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Pillar 3, market discipline is intended to complement the first two pillars and to encourage market discipline by developing a set of disclosure requirements, which will allow market participants to assess the capital adequacy of the institution.

Through this approach Basel II aims to correct most of the deficiencies that Basel I had suffered from. The new standards are more risk sensitive to business type and assets classes. This approach is multi-dimensional and focuses on all the operations of the bank. Accordingly banks, which have a larger risk exposure, will have to set apart more capital to meet the unexpected losses that go with it. The new framework intends to improve safety, soundness in the financial system and enhance competitive equality.

Basel II will have a major impact on the banking industry. With capital requirements loaded in favour of larger banks having better systems and consequent ability to benefit from the lower capital that goes with implementing more advanced approaches, the banking industry will witness a spate of large scale mergers, especially between internationally active banks, in their struggle to remain competitive.

Basel II would ensure a greater amount of financial stability in the economy. The capital requirement for each bank would be more closely tailored to various risks run by each bank. It provides incentives to adopt the latest advances in the field of risk management. A fine-tuned credit assessment processes will help the banks to 'risk price' their loan products better.

Basel II also suffers from various criticisms. It is said that risk-sensitive approaches will have pro-cyclical effects that will aggravate the booms and busts and thereby affect the real economy. The capital requirements will drop at the peak of economic cycles and increase at the bottom of cycles when capital can be more scarce and expensive. Basel II is applicable only to Scheduled Commercial Banks in India. It should be applicable uniformly to all banks and development financial institutions. Basel provides freedom to local regulators to implement the process by stage wise approaches. Despite its shortcomings, Basel II is forward looking and has been implemented in India from 31 March 2007.

Concluded.

* Contributed by: -
Nishant Bachkheti & Nilesh Maheshwari,
Core Committee Members Fin-Niche,
IMT, Ghaziabad.