Implementing BASEL II

Shubham Nath
MBA class of 2006

Avant Garde December 2004

The Origin
Basel was an attempt to reduce the number of bank failures by tying a bank's CAPITAL ADEQUACY RATIO to the risk of the loans it makes. For instance, there is less chance of a loan to the government going bad than a loan to, say, an Internet business. So the bank would not have to hold as much capital in reserve against the first loan as against the second. The first attempt to do this worldwide was by the Basel committee for international banking supervision in 1988. However, its system of judging the relative risk of different loans was crude. For instance, it penalized banks no more for making loans to a fly-by-night software company in Thailand than to Microsoft; no more for loans to South Korea, bailed out by the IMF in 1998, than to Switzerland. In 1998, "Basel 2" was proposed, using much more sophisticated risk classifications. However, controversy over these new classifications, and the cost to banks of administering the new approach, led to the introduction of Basel 2 being delayed until (at least) 2005.

The Revised Basel II
The Basel II Framework sets out the details for adopting more risk sensitive minimum capital requirements for banking organizations. The new framework reinforces these risk-sensitive requirements by laying out principles for banks to assess the adequacy of their capital and for supervisors to review such assessments to ensure banks have adequate capital to support their risks. It also seeks to strengthen market discipline by enhancing transparency in banks' financial reporting. Thus, we can broadly classify the accords of Basel II as follows:

Capital Adequacy requirement
Basel 2 intends to replace the existing approach by a system that would use external credit assessments for determining risk weights. It is intended that such an approach will also apply, either directly or indirectly and to varying degrees, to the risk weighting of exposures to banks, securities firms and corporates. The result will be reduced risk weights for high quality corporate credits, and introduction of a higher-than-100% risk weight for certain low quality exposures. A new risk weighting scheme to address asset securitisation, and the application of a 20% credit conversion factor for certain types of short-term commitments are also proposed.

Risk based Supervision
This ensures that the bank's capital position is consistent with its overall risk profile and strategy, thus encouraging early supervisory intervention. Supervisors should have the ability to require banks to hold capital in excess of minimum regulatory capital ratios.
Also, the new framework stresses the importance of bank management developing an internal capital assessment process and setting targets for capital that are commensurate with the bank's particular risk profile and control environment. This internal process then would be subject to supervisory review and intervention, where appropriate.

Market Disclosures
This strategy will encourage high disclosure standards and enhance the role of market participants in encouraging banks to hold adequate capital.

Opportunities in Store for India
The Basel II norms are in line for implementation by the year 2006. Though not mandatory for all countries to follow this regime, many including India are likely to adopt it. And the plausible advantages that this would have in store for India would be both banking as well as non-banking.
Banking Opportunities
With second highest growth rate in the world and huge scientific and general work force, India is now well recognized as one of the fast emerging nations in the world. A sound and evolved banking system would thus be a prime requirement to support the hectic and enhanced levels of domestic and international economic activities in the country. Though India is credited with a very strong banking system, in comparison to many peer group countries, still some better risk practices by Indian banks are required. A majority of Indian banks are either at nascent or at a very low level of competence in Credit, Market and Operational risk measurement and management system. They are lagging behind in use of modern risk methodologies and tools in comparison to their western counterparts. Economic reforms, higher market dynamics and large-scale globalization demand a robust risk management system in the Indian banks. As suggested by the recent Global Trust bank fiasco the current level of risk based supervision and market disclosures are also not very satisfactory in the Indian banking system. Basel II gives an opportunity and a framework for improvement to the Indian banks. A Basel II compliant banking system will further enhance the image of India in the League of Nations. The country rating of India will surely improve, and consequently facilitate a higher capital inflow in the country. This will tremendously help India to move on the higher growth trajectory in the coming decades.

Non-Banking Opportunities
The major advantage of Basel II to India is going to be in the area of services ? predominantly IT and manpower. The banks all over the world will have to make huge investments in order to be the Basel II compliant. These investments will be mainly in the areas of information technology systems (software tools, database management, Business Intelligence, hardware), training etc. to create risk infrastructure to address the three compliance pillars of the Basel II. Here is the opportunity for consultancy and IT companies in India and abroad. Indian IT companies with an established reputation of system implementation and service support can and must use this opportunity to enhance their business from the financial services domain. A broad understanding among WTO countries on GATS (General Agreement on Trade and Services) should help in the movement of cheaper Indian service personnel across the globe. IT/ITES industry in banking and financial services sector can enhance the present level of revenue from both on and off site services related to Basel II compliance. Some of the Indian IT majors like I ? flex, Infosys and Wipro are believed to be, in the advanced stage of preparation in terms of product and services, to embark upon the business opportunities provided by Basel II.