The Hindu Business Line : Making sense of Basel II norms

IN 1988, the Bank for International Settlement (BIS)-based Basel Committee on Banking Supervision came out with regulations regarding the capital requirements of banks. Although these were essentially intended for internationally operating banks, in due course, almost all countries adopted the regulations for their banks.

The crux of the Basel I requirements is the assignment of risk weights for different assets in a bank's book and aggregating the risk-weighted assets, of which 8 per cent was recommended as the capital of the bank.

The Committee's recommendations were not mandatory, but the world's central banks speeded up the process of compliance, particularly following the East Asian crisis and the collapse of certain hedge funds in New York, which threatened to bring down banking systems of the US and the developed world.

India adopted Basel I norms in 1992, closely following the inception of economic reforms.

The history of evolution of capital adequacy norms is interesting. One of the reasons for the US initiative with BIS (the central bank of central banks) culminating in Basel I norms was the desire of US political circles to level the playing field between US banks and competing banks, particularly from Japan.

Mr Paul Volcker, the then chairman of the US Federal Reserve, was able to get the Basel Committee to endorse a universal basis for assigning a uniform ratio of 8 per cent after weights for risks to various assets.

One of the problems perceived in Basel I norms was that the assignment of risk weights to individual classes of asset was not based on any detailed appraisal of risks.

All sovereign debt, in general, was given a risk weight of zero, while all corporate debt was given a weight of 100 per cent, irrespective of the difference in risk of the corporate concerned.

The risk weights led to some curious behaviour in lending. Banks started preferring to lend to governments, which required no capital addition, while even risk-free corporates, which had good rating, demanded additional capital.

This was a general complaint, which had its variations in regard to the differential treatment of governments in OECD (organisation for economic cooperation and development) and others, who were treated as more risky.

Be this as it may, the Basel Committee started work on a revision in the 1990s and issued an amended version in 1999.

The version was widely debated and after consultation, a revised Basel II document came out in June 2004.

The Reserve Bank of India (RBI) started its own consultative process involving various banks and other experts. It has now come out with its final draft version of Basel II, which is to become operational from 2007.

In the interim, RBI has invited comments.

The Basel II version as drafted by RBI in its letter dated February 15, 2005, is a comprehensive set of instructions, which will initiate a parallel run by banks starting in 2006.

The instructions go into great detail regarding the various classifications of the assets and the weights to be assigned.

The classification is, in fact, quite sophisticated. The RBI's draftsmen seemed to have excelled even the BIS experts in the "granularity" of the details they have gone into.

What remains is for each bank to adopt one of the methods suggested in the circular for assessing its risk weighted capital.

In its initial version, the Basel II had been criticised for introducing external rating agencies to do the risk assessment of the assets portofolios of various bank.

In its draft, the RBI has suggested this as an option, taking care to confine the rating agencies to a list approved by the Securities and Exchange Board of India (SEBI) and the RBI.

The other option is to do an internal rating , which has to be by the RBI after being cleared by SEBI.

While detailed risk assessment by the bank as indicated by the RBI is welcome, one wonders whether the game is worth the candle.

Whether the minute distinction between risk weights for different classes of assets is worth making, considering that we know little about the distribution of the probability of default of different loans, is not clear.

In any event, the RBI's circular will provide employment opportunities for a number of chartered accountants and bank analysts as consultants, to help banks assess the risks of their portfolios.

As an experienced chartered accountant observed in the context of the Sarbanes Oxley Act in the US, some regulations are employment-intensive. Such seems to be the unintended, but inevitable, feature of the February 15, 2005 circular of RBI on Basel II.

The consultative process initiated by the RBI will definitely elicit a number of suggestions for improvement of the circular, both in detail and in general .

Here a few points for the RBI to consider.

While the instructions in RBI's circular are quite detailed, they are also quite complex.

While there is no disagreement that the subject matter is difficult, was it necessary to make instructions almost an exercise in academics, ?

Most of our banks are used to capital requirements as per the old instructions, which called for respecting capital asset management earnings and liquidity, all captured in the acronym "Camel".

It requires a great deal of training to get our bankers to understand the sophistication of the new instructions, which may be simple for the experts at the RBI, but not for those in the various banking outposts of India.

The argument may be that the analysis is required to be done only at the headquarters, still the assessment of risks for individual loans has to be done at the points of delivery where levels of sophistication will be less.

Whether there is adequate gain in the detailed listing of asset classes and the risks attached to justify the labour involved is a matter to be explored in detail.

At this point of time, RBI is only thinking of a parallel run. Hopefully, the parallel run will disclose strengths and weaknesses in the present system, which it can correct.

While the RBI adopts a sensible approach of assigning 75 per cent risk weight to loans to small scale industries, one wonders whether a further sophistication is not possible when the loans are fully collateralised.

The instructions are quite detailed regarding the adjustment for collateral. In this context, the prejudice against residential mortgages as collateral shown in the draft requires reconsideration.

After all, most middle-income entrepreneurs have necessarily to offer residences as collateral. To disqualify this is unjust. The proposal discourages such mortgages as an offset to the debt valued at its face value.

The risk weights prescribed do help to introduce a bias in lending. It is, therefore, worthwhile looking, in particular, at the risk weights generally for loans secured against residential property.

This will hit housing finance companies and banks engaged in housing loans particularly.

To quote from the draft "claims fully secured by mortgages on residential property, or will be occupied by the borrower, shall be risk-weighted at 75 per cent". So will investment in mortgage-backed securities. It seems worth the while for RBI to revisit this issue, considering that loans against residential houses have substantially better repayment records. This also goes against the declared government policy of encouraging housing activity. RBI's risk weight should not be biased against lending for houses.

So far as the details of other risk weights are concerned noteworthy is a paragraph , which prescribes a risk weight of 100 per cent for investments up to 30 per cent in the paid-up equity of financial entities, which are not consolidated for capital purpose with the bank.

This will discourage banks from investing in other financial entities, such as special purpose vehicles, which may be needed for development purposes. In any event, government will need to study the implications of the risks from the point of view of their declared goal of strengthening the capital of existing banks, both in the public and the private sectors.

In this context, an intriguing provision in the RBI's instructions is that the banks' investments in equity or debt in other banks should not exceed 10 per cent of the investing banks' capital funds — Tier-I + Tier-II. Any investment in excess of this limit shall be deducted at 50 per cent from Tier-I and 50 per cent from Tier-II. This would seem to be contrary to the intention of the Finance Minister that Indian banks should strive to reach global stature.

He was referring to the possibilities of merger, where it will be difficult to regulate to such an extent that investment shall not exceed 10 per cent of the investing banks' capital funds if the targeted institution is a large entity.The revised Basel II instructions do not come as surprise to the commercial and industrial community at large. But it is important that their implications on bankers' lending behaviour are deliberated in detail before they become part of a regulatory structure. They should enable, not frustrate, the policy goal of financial deepening and economic development.

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