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Approach to Basel II
Speech by Shyamala Gopinath, Deputy Governor, RBI at the IBA briefing session at Bangalore on May 12, 2006


Rating agencies

In terms of Basel II requirements, national supervisors are responsible in determining whether the rating agencies meet the eligibility criteria. The criteria specified are objectivity in assessment methodology, independence from pressures, transparency, adequate disclosures, sufficient resources for high quality credit assessments and credibility.

India has four rating agencies of which three are owned partly/wholly by international rating agencies. Compared to developing countries, the extent of rating penetration has been increasing every year and a large number of capital issues of companies has been rated. However, since rating is of issues and not of issuers, it is likely to result, in effect, in application of only Basel I standards for credit risks in respect of non-retail exposures. While Basel II provides some scope to extend the rating of issues to issuers, this would only be an approximation and it would be necessary for the system to move to rating of issuers. Encouraging rating of issuers would be essential in this regard.

An internal working group is examining the process for identification of the domestic credit rating agencies which would be meeting the eligibility criteria prescribed under Basel II. It is expected that by this process would be over soon and banks would be informed the details of the rating agencies which qualify. Thereafter, the borrowers are expected to approach the rating agencies for getting themselves rated, failing which banks would be constrained to assign 100% risk weight at the minimum for unrated borrowers.

The Reserve Bank had invited all the four rating agencies to make a presentation on the eligibility criteria and a self assessment with regard to these criteria. The rating agencies have since made their presentations and these are under examination vis-à-vis the eligibility criteria for recognising the rating agencies, whose ratings can be used by banks for risk weighting purposes.

Migration to advanced approaches

After adequate skills are developed, both by the banks and also by the supervisors, some banks may be allowed to migrate to the Internal Rating Based (IRB) Approach. The obvious corollary is that only a few banks are expected to migrate to the advanced approaches – though after some time, and not immediately. Hence, the small banks would be well advised to focus their resources on understanding the mechanics of the functioning of the elementary approaches and identify the minimum requirements that these approaches demand. It would be in their interests to take the necessary initiatives which make the implementation of the elementary approaches effective and meaningful.

As a well established risk management system is a pre-requisite for implementation of advanced approaches under the New Capital Adequacy Framework, banks were required to examine the various options available under the Framework and lay a road-map for migration to Basel II. The feedback received from banks suggests that a few banks may be keen on implementing the advanced approaches but all are not fully equipped to do so straightaway and are, therefore, looking forward to migrate to the advanced approaches at a later date. Basel II provides that banks should be allowed to adopt / migrate to advanced approaches only with the specific approval of the supervisor, after ensuring that they meet / satisfy the minimum requirements specified in the Framework, not only at the time of adoption / migration, but on a continuing basis. [The minimum requirements to be met by banks relate to (a) internal rating system design, (b) risk rating system operations, (c) corporate governance and oversight, (d) use of internal ratings, (e) risk quantification, (f) validation of internal estimates, (g) requirements for recognition of leasing, (h) calculation of capital charges for equity exposures and (i) disclosure requirements.] Hence, it is necessary that banks desirous of adopting the advanced approaches do a stringent assessment of their compliance with the minimum requirements before they shift gears to migrate to these approaches. In this context, current non-availability of acceptable and qualitative historical data relevant to ratings, along with the related costs involved in building up and maintaining the requisite database, does influence the pace of migration to the advanced approaches available under Basel II.

Banks which are internationally active should look to significantly improve their risk management systems and migrate to the advanced approaches under Basel II since they will be required to compete with the international banks which are adopting the advanced approaches. This strategy would also be relevant to other banks which are looking at adoption of the advanced approaches. As you are aware adoption of the advanced approaches might help these banks to maintain lower capital. However, it would be relevant to refer here to the inverse relationship between the capital requirements and information needs. Adoption of the advanced approaches will require adoption of superior technology and information systems which aid the banks in better data collection, support high quality data and provide scope for detailed technical analysis - which are essential for the advanced approaches. Hence, banks aiming at maintaining lower capital by adopting the advanced approaches would also have to be prepared to meet the higher information needs.

While migration to the advanced approaches will basically be a business decision, I would like to mention a few things which may perhaps influence those decisions:

Implementation of advanced approaches under Basel II will not be mandatory for small banks which are undertaking traditional banking business and have a regional or limited presence.

Implementation of advanced approaches under Basel II should not be considered as fashionable and implementation of elementary approaches should not be considered as inferior.

Any decision to migrate to the advanced approaches should be a well deliberated, conscious decision of the bank’s Board, after taking into account, not only their capacity to compute the capital requirement under those approaches but also their capacities to sustain the bank’s risk profile and the consequent capital levels under various scenarios, especially stress scenarios.

The preconditions for migration to the advanced approaches would include (a) well established, efficient and independent risk management framework; (b) supported by well established, efficient IT and MIS infrastructure; (c) cost benefit analysis of adoption of advanced approaches; (d) availability of appropriate skills and capacity to retain / attract such skills at all points in time; and (e) a well established, effective and independent internal control mechanism for supplementing the risk management systems.

I hope the subsequent sessions would discuss in greater detail some of these issues. It is important for the sector as a whole to appreciate and internalize the basic philosophy of the Basel II, with all attendant costs and benefits.

Undoubtedly the discipline of risk management has significantly altered the ethos of the banking as an economic activity. But one point I would like to stress in conclusion is that banks should view the opportunities opened up by these complex financial instruments in the perspective of larger systemic interest. Today internationally, when market discipline is being considered an integral part of the regulatory framework, it is imperative for banks to realize that they are equal partners in ensuring financial stability; and this involves helping build up a risk management culture across all stakeholders. Any distortions brought about by misalignment of risk needs and the product being offered to address the risk can only harm and arrest the development of a healthy market.

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Dr. Y.V. Reddy, Governor, Reserve Bank of India on Basel II- Read Here

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