The Hindu Business Line : The Basel-II blushes

BANKS, being highly leveraged entities, need to guard against failures, which could cause significant distress to the economy. Basel-I norms were principally to ensure adequacy of capital of banks as a defined proportion of the risk weighted assets. These norms, however, do not take into account, the riskiness of individual asset, but adopt a broad-brush approach, on the basis of asset class. This `one-size-fits-all' model has given place to the more sophisticated Basel-II.

It is a three-pillar approach, one dealing with the measurement of minimum capital, the second with the supervisory review process (or risk-based supervision) and the third addressing issues of market discipline.

These norms essentially focus on corporate governance, in particular risk management. They aim at minimising the pro-cyclical swings seen in the banks' credit cycle. They explain how risks can change, as capital requirements respond to changes in the real underlying risk.

The supervisory review process of the New Accord is not only to ensure that banks have adequate capital to support all the risks in their business, but also to encourage banks to develop and use better risk management techniques in monitoring and managing their risks.

The supervisory review process recognises the responsibility of bank management in developing an internal capital assessment process and setting up capital targets commensurate with the bank's risk profile and control environment. In the New Accord, bank management continues to bear responsibility for ensuring adequate capital to support risks beyond the core minimum requirement.

Supervisors are expected to evaluate how well banks are assessing their capital needs relative to their risks and to intervene, where appropriate. This interaction is foster an active dialogue between banks and supervisors such that when deficiencies are identified, prompt and decisive action can be taken to reduce risk or restore capital.

Accordingly, supervisors may wish to focus on banks whose risk profile or operational experience warrants such attention. The intention of the Basel committee does not appear to be the reduction of the regulatory capital but to render it more risk-sensitive so as to deflect the debate to risk management, not just measurement of capital.

Currently, only credit and market risks attract capital charges. Will efficient risk management result in lesser regulatory capital for banks? Yes and no. Regulatory capital could be less for banks efficient in risk management and more for inefficient banks. But the new charge for operational risk could mean more capital than the present levels. Will the banks become less pro-cyclical, if risk management improves? The answer is yes. Basel-II requires banks to increase capital if loans get riskier. But banking system overall will be better capitalised and, hence, less vulnerable to cyclical shocks. However, badly capitalised banks that have not assessed their risks properly will face problems.

Analysts caution that Basel-II could cause more severe business cycles. Basel-II rules convert the probability that a borrower will default, the size and maturity of the loan and the bank's exposure at default into a capital charge. Other things being equal, the higher the probability of default, the higher the capital charges. During recession, there is higher probability of default and hence the need for higher capital charges, forcing the banks to tighten credit norms, which could accentuate recession.

Operational risk management is an additional dimension added in the draft. Banks need to provide additional regulatory capital charge for operational risk. Since major operational risk events are infrequent, some analysts feel an insurance arrangement is a better risk management strategy rather than a capital charge.

Basel-II is known for complicated risk management models and complex data requirements. Big international banks, as those in the US, prefer this new version, as they perceive that their superior technology and systems would make them Basel compliant and provide an edge in the competitive environment, in the form of lower regulatory capital.

But European banks are worried that they would be required to invest billions of dollars in upscaling their technology for data collection, so as to remain competitive. They are equally worried about the effectiveness of the regulatory oversight as they are conglomerates of various nations. In fact, some analysts even suspect that Basel-II is a clever way of imposing the US hegemony on international banking.

Indian banks do not perceive any immediate value in the new norms as they are globally insignificant players with simple and straight forward balance-sheet structures. In fact, Indian banks have fragile capital structures vis-a-vis world standards.

Surprisingly, they have been distributing huge dividends, unmindful of the low capital base. It is in this context that the recent Reserve Bank of India guidelines, linking dividend payments to the level of net non-performing assets is welcome.

Technology providers evidently welcome the New Accord as they perceive a mega business opportunity in the sale and service of sophisticated technologies to the banks to render them Basel compliant.

(The author, an Associate Dean of ICFAI University, is Consulting Editor of Professional Banker. He can be contacted at nrkaturi@yahoo.co.in)