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Basel II

About Basel II

Basel II is a type of recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision that was initially published in June 2004. The objective

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of Basel II is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face.

History of Basel

The Basel Committee was constituted by the Central Bank Governors of the G-10 countries in 1974. The G-10 Committee consists of members from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, The Netherlands, Spain, Sweden, Switzerland, The UK and The US. These countries are represented by their Central Bank and also by the authority with onus for the prudent supervision of banking business where this is not the central bank.

The Committee's Secretariat is located at the Bank for International Settlements in Basel, Switzerland. This committee meets four times in a year. The present Chairman of this committee is Mr. Nout Wellink (President of The Netherlands Bank). The Secretary General of the Basel Committee is Mr. Stefan Walter.

This committee on banking supervision provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and quality improvement of banking supervision worldwide. This committee is best known for its international standards on capital adequacy; the core principles of banking supervision and the concordat on cross-border banking supervision.

Basel Capital Accord

The Basel Capital Accord (Basel II) guidelines promulgated by the BIS to establish capital adequacy requirements and supervisory standards for banks to be implemented by 2007 and are structured by three pillars.

The Basel II is designed to facilitate a more comprehensive, sophisticated and risk sensitive approach for banks to calculate regulatory capital. The proposals will enable banks to align regulatory requirements more closely with their internal risk measurement and to improve operational process.

The Committee today consists of central bankers and supervisory regulators from 13 countries.

Basel I Vs. Basel II

Basel I is very simplistic in its approach towards credit risks. It does not distinguish between collateralized and non-collateralized loans, while Basel II tries to ensure that

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the anomalies existed in Basel I are corrected.

Advantages of Basel-II

It is believed that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. In practice, Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. In simple terms, the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability.

The basic purpose of this recommendation is to ensure that capital allocation is more risk sensitive, separating operational risk from credit risk and quantifying both, and attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.

In a nut-shell, Basel II -

  • Provides effective assessment methods.

  • Incorporates sensitivity to banks.

  • Makes better business standards.

  • Reduces losses to the banks.

    The above-mentioned advantages of Basel II recommendation are helpful in various ways to the Indian banking industry: -

  • Improving overall efficiency of banking and finance systems.

  • Takes global aspect into consideration for more rational decision making, improving the decision matrix for banks.

  • Allowing capital discrimination of the banking system by allocating proper risk weighs to each asset class.

  • Providing range of alternatives to choose from.

  • Allowing capital allocation based on ratings of the borrower making capital more risk-sensitive.

  • Providing an incentive for better and more objective risk measurement.

  • Encouraging mergers and acquisitions and more collaboration on the part of the banks, this ultimately leads to proper control over their capital and assets.

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    The 3-Pillar Approach of Basel II

  • Minimum Capital Requirement (Addressing Credit Risk, Operatinal Risk & Market Risk)

  • Supervisory Review (Provides Framework for Systematic Risk, Liquidity Risk & Legal Risk)

  • Market Discipline & Disclosure (To promote greater stability in the financial system)

  • Challenges With Indian Banking Industry

  • With the feature of additional capital requirements, the overall capital level of the banks will see an increase. But, the banks that will not be able to make it as per the

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    norms may be left out of the global system.

  • Another biggest challenge is re-structuring the assets of some of the banks would be a tedious process, since most of the banks have poor asset quality leading to significant proportion of NPA. This also may lead to Mergers & Acquisitions, which itself would be loss of capital to entire system.

  • The new norms seem to favor the large banks that have better risk management and measurement expertise, who also have better capital adequacy ratios and geographically diversified portfolios. The smaller banks are also likely to be hurt by the rise in weightage of inter-bank loans that will effectively price them out of the market. Thus, banks will have to re-structure and adopt if they are to survive in the new environment.

  • Since improved risk management and measurement is needed, it aims to give impetus to the use of internal rating system by the international banks. More and more banks may have to use internal model developed in house and their impact is uncertain. Most of these models require minimum historical bank data that is a tedious and high cost process, as most Indian banks do not have such a database.

  • The technology infrastructure in terms of computerization is still in a nascent stage in most Indian banks. Computerization of branches, especially for those banks, which have their network spread out in far-flung areas, will be a daunting task. Penetration of information technology in banking has been successful in the urban areas, unlike in the rural areas where it is insignificant.

  • Experts say that dearth of risk management expertise in the Asia Pacific region will serve as a hindrance in laying down guidelines for a basic framework for the new capital accord.

  • An integrated risk management concept, which is the need of the hour to align market, credit and operational risk, will be difficult due to significant disconnect between business, risk managers and IT across the organizations in their existing set-up.

  • Implementation of the Basel II will require huge investments in technology. According to estimates, Indian banks, especially those with a sizeable branch network, will need to spend well over $ 50-70 Million on this.

  • SWOT Analysis (In Indian Banking Context)