The Hindu Business Line : Basel II: The Duckworth-Lewis of banking

BASEL-II norms are to banking what Duckworth-Lewis is to cricket. Both are complex, mathematically inclined, enigma for the layman but still very logical and needs some intuition to understand. Duckworth-Lewis changed the rules of the game and as Basel II is likely to do too.

The business of a bank is to lend deposits to its customers. The interest earned from the loans is then used to pay for the deposits. While your deposits and interest are safe, the bank faces the risk of losing money on the loans they have given.

Succinctly put, while a bank's assets (loans and investments) are risky and prone to losses, its liabilities (deposits) are certain. Bank failures are mainly caused by losses on its assets in the form of default by borrowers (credit risk), losses on investments in different securities (market risk) and frauds, systems and process failures (operational risks).

From the fundamental accounting equation we know that the assets should equal the external liabilities plus capital. A loss in bank's assets will have to be balanced by a reduction in the capital because the liabilities (the deposits) are to be honoured under all circumstances. Therefore, it should have sufficient capital at all times to absorb losses on account of credit, market and operational risks. Banks fail when their capital is wiped out by such losses.

The rate of return that is expected on a bank's capital is higher than the interest it pays on deposits. Therefore, though sufficient capital is desirable to absorb losses, it comes with a high cost. This explains the low capital-to-assets ratio for banks vis-à-vis manufacturing companies.

The 1970s saw banks operating on wafer-thin capital base. Under-capitalised banks were prone to failure, which could have dramatic consequences for the economy. Failure of banks with a presence across countries was even riskier as it could have cross-country effects. Several international banks, especially Japanese outfits, tried to get short-term competitive advantage by keeping low capital and charging lower interest rates on their loans and advances. The definition of regulatory capital also differed from country to country.

The failure of the German Bank Herstatt in 1974 forced the central banks of the G-10 countries (Belgium, Canada, France, Germany, Italy, Japan, The Netherlands, Sweden, Switzerland, The United Kingdom and The United States) to delve deeper into the issue of under-capitalised banks and non-standardised banking regulations. These countries, along with Luxembourg, formed the "Basel Committee on Banking Supervision" under the aegis of the Bank of International Settlements (BIS) in 1974. Formed in 1930, the BIS is one of the oldest international financial institutions. It is actively involved in securing and maintaining international central banks cooperation.

In July 1988, the Basel Committee came out with a set of recommendations aimed at introducing minimum levels of capital for internationally active banks. Though these proposals were not legally binding on the signatory countries, more than hundred supervisors from different countries agreed to implement the Basel norms with modifications suited to their domestic economies. This first series of recommendations by Basel Committee are popularly known as Basel I norms.

These norms required the banks to maintain capital of at least 8 per cent of their risk-weighted loan exposures. Different risk weights were specified by the committee for different categories of exposure. For instance, government bonds carried risk-weight of 0 per cent, while the corporate loans had a risk-weight of 100 per cent.

The Basel Committee also laid down standard definitions for different types of capital. Capital was categorised as Tier I and Tier II capital. Tier I capital is mainly the permanent capital like equity. Tier II capital is the supplementary capital like subordinate debt.

Easy to implement, the norms were quickly adopted by many developed and developing countries. The norms were successful in improving the capitalisation ratios of the banks worldwide. In India, the banks were required by the Reserve Bank of India to maintain a higher capital-to-risk-weighted-assets ratio (CRAR) of 9 per cent.

That almost all Indian and internationally active banks are sufficiently capitalised now is a testimonial to the success of the norms.

Despite these achievements, these norms were becoming increasingly ineffective to address the fundamental changes in the banking sector over the past decade. There was a need to revise the Basel I norms.

The one-size-fits-all approach of using a single rate of CRAR did not take into consideration the actual risks faced by different banks. The norms used a simplified approach with only four broad risk-weights for credit risk measurement. Consequently, it could not provide enough granularity in risk measurement.

The increasing use of financial innovations such as securitisation and credit-risk derivatives allowed the banks to manipulate their balance-sheet figures in such a way that capital requirements were lowered without significant reduction in actual risks.

There was an inherent disincentive for banks to keep high-quality loans on their balance-sheets.

This was because the high-quality loans offered low returns but required the same capital as that of a low-quality-high-return loan. Also, Basel I focused strictly on financial risk but failed to recognise other risks (such as operational ones).

To set right these aspects, the Basel Committee came up with a new set of guidelines in June 2004, popularly known as the Basel II norms.

These new norms are far more complex and comprehensive compared to the Basel I norms. Also, the Basel II norms are more risk-sensitive and they rely heavily on data analysis for risk measurement and management. These norms are based on the three pillars of Capital Requirement, Supervisory Review and Market Discipline.

The new norms are a formidable challenge for the regulators and banks to understand and implement. These are expected to change the banking landscape and the way banks manage their risks. On the customer's side, there will be winners and losers depending on their risk profile. For India, these norms provide massive opportunities in the form of software services, outsourcing and consultancy services.

To emphasise the point, the Basel II recommendations are to banks what Duckworth-Lewis is to cricket, equally debatable and controversial. Though it is statistically estimated to perform well, the Duckworth-Lewis rule gives bizarre results; for instance, moving South Africa from a comfortable position to an impossible situation of having to score 21 runs on the last ball in the 1992 World Cup.

Similarly, though the Basel II recommendations enhance the business of the bank by better management of its risk, but it has such pitfalls as pro-cyclical nature of the recommendations, loan portfolio polarisation, potential hurdle for the emerging securitisation market and increased capital requirement. But it is certain that these norms are going to have a tremendous effect on our lives by changing the way banks do business with us.

(To be continued)

(The authors are students of IIM Indore, working on Basel II norms under the guidance of Mr R. Vishwanathan, a former Managing Director of SBI.)

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