Approach to Basel II
Speech by Shyamala Gopinath, Deputy Governor, RBI at the IBA briefing session at Bangalore on May 12, 2006
Ladies and Gentlemen, it is my pleasure to be here at this program on emerging paradigms in risk management. As expected of me, in my address today, I intend to share with you the broad contours of the regulatory approach, process and thinking in regard to some of the issues arising in context of Basel II.
Basel II aims to encourage the use of modern risk management techniques; and to encourage banks to ensure that their risk management capabilities are commensurate with the risks of their business. Previously, regulators' main focus was on credit risk and market risk. Basel II takes a more sophisticated approach to credit risk, in that it allows banks to make use of internal ratings based Approach - or 'IRB Approach' as they have become known - to calculate their capital requirement for credit risk. It also introduces, in addition to the market risk capital charge, an explicit capital charge for operational risk. Together, these three risks - credit, market, and operational risk - are the so-called 'Pillar 1' risks.
Banks' risk management functions need to look at a much wider range of risks than this - interest rate risk in the banking book, foreign exchange risk, liquidity risk, business cycle risk, reputation risk, strategic risk. The risk management role of helping identify, evaluate, monitor, manage and control or mitigate these risks has become a crucial role in modern-day banking. Indeed, it is probably not exaggerating the importance of this to say that the quality of a bank's risk management has become one of the key determinants of a success of a bank.
The policy approach to Basel II in India is to conform to best international standards and in the process emphasis is on harmonization with the international best practices. Commercial banks in India will start implementing Basel II with effect from March 31, 2007 though, as indicated by Governor, a marginal stretching beyond this date cannot be ruled out in view of latest indications of the state of preparedness. Though the Basel II framework provides various options for implementation, special attention was given to the differences in degrees of sophistication and development of the banking system while considering these options and it was decided that banks in India will initially adopt the Standardised Approach (SA) for credit risk and the Basic Indicator Approach (BIA) for operational risk. The prime considerations while deciding on the likely approach included the cost of implementation and the cost of compliance.
Before coming to specifics I may like to mention that overall capital is what makes financial systems stable. In general, expected losses are to be covered by earnings and provision and hence the need to price risk appropriately. Unexpected losses or losses beyond the normal range of expectations need have to be met by capital.
Let me briefly review the steps taken for implementation of Basel II and the emerging issues.
The RBI had announced in its annual policy statement in May 2004 that banks in India should examine in depth the options available under Basel II and draw a road-map by end-December 2004 for migration to Basel II and review the progress made at quarterly intervals.
The Reserve Bank organized a two-day seminar in July 2004 mainly to sensitise the Chief Executive Officers of banks to the opportunities and challenges emerging from the Basel II norms.
Soon thereafter all banks were advised in August 2004 to undertake a self-assessment of the various risk management systems in place, with specific reference to the three major risks covered under the Basel II and initiate necessary remedial measures to update the systems to match up to the minimum standards prescribed under the New Framework.
Banks were also advised to formulate and operationalise the Capital Adequacy Assessment Process (CAAP) as required under Pillar II of the New Framework.
Reserve Bank issued a Guidance Note on operational risk management in November 2005, which serves as a benchmark for banks to establish a scientific operational risk management framework.
We have tried to ensure that the banks have suitable risk management framework oriented towards their requirements dictated by the size and complexity of business, risk philosophy, market perceptions and the expected level of capital.
Risk Based Supervision (RBS) in 23 banks has been introduced on a pilot basis.
As per normal practice, and with a view to ensuring migration to Basel II in a non-disruptive manner, a consultative and participative approach had been adopted for both designing and implementing Basel II. A Steering Committee comprising senior officials from 14 banks (public, private and foreign) had been constituted wherein representation from the Indian Banks’ Association and the RBI was ensured. The Steering Committee had formed sub-groups to address specific issues. On the basis of recommendations of the Steering Committee, draft guidelines to the banks on implementation of the New Capital Adequacy Framework have been issued.
The Reserve Bank has constituted a sub group of the Steering Committee for making recommendations on the guidelines that may be required to be issued to banks with regard to the Pillar 2 aspects. The guidelines with regard to Pillar 2 aspects proposed to be issued would cover the bank level initiatives that may be required under Pillar 2.
The underlying philosophy while prescribing the Basel II principles for the Indian banking sector was that this must not result in further segmentation of the sector. Accordingly, it was decided that all scheduled commercial banks in India, both big and small, shall implement the standardised approach for credit risk and the basic indicator approach for operational risk with effect from March 31, 2007. However, the existing three-tier structure in respect of SCBs, the cooperative banks and RRBs may continue. Currently, the commercial banks are required to maintain capital for both credit and market risks as per Basel I framework; the cooperative banks, on the second track, are required to maintain capital for credit risk as per Basel I framework and through surrogates for market risk; the Regional Rural Banks, on the third track, have a minimum capital requirement which is, however, not on par with the Basel I framework.
By opting to migrate to Basel II at the basic level, the Reserve Bank has considerably reduced the Basel II compliance costs for the system. In a way, the elementary approaches which have been identified for the Indian banking system are very similar to the Basel I methodology. For instance,
a. there is no change in the methodology for computing capital charge for market risks between Basel I and Basel II;
b. the computation of capital charge for operational risk under the BIA is very simple and will not involve any compliance cost;
c. the computation of capital charge for credit risk will involve compilation of information in a marginally more granular level, which is expected to be achieved with a slight re-orientation of the existing MIS.
In the above circumstances, it might not be an entirely correct assessment that implementation of the elementary levels of Basel II significantly increases the cost of regulatory compliance. No doubt some additional capital would be required, but the cushion available in the system, which at present has a Capital to Risk Assets Ratio (CRAR) of over 12 per cent, provides for some comfort. The banks have also started exploring various avenues for meeting the capital requirements. The Reserve Bank has, for its part, issued policy guidelines enabling issuance of several instruments by the banks viz., innovative perpetual debt instruments, perpetual non-cumulative preference shares, redeemable cumulative preference shares and hybrid debt instruments so as to enhance their capital raising options.
With a view to have an objective assessment of the true cost of implementation of Basel II, banks would be well advised to institute an internal study to make a true assessment of the costs involved – exclusively for the elementary approaches. The informal feedback that we have from banks reflects that they do not see Basel II implementation as a ‘costly’ proposition.
However, banks need to ensure that expenditure incurred by them to improve their risk management systems, IT infrastructure, core banking solutions, risk models etc. should not be included as Basel II compliance costs, since these are expenses which a bank would incur even in the normal course of business to improve their efficiencies.
Operational risk was one area which was expected to increase capital requirement for the banks. The Reserve Bank had announced in July 2004 that banks in India will be adopting the Basic Indicator Approach for operational risk. This was followed up with the draft guidelines for the Basel II framework in February 2005 where the methodology for computing the capital requirement under the Basic Indicator Approach was explained to banks. Even at the system level, we find that the CRAR of banks is at present well over 12 per cent. This reflects adequate cushion in the system to meet the capital requirement for operational risks, without breaching the minimum CRAR.
There is also a perception that the capital requirement for operational risk will be lower under the advanced approaches rather than under the Basic Indicator Approach. I feel that, in the absence of details of the quality of operational risk management systems in banks and their operational risk loss experience, it may not be correct for the banks to assume that adoption of the advanced approaches would result in lesser capital than under the BIA.
Having addressed the specific issues on which I was supposed to 'brief', let me now turn to some other important issues.
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Dr. Y.V. Reddy, Governor, Reserve Bank of India on Basel II- Read Here