Final Proj Basel

The Analysis of Basel Norms and Implementation

KLE SOCEITY’s INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH, VIDYANAGAR, HUBLI.

MASTERS OF BUSINESS ADMINISTRATION ( Recognised and Affiliated to Karnataka University Dharwad) Project on “The Analysis of Basel Norms and its implementation” Undertaken At State Bank of India, Main Branch, Dharwad

Internal Guide Prof: Prashanth.C Faculty KLE’s IMSR

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Company Guide Mr.Subramanya Chief Manager State Bank of India

MBA IV Sem

The Analysis of Basel Norms and Implementation

Hubli

Dharwad

DECLARATION

I, Miss Shveta.R.Chikkamath hereby declare that the project for MCP title “ The Study of Basel Norms and its implementation” at State Bank of India, Main Branch Dharwad submitted in fulfillment of the requirement for the degree of “ Master of Business Administration” by Karnataka University Dharwad, is correct and by my own effort and is submitted elsewhere for the award of any degree.

Date: Place:

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( Shveta.R.Chikkamath)

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ACKNOWLEDGEMENT All my efforts will be meaningless, if I don’t express my sincere gratitude to the authorities, who rendered their support and guided me more than what I had expected from them, while carrying out my project. First and foremost I extend my heartfelt gratitude to our State Bank of India, Chief Manager Dharwad for giving me an opportunity to undertake my project in this prestigious bank. I express my sincere gratitude to Sir R.S. Prakash, Faculty Training Centre SBI and also Sir, Prasad Faculty Training Centre State Bank of India for their valuable support. I also express my gratefulness to Miss Shailaja. M.S Chief Manager, SBI Zonal Office. I also thank all SBI staff for supporting me in one or the other way. Dr.M.M.Bagali, I/c Director KLE’s Institute of Management Studies and Research for his encouragement in carrying out the project. I extend gratefulness to Prof Prashanth. C my institute guide his guidance. Lastly, I’m immensely grateful to my family and friends who have directly or indirectly Strived hard from commencement to completion of my project. \

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TABLE OF CONTENTS S.NO 1. 2. 3 4 6 7 8 9 10 11 12 13

INDEX EXECUTIVE SUMMARY INDUSRTY PROFILE COMPANY PROFILE The Analysis of Basel Norms and Implementation Background of Basel Accord BASEL I LOOPHOLES OF BASEL I OBJECTIVES OF BASEL II BASEL II GUIDELINES BASEL II FRAMEWORK CATEGORIES OF RISK CHALLENGES FOR INDIAN BANKING UNDER

14 15 16 17 18 19 20 21 22

BASEL II CHALLENGES FOR SBI MIGRATION TO BASEL BY SBI IMPACT OF BASEL NORMS ON INDIAN BANKS IMPACT OF BASEL NORMS ON SBI RELATION BETWEEN BASEL I & BASEL II CONCLUSIONS FINDINGS SUGGESTIONS & LIMITATIONS BIBLIOGRAPHY

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EXECUTIVE SUMMARY

In 1988 the Bank for International Settlements’ Basel Committee on Banking Supervision, commonly known as the Basel Committee, imposed the Basel Capital Accord. The Basel Capital Accord introduced a system for implementing a credit risk framework for determining the minimum amount of capital that a bank must hold as a cushion against risks. The Basel Capital Accord was adopted over time not only in member countries, but in virtually all countries operating international banks. One problem with the original Basel Capital Accord was that it took a "one size fits all" approach, without regard for the actual operational risk incurred by the bank. In 2004, the Basel II Accord was established. The new accord aligns the requirement for capital on hand with the actual risk involved, providing an incentive for banks to improve risk management. Managing Risk Operational risk is a broad term that applies to various types of risk, the most crucial of which involve a breakdown in either internal controls or corporate governance. Other areas that introduce operational risks are information

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technology and catastrophes such as fires, floods or earthquakes. These operational risks can lead to significant financial losses for the bank. If not properly mitigated and managed, these risks can introduce opportunities for loss. It may be direct fraud or error, or it could be a bank representative or officer exceeding their authority and conducting illegal or unethical transactions. If the proper framework is in place, these operational risks are reduced and the bank can be considered to be more secure under the Basel II guidelines.

OBJECTIVES OF THE PROJECT  The analysis of what is basel 1 and why was it implemented  To trace the loopholes of Basel I  The analysis what is Basel II  The objectives of Basel II  The analysis of credit risk, market risk and operational risks are quantified.  To analyse the challenges in implementing Basel II in State Bank of India.  To analyse impact of Basel II on Indian Banks with special reference to State Bank of India

Sources of Data Primary Data:

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Most of the data was extracted from Bank, State Bank of India Zonal Office, State Bank of India Training Centre. Discussion with Bank’s Employees, Circulars, Documents and soft copies.

Secondary Data Indian Banking Association Journal and Bank Website.

Significance of the Study “ The project report helps in understanding how important the risk management is Banking Sector”.

FINDINGS  It was observed that while undertaking a project none of the SBI employees knows about Basel II.  The Bank is going to raise additional capital of by way of equity shares through IPO to support additional capital requirement for implementing Basel II

 Earlier there were no separate departments for managing risks, but after implementing Basel II separate departments to have been entrusted with the task of managing Credit Risk, Market Risk and Operational Risk.  Skilled operational personnel is required for State Bank of India.

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 Basel II tends to reduce Capital Base of Indian Banks by 1% to 2%, except a few Banks  Complexities in Systems and Processes involved in Basel II make the implementation process difficult, time consuming and costly.  Standardised Approach is adopted by bank to assess Credit Risk in which external Credit rating Agencies are involved, this is due bank’s internal rating system is not full proof system which is not approved by RBI.

CONCLUSIONS  Basel II will improve risk management exercise in Banks.  State Bank of India will get international standard for adopting Basel II.  All the areas of risks have been taken care.  Some additional Capital is required.

SUGGESTIONS  Bank has to train all its employees so that everybody can understand about Basel Accord.

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 It has to recruit operationally skilled personnel in order to implement Basel accord.  Bank has to develop a full proof internal credit rating system so that it can go for Advanced approach in assessing credit risk

INDUSRTY PROFILE

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BANKING INDUSTRY OVERVIEW History: Banking in India has its origin as carry as the Vedic period. It is believed that the transition from money lending to banking must have occurred even before Manu, the great Hindu jurist, who has devoted a section of his work to deposits and advances and laid down rules relating to the interest. During the mogal period, the indigenous bankers played a very important role in lending money and financing foreign trade and commerce. During the days of East India Company, it was to turn of the agency houses top carry on the banking business. The general bank of India was the first joint stock bank to be established in the year 1786.The others which followed were the Bank of Hindustan and the Bengal Bank. The Bank of Hindustan is reported to have continued till 1906, while the other two failed in the meantime. In the first half of the 19th Century the

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East India Company established three banks; The Bank of Bengal in 1809, The Bank of Bombay in 1840 and The Bank of Madras in 1843.These three banks also known as presidency banks and were independent units and functioned well. These three banks were amalgamated in 1920 and The Imperial Bank of India was established on the 27th Jan 1921, with the passing of the SBI Act in 1955, the undertaking of The Imperial Bank of India was taken over by the newly constituted SBI. The Reserve Bank which is the Central Bank was created in 1935 by passing of RBI Act 1934, in the wake of swadeshi movement, a number of banks with Indian Management were established in the country namely Punjab National Bank Ltd, Bank of India Ltd, Canara Bank Ltd, Indian Bank Ltd, The Bank of Baroda Ltd, The Central Bank of India Ltd .On July 19th 1969, 14 Major Banks of the country were nationalized and in 15th April 1980 six more commercial private sector banks were also taken over by the government. The Indian Banking industry, which is governed by the Banking Regulation Act of India 1949, can be broadly classified into two major categories, non-scheduled banks and scheduled banks. Scheduled Banks comprise commercial banks and the co-operative banks. The first phase of financial reforms resulted in the nationalization of 14 major banks in 1969 and resulted in a shift from class banking to mass banking. This in turn resulted in the significant growth in the geographical coverage of banks. Every bank had to earmark a min percentage of their loan portfolio to sectors identified as “priority sectors” the manufacturing sector also grew during the 1970’s in protected environments and the banking sector was a critical source. The next wave of reforms saw the nationalization of 6 more commercial banks in 1980 since then the number of scheduled commercial banks increased four- fold and the number of bank branches increased to eight fold. After the second phase of financial sector reforms and liberalization of the sector in the early nineties. The PSB’s found it extremely difficult to complete with the new

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private sector banks and the foreign banks. The new private sector first made their appearance after the guidelines permitting them were issued in January 1993. This is how the Banking Industry grew.

The Indian Banking System: Banking in our country is already witnessing the sea changes as the banking sector seeks new technology and its applications. The best port is that the benefits are beginning to reach the masses. Earlier this domain was the preserve of very few organizations. Foreign banks with heavy investments in technology started giving some “Out of the world” customer services. But, such services were available only to selected few- the very large account holders. Then came the liberalization and with it a multitude of private banks, a large segment of the urban population now requires minimal time and space for its banking needs. Automated teller machines or popularly known as ATM are the three alphabets that have changed the concept of banking like nothing before. Instead of tellers handling your own cash, today there are efficient machines that don’t talk but just dispense cash. Under the Reserve Bank of India Act 1934, banks are classified as scheduled banks and non-scheduled banks. The scheduled banks are those, which are entered in the Second Schedule of RBI Act, 1934. Such banks are those, which have paid- up capital and reserves of an aggregate value of not less then Rs.5 lacs and which satisfy RBI that their affairs are carried out in the interest of their depositors. All commercial banks Indian and Foreign, regional rural banks and state co-operative banks are Scheduled banks. Non Scheduled banks are those, which have not been included in the Second Schedule of the RBI Act, 1934. The organized banking system in India can be broadly classified into three

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categories: (i) Commercial Banks (ii) Regional Rural Banks and (iii) Co-operative banks. The Reserve Bank of India is the supreme monetary and banking authority in the country and has the responsibility to control the banking system in the country. It keeps the reserves of all commercial banks and hence is known as the “Reserve Bank”.

Current scenario:Currently (2007), the overall banking in India is considered as fairly mature in terms of supply, product range and reach - even though reach in rural India still remains a challenge for the private sector and foreign banks. Even in terms of quality of assets and capital adequacy, Indian banks are considered to have clean, strong and transparent balance sheets - as compared to other banks in comparable economies in its region. The Reserve Bank of India is an autonomous body, with minimal pressure from the Government. With the growth in the Indian economy expected to be strong for quite some time especially in its services sector, the demand for banking services especially retail banking, mortgages and investment services are expected to be strong. Mergers & Acquisitions., takeovers, are much more in action in India. One of the classical economic functions of the banking industry that has remained virtually unchanged over the centuries is lending. On the one hand, competition has had considerable adverse impact on the margins, which lenders have enjoyed, but on the other hand technology has to some extent reduced the cost of delivery of various products and services. Bank is a financial institution that borrows money from the public and lends money to the public for productive purposes. The Indian Banking Regulation Act of 1949

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defines the term Banking Company as "Any company which transacts banking business in India" and the term banking as "Accepting for the purpose of lending all investment of deposits, of money from the public, repayable on demand or otherwise and withdrawal by cheque, draft or otherwise". Banks play important role in economic development of a country, like: o Bank mobilise the small savings of the people and make them available for productive purposes. •

Promotes the habit of savings among the people thereby offering attractive rates of

•

interest on their deposits

o Provides safety and security to the surplus money of the depositors and as well provides a convenient and economical method of payment. •

Banks provide convenient means of transfer of fund from one place to

another. •

Helps the movement of capital from regions where it is not very useful to

regions where it can be more useful. •

Banks advances exposure in trade and commerce, industry and agriculture

by knowing their financial requirements and prospects.

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•

Bank acts as an intermediary between the depositors and the investors.

Bank also acts as mediator between exporter and importer who does foreign trades.

Thus Indian banking has come from a long way from being a sleepy business institution to a highly pro-active and dynamic entity. This transformation has been largely brought about by the large dose of liberalization and economic reforms that allowed banks to explore new business opportunities rather than generating revenues from conventional streams (i.e. borrowing and lending). The banking in India is highly fragmented with 30 banking units contributing to almost 50% of deposits and 60% of advances.

The Structure of Indian Banking: The Indian banking industry has Reserve Bank of India as its Regulatory Authority. This is a mix of the Public sector, Private sector, Co-operative banks and foreign banks. The private sector banks are again split into old banks and new banks.

Reserve Bank of India [Central Bank]

Scheduled Banks

15 KLE’sScheduled Institute of Manageent Studies of Research Commercial Banks

Foreign Banks

Scheduled Co-operative Banks MBA IV Sem Regional Rural Banks

The Analysis of Basel Norms and Implementation

Private Sector Banks

Public Sector Banks

Scheduled Urban Co-Operative Banks

Nationalized SBI & its Associates Banks

Old Private Sector Banks

Scheduled State Co-Operative Banks

New Private Sector Banks

Chart Showing Three Different Sectors of Banks i)

Public Sector Banks

ii)

Private Sector Banks

Public Sector Banks

SBI and SUBSIDIARIES

Nationalized Banks

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SBI and subsidiaries This group comprises of the State Bank of India and its seven subsidiaries viz., State Bank of Patiala, State Bank of Hyderabad, State Bank of Travancore, State Bank of Bikaner and Jaipur, State Bank of Mysore, State Bank of Saurashtra, State Bank of India State Bank of India (SBI) is the largest bank in India. If one measures by the number of branch offices and employees, SBI is the largest bank in the world. Established in 1806as Bank of Bengal it is the oldest commercial bank in the Indian subcontinent. SBI provides various domestic, international and NRI products and services, through its vast network in India and overseas. With an asset base of $126 billion and its reach, it is a regional banking behemoth. The government nationalized the bank in1955, with the Reserve bank of India taking a 60% ownership stake. In recent years the bank has focused on two priorities, 1), reducing its huge staff through Golden handshakeschemes known as the Voluntary Retirement Scheme, which saw many of its best and brightest defect to the private sector, and 2), computerizing its operations.

The State Bank of India traces its roots to the first decade of19th century, when the Bank of culcutta, later renamed theBank of bengal, was established on 2 jun 1806. The government amalgamatted Bank of Bengal and two other Presidency banks, namely, the Bank of Bombay and the bank of Madras, and named the reorganized banking entity the Imperial Bank of India. All these Presidency banks were incorporated ascompanies, and were the result of theroyal charters. The Imperial Bank of India continued to remain a joint stock company. Until the establishment of a central bank in India the Imperial Bank and its early predecessors served as the nation's central bank printing currency.

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The State Bank of India Act 1955, enacted by the parliament of India, authorized the Reserve Bank of India, which is the central Banking Organisationof India, to acquire a controlling interest in the Imperial Bank of India, which was renamed the State Bank of India on30th April 1955. In recent years, the bank has sought to expand its overseas operations by buying foreign banks. It is the only Indian bank to feature in the top 100 world banks in the Fortune Global 500 rating and various other rankings. According to the Forbes 2000 listing it tops all Indian companies.

Nationalized banks This group consists of private sector banks that were nationalized. The Government of India nationalized 14 private banks in 1969 and another 6 in the year 1980. In early 1993, there were 28 nationalized banks i.e., SBI and its 7 subsidiaries plus 20 nationalized banks. In 1993, the loss making new bank of India was merged with profit making Punjab National Bank. Hence, now only 27 nationalized banks exist in India.

Regional Rural banks These were established by the RBI in the year 1975 of banking commission. It was established to operates exclusively in rural areas to provide credit and other facilities to small and marginal farmers, agricultural labourers, artisans and small entrepreneurs.

Private Sector Banks

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Private Sector Banks

Old private Sector Banks

New private Sector Banks

Old Private Sector Banks This group consists of the banks that were establishes by the privy sectors, committee organizations or by group of professionals for the cause of economic betterment in their operations. Initially, their operations were concentrated in a few regional areas. However, their branches slowly spread throughout the nation as they grow.

New private Sector Banks These banks were started as profit orient companies after the RBI opened the banking sector to the private sector. These banks are mostly technology driven and better managed than other banks.

Foreign banks These are the banks that were registered outside India and had originated in a foreign country. The major participants of the Indian financial system are the commercial banks, the financial institutions (FIs), encompassing term-lending institutions, investment institutions, specialized financial institutions and the state-level development banks, Non-Bank Financial Companies (NBFCs) and other market intermediaries such as the stock brokers and money-lenders. The commercial banks and certain variants of NBFCs are among the oldest of the market participants. The FIs, on the other hand, are relatively new entities in the financial market place.

IMPORTANCE OF BANKING SECTOR IN A GROWING ECONOMY

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In the recent times when the service industry is attaining greater importance compared to manufacturing industry, banking has evolved as a prime sector providing financial services to growing needs of the economy. Banking industry has undergone a paradigm shift from providing ordinary banking services in the past to providing such complicated and crucial services like, merchant banking, housing finance, bill discounting etc. This sector has become more active with the entry of new players like private and foreign banks. It has also evolved as a prime builder of the economy by understanding the needs of the same and encouraging the development by way of giving loans, providing infrastructure facilities and financing activities for the promotion of entrepreneurs and other business establishments. For a fast developing economy like ours, presence of a sound financial system to mobilize and allocate savings of the public towards productive activities is necessary. Commercial banks play a crucial role in this regard. The Banking sector in recent years has incorporated new products in their businesses, which are helpful for growth. The banks have started to provide fee-based services like, treasury operations, managing derivatives, options and futures, acting as bankers to the industry during the public offering, providing consultancy services, acting as an intermediary between two-business entities etc.At the same time, the banks are reaching out to other end of customer requirements like, insurance premium payment, tax payment etc. It has changed itself from transaction type of banking into relationship banking, where you find friendly and quick service suited to your needs. This is possible with understanding the customer needs their value to the bank, etc. This is possible with the help of well organized staff, computer based network for speedy transactions, products like credit card, debit card, health card, ATM etc. These are the present trend of services. The customers at present ask for convenience of banking transactions, like 24

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hours banking, where they want to utilize the services whenever there is a need. The relationship banking plays a major and important role in growth, because the customers now have enough number of opportunities, and they choose according to their satisfaction of responses and recognition they get. So the banks have to play cautiously, else they may lose out the place in the market due to competition, where slightest of opportunities are captured fast. Another major role played by banks is in transnational business, transactions and networking. Many leading Indian banks have spread out their network to other countries, which help in currency transfer and earn exchange over it. These banks play a major role in commercial import and export business, between parties of two countries. This foreign presence also helps in bringing in the international standards of operations and ideas. The liberalization policy of 1991 has allowed many foreign banks to enter the Indian market and establish their business. This has helped large amount of foreign capital inflow & increase our Foreign exchange reserve. Another emerging change happening all over the banking industry is consolidation through mergers and acquisitions. This helps the banks in strengthening their empire and expanding their network of business in terms of volume and effectiveness.

EMERGING SCENARIO IN THE BANKING SECTOR The Indian banking system has passed through three distinct phases from the time of inception. The first was being the era of character banking, where you were recognized as a credible depositor or borrower of the system. This era come to an end in the sixties.

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The second phase was the social banking. Nowhere in the democratic developed world, was banking or the service industry nationalized. But this was practiced in India. Those were the days when bankers has no clue whatsoever as to how to determine the scale of finance to industry. The third era of banking which is in existence today is called the era of Prudential Banking. The main focus of this phase is on prudential norms accepted internationally.

SBI GroupThe Bank of Bengal, which later became the State Bank of India. State Bank of India with its seven associate banks commands the largest banking resources in India.

Nationalisation-

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The next significant milestone in Indian Banking happened in late 1960s when the then Indira Gandhi government nationalized on 19th July 1949, 14 major commercial Indian banks followed by nationalisation of 6 more commercial Indian banks in 1980. The stated reason for the nationalisation was more control of credit delivery. After this, until 1990s, the nationalised banks grew at a leisurely pace of around 4% also called as the Hindu growth of the Indian economy. After the amalgamation of New Bank of India with Punjab National Bank, currently there are 19 nationalised banks in India

LiberalizationIn the early 1990’s the then Narasimha rao government embarked a policy of liberalization and gave licences to a small number of private banks, which came to be known as New generation tech-savvy banks, which included banks like ICICI and HDFC. This move along with the rapid growth of the economy of India, kick started the banking sector in India, which has seen rapid growth with strong contribution from all the sectors of banks, namely Government banks, Private Banks and Foreign banks. However there

had been a few hiccups for these new banks with many either being taken over like Global Trust Bank while others like Centurion Bank have found the going tough.

The next stage for the Indian Banking has been set up with the proposed relaxation in the norms for Foreign Direct Investment, where all Foreign Investors in Banks may be given voting rights which could exceed the present cap of 10%, at pesent it has gone up to 49% with some restrictions.

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The new policy shook the Banking sector in India completely. Bankers, till this time, were used to the 4-6-4 method (Borrow at 4%;Lend at 6%;Go home at 4) of functioning. The new wave ushered in a modern outlook and tech-savvy methods of working for traditional banks.All this led to the retail boom in India. People not just demanded more from their banks but also received more. CURRENT SCENARIOCurrently (2007), overall, banking in India is considered as fairly mature in terms of supply, product range and reach-even though reach in rural India still remains a challenge for the private sector and foreign banks. Even in terms of quality of assets and capital adequacy, Indian banks are considered to have clean, strong and transparent balance sheets-as compared to other banks in comparable economies in its region. The Reserve Bank of India is an autonomous body, with minimal pressure from the government. The stated policy of the Bank on the Indian Rupee is to manage volatility-without any stated exchange rate-and this has mostly been true.

With the growth in the Indian economy expected to be strong for quite some timeespecially in its services sector, the demand for banking services-especially retail banking, mortgages and investment services are expected to be strong. M&As, takeovers, asset sales and much more action (as it is unravelling in China) will happen on this front in India.

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The next stage for the Indian Banking has been set up with the proposed relaxation in the norms for Foreign Direct Investment, where all Foreign Investors in Banks may be given voting rights which could exceed the present cap of 10%, at pesent it has gone up to 49% with some restrictions. The new policy shook the Banking sector in India completely. Bankers, till this time, were used to the 4-6-4 method (Borrow at 4%;Lend at 6%;Go home at 4) of functioning. The new wave ushered in a modern outlook and tech-savvy methods of working for traditional banks.All this led to the retail boom in India. People not just demanded more from their banks but also received more. In March 2006, the Reserve Bank of India allowed Warburg Pincus to increase its stake in Kotak Mahindra Bank (a private sector bank) to 10%. This is the first time an investor has been allowed to hold more than 5% in a private sector bank since the RBI announced norms in 2005 that any stake exceeding 5% in the private sector banks would need to be vetted by them. Currently, India has 88 scheduled commercial banks (SCBs) - 28 public sector banks (that is with the Government of India holding a stake), 29 private banks (these do not have government stake; they may be publicly listed and traded on stock exchanges) and 31 foreign banks. They have a combined network of over 53,000 branches and 17,000 ATMs. According to a report by ICRA Limited, a rating agency, the public sector banks hold over 75 percent of total assets of the banking industry, with the private and foreign banks holding 18.2% and 6.5% respectively.

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Banking in India 1

Central Bank

Reserve Bank of India State Bank of India, Allahabad Bank, Andhra Bank, Bank

of

Baroda,

Bank

of

India,

Bank

of

Maharastra,Canara Bank, Central Bank of India, 2

Nationalised Banks

Corporation Bank, Dena Bank, Indian Bank, Indian overseas Bank,Oriental Bank of Commerce, Punjab and

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Sind Bank, Punjab National Bank, Syndicate Bank, Union Bank of India, United Bank of India, UCO Bank,and Vijaya Bank. Bank of Rajastan, Bharath overseas Bank, Catholic Syrian Bank, Centurion Bank of Punjab, City Union Bank, Development Credit Bank, Dhanalaxmi Bank, 3

Private Banks

Federal Bank, Ganesh Bank of Kurundwad, HDFC Bank, ICICI Bank, IDBI, IndusInd Bank, ING Vysya Bank, Jammu and Kashmir Bank, Karnataka Bank Limited, Karur Vysya Bank, Kotek Mahindra Bank, Lakshmivilas Bank, Lord Krishna Bank, Nainitak Bank, Ratnakar Bank,Sangli Bank, SBI Commercial and International Bank, South Indian Bank, Tamil Nadu Merchantile Bank Ltd., United Western Bank, UTI Bank, YES Bank.

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COMPANY PROFILE

STATE BANK OF INDIA Not only many financial institution in the world today can claim the antiquity and majesty of the State Bank Of India founded nearly two centuries ago with primarily intent of imparting stability to the money market, the bank from its inception mobilized funds for supporting both the public credit of the companies governments in the three presidencies of British India and the private credit of the European and India merchants

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from about 1860s when the Indian economy book a significant leap forward under the impulse of quickened world communications and ingenious method of industrial and agricultural production the Bank became intimately in valued in the financing of practically and mining activity of the Sub- Continent Although large European and Indian merchants and manufacturers were undoubtedly thee principal beneficiaries, the small man never ignored loans as low as Rs.100 were disbursed in agricultural districts against glad ornaments. Added to these the bank till the creation of the Reserve Bank in 1935 carried out numerous Central – Banking functions. Adaptation world and the needs of the hour has been one of the strengths of the Bank, In the post depression exe. For instance – when business opportunities become extremely restricted, rules laid down in the book of instructions were relined to ensure that good business did not go post. Yet seldom did the bank contravenes its value as depart from sound banking principles to retain as expand its business. An innovative array of office, unknown to the world then, was devised in the form of branches, sub branches, treasury pay office, pay office, sub pay office and out students to exploit the opportunities of an expanding economy. New business strategy was also evaded way back in 1937 to render the best banking service through prompt and courteous attention to customers.

A highly efficient and experienced management functioning in a well defined organizational structure did not take long to place the bank an executed pedestal in the areas of business, profitability, internal discipline and above all credibility A impeccable financial status consistent maintenance of the lofty traditions if banking an observation of a high standard of integrity in its operations helped the bank gain a pre- eminent status. No wonders the administration for the bank was universal as key functionaries of India

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successive finance minister of independent India Resource Bank of governors and representatives of chamber of commercial showered economics on it. Modern day management techniques were also very much evident in the good old days years before corporate governance had become a puzzled the banks bound functioned with a high degree of responsibility and concerns for the shareholders. An unbroken records of profits and a fairly high rate of profit and fairly high rate of dividend all through ensured satisfaction, prudential management and asset liability management not only protected the interests of the Bank but also ensured that the obligations to customers were not met. The traditions of the past continued to be upheld even to this day as the State Bank years itself to meet the emerging challenges of the millennium.

ABOUT LOGO

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THE PLACE TO SHARE THE NEWS ...…… SHARE THE VIEWS …… Togetherness is the theme of this corporate loge of SBI where the world of banking services meet the ever changing customers needs and establishes a link that is like a circle, it indicates complete services towards customers. The logo also denotes a bank that it has prepared to do anything to go to any lengths, for customers.

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The blue pointer represent the philosophy of the bank that is always looking for the growth and newer, more challenging, more promising direction. The key hole indicates safety and security.

MISSION, VISION AND VALUES MISSION STATEMENT: To retain the Bank’s position as premiere Indian Financial Service Group, with world class standards and significant global committed to excellence in customer, shareholder and employee satisfaction and to play a leading role in expanding and diversifying financial service sectors while containing emphasis on its development banking rule. VISION STATEMENT: ♦ Premier Indian Financial Service Group with prospective world-class Standards of efficiency and professionalism and institutional values. ♦ Retain its position in the country as pioneers in Development banking. ♦ Maximize the shareholders value through high-sustained earnings per Share. ♦ An institution with cultural mutual care and commitment, satisfying and Good work environment and continues learning opportunities.

VALUES:

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♦ Excellence in customer service ♦ Profit orientation ♦ Belonging commitment to Bank ♦ Fairness in all dealings and relations ♦ Risk taking and innovative ♦ Team playing ♦ Learning and renewal ♦ Integrity ♦ Transparency and Discipline in policies and systems.

ORGANISATION STRUCTURE

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MANAGING DIRECTOR

CHIEF GENERAL MANAGER

G. M (Operations)

G.M

G. M

(C&B)

(F&S)

G.M (I) & CVO

zonal officers

Functional Heads

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G.M (P&D)

The Analysis of Basel Norms and Implementation

THE ANALYSIS OF BASEL NORMS AND ITS IMPLEMENTATION

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BACKGROUND OF BASEL ACCORD The initiatives taken by the Basel Committee in addressing the rigidities in the 1988 Capital Accord by evolving a comprehensive and risk-sensitive New Basel Capital Accord (the New Accord) are timely. The range of options for providing capital would facilitate banks with varying degrees of sophistication to adopt appropriate method with supervisory validation. Further, the emphasis laid on the role of supervisory review process and market discipline, as essential complements to minimum capital requirements would go a long way in enhancing the efficacy of supervision. Reserve Bank’s association with the Basel Committee on Banking Supervision (BCBS) – the owner of the Basel II framework- dates back to 1997 as India was among the 16 nonmember countries that were consulted in the drafting of the Basel Core Principles. Reserve Bank of India became a member of the Core Principles Liaison Group in 1998 and subsequently became a member of the Core Principles Working Group on Capital. Within the Working Group, RBI has been actively participating in the deliberations on the Basel II framework and had the privilege to lead a group of six major non-G-10 supervisors which presented a proposal on a simplified approach for Basel II to the Committee.

Approach to reforms With the commencement of the banking sector reforms in the early 1990s, the RBI has been consistently upgrading the Indian banking sector by adopting international best practices. The approach to reforms is one of having clarity about the destination, deciding on the sequence and modulating the pace of reforms to suit Indian conditions. This has helped us in moving ahead with the reforms in a purposeful but non-disruptive manner.

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Basel I The progress made by the Indian banking system with regard to Basel I implementation before we discuss Basel II implementation. Adopting our general approach of gradualism, we implemented the Basel I framework with effect from 1992-93 which was, however, spread over 3 years– banks with branches abroad were required to comply fully by end March 1994 and the other banks were required to comply by end March 1996. Further, India responded to the 1996 amendment to the Basel I framework which required banks to maintain capital for market risk exposures, by initially prescribing various surrogate capital charges for these risks between 2000 and 2002. These were replaced with the capital charges as required under the BaselI framework in June 2004, which become fully effective from March2005. With the successful implementation of banking sector reforms over the past decade, the Indian banking system has shown substantial improvement on various parameters. It has become robust and displayed significant resilience to shocks. There is ample evidence of the capacity of the Indian banking system to migrate smoothly to Basel II norms.

RBI recognises that several of the concerns expressed and recommendations made by India and other emerging markets on the first consultative document have been taken into account and addressed in the second consultative document. Particularly, the proposals to do away with the sovereign floor in assigning risk weights and subscription to IMF’s Special Data Dissemination Standards (SDDS) and Core Principles for Effective Banking Supervision for preferential risk weighting, greater use of Export Credit Agencies (ECAs), additional risk weight bucket of 50% in respect of claims on corporates, simplified internal rating based approach, etc., reflect the Committee’s endeavour in

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evolving a consensual framework which could be adapted by all countries including emerging markets. In this context, the Basel Committee’s concerns for the constraints which are faced by the emerging markets and greater outreach by involving non G-10 countries in the standards setting exercise would lead to greater appreciation for the New Accord. However, some of the issues in the context of emerging markets are still to be addressed. RBI feels that the complexity and sophistication of the proposals restricts its universal application in emerging markets, where the banks continue to be the major segment in financial intermediation and would be facing considerable challenges in adopting all the proposals. The New Accord would involve shift in direct supervisory focus away to the implementation issues. Further, banks and the supervisors would be required to invest large resources in upgrading their technology and human resources to meet the minimum standards. The increasing reliance on external rating agencies in the regulatory process would undermine the initiatives of banks in enhancing their risk management policies and practices and internal control systems. The minimum standards set even for the Internal Rating Based (IRB) foundation approach are complex and beyond the reach of many banks. Further, while the Basel Committee desires neither to produce a net increase nor a net decrease in minimum regulatory capital, it is felt that the current proposals are going to result in significant increase in the capital charge for banks, especially in emerging markets. The emerging markets with their low technical skills, structural rigidities and less robust legal system, etc. would face serious implementation challenges. RBI, therefore, feels that the spirit of flexibility, universal applicability and discretion to national supervisors, consistent with the macro economic conditions specific to emerging markets ought to be preserved while finalizing the New Accord. Scope of Application

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RBI agrees with the Committee’s view that the focus of the New Accord may be primarily on internationally active banks, which would be followed by adherence by all significant banks after a certain period of time. The basic philosophy of the New Accord being to achieve competitive equality and financial stability and the Committee’s pronouncement that the underlying principles are generally suitable to all types of banks around the globe, the New Accord, like the 1988 Accord, should be applied, generally to all banks. However, RBI shares the views of Mr. Laurence H. Meyer, Member of the Board of Governors of the Federal Reserve System that ‘it is not at all obvious that the proposed standardised approach fits the needs of smaller banking organization engaged primarily in traditional banking activities… but I question whether the added implementation burdens are cost-effective for traditional banking organizations, especially since neither the current nor the proposed capital frameworks yet address what is perhaps the most critical risk factor for smaller banks – geographic and sectoral concentrations of credit risk’1. It is, therefore, suggested that a simplified standardised approach, based on internal rating systems of banks may be evolved and applied to banks, which are not internationally active. Under this approach, standardised risk weights in the range of 0% to 150% on the basis of internal ratings of banks, could be assigned, subject to mapping of such ratings with the benchmark Probability of Default (PD) estimated by the supervisor on the basis of pooled data from select banks. As a precursor, however, internal rating systems of banks need to be substantially upgraded and strengthened, keeping in view the best practices and the standards prescribed by the Basel Committee for IRB approach. Recognising, however, the fact that even the simplified approach is likely to be more extensive and complex than the 1988 Accord, the New Accord may be applied, in phases, at the discretion of national supervisors to banks on the basis of the complexity, scale of operation, etc. Each national supervisor may, however, be required to publicly

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announce a schedule for implementation of the New Accord and the status of implementation may be evaluated under the proposed framework for exchange of information amongst member countries. RBI, therefore, agrees with the view that the New Accord should initially be applied to all internationally active banks. Further, a simplified standardised approach, as suggested above, may be evolved for other banks and that national supervisors should have discretion to implement the New Accord, in a phased manner. As the main objective of the New Accord is to ensure competitive equality and providing a reasonable degree of consistency in application, it is necessary that all supervisors, across the world should have a common definition of internationally active and significant banks. Basel Committee may, therefore, define what constitute internationally active and significant banks. In this regard, RBI is of the view that all banks with cross-border business exceeding 15% of their total business may be defined as internationally active banks. Significant banks may be defined as those banks with complex structures and whose market share in the total assets of the domestic banking system exceeds 1%. In the event of no consensus evolving on a uniform definition, national supervisors should have discretion to define what constitutes an internationally active and a significant bank. Each national supervisor may, however, be required to announce the criteria adopted for defining internationally active and significant banks in its jurisdiction through the Basel Committee. The criteria, when endorsed, should be accepted by supervisors in other jurisdictions and by international agencies. Cross-holding of Capital

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RBI, while appreciating the Committee’s proposal that reciprocal cross-holdings of bank capital artificially designed to inflate capital position of banks should be deducted, feels that cross-holdings of equity and other regulatory investments also need to be moderated to preserve the integrity of the financial system and minimise the adverse effect of systemic risk and contagion. RBI is, therefore, of the view that the Basel Committee may consider prescribing a material limit (10% of the total capital) upto which cross-holdings of capital and other regulatory investments could be permitted and any excess investments above the limit would be deducted from total capital. 4.3 Claims on Sovereigns 4.3.1 RBI reiterates its earlier views that it will not be proper to link the risk weights assigned to claims on sovereigns on the basis of assessments of External Credit Assessment Institutions (ECAIs), as their credibility and past record lack empirical evidence. In the recent past, the credit rating agencies had resorted to sudden and rapid downgrading of certain countries, which experienced financial crises that exacerbated the tendency of financial institutions to risk for exit. RBI, therefore, reiterates that the ECAIs should not be assigned the direct responsibility for risk assessment of banking book assets. This also applies to the assessments of Export Credit Agencies (ECAs) as their independence and judgment are also subject to the same limitations as those of the rating agencies. 4.3.2 The Committee’s proposal that the assessments of ECAs are recognized only if they publish their risk scores and subscribe to the OECD 1999 country risk assessment methodology is appreciated. However, the OECD methodology and ECAs’ country risk

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classifications are still confidential. Further, their insight into the local conditions and issues specific to emerging markets is also not comprehensive. RBI, therefore, feels that such of the ECAs that disclose publicly their risk scores, rating process and procedure and subscribe to the publicly disclosed OECD methodology and qualify for use by national supervisors should only be eligible for use in assigning preferential risk weights.

Claims on Banks The flexibility to provide uniform risk weight i.e. one category less favourable than that assigned to claims on sovereign to all the banks (under first option) militates the basic philosophy of aligning capital adequacy assessment more closely with the key elements of risk. The mere location may not necessarily be a good indicator of a bank’s creditworthiness. This proposal provides competitive advantage to banks with weak financials by virtue of their having been incorporated in better-rated countries. RBI, therefore, reiterates its earlier view that the risk weighting of banks should be delinked from that of the credit rating of sovereigns in which they are incorporated. Instead, preferential risk weights should be assigned on the basis of their underlying strength and creditworthiness. 4.4.2 Banks are strongly regulated and supervised entities. In particular, weak banks and those banks, which show signs of problems, are subjected to rigorous on-site and off-site supervision and stringent prudential standards. Thus, risks inherent in inter-bank exposures are not comparable to that of the corporates. There is, therefore, a need for a

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modified treatment for claims on banks. The Basel Committee has provided discretion to national supervisors to assign a lower risk weight to the exposures to the sovereign of incorporation, denominated in domestic currency and funded in that currency. A similar flexibility should be provided in respect of claims on banks as well. RBI, therefore, feels that on the lines of discretion provided in the case of claims on sovereigns, the national supervisors may be given discretion to assign lower risk weight (one category less favourable than the risk weight to claims on sovereign), subject to a floor of 20% to claims on all banks, which are denominated in domestic currency and funded in that currency. The proposal to assign preferential risk weight to short-term claims may lead to regulatory arbitrage through roll-overs, concentration of short-term borrowings and serious asset-liability mismatches, which could trigger systemic crisis and contagion in the domestic inter-bank market. It would also be very difficult to monitor and control the rollovers of short-term claims, given the high volume of transactions in the inter-bank market. RBI, therefore, feels that preferential risk weights should not be linked to the maturity of the claims. Claims on Corporates RBI appreciates the Committee’s efforts in evolving a range of risk-sensitive options for assessing capital for credit risk. However, the reliance on ECAIs under the standardised approach for assigning preferential risk weights may not be a better option. First, the credibility of the rating agencies is at stake and there is no system of accountability for sharp deterioration in the credit quality of rated entities immediately after assigning a rating. Secondly, their access to information, especially in the absence of transparency

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and good corporate governance principles is severely restricted. Whereas, banks are privy to customer information and are less exposed to customer-related informational asymmetry. Thirdly, the population of rated entities, even in the advanced countries, and especially in the emerging markets, which have exposure to the banking system, is very few in number. Fourthly, the use of external credit rating agencies in the regulatory process may act as a disincentive for the banks to improve their credit risk management systems. It is appreciated that the expanded role envisioned for IRB approach provides positive incentives to banks in improving their credit risk management techniques. However, the adoption of the IRB approach, even under the foundation approach requires considerable investments in IT / human resources and rigorous supervisory oversights. Thus, most of the banks may not be able to adopt, even in advanced markets, the IRB foundation approach. RBI, therefore, feels that adoption of the IRB approach, as envisaged, may be possible only for internationally active banks within the time frame and transition period proposed by the Committee. For other banks, as an alternative, it is proposed that a simplified standardised approach to assign preferential risk weights based on internal ratings of banks may be evolved, subject to complying with the minimum standards prescribed by the Basel Committee for IRB approach. Under this approach, standardised risk weights, instead of the continuous function of PD, Loss Given Default (LGD) and Exposure at Default (EAD), in the range of 20% to 150% could be assigned, subject to mapping of these ratings based on the robustness of the rating systems and the benchmark PD estimated by the supervisor on the basis of pooled data from select banks. This approach could be extended to a greater number of counterparties such as unrated borrowers in the small/retail sector and will encourage banks to refine their credit risk assessment and monitoring process, which would facilitate better management of their

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loan books. This will also avoid the use of ECAIs in the regulatory process and reduce the burden of additional cost on this count. Also, the scarce supervisory resources will be optimally utilised for validating the banks’ internal rating systems rather than for approving ECAIs. This would also avoid conflict of jurisdiction over rating agencies. RBI, therefore, proposes that while internationally active banks may be required to follow the IRB approach, a simplified standardised approach may be evolved for other banks, whereby standardised risk weights in the range of 20% to 150% could be assigned on the basis of internal ratings of banks.

Higher-risk Categories The Committee’s proposals to assign 150% risk weight on unsecured portion of any asset that is past due for more than 90 days, net of specific provisions, would adversely affect the capital position of banks, especially those incorporated in emerging markets. Normally, banks take some time in initiating the legal process after recognising impairment. Further, there are well-established norms for recognition of and full provision for any known loan losses. Collaterals also back such loans. Thus, the proposal to assign 150% risk weight even after recognising, in full, diminution in the value of impaired loans would lead to pre-emption of scarce capital which does not reflect the historical loan loss experiences. In India, the adoption of the proposal alone would increase the risk-weighted assets of the banking system by USD 3.2 bio, entailing a drop in the existing CRAR by 31 bps. as on March 31, 2000. The 90-day norm also makes the regulatory capital extremely pro-cyclical. While during the boom period there would be low accretion to NPAs leading to lower provisioning

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requirements and higher capital adequacy ratio, during the recessionary phase, temporary cash flow problems accentuate the pace of accretion to NPAs and hence the need for higher provisioning requirements leading to lower capital adequacy ratio. Lending by banks especially in the emerging markets is basically for productive purposes and are adequately collateralised by various types of assets. The proposal to reckon only the eligible collaterals for the secured portion of assets, which are past due for more than 90 days, is too restrictive. National supervisors should have discretion to recognise a wider range of collaterals for reckoning the secured portion of the assets. RBI, therefore, feels that assets that are overdue over 90 days need not be placed under a separate higher-risk category

External Credit Assessments RBI appreciates the Committee’s endeavour in addressing most of the deficiencies inherent in the first document regarding the use of ECAIs. The operative details about implementation considerations viz. mapping process, multiple assessments, issuer versus issue assessment, etc. would go a long way in addressing the supervisory concerns expressed by many regulators including RBI. However, the proposal to use unsolicited ratings in the same way as solicited ratings would undermine the efficacy of using external assessments for regulatory purposes. The unsolicited ratings are generally superficial. The use of such ratings for assigning preferential risk weights would undermine the basic philosophy of the New Accord. It may also lead to the potential for trade off between competition and quality in the rating industry.

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RBI is of the view that preferential risk weights should be assigned only on the basis of solicited ratings. Internal Rating Based Approach RBI appreciates the Basel Committee’s proposal to offer a range of options of increasing sophistication for providing explicit capital charge for credit risk. RBI recognises the inherent attractiveness of the IRB foundation approach, which will result in better internal credit risk management and may have the potential to be used in the supervision of banks. However, the minimum requirements stipulated even under the IRB foundation approach are difficult to be enforced, especially in the emerging markets. Most of the banks do not have robust rating systems and historical data on PDs, nor do the supervisory authorities maintain time series data for estimating LGD. The transition period of three years proposed in the New Accord may, therefore, not be adequate for building database on various parameters. It is pertinent to quote Mr. Laurence H. Meyer that ‘despite the importance of evaluating a borrower’s probability of default, banks have been surprisingly slow, it seems, to distinguish among acceptable credit risk levels in their pricing and in their own assessments of capital adequacy… Last fall, the Basel Committee conducted an initial survey of large internationally active banks in order to estimate the quantitative effects of the proposal on their capital requirements. The Committee was disappointed in the modest number of banks worldwide that could provide meaningful distributions of credit quality, even for their corporate portfolios’2. RBI, therefore, suggests that a simplified standardised approach as indicated in para above might be evolved and applied to banks that are not internationally active.

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It is well recognised that the proposal to assign banking book exposures into six broad classes of exposures with different underlying credit risk characteristics - corporates, sovereigns, banks, retail, project finance and equity under IRB approach would better discriminate the likely pattern of portfolio losses. However, a common framework for definition of these loan portfolio segments, without recognising the institutional framework, value of accounts, geographical spread, etc., may pose severe implementation problems to banks in emerging markets. RBI, therefore, feels that national supervisors may have discretion and flexibility in defining the exposure classes, viz. corporate, retail, sovereign, project finance, etc. Operational Risk In the context of increasing globalization, enhanced use of technology, product innovations and growing complexity in operations, RBI agrees, in principle, with the Committee’s proposal to assign explicit capital charge for operational risk. RBI also acknowledges that the range of approaches of increasing sophistication - basic indicator, standardised and internal measurement - would set the basic framework for estimating capital for operational risk. Given the sophistication and database required for standardised and internal measurement approaches, most of the banks, especially those domiciled in emerging markets would be adopting the basic indicator approach. However, the current provisional estimate of around 30% of gross income, which as per Committee’s estimate works out to 20% of the current capital requirement as per the 1988 Accord, is expected to impose significant burden on the capital requirement of banks. Further, it also does not reflect the risk profile of various banks, operating under various levels of sophistication, markets, etc. It is observed that the fixed percentage has been prescribed on the basis of economic capital set by only 6 international banks for operational risk. As the magnitude of operational risk depends on complexity of

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operations, absorption of technology, value of transactions, legal / supervisory framework, internal control systems, etc., a uniform rate may not reflect the degree of operational risk. The Committee may consider undertaking studies on operational risk with particular reference to observed rate of losses, correlation between credit and market risks and operational risk, etc. RBI, therefore, feels that until a scientific method to measure the operational risk across countries is evolved, the Basel Committee may consider prescribing a lower capital charge of 15% of the gross income or 10% of the current capital requirement to align capital to the underlying risk profile. National supervisors may, however, be given discretion to prescribe higher capital charge towards operational risk in case of banks, which may be considered as ‘outliers’. Trading Book Issues The Basel Committee has indicated that the changes made in the trading book are consistent with the changes in the banking book capital requirements under the standardised approach. However, the Committee’s proposal to provide explicit capital charge on the basis of ratings is not consistent with the banking book capital requirements as discussed hereunder. Under the standardised approach, discretion has been provided to assign a lower risk weight to banks’ exposure to the sovereign of incorporation denominated in domestic currency and funded in that currency. A similar discretion should be provided for specific risk capital charge for trading book to avoid regulatory arbitrage.

Further, the graduated specific risk charge for qualifying securities has not been consistent with preferential risk weights proposed in the banking book, as these have

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been differentiated only on the basis of maturity rather than linking the capital charge to the rating of the instruments. Further, the uniform capital charge of 8% to other category does not reflect and compare with the risk weight of 150% or higher being proposed for claims on sovereigns, banks and corporates that are rated below B-. Unless, the capital charge or risk weights are uniform both in the trading and banking books, the New Accord may lead to banks going for regulatory arbitrage. RBI, therefore, feels that the capital charge for specific risk in the banking and trading books should be consistent to avoid regulatory arbitrages. Market Discipline – Third Pillar RBI shares the Committee’s view that too much information could blur the key signals to the market and agrees with the proposal to make a clear distinction between core and supplementary disclosures. Further, the proposals to mandate frequent disclosures on information, subject to rapid time decay, would facilitate market participants in taking informed decisions.

Transitional Arrangements The Committee has provided a three year transition period beginning from the date of implementation for applying full sub-consolidation. Similarly, a three-year transition period has been provided for the foundation IRB approach, during which period, the

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requirements could be relaxed, although supervisors would be expected to ensure that implementation of IRB approach is done by banks in a sound manner. While RBI feels that the above transition period would be sufficient for the internationally active banks, other banks may need more transition period even for implementing the suggested simplified standardised approach. RBI, therefore, feels that national supervisors may be given discretion to implement the New Accord, in a phased manner by banks, which are not internationally active and are engaged predominantly in traditional banking. . General Issues Impact on Capital under Standardised Approach Under the standardised approach, the Committee desires neither to produce a net increase nor a net decrease, on an average, in minimum regulatory capital, even after accounting for 20% explicit capital charge for operational risk. The Committee’s views are apparently based on the assumption that capital discharge would be available on assigning preferential risk weights to claims on sovereigns, banks and corporates, on the basis of external assessments and recognition of more collaterals under credit risk mitigation techniques.

However, RBI feels that the adoption of the New Accord would definitely enhance the minimum regulatory capital, especially for banks domiciled in emerging markets on account of the following:

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i.

All claims on sovereign (OECD or non-OECD) in India are currently assigned a uniform risk weight of 0%. The discretion to assign a lower risk weight would henceforth be available to claims on sovereign (or Central Bank) of incorporation, denominated in domestic currency and funded in that currency. Other sovereigns are required to be assigned risk weight in the range of 0% to 150% on the basis of e20%. The 20% risk weight would henceforth be converted as a floor. Most of the

ii.

banks are also not rated and therefore would have to be assigned a risk weight of 50%;

iii.

The population of rated corporates is very few in number and most of them would have to be risk weighted at 100%. The benefit of lower risk weight of 20% and 50% would therefore be available only to very few corporates;

iv.

Unsecured portion of any asset which is past due over 90 days, net of specific provisions, would have to be assigned a risk weight of 150%, which proposal alone would increase the risk-weighted assets of the banking system by USD 3.2 bio, entailing a drop in the existing CRAR by 31 bps. as on March 31, 2000;

v.

Claims on certain high-risk exposures viz. venture capital and private equity, at national discretion, are also required to be assigned a higher risk weight of 150%;

vi.

The deduction of significant investments in commercial entities; and

vii.

Explicit capital charge, constituting 20% of the current capital requirement for operational risk.

The benefit of credit risk mitigation techniques also may not be available as most of the banks in emerging markets are not in a position to comply with the preconditions stipulated by the Basel Committee. Thus, unless suitably modified, the adoption of the New Accord in its present format would result in significant increase in the capital charge for banks, especially in emerging markets.

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Areas of Further Consultation Some of the proposals contained in the New Accord warrant further consultation and the Committee itself has indicated that the work was in progress in specific areas viz. IRB approach, risk mitigation techniques, capital for operational risk, etc. As the objective of the New Accord is to evolve a consensual framework that could be adopted uniformly by all countries including emerging markets, the Committee may hold further consultations on these areas. Conclusion RBI appreciates the committee’s efforts in evolving the New Accord containing proposals that are comprehensive in coverage. When implemented, these would go a long way in making the capital allocation more risk-sensitive and use of supervisory oversight with market discipline would reinforce the supervisory framework and ensure financial stability. However, the complexity and sophistication of the proposals restricts its universal application in emerging markets, where the banks continue to be the major segment in financial intermediation and would be facing considerable challenges in adopting all the proposals. Like the 1988 Capital Accord, the New Accord should also preserve the spirit of simplicity and flexibility to ensure universal applicability including emerging markets. viii.

The New Accord would involve shift in direct supervisory focus away to the implementation issues. Further, banks and the supervisors would be required to invest large resources in upgrading their technology and human resources to meet the minimum standards. The increasing reliance on external rating agencies in the regulatory process would undermine the initiatives of banks in enhancing their risk external assessments;

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Similarly, the claims on all banks are also assigned a uniform risk weight of management policies and practices and internal control systems. The minimum standards set even for the IRB foundation approach are complex and beyond the reach of many banks. It is, therefore, essential that the Basel Committee should evolve a simplified standardised approach, which could be adopted uniformly by all banks that are not internationally active. Further, the transitional arrangements proposed in the New Accord may not be sufficient for these banks. National supervisors may, therefore, be given discretion to decide on the timeframe for implementing the Accord and applying it to various banks in their jurisdiction depending upon the scale and complexity of their operations.

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BASEL I

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BASEL I Basel I is the term which refers to a round of deliberations by central bankers from around the world, and in 1988, the Basel Committee (BCBS) in Basel, Switzerland, published a set of minimal capital requirements for banks. This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten (G-10) countries in 1992, with Japanese banks permitted an extended transition period. Basel I is now widely viewed as outmoded, and a more comprehensive set of guidelines, known as Basel II are in the process of implementation by several countries.

Background The Committee was formed in response to the messy liquidation of a Cologne-based bank in 1974. On 26 June 1974, a number of banks had released Deutschmark to the Bank Herstatt in exchange for dollar payments deliverable in New York. On account of differences in the time zones, there was a lag in the dollar payment to the counter-party banks, and during this gap, and before the dollar payments could be effected in New York, the Bank Herstatt was liquidated by German regulators. This incident prompted the G-10 nations to form towards the end of 1974, the Basel Committee on Banking Supervision, under the auspices of the Bank of International Settlements (BIS) located in Basel, Switzerland.

Capital Adequacy Ratio - Basle Accord 1988 The growing concern of commercial banks regarding international competitiveness and capital ratios led to the Basle Capital Accord 1988. The accord sets down the agreement among the G-10 central banks to apply common minimum capital standards to their banking industries, to be achieved by year end 1992. The standards are almost entirely

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addressed to credit risk, the main risk incurred by banks. The document consists of two main sections, which cover a. the definition of capital and b. the structure of risk weights. Based on the Basle norms, the RBI also issued similar capital adequacy norms for the Indian banks. According to these guidelines, the banks will have to identify their Tier-I and Tier-II capital and assign risk weights to the assets. Having done this they will have to assess the Capital to Risk Weighted Assets Ratio (CRAR). The minimum CRAR which the Indian banks are required to meet is set at 9 percent. Tier-I Capital •

Paid-up capital

•

Statutory Reserves

•

Disclosed free reserves

•

Capital reserves representing surplus arising out of sale proceeds of assets

Equity investments in subsidiaries, intangible assets and losses in the current period and those brought forward from previous periods, will be deducted from Tier I capital. Tier-II Capital •

Undisclosed Reserves and Cumulative Perpetual Preference Shares

•

Revaluation Reserves

•

General Provisions and Loss Reserves

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Background of the Basel Accord of 1988 The major impetus for the 1988 Basel Capital Accord was the concern of the Governors of the G10 central banks that the capital of the world's major banks had become dangerously low after persistent erosion through competition. Capital is necessary for banks as a cushion against losses and it provides an incentive for the owners of the business to manage it in a prudent manner.

The Existing Framework The 1988 Accord requires internationally active banks in the G10 countries to hold capital equal to at least 8% of a basket of assets measured in different ways according to their riskiness. The definition of capital is set (broadly) in two tiers, Tier 1 being shareholders' equity and retained earnings and Tier 2 being additional internal and external resources available to the bank. The bank has to hold at least half of its measured capital in Tier 1 form. A portfolio approach is taken to the measure of risk, with assets classified into four buckets (0%, 20%, 50% and 100%) according to the debtor category. This means that some assets (essentially bank holdings of government assets such as Treasury Bills and bonds) have no capital requirement, while claims on banks have a 20% weight, which translates into a capital charge of 1.6% of the value of the claim. However, virtually all claims on the non-bank private sector receive the standard 8% capital requirement. There is also a scale of charges for off-balance sheet exposures through guarantees, commitments, forward claims, etc. This is the only complex section of the 1988 Accord and requires a two-step approach whereby banks convert their off-balance-sheet positions

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into a credit equivalent amount through a scale of conversion factors, which then are weighted according to the counterparty's risk weighting. The 1988 Accord has been supplemented a number of times, with most changes dealing with the treatment of off-balance-sheet activities. A significant amendment was enacted in 1996, when the Committee introduced a measure whereby trading positions in bonds, equities, foreign exchange and commodities were removed from the credit risk framework and given explicit capital charges related to the bank's open position in each instrument.

Impact of the 1988 Accord The two principal purposes of the Accord were to ensure an adequate level of capital in the international banking system and to create a "more level playing field" in competitive terms so that banks could no longer build business volume without adequate capital backing. These two objectives have been achieved. The merits of the Accord were widely recognised and during the 1990s the Accord became an accepted world standard, with well over 100 countries applying the Basel framework to their banking system. However, there also have been some less positive features. The regulatory capital requirement has been in conflict with increasingly sophisticated internal measures of economic capital. The simple bucket approach with a flat 8% charge for claims on the private sector has given banks an incentive to move high quality assets off the balance sheet, thus reducing the average quality of bank loan portfolios. In addition, the 1988 Accord does not sufficiently recognise credit risk mitigation techniques, such as collateral and guarantees. These are the principal reasons why the Basel Committee decided to propose a more risksensitive framework in June 1999.

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Loopholes of Basel I Accord

 After ten years of implementation and taking into consideration the rapid technological, financial and institutional changes happened during the period many weaknesses started appearing in Basel I accord.

 Because of a flat 8% charge for claims on the private sector, banks have an incentive to move high quality assets off the balance sheet (capital arbitrage) through securitization. Thus, reducing the average quality of bank loan portfolio

 It does not take into consideration the operational risks of banks, which become increasingly important with the increase in the complexity of banks.

 Also, the 1988 Accord does not sufficiently recognize credit risk mitigation techniques, such as collateral and guarantees.

 The regulatory Capital requirement has been in conflict with increasingly sophisticated internal measures of economic Capital

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 It was concentrating on only on credit risk.

Why Basel II

 Basel I is less Risk Sensitive (More broad brush approach)  Basel II is more Risk Sensitive (Granular capturing of Risk Profile)  It has been a long way from Basel introduced in 1988 to the present Basel II in 2006.  The measures envisaged in Basel II are intended to identify and measure the Risk Profile of the Exposures and help Banks to initiate appropriate Risk Mitigation Measures.

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What is Basel II Basel 2 is the new capital accord signed in June 2004 at Bank for International Settlement located at Basel, Switzerland. It is an improvement over Basel 1 which had certain deficiencies which have now been removed. Basel 2 is based on three pillars: capital adequacy, supervisory review and market discipline. It is basically concerned with financial health of the banks worldwide. The focus in Basel 2 is the risk determination and quantification of credit risk, market risk and operational risk faced by banks. Reserve Bank of India has accepted the accord and issued guidelines to ensure compliance with the norms by March 31, 2008. Other scheduled commercial banks are required to implement Basel 2 by March 31, 2009

• Is Basel II –

A Risk Management Exercise ? (or) A Capital Management Exercise ?

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Basel II is basically a Risk Management Exercise  Doesn’t seek to change business models of the Bank.

 But requires to fine-tune/update Risk Management practices.

 Robust enough to capture all possible Risks the Bank is facing or likely to face.

 Initiate adequate and appropriate Risk Mitigation measures through effective Systems and Procedures

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Objectives of the New Basel Accord Broadly speaking, the objectives of Basel II are to encourage better and more systematic risk management practices, especially in the area of credit risk, and to provide improved measures of capital adequacy for the benefit of supervisors and the marketplace more generally. At the outset of the process of developing the new Accord, the Basel Committee developed the so-called three pillars approach to capital adequacy involving (1)minimum capital requirements, (2) supervisory review of internal bank assessments of capital relative to risk, and (3) increased public disclosure of risk and capital information sufficient to provide meaningful market discipline. Although the Committee’s proposals have evolved considerably over the past several years, these fundamental objectives and the three-pillar approach have held constant. It is hardly necessary to emphasize the importance of banks and banking systems to financial and economic stability. The ability of a sound and well-capitalized banking system to help cushion an economy from unforeseen shocks is well known, as are the negative consequences of a banking system that itself becomes a source of weakness and instability. A critical potential weakness of financial markets is that risks are in many cases under-estimated and not fully recognized until too late, with a concomitant

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potential for excessive consequences once they have been fully realized. This is why the Basel Committee’s efforts to promote greater recognition of risks and more systematic attention to them are vitally important.

The essence of Basel II is a focus on risk differentiation and the need for enhanced approaches to assessing credit risk. Some critics have argued that it is preferable to downplay differences in risk, and indeed forbearance can sometimes appear the most expedient strategy. But experience has also shown that this will not work as an overall approach because ignoring risks inevitably leads to larger problems down the road. Thus, one of the key messages of Basel II is that bankers, supervisors, and other market participants must become better attuned to risk and better able to act on those risk assessments at the appropriate time. Bank supervisors must get better at addressing issues pre-emptively rather than in crisis mode.

Significant attention to risk management is one of the primary mechanisms available to help banks and supervisors do that. Basel II seeks to provide incentives for greater awareness of differences in risk through more risk-sensitive minimum capital requirements. The Pillar 1 capital requirements will, by necessity, be imperfect measures of risk as any rules-based framework will be. The objective of the proposals is to increase the emphasis on assessments of credit and operational risk throughout financial institutions and across markets.

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Perhaps even more important in the long run is the second pillar of the new Accord. Pillar 2 requires banks to systematically assess risk relative to capital within their organization. The review of these internal assessments by supervisors should provide discipline on bank management to take the process seriously and will help supervisors to continually enhance their understanding of risk at the institutions. The third pillar of Basel II provides another set of necessary checks and balances by seeking to promote market discipline through enhanced transparency. Greater disclosure of key elements of risk and capital will provide important information to counterparties and investors who need such information to have an informed view of a bank’s profile.

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BASEL II GUIDELINES 

Basel II Committee set up by Bank for International Settlements (BIS) released the first version of Basel II in June 2006.

 A Comprehensive Version, incorporating amendments to relating to Market Risks, Trading Activities and the Treatment of Double Default Effects, was released in June 2006.  Basel II Guidelines in Indian context were finalized by RBI, after due deliberations and brain-storming by select 14-member Committee of Banks from Public Sector and Private Sector.  Our Bank is also a member and headed the Sub-Committee on ‘National Discretion’. RBI released Basel II Final Guidelines vide their notification dated 27.04.2007.

Effective Date

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Foreign banks operating in India and Indian banks having operational presence outside India should adopt Standardised Approach (SA) for credit risk and Basic Indicator Approach (BIA) for operational risk for computing their capital requirements under the Revised Framework with effect from March 31, 2008. All other commercial banks (excluding Local Area Banks and Regional Rural Banks) are encouraged to migrate to these approaches under the Revised Framework in alignment with them but in any case not later than March 31, 2009. These banks shall continue to apply the Standardised Duration Approach (SDA) for computing capital requirement for market risks under the Revised Framework.

Parallel run With a view to ensuring smooth transition to the Revised Framework and with a view to providing opportunity to banks to streamline their systems and strategies, banks were advised to have a parallel run of the revised Framework. A copy of the quarterly reports to the Board of Directors may be continued to be submitted to the Reserve Bank of India – one each to the Department of Banking Supervision, Central Office and the Department of Banking Operations and Development, Central Office.

Migration to other approaches under the Revised Framework

Banks are required to obtain the prior approval of the Reserve Bank to migrate to the Internal Rating Based Approach (IRBA) for credit risk and the Standardised

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Approach (TSA) or the Advanced Measurement Approach (AMA) for operational risk for computing regulatory capital requirements. A separate communication in this regard will be issued to banks at a later date, specifying the pre-requisites and procedure for approaching the Reserve Bank for seeking its prior approval for such migration

BASEL II FRAMEWORK

THREE PILLARS OF BASEL II

Minimum Capital Requirement

Credit Risk

Supervisory Review Process

Market Risk

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Standardis ed Approach

IRBA

Standardised Duration Approach

Basic Indicator Approach

Internals Model Approach

Standardised Approach

Advanced Measurement Approach

1 The first Pillar: Minimum capital requirement The definition of capital in Basel 2 will not modify and that the minimum ratios of capital to risk-weighted assets including operational and market risks will remain 8% for total capital. Tier 2 capital will continue to be limited to 100% of Tier 1 capital. The main changes will come from the inclusion of the operational risk and the approaches to measure the different kinds of risks.

Capital Unchanged

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Risk-Based Capital Ratio= Capital _____________________________________________ Credit Risk + Market Risk+Operational Risk

Approaches to measure credit Risk 1.Standardised Approach 2.IRBA

Approaches to Measure Market Risk 1.Standardised Approach 2.Internal Model Approach

Approaches to measure operational risk 1.Basic Indicator Approach 2. Standardised Approach 3.IMA

While there were no changes in the approaches to measure the market risk there were fundamental changes in the approaches to measure the credit risk, which we will discuss in section 3. Regarding the operational risk it is introduced for the first time in this accord. In the standardized approach to credit risk, exposures to various types of counter parties, e.g. sovereigns, banks and corporates, will be assigned risk weights based on assessments by external credit assessment institutions. To make the approach more risk sensitive an additional risk bucket (50%) for corporate exposures will be included. Further, certain categories of assets have been identified for the higher risk bucket (150%). The “foundation” approach to internal ratings incorporates in the capital

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calculation the banks’ own estimates of the probability of default associated with the obligor, subject to adherence to rigorous minimum supervisory requirements. Estimates of additional risk factors to calculate the risk weights would be derived through the application of standardized supervisory rules. In the “advance” IRB approach, banks that meet even more rigorous minimum requirements will be able to use a broader set of internal risk measures for individual exposures.

The Second Pillar: Supervisory Review Process In Basel 1 the risk weight were fixed and the implementation of the accord was straight forward. In Basel 2 the bank can choose from a menu of approaches to measure the credit, market and operational risks. This process of choosing the approach requires the review of the availability of the minimum requirements to implement the approach. In addition to that, in IRB approaches the risk weight is computed from inputs from the bank (like the probability of default). It is necessary in this case to make sure that the bank inputs are measured or estimated in an accurate and robust manner. Basel committee suggests four principles to govern the review process: Principle 1: Banks should have a process for assessing their overall capital in relation to

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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 their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the results 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.

The Third Pillar: Market Discipline The third pillar in Basel 2 aims to bolster market discipline through enhanced disclosure by banks. Effective disclosure is essential to ensure that market participants can better understand banks’ risk profiles and the adequacy of their capital positions. The new framework sets out disclosure requirements and recommendations in several areas, including the way a bank calculates its capital adequacy and its risk assessment methods. The core set of disclosure recommendations applies to all banks, with more detailed

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requirements for supervisory recognition of internal methodologies for credit risk, mitigation techniques and asset securitization.

The Risk Categories of Bank Credit risk The risk that a borrower or counterparty might not honour its contractual obligations Very relevant to operating staff.

The Standardized approach for credit risk

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The standardized approach is conceptually the same as the present Accord, but it is more risk sensitive. The bank allocates a risk-weight to each of its assets and offbalancesheet positions and produces a sum of risk-weighted asset values. A risk weight of 100% means that an exposure is included in the calculation of risk weighted assets at 10 its full value, which translates into a capital charge equal to 8% of that value. Similarly, a risk weigh of 20% results in a capital charges of 1.6%. Because of its simplicity it is expected that it will be used by a large number of banks around the globe for calculating minimum capital requirements. Under Basel 1 individual risk weights depend on the board category of borrower (i.e. sovereigns, banks or corporates). Under Basel 2 the risk weights are to be refined by reference to a rating provided by an external credit assessment institution (such as a rating agency) that meets strict standards. For example, for corporate lending, the existing Accord provides only one risk weigh category of 100% but the new Accord will provide four categories (20%, 50%, 100% and 150%)3. The following table illustrates the relation between the risk weights and credit assessment for corporate lending.

Credit Assessment AAA to AA- A+ to A- BBB+ to BB- Below BB- Unrated Risk Weights 20% 50% 100% 150% 100% Banks’ exposures to the lowest rated corporates are captured in the 150% risk-weight category. 150% risk-weight can be assigned for example to unsecured portions of assets that are past due for more than 90 days, net of specific provisions. Similar frameworks for sovereigns and banks credit risk weighs will be applied. For bank’s exposures to sovereigns4, the Basel 2 proposes the use of published

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credit scores of export credit agencies (ECA) and developed a method for mapping such ratings to the standardized risk buckets.

In a suggested simple form for the foundation method one can use for corporate risk weight of 100% if the external credit assessment will not be available. 4 The term “sovereigns” includes sovereign governments; central banks and public sector entities treated as sovereign governments by the nations supervisor.

Operational requirements for the standardized approach In the standardized approach, national supervisors will not allow banks to assign risk weight based on external assessments in a mechanical fashion. Rather, supervisors and banks are responsible for evaluating the methodologies used by external credit assessment institutions (ECAI) and the quality of the ratings produced. The supervisors will use the following six criteria in recognizing ECAIs as outlined by Basel committee:

Objectivity. The methodology for assigning credit assessments must be rigorous, systematic, and subject to some form of validation based on historical experience. Moreover, assessments must be subject to ongoing review and responsive to changes in financial condition. Before being recognized by supervisors, an assessment methodology for each market segment, including rigorous back testing, must have been established for at least one year and preferably three.

Independence: An ECAI should be independent and should not be subject to political or economic pressures that may influence the rating. International access/Transparency: The individual assessments should be

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available to both domestic and foreign institutions with legitimate interests and at equivalent terms. In addition, the general methodology used by the ECAI should be publicly available.

Disclosure: An ECAI should disclose the following information: its assessment methodologies, including the definition of default, the time horizon and the meaning of each rating; the actual default rates experienced in each assessment category; and the transitions of the assessments, e.g. the likelihood of AAA rating becoming AA over time.

Resources: An ECAI should have sufficient resources to carry out high quality credit assessments. Credibility: To some extent, credibility is derived from the criteria above. In addition, the reliance on an ECAI’s external credit assessments by independent parties (investors, insurers, trading partners) is evidence of the credibility of the assessments of an ECAI. Banks may elect to use a subset of the ECAI assessments deemed eligible by their national supervisor, though the assessments must be applied consistently for both risk weighting and risk management purposes. The requirement is intended to limit the potential for external credit assessments to be used in a manner that results in reduced capital requirements but is inconsistent with sound risk management practices. Basel 2 address also practical considerations, such as the use of multiple external credit assessments, issuer versus issue assessments, short-term versus long-term assessments and unsolicited assessments.

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Internal ratings-based approach (IRB) The IRB approach provides a similar treatment for corporate, bank and sovereign exposures, and a separate framework for retail, project finance and equity exposures. For each exposure class, the treatment is based on three main elements: risk components, where a bank may use either its own or standardized supervisory estimates; a risk-weight function which converts the risk components into risk weight to be used by banks in calculating risk-weighted assets; and a set of minimum requirements that a bank must meet to be eligible for IRB treatment.

Credit Risk – State Bank of India’s Preparedness  Existing Internal Credit Risk Assessment System refined and extended to cover Advance Accounts of Rs. 25 lacs and above.

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 Existing Internal Credit Information System is being fine-tuned to meet Basel II requirements, now covering Whole Bank.

 Models for implementation of Integrated Risk Management and Operational Risk Management are being implemented.

 Consultants are being appointed for Portfolio Credit Risk Modelling Exercise

Credit Risk–Corporate & Retail Classification

 Fund based + Non Fund based Limits < or = Rs. 5 crs and/or Turnover
 Fund based + Non Fund based Limits > Rs. 5 crs and/or Turnover = or >Rs. 50 crs are classified as Corporate Exposures and assigned RWs as per Rating.

 Sovereigns, MDBs, Banks, Public Sector Entities, Primary Dealers, Banks and Staff Residential Housing Loans are outside the scope of Retail and Corporate classification.

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 Specified categories like Commercial Real Estate, Venture Capital, Capital Market Exposures, Personal Loans and exposures to Non-Deposit taking Systematically Important NBFCs (Asset size of over Rs.100 crs) are outside the scope of Retail and Corporate classification.

CREDIT RISK ASSET NETTING

 Asset Netting means reducing value of eligible Collaterals from Outstanding to arrive at the Net Exposure amount.

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 Basel II recognizes only Financial Collaterals and Gold for Asset Netting.  To be eligible for Asset Netting, lien on Collaterals is to be marked and legal certainty is to be met.  Banker’s General Lien is not permitted (which is available in Basel I scenario).

 For Asset Netting, value of Basel II collaterals is considered account-wise and not in aggregate. i.eThe additional collateral available for a particular Exposure cannot be used for Asset Netting of other Exposures, unless charge is extended.

 All Advances including Staff loans are eligible for Asset Netting, if Basel II collaterals are available

Market Risk

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-

The risk of adverse price movements such as exchange rates, the value of securities, and interest rates - Less relevant to operating staff, more or less centralised @ Corporate centre

Although the Basel Committee issued “Amendment to the Capital Accord to incorporate Market Risks” in1996, RBI as an interim measure, advised banks to assign an additional risk weight of 2.5% on the entire investment portfolio. RBI feels that over the years, bank’s ability to identify and measure market risk has improved and therefore, decided to assign explicit capital charge for market risk in a phased manner over a two year period as under -. a. Banks would be required to maintain capital charge for market risk in respect of their trading book exposure (including derivatives) by March 2005. b. Banks would be required to maintain capital charge for market risk in respect of securities under available for sale category by March 2006 puting capital charge for interest rate related instruments in the trading book, equities in the trading book and foreign exchange risk (including gold and precious metals) in both trading and banking book. Trading book will include: ◆ Securities included under the Held for Trading category ◆ Securities included under the Available for Sale category ◆ Open gold position limits ◆ Open foreign exchange position limits ◆ Trading position in derivatives and derivatives entered into for hedging trading book exposures. As per the guidelines, minimum capital requirement is expressed in terms of two separately calculated charges:

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a. Specific Risk and b. General Market Risk Specific Risk: Capital charge for specific risk is designed to protect against an adverse movement in price of an individual security due to factors related to individual issuer. This is similar to credit risk. The specific risk charges are divided into various categories such as investments in Govt securities, claims on Banks, investments in mortgage backed securities, securitized papers etc. and capital charge for each category specified.

General Market Risk: Capital charge for general market risk is designed to capture the risk of loss arising from changes in market interest rates. The Basel Committee suggested two broad methodologies for computation of capital charge for market risk, i.e., Standardized Method and Internal Risk Management Model Method. As Banks in India are still in a nascent stage of developing internal risk management models, in the guidelines, it is proposed that to start with, the Banks may adopt the Standardized Method. Again, under Standardized Method, there are two principle methods for measuring market risk – maturity method and duration method. As duration method is a more accurate method of measuring interest rate risk, RBI prefers that Banks measure all of their general market risk by calculating the price sensitivity (modified duration) of each position separately. For this purpose detailed mechanics to be followed, time bands, assumed changes in yield etc. have been provided by RBI.

Market Risk State Bank of India’s Preparedness

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 Exploring the feasibility of using KVaR+ software for mapping Treasury Operations

for Market Risk.

 Developed adequate hedging mechanisms to absorb the impacts of Market Risk.

 Our Investment Risk is akin to the Country Risk and thus well protected.

 Implementation of Oracle Based ALM Software is in progress, to provide comprehensive ALM data analysis.

Market Risk State Bank of India’s Concerns  During the FY: 2005-06, additional Capital charge of around Rs. 1200 crores has been provided on account of Market Risk on AFS category of Investments.  Securitization Transactions are subjected to stringent treatment thus making them less attractive.

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Operational Risk The risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events – Newly introduced & also very relevant to operating staff

Capital Charge for Operational Risk The Basel Committee has defined the Operational Risk as “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events”. This definition includes legal risk but excludes strategic and reputational risk. The objective of the operational risk management is to reduce the expected operational losses using a set of key risk indicators to measure and control risk on continuous basis and provide risk capital on operational risk for ensuring financial soundness of the Bank.

Basic Indicator Approach Under the basic indicator approach, Banks are required to hold capital for operational risk equal to the average over the previous three years of a fixed percentage (15% - denoted as alpha) of annual gross income. Gross income is defined as net interest income plus net non-interest income, excluding realized profit/losses from the sale of securities in the banking book and extraordinary and irregular items.

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Standardized Approach Under the standardized approach, bank’s activities are divided into eight business lines. Within each business line, gross income is considered as a broad indicator for the likely scale of operational risk. Capital charge for each business line is calculated by multiplying gross income by a factor (denoted beta) assigned to that business line. Total capital charge is calculated as the three-year average of the simple summations of the regulatory capital across each of the business line in each year. The values of the betas prescribed for each business line are as under:

Business Line Corporate Finance Trading and sales

Beta Factor 18% 18%

Retail banking

12%

Commercial banking

15%

Payment and Settlement Agency Sevices Asset Management Retail Brokerage

18% 15% 12% 12%

Advanced Measurement Approach Under advanced measurement approach, the regulatory capital will be equal to the risk measures generated by the bank’s internal risk measurement system using the

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prescribed quantitative and qualitative criteria.

Operational Risk

State Bank Of India’s Preparedness

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 Operational Risk Management Committee, is developing the ORM Policy to assess the losses to: i)

Physical Assets ii) Business and Systems iii) Process Management and Delivery Mechanism.  Business Process Re-engineering Team is in place evaluating the processes and redefining the Systems & Procedures to mitigate incidence of losses on account of Processes and Systems.

Operational Risk - Our Concerns

 At 12% CAR, the Bank may be required to provide additional capital charge of around

Rs. 4500 crores towards Operational Risk.

 The Bank has established systems and procedures and hence, may be required to provide lesser capital for Operational Risk under Advanced Approaches .

 However, given the current level of MIS and Technical Sophistication, our Bank for the present, may be in a position to adopt Basic Indicator Approach only.

MIS – State Bank of India’s Preparedness

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 Moving towards Core Banking Solutions, which will help byrobust MIS and mapping of Historical Data.  CBS Data Structure is being fine-tuned to factor-in data needs for CAR compilation.

 Data Warehouse is being setup to store and retrieve Historical Data.  In-house teams from BI (MIS) and IT-SS Depts. are developing solutions for Autogeneration of CAR B II on CBS and BankMaster branches respectively.

MIS and others – State Bank of India Concerns  Quality of data inputted by the branches is found wanting.  Developing of robust MIS to facilitate mapping of valid auditable historical data.

 Transition requires huge investments in Technical Up-gradation, for mapping of validated auditable historical data etc .  Adverse balances in Agency Clearing A/c leads to additional RWs.  Adverse comments by the Statutory Auditors

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CHALLENGES FOR INDIAN BANKING SYSTEM UNDER BASEL II A feature, somewhat unique to the Indian financial system is the diversity of its composition. We have the dominance of Government ownership coupled with significant private shareholding in the public sector banks and we also have cooperative banks, Regional Rural Banks and Foreign bank branches. By and large the regulatory standards for all these banks are uniform. Costly Database Creation and Maintenance Process: The most obvious impact of BASEL II is the need for improved risk management and measurement. 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 5 years bank data which is a tedious and high cost process as most Indian banks do not have such a database Additional Capital Requirement: In order to comply with the capital adequacy norms we will see that the overall capital level of the banks will raise a glimpse of which was seen when the RBI raised risk weightages for mortgages and home loans in October 2004. Here there is a worrying aspect that some of the banks will not be able to put up the additional capital to comply with the new regulation and they may be isolated from the global banking system.

Large Proportion of NPA's:

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A large number of Indian banks have significant proportion of NPA's in their assets. Along with that a large proportion of loans of banks are of poor quality. There is a danger that a large number of banks will not be able to restructure and survive in the new environment. This may lead to forced mergers of many defunct banks with the existing ones and a loss of capital to the banking system as a whole

Low Degree of Corporate Rating Penetration: India has as few as three established rating agencies and the level of rating penetration is not very significant as, so far, ratings are restricted to issues and not issuers. While Basel II gives 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 ratings of issuers. Encouraging ratings of issuers would be a challenge. Cross Border Issues for Foreign Banks: In India, foreign banks are statutorily required to maintain local capital and the following issues are required to be resolved; Validation of the internal models approved by their head offices and home country supervisor adopted by the Indian branches of foreign banks. Date history maintained and used by the bank should be distinct for the Indian branches compared to the global data used by the head office capital for operational risk should be maintained separately for the Indian branches in India

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NOT WHEN BUT HOW? The important decision for India is not whether to stay on Basel I or move to Basel II, but of which of the many alternatives on offer, should be adopted. Given the lack of rating penetration, the Standardized Approach yields little in linking capital to risk while the IRB approach looks complex to implement and difficult to monitor. In the event of some banks adopting IRB Approach, while other banks adopt Standardised Approach, banks adopting IRB Approach will be much more risk sensitive than the banks on Standardised Approach, since even a small change in degree of risk might translate into a large impact on additional capital requirement for the IRB banks. For banks adopting Standardised Approach the relative capital requirement would be less for the same exposure and would be inclined to assume exposures to high risk clients, which were not financed by IRB banks. As a result, high risk assets could flow towards banks on Standardised Approach which need to maintain lower capital on these assets. Similarly, low risk assets would tend to get concentrated with IRB banks which need to maintain lower capital on these assets. Hence, system as a whole may maintain lower capital than warranted. Keeping in view the above complications we suggest as a transitional tool, a Centralized Rating Based(CRB) approach where the RBI dictates a rating scale and asks banks to rate borrowers according to that centralized scale. The great benefit of the approach is that the RBI would be able to monitor and control banks' ratings and hence monitor and control their capital sufficiency in relation to risk much more effectively. These kinds of comparisons combined with simple procedures for spotting outliers and keeping a track

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of the different banks' ratings of the main borrowers from the financial system will be extremely valuable tools for a RBI. Finally the CRB approach should be used as a precursor to IRB. Once the CRB approach is working the RBI could then work with banks to approve their own rating scales and rating methodology using the basic CRB approach as a reference tool.

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The Analysis of Basel Norms and Implementation

Challenges in Implementation in SBI

 Complexities in Systems and Processes involved in Basel II make the implementation process difficult, time consuming and costly.  Availability and mapping of Validated and Auditable Data and Integration of the same to Basel II norms.

 Adaptability of Operating Personnel to the New Skills .  Internationally active Bank like ours will face problem due to localization of Basel II norms in different Geographical Zones due to Home & Host Country Regulations

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The Analysis of Basel Norms and Implementation

MIGRATION TO BASEL II BY SBI TIME LINES

 Our Bank has to migrate to Basel II Framework by 31.03.2008, both at the Solo and at the Consolidated Level.

 The Board of Directors directed that Bank complete all Basel II related activities and equip itself to migrate by 30.09.2007.  The time-line set by the Board is highly demanding and requires conscious and concerted efforts by all of us.

 Bank has to conduct Parallel Run of all Basel II related activities.  Compilation of CAR B II is one of the important activities of Parallel Run.

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The Analysis of Basel Norms and Implementation

MIGRATION TO BASEL II -MONITORING

 An Integrated Risk Governance Structure is set up to facilitate early migration to Basel II.  Separate departments are set up to monitor and manage Credit Risk, Market Risk and Operational Risk.  Risk based Internal Audit has been implemented across the Bank.

 An In-house Committee is overseeing the Transition to Basel II.

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The Analysis of Basel Norms and Implementation

THE IMPACT OF BASEL NORMS

Basel II is the new regulatory framework within which all banks will have to work. Its aim is to safeguard the stability of the financial sector and one of its aspects is a comprehensive approach to risk. The first phase of the Accord will take effect in 2007, and the second phase will be implemented in 2008. The Accord regulates the amount of capital that banks will have to set aside for their loans. In addition, it prescribes that this capital must be a better reflection of the actual credit risks represented by the companies to which the banks lend. Banks can select from three methods of determining the risks and the associated capital requirements; the banks with the most sophisticated risk management will be rewarded with a lower capital requirement relative to their existing capital bases. This is one of the reasons why credit will not necessarily become more expensive. There is also no question of credit crunch; banks' loan portfolios have in fact grown as a proportion of their total assets. As from 1 January 2007, banks will be required to have historical credit information on their lending customers; this information is needed to evaluate their customers'

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The Analysis of Basel Norms and Implementation

creditworthiness. Three quarters of companies are currently reported to have insufficient information about the banks' new credit risk criteria.

An increase in the transparency of company accounting and of the information exchanged with banks is intended to result in greater objectivity with regard to the granting of new credit lines. The more favourable the company's risk profile, the better the credit risk rating and the more favourable the bank's terms and conditions will be. Creditworthiness a management priority The banks' credit risk assessment will be repeated during the term of the financing; this seems to be paving the way for a greater role for companies' accountants. Systematic analysis of a company's creditworthiness is a useful part of medium-term planning. A company's creditworthiness must be a management priority. Efficient debtor management, good payment history, and up-to-date financial reporting will help to boost credit ratings. Banks use both quantitative and qualitative criteria to assess credit risk. The quantitative factors are gearing, liquidity, profitability, debt repayment capacity, and security. The qualitative factors are the quality and the expertise of the management, the market environment, and the legal form of the business. They use many different information sources, ranging from balance sheets and profit and loss accounts, to business plans and tax returns, but also meetings with the management. A company that does not score well in a bank's credit risk assessment may face difficulties in the future. Under Basel II, the bank would then be forced to make its loans

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more expensive, to restrict outstanding credit lines, or to refuse to grant further loans. In order to improve their credit risk assessment or rating, companies have the option of making greater use of off-balance sheet finance, such as leasing or factoring. Another option is to raise private equity.

Undercapitalisation is a mortgage on the future Under Basel II the basic lending criteria will certainly continue to be the competence of the management, the company's ability to repay the loan, and adequate equity. Companies demonstrate their ability to repay debt using credible business plans and historical cash flows. Under Basel II, the cash flows that companies are able to demonstrate will become more important. Companies must also demonstrate their inherent profitability and the managers of many SMEs and medium-sized corporates will certainly have to address this issue. Benefits in kind and the segregation of corporate and personal assets must be properly organised. In this way, the business can organise its activities at the level of a management company, thereby increasing the transparency of the operating company. Basel II will also have a major impact on equity, as the penalties for undercapitalisation will increase. Undercapitalisation is generally tax-driven and under a /historically high tax burden in many countries, overcapitalisation has become synonymous with an expensive price tag. Too many companies have excessively high gearing. In Europe, for instance, bank loans account for 22% of financing, compared with 12% in the UK, and

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The Analysis of Basel Norms and Implementation

4% in the US. Undercapitalisation constitutes a mortgage on the future; this situation needs to change. Profit retention and capital injections have become fiscally more attractive in recent years and personal equity needs to be used more extensively to finance businesses.

The new lending relationship: six recommendations What precautions can a company take in order to avoid a poor credit risk assessment? The European Commission has put forward six recommendations, which are the basic rules governing lending relationships in the new Basel II environment. The collection of information and credit rating systems vary from bank to bank. One recommendation is that companies should obtain information at the outset on the type of documentation that the bank issues, on its approach to credit assessment, on the information that it will require, and on whether it will disclose the results of its credit assessment. The company must develop the discipline to present complete, unambiguous information to the bank within the agreed time period. Each bank has different credit terms. The factors that affect these terms are, in descending order of importance: the credit risk assessment, security (in the form of cash, property, securities, receivables, stocks, etc.), the term of the loan, special clauses (maximum gearing, minimum liquidity, debt to equity ratio, etc.), the relationship with

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the customer, the volume of loans (borrowers can generally secure better terms by raising a number of loans from the same bank). An active credit rating system requires companies' managements to be vigilant; they need to monitor the quantitative and qualitative factors that change their companies' risk profiles. A company's position will be monitored from a distance throughout the term of a credit by the bank. Disappointing figures, the expiry of supplier credit, a negative cash flow, or fluctuating accounting ratios can result in a breach in its loan terms and all represent alarm signals. In particular, companies should make their banks aware of the real financial situation in the market environment. Finally, the company can use other types of finance, including innovative products. Measures to reduce borrowing requirements In summary, Basel II tightens up requirements on the demand side for loans and it is worth giving serious consideration to measures to limit borrowing requirements and to alternative credit products, which can have a considerable impact on a company's balance sheet. Companies can reduce their borrowing requirements by using leasing, factoring, and/or efficiency gains. All three are reflected on the asset side of the balance sheet. Leasing affects capital employed, factoring affects debtors, and efficiency gains affect the assets that can be converted into cash within one year. Efficiency gains lie primarily in lower stocks and/or real productivity gains. Use of alternative forms of finance is growing. These include private equity, mezzanine

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structures, and even financial incentives, such as government subsidies. These are shown as liabilities on the balance sheet. Private equity affects the company's capital base, mezzanine finance affects borrowings and the capital base, and subsidies affect borrowings. Mezzanine finance is funding using hybrid debt and equity, and is expected to become increasingly widely used. By 2007, all European banks will be offering this type of finance.

IMPACT OF BASEL NORMS ON INDIAN BANKS  Banks will have to develop: o

Credit and Operational Risk Models

o

Business Models and Surrounding Processes

o

Skill levels of Operating Personnel

o

Valid and Integrated Data Backup

o  Advanced Measurement Methods require at least 5 years Auditable and Reconcilable Data  New Framework tends to reduce Capital Base of Indian Banks by 1% to 2%, except a few Banks.  With the advent of Basel II, Indian Banks may be required to raise over Rs. 1,70,000 crs additional Capital during the coming 3 years.

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The Analysis of Basel Norms and Implementation

IMPACT OF BASEL NORM on SBI

 Our Bank is moderately affected on account of Credit Risk, but adversely affected on account of Operational Risk.  Without any additional Capital support, Basel II would tend to reduce CAR of the Bank by around 150 bps.

 The Projected CAR tends to slide immediately by around 1.50%, but the negative impact is expected to be neutralized over a period of 5 years

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The Analysis of Basel Norms and Implementation

Rationale for a new Accord or Comparison Between Both The Accords The Existing Accord ( Basel I)

The Proposed Accord ( Basel II)

For on a single risk measure

More emphasis own bank’s internal methodologies, supervisory review and market discipline

One size fits for all

Flexibility, menu of approaches, incentives for better risk management

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The Analysis of Basel Norms and Implementation

Broad Brush Approach

More risk sensitivity

CONCLUSIONS Basel II is an international Accord which is implemented India by all the internationally active banks this will change the entire banking scenario. The norm is very complex and it is recently implemented due to which entire data could not be collected.

 Basel II will improve risk management exercise in Banks.  State Bank of India will get international standard for adopting Basel II.  All the areas of risks have been taken care.  Some additional Capital is required.

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The Analysis of Basel Norms and Implementation

FINDINGS  It was observed that while undertaking a project none of the SBI employees knows about Basel II.  The Bank is going to raise additional capital of by way of equity shares through IPO to support additional capital requirement for implementing Basel II

 Earlier there were no separate departments for managing risks, but after implementing Basel II separate departments to have been entrusted with the task of managing Credit Risk, Market Risk and Operational Risk.

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 Skilled operational personnel is required for State Bank of India.

 Basel II tends to reduce Capital Base of Indian Banks by 1% to 2%, except a few Banks  Complexities in Systems and Processes involved in Basel II make the implementation process difficult, time consuming and costly.  Standardised Approach is adopted by bank to assess Credit Risk in which external Credtit rating Agencies are involved, this is due bank’s internal rating system is not full proof system which is not approved by RBI.

SUGGESTIONS  Bank has to train all its employees so that everybody can understand about Basel Accord.  It has to recruit operationally skilled personnel in order to implement Basel accord.  Bank has to develop a full proof internal credit rating system so that it can go for Advanced approach in assessing credit risk

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LIMITATIONS  The time stipulated for the project was limited  Some confidential information was not revealed by the bank.  Some employees were not co-operative

BIBLIOGRAPHY •

Indian Nanking Association Journal

•

www.bis.com

•

Bank’ Magazines

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