by the banks.

The introduction of risk-based supervision requires bank to reorient their organisational


set up. The approach is intended to:

• Widen scope of internal audit and redirect resources.


• Evaluate adequacy and effectiveness of risk management procedures and
internal control systems.
• Proactive approach to internal auditing.
• Help management in mitigating risks.
• Ensure effectiveness of control systems in monitoring inherent risks
Prioritise audit areas
• Allocate audit resources according to risk assessment.

A.I.M.S. 53
Effects of Basel II Implementation on Indian Banking System Bank of Baroda

Banking supervision should respond to the changes in the banking


sector, and the regulatory instruments should implement changes in their
supervisory policies, procedures and practices that will help them assess
effectively the safety of individual banks.

Until now the present inspection used to concentrate on transaction testing, accuracy
and reliability of accounting records, financial reports, testing of integrity, reliability and
timeliness of control reports, review of quality of assets, its classification and adherence to
legal and regulatory requirements. Although the risk is inherent in the banking business there
is no mention of risk in any inspection report. Therefore, there is a need to move from this
inspection system to risk focussed internal audit by setting up necessary risk management
architecture in place.

Audit is an important tool of good Corporate Governance. Audits are a reassurance to


all those who have a financial interest/stakes in banks. The internal control measures help
organisation discharge its functions, more effectively and efficiently. Because of good audit
certificate, the organisation as well as people of the organisation is held in high esteem in the
eyes of the investors and customers.

Risk Based Internal Audit (RBIA) is based on futuristic approach and it requires
necessary steps to identify measure, control and mitigate the risk.

INTERNAL AUDIT RISK BASED INTERNAL AUDIT


Transaction based. No risk assessment. 100% Risk based. Level of transaction testing
transaction testing. depends on risk assessment.
Process identical for each branch/unit. Process differs according to risk assessment.
Periodicity linked to rating. Periodicity linked to risk assessment.
Backward looking – focus on historical
Forward looking – suggestions for risk
accounts, past performance and compliance
mitigation.
because of lack of risk focus.
Inadequate optimisation of audit resources. Effective optimisation of audit resources.
Essential for regulatory Risk Based
No direct linkage to supervisory process.
Supervision.

RBIA has to independently assure Board that


• Risk management processes is in place and operating as planned
• Processes are of sound design
• Management responses to risks are effective and adequate
• To reduce risk to acceptable level (Board)
• Appropriate internal controls are in place for risks management intends to treat
(control)

A.I.M.S. 54
Effects of Basel II Implementation on Indian Banking System Bank of Baroda

The bank has to decide on the level of transaction testing based on its
RBIA policy duly approved by its Board. The bank has to prepare a Risk
Audit Matrix which would be based on the magnitude and frequency of risk.

Risk Audit Matrix assessing magnitude and frequency of risk and preparing a matrix
based on it. Risk Audit Matrix should include inputs like previous Internal Audit reports and
compliance thereof, proposed changes in business lines or change in focus, significant change
in management/key personnel, results of latest regulatory examination report, reports of
external auditors, industry trends and other environmental factors, time lapsed since last audit,
volume of business and complexity of activities, substantial performance variations from the
budget.

Under the Risk Based Internal Audit branches under low risk shall be inspected at an
interval of 18 months, branches under medium risk at an interval of 12 to 15 months, branches
under high risk at an interval of 12 months and branches under very high risk/ extremely high
risk shall be inspected at the interval of 9 to 12 months. This will optimise utilisation of audit
resources available with the Inspection Division and comply with the sound, tested,
understandable Risk Based Internal Audit System as required by BASEL II.

DISCLOSURE

The implications of market discipline are varied and have more to do with the
stakeholders that are outside the bank. Obviously, most significant amongst the stakeholders
are the regulators. The discussions with them about the disclosures to be made, along with
their contents and frequency should be the first step. Having a clear idea of the disclosures
should facilitate the generation of required information flows as also equipping the staff to
comply with the requirements. Either technological or manual preparations for compilation of
the disclosures would be necessary. Developing procedures for meeting the disclosure
prescriptions should be a focussed task.

BASEL II is not the first time the banks would be making disclosures. Banks do have
statutory and traditional forms of disclosures. BASEL II calls for different types of disclosures
like risk philosophy, risk profile, exposure classification, etc. It is likely that the existing
processes would need certain modifications and action to meet with these emerging data
requirements. Identifying the data gaps between present and proposed disclosures should be
important task.

Formally and informally, it is necessary to assess the impact of new disclosure on


business and public. The customers and shareholders are generally more interested in the
disclosures as they provide information normally not available in financial statements.
Shareholders asking questions on these disclosures made are being reviewed. The sensitivity
of disclosures is also another area to be looked into. For multi-national banks, the disclosure
requirements could be contradictory and the bank would have to find a way to address such a
situation.

A.I.M.S. 55
Effects of Basel II Implementation on Indian Banking System Bank of Baroda

ROLE OF IT

Compliance with BASEL II prescriptions calls for a huge amount of data, as can be
seen from the following table.

BANK VARIETY OPERATIONAL


CREDIT RISK MARKET RISK
OF DATA RISK
Data on exchange
Transactions Borrower Issue data Loss event data
rates
Data on interest rates
Guarantor Data Casual Data
Operational CRM Data on Securities
Asset specific Data Loss effect
data prices
Data on collections Key risk Indicators
Data on instruments
External Default
Analytical CRM Data Proxies
Data on correlation
Data Data on ratings and Risk Inventories
migration of ratings
Risk Management Industry level Data
Self Assessment Data
data Macro level Data
Economy and
Correlation data
Industry Data

Information Technology has multi faceted role in BASEL II compliance. BASEL II


promises significant business benefits to those who have systems in place to access and utilize
far more detailed and precise information. It calls for integration of data on finance, operations
and risk management. The exercise lends an opportunity to get out of legacy systems and
procedures including IT system. Fundamental rethinking on how a bank’s data and
information is provided and controlled is required. Three pillars of BASEL II are
interdependent and must be addressed to concurrently.

The technology part becomes more prominent when the bank decides to accept internal
ratings based approach. Internal Rating based approaches revolve around, probability of
default, loss given default, exposure at default and other parameters. To meet this end what is
needed is defining and capturing loss data, capturing and extracting exposure data and
identifying and capturing risk mitigation data.

Data issues would revolve around sources, data types, quality and granularity of data.
More particularly, operational risk management pre-supposes,
• Framework and systems in data integration as the banking activities are to be
categorized in nine different segments.
• Taking a view on low frequency – high severity occurrences so as to make judgments
about the future.

A.I.M.S. 56
Effects of Basel II Implementation on Indian Banking System Bank of Baroda

• A well-designed organization structure for risk management to


facilitate interaction among functionalities
• Examination of the potential for risk mitigation, outsourcing and alike
issues
• Attainment of more synergy and little overlap

The new definition of banking is trading on Information relating to money, market,


customer and risks. There is a direct relationship between risk and technology. Risk is a
function of uncertainty, which varies according to the quality of information. The components
of information quality are accuracy, timelines, relevance and adequacy. Both adequacy and
timelines are a function of information technology while relevance and adequacy can be
determined through information technology as well as management science or
statistical/mathematical models. The entire risk concept and its management in BASEL II thus
hover around Information technology.

OTHER EFFECTS

Large Scale Consolidation

The Reserve Bank of India (RBI), in its “road map” for the banking industry, has
revealed that the Indian market will be opened for international banks in 2009. This may
facilitate the emergence of a large number of foreign banks in India and such foreign banks are
expected to tap the huge potentials with their strong capital bases, updated as well as strong IT
based infrastructural facilities and customer – centric approaches.

Such forthcoming competition is expected to raise some critical issues such as


management of credit, market and operational risks, effective leadership and decision making
procedure, attractive policies for retaining global talent, etc. Moreover, banks which do not
comply with the BASEL II norms, will have to merge with other larger banks, as a result of
which, large scale mergers and acquisitions (M&As) may become very much evident in the
days to come.

Consolidation in banking industry is expected to emerge as a key word. Initiatives have


already been taken by policy makers for eliminating inherent legal constraints in the process of
consolidation. Several branches of State Bank group may shortly be a part of SBI and that
synergy is expected to uplift the SBI into one among global giants in banking industry.

Enhanced Role of Regulator

The role of the regulator (RBI) will be greatly enhanced under Basel II. It will be in-charge
of the supervisory review process as well as maintaining market discipline. The supervisory
review process will involve:

• Ensuring that banks have adequate capital subject to regulatory approval

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• Encouraging banks to develop and use better risk management


techniques
• Evaluate banks on
o Bank's assessment of capital needs relative to risk
o Effectiveness of risk management systems
o Effectiveness of internal control process

In addition, the RBI will also be involved in framing a set of disclosure requirements to
maintain market discipline. This will complement the minimum capital requirement (Pillar 1)
and supervisory review process (Pillar 2). All this will lead to greater transparency, which
should improve the quality of decision-making and benefit the financial sector as a whole.

Impact on Loan Pricing, Portfolio Composition, Bank Performance and the Lending
Process as a Whole

It will lead to more efficient loan pricing: The loan pricing will become more fine-
tuned and will reflect the risks and the costs involved. This will benefit the more efficient
borrowers while the more risky borrowers will be penalized. The most important cost element
after the transition to Basel II will be the addition or the reduction in capital requirements for
lending to various sectors. This is possible as Basel II involves an individual analysis of the
risks for the various sectors and hence the resultant capital required.

The risk appetite of the entire banking sector should decrease with the shift to Basel II.
There would be a shift towards higher quality borrowers over time and hence the risk of the
overall portfolio should decrease.

Further since the pricing of the loans will be based on the risks assessment and will be
done only after proper and thorough screening of the borrower, the efficiency of the entire
lending process should improve. Loans will be granted to only good borrowers. The more
risky borrowers will have difficulty in finding banks that are willing to lend to them. This
should results in reduced Non Performing Assets for the banking sector as a whole resulting in
better solvency of the Indian banking system.

It should also result in increased margins for the more efficient banks resulting from
savings on account of reduced capital requirement and probable increase in business while the
lesser efficient players would find the going tough, as they will be required to provide a higher
level of capital and this should reflect on their margins.

Impact on Business Model

The impact on the business models of the banks will be as follows:

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Effect on Business Model

With the advent of Basel II, banks with a risk appetite, i.e. high risk - high return
lending strategy or lending without proper appraisal merely to generate additional business
will find the going tough. We believe that such business models, which take disproportionately
high risks, will not survive. The business models, which should survive, will be where risks
are within acceptance levels for the banks backed by adequate returns.

Impact on Borrowers – Interest Rates

Borrower wise Impact of Basel II

The more efficient borrowers will have easier and larger access to funds while the more
risky borrowers will find it tough to garner funds at favourable rates. In the extreme case, some
borrowers will find no banks that are willing to lend to them. One can imagine the effect it will
have on the companies. Imagine two companies from the same sector - one with a high credit
rating say AAA and other with a lower rating say BBB. Even a 2% interest rate differential
here can transform into a huge competitive advantage for the AAA rated borrower. This will
force the inefficient players to get more disciplined in order to be competitive in the market
place. This will promote greater efficiency and led to a more efficient and stronger banking,
financial and the corporate sector.

Further under Basel II, with the sense of competitiveness introduced within the banking
as well as the corporate sector, the competition will become more service based rather than
cost based. Banks will need to differentiate based on the services provided rather than the

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customer segment catered to (low risk/high risk). This is because we do not


expect business models that are based on risk appetite to survive under Basel
II.

In addition, the inefficient players will be weeded out or will have to fall in line. All this
should lead to improved quality of services for the consumer. Further the improved solvency
of the banks will also benefits the customers, as the quality of their investments will improve.

Impact on Borrowers - Costs

The costs involved will be: -

• IT costs
• Internal rating costs
• Corporate governance, increased control and supervisory costs

The major items of cost here will be the statistical costs to analyze the past data of loans in
order to study their behaviour and to come up with any trends. This will involve the use of
three-dimensional databases of the type, which are currently not available with the Indian
Banks. This will help in deciding the risks involved in lending to various sectors and classes of
borrowers. This will be of great aid to the banks in deciding the capital requirements
applicable to the borrowings and the sector-wise exposure that it wants to take. These and
other costs will be higher for inefficient banks.

Risk-Return Trade Off

It involves a number of risk-return trade-off and hence a proper cost benefit analysis is
required. On the cost side there will be tangible costs like IT costs, costs for statistical
validation of trends etc. while the intangibles costs may be attributed to the complexity of the
rules and the difficulty in complying with them. On the benefit side, will be better risk
management and greater efficiency & profitability for the banks. In addition, it will also reduce
the operational risks faced by a bank, example frauds, etc.

With increased globalization and integration of the world financial markets, it will
offer competitive advantage to the Indian Banks that adopt Basel II. If Indian Banks want to
compete in the global space then Basel II will be a necessity and not a choice. The example
that follows will prove the same. Consider an Indian Bank, which has not adopted Basel II
(after its adoption in other parts of the world) seeking a foreign currency credit line from a
multinational bank abroad. It will in all probability be required to recast its capital adequacy as
per Basel II. Such a reactive measure at that point could lead to large delays as well as costs
for such recasting. Hence it makes sense for Indian banks to move to Basel II as soon as other
bigger international banks adopt it. They need not be the first to adopt it but they should not
also delay it very much as it will certainly hurt their competitive advantage and the ability to
compete on a large scale.

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10. CONCLUSION

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CONCLUSION

The project briefly describes the various effects that the Indian Banking System had on
it because of the implementation of BASEL II.

Some of these effects are directly dependent on the pillars of BASEL II framework
while some of the effects are because of the changes the banks make in their structure.

The project highlights these effects in a structured manner and scrutinizes the
differences in the banking structure under BASEL I and now under BASEL II. Bank of Baroda
is considered as an example in some of the effects and these effects are studied. The Capital
Adequacy ratio which has to be maintained by bank is highlighted along with the role of the
external rating agencies. Also the disclosures and the role of IT play a major role while
implementing BASEL II.

The impact on Business model of banks, impact on borrowers, impact on loan pricing
and lending process, the enhanced role of the regulator, etc. are some of the other effects that
the BASEL II implementation will have on the Indian Banking Sector are also studied in this
project.

All this will lead to greater transparency, which should improve the quality of decision-
making and benefit the financial sector as a whole. BASEL II implementation will help Indian
banks to gain a competitive edge in the global markets and compete with the international
banks.

The implementation of BASEL II will elevate the Indian Banking Sector to the
international standards and compliance with these norms would help an Indian Bank to thrive,
compete and succeed beyond leaps and bounds in the Global Markets.

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11. FUTURE SCOPE OF


THE PROJECT

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FUTURE SCOPE OF THE PROJECT

BASEL II framework is revised with every meeting in the BASEL Committee. The
RBI mandates these changes regularly in the Banking Sector.

Changes are made in the structure of the Indian Banking Sector because of these
implementations.

The future scope of this project is to study these changes in the structure of the Banking
Sector caused due to implementation of these revised frameworks under BASEL II.

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12. BIBLIOGRAPHY

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BIBLIOGRAPHY

BOOKS:

Risk Management in Banks – ICFAI

Treasury and Risk Management in Banks – Indian Institute of Banking and Finance

Risk Management – Satyajit Das

WEBSITES:

www.bis.org

www.rbi.org.in

www.bankofbaroda.com

www.google.com

www.wikipedia.com

www.investopedia.com

www.bankingindia.com

www.howstuffworks.com

OTHERS:

Bobmaitri – Magazine of Bank of Baroda – Various Editions

THE CHARTERED ACCOUNTANT – ICAI – Various Editions

Various Circulars of Bank of Baroda

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