c

c c

BASEL II NORMS
ROLL NO 7, 11,15,16,17
<
c
c
c
 c c
 c
c  c c c
c c< c c cc
 <cc c cc
c  c c cc
<
<c c

 c
 c c
 c


 c
 c  c
 c


 c
 cc c

c
c 

j
ccjjc


c  ccj c  c

c 
 c

c INTRODUCTION AND OBJECTIVE OF THE REPORT 3

c PILLAR 1 5

c CREDIT RISK Ȃ IRB APPROACH AND OBJECT FINANCE 8

c PILLAR 2 16

c PILLAR 3 17

c THE IMPLEMENTATION IN INDIAN BANKS- ISSUES AND 18

CHALLENGES

c
c 


j ccjc  jc

To study:
ôc Object financing guidelines under Basel 2 Norms, and
ôc Deal with Basel 2 norms and their impact on banking in general.

  cc
c c

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.

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.

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

The Committee does not possess any formal supranational supervisory authority, and
its conclusions do not, and were never intended to, hav e legal force. Rather, it
formulates broad supervisory standards and guidelines and recommends statements of
best practice in the expectation that individual authorities will take steps to implement
them through detailed arrangements - statutory or otherwise - which are best suited to
their own national systems.

cc c

Basel I, that is, the 1988 Basel Accord, primarily focused on credit risk. Assets of banks
were classified and grouped in five categories according to credit risk, carrying risk
weights of zero (for example home country sovereign debt), ten, twenty, fifty, and up to
one hundred percent (this category has, as an example, most corporate debt). Banks
with international presence are required to hold capital equal to 8 % of the risk-
weighted assets.
c 

Since 1988, this framework has been progressively introduced in member countries of
G-10, currently comprising 13 countries, namely, Belgium, Canada, France, Germany,
Italy, Japan, Luxembourg, Netherlands, Spain, Sweden, Switzerland, United Kingdom
and the United States of America.

cc c

c is the second of the Basel Accords, which are recommendations on banking
laws and regulations issued by the Basel Committee on Banking Supervision. The
purpose of Basel II, which was initially published in June 2004, is to create an
international standard that banking regulators can use when creating regulations about
how much capital banks need to put aside to guard against the types of financial and
operational risks banks face.

Basel II attempts to accomplish this by setting up rigorous risk and capital management
requirements designed to ensure that a bank holds capital reserves appropriate to the
risk the bank exposes itself to through its lending and investment practices.

c cc c

1) c Ensuring that capital allocation is more risk sensitive;

2) c Separating operational risk from credit risk, and quantifying both;
3) c Attempting to align economic and regulatory capital more closely to reduce the
scope for regulatory arbitrage.

BASEL II uses a l!"c#"l concept:

(1) Minimum capital requirements (addressing risk),

(2) Supervisory review and
(3) Market discipline Ȃ to promote greater stability in the financial system.

cc c
In response to the recent financial crisis, the Basel Committee on Banking Supervision
(BCBS) set forth to update their guidelines for capital and banking regulations:

On December 19, 2009 the BCBS issued a press release which presented to the public
two consultative documents for review and comment:

ôc Strengthening the resilience of the banking sector

ôc International framework for liquidity risk measurement, standards and
monitoring
c 

$"%c&'c!()c"&#&*c(c
c c

ôc First, the quality, consistency, and transparency of the capital base will be raised.
ôc Second, the risk coverage of the capital framework will be strengthened.
ôc Third, the Committee will introduce a leverage ratio as a supplementary measure
to the Basel II risk-based framework.
ôc Fourth, the Committee is introducing a series of measures to promote the build-
up of capital buffers in good times that can be drawn upon in periods of stress
("Reducing procyclicality and promoting countercyclical buffers").
ôc Fifth, the Committee is introducing a global minimum liquidity standard for
internationally active banks that includes a 30-day liquidity coverage ratio
requirement underpinned by a longer-term structural liquidity ratio.

"cc

The first pillar sets out minimum capital requirement. The new framework maintains
minimum capital requirement of 8% of risk assets. Under the new accord capital
adequacy ratio will be measured as underȄ
Total capital (unchanged) = (TierI+ TierII+ Tier III)/Risk Weighed Assets = Credit risk+
Market risk + Operational risk (Tier III capital has not yet been introduced in India.)
c (+$*c c ",c (&-.c &#"&(c ",c /c +"*c ",c /c ",c ",
Keeping in
view RBI's goal to have consistency and harmony with international standards, it has
been decided that all commercial banks in India shall adopt Standardized Approach
(SA) for credit risk and Basic Indicator Approach (BIA) for operational risk. Banks shall
continue to apply the Standardized Duration Approach (SDA) for computing capital
requirement for market risks.

Under the Standardized Approach, the rating assigned by the eligible external credit
rating agencies will largely support the measure of credit risk. RBI has identified
external credit rating agencies that meet the eligibility criteria specified under the
revised Framework. Banks may rely upon the ratings assigned by the external credit
rating agencies chosen by the RBI for assigning risk weights for capital adequacy
purposes.

The RBI decided that banks may use the ratings of the following domestic credit rating
agencies for the purposes of risk weighting their claims for capital adequacy purposes:
a) Credit Analysis and Research Ltd. b) CRISIL Ltd. c) FITCH Ltd. and d) ICRA Ltd. Banks
may use the ratings of the following international credit rating agencies for the
purposes of risk weighting their claims for capital adequacy purposes a) Fitch; b)
Moody's; and c) Standard & Poor's.

Banks should use the chosen credit rating agencies and their ratings consistently for
c c c

hct cc
i crcthcris cw i hti c
cris c


tcurs s c
 sc ustc
iss cth c
sccth cr itcr
ti
c

i scth
tcth cus crcth cris cw i
hti
cc
th irc
ss ts cth cris cw i
htsc
ssi
t cwithcth c
rtiu
rcr
ti
c
r
 sc
sc t r i c
c RIc rc
hc i
i c r itc r
ti
c

c
sc w c
sc th c

r

t c ris c w i
ht c

ss ts cFrcist
 cIus
c
 c t r citccwithcRI ILc
c
h

c
 c
t r citccwithcREcrcr
ti
c
iitc
scr uir cu rc
s cII c
^
 0


  
   ^  
^

 jh c st

ri c
r
hc isc
 tu
c th c s
c
sc th c
r s tc
rc utc isc r c ris c
< !"!#$%!c <%'*"##$#& c s siti c jh c 
 c

t sc
c

c

"&'(


"&'( )",%-&".
ris c w i
htc tc
hc c itsc
ss tsc

c 

 c sh tc sitisc
)&* !#& c

c ru sc
c su c c ris c
!+ '%!c


w i
ht c
ss tc 
u sc c ris c
w i
htc c c
sc th
tc
c
xsur c isc iu c ic th c 
u
tic c ris c w i
ht c
ss tsc 
u c whihc tr
s
t sc
itc
c
it
ch
r
c u
ctcccth
tc
u cIiiu
cris cw i
htcurr tc  sc
cth cr
c
t
rccrrw rci cs r i
c
 scrcrr
t c





 


   ^
1 

 rcth cIRc
r
hc
 scwic c
w ccth csu risrsctcus cth ircit r
c
sti
t sc c ris c   tsc tc
ss ssc r itc ris c ic th irc rtisc su tc tc stritc
th
i
c
c issur c st

rsc c 
 c sti
t sc
hc rrw rǯsc
r itwrthi ssc
cth cr sutsc
r ctr
s
t citc sti
t scc
cutur ct ti
cssc

utcwhihcr cth c
siscc ii u c
it
cr uir tscc

jh cris c  tsciu c
sur sccc

ôc Pr
iitcc 
utcP c c c Lssc!i c 
utcL! cc

ôc Exsur c
tc 
utcE c
cc c E ti c
turitcc

c
c c c


^  



 0  


 sc ustc
c th c s uriti
tic r
wr c rc  t r ii

c r
u
trc 
it
c
r uir tcc xsur c
risi
cr cs uriti
tic
 scth
tc
cth cst

ri c

r
hctcr itcris crcth cu ri
c xsur c ustcus cth cst

ri c
r
hc
u rcth cs uriti
ticr
wr c"i i
rc
 scth
tch
 cr  i c
r
ctcus c
IRc
r
hc rc th c t c c u ri
c xsur c ustc us c th c IRc
r
hc rc th c
s uriti
tic

 0
 0

sc  rc th c
ui i sc ii u c
 
 
it
c r uir tc isc xr ss c ic
 t r sc c twc s 
r
t c 
u
t c
h
r
s c
 %" 1c
< !"!#$%!c


"&'(
&!%1c
0%!c
c" iicRis c
ccc c c cc


"&'(
c!  r
c
r tcRis c

*"#/c *"#& c 
^^ 0#c 
it
c h
r

c rc

0%!
0%!
s iic ris c isc  si
 c tc rt tc



istc
c
 rs c  tcicri cc
ciiiu
cs uritcu ctc
trscr 
t ctc
iiiu
cissu rcjhisciscsi i
rctcr itcris cjh cs iicris ch
r
sc
r cii citc

riusc
t
ri scsuhc
sci st tscic!ǯtcs uriti sc
i scc
 sci st tsc
ic rt


c 
 c s uriti sc s uriti c 
 rsc tc
c 
it
c h
r
c rc
hc

t
rcs ii c






  0
 0#c
it
ch
r
crc
 r
c
r tcris cisc si
 ctc
tur cth c
ris c c ssc
risi
c r c h

sc ic
r tc it r stc r
t sc jh c 
s c  itt c
su

st ctwcr
c th
i scrc ut
ticc
it
ch
r
crc
r tcris c
i c"t

ri c thc
cIt r
cRis c


tc c thcc



ic u rc "t

ri c  thc th r c
r c twc rii c thsc rc
suri
c

r tc ris c$c
turitc thc
c ur
tic thc sc ur
tic thc isc
c r c

ur
t c thcc
suri
cit r stcr
t cris cRIcr  rscth
tc
 sc
sur c
cc
th irc
 r
c
r tcris cc
u
ti
cth cri cs sitiitc ii cur
ticc
hc
sitics 
r
t c





 0

^
^     ^




  rc th c 
sic ii
trc

r
hc
 sc
r cr uir c
!+ '%!c

0#'c !#'&"c < !"!#$%!c
%0*"%,% c


"&'(

"&'(


"&'(
c 2

to hold capital for operational risk equal to the average over the previous three years of
a fixed percentage (15% - denoted as alpha) of annual gross income. Gross income is
defined as net interest income plus net non-interest income, excluding realized
profit/losses from the sale of securities in the banking book and extraordinary and
irregular items.

 j   c    c

Under the standardized approach, bank s activities are divided into eight business lines.
Within each business line, gross income is considered as a broad indicator for the likely
scale of operational risk. Capital charge for each business line is calculated by
multiplying gross income by a factor (denoted beta) assigned to that business line. Total
capital charge is calculated as the three-year average of the simple summations of the
regulatory capital across each of the business line in each year.

 c   jc    c

Under advanced measurement approach, the regulatory capital will be equal to the risk
measures generated by the bank s internal risk measurement system using the
prescribed quantitative and qualitative criteria.

  jc 0c2cj c j  c j 3
c   c

The risk components include measures of the probability of default (PD), loss given
default (LGD), the exposure at default (EAD), and effective maturity (M).

^

 
 

c Under the IRB approach, banks must categorize banking-book exposures into
broad classes of assets with different underlying risk characteristics, subject to
the definitions set out below. The classes of assets are (a) corporate, (b)
sovereign, (c) bank, (d) retail, and (e) equity.

c Within the corporate asset class, five sub-classes of specialized lending are
separately identified.

c Within the retail asset class, three sub-classes are separately identified.

c Within the corporate and retail asset classes, a distinct treatment for purchased
receivables may also apply provided certain conditions are met.

^
  

c In general, a corporate exposure is defined as a debt obligation of a corporation,

partnership, or proprietorship. Banks are permitted to distinguish separately
exposures to small- and medium-sized entities (SME)
c 3

c Within the corporate asset class, five sub-classes of specialized lending (SL) are
identified. Such lending possesses all the following characteristics, either in legal
form or economic substance:

c The exposure is typically to an entity (often a special purpose entity

(SPE)) which was created specifically to finance and/or operate physical
assets;

c The borrowing entity has little or no other material assets or activities,

and therefore little or no independent capacity to repay the obligation,
apart from the income that it receives from the asset(s) being financed;

c The terms of the obligation give the lender a substantial degree of control
over the asset(s) and the income that it generates; and

c As a result of the preceding factors, the primary source of repayment of

the obligation is the income generated by the asset(s), rather than the
independent capacity of a broader commercial enterprise.

<  

c  jc    c Project finance (PF) is a method of funding in which the lender
looks primarily to the revenues generated by a single project, both as the source
of repayment and as security for the exposure. This type of financing is usually
for large, complex and expensive installations that might include, for example,
power plants, chemical processing plants, mines, transportation infrastructure,
environment, and telecommunications infrastructure. Project finance may take
the form of financing of the construction of a new capital installation, or
refinancing of an existing installation, with or without improvements .In such
transactions, the lender is usually paid solely or almost exclusively out of the
money generated by the contracts for the facility s output, such as the electricity
sold by a power plant. The borrower is usually an SPE that is not permitted to
perform any function other than developing, owning, and operating the
installation. The consequence is that repayment depends primarily on the
project s cash flow and on the collateral value of the project s assets. In contrast,
if repayment of the exposure depends primarily on a well-established,
diversified, credit-worthy, contractually obligated end user for repayment, it is
considered a secured exposure to that end-user.
c
c 
jc    cObject finance (OF) refers to a method of funding the acquisition
of physical assets(e.g. ships, aircraft, satellites, railcars, and fleets) where the
repayment of the exposure is dependent on the cash flows generated by the
specific assets that have been financed and pledged or assigned to the lender. A
primary source of these cash flows might be rental or lease contracts with one or
several third parties. In contrast, if the exposure is to a borrower whose financial
c 4

condition and debt-servicing capacity enables it to repay the debt withoutundue

reliance on the specifically pledged assets, the exposure should be treated as
acollateralised corporate exposure.

·c   j c   c

åc 3   c  cj jc

c   3  j  j4c  c  cj jc

There are three key elements

a.c Risk components
estimates of risk parameters provided by banks some

of which are supervisory estimates.

b. c Risk-weight functions
the means by which risk components are

transformed into risk-weighted assets and therefore capital
requirements.

c.c Minimum requirements
the minimum standards that must be met in

order for a bank to use the IRB approach for a given asset class.

For many of the asset classes, 2 approaches are available

1. c Foundation approach: Under the foundation approach, banks must provide thei r
own estimates of PD associated with each of their borrower grades, but must use
supervisory estimates for the other relevant risk components. The other risk
components are LGD, EAD and M.

Exception for SL category assets§Banks that do not meet the requirements for
the estimation of PD under the corporate foundation approach for their SL assets
are required to map their internal risk grades to five supervisory categories, each
of which is associated with a specific risk weight. This version is termed the
Ǯsupervisory slotting criteria approach .

2. c Advanced approach: Under the advanced approach, banks must calculate the
effective maturity (M) 67 and provide their own estimates of PD, LGD and EAD.

3 
 

 
      

c 3
 


 
 

c 3
 

3

c Banks that do not meet the requirements for the estimation of PD under the
corporate IRB approach will be required to map their internal grades to five
supervisory categories, each of which is associated with a specific risk weight.
c 

c Although banks are expected to map their internal ratings to the supervisory
categories for specialised lending using the slotting criteria provided in Annex 6,
each supervisory category broadly corresponds to a range of external credit
assessments as outlined below.

c

 c
 ccc 
c c c

c
c 

c
c 

c
c 

c
c 

c
c
c
c 

  c c   4c  5c c 1c

It requires the banks to develop an Internal Capital Adequacy Assessment Process

(ICAAP) which should encompass their whole risk universe Ȃ by addressing all those
risks which are either not fully captured or not at all captured under the other two
Pillars Ȃ and assign an appropriate amount of capital, internally, for all such risks,
commensurate with their risk profile and control environment. Under the Supervisory
Review, the supervisors would conduct a detailed examination of the ICAAP of the
banks, and if warranted, could prescribe a higher capital requirement, over and above
the minimum capital ratio envisaged in Pillar 1.

 j cc   4c  5 c

The supervisory review process of the Framework is intended 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 recognizes the responsibility of bank management in
developing an internal capital assessment process and setting capital targets that are
commensurate with the bank s risk profile and control environment. In the Framework,
bank management continues to bear responsibility for ensuring that the bank has
adequate capital to support its risks beyond the core minimum requirements.
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 intended
to 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.
Capital should not be regarded as a substitute for addressing fundamentally inadequate
control or risk management processes.

 c04c  cc   4c  5 c

"(+#c Banks should have a process for assessing their overall capital adequacy in
relation to their risk profile and a strategy for maintaining their capital levels.
Banks must be able to demonstrate that chosen internal capital targets are well founded
and that these targets are consistent with their overall risk profile and current
operating environment. In assessing capital adequacy, bank management needs to be
mindful of the particular stage of the business cycle in which the bank is operating.
The five main features of a rigorous process are as follows:
ôc Board and senior management oversight
ôc Sound capital assessment
ôc Comprehensive assessment of risks
ôc Monitoring and reporting
c 

ôc Internal control review

"(+#c  Supervisors should review and evaluate banks internal capital adequacy
assessments and strategies, as well as their ability to monitor and ensure their
compliance with regulatory capital ratios. Supervisors should take appropriate
supervisory action if they are not satisfied with the result of this process. Supervisors
should also evaluate the degree to which a bank has in place a sound internal process to
assess capital adequacy. The emphasis of the review should be on the quality of the
bank s risk management and controls and should not result in supervisors functioning
as bank management. The periodic review can involve some combination of:
ôc On-site examinations or inspections
ôc Off-site review
ôc Discussions with bank management
ôc Review of work done by external auditors (provided it is adequately focused on
the necessary capital issues)
ôc Periodic reporting.

"(+#c Supervisors should 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. Pillar 1 capital requirements will include a buffer for uncertainties
surrounding the Pillar 1 regime that affect the banking population as a whole. Bank-
specific uncertainties will be treated under Pillar 2. Supervisors will need to consider
whether the particular features of the markets for which they are responsible are
adequately covered. Supervisors will typically require (or encourage) banks to operate
with a buffer, over and above the Pillar 1 standard.

"(+#c  Supervisors should seek to intervene at an early stage to prevent capital

from falling below the minimum levels required to support the risk characteristics of a
particular bank and should require rapid remedial action if capital is not maintained or
restored. Supervisors should consider a range of options if they become concerned that
a bank is not meeting the requirements embodied in the supervisory principles outlined
above. These actions may include intensifying the monitoring of the bank, restricting
the payment of dividends, requiring the bank to prepare and implement a satisfactory
capital adequacy restoration plan, and requiring the bank to raise additional capital
immediately.

  c c 0jc   c
The Pillar 3 of the framework, focuses on the effective public disclosures to be made by
the banks, and is a critical complement to the other two Pillars. It recognizes the fact
that apart from the regulators, the banks are also monitored by the markets and that the
discipline exerted by the markets can be as powerful as the sanctions imposed by the
c 2

regulator. It is premised on the basic principle that the markets would be quite
responsive to the disclosures made and the banks would be duly rewarded or penalized,
in tune with the nature of disclosures, by the market forces.

The Committee aims to encourage market discipline by developing a set of disclosure

requirements which will allow market participants to assess key pieces of information
on the scope of application, capital, risk exposures, risk assessment processes, and
hence the capital adequacy of the institution. The Committee believes that such
disclosures have particular relevance under the Framework, where reliance on internal
methodologies gives banks more discretion in assessing capital requirements.
In principle, banks disclosures should be consistent with how senior management and
the board of directors assess and manage the risks of the bank. Under Pillar 1, banks use
specified approaches/methodologies for measuring the various risks they face and the
resulting capital requirements. The Committee believes that providing disclosures that
are based on this common framework is an effective means of informing the market
about a bank s exposure to those risks and provides a consistent and understandable
disclosure framework that enhances comparability.
Under safety and soundness grounds, supervisors could require banks to disclose
information. Alternatively, supervisors have the authority to require banks to provide
information in regulatory reports. Some supervisors could make some or all of the
information in these reports publicly available. Further, there are a number of existing
mechanisms by which supervisors may enforce requirements. These vary from country
to country and range from Dzmoral suasiondz through dialogue with the bank s
management (in order to change the latter s behaviour), to reprimands or financial
penalties.
A bank should decide which disclosures are relevant for it based on the materiality
concept. Information would be regarded as material if its omission or misstatement
could change or influence the assessment or decision of a user relying on that
information for the purpose of making economic decisions.
Management should use its discretion in determining the appropriate medium and
location of the disclosure. c
c
jc j j cc
c c c  c

0c2c c c c
cThe attempts at harmonizing the capital adequacy standards internationally date back
to 1988, when the DzBasle Committee on Banking Regulations and Supervisory
Practicesdz, as it was then named, released a capital adequacy framework, now known as
Basel I. This initiative set out the first internationally accepted framework for
measuring capital adequacy and a minimum ratio to be achieved by the banks. This
norm was widely adopted in over 100 countries, and in India, it was implemented in
1992. Over the years, however, the Basel I framework was found to have several
limitations such as its broad-brush approach to credit risk, its narrow coverage confined
c 3

to only credit and market risks, and non-recognition of credit risk mitigants, which
encouraged capital arbitrage through structured transactions. Moreover, the rapid
advances in risk management, information technology, banking markets and products,
and banks internal processes, during the last decade, had far outpaced the simple
approach of Basel I to measuring capital. A need was, therefore, felt to replace this
Accord with a more risk-sensitive framework, which would address these shortcomings.
Accordingly, after a wide-ranging global consultative process, the Basel Committee on
Banking Supervision (BCBS) released on June 26, 2004 the document DzInternational
Convergence of Capital Measurement and Capital Standards: A Revised Frameworkdz,
which was supplemented in November 2005 by an update of the Market Risk
Amendment. This document, popularly known as DzBasel II Frameworkdz, offers a new set
of international standards for establishing minimum capital requirements for the
banking organizations. It capitalizes on the modern risk management techniques and
seeks to establish a more risk-responsive linkage between the banks operations and
their capital requirements. It also provides a strong incentive to banks for improving
their risk management systems. The risk sensitiveness is sought to be achieved through
the now-familiar three mutually reinforcing Pillars.

j!c#"&+c*&#*c(c (*c'&"c#(&(c&'c!c
c(&" c

Though the Indian banks became fully compliant with Basel I Accord in March 2005, the
RBI had initiated preparatory measures even prior to that. In August 2004, soon after
the new framework was released by the BCBS, the banks were advised to conduct a self-
assessment of their risk management systems and to initiate remedial measures, as
needed, keeping in view the requirements of the Basel II framework. Further, to secure
a consultative and participative approach for a non-disruptive migration to Basel II, a
Steering Committee was constituted in October 2004, comprising senior officials from
14 select banks (a mix of public sector, private sector and foreign banks). It formed
several sub-groups to address specific issues under Basel II and made its
recommendations to the Reserve Bank. Based on these inputs, in February, 2005, the
RBI issued the draft guidelines, for public comments, on implementation of Pillar 1 and
Pillar 3 requirements of the Basel II framework. In the light of the feedback received
from a wide spectrum of banks and other stake holders, the draft guidelines were
revised and again placed in public domain on March 20, 2007 for a second round of
consultations. Keeping in view the additional feedback received, the guidelines were
finalized and issued on April 27, 2007. As regards the Pillar 2, the banks have been
asked to put in place the requisite Internal Capital Adequacy Assessment Process
(ICAAP) with the approval of their Boards.

The process of implementing Basel II norms in India is being carried out in phases.
Phase I has been carried out for foreign banks operating in India and Indian banks
having operational presence outside India with effect from March 31,2008.

In phase II, all other scheduled commercial banks (except Local Area Banks and RRBs)
will have to adhere to Basel II guidelines by March 31, 2009. With the deadline of March
31, 2009 for full implementation of Basel II norms fast approaching, banks are looking
to maintain a cushion in their respective capital reserves.
c 4

j!c($c+#c&c",3-)!*cc"&c 1c(c (*cc#+*cc67.c

&(c #"+()c #&(c 8&9c !c
c c ":$"(
c c !c 8(,c !9c !"c
#c&c ,c5)!*c c &c 1c8&9c!c#$*c":$"(c&'c

c )$*(c 71c (*c
c )$*(c 671
c c #"c
c c (&".c (*(c
8(,c!&$*c((c"c c+#c&'ccc7

The Government of India has emphasized that public sector banks should maintain
CRAR of 12%. For this, it announced measures to re -capitalize most of the public sector
banks, as these banks cannot dilute stake further, as the Government is required to
maintain a stake of minimum 51% in these banks.
Failure to adhere to Basel II can attract RBI action including restricting lending and
investment activities. Since fund raising has been difficult in the recent turbulent times,
the question was whether the full implementation of Basel II norms would be deferred.
However, the implementation is unlikely to be deferred with the Government taking
steps to recapitalize some public sector banks. The Government announced 1st round of
recapitalization for 3 banks, viz., Central Bank, UCO Bank and Vijaya Bank.
Further for public sector banks, the Govern ment prescribed CRAR of at least 12%. There
are 5 banks which have CRAR less than 12% as of December 31, 2008, viz., Bank of
Maharashtra, Central Bank, Dena Bank, IDBI Bank and Vijaya Bank. Since the
Government's stake in public sector bank cannot be allowed to go below 51 %, these
banks cannot take recourse to equity funding for Tier I capital. Of these banks,
government holding in Dena Bank is very close to 51%; it is therefore not possible for it
to raise further equity capital (without diluting the Government's stake to below 51 %).
The Government, in the Interim Budget, embarked approx. Rs200bn for re-capitalizing
public sector banks whose CRAR is less than 12%, as well as for other public sector
banks for future business growth. The first round of recapitalization has already been
announced, via a Rs38bn recapitalization package for 3 banks, viz., Central Bank, UCO
bank and Vijaya Bank whose tier I capital was less than 6%.
The Government has announced that there will be 2nd round of recapitalization. We
believe Bank of Maharashtra will have to be recapitalized soon with detailed plan, since
its Tier I capital is below 6%. Its government stake is 76%, which is much above the
needed 51 %, indicating scope for an equity dilution. However, the current market
conditions may render an equity issue difficult.

#+c&'c
c c#(&(c&(c!c (*(c
(,()c (*$"%cc

(+"c(c&9"c+#c":$"( c

First, the new norms might, in some cases, lead to an increase in the overall regulatory
capital requirements for the banks, particularly under the simpler approaches adopted
in India, if the additional capital required for the operational risk is not offset by the
capital relief available for the credit risk. This would of course depend upon the risk
profile of the banks portfolios and also provide an incentive for better risk management
but the banks would need to be prepared to augment their capital through strategic
capital planning.

!()c(c#c ,c5)!*c c &c 1

Most of the banks are already adhering to the Basel II guidelines. However, the
c 

Government has indicated that a cushion should be maintained by the public sector
banks and therefore their CRAR should be above 12%.
Basel I focused largely on credit risk, whereas Basel II has 3 risks to be considered, viz.,
credit risk, operational risk and market risks. As Basel II considers all these 3 risks,
there are chances of a decline in the Capital Adequacy Ratio.
c
)!c+&c'&"c$#3)"*&(c&'c+!(&&)%

Full implementation of the Basel II framework would require up-gradation of the bank-
wide information systems through better branch-connectivity, which would entail huge
costs and may raise IT-security issues. The implementation of Basel II can also raise
issues relating to development of HR skills and database management. Small and
medium sized banks may have to incur enormous costs to acquire required technology,
as well as to train staff in terms of the risk management activities. There will be a need
for technological up-gradation and access to information like historical data etc.

()c",

Problems embedded in Basel II norms include rating of risks by rating agencies.

Whether the country has adequate number of rating agencies to discharge the functions
in a Basel II compliant banking system, is a question for consideration. Further, to what
extent the rating agencies can be relied upon was also a matter of debate, in the light of
the recent US experience.

Entry norms for recognition of rating agencies should be stricter. Only firms with
international experience or background in ratings business should be allowed to enter.
This is necessary given that the Indian ratings industry is in its growth phase, especially
with the implementation ot new Basel II capital norms that encourage companies to get
rated.
While the RBI has accredited four rating agencies operating in India, the rating
penetration in India is rather low. Moreover, credit rating in India is confined to rating
of the instruments and not of the issuing entities as a whole. Besides, the credit rating
provides only a lagged indicator of the credit standing of an entity, and is not a lead
indicator. The banks would, therefore, need to actively reckon this aspect in their ICAAP
exercise.
-c",c&*()c+!(:$c
Implementing the ICAAP under the Pillar 2 of the framework would perhaps be the
biggest challenge for the banks in India as it requires a comprehensive risk modeling
infrastructure to capture all the risks that are not covered under the other two Pillars of
the framework. The validation of the internal models of the banks by the supervisors
would also be an arduous task.

!()c!*c'&"c!c8(,c
In regard to adoption of advanced approaches available under Basel II, the RBI has not
stipulated any timeframe for adoption of these approaches but a migration to advanced
approaches would certainly pose significant challenges to both Ȃ the banks as well as
c 

the supervisors. In this case, a slightly different set of issues and challenges is likely to
arise which would need to be kept in view in any decision to migrate to them.
;c The banks will need to demonstrate to the supervisors that they meet the
minimum criteria stipulated in the Basel II framework to be eligible to adopt the
IRB approaches. This could require suitable adjustments in the risk-rating design
and its operations for various product lines in the banks as also the governance
structure to ensure the integrity of the rating process.
;c Unlike the simpler approaches under Basel II, the advanced approaches are very
data intensive and require high-quality, consistent, time-series data for various
borrower- and facility-categories for a period of five to seven years to enable
computation of the required risk parameters (such as default probability and
loss given default, etc.). The banks would perhaps need a thorough review of
their internal processes with a view to redesign and upgrade them to be able to
capture the information needed for creating the requisite databases.
;c Robust risk management architecture, including a strong stress-testing
framework for scenario analyses, would be a necessity under the advanced
approaches. A system within the banks to validate the accuracy of the internal
rating processes would be an essential element of the risk management set up.
;c An overarching requirement for efficient data management and for effective risk
management structures, would be an state-of-the-art technological
infrastructure which might need significant investment and improvement to
achieve seamless enterprise-wide integrated risk management, for which
sharply focused strategic planning would be necessary.
;c With considerable leeway available to the banks under the advanced approaches
in determining the regulatory capital requirements, the highest standards of
corporate governance would be critical for maintaining the integrity of the
advanced approaches.
;c The complexity of advanced approaches requires highly skilled staff and the
human resource management in the banking industry, particularly for the public
sector banks, could emerge to be a binding constraint, in adopting advanced
approaches. This would need innovative strategies and concerted efforts on the
part of the banks to be able to attract and retain the right mix of talent in the
organization.
Thus the advanced approaches would also cast an onerous responsibility on the
supervisors of not only guiding the banking system through the implementation phase
but also of validating the internal models, system and processes adopted by the
regulated banks. This, needless to say, would require considerable capacity building and
augmentation of the domain knowledge and expertise of the supervisors themselves to
ensure a non-disruptive migration to the advanced approaches under Basel II.