The Hindu Business Line : Basle II norms: Challenge and opportunity for Indian banks

THE traditional face of banks as mere financial intermediaries has changed because of the paradigm shifts from balance-sheet to off-balance-sheet intermediation, from capital adequacy to capital efficiency, and pure banking to financial services.

Appropriate risk management architecture is a function of the size, complexity of business, risk philosophy, market perception and the level of capital of banks. Competition needs to foster convergence towards best practices in risk management because of the growing role of market forces and the need for internationally consistent prudential norms.

Domestic financial integration cannot be looked at in isolation from the global system. In a completely integrated financial system, the vulnerabilities of any player are quickly transmitted to others. Banks have to develop a near foolproof system, with adequate supervisory and regulatory safeguards, and protection against risks.

Financial liberalisation tends to increase financial fragility. The "one-size-fits-all" approach of Basle I recognised only credit risk without considering market, operational and liquidity risks and was confined to a broad-band categorisation of credit exposures without distinguishing between differing risk profiles and risk management standards across banks, equal allocation of risk weights, and so on.

Reinforcing pillars

Basle II, which is based on three "mutually reinforcing" pillars of minimum capital requirements (shift from regulatory to economic capital), supervisory review (review of risk management process) and market discipline (core-principle: mandatory disclosure-supplementary principle- institution specific), provides options for banks and banking systems to determine the capital requirements for credit and operational risks and enables banks/supervisors to select appropriate approaches for their operations and financial markets.

This comprehensive coverage of risks, enhanced risk sensitivity of capital requirements and flexible menu of options for a refined measurement of capital requirements have important implications for Indian banking given the inadequacy of both historic and current dataand the low level of rating penetration.

Credit, market and operational risk

A bank generally faces credit, market and operational risks. Although lending is the most obvious source of credit risk, risk practically stems from banking and trading activity, both on and off the balance-sheet.

The implementation of the risk policy principles is fraught with difficulties. Reviewing and monitoring of collateral in terms of appropriate valuation, maintenance of margins and shortfalls and examining limits to different businesses are also called for.

Principles for the management of credit risk stress that senior management is responsible for implementing a structured credit policy with focus on approval processes, administration processes and controls on problem areas.

Market risk emanates from market dynamics, such as variations in interest rates, foreign exchange rates, maturity mismatches, credit spreads, and equity and commodity prices, structural risks, legal restrictions, regulatory requirements, limitations of local funding or hedging markets, use of non-cash market instruments, such as futures, forwards and swaps, and position-taking and balance sheet flexibility.

Efficient liquidity planning requires the development and maintenance of various models for market risk exposures, liquidity planning under alternative scenarios, prudential limits, and liquidity review. In a floating interest rate scenario, banks may price their assets and liabilities to different benchmarks to counter non-parallel movements in the yield curve.

For management of foreign exchange, appropriate limits for open position and gaps for each trading currency will need to be fixed.

Operational risk from inadequate or failed internal processes, people or systems or from external events such as natural disasters, enemy attacks, failure of IT infrastructure, frauds by employees/vendors or rogue traders is systemic.

The establishment of an operational risk framework is essential. This includes control processes, development of operational risk measurement/modelling methodologies, management reporting systems and governance mechanisms, including review of the procedures m and developments in core banking and business policy.

Approaches to quantifying capital requirements

The "calibration" of alternative regimes in calculating regulatory capital requirements is expected to encourage banks to implement sophisticated mechanisms to lower capital requirement. While the regulator set the risk weights under Basle-I, banks enjoy flexibility under Basle-II, subject to certain prerequisites.

Two principal methods of measuring standardised market risk are a "maturity" method and a "duration" method. As "duration" method is a more accurate method of measuring interest rate risk, standardised duration method has been adopted to arrive at the capital charge. Accordingly, banks are required to measure the general market risk charge by calculating the price sensitivity (modified duration) of each position separately. The credit risk model estimates the probability of loans default and links it to capital charge.

Factors such as data limitations, parameter specification and estimation, model validation and stress-testing, however, hamper the applicability of these models in setting regulatory capital.

Reality check

While Basle-II better aligns regulatory capital with actual risk, it transcends regulatory compliance to provide banks an opportunity to achieve distinctive competitive advantage by adroit risk management. These recommendations, which are more risk-sensitive, would impact capital requirement, profitability, risk management, borrowers, rating agencies, technology and asset quality in different ways.

The current shortfall in banking capital (estimated at between $6 billion and $8billion) is likely to rise with burgeoning bank lending. Banking capital could be shored up by public equity offers, venture capital, selling stakes to large foreign banks to meet fluctuations in capital requirements stemming from fluctuating quality of risk exposures and fully meet all elements of expected losses by provisioning.

Most banks require streamlined risk management - identification, control and mitigation of risk, prudent asset liability mix, adequate capital provision, transparency and disclosure norms. Implementation of Basle-II guidelines requires vastly improved IT architecture for business decisions and to cope appropriately with the Pillar 3 disclosure requirements.

These include bank-wise loan policy, streamlining credit delegation, prudential limits for single/group borrowers/industries and sensitive sectors/regions. It also requires sharing of information on bad debts and defaulters among banks, advanced risk measures linked to variation, duration and better gap analysis and developing systems to measure and control operational risks. Introducing a comprehensive credit rating system covering all exposures and stress-testing it for efficiency will be a major real-time challenge for the banks. Capacity-building, both in banks and the regulatory bodies, requires streamlined MIS, reskilling staff and enhanced supervisory capabilities, development of domestic rating agencies, increased rating penetration and improved governance standards and oversight.

The challenges are many but the payoff could be huge in terms of putting the banking system in sync with international best practices and giving it enhanced strength and resilience.

(The author is Chief Economist, Canara Bank, Bangalore.)

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Opening strategic windows

Farming options in a global village

Can inflationary pressures be ignored?

Is there a way to safely escrow our trust in governance?

Private hospitals

Basle II norms: Challenge and opportunity for Indian banks

FDI in retail: More benefits than costs

Rebuilding `Silicon Valley'