Chamelidevi Group of Institution

School Of Management

Assignment on

“BASEL”

Submitted to: Submitted by:

Prof. Manish Joshi Mayank masih

PGDM IIIrd sem

 History

The Basel Committee was formed in response to the messy liquidation of a Cologne-
based bank in 1974. On 26 June 1974, a number of banks had released Deutschmark to
the Bank Herstatt in exchange for dollar payments deliverable in New York. On account
of differences in the time zones, there was a lag in the dollar payment to the counter-party
banks, and during this gap, and before the dollar payments could be effected in New
York, the Bank Herstatt was liquidated by German regulators.

This incident prompted the G-10 nations to form towards the end of 1974, the Basel
Committee on Banking Supervision, under the auspices of the Bank of International
Settlements (BIS) located in Basel, Switzerland.

The major impetus for the 1988 Basel Capital Accord was the concern of the Governors
of the G10 central banks that the capital of the world's major banks had become
dangerously low after persistent erosion through competition. Capital is necessary for
banks as a cushion against losses and it provides an incentive for the owners of the
business to manage it in a prudent manner
 Implementation in India

Ever since its introduction in 1988, capital adequacy ratio has become an important
benchmark to assess the financial strength and soundness of banks. It has been successful
in enhancing competitive equality by ensuring level playing field for banks of different
nationality. A survey conducted for 129 countries participating in the ninth International
Conference of Banking Supervision showed that in 1996, more than 90% of the 129
countries applied Basel-like risk weighted capital adequacy requirement. Reserve Bank
of India introduced risk assets ratio system as a capital adequacy measure in 1992, in line
with the capital measurement system introduced by the Basel Committee in 1988, which
takes into account the risk element in various types of funded balance sheet items as well
as non-funded off-balance sheet exposures. Capital adequacy ratio is calculated on the
basis of various degrees of risk weights attributed to different types of assets. As per
current RBI guidelines, Indian banks are required to achieve capital adequacy ratio of 9%
(as against the Basel Committee stipulation of 8%.
 About the Basel Committee

The Basel Committee on Banking Supervision provides a forum for regular cooperation
on banking supervisory matters. Its objective is to enhance understanding of key
supervisory issues and improve the quality of banking supervision worldwide. It seeks to
do so by exchanging information on national supervisory issues, approaches and
techniques, with a view to promoting common understanding. At times, the Committee
uses this common understanding to develop guidelines and supervisory standards in areas
where they are considered desirable. In this regard, the Committee is best known for its
international standards on capital adequacy; the Core Principles for Effective Banking
Supervision; and the Concordat on cross-border banking supervision.

The Committee's members come from Argentina, Australia, Belgium, Brazil, Canada,
China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea,
Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa,
Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. The
present Chairman of the Committee is Mr Nout Wellink, President of the Netherlands
Bank.

The Committee encourages contacts and cooperation among its members and other
banking supervisory authorities. It circulates to supervisors throughout the world both
published and unpublished papers providing guidance on banking supervisory matters.
Contacts have been further strengthened by an International Conference of Banking
Supervisors (ICBS) which takes place every two years.

What was the need?

The Committee was formed in response to the messy liquidation of a Cologne-based

bank (Herstatt) in 1974. On 26 June 1974, a number of banks had released Deutsche
Mark (German Mark) to the Bank Herstatt in exchange for dollar payments deliverable in
New York. On account of differences in the time zones, there was a lag in the dollar
payment to the counter-party banks, and during this gap, and before the dollar payments
could be effected in New York, the Bank Herstatt was liquidated by German regulators.
 Basel I

It is the term which refers to a round of deliberations by central bankers from around the
world, and in 1988, the Basel Committee (BCBS) in Basel, Switzerland, published a set
of minimal capital requirements for banks. This is also known as the 1988 Basel Accord,
and was enforced by law in the Group of Ten (G-10) countries in 1992, with Japanese
banks permitted an extended transition period. Basel I is now widely viewed as out
modeled, and a more comprehensive set of guidelines, known as Basel II are in the
process of implementation by several countries.

History of Basel I

The Committee was formed in response to the messy liquidation of a Cologne-based

bank in 1974. On 26 June 1974, a number of banks had released Deutschmark to the
Bank Herstatt in exchange for dollar payments deliverable in New York. On account of
differences in the time zones, there was a lag in the dollar payment to the counter-party
banks, and during this gap, and before the dollar payments could be effected in New
York, the Bank Herstatt was liquidated by German regulators.

This incident prompted the G-10 nations to form towards the end of 1974, the Basel
Committee on Banking Supervision, under the auspices of the Bank of International
Settlements (BIS) located in Basel, Switzerland.

Capital Adequacy Ratio - Basle Accord 1988

The growing concern of commercial banks regarding international competitiveness and

capital ratios led to the Basle Capital Accord 1988. The accord sets down the agreement
among the G-10 central banks to apply common minimum capital standards to their
banking industries, to be achieved by year end 1992. The standards are almost entirely
addressed to credit risk, the main risk incurred by banks. The document consists of two
main sections, which cover:
1.The definition of capital and

2.The structure of risk weights.

Based on the Basel norms, the RBI also issued similar capital adequacy norms for the
Indian banks. According to these guidelines, the banks will have to identify their Tier-I
and Tier-II capital and assign risk weights to the assets. Having done this they will have
to assess the Capital to Risk Weighted Assets Ratio (CRAR). The minimum CRAR
which the Indian banks are required to meet is set at 9 percent.

.Why Basel II

The new framework intends to provide approaches which are both more
comprehensive and more sensitive to risks than the 1988 Accord,

While maintaining the overall level of regulatory capital. Capital requirements that are
more in line with underlying risks will allow banks to manage their businesses more
efficiently. The new framework is less prescriptive than the original Accord. At its
simplest, the framework is somewhat more complex than the old, but it offers a range of
approaches for banks capable of using more risk-sensitive analytical methodologies.
These inevitably require more detail in their application and hence a thicker rule book.
The Committee believes the benefits of a regime in which capital is aligned more closely
to risk significantly exceed the costs, with the result that the banking system should be
safer, sounder, and more efficient.
What is Basel II

Basel 2 is the new capital accord signed in June 2004 at Bank for International Settlement
located at Basel, Switzerland. It is an improvement over Basel 1 which had certain
deficiencies which have now been removed. Basel 2 is based on three pillars: capital
adequacy, supervisory review and market discipline. It is basically concerned with
financial health of the banks worldwide. The focus in Basel 2 is the risk determination
and quantification of credit risk, market risk and operational risk faced by banks. Reserve
Bank of India has accepted the accord and issued guidelines to ensure compliance with
the norms by March 31, 2008. Other scheduled commercial banks are required to
implement Basel 2 by March 31, 2009.

Rationale for a new Accord: need for more flexibility and risk sensitivity

The existing Accord The proposed new Accord

Focus on a single risk measure More emphasis on banks’ own internal

methodologies, supervisory review, and

market discipline
One size fits all Flexibility, menu of approaches, incentives

for better risk management

Broad brush structure

More risk sensitivity

Basel II is basically a Risk Management Exercise

 Doesn’t seek to change business models of the Bank.

 But requires to fine-tune/update Risk Management practices.

 Robust enough to capture all possible Risks the Bank is facing or likely to
face.

 Initiate adequate and appropriate Risk Mitigation measures through effective

Systems and Procedures

Objectives of the New Basel Accord

Broadly speaking, the objectives of Basel II are to encourage better and more systematic
risk management practices, especially in the area of credit risk, and to provide improved
measures of capital adequacy for the benefit of supervisors and the marketplace more
generally. At the outset of the process of developing the new Accord, the Basel
Committee developed the so-called three pillars approach to capital adequacy involving

Reasons:

Safety and soundness in today’s dynamic and complex financial system can be attained
only by the combination of effective bank-level management, market discipline, and
supervision. The 1988 Accord focused on the total amount of bank capital, which is vital
in reducing the risk of bank insolvency and the potential cost of a bank’s failure for
depositors. Building on this, the new framework intends to improve safety and soundness
in the financial system by placing more emphasis on banks’ own internal control and
management, the supervisory review process, and market discipline.

Although the new framework’s focus is primarily on internationally active banks, its
underlying principles are intended to be suitable for application to banks of varying levels
of complexity and sophistication. The Committee has consulted with supervisors
worldwide in developing the new framework and expects the New Accord to be adhered
to by all significant banks within a certain period of time.

The 1988 Accord provided essentially only one option for measuring the appropriate
capital of internationally active banks. The best way to measure, manage and mitigate
risks, however, differs from bank to bank. An Amendment was introduced in 1996 which
focused on trading risks and allowed some banks for the first time to use their own
systems to measure their market risks. The new framework provides a spectrum of
approaches from simple to advanced methodologies for the measurement of both credit
risk and operational risk in determining capital levels. It provides a flexible structure in
which banks, subject to supervisory review, will adopt approaches which best fit their
level of sophistication and their risk profile. The framework also deliberately builds in
rewards for stronger and more accurate risk measurement.

ISSUES AND CHALLENGES

While there is no second opinion regarding the purpose, necessity and usefulness of the
proposed new accord – the techniques and methods suggested in the consultative
document would pose considerable implementation challenges for the banks especially in
a developing country like India.

Capital Requirement: The new norms will almost invariably increase capital
requirement in all banks across the board. Although capital requirement for credit risk
may go down due to adoption of more risk sensitive models – such advantage will be
more than offset by additional capital charge for operational risk and increased capital
requirement for market risk. This partly explains the current trend of consolidation in the
banking industry.

Profitability: Competition among banks for highly rated corporates needing lower
amount of capital may exert pressure on already thinning interest spread. Further, huge
implementation cost may also impact profitability for smaller banks.

Risk Management Architecture: The new standards are an amalgam of

international best practices and calls for introduction of advanced risk management
system with wider application throughout the organization. It would be a daunting task to
create the required level of technological architecture and human skill across the
institution.

Rating Requirement: Although there are a few credit rating agencies in India – the
level of rating penetration is very low. A study revealed that in 1999, out of 9640
borrowers enjoying fund-based working capital facilities from banks – only 300 were
rated by major agencies. Further, rating is a lagging indicator of the credit risk and the
agencies have poor track record in this respect. There is a possibility of rating blackmail
through unsolicited rating. Moreover rating in India is restricted to issues and not issuers.
Encouraging rating of issuers would be a challenge.

Choice of Alternative Approaches: The new framework provides for alternative

approaches for Computation of capital requirement of various risks. However,
competitive advantage of IRB approach may lead to domination of this approach among
big banks. Banks adopting IRB approach will be more sensitive than those adopting
standardized approach. This may result in high-risk assets flowing to banks on
standardized approach - as they would require lesser capital for these assets than banks on
IRB approach. Hence, the system as a whole may maintain lower capital than warranted
and become more vulnerable. It is to be considered whether in our quest for perfect
standards, we have lost the only universally accepted standard. Absence of Historical
Database: Computation of probability of default, loss given default, migration mapping
and supervisory validation require creation of historical database, which is a time
consuming process and may require initial support from the supervisor. Incentive to
Remain Unrated: In case of unrated sovereigns, banks and corporates the prescribed risk
weight is 100%, whereas in case of those entities with lowest rating, the risk weight is
150%. This may create incentive for the category of counterparties, which anticipate
lower rating to remain unrated.

Supervisory Framework: Implementation of Basel II norms will prove a

challenging task for the bank supervisors as well. Given the paucity of supervisory
resources there is a need to reorient the resource deployment strategy. Supervisory cadre
has to be properly trained for understanding of critical issues for risk profiling of
supervised entities and validating and guiding development of complex IRB models

Corporate Governance Issues:

Basel II proposals underscore the interaction between sound risk management practices
and corporate good governance. The bank’s board of directors has the responsibility for
setting the basic tolerance levels for various types of risk. It should also ensure that
management establishes a framework for assessing the risks, develop a system to relate
risk to the bank’s capital levels and establish a method for monitoring compliance with
internal policies.

National Discretion: Basel II norms set out a number of areas where national
supervisor will need to determine the specific definitions, approaches or thresholds that
wish to adopt in implementing the proposals. The criteria used by supervisors in making
these determinations should draw upon domestic market practice and experience and be
consistent with the objectives of Basel II norms.

Disclosure Regime: Pillar 3 purports to enforce market discipline through stricter

disclosure requirement. While admitting that such disclosure may be useful for
supervisory authorities and rating agencies – the expertise and ability of the general
public to comprehend and interpret disclosed information is open to question. Moreover,
too much disclosure may cause information overload and may even damage financial
position of bank.

Disadvantage for Smaller Banks:

The new framework is very complex and difficult to understand. It calls for revamping
the entire management information system and allocation of substantial resources.
Therefore, it may be out of reach for many smaller banks. As Moody’s Investors Services
puts it, “It is unlikely that these banks will have the financial resources, intellectual
capital, skills and large scale commitment that larger competitors have to build
sophisticated systems to allocate regulatory capital optimally for both credit and
operational risks.”

Discriminatory against Developing Countries:

Developing counties have high concentration of lower rated borrowers. The calibration of
IRB has lesser incentives to lend to such borrowers. This, along with withdrawal of
uniform risk weight of 0% on sovereign claims may result in overall reduction in lending
by internationally active banks in developing countries and increase their cost of
borrowing.

External and Internal Auditors: The working Group set up by the Basel Committee to
look into

Implemetational issues observed that supervisors may wish to involve third parties, such
a external auditors, internal auditors and consultants to assist them carrying out some of
the duties under Basel II. The precondition is that there should be a suitably developed
national accounting and auditing standards and framework, which are in line with the best
international practices. A

minimum qualifying criteria for firms should be those that have a dedicated financial
services or banking division that is properly researched and have proven ability to
respond to training and upgrades required of its own staff to complete the tasks
adequately.

With the implementation of the new framework, internal auditors may become
increasingly involved in various processes, including validation and of the accuracy of
the data inputs, review of activities performed by credit functions and assessment of a
bank’s capital assessment process.

BASEL II GUIDELINES

 Basel II Committee set up by Bank for International Settlements (BIS) released

the first version of Basel II in June 2006.

 A Comprehensive Version, incorporating amendments to relating to Market

Risks, Trading Activities and the Treatment of Double Default Effects, was
released in June 2006.

 Basel II Guidelines in Indian context were finalized by RBI, after due

deliberations and brain-storming by select 14-member Committee of Banks from
Public Sector and Private Sector.

Our Bank is also a member and headed the Sub-Committee on ‘National Discretion’.

Conclusion:
There are two problems. The Basel Accord is designed by rich countries, and is not
appropriate for other countries. Yet it is increasingly a legal requirement for all countries.
Something needs to change: if the Accord is to apply to all, it should be made more
appropriate for developing countries. Alternatively, it should cease to be an obligation.
Developing countries should cooperate, probably at the regional level, to design their
own variants. These variants should probably be simple, rule-based, non-discretionary,
and have inbuilt redundancy. No regime can fully correct for government or market
failure, but a regime designed to be robust to government failure is more likely not to fail
completely.

Implementation of Basel III has been described as a long journey rather than a destination
by itself. Undoubtedly, it would require commitment of substantial capital and human
resources on the part of both banks and the supervisors. RBI has decided to follow a
consultative process while implementing Basel III norms and move in a gradual,
sequential and co-ordinate manner. For this purpose, dialogue has already been initiated
with the stakeholders. As envisaged by the Basel Committee, all the professionals will
make a positive contribution in this respect to make Indian banking system stronger.