Term PaperOF

BANKING AND INSURANCE

TOPIC: TO STUDY THE VARIOUS TYPES OF RISKS INVOLVED IN BANKING SECTOR AND ALSOCRITICALLY EXAMINE THE FUNCTIONING OF BASEL 2 NORMS IN INDIAN BANKING SECTOR.

Submitted by: Submitted to: MOHIT SHUKLA Mr. Anoop MohantySEC: S1803,B32REG. ID: 10810287

ACKNOWLEDGEMENT

It is immense pleasure for me to put on record my profound gratitude to the persons who has

supported me in substantial ways for the successful submission of this dissertation.

I wholly confess that the credit of this report is not only my treasure as I have merely brought

together the teaching, guidelines, knowledge, tips and notes from different members of the

institutes.

May I also, in the same breath, express my gratefulness to my honourable teacher and my

project guide Mr. Anoop Mohanty for enlightening and guiding me at every step of the

completion of this project and for acquainting me with the work environment and providing

productive suggestion to handle problems.

Last but not the least, my sincere thanks to my parents and my friends for supporting me.

An Overview of Banking Sector in India

Till the end of late 18th century, Banks in India, in the modern sense of the term, weren’tthere. During the time of the American Civil War, the supply of cotton to Lancashire (Thetextile hub of UK) stopped from the Americas. At that time some banks were opened,which functioned as entities to finance industry, including speculative trades in cotton.Most of the banks opened in India during that period could not survive and failed becauseof the high risk which came with large exposure to speculative ventures. It was a disasterfor depositors who lost money and therefore lost interest in keeping deposits with banks.In the year 1786, ‘The General Bank of India’ was the first bank to come into existence inIndia. And then, almost a century later, in the year 1870, The Bank of Hindustan becamethe 2nd bank in India. Unfortunately, both these banks are now defunct.The Bank of Bengal which later became the State Bank of India the oldest bank to be still in existence, that too as the largest bank in India, is the ‘State Bank of India’. Albeit, the name was not the same as today rather was ‘The Bank of Bengal’ which started its operations in Calcutta in June, 1806. Interestingly, if people think that the entry of foreign banks in India is only a post-reform phenomenon, they are absolutely incorrect. In fact, in as early as 1850s, foreign banks like Credit Lyonnais started their Calcutta (now Kolkata) operations. At that point of time, Calcutta was the most active trading port, thanks to the trade of the British Empire, and due to which banking activity took roots there and prospered.The first fully Indian owned bank was the ‘Allahabad Bank’, which was established in1865. By the 1900s, the market expanded with the establishment of banks such as PunjabNational Bank, in 1895 in Lahore and Bank of India, in 1906, in Mumbai - both of whichwere founded under private ownership. The Reserve Bank of India formally took on theresponsibility of regulating the Indian banking sector from 1935. At least 94 banks in India failed during the years 1913 to 1918. This was really a turbulent time for the world as a whole and the banking sector in India specially. This was the period which witnessed the First World War (1914-1918). Since then through the end of the Second World War (1939-1945), and two years thereafter until India achieved independence, were very challenging period for Indian banking. The years of the First World War were turbulent, and it took toll on many banks which simply collapsed despite the Indian economy gaining indirect boost due to war-related economic activities.

CURRENT SCENERIO OF INDIAN BANKING SECTOR

Indian Banking sector is dominated by Public sector banks (PSBs) which accounted for 72.6% of total advances for all SCBs as on 31st March 2008. PSBs have rapidly expanded their foot prints after nationalisation of banks in India in 1969 and further in 1980. Although there is a restrictive entry/expansion for private and foreign banks in India, these banks have increased their presence and business over last 5 years.

Peculiar characteristic of Indian banks unlike their western counterparts such as high share of household savings in deposits (57.4% of total deposits), adequate capitalisation, stricter regulations and lower leverage makes them less prone to financial crisis, as was seen in the western world in mid FY09.

The Scheduled Commercial Banks (SCBs) in India have shown an impressive growth from FY04 to the mid of FY09. Total deposits, advances and net profit grew at CAGR of 19.6%, 27.4% and 20.2% respectively from FY03 to FY08. Banking sector recorded credit growth of 33.3% in FY05 which was highest in last 2 and half decades and credit growth in excess of 30% for three consecutive years from FY04 to FY07, which is best in the banking industry so far. Increase in economic activity and robust primary and secondary markets during this period have helped the banks to garner larger increase in their fee based incomes. A significant improvement in recovering the NPAs, lowest ever increase in new NPAs combined with a sharp increase in gross advances for SCBs translated into the best asset quality ratio for banking sector in last two decades. Gross NPAs to gross advances ratio for SCBs decreased from the high of 14% in FY2000 to 2.3% in FY08.

With in the group of banks, foreign and private sector banks grew at higher rate than the industry from FY03 to FY08 primarily because of lower base effect and rapid expansion undertaken by these banks. In FY09, overall growth in credit and deposits was led by PSBs. However, growth of private and foreign banks was significantly lower in FY09 due to their high exposure to stressed sectors and problem at parent level for foreign banks. Unsecured bank credit has risen over the years and stood at 23.3% of bank credit in FY08 as compared to just 10.9% in FY2000. Lending to sensitive sector has also grown at CAGR of 46.1% from FY05 to FY08.

“Currently, India has 88 scheduled commercial banks (SCBs) - 28 public sector banks (that is with the Government of India holding a stake), 29 private banks (these do not have government stake; they may be publicly listed and traded on stock exchanges) and 31 foreign banks. They have a combined network of over 53,000 branches and 17,000 ATMs. According to a report by ICRA Limited, a rating agency, the public sector banks hold over 75 percent of total assets of the banking industry, with the private and foreign banks holding 18.2% and 6.5% respectively.”

EXECUTIVE SUMMARY

There is always a risk associated with the activities of financial institutions or banks or businesses. The greater the risk associated with an activity the greater will be the chances to generate high returns. There are various types of risks involved in banking sector like operation risk, market risk etc which is discussed in this study.Also the functioning of Basel II norms in Indian banking sector is discussed in the study. Indian banking companies are required to ensure full implementation of Basel II guidelines by March 31, 2009. The first phase of Basel II was implemented in India with foreign banks operating in India and Indian banks having operational presence outside India complying with the same effective end of March 2008. With Basel II norms coming into force in 2009, maintaining adequate capital reserves will become a priority for banks.

Basel II mandates Capital to Risk Weighted Assets Ratio (CRAR) of 8% and Tier I capital of 6%. The RBI has stated that Indian banks must have a CRAR of minimum 9%, effective March 31, 2009. All private sector banks are already in compliance with the Basel II guidelines as regards their CRAR as well as Tier I capital. Further, the Government of India has stated that public sector banks must have a capital cushion with a CRAR of at least 12%, higher than the threshold of 9% prescribed by the RBI.

REVIEW OF LITERATURE

K. A. Rekha(2006) gives the information that without risk, the financial System would be vastly simplified. However, risk is omnipresent in the real world. Financial Institutions, therefore, should manage the risk efficiently to survive in this highly uncertain world. The future of banking will undoubtedly rest on risk management dynamics.. The effective management of credit risk is a critical component of comprehensive risk management essential for long-term success of a banking institution. Credit risk is the oldest and biggest risk that bank, by virtue of its very nature of business, inherits.

Prakash Neetu (2006) has tried to find that most of the countries of the world, banks have been facing serious credit issue-related problems besides market risk and operational risk because 90-95% of a bank's business stems from credit operations. Managing credit risk is crucial on account of default of principal itself. Banks have to appropriately price their loan products on the basis of directions given by the Reserve Bank of India such as fixation of exposure limits, provisioning of NPAs, risk rating models, risk diversification, risk sharing techniques such as credit derivatives, securitization, intra-bank participation, consortium finance, risk insurance, etc. Indian banks, particularly the public sector banks, are ready to migrate to Basel II Accord only at a conceptual level and academic level. They have to make necessary changes in the risk management framework and the technological framework, enhance further adoption of sound MIS, best international banking practices, upgrade skills and developments of the staffs, appropriate credit rating mechanism, etc. Indian banking sector can then implement the Basel Norms, and can face international banking competition smoothly.

J.Anoop, Banerjee, Francis (2007) gives the overview that the major cause of serious banking problems over the years continues to be directly related to credit standards for borrowers and counterparties, poor portfolio risk management, or a lack of attention to deterioration in the credit standing of a bank's counterparties. According to this research, credit risk continues to be the leading source of problems in banks world-wide and the research paper tries to address how banks assess the creditworthiness of borrowers.

J. Usha (2008) assesses in detail the status of operational risk management in the Indian banking system in the context of Basel II. The expected coverage of banking assets and the approach adopted for operational risk capital computation is compared broadly with the position of the banking system in Asia, Africa and the Middle East. A survey conducted on twenty two Indian banks indicates insufficient internal data, difficulties in collection of external loss data and modelling complexities as significant impediments in the implementation of operational risk management framework in banks in India.

What is Risk?

Risk is the potential that every event expects or does not expect, may have an adverse effect on the earning or capital of the financial institution. There is always a risk associated with the activities of financial institutions or banks or businesses. The greater the risk associated with an activity the greater will be the chances to generate high returns. “The biggest risk is not taking risk.” Risk means different things to different people. For some it is "financial (exchange rate, interest-call money rates), mergers of competitors globally to form more powerful entities and not leveraging IT optimally" and for someone else "an event or commitment which has the potential to generate commercial liability or damage to the brand image". Since risk is accepted in business as a trade-off between reward and threat, it does mean that taking risk bring forth benefits as well. In other words it is necessary to accept risks, if the desire is to reap the anticipated benefits.

Risk in Banking

Risk manifest themselves in many ways and the risks in banking are a result of many diverse activities, executed from many locations and by numerous people. As a financial intermediary, banks borrow funds and lend them as a part of their primary activity. This intermediation activity, of banks exposes them to a host of risks. The volatility in the operating environment of banks will aggravate the effect of the various risks.

1.3Typology of Risk Exposure:

Based on the origin and their nature, risks are classified into various categories. The most prominent financial risks to which the banks are exposed to taking into consideration practical issues including the limitations of models and theories, human factor, existence of frictions such as taxes and transaction cost and limitations on quality and quantity of information, as well as the cost of acquiring this information, and more.

Credit Risk

Market Risk

Operation Risk

Liquidity Risk

Human Factor risk

Legal Risk

The Graph below is representing different types of risks in banking sector

MARKET

RISK

LIQUIDITY RISK OPERATIONAL RISK

HUMAN FACTOR RISK

CREDIT RISK LEGAL & REGULATORY RISK

FUNDING LIQUIDITY RISK

TRADING LIQUIDITY RISK

TRANSACTION RISK

PORTFOLIO CONCENTRATION

ISSUE RISK ISSUER RISKCOUNTERPARTY RISK

EQUITY RISKINEREST RATE

RISKCURRENCY RISK COMMODITY

RISK

RISK

MARKET RISK

Market risk is that risk that changes in financial market prices and rates will reduce the value of the bank’s positions. Market risk for a fund is often measured relative to a benchmark index or portfolio, is referred to as a “risk of tracking error” market risk also includes “basis risk,” a term used in risk management industry to describe the chance of a breakdown in the relationship between price of a product, on the one hand, and the price of the instrument used to hedge that price exposure on the other. The market-Var methodology attempts to capture multiple component of market such as directional risk, convexity risk, volatility risk, basis risk, etc.

1. CREDIT RISK

Credit risk is that risk that a change in the credit quality of a counterparty will affect the value of a bank’s position. Default, whereby counterparty is unwilling or unable to fulfill its contractual obligations, is the extreme case; however banks are also exposed to the risk that the counterparty might downgraded by a rating agency.

Credit risk is only an issue

when the position is an asset, i.e., when it exhibits a positive replacement value. In that instance if the counterparty defaults, the bank either loses all of the market value of the position or, more commonly, the part of the value that it cannot recover following the credit event. However, the credit exposures induced by the replacement values of derivative instruments are dynamic: they can be negative at one point of time, and yet become positive at a later point in time after market conditions have changed. Therefore the banks must examine not only the current exposure, measured by the current replacement value, but also the profile of future exposures up to the termination of the deal.

2. LIQUIDITY RISK

Liquidity risk comprises both

Funding liquidity risk Trading-related liquidity risk.

Funding liquidity risk relates to a financial institution’s ability to raise the necessary cash to roll over its debt, to meet the cash, margin, and collateral requirements of counterparties, and (in the case of funds) to satisfy capital withdrawals. Funding liquidity risk is affected by various factors such as the maturities of the liabilities, the extent of reliance of secured sources of funding, the terms of financing, and the breadth of funding sources, including the ability to access public market such as commercial paper market. Funding can also be achieved through cash or cash equivalents, “buying power ,” and available credit lines.

Trading-related liquidity risk, often simply called as liquidity risk, is the risk that an institution will not be able to execute a transaction at the prevailing market price because there is, temporarily, no appetite for the deal on the other side of the market. If the transaction cannot be postponed its execution my lead to substantial losses on position. This risk is generally very hard to quantify. It may reduce an institution’s ability to manage and hedge market risk as well as its capacity to satisfy any shortfall on the funding side through asset liquidation.

3. OPERATIONAL RISK

It refers to potential losses resulting from inadequate systems, management failure, faulty control, fraud and human error. Many of the recent large losses related to derivatives are the direct consequences of operational failure. Derivative trading is more prone to operational risk than cash transactions because derivatives are, by their nature, leveraged transactions. This means that a trader can make very large commitment on behalf of the bank, and generate huge exposure in to the future, using only small amount of cash. Very tight controls are an absolute necessary if the bank is to avoid huge losses.

Operational risk includes” fraud,” for example when a trader or other employee intentionally falsifies and misrepresents the risk incurred in a transaction. Technology risk, and principally computer system risk also fall into the operational risk category.

4. LEGAL RISK

Legal risk arises for a whole of variety of reasons. For example, counterparty might lack the legal or regulatory authority to engage in a transaction. Legal risks usually only become apparent when counterparty, or an investor, lose money on a transaction and decided to sue the bank to avoid meeting its obligations. Another aspect of regulatory risk is the potential impact of a change in tax law on the market value of a position.

5. HUMAN FACTOR RISK

Human factor risk is really a special form of operational risk. It relates to the losses that may result from human errors such as pushing the wrong button on a computer, inadvertently destroying files, or entering wrong value for the parameter input of a model.

What are Basel I and Basel II norms

While Basel I framework was confined to the prescription of only minimum capital requirements for banks, the Basel II framework expands this approach not only to capture certain additional risks in the minimum capital ratio but also includes two additional areas, viz. Supervisory Review Process and Market Discipline through increased disclosure requirements for banks. Thus, Basel II framework rests on the following three mutually- reinforcing pillars:

Pillar 1: Minimum Capital Requirements — prescribes a risk-sensitive calculation of capital requirements that, for the first time, explicitly includes operational risk along with market and credit risk.

Pillar 2: Supervisory Review Process (SRP) — envisages the establishment of suitable risk management systems in banks and their review by the supervisory authority.

Pillar 3: Market Discipline — seeks to achieve increased transparency through expanded disclosure requirements for banks.

Implications of Basel 1 and 2 on Indian Banking

The Basel Committee on Banking Supervision provides a forum for regular cooperation on

banking supervisory matters. Its objective is to enhance understanding of key supervisory

issues and improve the quality of banking supervision worldwide. The first accord by the

name .Basel Accord I. was established in 1988 and was implemented by 1992. It was the very

first attempt to introduce the concept of minimum standards of capital adequacy. It is only

related with credit risk. Basel II is a new capital adequacy framework applicable to Scheduled

Commercial Banks in India as mandated by Reserve Bank of India (RBI). ‘Basel Capital

Accord’ deals with Capital Measurement and Capital Standards for Banks, which align

regulatory capital requirements more closely with underlying risks. The Accord has been

accepted by over 100 countries including India. In April 2007, RBI published the final

guidelines for Banks operating in India. The main structure of ‘Basel II’ rests on three pillars:

I. Minimum Capital Requirements

II. Supervisory Review Process; and

III. Market Discipline

‘Minimum Capital Requirements’ have been prescribed for Credit Risk, Market Risk

and Operational Risk.

Credit Risk

Under the old Basel I framework, all assets used to get a ‘one-size-fits-all’ treatment and

were given a uniform risk weight age of 100% while the stipulated minimum capital

adequacy ratio (CAR) for a Bank was 9%. Under Basel II, while the minimum CAR is

unchanged at 9%, the risk weights assigned to assets would be proportionate to the credit risk

associated with these assets. Within Basel II, various approaches have been prescribed with

progressively increasing risk sensitivity. In the first stage, Indian Banks would have to adopt

‘Standardized approach’ for Credit risk [followed by Foundation Internal Rating Based (IRB)

Approach and Advanced IRB Approach]. Under the ‘Standardized Approach’, credit ratings

awarded by recognized rating agencies (such as CARE) would be used to assign risk weights

to bank exposures.

Market Risk

Banks are to apply Standardized Duration Approach for computing capital requirement of

market risks. This is not different from the approach under Basel I.

Operational Risk

Basel II has also an additional provision for Operational Risk which was absent in Basel I.

Operational risk deals with loss from failed systems and processes, people or as a result of

external events. Various approaches have been prescribed by the Basel Capital Accord for

addressing this risk, viz., Basic Indicator Approach, Standardized Approach and Advanced

Measurement Approach (in the order of increasing complexity and data requirements). To

start with, RBI has prescribed adoption of ‘Basic Indicator Approach’ for Indian Banks.

Supervisory Review Process is “intended not only to ensure that banks have adequate capital

to support all the risks in their business, but also to encourage banks to develop and use better

risk management techniques in monitoring and managing their risks”.“Supervisors are

expected to evaluate how well banks are assessing their capital needs relative to their risks

and to intervene, where appropriate.”

Market Discipline refers to disclosure requirements of Banks and is to complement both

Pillar I and II.

Advantages of Basel II over Basel I

Basel 1 Proposed new Accord or Basel II

Focus on a single risk measure, primarily on

credit risk. Doesn't cover operation risk

More emphasis on banks' own internal 

methodologies, supervisory review, and

market discipline

One size fits all Flexibility, menu of approaches, incentives

for better risk management

Broad structure More risk sensitivity

Uses arbitrary risk categories & risk weights Risk weights linked to external ratings

assigned by ECAI or IRB by bank

Basel II Norms for Indian Banks

 

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. The process of implementing Basel II norms in India is being carried out in phases. Phase I has been carried out for foreign banks operating in India and Indian banks having operational presence outside India with effect from March 31,2008.

In phase II, all other scheduled commercial banks (except Local Area Banks and RRBs) will have to adhere to Basel II guidelines by March 31, 2009. With the deadline of March 31, 2009 for full implementation of Basel II norms fast approaching, banks are looking to maintain a cushion in their respective capital reserves. The minimum capital to risk-weighted asset ratio (CRAR) in India is placed at 9%, one percentage point above the Basel II requirement. All the banks have their Capital to Risk Weighted Assets Ratio (CRAR) above the stipulated requirement of Basel guidelines (8%) and RBI guidelines (9%). As per Basel II norms, Indian banks should maintain tier I capital of at least 6%.The Government of India has emphasized that public sector banks should maintain CRAR of 12%. For this, it announced measures to re-capitalize most of the public sector banks, as these banks cannot dilute stake further, as the Government is required to maintain a stake of minimum 51% in these banks.

Basel II Norms

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.

  

Basel II is based on 3 pillars that allow banks and supervisors to evaluate properly the various risks that banks face. These three pillars are:(i)    Minimum capital requirements,(ii)   Supervisory review of an institution's capital adequacy and internal assessment process;(iii)   Market discipline through effective disclosure to encourage safe and sound banking practices.   Computation of Total CRAR and Tier I capital under Basel II  Basel II Tier I CRAR = Tier I capital / (Credit Risk RWA + Operational Risk RWA + Market Risk RWA)Basel II Total CRAR = Total capital / (Credit Risk RWA + Operational Risk RWA + Market Risk RWA) RWA - risk weighted assets 

  

  Global Scenario on Basel II

Banking regulators in around the world are planning to implement Basel II, but with varying timelines and use to 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 to 2008 whereas Japanese banks implemented in 2007. Australia implemented the Basel II Framework in 2008. US banks are scheduled to switch over in 2009. 

 

Three Pillars of Basel II 

 Pillar 1 includes 3 risks now, operational risk + credit risk + market risk. 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, Indus land bank entered into MOU with CRISIL and Allahabad bank entered into MOU with CARE for rating facility as required under Basel II. 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.  

Impact of Basel II implementation on the Indian Banking Industry Changes in Capital Risk Weighted Assets Ratio (CRAR)

Most of the banks are already adhering to the Basel II guidelines. However, the Government has indicated that a cushion should be maintained by the public sector banks and therefore their CRAR should be above 12%.

Basel I focused largely on credit risk, whereas Basel II has 3 risks to be considered, viz., credit risk, operational risk and market risks. As Basel II considers all these 3 risks, there are chances of a decline in the Capital Adequacy Ratio. However, on the basis of data we collated, we observe that following public sector banks' CRAR as at December 31, 2008, as per Basel I, increased as computed under Basel II norms, primarily on account of reduction in the risk weights. Table 1: CRAR as per Basel I and Basel II

  High costs for up-gradation of technology

Full implementation of the Basel II framework would require up-gradation of the bank-wide information systems through better branch-connectivity, which would entail huge costs and may raise IT-security issues. The implementation of Basel II can also raise issues relating to development of HR skills and database management. Small and medium sized banks may have to incur enormous costs to acquire required technology, as well as to train staff in terms of the risk management activities. There will be a need for technological upgradation and access to information like historical data etc.

Rating risksProblems embedded in Basel II norms include rating of risks by rating agencies. Whether the country has adequate number of rating agencies to discharge the functions in a Basel II compliant banking system, is a question for consideration. Further, to what extent the rating

agencies can be relied upon was also a matter of debate, in the light of the recent US experience.

Banks Compliance with Basel II (Tier I capital norm of 6%)

Listed Private sector banks

 Table 3: Listed Public sector banks

 

Basel II mandates banks to have tier 1 capital of at least 6%. Data on Tier I capital of all banks as on December 31, 2008 was not readily available. We therefore examined the Tier I capital ratios of banks as on March 31, 2008.

From the table it can be seen that 4 listed public sector banks, viz., Bank of Maharashtra, Central Bank of India, UCO Bank and Vijaya Bank, which had their Tier I capital ratios below 6%, as on March 31, 2008.

Central Bank of India's tier I capital fell further as on December 31,2008 to 5.33%, which is below the stipulated norm under Basel II.

[

As on December 31, 2008, the tier I capital for UCO bank stood at 5.44%.

Extension of Tier I capital norm of 6%

Even if the banks are not able to meet the tier 1 capital limit of 6% by March 31, 2009, there are no issues in purview of the new guidelines. As per the revised Basel II guidelines, banks which would not be able to meet the minimum Tier I capital adequacy of 6% from the date of implementation of Basel II, will be provided time till March 31, 2010.  Compliance with Basel II - CRAR norm of 9%

On an average, (as on December 31, 2008), private sector banks had a higher CRAR of 14.15%, vis-a-vis 12.60% tor public sector banks.

Table 4: Listed Private sector banks

 Observations

The table above shows that private banks are well placed with their respective CRAR well above 9%, which is the stipulated CRAR norm under Basel II.

On an average, the CRAR for private sector banks increased from 13.53% on March 31, 2008 to 14.15% on December 31, 2008.

Since the Government of India has mandated public sector banks to have CRAR of at least 12% for meeting the capital requirement as well as business growth, we observe

that among private sector banks, Bank of Rajasthan and ING Vysya Bank have their CRAR below 12%. In case of ING Vysya bank, its CRAR grew by 52bps from March to December 2008, yet it is still below 12%. We believe these banks could require funding in the future for growth prospects.

   Listed Public sector banks

  Observations The reported CRAR for Allahabad Bank, Bank of Baroda, Bank of India, Indian Bank,

Indian Overseas Bank, Punjab National Bank, State Bank of India, Syndicate Bank and UCO Bank are as per Basel II guidelines.

On an average, the CRAR for public sector banks increased from 11.94% on March 31, 2008 to 12.60% on December 31, 2008.

Government of India issued a directive to public sector banks to maintain CRAR of at least 12%. As on December 31, 2008, 5 public sector banks, viz., Bank of Maharashtra, Central Bank, Dena Bank, IDBI Bank and Vijaya Bank reported CRAR below 12%, the government stipulated directive.

Under 1é round of re-capitalization package, government announced a sum of Rs3800Cr for Central Bank, UCO bank and Vijaya Bank.

2nd round of re-capitalization is also being considered. Dena Bank and Bank of Maharashtra are likely to be funded.

  

Public sector banks with government stake of 51% may get government recapitalization

 As on December 31, 2008, the Government's stake in Andhra Bank, Dena Bank and Oriental Bank of Commerce is close to 51 % each. These banks cannot raise money through the primary market as the Government shareholding is just a tad above the statutory level of 51%. Therefore further equity dilution is all but ruled out.

Dena bank with CRAR of 11.79% and Government stake of 51.19% may need funding. The Government of India stated that it would provide funds to all public sector banks whose CRAR is between 10% and 12%. Dena Bank will get Government aid in the 2nd round of re-capitalization.

Andhra Bank's CRAR as of December 31, 2008 is 13.43%, much above the required norm. Its CRAR increased 182bps y-o-y basis. Yet, for future funding and knowing that its government stake is 51.55%, must be eligible for recapitalization.

Oriental Bank of Commerce's CRAR is 12.01 %, just meeting the norm but the government may still infuse capital in these banks so that their CRAR doesn't fall after business expansion. It is more likely to get recapitalized as its government stake is 51.09%.

Dena Bank, Oriental Bank of Commerce and Andhra Bank could benefit from the 2nd capital infusion plan, since the government's holding in these three banks is very close to the maximum permissible limit of 51%.  

 

CONCLUSION

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.

Basel II mandates Capital to Risk Weighted Assets Ratio (CRAR) of 8% and Tier I capital of 6%. The RBI has stated that Indian banks must have a CRAR of minimum 9%, effective March 31, 2009. All private sector banks are already in compliance with the Basel II guidelines as regards their CRAR as well as Tier I capital. Further, the Government of India has stated that public sector banks must have a capital cushion with a CRAR of at least 12%, higher than the threshold of 9% prescribed by the RBI.

There are 4 banks viz. Bank of Maharashtra, Central Bank, UCO Bank and Vijaya Bank, whose tier I capital as on March 31, 2008 was below the stipulated norm of 6%.

Failure to adhere to Basel II can attract RBI action including restricting lending and investment activities. However, private sector banks as well as public sector banks are likely to comply with Basel II norms by March 31, 2009. The Government announced 1st round of recapitalization for 3 banks, viz., Central Bank, UCO Bank and Vijaya Bank (whose tier I capital was less than 6%) for an aggregate sum of Rs38bn.

Further for public sector banks, the Government has prescribed CRAR of at least 12%. There are 5 banks which have CRAR less than 12% as of December 31, 2008, viz., Bank of Maharashtra, Central Bank, Dena Bank, IDBI Bank and Vijaya Bank. Since the Government's stake in public sector bank cannot be allowed to go below 51 %, these banks cannot take recourse to equity funding for Tier I capital. Of these banks, government holding in Dena Bank is very close to 51%; it is therefore not possible for it to raise further equity capital (without diluting the Government's stake to below 51 %).

The Government, in the Interim Budget, embarked approx. Rs200bn for re-capitalizing public sector banks whose CRAR is less than 12%, as well as for other public sector banks for future business growth.

The Government has announced that there will be 2nd round of recapitalization. We believe Bank of Maharashtra will have to be recapitalized soon with detailed plan, since its Tier I capital is below 6%. Its government stake is 76%, which is much above the needed 51 %, indicating scope for an equity dilution. However, the current market conditions may render an equity issue difficult.

The recapitalization move by the Government seems to be a precautionary measure to avoid any kind of risk during the times of a global financial turmoil and would improve market confidence in the banking system. We believe the recapitalization will increase the Government's stakes in public sector banks, so that they will be able to opt for fund raising in the future, when credit off-take picks up momentum.

REFRENCES

www.business.mapsofindia.com › India Industry

www.questia.com/PM.qst?a=o&se=gglsc&d=5000428082

www.bseindia.com/downloads/BankingSector.pdf

www.thehindubusinessline.com/.../2007022000930900.htm

www.coolavenues.com/forums/showthread.php?p=52882