BASEL II

It's going to be a testing time for the Indian banking sector as it ushers in the new Basel II norms.
-Amit Singh Sisodiya and Sanjoy De

From March 31, 2007, all commercial banks in India have to adhere to the new international capital adequacy norms, thanks to Basel II. This new Accord, which is an advanced version of Basel I, provides a comprehensive measure and minimum standard for capital adequacy. It aims to align the regulatory capital requirements more closely to the underlying risks that banks face. Moreover, these regulations are intended to promote a more scientific approach to capital supervision, and develop the ability to manage risks as well as encourage enhanced market discipline.

Know your risks

Basel II Accord is based on three mutually reinforcing pillars—namely, minimum capital requirements, supervisory review, market discipline—that attempt to achieve comprehensive coverage of risks and enhance risk sensitivity of capital requirements. Pillar I ensures that banks calculate their risks accurately and maintain adequate capital to cover risks. Three types of risks, i.e., credit risk, operational risk and market risk, come within the ambit of Pillar I. The second pillar provides the much-needed regulatory support to Pillar I, re-equipping regulators with much improved "tools" over those available under Basel I. The third pillar is designed to allow the market to gauge the overall risk position of a bank and allows the counterparties of the bank to price and deal appropriately. This new Accord emphasizes on the treatment of credit risk in a more scientific manner and also treats operational risks explicitly. The methods for measuring credit risk have been categorized as: (a) Standardized Approach: The risk weight for sovereign (Government and Central Bank), interbank, corporate and, non-corporate accounts will be based on External Credit Assessment Institution (ECAI) ratings, (b) Internal Rating Based (IRB) approach: The risk weightage and capital charges are determined based on the qualitative inputs provided by the banks themselves.

The Basel II will require banks to provide capital against operational risk for the first time. Also, the capital charge for market risk was not prescribed until recently. From its side, the RBI has issued a policy framework allowing the banks to issue instruments such as innovative perpetual debt (tier I) instruments, perpetual non-cumulative and redeemable cumulative preference shares (tier I) and hybrid debt instruments (tier II) so as to enhance their capital raising capability. According to the RBI Annual Report for 2005-06, leading domestic banks will be the first to implement these revised capital adequacy rules, while the relatively weaker banks will be allowed to continue with the current Basel I guidelines. In fact, it is expected that only 5-6 major Indian banks are financially in a position to initiate the new stringent norms within the stipulated time period.

Pros and cons

In the new financial regime, banks will be more willing to lend to the priority sectors like Small & Medium Enterprises (SMEs), as it will cost less to make provision for such loans. This is because risk weightage for such loans will be clipped to 75%, from the existing 100%. This implies that priority sector bank lending will get the same weightage as the retail lending under the new norms. "Priority sector lending is likely to improve after the implementation of Basel II norms in March 2007. Hitherto perceived as a high risk portfolio, banks are redefining the SME concept. There will be more customized and product-wise approach to the SME lending," according to a PwC source as quoted in The Economic Times.

The higher risk sensitivity of the norms provides little incentive to lend to borrowers with declining credit quality. Generally, during economic recession, corporate profits and ratings tend to aggravate. This can instigate banks to call off lending to the corporates with falling credit ratings at a time when these companies will be in desperate need of credit. Notwithstanding, the Basel II norms are expected to impact the global financial system considerably. Compliance to the Basel II norms will require a vast pool of historical data and adoption of advanced techniques and softwares for estimating risk. This will inevitably translate into huge demand for IT and BPO services. So, in the post-Basel II period, banks will increasingly give attention to Information and Communication Technology (ICT), especially information security, to maintain their standard globally, which will invariably escalate costs of the banks. Small and medium-sized banks will find it really hard to finance such high implementation costs of the norms. If the banking sector regulator ordains a compulsory implementation of these norms, weaker banks will have no other option but to merge with other banks. Therefore, it is expected that banking sector will witness increased consolidation in the form of mergers and acquisitions. The speculation is high that the new financial order may hasten the exit of innumerable small banks and lead to the emergence of a few robust banks.

Further, as per the RBI guidelines, the new Accord is applicable only to scheduled commercial banks. This may have an undesirable effect: Banks under the norms may charge customers a higher price for day-to-day banking activities to compensate for the additional cost of operational risk capital. As a result, customers may move to banks that charge lower rates, since these institutions will not be required to adopt the new RBI capital adequacy norms. This may lead to a situation where the customers have the incentive to opt for riskier banks.
According to a study conducted by Aptiva Consulting, the risk managers in India are charting a lonely course in the implementation of Basel norms. The survey reveals that RBI has maintained a prolonged silence that may have diluted the urgency for banks to ratchet up their compliance levels. More than 65% of banks initiated the implementation mode without a preceding planning exercise. Nearly 50% banks are ill-equipped to assess and report operational risk loss data. Moreover, the survey notes that most of the banks find it hard to make a cost-benefit analysis on how much the implementation will cost and to what extent banks can benefit from the Accord.
Indian banking system consists of 85 commercial banks, which account for about 78% (total assets); over 3,000 cooperative banks, which account for 9%; and 196 Regional Rural Banks, which account for 3% of the entire financial sector. Taking into consideration the size and complexity of operations of these diverse institutions, the capital adequacy norms applicable to these entities have been maintained at varying levels of stringency. Given the differential risk appetite across banks and their business philosophies, it is likely that banks will "self-select" their own approach, which in turn, is likely to provide a stabilizing influence on the system as a whole.

Gearing up

In January 2006, the RBI has permitted banks to raise hybrid capital (tier I and tier II) in domestic currency. Subsequently, in July 2006, the banks were given permission to raise capital in foreign currency too. UTI Bank was the first Indian bank to resort to foreign currency hybrid route to augment capital base. In early August, UTI Bank raised $150 mn of 15-year subordinated upper tier II bonds in the international market. India's second-largest lender ICICI Bank also announced a $340 mn perpetual debt offering, the first of its kind from India, while the state-run Bank of India is looking to raise $200 mn via the 15-year debt. State Bank of India (SBI), the largest bank in the country, plans to raise $200 mn through tier II bonds in the overseas market. HDFC Bank, another major bank in the country, has raised Rs. 200 cr through a hybrid issue. The bank has filed a shelf-prospectus that allows it to mobilize up to Rs. 400 cr. A host of other banks are also looking to raise money from both the domestic and overseas markets. UCO Bank and Indian Overseas Bank are looking forward to raise more than Rs. 2,000 cr via bonds and hybrid issues in the current fiscal year. According to banking experts, a hybrid debt offering is about 7-8% cheaper than an equity stake sale. "The rapid loan growth and the upcoming Basel II norms have obliged banks to shore up their balance sheets and it is cheaper and attractive to issue debt," commented a banking analyst in The Economic Times. Strong economic growth in India, averaging 8% in the past three years, has prompted renowned international rating agencies like Fitch and Moody's to upgrade India's sovereign ratings, thereby, helping the banks to sell debt issues in the international markets.

The Basel II capital norms are basically meant to be implemented by banks with global operations, but it is the discretion of the national banking regulators whether to extend it to the entire banking sector in the country or not. The RBI, however, has not indicated anywhere as to which banks need not implement Basel II norms from March 31, 2007. In reality, the banks in India must have heaved a sigh of relief when the governor of RBI hinted that the implementation date was likely to be reviewed. Thus, it is very much likely that in the post-March 2007 scenario, Basel II, Basel I and non-Basel entities will be operating simultaneously in the Indian banking sector