The Hindu Business Line : Basel II - Credit risk magnified in India

Truly it is said that the "Devil is in the details". The Reserve Bank of India has sprung a surprise by hiking up the capital charge for credit risk on loans of banks. This has been done through a minor provision in the guideline for new capital adequacy framework (commonly known as Basel II norms) issued recently by the RBI.

Generally, Basel II brought in additional capital requirements for "Operational Risk" and the norms were perceived to be neutral or more beneficial to banks in regard to credit risk. But in India, banks have been hit hard in regard to credit risk on un-rated borrowers.

To trace the origin of Basel rules, banks exist primarily to take deposits from public and lend to industry, business and others. These loans carry "credit risk", i.e., loan becoming bad (non-performing). Since banks operate largely with deposits from the public, regulators and Governments are worried that banks might be tempted to operate on thin capital and expose depositors to undue risks. Therefore, banks world over are required to keep a specified percentage of their loan portfolio as "Capital" so that, when a loan goes sour, the loss is borne by capital and not by depositors. The rules were originally framed about two decades ago by a group of international banks and Indian banks have also adopted them. The rules, named "Basel I norms" proved to be deficient/inadequate over the years and a revised set of rules called "Basel II norms" were framed some years ago. These are complex and acceptance in many countries is taking time.

Credit risks

Basel rules encompass credit, market and operational risks. In this article, we discuss one facet of credit risks. In Basel I, banks were required to keep at least 8 per cent of their credit portfolio as "Capital", the idea being that even if a bank were to suffer a loss up to 8 per cent on its loans, the depositors should not suffer. Since, the aim was to protect the depositors, "Capital" was given a wide definition: it included, besides shareholders' funds, also long-term loans obtained by banks, which need not be repaid before all the depositors are paid off, i.e., subordinated to depositors' claims. The latter was called "Tier II" capital. In addition to loans, credit facilities include guarantees, letters of credit and other commitments of banks, which have the potential to become funded claims on banks, if the customer were to fail. Initially, the RBI adopted the international norms and asked banks to maintain 8 per cent of their credit exposure as capital. Subsequently, the level was raised to 9 per cent by the RBI, although internationally it is kept at 8 per cent.

Major criticisms

Three of the major criticisms against Basel I norms were: 1) The norms treated all borrowers alike; 2) No weightage was given to availability of security for a credit facility; and 3) It treated loans of varying maturity in the same manner. All these issues were suitably addressed in Basel II rules. Taking the last point first, the original rule prescribed the same amount of capital whether the loan was for a short period of a few months or for a very long period of 10 years or more. Any seasoned lender knows that longer the period of a loan, the greater the risk attached to it. Basel II has not fully dealt with the problem, but made some distinctions between short and long-term loans given by one bank to another.

Regarding the second point, due consideration is given in Basel II for the value of security, while computing the capital charge for a loan. To the extent covered by realizable value of security after doing "haircuts" (reckoning reduction in value, in the event of forced sale, etc), there need be no capital charge for the credit facility.

Turning to the first issue, in Basel I, banks were required to keep 8 per cent of loan as capital, whether the borrower is a first class blue chip company, with little, if any, risk, or it is a third rate company with poor track record. Basel II ordained that depending on the creditworthiness of the borrower, the capital to be kept could vary. For the highest rated borrower - carrying the lowest risk - the weightage is 20 per cent. Thus for such a borrower, banks need to keep only 20 per cent of 8 per cent or 1.6 per cent of the credit exposure as capital. Five different risk weights, 20 per cent, 30 per cent, 50 per cent, 100 per cent and 150 per cent have been prescribed.

The RBI has adopted this, but has retained the higher base level of 9 per cent (against 8 per cent in other countries).

The question arose as to how the "credit worthiness" is to be determined. It was decided to adopt the rating accorded by independent credit rating agencies. The three biggest, worldwide, are Standard & Poor, Moodys and Fitch. It appears, however, that these agencies were not fully comfortable with banks and regulators solely depending on their ratings; currently, they not answerable to anyone, barring the "market", viz, if they fail, the market can punish them by discounting or discarding their ratings.

After examination, it was decided that the credit rating given by banks themselves for borrowers could be adopted, over a period of time. All banks of some standing `rate' their borrowers to assess the risk posed by them and thereby to fix interest rate, as higher the risk, larger should be the reward or interest rate. The rating was based on the financial health, past track record and future prospects of the borrower. But then, the regulators were not quite sure about the robustness of the credit rating model adopted by each bank. Therefore, it was felt that the rating model should be validated: it should be found to be in order, by validation or confirmation of the efficacy of the model from past experience.

Graduated approach

Conceding that a bank's own rating model is more acceptable than that of another agency, a graduated approach is adopted. Initially, the rating agencies' judgment will be accepted, in "Standardized Approach". Later, when any bank's own rating model is validated, "Internal Rating" models will be accepted; here again, in the first stage it will be Foundation approach and later Advanced approach. The RBI has decided that all banks in India will, for the present, adopt only Standardized approach for credit risk measurement. This will be applicable to "foreign banks operating in India and Indian banks having operational presence outside India" with effect from March 31, 2008 and for all other commercial banks (except regional rural banks and local area banks) with effect from March 31, 2009. All these are applicable to corporate and larger borrowers. Smaller borrowers enjoying facilities up to Rs 5 crore would be classified as "Retail" and a credit risk weight of 75 per cent (6.75 per cent capital) is specified.

In the standardised approach, there is an inexplicable provision. For the lowest rated borrower, the weight is 150 per cent, whereas for an un-rated (one who has not obtained any rating from a rating agency), the weight is 100 per cent. The RBI has followed this rule with a caveat. "To begin with, for the financial year 2008-09, all fresh sanctions or renewals in respect of un-rated claims on corporates in excess of Rs 50 crore will attract a risk weight of 150 per cent". With effect from April 1, 2009, all such exposures in excess of Rs 10 crore will attract a risk weight of 150 per cent.

Since hardly about 400 non-financial companies seem to have been rated for their bond issues by Crisil, the leading rating agency, the rule will mean that in a large number of advances, the risk weight is increased by 50 per cent. To amplify, the threshold of Rs 10 crore includes loans, guarantees, letters of credit, foreign exchange exposures etc. Many corporate and non-corporate borrowers in diamond, construction, textile industries and others would be covered by this rule. It is doubtful if the four rating agencies in India are currently equipped to do the rating of such large number of borrowers.

If they ramp up their operations, for this purpose, in a short time, will their output not suffer in quality?

The most important issue is why a borrower (not rated by an agency) is necessarily considered to carry the highest risk. Has any quick review been done to warrant capital of 13.5 per cent (150 per cent of 9 per cent) for such exposures? Given that the average levels of net NPA of scheduled commercial banks in India has gradually come down from 5.50 per cent in 2001-02 to 1.20 per cent in 2005-06 (source: RBI's Annual Report on Trend & Progress of Banking in India 2005-06), the level of capital prescribed by the RBI for un-rated borrowers does appear unreasonably high.

Another minor issue is the treatment meted out to cash credit exposures by the RBI. Admitting that a cash credit may be sanctioned for a period of one year or less, the RBI mentions that these exposures tend to be rolled over and therefore, cash credit is reckoned as long-term exposure.

While every lending banker knows that cash credit is the longest of the long-term loans, still the bank has the legal right not to renew or roll over the loan at the end of one year or so; such a right is absent in long-term loans. Therefore, it stands to logic that cash credit ought to be treated as short-term loan.

The above two issues, increasing capital charge for un-rated exposure and treating cash credit as long-term loan need to be reviewed by the RBI and modified, lest banks in India are given a raw deal, compared to their counterparts in other countries. Will the Indian Banks Association take up the matter suitably with the RBI?

(The author is former Deputy Managing Director of SBI)