The Hindu Business Line : How `adequate' is Basel II

THE Bank for International Settlements has, for over the last decade and a half, been grappling with the issue of how much capital a bank should have.

After scanning the environment in which banks operate and understanding the risks involved, the BIS arrived at the minimum capital requirement for banks as 8 per cent of risk weighted assets.

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 MRC was accepted and a time-table 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.

In recent times, the Basel II norms, which the banks are expected to implement from 2006, have been the subject of much discussion.

Basel II norms and how they differ from Basel I

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 insofar 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 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 recognises 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.

There is a lot of merit in Basel II recommendations and there can be no doubt that implementation of the same will improve the stability and strength of the banking sector.

Also, it must be recognised that some adverse selection could also result, negating the intended benefits of Basel II. It will be obvious that all banks will be driven to improve their credit quality by concentrating on lending to top-notch customers which are relatively fewer at this point in time in India.

As it is, triple-A corporates are chased by the banks and the trend is for such borrowers to set the price of loan products. The fallout will be that banks' margins will be hit and protection will come in the form of lowering interest on deposits.

On the other hand, banks that for some reason cannot bring to books high-class credits, will be able get a higher yield from loan assets enabling them to pay higher rate of interest on deposits. There will, thus, be one set of banks with high quality assets paying lower interest on deposits and another paying higher interest on deposits but having riskier assets. Given the understanding of lay public about risk, one can imagine where deposits will flow. Recent history on cooperative banks is testimony to the point.

Basel II might result in weaker banks being patronised by depositors due to lure of higher interest. Thus, the very purpose of prescribing minimum capital as a fallback in times of crises to protect depositors may not be achieved.

Strong borrowers are generally large corporates and in their attempt to keep borrowing costs down the tendency is to avail large limits. Being triple A, capital allocation under Basel II will be lower for such credits. The situation, thus, can be between one bank with few but very strong credit assets, say, with capital allocation of 5 per cent and another with

large number of smaller marginal credit assets with capital allocation of, say, 8 per cent.

In the event of an Enron-type happening, which will take greater hit? The bank perceived to be strong with lesser MRC or that perceived as weak and with higher MRC, and for reasons stated earlier, paying higher interest on deposits? Which bank is safer from the depositor perspective?

The industry — banks and regulators — may want to consider and come up with safeguards.

(The author, a well-experienced banker, is now a consultant on debt management.)