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With special reference to my dissertation report title, I would like to mention that the financial services have grown up at a rapid speed across the globe. In last few decades, the banking industry has undergone through a massive expansion phase, right from its areas of operations geographically, to its product and services. Now a day, the banking industry has an attractive, flexible and customized portfolio of product & services like never before, which in turn, has increased the complexity in day to day operations of banks across the world. This situation has created an intensive need for the establishment of a regulatory framework in order to safeguard the interests of banks from different types of risk prevailing in the financial horizon through out the globe.

Therefore, a number of reforms and directives have been introduced at regular intervals of time from different international platforms, Base -II is the most recent among all of them. Basel -II norms incorporates the different types of risks related with the modern banking system, the sensitiveness of risk, supervisory framework and fair disclosure practices. This report establishes its association with the 'Basel-II Accord', its different aspects, sorts of risk associated with the banking operations, problems faced by the banks while going through the implementation process and suggesting the measures for successful implementation of Basel- II Norms. This report will be helpful in creating awareness among the bankers about the importance of regulatory framework as banks have faced the deadly challenges in times of global recessionary phase in recent times.

The data has been collected through primary and secondary sources and also through expert interviews. The major problems faced by banks for successful implementation of Basel norms are lack of technical framework, complications in calculation of CRAR, up gradation of the bank-wide information system through better branch-connectivity, which entailed cost etc. The suggestions made are that successful implementation of the Basel-II accord demands that more and more focus should be given on the development and improvement of a sound risk management and measurement expertise at different level of hierarchy within the banks. Proper database management system should be developed and creating awareness among the bankers and the operational staffs should be the prime concern for the banks.

Chapter - 1


1.1 Objectives

The major objectives associated with this research thesis are as follows:-

§ To get the relevant knowledge of banking industry, in particular the banking reforms.

§ A comprehensive study of Basel - II Norms.

§ To get the knowledge about the different sorts of risk associated with the banking operations.

§ Finding out the problems faced by the banks while going through the implementation process.

§ Suggesting the measures for successful implementation of Basel - II Norms

§ This report will be helpful in creating awareness among the bankers about the importance of regulatory framework as banks have faced the deadly challenges in times of global recessionary phase in recent times.

1.2 Scope

The scope of this research is associated with the banking industry. The banks, in recent times, have increased their areas of operations manifold and became global. This has also made the banks more concern about the customers and their convenience regarding the products and services offered by them. The increased level of customer base has intensified the threat of risk from the different players of the market.

The scope of this thesis involves the measures to safeguard the interests of the banks in the form of regulatory standards laid down by the Bank for International Settlements (BIS), Switzerland. The scope of this study is primarily associated with the Minimum Capital Adequacy Ratio of the Basel - II norms. This study will help me in finding out the level of difficulties faced by an organization, the management, and the key person from the implementation team, while implementing the guidelines of such kinds of reforms and how they get rid of the problems. The report incorporates the various tools and techniques used for implementing the Pillar-I of the Basel - II accords likewise the categorization of the customers, the role of the internal and external rating agencies for evaluating the credit worthiness of the customers, etc.

1.3 Research Methodology

Methodology describes the method which the individual use while doing the research. Regarding the requirements of my dissertation, I have chosen the methods of Secondary Data Studies and Surveys with help of open-ended structured questionnaire. The methods are selected on the basis of the problem statement, as the study of secondary data will provide me an insight about the Basel - II norms and survey will support me in finding the answers to the problem statement from the persons who were actively involved in the implementation process.

1.4 Sampling Procedure

Sampling has been done on the basis of the non-probability convenience sampling as the information required for the research process demands the certain level of expertise of this field.

1.5 Sample Size

Sample size was of 10 banks.

1.6 Data Collection

Data was collected through secondary data sources and an open-ended structured questionnaire and through expert interviews also.

Chapter - 2


Risk Models and Basel II: A Review of the Literature By Thomas A. Jacobs (May 3, 2004). This paper has reviewed the new Basel Capital Adequacy accord in light of risk modeling as presented in the literature. The weakness of VAR as a risk measure and the implications of the Basel Committee's embrace of its use in all modeling attempts calls for further research. The decision to measure capital on operational risk but not interest rate risk appears inconsistent with arguments regarding model evolution as the determinant of risk quantification in capital requirements.

Basel Norms Challenges In India,By- Swapan Bakshi. "Implementation of Basel II has been described as a long journey rather than a destination by itself. RBI has decided to follow a consultative process while implementing Basel II norms and move in a gradual, sequential and co-ordinated manner." Undoubtedly, it would require commitment of substantial capital and human resources on the part of both banks and the supervisors. RBI has decided to follow a consultative process while implementing Basel II norms and move in a gradual, sequential and co-ordinated manner. For this purpose, dialogue has already been initiated with the stakeholders. As envisaged by the Basel Committee, the accounting profession too, will make a positive contribution in this respect to make Indian banking system stronger.

Basel II - A Challenge and an Opportunity to Indian Banking: Are we ready for it? By- FICCI. As the deadline of implementing Basel-II approaches, Indian banks are still preparing to solve the risk puzzle for a more transparent and risk-free financial base. The road to the Basel-II will not be an easy one for Indian banks. FICCI has conducted a survey to analyze the state of preparedness of commercial banks (which includes Public sector banks, Private banks and foreign banks) in Implementation of Basel II norms. The survey questionnaire covered some of the most important aspects related to Implementation of Basel II. Based upon the data collated, some of the important findings of the survey are enumerated as below:

Ø General state of preparedness

Ø Capital requirements

Ø Impact on credit

Ø Expectations from regulators

Adoption of Basel II Norms: Are Indian Banks Ready? By Radhakrishnan R Ravi Bhatia,IIM Calcutta. In all the regards the big banks (read PSB and large private banks) will have the marked advantage over the small and medium sized banks. This might lead to considerable level of consolidation in the Indian Banking Industry. In the present market scenario, the banks might find it difficult to raise funds through the capital markets to raise funds for servicing the capital adequacy requirements. The maximum level of dilution allowed of government's stake is 51% in PSB which might cap their capital market funding. The nationalized banks can access the market up to the level of Rs5, 171 crores still maintaining the government's stake. To solve this there needs to be a relaxation in the allowed dilution level up to atleast 33%. An area of relaxation is in the case of private banks which are allowed to access capital from foreign sources up to 74% with no single entity allowed to have an FDI of above 10%. This is leading to foreign firms having substantial stake in Indian private banks. Hence, regarding the opening of Indian banking sector to foreign banks RBI is going for a measured and synchronized manner with the maturity of the Indian Banking sector in terms of size and risk management. It is taking a measured approach instead of directly opening the gates for the foreign banks.

Banks Basel II Norms requirement regarding internal control - Field study on Indian banks, Delhi Business Review X Vol. 10, No. 2 (July - December 2009). Generally, Basel II norms represent opportunities and challenges for Jordan and international banks, since their efforts and attempts in raising banking risk management culture, reducing its fluctuations, reducing Basel principles provisions and banking operations bosses. Findings revealed that Jordan bank do implement Basel II norms related to internal control in all of its following dimensions: Administrative supervising, control culture, risks definition and evaluation, control activities and tasks separation, information and communications, separation following and imperfection correction. So they are qualified to benefit of such implementation results. Such results match with Castro (2006) interpretations which indicate that giving supervising parties and internal auditing group a broad role to develop their special methods, and not to force them to use it, will contribute in achieving better matching with Basel II norms. Results do not reveal any significant nationality on the extent of implementing Basel II norms. It seems that availability of internal control systems and providing the same with work freedom shall not be limited only to Jordan banks but the existence of Arab, and foreign banks in Jordan. The intensive competition between banks and the similarity of works, methods regarding banking credit, using electronic equipment and central bank supervising is the reason of non-existence of such differences.

Basel II norms: Strength from three pillars by Dinesh Chaudhary, Paramdeep Singh, Pawan Prabhat. Given the kind of responsibilities, the supervisor's role assumes high importance in the new Basel II accord. Pillar II does not seek to harmonise supervisory processes across countries as they have different supervisory objectives, legal processes and authority of supervisors. It allows for sufficient national discretion but still it wants supervisors to maintain some degree of consistency in their approaches. BASEL II norms are expected to have far-reaching consequences on the health of financial sectors worldwide because of the increased emphasis on banks' risk-management systems, supervisory review process and market discipline.

Basel II and India by Bandyopadhyay, Tamal (2006), "Valuation Vortex", Business Standard Banking Annual,November,ICRA (2005), Basel II and India, ICRA Rating Feature, March. The wide disparities in credit-deposit ratios across urban and rural areas, have to be dealt with through deliberate polices that direct banks to extend loans in rural areas. Banks such as the UCO bank and the United Bank of India in order to present clean balance sheets have allowed their credit-deposit ratios to touch levels as low as 20-30 per cent. Such anomalies arise because social banking is no longer the priority of the financial institutions and financial regulator. While there are numerous norms and effective monitoring to regulate the non-performing assets and the risk-weighted capital adequacy norms, the regulatory oversight of social banking has been abysmal. Unless the Indian state once again recognises the need for social banking, it is difficult to conceive of an inclusive banking strategy.Unfortunately the decision to continue with liberalization and institutionalizing it through the adoption of the more stringent norms would only encourage the diversion of credit tohigher rated corporates and the retail lending sector, aggravating the adverse consequences of past financial reform and the adoption of Basel I. Much of the so-called risk-aversion of banks which goes against loans to the small and medium industries have their origin in the quick adoption of the Basel approved credit risk adjusted ratios (CRAR) for capital. Implementing Basel II will further accentuate the ongoing trend by moving credit away from agriculture and industrial units in the small sector. This despite the fact that small and medium enterprises (SMEs) which include the SSIs currently contribute 40 per cent of total industrial production and over 34 percent of national exports for the country. These are factors to be considered by countries like India which may not be as concerned about the effects of Basel II on the availability and cost of international lending.

Chapter - 3


3.1 History of Banking Industry

Without a sound and effective banking system in India it cannot have a healthy economy. The banking system of India should not only be hassle free but it should be able to meet new challenges posed by the technology and any other external and internal factors.

For the past three decades India's banking system has several outstanding achievements to its credit. The most striking is its extensive reach. It is no longer confined to only metropolitans or cosmopolitans in India. In fact, Indian banking system has reached even to the remote corners of the country. This is one of the main reason of India's growth process. The government's regular policy for Indian bank since 1969 has paid rich with the nationalization of 14 major private banks of India.

Not long ago, an account holder had to wait for hours at the bank counters for getting a draft or for withdrawing his own money. Today, he has a choice. Gone are days when the most efficient bank transferred money from one branch to other in two days. Now it is simple as instant messaging or dial a pizza. Money has become the order of the day. The first bank in India, though conservative, was established in 1786. From 1786 till today, the journey of Indian Banking System can be segregated into three distinct phases. To make this write-up more explanatory, I prefix the scenario as Phase I, Phase II and Phase III. They are as follows:

Phase I

The General Bank of India was set up in the year 1786. Next came Bank of Hindustan and Bengal Bank. The East India Company established Bank of Bengal (1809), Bank of Bombay (1840) and Bank of Madras (1843) as independent units and called it Presidency Banks. These three banks were amalgamated in 1920 and Imperial Bank of India was established which started as private banks, mostly Europeans shareholders.

In 1865 Allahabad Bank was established and first time exclusively by Indians, Punjab National Bank Ltd. was set up in 1894 with headquarters at Lahore. Between 1906 and 1913, Bank of India, Central Bank of India, Bank of Baroda, Canara Bank, Indian Bank, and Bank of Mysore were set up. Reserve Bank of India came in 1935.

During the first phase the growth was very slow and banks also experienced periodic failures between 1913 and 1948. There were approximately 1100 banks, mostly small. To streamline the functioning and activities of commercial banks, the Government of India came up with The Banking Companies Act, 1949 which was later changed to Banking Regulation Act 1949 as per amending Act of 1965 (Act No. 23 of 1965). Reserve Bank of India was vested with extensive powers for the supervision of banking in India as the Central Banking Authority. During those days public has lesser confidence in the banks. As an aftermath deposit mobilization was slow. Abreast of it the savings bank facility provided by the Postal department was comparatively safer. Moreover, funds were largely given to them.

Phase II

Government took major steps in this Indian Banking Sector Reform after independence. In 1955, it nationalized Imperial Bank of India with extensive banking facilities on a large scale specially, in rural and semi-urban areas. It formed State Bank of India to act as the principal agent of RBI and to handle banking transactions of the Union and State Governments all over the country.

Seven banks forming subsidiary of State Bank of India was nationalized in 1960 on 19th July, 1969, major process of nationalisation was carried out. It was the effort of the then Prime Minister of India, Mrs. Indira Gandhi. 14 major commercial banks in the country were nationalised. Second phase of nationalisation Indian Banking Sector Reform was carried out in 1980 with seven more banks. This step brought 80% of the banking segment in India under Government ownership. The following are the steps taken by the Government of India to Regulate Banking Institutions in the Country:

  • 1949 : Enactment of Banking Regulation Act.
  • 1955 : Nationalisation of State Bank of India.
  • 1959 : Nationalisation of SBI subsidiaries.
  • 1961 : extended to deposits.
  • 1969 : Nationalisation of 14 major banks.
  • 1971 : Creation of credit guarantee corporation.
  • 1975 : Creation of regional rural banks.
  • 1980 : Nationalization of seven banks with deposits over 200 crores.

After the nationalization of banks, the branches of the public sector bank India rose to approximately 800% in deposits and advances took a huge jump by 11,000%. Banking in the sunshine of Government ownership gave the public implicit faith and immense confidence about the sustainability of these institutions.

Phase III

This phase has introduced many more products and facilities in the banking sector in its reforms measure. In 1991, under the chairmanship of M Narasimham, a committee was set up by his name which worked for the liberalization of banking practices. The country is flooded with foreign banks and their ATM stations. Efforts are being put to give a satisfactory service to customers. Phone banking and net banking is introduced. The entire system became more convenient and swift. Time is given more importance than money. The financial system of India has shown a great deal of resilience. It is sheltered from any crisis triggered by any external macroeconomics shock as other East Asian Countries suffered. This is all due to a flexible exchange rate regime, the foreign reserves are high, the capital account is not yet fully convertible, and banks and their customers have limited exposure.

India's banking sector is growing at a fast pace. It has become one of the most preferred banking destinations in the world. Indian markets provide growth opportunities, which are unlikely to be matched by the mature banking markets around the world. FICCI conducted a survey to analyze the potential offered by Indian Banking System and achievement of global competitiveness by Indian banks. The questions largely revolved around where we are, how will India go about it, what structures need to be created and when will it happen?

Some of the major strengths of Indian banking industry, which have helped mark its place on the global banking scene as highlighted by our survey respondents were Regulatory Systems (84.21%), Economic Growth Rate (63.15%), Technological Advancement (52.63%), Risk Assessment Systems (47%) and Credit Quality (42.1%). Some of the areas that need to be geared up for future growth, identified by the survey respondents are Diversification of markets beyond big cities (84.2%), HR Systems (63.15%), Size of banks (52.63%) High Transaction Costs (47.3%), Banking Infrastructure (42%) and Labour Inflexibilities (42%).

To a question on achieving global competitiveness, Consolidation in the financial sector has emerged to be the most significant measure required to create world class banking system followed by Strict Corporate Governance Norms, Regional Expansion, Higher FDI limits and FTA's.

On being asked to rate India on certain essential banking parameters (Regulatory Systems, Risk Assessment Systems, Technological Systems and Credit Quality) in comparison with other countries i.e China, Japan, Sinagapore, Russia, UK and USA, the following results emerged. Regulatory systems of Indian banks were rated better than China andØ Russia; at par with Japan and Singapore but less advanced than UK and USA. Respondents rated India's Risk management systems more advanced thanØ China and Russia; at par with Japan, and less advanced than Singapore, UK and USA. 83% of our respondents highlighted that Basel II implementation would take us a step ahead in global competitiveness. Technological systems of Indian banks have been rated more advancedØ than China and Russia; at par with Japan, but less advanced than Singapore, UK and USA. Majority of respondents quoted credit quality of Indian banks betterØ in comparison with China, Japan and Russia; at par with Singapore but below par with UK and USA. 75 per cent of the foreign bank's respondents rated their working experience in India as " extremely good". Given India's potential over the next decade and beyond, 100 per cent foreign banks respondents stated that they have formulated strategies for future expansion in India.

55 per cent of the respondents highlighted that the FTA's signed by India till now have helped enhance global trade and thus been of help to banks in their global expansion strategy.

On possible Comprehensive Economic Co-Operation Agreement (CECA) with EU, 85 per cent of domestic banks respondents also emphasized that India should not give full domestic status to EU based banks under the proposed India-EU CECA. 69 per cent of respondents stated that 20 - 30 % proportion of their total Income is constituted by fee-based incomes. Bancassurance and selling of mutual funds were recognized as the most tapped business opportunities by the bankers closely followed by Forex Management. Out of these selling of mutual funds was identified as the most profitable venture by 47 per cent of respondents.

The penetration of banking services to Indian households stands at a mere 35.5%. Some of the efforts highlighted to increase this penetration level were: Tapping the Rural markets (87.5 per cent respondents) and Opening more branches in Tier II and Tier III towns.

3.2 Indian Banking: Paradigm Shift

A regulatory point of view

The decade gone by witnessed a wide range of financial sector reforms, with many of them still in the process of implementation. Some of the recently initiated measures by the RBI for risk management systems, anti money laundering safeguards and corporate governance in banks, and regulatory framework for non bank financial companies, urban cooperative banks, government debt market and forex clearing and payment systems are aimed at streamlining the functioning of these instrumentalities besides cleansing the aberrations in these areas. Further, one or two all India development financial institutions have already commenced the process of migration towards universal banking set up. The banking sector has to respond to these changes, consolidate and realign their business strategies and reach out for technology support to survive emerging competition. Perhaps taking note of these changes in domestic as well as international arena, organisers of this Conference have appropriately chosen the topic 'paradigm shift in Indian Banking' as the central theme for this year's bank-economists Meet and they deserve our appreciation.

1.) Regulatory framework for banks was one area which has seen a sea-change after the financial sector reforms and economic liberalisation and globalization measures were introduced in 1992-93. These reforms followed broadly the approaches suggested by the two Expert Committees both set up under the chairmanship of Shri M. Narasimham in 1991 and 1998, the recommendations of which are by now well known. The underlying theme of both the Committees was to enhance the competitive efficiency and operational flexibility of our banks which would enable them to meet the global competition as well as respond in a better way to the regulatory and supervisory demand arising out of such liberalisation of the financial sector. Most of the recommendations made by the two Expert Committees which continued to be subject matter of close monitoring by the Government of India as well as RBI have been implemented. Government of India and RBI has taken several steps to:

(a) Strengthen the banking sector,

(b) Provide more operational flexibility to banks,

(c) Enhance the competitive efficiency of banks, and

(d) Strengthen the legal framework governing operations of banks.

2.) The important measures taken to strengthen the banking sector are briefly, the following:

(a) Introduction of capital adequacy standards on the lines of the Basel norms, prudential norms on asset classification, income recognition and provisioning, Introduction of valuation norms and capital for market risk for investments

(b) Enhancing transparency and disclosure requirements for published accounts, Aligning exposure norms - single borrower and group-borrower ceiling - with inter-national best practices

(c) Introduction of off-site monitoring system and strengthening of the supervisory framework for banks.

Some of the important measures introduced to provide more operational flexibility to banks are:

a.) Besides deregulation of interest rate, the boards of banks have been given the authority to fix their prime lending rates. Banks also have the freedom to offer variable rates of interest on deposits, keeping in view their overall cost of funds.

b.) Statutory reserve requirements have significantly been brought down the quantitative firm-specific and industry-specific credit controls were abolished and banks were given the freedom to deploy credit, based on their commercial judgement, as per the policy approved by their Boards.

c.) The banks were given the freedom to recruit specialist staff as per their requirements, the degree of autonomy to the Board of Directors of banks was substantially enhanced

d.) Banks were given autonomy in the areas of business strategy such as, opening of branches / administrative offices, introduction of new products and certain other operational areas.

Some of the important measures taken to increase the competitive efficiency of banks are the following:

a.) Opening up the banking sector for the private sector participation.

b.) Scaling down the shareholding of the Government of India in nationalized banks and of the Reserve Bank of India in State Bank of India.

3.) Measures taken by the Government of India to provide a more conducive legal environment for recovery of dues of banks and financial institutions are:

a.) Setting up of Debt Recovery Tribunals providing a mechanism for expeditious loan recoveries.

b.) Constitution of a High Power Committee under former Justice Shri Eradi to suggest appropriate foreclosure laws.

c.) An appropriate legal framework for securitisation of assets is engaging the attention of the Government,

4.) This paradigm shift in the regulatory framework for banks had achieved the desired results. The banking sector has shown considerable degree of resilience.

(a) The level of capital adequacy of the Indian banks has improved: the CRAR of public sector banks increased from an average of 9.46% as on March 31, 1995 to 11.18% as on March 31, 2001.

(b) The public sector banks have also made significant progress in enhancing their asset quality, enhancing their provisioning levels and improving their profits. The gross and net NPAs of public sector banks declined sharply from 23.2% and 14.5% in 1992-93 to 12.40% and 6.7% respectively, in 2000-01. Similarly, in regard to profitability, while 8 banks in the public sector recorded operating and net losses in 1992-93, all the 27 banks in the public sector showed operating profits and only two banks posted net losses for the year ended March 31, 2001. The operating profit of the public sector banks increased from Rs.5628 crore as on March 31, 1995 to Rs.13,793 crore as on March 31, 2001. The net profit of public sector banks increased from Rs.1116 crore to Rs.4317 crore during the same period, despite tightening of prudential norms on provisioning against loan losses and investment valuation. The accounting treatment for impaired assets is now closer to the international best practices and the final accounts of banks are transparent and more amenable to meaningful interpretation of their performance.

5.) Much more has to be done in this area and I would like the banks to view these measures for strengthening their fundamentals as a seamless exercise. Globally some of the best managed banks in developed countries are proactive in building up reserves when the profits are on the upswing and do not wait for regulatory goading. Many of them unhesitatingly resort to timely write off and provisioning in respect of problem assets. This is a culture I would like Indian banks to emulate. I would suggest to Indian banks to go for larger provisioning when the profits are good without frittering them away by way of dividends, however tempting it may be. As a method of compulsion, RBI has recently advised banks to create an Investment Fluctuation Reserve upto 5 per cent of the investment portfolio to protect the banks from varying interest rate regime.

6.) One of the means for improving financial soundness of a bank is by enhancing the provisioning standards of the bank. The cumulative provisions against loan losses of public sector banks amounted to a mere 41.67% of their gross NPAs for the year ended March 31, 2001. The amount of provisions held by public sector banks is not only low by international standards but there has been wide variation in maintaining the provision among banks. Some of the banks in the public sector had as low provisioning against loan losses as 30% of their gross NPAs and only 5 banks had provisions in excess of 50% of their gross NPAs. This is inadequate considering that some of the countries maintain provisioning against impaired assets at as high as 140%. Indian Banks should improve the provisioning levels to at least 50% of their gross NPAs. There should therefore be an attitudinal change in banks' policy as regards appropriation of profits and full provisioning towards already impaired assets should become a priority corporate goal.

7.) The banks should also develop a concept of building desirable capital over and above the minimum CRAR which is insisted upon in developed regulatory regimes like UK. This can be at, say around 12 percent as practised even today by some of the Indian banks, so as to provide well needed cushion for growth in risk weighted assets as well as provide for unexpected erosion in asset values.

8.) As banks would have observed, the changes in the regulatory framework are now brought in by RBI only through an extensive consultative process with banks as well as public wherever warranted. While this serves the purpose of impact assessment on the proposed measures it also puts the banks on notice to initiate appropriate internal readjustment to meet the emerging regulatory prescriptions. Though adequate transitional route has been provided for switchover to new regulatory measures such as scaling down the exposure to capital market, tightening the prudential requirements like switch over to 90 day NPA norm, reduction in exposure norms, etc., I observe from the various quarters from which RBI gets its inputs that the banks are yet to take serious steps towards implementation of these measures. I would like to exhort my banker friends to move in this regard at a faster pace so that compliance with the norms is in place and at the same time, it will turn out to be a painless exercise.

9.) I would like to inform that the prompt corrective action framework which had already been circulated amongst all concerned and undergoing consultative process with the Government may reach the enforcement stage shortly. Such a mandatory framework when it comes into effect won't distinguish between banks; banks which fall short of the prescribed levels of CRAR and ROA and exceed net NPA level would be facing the mandatory enforcement actions irrespective of the stable ownership. The banks should well note to go in for proactive measures towards improving the financial fundamentals and restore the soundness and stability of the institution than waiting for the supervisor's cease and desist orders to initiate such corrective steps.

10.) The Boards of banks have been accorded considerable autonomy in regard to their corporate strategy as also several other operational matters. This does not, however, seem to have translated to any substantial improvement in customer service. It needs to be recognised that meeting the requirements of the customer - whether big or small - efficiently and in a cost effective manner, alone will enable the banks to withstand the global competition as also the competition from non-bank institutions.

11.) The profitability of the public sector banks is coming under strain. Despite the resilience shown by our banks in the recent times, the income from recapitalisation bonds accounted for a significant portion of the net profits for some of the nationalised banks. The Return on Assets (RoA) of public sector banks has, on an average, declined from 0.54 for the year ended March 31, 1999 to 0.43 for the year ended March 31, 2001.

12.) Therefore, the Boards' attention needs to be focused on improving the profitability of the bank. The interest income of public sector banks as a percentage of total assets has shown a declining trend since 1996-97: it declined from 9.69 in 1996-97 to 8.84 in 2000-01. Similarly, the spread (net interest income) as a percentage of total assets also declined from 3.16 in 1996-97 to 2.84 in 2000-01. The importance of interest spreads and ways of improving net interest margins by public sector banks were discussed threadbare in a technical seminar at NIBM recently which many of you attended. If the new private banks and foreign banks can despite a high cost of funds could still optimize their profits, why not public sector banks and old private sector banks which have a much wider reach to low cost deposits through large branch network achieve the same? I would like the CMDs of banks to initiate cost cutting measures in the operating expenditure besides giving a customer oriented thrust for attracting quality clientele through quality service. The banks should learn to operate with inherent constraints. You should compete in areas where you have competency and cooperate with competitors where it pays. This change in attitude would, I believe, bring in better margins and optimize your profits.

13.) A disheartening feature is that a large number of public sector banks have recorded far below the median RoA of 0.4% for 2000-01 in their peer group. Incidentally the RoA recorded by new private banks and foreign banks ranged from 0.8% to 1% for the same period. An often quoted reason for the decline in profitability of public sector banks is the stock of NPAs which has become a drag on the bank's profitability. As you are aware, the stock of NPAs does not add to the income of the bank while at the same time, additional cost is incurred for keeping them on the books. To help the public sector banks in clearing the old stock of chronic NPAs, RBI had announced 'one-time non discretionary and non discriminatory compromise settlement schemes' in 2000 and 2001. Though many banks tried to settle the old NPAs through this transparent route, the response was not to the extent anticipated as the banks had been bogged down by the usual fear psychosis of being averse to settling dues where security was available. The moot point is if the underlying security was not realised over decades in many cases due to extensive delay in litigation process, should not the banks have taken advantage of the one time opportunity provided under RBI scheme to cleanse their books of chronic NPAs ? This would have helped in realising the carrying costs on such non-income earning NPAs and released the funds for recycling. I would expect the banks to pursue action in tackling large wilful defaults, effective utilisation of DRTs, and go in for compromise settlements wherever feasible under the banks' own schemes with transparency and accountability.

14.) The Boards of public sector banks need to be alive to the declining profitability of the banks. One of the reasons for the low level of profitability of public sector banks is the high operating cost. The cost income ratio (which is also known as efficiency ratio of public sector banks) increased from 65.3 percent for the year ended March 31, 2000 to 68.7 per cent for the year ending March 31, 2001. The staff expenses as a proportion to total income formed as high as 20.7% for public sector banks as against 3.3% for new banks and 8.2% for foreign banks for the year ended March 31, 2001. There is thus an imperative need for the banks to go for cost cutting exercise and rationalize the expenses to achieve better efficiency levels in operation to withstand declining interest rate regime.

15.) As you have observed from Governor's address in the recent NIBM annual day function, the corporate governance principles acquire a different connotation when applied to the banking system. Unlike other sectors, banks are highly leveraged institutions and depositors being larger stake holders than equity owners require to be protected. In a deregulated environment, the Boards of banks are expected to play a more pro-active role in preserving the financial soundness and stability of the institution for depositors' protection, besides enhancing shareholders value. The decisions in regard to deployment of resources and pricing of the assets and liabilities are vested with the Boards themselves. This brings us to the need for a professional and qualified Board of Directors who are able to guide the bank in regard to audit, risk management, transparency, etc. in a de-regulated environment.

16.) Taking a cue from the recent happenings in some of the banks in relation to capital market exposures and recognizing the need for better corporate governance in the banks, RBI has recently constituted a High Powered Group under the Chairmanship of Dr Ashok Ganguly, a director of the Central Board of RBI. The group has drawn representatives from various fields including from management institutes, non official directors of banks, and eminent industrialists and is in the process of formulating its recommendations to strengthen the internal defenses at all levels. The international recommendations in this area call for transparency and accountability at the Board level as well at various senior management and other functional levels so that policy and operational aberrations and deviations from good practices are effectively checked and prevented. The CMDs/CEOs of banks both in private and public sector should try to promote participative governance and adopt well defined disclosure standards at Board level as well as at controlling levels down the line.

17.) Boards of banks have much more freedom now than they had a decade ago, and obviously they have to play the role of change agents. They should have the expertise to identify, measure and monitor the risks facing the bank and be capable to direct and supervise the bank's operations and in particular, its exposures to various sectors of the economy, and monitoring / review thereof, pricing strategies, mitigation of risks, etc. The Board of the banks should also ensure compliance with the regulatory framework, and ensure adoption of the best practices in regard to risk management and corporate governance standards. The emphasis in the second generation of reforms ought to be in the areas of risk management and enhancing of the corporate governance standards in banks.

18.) Another crucial area which should receive the attention of the Board, viz., the preparedness for switching over to the New Capital Adequacy Framework being introduced by the Basel Committee on Banking Supervision, effective from 2005. The basic thrust of the New Framework is to assign capital in relation to the underlying risk of the counterparties instead of the existing one-size-fits-all formula for assessing credit risk. This would require a more scientific assessment of the credit risk by the banks. In order to have a smooth transition to the New Framework, the banks would need to substantially upgrade their MIS and risk management systems. The banks would also need to upgrade the technical skills of their staff. The adoption of the New Framework, it has been estimated by some analysts, could lead to an increase in the existing level of capital of banks by about 2 percentage points. The signals to the banks are therefore, to enhance the level of core capital, strengthen MIS and historical data base and upgrade the skills of the personnel.

Chapter - 4


4.1 Basel Committee

History of Basel Committee and its members

The Basel Committee, established by the central-bank Governors of the Group of Ten countries at the end of 1974, meets regularly four times a year. It has four main working groups which also meet regularly.

The Committee's members come from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, United Kingdom and United States. Countries are represented by their central bank and also by the authority with formal responsibility for the prudential supervision of banking business where this is not the central bank. The present Chairman of the Committee is Mr Nout Wellink, President of the Netherlands Bank, who succeeded Mr Jaime Caruana on 1 July 2006. The Committee does not possess any formal supranational supervisory authority, and its conclusions do not, and were never intended to, have legal force. Rather, it formulates broad supervisory standards and guidelines and recommends statements of best practice in the expectation that individual authorities will take steps to implement them through detailed arrangements - statutory or otherwise - which are best suited to their own national systems. In this way, the Committee encourages convergence towards common approaches and common standards without attempting detailed harmonisation of member countries' supervisory techniques.The Committee reports to the central bank Governors of the Group of Ten countries and to the heads of supervisory authorities of these countries where the central bank does not have formal responsibility. It seeks their endorsement for its major initiatives. These decisions cover a very wide range of financial issues. One important objective of the Committee's work has been to close gaps in international supervisory coverage in pursuit of two basic principles: that no foreign banking establishment should escape supervision; and that supervision should be adequate. To achieve this, the Committee has issued a long series of documents since 1975.

In 1988, the Committee decided to introduce a capital measurement system commonly referred to as the Basel Capital Accord. This system provided for the implementation of a credit risk measurement framework with a minimum capital standard of 8% by end-1992. Since 1988, this framework has been progressively introduced not only in member countries but also in virtually all other countries with internationally active banks. In June 1999, the Committee issued a proposal for a revised Capital Adequacy Framework. The proposed capital framework consists of three pillars: minimum capital requirements, which seek to refine the standardised rules set forth in the 1988 Accord; supervisory review of an institution's internal assessment process and capital adequacy; and effective use of disclosure to strengthen market discipline as a complement to supervisory efforts. Following extensive interaction with banks, industry groups and supervisory authorities that are not members of the Committee, the revised framework was issued on 26 June 2004. This text serves as a basis for national rule-making and for banks to complete their preparations for the new framework's implementation.

Over the past few years, the Committee has moved more aggressively to promote sound supervisory standards worldwide. In close collaboration with many non-G10 supervisory authorities, the Committee in 1997 developed a set of "Core Principles for Effective Banking Supervision", which provides a comprehensive blueprint for an effective supervisory system. To facilitate implementation and assessment, the Committee in October 1999 developed the "Core Principles Methodology". The Core Principles and the Methodology were revised recently and released in October 2006.

In order to enable a wider group of countries to be associated with the work being pursued in Basel, the Committee has always encouraged contacts and cooperation between its members and other banking supervisory authorities. It circulates to supervisors throughout the world published and unpublished papers. In many cases, supervisory authorities in non-G10 countries have seen fit publicly to associate themselves with the Committee's initiatives. Contacts have been further strengthened by International Conferences of Banking Supervisors (ICBS) which take place every two years. The last ICBS was held in Mexico in the autumn of 2006. The Committee's Secretariat is provided by the Bank for International Settlements in Basel. The fifteen person Secretariat is mainly staffed by professional supervisors on temporary secondment from member institutions. In addition to undertaking the secretarial work for the Committee and its many expert sub-committees, it stands ready to give advice to supervisory authorities in all countries.

4.2 Basel I

The first accord was the Basel I. It was issued in 1988 and focused mainly on credit risk by creating a bank asset classification system.The Basel Capital Accord is an Agreement concluded among country representatives in 1988 to develop standardized risk-based capital requirements for banks across countries. The Accord was replaced with a New capital adequacy framework (Basel II), published in June 2004. The capital adequacy framework (also known as the Risk-Weighted Capital Adequacy framework) sets out the approach for the computation of minimum capital required by a banking institution to operate as a going concern entity. The capital adequacy framework can be divided into three broad categories which consists of the general capital adequacy requirements, components of eligible regulatory capital and the Risk- Weighted Assets (RWA).

Risk-Weighted Assets (RWA)

Capital as defined in the Risk-Weighted Capital Adequacy Framework (General Requirements) is compared against the level of the banking institution's RWA. The amount of RWA would be derived from different categories of assets and off-balance sheet exposures, weighted according to broad categories of relevant riskiness.

Credit RWA

The credit RWA is measured by classifying on-balance sheet assets6 and assigning risk weights to each class of assets according to the relevant riskiness. It also incorporates off-balance sheet exposures, which bear a significant credit risk, calculated as follows:

i) The conversion of off-balance sheet exposures into credit equivalent; and

ii) The application of a risk weight to the credit equivalent according to the nature of the obligor.

The aggregate weighted on-balance sheet assets and weighted credit equivalent of the off-balance sheet exposures will form the total credit RWA which acts as the denominator7 of the RWCR. The classification of risk weights is kept as simple as possible and only 5 weights (0%, 10%, 20%, 50% and 100%) are used. Inevitably, there have been some broad-brush judgments made in deciding which weight would apply to different types of assets. Therefore, the weightings should not be regarded as a substitute for banking institutions' commercial judgment for purposes of market pricing of the different instruments.

Market RWA

The capital treatment for market risk addresses:

i) The interest rate and equity risks pertaining to financial instruments34 in the trading book;

ii) Foreign exchange risk in the trading and banking books.

Ø Interest Rate Risk

The minimum capital requirement for interest rate risk is the summation of the capital charges for:

(i) Specific risk of each security, whether it is a short or a long position; and

(ii) General market risk, where long and short positions in different securities or instruments may be off-setted.

Ø Specific risk

The capital requirement for specific risk is designed to protect against adverse movements in the price of an individual security owing to factors related to the issuer. In measuring the risk, offsetting will be restricted to matched positions in the identical issue (including positions in derivatives). Even if the issuer is the same, no offsetting is permitted between different issues since differences in coupon rates, liquidity, call features, etc. mean that prices may diverge in the short run. Table 4 specifies the applicable specific risk charges for interest rate related financial instruments for issuers of G10 and non-G10 countries

Ø General risk

The capital requirements for general risk are designed to capture the risk of loss arising from changes in market interest rates. Within the standard approach, a choice between two principal methods of measuring the risk is permitted; "maturity" method or "duration" method. Upon adoption of a method, banking institutions are not allowed to switch between methods without the consent of the Bank.

4.3 Loopholes of Basel I Accord

n 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.

n 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

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

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

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

n It was concentrating on only on credit risk.

4.4 Basel II

It is the second accord which focuses on operational risk along with market risk and credit risk. Basel II tries to ensure that the anomalies existed in Basel I are corrected. Basel II is the international capital adequacy framework to banks that prescribes capital requirements for credit risk, market risk and operational risk. Basel II is the second of the Basel Accords recommended on banking laws and regulations issued by Basel Committee on Banking Supervision. The purpose behind applying Basel II norms to Indian banks is to help them comply with international standards. These international standards can help protect the international financial system from problems that may arise from the collapse of a major bank.

Basel II is stated to set up rigorous risk and capital management requirements to ensure that banks have capital reserves appropriate to their risk profile. The outcome is that the greater the risk to which a bank is exposed, greater is the amount of capital it will require to hold to protect its solvency and overall stability. It will also force banks to enhance disclosures, which will help create more transparency and trust in the banking system itself. We believe transparency in financial reporting will improve. Total CRAR and Tier I capital is expected to expand with implementation of Basel II norms.

3 Pillars of Basel II

Pillar 1 includes 3 risks now, operational risk + credit risk + market risk.

Basel II and the Capital Requirements Directive

Basel II applies to internationally active banks. As noted above, in the European Union, the framework has been implemented through the Capital Requirements Directive (CRD). The CRD affects certain types of investment firms and all deposit takers (including banks and building societies), except credit unions. The framework under the CRD reflects the flexible structure and the major components of Basel II. It has been based on the three "pillars", but has been tailored to the specific features of the EU market.

Minimum capital requirements

Basel II requires that an institution's total regulatory capital must be at least 8% of its risk weighted assets, based on measures of its credit risk, market risk and operational risk. This ratio is unchanged from Basel I.

Measuring credit risk

In relation to credit risk, Basel II permits banks to use one of two methodologies. They can assess risk using the "Standardised" Approach, which involves external credit assessments, or they can use their own internal systems for rating credit risk. The standardised approach is similar to Basel I but risk weights are based on credit ratings provided by external credit assessment institutions such as rating agencies. In contrast, the foundation and advanced internal ratings based approaches reflect the fact that many internationally active banks already have in place extremely sophisticated internal methods for modeling, assessing and managing risk. These latter methods can be used only with the explicit approval of the institution's supervisor.

Measuring operational risk

One of the key changes in Basel II is the addition of an operational risk measurement to the calculation of minimum capital requirements. This has also been included in the CRD. Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, such as exposure to fines, penalties and private settlements. It does not, however, include strategic or reputational risk. In calculating operational risk capital charges, Basel II sets out three different methods which may be adopted.

The Basic Indicator Approach is the simplest of the three approaches, and will be the default option for most firms. It applies a calculation based on the firm's income to determine its capital requirements.

The Standardised Approach (not to be confused with the approach for credit risk of the same name) again relies on calculations based on income, but with different percentages applying across different business lines. To be able to take advantage of the Standardised Approach, firms will have to meet certain qualifying criteria.

The Advanced Measurement Approach is the most advanced of the three options. Under this approach, each firm calculates it own capital requirements, by developing and applying its own internal risk measurement system. As with the Standardised Approach, the firm must meet certain qualifying criteria, and the risk measurement system must be validated by the FSA before it will be allowed to take advantage of the AMA.

Calculating market risk

As with credit and operational risk, Basel II is designed to reflect the increasingly sophisticated risk management practices that exist in many financial institutions by offering them the opportunity to use advanced internal models for calculating market risk. The aim is to encourage institutions to monitor and control risk effectively, by obliging them to make a series of disclosures about their risk profiles and regulatory capital procedures which are available to market participants. The intention is that they strike a balance between meaningful disclosures and the need to protect confidential and proprietary information. Keeping in view RBI's goal to have consistency and harmony with international standards, it has been decided that all commercial banks in India shall adopt Standardized Approach (SA) for credit risk and Basic Indicator Approach (BIA) for operational risk. Banks shall continue to apply the Standardized Duration Approach (SDA) for computing capital requirement for market risks.

Under the Standardized Approach, the rating assigned by the eligible external credit rating agencies will largely support the measure of credit risk. RBI has identified external credit rating agencies that meet the eligibility criteria specified under the revised Framework. Banks may rely upon the ratings assigned by the external credit rating agencies chosen by the RBI for assigning risk weights for capital adequacy purposes.

The RBI decided that banks may use the ratings of the following domestic credit rating agencies for the purposes of risk weighting their claims for capital adequacy purposes: a) Credit Analysis and Research Ltd. b) CRISIL Ltd. c) FITCH Ltd. and d) ICRA Ltd. Banks may use the ratings of the following international credit rating agencies for the purposes of risk weighting their claims for capital adequacy purposes a) Fitch; b) Moody's; and c) Standard & Poor's. Banks should use the chosen credit rating agencies and their ratings consistently for each type of claim, for both risk weighting and risk management purposes. Banks will not be allowed to "cherry pick" the assessments provided by different credit rating agencies. Banks must disclose the names of the credit rating agencies that they use for the risk weighting of their assets, the risk weights associated with the particular rating grades as determined by RBI for each eligible credit rating agency as well as the aggregated risk weighted assets. For instance recently, Induslnd bank entered into MOU with CRISIL and Allahabad bank entered into MOU with CARE for rating facility as required under Basel II.

Computation of Total CRAR and Tier I capital under Basel II

Basel II Total CRAR = Total capital / (Credit Risk RWA + Operational Risk RWA + Market Risk RWA) RWA - risk weighted assets.

Pillar 2 requirements give supervisors, i.e., the RBI, the discretion to increase regulatory capital requirements. The RBI can administer and enforce minimum capital requirements from bank even higher than the level specified in Basel II, based on risk management skills of the bank. RBI will consider prescribing a higher level of minimum capital ratio for each bank under the Pillar 2 framework on the basis of their respective risk profiles and their risk management systems. Further, in terms of the Pillar 2 requirements of the New Capital Adequacy Framework, banks are expected to operate at a level well above the minimum requirement.

Pillar 3 demands comprehensive disclosure requirements from banks. For such comprehensive disclosure, IT structure must be in place for supporting data collection and generating MIS which is compatible with Pillar 3 requirements.

While Basel I was useful, as it brought into focus the need to bridge gap between capital requirements and risk profiles of commercial banks, Basel II is a step forward by forcing banks to recognize the need to distinguish between credit quality of individual borrowers. Basel II will help promote increased transparency and better reporting systems. In short, compliance is a win-win situation for all concerned. Banks will have to continuously improve the quality of their internal loss data, with Basel II requiring them to have at least five years of data, including a downturn.

The Terminology

Capital to Risk Weighted Assets Ratio (CRAR) is also known as Capital Adequacy Ratio which indicates a bank's risk-taking ability. The RBI uses CRAR to track whether a bank is meeting its statutory capital requirements and is capable of absorbing a reasonable amount of loss.

CRAR = (Tier I capital + Tier II capital) / Risk-Weighted Assets

Capital funds are broadly classified as Tier 1 and Tier 2 capital. Two types of capital are measured: Tier one capital, which absorbs losses without a bank being required to cease trading, and Tier two capital, which absorbs losses in the event of winding-up and so provides a lesser degree of protection to depositors.

Tier I capital (core capital) is the most reliable form of capital. The major components of Tier I capital are paid up equity share capital and disclosed reserves viz. statutory reserves, general reserves, capital reserves (other than revaluation reserves) and any other type of instrument notified by the RBI as and when for inclusion in Tier I capital. Examples of Tier 1 capital are common stock, preferred stock that is irredeemable and non-cumulative, and retained earnings.

Tier II capital (supplementary capital) is a measure of a bank's financial strength with regard to the second most reliable forms of financial capital. It consists mainly of undisclosed reserves, revaluation reserves, general provisions, subordinated debt, and hybrid instruments. This capital is less permanent in nature.

The reason for holding capital is that it should provide protection against unexpected losses. This is different from expected losses for which provisions are made.

4.5 Basel I V/s. Basel II

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

4.6 Advantages of Basel-II

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

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

. In a nut-shell, Basel II -

  • Provides effective assessment methods.
  • Incorporates sensitivity to banks.
  • Makes better business standards.
  • Reduces losses to the banks.

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

  • Improving overall efficiency of banking and finance systems.
  • Takes global aspect into consideration for more rational decision making, improving the decision matrix for banks.
  • Allowing capital discrimination of the banking system by allocating proper risk weighs to each asset class.
  • Providing range of alternatives to choose from.
  • Allowing capital allocation based on ratings of the borrower making capital more risk-sensitive.
  • Providing an incentive for better and more objective risk measurement.
  • Encouraging mergers and acquisitions and more collaboration on the part of the banks, this ultimately leads to proper control over their capital and assets.

4.7 Major challenges

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

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

The new norms seem to favor the large banks that have better risk management and measurement expertise, who also have better capital adequacy ratios and geographically diversified portfolios. The smaller banks are also likely to be hurt by the rise in weightage of inter-bank loans that will effectively price them out of the market. Thus, banks will have to re-structure and risk, will be difficult due to significant disconnect between business, risk managers and IT across the organizations in their existing set-up.

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

Global Scenario on Basel II

Banking regulators in around the world are planning to implement Basel II, but with varying timelines and use of the varying methodologies being restricted. European banks already report their capital adequacy ratios according to the new system. European banks implemented Basel II at the start of 2008 whereas Japanese banks implemented in 2007. Australia implemented the Basel II Framework in 2008. US banks are scheduled to switch over in 2009.

4.8 SWOT Analysis of Basel II


  • Aggression towards development of the existing standards by banks.
  • Strong regulatory impact by central bank to all the banks for implementation.
  • Presence of intellectual capital to face the change in implementation with good quality.


  • Poor Technology Infrastructure.
  • Ineffective Risk measures.
  • Presence of more number of smaller banks that would likely to be impacted adversely.


  • Increasing Risk Management Expertise.
  • Need significant connection among business, credit and risk management and Information Technology.
  • Advancement of Technologies.
  • Strong Asset base would help in bigger growth.


  • Inability to meet the additional Capital Requirements.
  • Loss of Capital to entire banking system, due to Mergers and Acquisitions.
  • Huge Investments in Technologies.

Chapter - 5


The objective of this report can be achieved only through the expert interviews as the topic itself is not familiar with most of the population. While following the questionnaire and collecting the information as per the questionnaire, followings are the major findings which I would like to mention:-

1. How do you perceive the Basel-II Accord?

§ The respondents from 7 banks consider the Basel-II Accord as prominent tool for the minimization and limited exposure towards the risk on their credit functioning. They admit the superiority of Basel-II accord over the Basel-I. According to them, the method of calculation of risk through Capital to Risk Weighted Assets Ratio(CRAR) is more authentic in revised Capital Adequacy framework as compared to the Basel-I. This is more effective for the banks. It is said that the Basel-II requires allocation of larger fund base as provisions for NPA's, but in practical, now banks have to maintain lesser provisions as segmenting the risk category has made it possible for banks that they can allot fund according to the degree of risk. This, in turn, also makes more funds available with the banks for their requirements.

§ According to the officials of 3 banks, Mitigation of the credit risk is the most valuable and promising feature of the new capital adequacy framework Basel-II. It has equipped the banks with the safeguard measures in order to deal with the risky exposure of their credit portfolio. Segmentation of different heads on the basis of Risk weighted Assets in a single portfolio of credit has supported the banks in their risk measurement exercise.

2. What is your standpoint regarding the Pillar-I norms which is associated with the Minimum Capital Requirement?

§ An official at Punjab National Bank said that Pillar-I has given a new concept of Credit Risk Mitigation (CRM) and Hair Cut along with its other provisions. In Pillar-I, the primary and collateral security are not treated in a distinguished manner or approach but they are considered in a same manner. This means if a loan is granted of Rs.100 and collateral is provided worth Rs.40, then risk weight would be assigned to Rs.60 only and accordingly provisions would be made for Rs.60 only.

§ One of the respondent of Bank of India said that one of the distinguishing feature of Pillar-I of new capital adequacy requirement framework relates to the fine tuning of the methodology for assessment of exposure and collaterals for the purpose of calculation of Capital Risk Weighted Assets Ratio (CRAR).

§ CRM deals with the recognition of certain collaterals based upon their worthiness to cover the risk exposure and the degree of risk is assigned upon the fixed criteria. CRM allows a wider range of credit exposure as it is regulated for regulatory capital requirement. Hair Cuts are discounting factors to be applied on CRM value. In India, banks are allowed to go for standard supervisory Hair Cut.

3. What is the implementation scenario at this stage?

§ The spokesperson of Citibank said that We have thoroughly implemented the Basel-II norms right from our corporate office to the branches working at the grass root level in a phase wise manner.

§ The contact person at Bank of India said we have initiated the implementation process of Basel-II on a parallel run with the already existing Basel-I, on a quarterly basis since 01/04/06 and finally we have implemented Basel-II accord on 31/03/09.

4. What were the resources which you employed to ensure the success of the implementation?

§ Punjab National Bank official replied that this was implemented through LADDER (Loan & Advances Data Desk Evaluation Report) System and the calculation of Capital Adequacy and Risk Weighted Asset(RWA) are being generated through LADDER System. D2K Technology, a kind of Software is introduced for calculation of risk sensitiveness' of loans and advances. Input in form of different sort of data is being provided to the system and the system itself provides the output.

§ The official of a bank replied that with the help of several phases of parallel runs and providing appropriate training to the team member involved in the implementation process and to the Branch Managers, who were made liable for implementing the Basel-II at the grass root level i.e. at the branch level, we have ensured the success of the accord. We have done a lot for data mining and sorting the data in a prescribed format, for successful implementation of the Base-II reforms.

5. What was your experience in this process?

§ The Punjab National Bank official replied that to provide a better framework for implementing the Basel-II Accord, we have upgraded our LADDER System to suit the desired requirement of Basel-II. We collected data from the credit department of our branches and the collected data was consolidated at the circle level and the data collected from different circle offices was consolidated at the Zonal Offices and ultimately at the Head Office level.

§ The contact person of Bank of India replied that the whole exercise involved in the implementation of Basel-II has fine tuned the credit operations of all the banks including ours also. By going through the Basel-II Capital Adequacy Framework, we have been able to achieve the desired goal i.e., to maintain the CRAR at 11.75% on 31/03/07, 12.04% on 31/03/08 and now we are operating at 13.26% as on 30/06/09 as compared with the minimum level of 9% as prescribed by the RBI.

6. What were the problems you witnessed while going through the implementation process?

        The list of problems stated by various respondents are :

§ Initially the problem of methodology to be opted for the proper implementation of the Basel-II framework

§ adjustment of Hair Cut applicable to the collaterals,

§ increased provisions for NPA's, calculation of RWA,

§ treatment of term deposit receipts,

§ NSC, KVP, calculation and supply of appropriate data for the sheets which were 20 in number,

§ Life Insurance Policies with declared surrender values,

§ Treatment of financial collaterals in case of year mark limit, etc.

§ The operations which were to be performed with the accumulation and validation of the existing database of the loan account. (database management)

§ Trained manpower and awareness level of the employees,

§ limit exposure, collateral security,

§ Non-fund base business, inter alia, up gradation of the bank-wide information system through better branch-connectivity, which entailed cost and may also raise some IT-security issues.

§ Banks required a higher amount of capital under the Basel II framework.

7. Which was the most crucial one and why?

§ One of the respondent who belonged to Punjab National Bank said Proper data up gradation and restructuring of the LADDER System were the most crucial problems which our bank had to face while going for the implementation process. This was so because the consolidation of the data from the wide spread network of branches, had been performed after the rigorous task of data mining and data validation. The data was organized in a prescribed format sent from the Head Office, which demands the detailed information regarding the credit portfolio of individual customers, segmentation of the different securities based upon their amount and risk exposure, information regarding bank's own exposure towards its credit portfolio and associated risk to that along with the operational arising out from the day to day activities of the banks.

§ The bank official of Bank of India said that we have 20 spreadsheets to be filed up for the calculation of CRAR in Basel-II framework. This required a very minute and accurate observation skills and a certainly a higher level of expertise. If the data is supplied or filled according to the requirements of the sheet, then only the calculation at the higher level can be performed and the desired outcome can be generated. If the person responsible for filling up the sheets fails to do so, then it will be a mere kiosk, which generally happens also.

8. How did you overcome with the problems associated?

§ huge amount on the creating the technical infrastructure,

§ bank-wide information system,

§ data base management,

§ adequate and phase wise training sessions for the human resource involved in the implementation process,

§ circulars and various other types of awareness programs was introduced in order to develop the human resource skill set.

§ appropriate calculation and report generation for the CRAR

§ Istallation of required software meeting with the requirements of the new capital adequacy framework of Basel-II

9. Does Basel-II still relevant or we need Basel-III?

§ 9 out of 10 respondents feel that Basel II is relevant and appropriate.

§ Punjab National Bank official said that Basel-II has been implemented in recent times and there are a lot of other banks where it is yet to be implemented. We are still waiting for the impact of Basel-II on the overall functioning of the banking industry in India, so I think Basel-II is still relevant.

§ Citibank official replied that Basel-II has just begun its journey in India and it has a long way to go. Thus, Basel-II is relevant.

10. What would you like to add more?

§ The Punjab national bank official added that, we are using Standardized Approach for the calculation of credit risk, Basic Indicator Approach for operating risk and Standardized Approach for market risk. I would also like to mention that the Internationally accepted norms like Basel-II is more adaptive in developed countries where the required infrastructural and technological support and skilled personnel are already available, but in Indian context, such kind of any accord should be introduced and implemented after making the prerequisites available for the banks.

§ Banks are required to expose a certain amount of equity so that their shareholders take the first loss and shield depositors from the impact of inappropriate and wrong business decisions. Basel-II, the risk based capital is going to be one of the primary drivers of the train towards global banking and aimed to promoting banking industry. The approach adopted for the calculation of the credit risk is the Standardized Approach, for operational risk it is Basic Indicator Approach and for the market risk it is Standardized Approach.

11. Impact on Credit

80 percent of the respondent banks quoted that increased capital requirements imposed by the Basel accord will not make their banks more risk averse towards credit dispensation. Merely 10% felt that implementation of Basel II could have an adverse impact on banks lending to commercial sector. Small and Medium enterprises and Farm and rural sectors are likely to be the most affected sectors.

Diagram showing risk aversion of bank with credit dispensation.

12. Expectations from Regulator

§ 90% of the respondents were completely satisfied with the support given by the RBI in respect to Basel II implementation. However some of them felt that there Should be consistency in implementation of these norms in terms of timing and approach. Further there should be greater consultation with internationally active banks that face significant cross-border implementation challenges.

Diagram Showing bank satisfaction with support given by RBI in respect to BASEL II

§ To a question on comfort level with the stricter disclosure requirements under the Basel II norms, 50 percent of respondents expressed that they were completely comfortable with these requirements, whereas rest felt that they were comfortable to some extent.

§ Operational risk measurement is one of the new planks of the Basel II accord.70 percent of respondents quoted that capital allocation to operational risk will not be counter productive. They instead believe that explicit charge on operational risk will direct more focus on it, which will further enhance operational risk management and operational efficiency for the banks. Also such an allocation would create a cushion for the claims or losses on this account. However the remaining felt that in the Indian context, capital requirements are too high as the Indian banks, unlike their foreign counterparts are not much involved in speculative activities such as derivatives. Hence the capital requirement for operational risk should be lower for the Indian Banks than what is specified in Basel-II Accord.

Diagram showing banks belief towards capital requirements as specified in BASEL

Chapter - 6



After the completion of the entire exercise which I have performed and the findings at which I arrived, these can be possible suggestions from my side. I am not authorized to dictate the terms for the successful implementation of Basel-II, still the followings are my suggestions:-

§ The first and the foremost criteria for the implementation and adoption of any type of internationally accepted accords such as Basel-II, should be the availability of the required infrastructure in advance.

§ With the feature of additional capital requirements, the overall capital level of the banks will see an increase. For this very purpose banks should be some more relaxations to enjoy their rights for raising required fund base from the market.

§ One of the biggest challenges is re-structuring the assets of the banks which would be a tedious process, since most of the banks have poor asset quality leading to significant proportion of NPA. This also may lead to Mergers & Acquisitions, which itself would be loss of capital to entire system. So, this aspect should also be taken into care while implementing the Basel-II norms with the banks.

§ The new norms seem to require a better level of risk management and measurement expertise, and also better capital adequacy ratios and geographically diversified portfolios. Thus more and more focus should be given on the development and improvement of a sound risk management and measurement expertise at different level of hierarchy within the banks.

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

§ There is a lot more that should be done in the field of building the necessary technological enhancements in terms of computerization of branches in order to support the respective head offices with the required input of information. Because, the technology infrastructure in terms of computerization is still in a nascent stage in most Indian banks. Computerization of branches, especially for those banks, which have their network spread out in far-flung areas, will be a daunting task. Penetration of information technology in banking has been successful in the urban areas, unlike in the rural areas where it is insignificant.

§ While going through the interview with the experts of this field, i.e. the experts involved in Basel-II implementation process say that dearth of risk management expertise in the Indian banking sector is serving as a hindrance in laying down guidelines for a basic framework for the new capital accord. There is an urgent need for the experts who can deal with the field of risk management in the implementation scenario of the Basel-II.

§ An integrated risk management concept, which is the need of the hour to align market, credit and operational risk, will be difficult due to significant disconnect between business, risk managers and IT across the organizations in their existing set-up. Thus, there should be a proper coordination and alignment between the experts of the risk management and the masters of IT to ensure the success of the Basel-II framework.

§ Another practical problem which I came to know is that the number of sheets related to the classification of different heads, to be filled by the operational staff, is really a tedious task to do. This involves a lot of minute observations while filling up those sheets and has an ample scope for confusion which will turn into mistakes. So, there should be simplifications in filling up those sheets to reduce the complications and improving the assurance of getting the success.

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


Banking Industry has been growing leaps and bounds and it has become global and this global presence has converted into global complications also. Basel-II is one of the latest reforms in this regard to cope up with the challenges banks are facing now a days and to safeguard the interests of the banks exposed to the volatile credit market. The Basel Committee on Banking Supervision is a Guideline for Computing Capital for Incremental Risk. It is a new way of managing risk and asset-liability mis-matches, like asset securitization, which unlocks resources and spreads risk, are likely to be increasingly used. This was designed for the big banks in the BCBS member countries, not for smaller or less developed economies.

While going through the implementation process, banks have faced certain problems likewise inadequate technical expertise, rigorous calculations, lack of aware and expert manpower, new concepts of CRM and Hair cut, filling up the information sheets, etc. But, banks have successfully managed to overcome this problem and now in a position where they have started implementing it to their banks.

The major challenge the country's financial system faces today is to bring informal loans into the formal financial system. By implementing Basel II norms, our formal banking system can learn many lessons from money-lenders. Its implementation may involve significant changes in business model in which potential economic impacts must be carefully monitored.

In a nut-shell, we would like to conclude that keeping in view the cost of compliance for banks and supervisors, the regulatory challenge would be to migrate to Basel II in a non-disruptive manner. We would like to continue the process of interaction with other countries to learn from their experiences through various international forums. India is one of the early countries which subjected itself voluntarily to the FSAP of the IMF, and our system was assessed to be in high compliance with the relevant principles. With the gradual and purposeful implementation of the banking sector reforms over the past decade, the Indian banking system has shown significant improvement on various parameters, has become robust and displayed ample resilience to shocks in the economy. There is, therefore, ample evidence of the capacity of the Indian banking system to migrate smoothly to Basel II. Indian banking companies are required to ensure full implementation of Basel II guidelines by March 31, 2009. With Basel II norms coming into force in 2009, maintaining adequate capital reserves will become a priority for banks.


Ø › Publications


















Ø Risk Models and Basel II: A Review of the Literature By Thomas A. Jacobs (May 3, 2004)

Ø Basel Norms Challenges In India,By- Swapan Bakshi

Ø Basel II - A Challenge and an Opportunity to Indian Banking: Are we ready for it? By- FICCI

Ø Adoption of Basel II Norms: Are Indian Banks Ready? By Radhakrishnan R Ravi Bhatia,IIM Calcutta

Ø Banks Basel II Norms requirement regarding internal control - Field study on Indian banks, Delhi Business Review X Vol. 10, No. 2 (July - December 2009)

Ø Basel II norms: Strength from three pillars by Dinesh Chaudhary, Paramdeep Singh, Pawan Prabhat

Ø Basel II and India by Bandyopadhyay, Tamal (2006), "Valuation Vortex", Business Standard Banking Annual,November,ICRA (2005), Basel II and India

Ø Basel II: A Contrating Perspective by Edward J. Kane , Boston College



This is a questionnaire regarding the dissertation topic "Compliance of Basel norms by Indian banks and its effect on their performance."

Q.1.        How do you perceive the Basel-II Accord?

Q.2.        What is your standpoint regarding the Pillar-I norms which is associated with the Minimum Capital Requirement?

Q.3.        What is the implementation scenario at this stage?

Q.4.        What were the resources which you employed to ensure the success of the implementation?

Q.5.        What was your experience in this process?

Q.6.        What were the problems you witnessed while going through the implementation process?

Q.7.        Which was the most crucial one and Why?

Q.8.        How did you overcome with the problem associated?

Q.9.        Do you think Basel-II is still relevant or we need Basel-III?

Q.10.        What would you like to add more to improve the quality of thesis report?