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Abstract

The Basel II Accord, released during June 2004, is `an improved capital adequacy framework intended to foster a strong emphasis on risk management and to encourage ongoing improvements in banks’ risk assessment capabilities’, as Basel I accord has very limited risk sensitivity and lacks risk differentiation for measuring credit risk.

Basel II Accord emphasizes on three Pillars viz.

, Capital Adequacy (Credit and Operational Risk Management), Supervisory Review and Market Discipline (Disclosure of all banking activities, which allows the market to have a better picture of the overall risk position of the bank).

The policy approach to Basel II in India is to conform to best international standards and in the process, emphasis is on harmonization with the international best practices. Foreign banks and those Indian banks that have operations outside the country have to implement the Basel II norms from March 31, 2008, while for all other commercial banks, excluding the local area banks and regional rural banks, the rules will come into effect from March 31, 2009.

Under the current scenario of Indian banking industry working under the parental guidance of Reserve Bank of India, Indian Banking Industry has to face various challenges in conforming to the Basel II norms. The major challenges identified for the banking industry in India are qualitative and quantitative as well in nature. The challenges include the readiness of the banks with regard to Information Technology / Software viz., availability / development of databases, lack of core system & architecture with some of the banks, requirement of sophistication & maturity, late start / lower levels of computerization. Also, in the process of risk management (both Credit & Operational), to maintain high capital reserves huge investments are required.

The new Accord will increase the level of capital that is required for the banking institutions in the region, mainly owing to the new operational risk charge. Measuring risks will become more explicit in the new Accord. Measuring credit, market, operational, interest rate, liquidity and other risks in compliance with the new Accord will not be an easy task for either bank managers or supervisory authorities, where there is a lack of ratings agencies and the majority of individual claims remain unrated. Further, banks and supervisors will be required to invest considerable resources in upgrading technology, including adequate data access, technical capacity and human resources to meet the minimum standards in the new Accord. One of the major challenges is prioritization of sectors by individual banks for funding. Vital sectors in India like agriculture & small-scale industries, which are prone to high risk, may get affected in the process of credit risk management, which is one of the important pillars of Basel II Accord.

Implementing the new Accord is not an easy task for either supervisory authorities or bank managers. It is important to stress that higher capital requirements might be desirable, to promote the safety and soundness of individual banks and the overall financial system. The increased capital requirements will safeguard the interests of depositors and reduce the probability of calling on public resources in the event of a crisis.

1.0 Introduction

Basel Committee
The Basel Committee on Banking Supervision established in 1974, provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. It seeks to do so by exchanging information on national supervisory issues, approaches and techniques, with a view to promoting common understanding. At times, the Committee uses this common understanding to develop guidelines and supervisory standards in areas where they are considered desirable. In this regard, the Committee is best known for its international standards on capital adequacy; the Core Principles for Effective Banking Supervision; and the Concordat on cross-border banking supervision.

The Committee's members come from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom and the United States. Countries are represented by their central bank and also by the authority with formal responsibility for the prudential supervision of banking business where this is not the central bank.

The Committee encourages contacts and cooperation among its members and other banking supervisory authorities. It circulates to supervisors throughout the world both published and unpublished papers providing guidance on banking supervisory matters. Contacts have been further strengthened by an International Conference of Banking Supervisors (ICBS) which takes place every two years.

The Committee's Secretariat is located at the Bank for International Settlements in Basel, Switzerland, and is staffed mainly by professional supervisors on temporary secondment from member institutions. In addition to undertaking the secretarial work for the Committee and its many expert sub-committees, it stands ready to give advice to supervisory authorities in all countries.

Main Expert Sub-Committees

The Committee's work is organized under four main sub-committees:
• The Accord Implementation Group
• The Policy Development Group
• The Accounting Task Force
• The International Liaison Group

The Accord Implementation Group (AIG) :
a) it was established to share information and thereby promote consistency in implementation of the Basel II Framework
b) Currently the AIG has two subgroups that share information and discuss specific issues related to Basel II implementation

The Policy Development Group (PDG):
It replaced the Committee's former Capital Task Force. Its primary objective is to support the Committee by identifying and reviewing emerging supervisory issues and, where appropriate, proposing and developing policies that promote a sound banking system and high supervisory standards.

The Accounting Task Force (ATF):
It works to help ensure that international accounting and auditing standards and practices promote sound risk management at financial institutions, support market discipline through transparency, and reinforce the safety and soundness of the banking system.

The International Liaison Group (ILG):

a) it replaces the former Core Principles Liaison Group - which had focused considerably on the initial implementation and later revision of the 1997 Core Principles for Effective Banking Supervision - and provides a forum for deepening the Committee's engagement with supervisors around the world on a broader range of issues.

b) It gathers senior representatives from eight Committee member countries (France, Germany, Italy, Japan, the Netherlands, Spain, the United Kingdom and the United States), 16 supervisory authorities that are not members of the Committee (Argentina, Australia, Brazil, Chile, China, the Czech Republic, Hong Kong, India, Korea, Mexico, Poland, Russia, Saudi Arabia, Singapore, South Africa, and the West African Monetary Union).

2.0 BASEL 1
It aimed to standardized the computation of risk based capital across banks and across countries.
The 1988 Basel Accord focused primarily on credit risk. Bank assets were classified into five risk buckets i.e. grouped under five categories according to credit risk carrying risk weights of zero, ten, twenty, fifty and one hundred per cent. Assets were to be classified into one of these risk buckets based on the parameters of counter-party (sovereign, banks, public sector enterprises or others), collateral (e.g. mortgages of residential property) and maturity. Generally, government debt was categorized at zero per cent, bank debt at twenty per cent, and other debt at one hundred per cent. 100%.

Banks were required to hold capital equal to 8% of the risk weighted value of assets. Since 1988, this framework has been progressively introduced not only in member countries but also in almost all other countries having active international banks.

The 1988 accord can be summarized in the following equation:

Total Capital = 0.08 x Risk Weighted Assets (RWA)

Amendment:

In 1996, BCBS published an amendment to the 1988 Basel Accord to provide an explicit capital cushion for the price risks to which banks are exposed, particularly those arising from their trading activities. This amendment was brought into effect in 1998.

3.0 BASEL 2
The Accord
The New Basel Capital Accord, often referred to as the Basel II Accord or simply Basel II, was approved by the Basel Committee on Banking supervision of Bank for International Settlements in June 2004 and suggests that banks and supervisors implement it by beginning 2007, providing a transition time of 30 months. It is estimated that the Accord would be implemented in over 100 countries, including India.Basel II takes a three-pillar approach to regulatory capital measurement and capital standards - Pillar 1 (minimum capital requirements); Pillar 2 (supervisory oversight); and Pillar 3 (market discipline and disclosures).

Objective:
The overall objective of Basel II is to increase the safety and soundness of the (international) financial system by :
• making capital requirements for banks more risk sensitive while
• maintaining the same level of overall average regulatory capital in the banking system.

 Pillar 1 spells out the capital requirement of a bank in relation to the credit risk in its portfolio, which is a significant change from the “one size fits all” approach of Basel I. Pillar 1 allows flexibility to banks and supervisors to choose from among the Standardized Approach, Internal Ratings Based Approach, and Securitization Framework methods to calculate the capital requirement for credit risk exposures. Besides, Pillar 1 sets out the allocation of capital for operational risk and market risk in the trading books of banks.

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