As per the RBI document, the provisions of the new Capital Accord are applicable only to scheduled commercial banks. This can have an undesirable outcome.

Institutions under the new Capital Accord may charge customers a higher price for day-to-day banking activities to make up for the additional cost of operational risk capital. As a result, customers could be driven to institutions charging lower rates. Typically, such institutions will be able to charge a lower rate because they won't be required to adopt the new RBI capital adequacy norms.

This may create a situation where customers have an incentive to opt for riskier banks. This surely is not the intention of the RBI.

It is in the interest of the financial community to seek clarity from the regulator on some questions. One, what will the criteria be for allowing banks to migrate to the advanced approaches under Basel II? And, two, is there a roadmap the banks can follow to comply with these approaches?

By laying down clear guidelines the RBI will be assisting banks in planning their resource allocation to adopt the advanced approaches. Without such guidelines, adoption of the approaches may be delayed as banks will not be clear on when and how they will get returns for making the additional investments.

By not allowing use of the advanced approaches under Basel II, the RBI might be being too cautious and missing an opportunity to upgrade the banking risk management practices.

The RBI document states, "Banks in India will be allowed to use only the standard supervisory haircuts for both the exposure as well as the collateral." Not allowing development of internal haircuts under the Standardised Approach may prevent the development of internal modelling and analysis capabilities.

Basel II norms have been debated for quite some time now. Some issues are outstanding and are being discussed in various forums. The current RBI document does not vary from the existing Basel II position. The following instances come to mind.

Double default: The impact of credit-protection like guarantees does not take into account the extra safety because of the need for a double default (that is, both the obligor and the guarantor need to default) before a loss is incurred.

Portfolio diversification effects: Both the Basel Accord and the RBI's document ignore the diversification benefits of a portfolio of assets. That diversification reduces risk — a well-known golden rule in risk management. Why then should this not be practised for capital adequacy calculations?

The RBI should consider providing thought leadership in these areas and take proactive steps by moving forward on existing concerns with Basel II.

The supervisory review process is integral to Basel II under Pillar 2. This only gets a cursory mention in the RBI document.

Pillar 2 is critical for the success of Basel II because it is the foundation for robust risk-management practices. That, after all, should be the real purpose of the new capital adequacy framework.

The final Basel Accord puts the primary responsibility of assessing and maintaining capital requirements on banks. It suggests that banks put in place the necessary processes for doing this.

The key processes to be put in place are senior management oversight, sound capital assessment, comprehensive assessment of risks, monitoring and reporting and internal controls review.

The Accord emphasises the need for regulators to develop the capability to evaluate risk profile and capital adequacy of banks and take corrective action, where necessary.

Similar guidelines would be invaluable for the Indian banking industry's journey towards better risk management. The need to improve risk management and control environment probably precedes the need to use advanced techniques. Should the RBI proposals not have provided guidelines for improving internal as well as external supervision?

As per the RBI document, the claims denominated in Indian rupees on banks operating in India will be risk weighted as under:

(i) All exposures to scheduled banks will be assigned a risk weight one category less favourable than the Sovereign. Hence, all claims on these banks will be risk weighted at 20 per cent.

(ii) All exposures on other banks will be assigned a risk weight of 100 per cent. If the RBI wishes to strengthen the banking system then the norms for risk weighting exposure should apply to bank exposures as well. Not all banks are on the same financial footing as others. Therefore, applying the same risk weight (20 per cent) on exposures to all banks does not offer banks any capital incentive to employ prudential practices while deciding on counter-party bank exposure limits.

Bank failures are not new in India. In fact, a few examples from the recent past come readily to mind, Nedungadi Bank (merged with Punjab National Bank) and Global Trust Bank (merged with Oriental Bank of Commerce).

Banks should be sensitised to the fact that lending to other banks is also fraught with risk. They should be just as diligent as when they are lending to corporates.

Another positive fallout of using bank ratings for capital calculation is that banks will have to be rated by a recognised agency to benefit from a lower capital charge. This rating, once in the public domain, can serve as a risk indicator to investors and depositors.

Under the Standardised Approach for credit risk, risk weights assigned to credit exposures will depend on the rating of the obligor or the particular issue. This makes the role of the credit rating agencies critical in the capital adequacy process.

The RBI proposes to undertake the process of identifying eligible credit rating agencies "in due course". The RBI should specify the criteria for an eligible rating agency at the outset.

For instance, the Basel II document proposes six parameters — objectivity, independence, international access/transparency, disclosure, resources and credibility — to evaluate credit rating agencies for eligibility.

A declaration of the criteria will enable credit rating agencies to prepare for their new role in the banking sector.

For example, it will clarify to the credit rating agencies the resources that they will need to upgrade their internal rating methodologies.

Developing rules and guidelines for the rating industry in India remains an unfinished agenda of the RBI. The rating and banking industry need to initiate the debate.

As adopting the new Accord may result in increased capital requirements for some banks, an impact study by the RBI on the additional capital requirement will benefit banks and the financial community. Such a study will help banks and investors prepare for the capital mobilisation that will follow.

There is an air of reform in India today. India is becoming a significant global economic player. The engines of commerce are roaring. It is imperative for the financial service industry keep pace.

Reforming the Indian banking sector is already on the political agenda. Therefore, it is paramount that the banking industry and all its stakeholders begin an earnest discussion on what needs to be done.

The RBI's new capital adequacy proposal invites discussion. The banking industry will need to make itself heard.

(The authors are senior consultants with the Banking Domain Competency Group of Infosys Technologies and core members of the company's Basel 2 team. The views are personal. Feedback may be sent to mohit_charnalia@infosys.com and vaidyanathan_v@infosys.com)

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