Banking Reforms 1 PDF

REFORMS IN THE BANKING SECTOR
Banking sector reforms were initiated to upgrade the operating standards,

health, and financial soundness of banks to internationally accepted
levels in an increasingly globalised market.
Ankur srivastava
srivankur@rediffmail.com
09212803190
The government of India set up the Naraimham Committee (1991) to

examine all aspects relating to
Structure,
Organisation, and
Functioning
of the Indian banking system.
The recommendation of the committee aimed at creating a competitive
and efficient banking system.
Measures like capital adequacy, income recognition, asset classification,
norms for investment, entry of private sector banks, gradual reduction of
SLR and CRR were recommended and implemented to strengthen the
banking system.
These recommendations changed the face of Indian banking. Public
sector banks faced a stiff competition with the entry of the private sector
banks.
Ankur srivastava
09212803190
Other committees:
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1. Khan committee (1997) constituted to examine the

harmonization of the role & operations of DFI & banks.
Major recommendations (1998) were:
Gradual move towards universal banking.
Exploring the possibility of gainful merger as between banks;
banks & FI; encompassing either strong and weak entities or
two strong ones.
Developing a function specific regulatory framework and a risk
based supervisory framework.
Establishment of a super regulator to supervise and coordinate
the activities of the multiple regulators.
Speedy implementation of legal reforms to hasten debt
recovery.
Reducing CRR to international standards & phasing out SLR.
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2. Verma committee was one of the most controversial

committee.
Major recommendations were:
Greater use of information technology; even in weak public

sector banks.
Restructuring of weak banks but not merging them with the
strong banks.
Market driven merger sale of foreign branches.
Closure of subsidiaries of weak public sector banks.
VRS for at least 25% of the staff.
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The banking sector reforms aimed at:
Improving the policy framework by reducing the

reserve requirements, changing the administered structure
of lending rates, enlarging the scope of priority sector
lending and linking the lending rates with the size of
advances.
Improving the financial health by prescribing
prudential norms.
Improving the institutional infrastructure through
recapitalization, infusing competition, and strengthening of
supervisory system.
Ankur srivastava
09212803190
The chief merit of the reform process is that the reform measures were
undertaken and implemented gradually and cautiously.
The first phase of the banking sectors is complete and the second
generation reforms are under way.
The second generation reforms are those that did not form part of the
first generation reforms but needed to be prioritized in the agenda for the
next decade. Many of the important recommendations of the
Narasimham committee II have been accepted and are under
implementation.
Ankur srivastava
09212803190
The banking reforms concentrate on strengthening the foundation of

banking sector by:
Structure.
Technological up gradation.
Human resource development.
And to move towards international best practices in the areas relating to:
Banking policy,
Institutional,
Supervisory, and
Legislation.
Ankur srivastava
09212803190
Banking sector reforms

Phase I
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Recommendation of the committee of the Banking Sector Reforms,

1991, Narasimham committee I
Deregulation of the interest rate structure.

Progressive reduction in pre-emptive reserves.
Liberalization of the branch expansion policy.
Introduction of prudential norms to
oTo ensure capital adequacy,
oProper income recognition classification of assets based on their
quality, and
oProvisioning against bad and doubtful debts.
contt
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09212803190
contt
Decreasing the emphasis laid on directed credit and phasing out the
concessional rate of interest to priority sector.
Deregulation of the entry norms for the private sector banks and
foreign banks.
Permitting public and private sector banks to access the capital market.
Setting up the asset reconstruction fund.
Constituting the special debt recovery tribunals.
Freedom to appoint chief executive and officers of the banks.
Changes in the constitutions of the board.
Bringing NBFCs under the ambit of regulatory framework.
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09212803190
Recommendation of the committee of the Banking Sector Reforms,

1998, Narasimham committee II
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Capital adequacy
Capital adequacy ratio to be raised from 8% to 10% by 2002.
100% of fixed income portfolio marked-to-market by 2001 (up from
70%).
5% market risk weight for fixed income securities and open foreign
exchange position limits (no market weights previously).
Commercial risk weight (100%) to government guaranteed advances
(previously treated as risk free).
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Asset quality
Banks should aim to reduce gross non-performing assets to 3% and net
NPAs to 0% by 2002.
90 days overdue norm to be applied for cash-based income recognition
(down from 180 days).
Government-guaranteed irregular accounts to be classified as NPA &
provided for.
Asset Reconstruction Company to take on NPA of weak banks against
issue of risk-free bonds.
Directed credit obligations to be reduced from 40% to 10%.
Mandatory general provisions of 1% of standard assets and specific
provision to be made tax-deductible.
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Systems and methods

Banks to start recruitment of skilled, specialized manpower from the
market.
Overstaffing to be dealt with by redeployment and right-sizing via
VRS.
Public sector banks to be given flexibility in remuneration structure.
Rapid introduction of computerization and technology.
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Industry structure
Only two categories of financial sector players to emerge: banks and
non-bank finance companies; DFI to covert to banks or remain nonbanking companies.
Mergers to be driven by market and business considerations, not
imposed by regulators.
Weak banks to convert to narrow banks, restructure, or close down if
proven unviable.
Entry of new private sector banks and foreign banks to continue.
Banks to be given greater functional autonomy, and minimum
government shareholding to be reduced to 33% from 55% for the SBI
and 51% for other public sector banks.
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Regulation and supervision

Banking regulation and supervision to be progressively de linked from
monetary policy.
Board for financial regulation and supervision to be constituted with
statutory powers; board members should be professionals.
Greater emphasis on public disclosure as opposed to disclosure to
regulators.
Legal amendments
Broad range of legal reforms to facilitate recovery of problem loans.
Introduction of laws governing electronic funds transfer.
Amendments in the Banking Regulation Act, the Nationalization Act
and the State Bank of India Act to allow greater autonomy, higher private
sector shareholding, and so on.
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Prudential Regulation
There are two modes for bank regulation:
Economic regulation, and

Prudential regulation
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Economic regulation:
This model calls for:
Imposing constraints on interest rates,
Tightening entry norms, and directed lending.
In the pre-reform era, the RBI regulated banks through economic
regulation. However, the empirical evidences indicated that this
model hampered the productivity and efficiency of the banking
system. Hence, the RBI adopted prudential regulation.
Ankur srivastava
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Prudential regulation
Prudential regulatory model calls for imposing the regulatory capital
level to maintain the health of banks and the soundness of the financial
system. It allows greater play for market forces than economic regulatory
model.
The RBI issued prudential norms based on the recommendations of the
Narasimham committee report.
The major objective of prudential norms was to ensure:
Financial safety,
Financial soundness,
Solvency
of banks.
These norms strive to ensure that banks conduct their business activities
as prudent entities, i.e., not indulging in excessive risk taking and
violating regulations in pursuit of profit.
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Banking reforms were initiated by implementing prudential

norms consisting of capital adequacy ratio, asset
classification, income recognition, and provision.
The core of financial sector reforms has been the
broadening of prudential norms to the best internationally
recognized standards.
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Capital Adequacy and Tier I and Tier II Capital

Banks are required to maintain unimpaired minimum capital funds
equivalent to the prescribed ratio on the aggregate of the risk weighted
assets and other exposures. Capital adequacy ratio is a measure of the
amount of banks capital expressed as a percentage of its risk-weighted
credit exposures.
This capital framework was introduced for Indian scheduled commercial
banks, based on the Basel Committee proposals (1998), which prescribe
two tiers of capital for the banks:
Tier I capital which can absorb losses without a bank being required to
cease trading, and
Tier II capital which can absorb losses in the event of a winding-up.
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Tier I or core capital (the most permanently and readily available

support against unexpected losses) includes:
Paid-up capital, statutory reserves, share premium.
Capital reserve (representing surplus on sale of assets and held in a
separate account only to be included) and other disclosed free
reserves (if any) minus equity investments in subsidiaries, intangible
assets, and losses in the current period, and those brought forward
from previous periods.
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09212803190
Tier II capital includes:

Undisclosed reserves and fully paid-up cumulative perpetual preference
shares.
Revaluation reserves arising out of revaluation of assets that are undervalued
in the banks books (like bank premises and marketable securities).
General provisions and loss reserves, not attributable to the actual diminution
in value or identifiable potential loss in any specific asset and available to meet
unexpected losses.
Hybrid debt capital instruments that combine characteristics of equity & debt.
Subordinated debt that is fully paid up, unsecured, subordinated to the claims
of other creditors, free of restrictive clauses, and not redeemable at the
initiatives of the holder or without the consent of the supervisory authority of
banks. If subordinated debt carries a fixed maturity, it should be subject to
progressive discounts and have an initial maturity of not less than 5 years. Tier
II capital should not be more than 100% of tier I capital and subordinated debt
instruments should be limited to 50% of tier I capital. Revaluation reserve
should be applied a discount of 35% for inclusion in tier II capital. General
provision/loss reserves should not exceed 1.25% of the total weighted risk
asset.
Ankur srivastava
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Banks will have to disclose any shortfall in their capital to depositors and
all stakeholders.
In order to provide additional options to banks for raising capital funds,
the Reserve bank allowed them in January 2006 to issue instruments
such as:
a.Innovative perpetual debt instruments eligible for inclusion as tier I
capital,
b.Debt capital instruments eligible for inclusions as Upper Tier II capital,
c.Perpetual non-cumulative preference shares eligible for inclusion as
Tier II capital, and
d.Redeemable cumulative preference shares eligible for inclusion as Tier
II capital.
Ankur srivastava
09212803190
Capital Adequacy Norms

Banks capital is vital as it is the lifeblood that keeps the bank alive; it
also gives the bank the ability to absorb shocks and thereby, avoid the
likelihood of bankruptcy.
Capital adequacy ratio is a measure of the amount of a banks capital
expressed as a percentage of its risk-weighted credit exposures.
Capital adequacy ratio refers to the risk weight assigned to an asset
raised by the banks in the process of conducting business and to the
proportion of capital to be maintained on such aggregate risk
weighted assets.
The RBI stipulates a CAR of 9% for all banks.
Ankur srivastava
09212803190
The Basel norm of capital adequacy was introduced in India following

the recommendations of the Narasimham Committee (1991).
Globally, the structure and operation of banks underwent a rapid
transformation in the 1980s. This was due to a revolution in information
technology, which led to an increase in competitive among banks and a
fall in profitability of banks.
As a result, there was a growing apprehension about the deteriorating
levels of capital of the banks.
Hence, the Basel Capital Adequacy Norms were enacted in 1988.
Ankur srivastava
09212803190
The Basel Accord (1988) suggested the following principles of capital

adequacy:
A bank must hold equity capital at least 8 % of its assets when
multiplied by appropriate risk weights. The four risk weight suggested by
the Basel Committee was 0%, 1.6%, 4% and 8% for the various
categories of assets.
When capital falls below this minimum requirement, shareholders may
be permitted to retain control provided they agree to recapitalize the
bank.
When this is not done, the regulatory authority may, at its discretion,
sell or liquidity the banks.
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Initially, the RBI directed the banks to maintain a minimum capital of

8% on the risk-weighted assets. The Committee on banking sector
reforms (1998) suggested further tightening of the capital adequacy.
Subsequently the capital to risk-weighted asset ratio (CRAR) norm was
revised upward to 9% to be attained by March 2000.
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The concept of capital adequacy ratio relates to risk weight assigned to

an asset raised by the banks in the process of conducting business and to
the proportion of capital to be maintained on such aggregate riskweighted assets. Capital adequacy ratio is calculated on the basis of risk
weightages on assets in the books of banks. Each business transaction
carries a specific risk and a portion of capital has to be earmarked for this
risk. This portion acts as a secret reserve to cushion any possible future
loss. Higher capital adequacy will drive banks towards greater efficiency
and this could force banks to bring down operating costs. Capital
adequacy enables banks to expand their balance sheet and strengthen
their fundamentals, which, in turn, help the bank to mobilize capital at
reasonable costs. Hence, quality and risk weightage of assets are the new
important parameters which are crucial for the growth of banks.
Ankur srivastava
09212803190
The RBI stipulates a CAR of 9% for all banks and a CAR below this
stipulation indicates the inadequacy of a banks capital, compared to its
assets (largely loan advanced and investments) weighted against the risk
they carry. In other words, the capital for these banks does not match up
to the risk profile of their advances.
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The New Basel Capital Accord
The bank for international settlement (BIS) is an international

organization which fosters international monetary and financial cooperation and serves as a bank for Central banks.
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The Basel committee, established by the Central Bank Governors of the

group countries at the end of 1974, meets regularly four times a year. It
has about 30 technical working groups and task forces which also meet
regularly.
India is a member of G-20 countries that advises the Financial Stability
Forum (FSF). The Core Principle Liaison Group set up the Basel
Committee on Banking Supervision (BCBS) to promote and monitor
principles of banking supervision and the working groups on capital,
which discusses proposals for revising the capital adequacy framework.
India is also an early subscriber to the Special Data Dissemination
Standards (SDDS) and one of the first countries to accept the financial
sector assessment programme of the IMF and the World Bank.
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Different central banks in their own respective countries governed the

banks by the rules set by them. International banks had to adhere to
different regulations in different countries. To provide a level playing
field for banks, the group of 15 most industrialized countries agreed on
some common rules which came to be known as Basel Accord. The
central banks of more than 100 countries adopted it over a period of
time.
The problems in South-east Asian economies, recessionary trends in the
Japanese economy, the financial sector problems encountered in Latin
American economies, and some in European economies emphasized that
capital adequacy norms were not adequate to hedge against failures.
Ankur srivastava
09212803190
These norms (1988) helped to arrest the erosion of the banks capital
ratios. However, they were not found to be adequate due to their
perceived rigidities. Moreover, the financial markets, financial
intermediaries, business of banking, risk management practices, and
supervisory approaches have undergone significant changes.
These baseline capital adequacy norms were found to be inadequate as
they almost entirely addressed credit risk. In response to the same, the
BCBS brought out their Consultative paper on New Capital Adequacy
Framework in June 1999 and a second revision in January 2001 after an
informed public debate. The new rules have been effective from 2005.
The BCBS announced the establishment of an Accord Implementation
Group.
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09212803190
Basle Accord I & II - Differences
Talks of Credit Risk only

Capital Charge for Credit
Risk 8%
Does not mention separate
Capital charge for Market
and Operational Risk
No mention about market
Discipline
No effort to quantify
Market and Operational
Risk
Talks of Credit, Market and

Operational Risks
Capital Charge dependant
on Risk rating of assets
Capital Charge to include
risks arising out of Credit,
Market and Operational
risks. Not a broad brush
approach
Quantitative approach for
calculation of Market and
Operational risks as for
Credit Risk.
Basel II Accord- Need & Goals

Linking of risks with capital in terms of Basel
Accord I needed a revision for the following
reasons:
- Credit assessment under Basel I is not risk
sensitive enough. One Suit fit all approach was
applied to all types of entities with uniform 100%
risk weightage.
- Risk arising out of operation were ignored
though it has potential of affecting the banks
survival.
The primary objectives of the new accord are:

1.The promotion of safety and soundness of the financial system,
2.The enhancement of competitive equality,
3.The constitution of a more comprehensive approach to addressing risk.
The New Basel Accord is based on three mutually reinforcing pillars that
allow banks and supervisors to evaluate properly the various risks that
the banks face.
The Basel II Accord is based on three pillars:
Minimum Capital Requirement
Supervisory review process &
Market discipline
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Three pillars of the Basel II framework
Minimum Capital
Requirements
Supervisory
Review Process
Credit risk
Banks own capital strategy
Operational risk
Supervisors review
Market risk
Market Discipline
Enhanced disclosure
Three Pillars of Basel II

Minimum
Capital
Supervisory
Review
Market
Discipline
The new Basel Accord is based on Three Pillars
Focus on
Advanced
internal
methods for
capabilities
capital
Supervisors to
allocation
review banks
Capital charge
internal
for operational
assessment
risk
and strategies
Focus on
disclosure
40
Framework
The New Basel Capital Accord focuses on the following:

Minimum capital requirements, which seek to refine the
measurement framework, set out in the 1988 accord.
Supervisory review of an institutions capital adequacy and internal

assessment process.
Market discipline through effective disclosure to encourage safe
and sound banking practices.
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Pillar I-Minimum capital requirement (Measurement of

Risk)
The new framework maintains both the current definition of capital and
the minimum requirement of 8% of capital to risk weighted assets. The
revised accord will be extended on a consolidation basis to holding
companies of banking groups. The accord stresses upon the improvement
in the measurement of risks. The new accord has elaborated the credit
risk measurement methods and emphasized the measurement of
operational risk.
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Minimum Capital Requirement

Pillar One
Standardized
Internal Ratings
Credit Risk
Credit Risk Models
Credit Mitigation
Risks
Trading Book
Market Risk
Banking Book
Operational
Other Risks
Other
Pillar I Minimum Capital Requirements

The new Accord maintains the current definition of total capital and the minimum 8% requirement*
Total capital
= Banks capital ratio
Credit risk + Market risk + Operational risk
(minimum 9%)
Total Capital
Total capital = Tier 1 + Tier 2

Tier 1: Shareholders equity + disclosed reserves
Tier 2: Supplementary capital (e.g. undisclosed reserves, provisions)
Credit Risk
The risk of loss arising from default by a creditor or counterparty
Market Risk
The risk of losses in trading positions when prices move adversely
Operational Risk
The risk of loss resulting from inadequate or failed internal processes, people
and systems or from external events
* The revisions affect the denominator of the capital ratio - with more sophisticated measures for credit risk, and introducing an explicit capital charge for operational
risk
Capital Requirement What

New?
1. Minimum Capital RequirementsCredit Risk (Pillar One)

Standardized approach
(External Ratings)
Internal ratings-based approach
Minimum
Capital
Requirement
Foundation approach
Advanced approach
Credit risk modeling

(Sophisticated banks in the future)
The Basel II has recommended three approaches for estimating capital

for credit risk:
The standardized approach: expands the scale of risk weights and
uses external credit ratings to categorize credits. This approach can be
employed by less complex banks.
The foundation internal risk based (IRB) approach: by more
complex banks having more advanced risks management capabilities.
This approach allows the banks to use its internal estimates of the
borrowers creditworthiness to assess credit risk in the portfolio subject
to strict methodological and disclosure standards. One of the most
noteworthy features of Basel II is assigning capital charge for operational
risk. Three approaches namely, basic indicator (BI), standardised (SA)
and advanced measurement (AMA) approaches have been recommended
for estimating capital for operational risk.
The advanced internal risk based (AIRB) approach: calls for
significant investment as compared to the other two approaches.
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Internal Ratings Based Approach

Exposures in five categories because of
different risk characteristics
Sovereigns
Banks
Corporates
Retail
NPA
Evolutionary Structure of the Accord
Credit Risk Modeling ?

Advanced IRB Approach
Foundation IRB Approach
Standardized Approach
Pillar I Credit Risk
Pillar 1 Credit Risk stipulates three levels of increasing sophistication. The more sophisticated
approaches allow a bank to use its internal models to calculate its regulatory capital. Banks who move
up the ladder are rewarded by a reduced capital charge
Advanced Internal
Ratings Based
Approach
Foundation Internal
Ratings
Based Approach
Standardized
Approach
Banks use internal estimations of PD,

loss given default (LGD) and exposure at
default (EAD) to calculate risk weights
for exposure classes
Banks use internal estimations of probability of

default (PD) to calculate risk weights for
exposure classes. Other risk components are
standardized.
Risk weights are based on assessment by

external credit assessment institutions
Reduce Capital requirements
Standardized Approach
Provides Greater Risk Differentiation than 1988

Risk Weights based on external ratings
Five categories [0%, 20%, 50%, 100%, 150%]
The loans considered past due be risk weighted at
150 percent unless a threshold amount of specific
provision has already been set aside by the bank
against the loan
Special treatment for Retail & SME sectors
Standardized Approach:
New Risk Weights (January 2001)
Assessment
Claim
AAA to A+ to A- BBB+ to
AASovereigns
Banks
BBB-
BB- (B-)
(B-)
0%
20%
50%
100%
150%
100%
Option 11
20%
50%
100%
100%
150%
100%
Option 22
20%
50%3
100%3
150%
20%
50%
(100%)
100%
150%
Corporates
1
BB+ to Below BB- Un-rated
50%3
100%
50% 3
100%
Risk weighting based on risk weighting of sovereign in which the bank is incorporated.
Risk weighting based on the assessment of the individual bank.
Claims on banks .of a short original maturity, for example less than six months, would
receive a weighting that is one category more favourable than the usual risk weight on
the banks claims
3
Capital for Credit Risk- Internal Rating Based
Approach:
Three elements:
Risk Components [PD, LGD, EAD]
Risk Weight conversion function
Minimum requirements for the management of policy
and processes
Emphasis on full compliance
EL (Expected Loss) = PDxLGDxEAD
Definitions;
PD = Probability of default
LGD = Loss given default
EAD = Exposure at default
Note: BIS is Proposing 75% for unused commitments
EL = Expected Loss

Market Risk:
(a) Standardised Method
(i) Maturity Method
(ii) Duration Method
(b) Internal Models Method
What is Operational Risk?

Earlier stood for non-financial risks
Current Basel II definition is the risk of loss
resulting from inadequate or failed internal
processes, people and systems or from
external events
Basel II definition
Cont
Includes both internal and external event risk
Legal risk is also included, but reputational risk
not included
Direct losses are included, but indirect losses
(opportunity costs) are not
Examples of OR Loss Events

Types of OR*
Examples
Unauthorized transaction resulting in monetary loss

Embezzlement of funds
Branch robbery
External Fraud
Hacking damage (systems security)
Employment Practices & Employee discrimination issues
Workplace Safety
Inadequate employee health or safety rules
Money laundering
Clients, Products & Business
Lender liability from disclosure violations or
Practices
aggressive sales
Natural disasters, e.g. earthquakes
Damage to Physical Assets
Terrorist activities
Business Disruption and
Utility outage (e.g. blackout)
System Failures
Data entry error
Execution,
Delivery
&
Incomplete or missing legal documents
Process Management
Disputes with vendors/outsourcing
Internal Fraud
* Based on Basel Committees OR loss event classification

Capital Charge for Operational RiskAs in credit, three alternate approaches are
prescribed:
- Basic Indicator Approach
- Standardised Approach
- Advanced Measurement Approach
1). Basic Indicator Approach

(Capital Charge for Operational Risk)
To begin with, RBI has advised bank to

follow Basic Indicator Approach in India
which is 15% of the average Gross Income
over three year.
KBIA = [ (GI*) ] / n,
Where
KBIA = the capital charge under the Basic Indicator Approach.
GI = annual gross income, where positive, over the
previous three
years
=
15% set by the Committee, relating the industry-wide level of required
capital to the industry-wide level of the indicator.
n=
number of the previous three years for which gross income is

positive
Gross income = Net profit (+) Provisions & Contingencies (+) operating
expenses (Schedule 16) (-) profit on sale of HTM investments (-) income from
insurance (-) extraordinary / irregular item of income (+) loss on sale of HTM
investments.
2). Standardized Approach (the betas)

Capital = b*gross income, by business line
Standardized / Alternative Standardized
Banks activities divided (mapped) into 8 business lines
Capital charge is sum of specified % (beta) of each business
lines average annual gross income over previous 3 years*
Beta varies by business line (12%-18% range)
General criteria required to qualify for its use
Active involvement of Board and senior management in OR
management framework
Existence of OR management function, reporting and systems
Systematic tracking of OR data (including losses) by business line
OR processes and systems subject to validation and regular
independent review by internal and external parties
Advantages/ Disadvantages
Strength:
Simplicity
Limitations:
Blunt charge, not risk-sensitive:
One size fits all
Risk does not increase linearly with gross income
Fails to capture effect of banks management of

operational risk
No incorporation of qualitative factors
No incentive for banks to invest in op risk infrastructure
3) Advanced Measurement Approach (AMA)

(Capital Charge for Operational Risk)
Capital = firm specific calculation, statistically based
methodology
Intended to overcome the lack of risk sensitivity in the
simpler approaches by setting regulatory capital based
on the banks internal risk measurement models
These models use the banks own metrics to measure
operational risk, internal loss data, external loss
experience, scenario analysis, and risk mitigation
techniques to set capital commensurate with the
operational risk posed by the banks activities
ADVANTAGE
COMPARING OPERATIONALRISK WITH MARKET RISK AND CREDIT RISK

Market Risk
Credit Risk
Operational Risk
Yes
Yes
Difficult1
Position; Risk sensitivity
Money lent; Potential

exposure
Difficult no ready position

equivalent available1
Known
Known
Unknown
Context
dependency
Low
Medium
High
Data frequency
High
Medium
Low
VAR; Stress testing;

Economic risk capital
Rating models; Loss

models; Economic risk
capital
No industry consensus; top-down

scenarios may be useful
Good
Reasonable
Low
Adequate data for

backtesting
Backtesting difficult to
perform over short term
Results very difficult to test over any

time horizon
Usage issues
Instability of underlying
price volatility;
Correlation instability in
stressed markets
Many issues: correlations,

ratings through time, data
lumpy
Results could be misleading;

distraction effect; false reliance; lack
of cause and effect; redundant
systems
Summary
Market risk models well

established and proven
tools
Using models considered

reasonable but should
be used with care
Models appear flawed
Quantifiable
exposure
Exposure
measure
Portfolio
completeness
Risk assessment
Accuracy
Testing
New Basel Accord II: supervisory review process-
Defines the role of supervisors

with regard to capital adequacy
Pillar II
Pillar II-Supervisory Review Process (Assessment of Risk)

This process emphasizes the need for banks to develop sound internal
processes to assess the capital adequacy based on a thorough evaluation
of its risks and set commensurate targets for capital. The internal
processes would then be responsible for evaluating the way the banks are
measuring risks and the robustness of the systems and processes.
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The four basic and complementary principles on which the Pillar 2 rests
are:
a.A bank should have a process for assessing its overall capital adequacy
in relation to its risk profile as well as a strategy for maintaining its
capital levels;
b.Supervisors should review and evaluate a banks internal capital
adequacy assessment and strategy as well as its compliance with
regulatory capital ratios;
c.Supervisors expect banks to operate above the minimum regulatory
capital ratios and should have the ability to require banks to hold capital
in excess of the minimum; and
d.Supervisors should seek to intervene at an early stage to prevent capital
from dipping below prudential levels.
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09212803190
Implementation of Pillar II requires that a comprehensive assessment of

risks be carried out by both the banks (internally) and the supervisor
(externally).
A Board for Financial Supervision has been set up with an Advisory
Council to strengthen the supervisory system of banks and an
independent Department of Banking Supervision has been set up in the
RBI to assist the board
Ankur srivastava
09212803190
New Basel Accord II:

Market Discipline
Disclosure requirements that
allow market participants to
assess key information about a
banks risk profile and level of
capitalisation.
Pillar-III
Pillar III-Market Discipline (Disclosure/Transparency)

Market discipline can be bolstered through enhanced disclosure by
banks. The new framework sets out disclosure requirements in several
areas, including the way in which banks calculate their capital adequacy
and their risk assessment methods. The transparency and disclosure
standards recommended in the IAS have been implemented in a phased
manner. Banks are required to ensure that there are no qualifications by
the auditors in their financial statements for non-compliance with any of
the standards. Banks are now required to disclose maturity pattern of
deposits, borrowings, investments, advances, foreign currency assets and
liabilities, movements in NPA, lending to sensitive sectors, total
investments made in equity share, convertible debentures and equity
oriented mutual funds and movement of provisions held towards
depreciation of investments.
Ankur srivastava
09212803190
Basel I
Basel II
Focused on Single risk

Measure
More emphasis on banks own internal risk

management methodologies, supervisory review
and market discipline
One-size-fits- all
Flexibility; Menu of approaches; Capital

incentive for better risk management;
Granularity in the valuation of assets and type of
business and in the risk profile of their systems
and operations
Broad Brush structure
More risk sensitive; multi-dimensional; focus on

all operational components of banks
Table 1: Comparison of Basel I and Basel II standards Source: The new Basel
capital accord: an explanatory note, BIS
Ankur srivastava
09212803190

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REFORMS IN THE BANKING SECTOR

Banking sector reforms were initiated to upgrade the operating standards,

The government of India set up the Naraimham Committee (1991) to

1. Khan committee (1997) constituted to examine the

2. Verma committee was one of the most controversial

Greater use of information technology; even in weak public

The banking sector reforms aimed at:

Improving the policy framework by reducing the

The banking reforms concentrate on strengthening the foundation of

Banking sector reforms

Recommendation of the committee of the Banking Sector Reforms,

Deregulation of the interest rate structure.

Recommendation of the committee of the Banking Sector Reforms,

Systems and methods

Regulation and supervision

Economic regulation, and

Banking reforms were initiated by implementing prudential

Capital Adequacy and Tier I and Tier II Capital

Tier I or core capital (the most permanently and readily available

Tier II capital includes:

Capital Adequacy Norms

The Basel norm of capital adequacy was introduced in India following

The Basel Accord (1988) suggested the following principles of capital

Initially, the RBI directed the banks to maintain a minimum capital of

The concept of capital adequacy ratio relates to risk weight assigned to

The New Basel Capital Accord

The bank for international settlement (BIS) is an international

The Basel committee, established by the Central Bank Governors of the

Different central banks in their own respective countries governed the

Basle Accord I & II - Differences

Talks of Credit Risk only

Talks of Credit, Market and

Basel II Accord- Need & Goals

The primary objectives of the new accord are:

Three pillars of the Basel II framework

Banks own capital strategy

Three Pillars of Basel II

The new Basel Accord is based on Three Pillars

The New Basel Capital Accord focuses on the following:

Supervisory review of an institutions capital adequacy and internal

Pillar I-Minimum capital requirement (Measurement of

Minimum Capital Requirement

Pillar I Minimum Capital Requirements

Total capital = Tier 1 + Tier 2

The risk of loss arising from default by a creditor or counterparty

The risk of losses in trading positions when prices move adversely

Capital Requirement What

1. Minimum Capital RequirementsCredit Risk (Pillar One)

Credit risk modeling

The Basel II has recommended three approaches for estimating capital

Internal Ratings Based Approach

Evolutionary Structure of the Accord

Credit Risk Modeling ?

Pillar I Credit Risk

Banks use internal estimations of PD,

Banks use internal estimations of probability of

Risk weights are based on assessment by

Reduce Capital requirements

The New Basel Capital Accord

Provides Greater Risk Differentiation than 1988

BB+ to Below BB- Un-rated

Risk weighting based on the assessment of the individual bank.

The New Basel Capital Accord