The Hindu Business Line : Basel II norms: Strength from three pillars

PILLAR I of Basel II norms provide banks with guidelines to measure the various types of risks they face — credit, market and operational risks — and the capital required to cover these risks.

Credit risk

A bank always faces the risk that some of its borrowers may renege on their promises for timely repayments of loan, interest on loan or meet the other terms of contract. This risk is called credit risk, which varies from borrower to borrower depending on their credit quality. Basel II requires banks to accurately measure credit risk to hold sufficient capital to cover it.

Factors affecting credit risk can be summarised by the following formula:

Expected Loss (EL) on a loan = Exposure at default (EAD) * Loss given default (LGD) * Probability of Default (PD)

The bank can also suffer losses in excess of expected losses, say, during economic downturns. These losses are called unexpected losses. Ideally, a bank should recover expected loss on a loan from its customer through loan pricing. The capital base is required to absorb the unexpected losses, as and when they arise.

Market risk

As part of the statutory requirement, in the form of SLR (statutory liquidity ratio), banks are required to invest in liquid assets such as cash, gold, government and other approved securities. For instance, Indian banks are required to invest 25 per cent of their net demand and term liabilities in cash, gold, government securities and other eligible securities to comply with SLR requirements.

Such investments are risky because of the change in their prices. This volatility in the value of a bank's investment portfolio in known as the market risk, as it is driven by the market. The change in the value of the portfolio can be due to changes in the interest rates, foreign exchange rates or the changes in the values of equity or commodities.

Operational risk

Several events that are neither due to default by third party nor because of the vagaries of the market. These events are called operational risks and can be attributed to internal systems, processes, people and external factors.

Pillar I ensures that banks measure their risks properly and maintain adequate capital to cover them. But can Pillar I alone ensure that there are no more bank failures? No. As any stable structure cannot stand on a single pillar, Basel II relies on the pillars of supervisory reviews and market discipline to keep the banks healthy.

Pillar II ensures that not only do the banks have adequate capital to cover their risks, but also that they employ better risk management practices so as to minimise the risks. Capital cannot be regarded as a substitute for inadequate risk management practices.

This pillar requires that if the banks use asset securitisation and credit derivatives and wish to minimise their capital charge they need to comply with various standards and controls. As a part of the supervisory process, the supervisors need to ensure that the regulations are adhered to and the internal measurement systems are standardised and validated.

The supervisory process is based on four principles:

Principle 1: Banks should have a process for assessing their overall capital adequacy vis-a-vis their risk profile and a strategy for maintaining their capital levels.

Principle 2: Supervisors should review and evaluate banks' internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.

Principle 3: 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.

Principle 4: 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.

Given the kind of responsibilities, the supervisor's role assumes high importance in the new Basel II accord. Pillar II does not seek to harmonise supervisory processes across countries as they have different supervisory objectives, legal processes and authority of supervisors. It allows for sufficient national discretion but still it wants supervisors to maintain some degree of consistency in their approaches.

Market discipline

Banking operations are becoming complex and difficult for supervisors to monitor and control. Though supervisors try to inculcate corporate governance in banks, they can take cue from the market to buttress their supervisory and monitoring activities. In this context, Basel Committee has recognised that market discipline is so important that it warrants being the third pillar of Basel II norms.

This market discipline is brought through greater transparency by asking banks to make adequate disclosures.

The potential audiences of these disclosures are supervisors, bank's customers, rating agencies, depositors and investors.

With frequent and material disclosures, outsiders can learn about the bank's risk. Armed with this information, the outsiders can always protect themselves by ending their relationships with the bank.

Market discipline has two important components:

Market signalling in form of change in bank's share prices or change in bank's borrowing rates

Responsiveness of the bank or the supervisor to market signals

Seeing the importance of the impact that the markets can have on banks, Pillar III provides a comprehensive menu of public and regulatory disclosures like disclosures related to capital structure (core and supplementary capital), capital adequacy, risk assessment and risk management processes to enhance the transparency in banking operations.

What they mean for banks

BASEL II norms are expected to have far-reaching consequences on the health of financial sectors worldwide because of the increased emphasis on banks' risk-management systems, supervisory review process and market discipline.

The new norms bring to fore not only the issues of bank-wide risk measurement but also of active risk management.

This will help in better pricing of the loans in alignment with their actual risks. The beneficiary will be the customer with high credit-worthiness and ratings as they will be able to get cheaper loans.

Basel II norms require vast amount of historical data and advanced techniques and software for calculation of risk measures. This will translate into huge demand for IT, BPO and outsourcing services.

According to estimates, cost of implementation of the new norms may range from $10 million to $150 million depending on the size of the bank.

A flip side is that the knowledge acquired by the big banks due to the implementation of complex norms would act as an entry barrier to any new competition entering into the market, as international markets provide incentive to sovereigns and banks that have implemented Basel II.

Small and medium sized banks will find it difficult to finance high implementation costs of the norms. If national supervisors make the norms compulsory to implement, these banks might have no other option but to merge with other banks. Therefore, consolidation in banking industry with increased mergers and acquisitions is expected.

Higher risk sensitivity of the norms provides no incentive to lend to borrowers with declining credit quality. During economic downturns, corporate profits and ratings tend to decline. This can lead to banks pulling the plugs on lending to corporates with falling credit ratings, at a time when these companies will be in desperate need of credit.

The opposite is expected during economic booms, when corporate credit worthiness improves and banks will be more than willing to lend to corporates.

With better risk measurement practices in place the capital allocation for loans to quality borrowers are going to decrease. Banks can use this capital for other purposes to increase profits. But the population of rated corporate is small in India and most of them would have to be assigned a risk weight of 100 per cent.

The benefit of lower risk weight of 20 per cent and 50 per cent would, therefore, be available only for loans to a few corporates. The cover required for bad loans will increase exponentially with deteriorating credit quality, which can lead to an increase in capital requirement.

(The authors are students of MBA at IIM Indore, working on Basel II norms under the guidance of Mr. R. Vishwanathan, former Deputy MD, SBI.)

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