Basel II : Why not 8% Capital for Credit Risk?

A regulatory capital of 9% for credit risk vis-à-vis a minimum of 8% prescribed under Basel II may not augur well for Indian banks, more so during the transition.

Banks are essentially known for transferring financial resources from net savers to net borrowers. The banking sector plays a dominant role in the complex financial system of a country by providing liquidity and payment services to the real sector. It institutionalizes savings by accepting deposits from the public and using them to make credit available to households, government, businesses, and others. This intermediation is basically achieved through four transformation mechanisms: Liability-asset transformation, size transformation, maturity transformation, and risk transformation. It is in this context that banks are exposed to various embedded risks: market risk, credit risk, and operational risk. Secondly, banks being highly leveraged, these inherent risks have enough potential to inflict catastrophic losses unless they are managed effectively. Hence Merton Miller, the Nobel Laureate said: "Banking is 19 ^th century disaster-prone industry."

And, at the same time, as the empirical studies of Levine (1997) suggest, the economic growth of a country is positively related to the stage of financial development, in terms of the size of the financial markets relative to GDP, by facilitating better risk-sharing and mitigating informational problems. But the recent advances in computation and communication technology, and the emergence of assorted products, accompanied by liberalization and globalization of financial markets, have all cumulatively increased the exposure of banks to varied risks. This have resulted in the need for effective risk management across the financial architecture. For, failure of one bank can pull down a country's very financial system.

Realizing the criticality of `contagion' risk, and the need for its effective management, the Bank for International Settlement (BIS) came up with guidelines way back in 1988, which are popularly known as Basel I for implementation across the globe, so that all banks are supervised according to a set of broad principles. Under these norms, it was for the first time suggested that banks should maintain certain minimum capital as a ratio to its risk-weighted assets, so that a bank will remain capable of absorbing losses emanating from credit risk in the long run. In 1992, the Reserve Bank of India (RBI) adopted these norms for implementation among the Indian banks. It essentially involved assignment of prescribed risk weights to balance sheet assets, non-fund items and other off-balance sheet exposures, and maintaining unimpaired minimum capital equivalent to the prescribed ratio of 9% on the aggregate of these items.

Basel II accord

Basel I norms were simple: it adopted a straightforward "one-size-fits all" approach. It failed to recognize that there could be a differing credit quality within the same class of assets. It failed to create a level playing field for banks—it taxed some activities while understating some risks of others. To obviate these limitations of Basel I, the Basel Committee came up with a revised framework—International Convergence of Capital Measurement and Capital Standards (Basel II)—in June 2006. Basel II is considered as more risk-sensitive than Basel I. It essentially rests on three mutually reinforcing pillars: the first pillar prescribes minimum capital requirements for credit, market and operational risk; the second pillar prescribes supervisory review, risk management guidance to banks, and supervisory transparency and accountability; and the third pillar prescribes market discipline to complement the minimum capital requirements and the supervisory review processes.

The framework under pillar one offers three distinct options for calculating capital requirements under credit risk and three other options for computing capital requirement under operational risk. The options for computing capital under credit risk are: Standardized Approach - measuring credit risk in a standardized manner duly supported by external credit assessments; Foundation Internal Rating-based Approach - banks use their own internal rating systems for credit risk with explicit approval of the supervisory bank for estimating Probability Default (PD) while relying on supervisory estimates for other risk components; and Advanced Internal Rating-based Approach - under which banks provide their own estimates of PD, Loss Given Default (LGD), Exposure at Default (EAD), and Effective Maturity(EM). The revised framework, thus, allows banks to use their own assessments of risk as arrived at by using their own internal rating systems.

RBI directives

In order to align the Indian banking system with global standards, the RBI decided to adopt the Basel II norms and accordingly proposed a road map for its implementation: all foreign banks operating in India and Indian banks having operational presence outside India shall adopt the Standardized Approach for credit risk management, which means calculation of Capital to Risk-weighted Assets Ratio (CRAR) and maintenance of a minimum CRAR of 9% with effect from March 31, 2008 and the others by March 31, 2009.

Under the standardized approach, banks have to use the services of external rating agencies that are approved by the RBI for getting their credit exposures rated for allocating regulatory capital as per the mapping prescribed in the guidelines. To begin with, banks are asked to risk-weight their claims on corporates as per the ratings assigned by the rating agencies approved by the RBI. Thus, `AAA' to `AA' rated claims will have risk weight of 20%, while the `A' rated company will attract a weight of 50%, `BBB' - 100%, `BB' and below 150% and so on. To begin with, all unrated claims on corporates in excesses of Rs. 10 cr will attract a risk weight of 150%. Corporate loans subjected to restructuring should be assigned a higher risk weight of 25% until satisfactory performance under the revised repayment schedule has been established for one year from the date of installments fallen due under the revised schedule. Similarly, exposures included in retail portfolio shall be assigned a risk-weight of 75%.

Implementation challenges

The proposed guidelines under Basel II will enable a bank to enjoy a good amount of cushion in maintaining capital adequacy, provided a bank can compute its credit risk correctly. To adopt the standardized approach suggested by the RBI, banks have to rely on outside rating agencies very heavily. Otherwise, they have to provide a uniform risk-weight of 150% to all exposures of corporates, which means, no gain out of the implementation of Basel II norms vis-à-vis Basel I that was discarded under the plea that it did not differentiate the best risk-managed banks from the rest.

Secondly, the availability of qualitative and quantitative data on credit quality—in terms of credit migration, probability of default, loss given default and exposure at default—ideally for 5-7 years is the minimum requirement for the smooth transition to Basel II Accord. There is, however, no such data available with many of the Indian banks. In the absence of such data, Indian banks face a Herculean task in migrating from Basel I to Basel II norms and gain the advantages in terms of reduced demand for regulatory capital based on individual bank's risk management efficiency. Thirdly, rating agencies in India are known to rate instruments but not borrowers and this may initially pose a challenge both to banks and rating agencies. Such rating by outside agencies is sure to increase the expenses of banks besides delaying the process of credit sanctioning. And shifting to an internal rating-based calculation of regulatory capital under credit risk may not be that quickly possible, for internal credit rating system in most of the Indian banks is at an embryonic stage. Over and above all this, management of credit risk under Basel II requires new skill-sets among the employees. It simply calls for new attitudinal as well as technical skills to manage credit risk through risk mitigation techniques and implement Basel II with least hiccups to the process of ongoing financial intermediation in the country.

Why not 8% capital?

That being the challenge the Indian banks face initially while transiting from Basel I to Basel II compliance, the prescription of 9% regulatory capital under credit risk as against Basel II's prescription of a minimum capital of 8% is quite baffling. Such an increase in regulatory capital may undermine the interests of Indian banks, particularly of those operating in the overseas markets as they would be competing with global giants that are operating with 8% regulatory capital.

Indian banks, unlike many of their Western counterparts, are also subject to reserve requirements: they have to maintain 6.5% of their total deposits as cash deposit with the RBI under Cash Reserve Ratio and 25% in gilt securities under Statutory Liquidity Ratio. They are thus required to keep 31.75% of their total working funds as directed by the central bank and be content with whatever interest earned thereof. They also have to undertake directed-lending, where again, return on such investments is low.

As of March 2005, the share of credit towards the industry stood at 38% of the total credit from scheduled commercial banks, which means the balance 62% is spread across agriculture and other retail loans. Such credit exposure— whether it is of quality or not, whether measured, monitored, and managed effectively or not—is to be risk-weighted, flat at the rate of 75% for allocating regulatory capital, unmindful of credit quality.

Most of the banks from India are from public sector. They have their own compulsions: payment of dividend to the owner government for bridiging the fiscal deficit even at the cost of building up reserves that could enable them to undertake fresh business; not being able to raise fresh capital from the market for fear of diluting the government equity; etc. At the same time, many a time government itself has expressed its inablity to infuse fresh capital into these banks under the plea of its obligations towards fiscal responsibilities.

It is in this context that the RBI's prescription of a minimum of 9% regulatory capital as against the 8% prescribed by Basel II Committee is compelling one to infer that it may work against the interests of the Indian banks, particularly, during the transition, even if it leads to capital inefficiency, particularly in the case of those operating globally.

Would it not, therefore, be prudent to initially prescribe a minimum regulatory capital of 8% against credit risk as recommended by Basel II, and gradually increase it to 9% as the industry gains experience in managing credit risk in alignment with Basel II prescriptions?