V Leeladhar: Basel II and credit risk management
Inaugural address by Mr V Leeladhar, Deputy Governor of the Reserve Bank of India, at the
programme on Basel II and Credit Risk Management, organised by the Centre for Advanced
Financial Learning for the whole-time directors of the commercial banks, Goa,
15 September 2007.
* * *
Mr. Gordy, Mr. Bhattacharya, distinguished participants, ladies and gentlemen,
I am delighted to be with you this morning at the inaugural of the third programme in the
series being organised under the aegis of the Centre for Advanced Financial Leaning (CAFL)
on the theme of Basel II and Credit Risk Management. I am indeed thankful to the organisers
for providing me this valuable opportunity to share my thoughts on this very topical subject
with this august audience - which, needless to say, has a pivotal role to play in implementing
the Basel II framework in the Indian banking system. In fact, this programme itself, which has
been tailor made for the whole-time directors of the Indian banks, signifies the importance
the RBI attaches to sensitising the top management of the banks to the conceptual
constructs underpinning the new framework.
2. I am inclined to believe that the Basel II framework is no longer a novelty for most of you.
While the technical aspects of credit risk management in the Basel II environment will be
covered during the course of this two-day seminar, I would like to present a brief bird's eye
view of the evolution of the capital adequacy norm for the banks over the decades so as to
put the new framework in perspective, the imperatives that led to its refinement in the form of
Basel II, the expectations of the RBI from the banking system during the implementation
phase and beyond, and the issues and challenges facing us that will need to be addressed in
implementing the new framework in a non-disruptive manner.
The evolution of capital standards
3. It is interesting to note that till the 1980s, the risk-weighted approach to capital adequacy
was not in vogue but the bank's capital was measured through the traditional gearing ratios.
During the 1980s, the increasing competition amongst the international banks and rapid
growth in their assets had led to concerns about their deteriorating capital levels. This
concern was aggravated by the debt crisis in some of the emerging markets. While the
national authorities and regulators in many countries began exhorting their banks to improve
their capital ratios, it was realised that varying approaches to capital measurement across
countries made international comparisons difficult and there was a need to evolve an
internationally consistent approach to capital measurement. Moreover, the market
developments by the mid-1980s, coupled with the regulatory pressures for improving the
capital ratios for the on-balance sheet activities of the banks, had also witnessed a
phenomenal growth in the banks' off-balance sheet business - which, at that time, was not
subject to regulatory capital charge. In this background, the efforts were intensified in 1986 to
evolve a common and risk-weighted approach to capital measurement rather than the
traditional gearing measure. During 1987, the "Basle Committee on Banking Regulations and
Supervisory Practices", as it was then named, arrived at a consensus on 8% as the minimum
capital adequacy ratio. After a period of consultation with the banks around the world, this
framework was formally adopted in 1988 and was widely endorsed by the supervisory
community, world-wide. This standard came to be commonly known as the Basel Accord or
Basel I Framework. It was the first ever attempt at harmonising the banks' capital standards
across the countries, for securing greater international competitive equality and to obviate
regulatory capital as a source of competitive inequality.
4. The Accord, in its original form, addressed only the credit risks in the banks' operations. It
was only in 1996 that an amendment was made to cover the market risks also. The Accord
had adopted a risk-sensitive approach for making the banks' capital more responsive to the
riskiness of their operations. This meant that a bank with a higher risk profile would have to
maintain a higher quantum of regulatory capital while also ensuring the minimum capital
ratio. The framework also stipulated, for the first time, a regulatory capital charge for the
offbalance sheet business of the banks so as to capture their risk exposures more
comprehensively. Pursuant to the recommendations of the Committee on the Financial
System (the first Narsimham Committee, 1991), this framework was implemented in India in
1992 in a phased manner.
The imperatives for Basel II
5. With the passage of time, it was realised that the Basel I framework had several
limitations. The limitations related mainly to the underlying approach as also a
less-thancomprehensive scope of the Accord in capturing the entire risk universe of the banking
entities. Let me dwell a little more on these aspects.
First, the Accord had a broad-brush approach under which the entire exposures of banks
were categorised into three broad risk buckets viz., sovereign, banks and corporates, with
each category attracting a risk weight of zero, 20 and 100 per cent, respectively. Such a risk
weighting scheme did not provide for sufficient calibration of the counterparty risk since, for
instance, a corporate with "AAA" rating and one with "C" rating would attract identical risk
weight of 100 per cent and require the same regulatory capital charge, despite significant
difference in their credit standing. This, in turn, engendered a rather perverse incentive for
the banks to acquire higher-risk customers in pursuit of higher returns, without necessitating
a higher capital charge. Such bank behaviour could potentially heighten the risk profile of the
banking systems as a whole. The design of the Accord was, therefore, viewed as distorting
the incentive structure in the banking markets and dissuading better risk management.
Second, the Accord addressed only the credit risk and market risk in the banks' operations,
ignoring several other types of risks inherent in any banking activity. For instance, the
operational risk, that is, the risk of human error or failure of systems leading to financial loss,
was not at all addressed - as were the liquidity risk, credit concentration risk, interest rate
risk in the banking book, etc.
Third, since 1988, the emergence of innovative financial products had transformed the
contours of the banking industry and its business model the world over. The credit-risk
transfer products, such as securitisation and credit derivatives, enabled removal of
onbalance sheet exposures from the books of the banks when they perceived that the
regulatory capital requirement for such exposures was too high and hiving off such
exposures would be a better strategy. The Basel I framework did not accommodate such
innovations and was, thus, outpaced by the market developments.
6. In this background, a need was felt to create a more comprehensive and risk-sensitive
capital adequacy framework to address the infirmities in the Basel-I Accord. The Basel
Committee on Banking Supervision (BCBS), therefore, after a world-wide consultative
process and several impact assessment studies, evolved a new capital regulation
framework, called "International Convergence of Capital Measurement and Capital
Standards: A Revised Framework", which was released in June 2004. The revised
framework has come to be commonly known as "Basel II" framework and seeks to foster
better risk management practices in the banking industry.
The objectives of Basel II
7. In order to better appreciate the impact of Basel II on the banking industry, it is worth
recalling the objectives of the Basel Committee regarding the overall level of capital
requirements. According to the revised framework, issued in June 2004:
"The objectives are to broadly maintain the aggregate level of minimum
capital requirements, while also providing incentives to adopt more
advanced risk-sensitive approaches of the revised framework".
Governor Susan Schmidt Bies of the Federal Reserve System of the USA has described the
objectives of Basel II a little more elaborately in the following words:
"The major objectives of Basel II include creating a better linkage between
the minimum regulatory capital and risk, enhancing market discipline,
supporting a level playing field in an increasingly integrated global financial
system, establishing and maintaining a minimum capital cushion sufficient
to foster financial stability in periods of adversity and uncertainty, and
grounding risk measurement and management in actual data and formal
quantitative techniques. Let me emphasize that last objective, since it is
often overlooked. Critical to Basel II is the effort to improve risk
measurement and management, especially at our largest, most complex
organizations."1
Thus, it would be reasonable to infer that the main focus of the new framework is on
providing the right incentives to the banks to adopt data-based, quantitative risk management
systems to be able to adopt the advanced risk-sensitive approaches of the revised
framework, which, in turn, would contribute to systemic and financial stability. Hence,
inducing the adoption of advanced risk management systems by the banking institutions
would seem to lie at the heart of the new framework.
Select aspects of Basel II framework
8. Given the foregoing objectives of the new framework, it may be useful to take a brief stock
of the salient aspects of this dispensation, which could be of particular interest to this
audience.
A comprehensive approach
9. One of the unique aspects of Basel II is its comprehensive approach to risk measurement
in the banking entities, by adopting the now-familiar three-Pillar structure, which goes far
beyond the first Basel Accord. To recapitulate, these are: Pillar 1 - the minimum capital ratio,
Pillar 2 - the supervisory review process and Pillar 3 - the market discipline. The Pillar 1
provides a menu of alternative approaches, from simple to advanced ones, for determining
the regulatory capital towards credit risk, market risk and operational risk, to cater to the wide
diversity in the banking system across the world. Pillar 2 requires the banks to establish an
Internal Capital Adequacy Assessment Process (ICAAP) to capture all the material risks,
including those that are partly covered or not covered under the other two Pillars. The ICAAP
of the banks is also required to be subject to a supervisory review by the supervisors. The
Pillar 3 prescribes public disclosures of information on the affairs of the banks to enable
effective market discipline on the banks' operations.
10. As you are aware, RBI has already issued the guidelines for the new capital adequacy
framework in regard to Pillar 1 and Pillar 3 on April 27, 2007. As regards Pillar 2, the banks
have been advised to put in place an ICAAP, with the approval of the Board. A two-stage
implementation of the guidelines is envisaged to provide adequate lead time to the banking
system. Accordingly, the foreign banks operating in India and the Indian banks having
operational presence outside India are required to migrate to the Standardised Approach for
credit risk and the Basic Indicator Approach for operational risk with effect from March 31,
2008. All other Scheduled commercial banks are encouraged to migrate to these approaches
under Basel II in alignment with them, but, in any case, not later than March 31, 2009. It has
been a conscious decision to begin with the simpler approaches available under the
framework, having regard to the preparedness of the banking system. As regards the market
risk, under Basel II also, the banks will continue to follow the Standardised-Duration Method
as already adopted under the Basel I framework. For migration to the advanced approaches
available under the framework, prior approval of the RBI would be required.
Pillar 2 considerations
11. While the implications of Pillar 1 and Pillar 3 are fairly well known in the banking
community, the importance of Pillar 2 in the new framework is perhaps not that well
understood. I would, therefore, like to take this opportunity to dwell a little more on the
criticality of effective implementation of Pillar 2 by the banks while adopting the new
framework, in view of its importance.
12. As I mentioned earlier, the Pillar 2 of the framework deals with the "Supervisory Review
Process" (SRP). The objective of the SRP is to ensure that the banks have adequate capital
to support all material risks in their business as also to encourage them to adopt
sophisticated risk management techniques for monitoring and managing their risks. This, in
turn, would require a well-defined internal assessment process within the banks through
which they would determine the additional capital requirement for all material risks, internally,
and would also be able to assure the RBI that adequate capital is actually held towards their
all material risk exposures. The process of assurance could also involve an active dialogue
between the bank and the RBI so that, when warranted, appropriate intervention could be
made to either reduce the risk exposure of the bank or augment / restore its capital. Thus,
ICAAP is an important component of the Supervisory Review Process. What is important to
note here is that the Pillar 1 stipulates only the capital ratio for the banks whereas
minimum
the Pillar 2 provides for a bank-specific review by the supervisors to make an assessment
whether all material risks are getting duly captured in the ICAAP of the bank. If the supervisor
is not satisfied in this behalf, it might well choose to prescribe a higher capital ratio, as per its
assessment.
13. I would like to emphasise that the ICAAP under the Pillar 2 is the element which makes
the Basel II framework comprehensive in its sweep by addressing the entire risk domain of
the banks. As I mentioned, the ICAAP is expected to address all material risks facing the
fully
bank but the three main areas in particular viz., those aspects not captured under the
Pillar 1 process; factors not taken into account by Pillar 1 process; and the factors external to
the bank. Another dimension of the ICAAP would be to monitor compliance with the Pillar 1
and Pillar 3 requirements. Thus, illustratively, we would expect the banks' ICAAP to take
account of the credit concentration risk, interest rate risk in the banking book, business and
strategic risk, liquidity risk, and other residual risks such as reputation risk and business
cycle risk. The challenge for the banks would be to quantify these risks and then, to translate
those consistently into an appropriate amount of capital needed, commensurate with the
bank's risk profile and control environment. Needless to say, this would call for instituting
sophisticated risk management systems, including a robust stress-testing and economic
capital allocation framework, coupled with strong validation mechanisms to ensure the
integrity of the entire ICAAP, to be able to achieve the objectives underpinning the ICAAP
and the Supervisory Review envisaged under Pillar 2. I am sure, the Pillar 2 dimension would
be receiving the high priority it deserves in the implementation strategy of the banks. It is
useful to note that the ICAAP, as its name suggests, is envisaged to be essentially a
bankdriven process, which would of course be subject to a supervisory review.
The parallel run
14. Another aspect which I would like to mention here today is the parallel run prescribed by
the RBI which the banks were required to carry out since June 2006, as a prelude to
migration to the simpler approaches of Basel II. The objective was to familiarise them with
the requirements of the new framework. During the period of parallel run, the banks are
required to compute, parallely, on an on going basis, their capital adequacy ratio - both
under Basel I norms, currently applicable, as well as the Basel II guidelines to be applicable
in future. This analysis of the capital adequacy ratio is to be placed before the Boards of the
banks every quarter and is also transmitted to the RBI. In addition, an assessment of
compliance with the Board-approved policies on collateral management, credit risk
mitigation, disclosures and ICAAP, adequacy of the management information system, impact
of various elements of the portfolio on the capital adequacy ratio, as also the results of the
process for validating the CRAR are also to be placed before the Board. The validation
mechanism, to my mind, would be a critical element of the parallel run as it would help
ensuring the accuracy and integrity of the entire process. I would urge all of you to pay due
attention to the parallel run exercise in the interest of smooth migration to Basel II on the cut
off date.
Migration to advanced approaches under Basel II
15. As I mentioned earlier, the Basel II framework provides a menu of alternative approaches
for determination of regulatory capital for credit, market and operational risks. While in India,
we have decided to implement the simpler approaches within the stipulated timeframe, as
regards migration to the advanced approaches, the RBI has not indicated any specific
timeframe. However, the banks that plan to migrate to the advanced approaches would need
prior approval of the RBI - for which requisite guidelines would be issued in due course.
Nonetheless, the banks planning such migration would be well advised to undertake an
objective and rigorous self-assessment vis-a-vis the qualifying criteria envisaged under the
Basel II framework for adoption and ongoing use of the advanced approaches. Such an
assessment would be helpful for the banks in chalking out a realistic roadmap for a smooth
switchover to the advanced approaches, as and when these are introduced by the RBI.
16. It needs to be, however, borne in mind that implementation of advanced approaches
under Basel II, particularly for the credit risk, would be a data-intensive exercise. While the
data needs under the simpler approaches would be largely similar to those under the Basel I
framework, the data requirements of banks would be significantly higher to even qualify for
adopting the Advanced Approaches as the banks would require adequate and
acceptablequality historical data to compute the capital requirements under the Advanced Approaches.
At the minimum, banks may need to have acceptable historical data for the past five to seven
years for computing the risk parameters such as probability of default, loss given default and
operational risk losses. The banks which consider migration to advanced approaches will,
therefore, need to first build up a comprehensive database for the purpose.
Credit risk management under Basel II
17. Even though Basel-II framework has a broader scope and includes "operational risk"
under Pillar 1 and public disclosures under Pillar 3, the credit risk still claims the largest
share of the regulatory capital. This underscores the significance of credit risk in the bank's
operations. This is hardly surprising reckoning that the several banking crises in many
countries had their roots in lax credit standards, poor portfolio risk management, and the
inability or failure to evaluate the impact of the changing economic environment on credit
worthiness of the banks' borrowers. The sub-prime crisis in the USA is the most recent
example of the inadequate credit risk assessment. The advent of advanced approaches for
credit risk in India under the Basel II Framework in the days to come, could be expected to
provide an impetus for adopting more sophisticated credit risk management techniques in
banks.
18. In this context, I would like to recall that as far back as in October 1999, the RBI had
issued guidelines, with an integrated approach, on risk management in banks. Having regard
to diversity of banks, they were advised to design their own risk management architecture, in
tune with their size, complexity of business, risk philosophy, market perception and the level
of capital. With a view to fine tuning the risk management systems in banks and to help
smaller banks in achieving the minimum standards, RBI has also issued guidance notes on
management of credit and market risk in October 2002. While the broad principles underlying
the guidelines would still be valid, banks would be well advised to modernize and upgrade
their risk management configuration in step with the market developments.
The path ahead
19. Before I conclude, let me briefly touch upon a few of the issues and challenges that could
emanate from the adoption of Basel II framework, particularly, in the Indian context.
First, it is understood that the Basel II framework provides for as many as about 130 areas of
national discretion to be exercised by the country supervisors, as per local conditions. Thus,
it has been argued that potentially, there could be 130 variations of the new framework under
different jurisdictions. If that be the case, the international comparability of the bank-capital
standards would be difficult to achieve across the countries and perhaps, the original
objective of reducing the international competitive inequality amongst the banks could get
compromised.
Second, with migration to the advanced approaches in future, the banks following the
advanced approaches are likely to have a more risk-sensitive architecture for capital
computation compared to those on the standardised approach. This could potentially lead to
the riskier assets gravitating towards the banks on the less-risk-sensitive Standardised
Approach, which would need lower capital for such assets than the banks on the advanced
approaches, while the high quality assets flowing to the banks on the advanced approaches.
This could ultimately result in a lower amount of capital in the system as a whole, which
might not be a very welcome prospect, specially from the supervisory perspective.
Third, while the Pillar III disclosures could be quite useful for the market analysts and
sophisticated users of this information, the utility of such disclosures for the common man
remains a moot point. Besides, the disclosures under Basel II will also need to be
harmonised with those required under the International Financial Reporting Standards so as
to avoid any conflicts and excessive burden of disclosure.
Fourth, in the Indian context, the rating penetration is very low and is generally confined to
the larger corporates while the smaller entities are generally unrated. With the adoption of
the Standardised Approach in India, which places heavy reliance on the external rating of the
bank clients, a view has been expressed that the small and medium enterprises, which are
below the rating threshold, may get somewhat handicapped in availing bank credit in the
absence of credit rating. This may perhaps call for special efforts to maintain the credit flow
to this segment of the borrowers.
Fifth, the risk sensitive approach of the Basel II Framework is likely to give rise to
procyclicality in the capital requirements of the banks since in an economic downturn, the capital
requirements would rise but will decline during an economic boom. It is argued that such an
impact on the banks could accentuate the effects of the cycle and could increase the volatility
in the banking system.
Finally, in implementing the new framework, which requires specialised skill sets, the
challenge of human resource management for the Indian banking sector would be a
constraint to reckon with. The banks would, therefore, need to evolve innovative HRM
practices to be able to attract and retain the right mix of people to ensure effective
operationalisation and maintenance of sophisticated risk management infrastructure.
Conclusion
20. In conclusion, I would only like to stress that the central message of the Basel II
Framework is the progressive refinement and sophistication of the risk management
configuration of the banking system. The banks with better risk management skills would not
only have competitive advantage in the market place but would also be better positioned to
capitalise on the opportunities for organic and inorganic growth. While the Basel II framework
creates an enabling environment for enhancing the risk management capability in the banks
by providing the right incentives, it is entirely up to you to grasp the nettle and upgrade the
risk governance in your organisation to achieve a sharper risk-reward profile. I am confident
that the deliberations at this two-day seminar would provide you valuable insights into the
relevant issues to enable a smoother migration to the new framework. I wish the
deliberations at the seminar all success.
Thank you.