The Hindu Business Line : Putting Basel II pillars in place

Basel II norms, to be implemented from 2007, has been evolved to reinforce the structural soundness of banks, particularly the international outfits. It has been framed mainly to suit the industrialised G-10 countries where the demand for primary credit has long saturated. However, there is a feeling that the Basel II norms may go against the interests of developing countries, small enterprises and infrastructure projects, which deserve a liberal approach to bank credit.

THE Bank for International Settlements based in the Swiss city of Basel has announced the International Convergence of Capital Measurement and Capital Standards: A revised framework, commonly known as Basel II, with the object of preventing major bank failures. The new framework, according to its authors, ``will enhance banks' safety and soundness, strengthen the stability of the financial system as a whole, and improve the financial sector's ability to serve as a source for sustainable growth for the broader economy''.

The Basel committee, which consists of officials of central banks of the industrialised G-10 countries, has been debating the new framework since 1999. The revised norms seek to buttress the capital structure of banks, on the one hand, and tighten up risk management, on the other, so that the banks could absorb the impact of a major default in future.

Basel I

Forces of deregulation, technological innovation and globalisation unleashed a tremendous growth in global banking in the 1980s. However, unbridled growth in global banking without adequate regulation and supervision inevitably led to recurring banking crisis in one economy after another. To prevent such crises, the Basel committee evolved a set of core principles of sound banking based on the prevalent international best practices.

These norms, which came to be known as Basel I, comprised able risk management, capital adequacy, sound supervision and regulation and transparency of operation. Basel I was the first to arrive at an internationally accepted definition of bank capital as also to prescribe a minimum acceptable level of capital for banks. The norms were announced in 1988 and were adopted by the banks by the end-1992.

However, subsequent events such as the Asian financial crisis exposed the inadequacies of these norms in dealing with systemic crisis in global banking. Hence, the Basel committee in June 1999 proposed a new set of norms to reinforce the structural soundness of the banks, particularly the international banks. These norms, which came to be called Basel II, sought to make use of the advances in risk management practices and technology to match the required capital more closely with the multiple risks faced by the banks. However, the new framework is expected to maintain the aggregate level of minimum capital requirements as stipulated in Basel I.

Originally, Basel II was to be announced in 2004 and later postponed to 2005. The new framework will now be available for implementation, starting 2007, and the advanced risk management techniques will be ready after a year's trial.

Three pillars

Basel II, as conceived, rests on `three pillars'. The first is the closer alignment of the bank capital with the range of perceived risks. Basel I categorised credit risks in broad terms without taking into account individual credit worthiness or the lack of it. This is being sought to be rectified now by stipulating higher capital for higher risks and vice-versa. Three options have been given for apportioning the risk capital, depending on the level of operation and sophistication of the respective banks.

Normal banks can follow the "standardised approach", whereby they can use external credit ratings to assess the risk. More sophisticated banks can follow one of the two "internal ratings-based" (`IRB') approaches wherein banks rely partly on their own assessment subject to strict supervision. In addition to the credit risk and market risk covered by the Basel I framework, Basel II also provides for operational risk, namely, losses caused by failures in systems, processes, staff or that are caused by external events such as natural disasters.

Again, three options have been recommended depending on the nature and sophistication of individual banks.

Pillar II is represented by the effective supervisory review of Pillar I, whereby national bank supervisors are expected to evaluate the activities and risk profiles of individual banks in order to determine whether those banks have provided adequate capital under Pillar I and suggest ways to set right the discrepancies, if any.

Pillar III is represented by the need to impose market discipline on the banks to ensure prudent management. This is being sought to be done by enhancing the degree of transparency and public disclosures in banks' public reporting.

Basel II would entail an unprecedented scale of technology in the collection, analysis and monitoring of banking data. It will also require highly skilled manpower. As an IT expert put it, "Basel II and the broader demand for higher levels of compliance and disclosure provides banks with a timely opportunity to re-architect their patchwork quilt of technologies, applications and databases''. And, of course, the banks will have to pick up prodigious bills.

India's case

Basel II framework has been evolved to suit mainly the industrialised G-10 countries where the demand for primary credit has long been saturated. In fact, there has been a general concern that the Basel II norms may go against the interests of developing countries, small enterprises and infrastructure projects, which deserve a liberal approach to bank credit. In other words, critics fear that Basel II might accentuate the classic dilemma faced by the developing countries — whether to have sound banking or good roads.

Moreover, developing countries such as India and China enjoy a tradition of public trust in government banks, which continue to do business in good times and bad, irrespective of the level of capital they hold. Under the circumstances, the question arises why should these countries opt for elaborate and cumbersome regulations such as Basel II. Again, critics point out, minimum capital requirement is only good as far as it goes and wonder how good it will be when crisis hits the banks. Most banks which suffered in the Asian financial crisis were well capitalised with capital adequacy well above the required levels.

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 nationalisation. 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, 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.

However, putting Basel II in place is going to be far more challenging than Basel I. Assuming that the banks can get over the technological and operational hurdles, switching over to Basel II norms can no doubt turn the Indian banks, mainly the PSBs, more efficient and competitive globally. This, in turn, will help strengthen the financial sector to undertake further reforms including capital account convertibility more confidently.

At the same time, the question needs to be answered whether too much regulation will stifle bank credit growth which is already decelerating. Recent developments such as the Sarfaesi Act and the shrinking of the loan impairment period to 90 days is believed to have had a dampening effect on the demand for bank credit. Rushing into Basel II might make it worse. As the G-10 governors have rightly suggested, other countries could adopt the new framework "at their own pace, based on their own priorities''.

(The author is an economist with Indian Overseas Bank. He can be contacted at dvenu@vsnl.net)