V Leeladhar: India's preparedness for Basel II implementation
Address by Mr V Leeladhar, Deputy Governor of the Reserve Bank of India, at the panel
discussion during the "FICCI-IBA Conference on Global Banking: Paradigm Shift", Mumbai,
13 September 2007.
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Dear Friends,
It is my pleasure and privilege to be here with you this morning and to be sharing my
experience and views with this august audience regarding India's preparedness for Basel II
implementation. I am very thankful to the organisers for having afforded me this opportunity
today. As you are well aware, implementation of the new capital adequacy framework has
been a long and exacting journey in most of the jurisdictions, and so is the case with India.
The countries are at various stages of implementation. In India, having regard to the country
context and in tune with the overall approach to regulatory reforms, we have adopted a
calibrated approach for a phased implementation of Basel II so as to secure a non-disruptive
migration to the new framework. In my remarks today, I would like to briefly touch upon the
evolution of the revised framework, its broad structure, preparatory measures taken by the
RBI for implementing this framework and the challenges that will need to be tackled in
migration to Basel II.
At the outset, let me hasten to add that while we are moving towards the Basel II Framework,
the RBI has adopted a three-track approach to capital adequacy regulation in India, with the
norms stipulated at varying degrees of stringency for different categories of banks. Similar
differentiated approach has been adopted in some other jurisdictions also. This has been a
deliberate choice for us having regard to the size, nature and complexity of operations and
relevance of different types of banks to the Indian financial sector, the need to achieve
greater financial inclusion and to provide an efficient credit delivery mechanism. Thus, the
commercial banks, which account for the lion's share in the total assets of the banking
system, will be on Basel II standards while the co-operative banks will remain on Basel I
norms for credit risk with surrogate measures for market risk. The Regional Rural Banks, on
the other hand, which have limited operations in rural areas, will be on non-Basel standards.
Basel II
The attempts at harmonising the capital adequacy standards internationally date back to
1988, when the "Basle Committee on Banking Regulations and Supervisory Practices", as it
was then named, released a capital adequacy framework, now known as Basel I. This
initiative set out the first internationally accepted framework for measuring capital adequacy
and a minimum ratio to be achieved by the banks. This norm was widely adopted in over 100
countries, and in India, it was implemented in 1992. Over the years, however, the Basel I
framework was found to have several limitations such as its broad-brush approach to credit
risk, its narrow coverage confined to only credit and market risks, and non-recognition of
credit risk mitigants, which encouraged capital arbitrage through structured transactions.
Moreover, the rapid advances in risk management, information technology, banking markets
and products, and banks' internal processes, during the last decade, had far outpaced the
simple approach of Basel I to measuring capital. A need was, therefore, felt to replace this
Accord with a more risk-sensitive framework, which would address these shortcomings.
Accordingly, after a wide-ranging global consultative process, the Basel Committee on
Banking Supervision (BCBS) released on June 26, 2004 the document "International
Convergence of Capital Measurement and Capital Standards : A Revised Framework", which
was supplemented in November 2005 by an update of the Market Risk Amendment. This
document, popularly known as "Basel II Framework", offers a new set of international
standards for establishing minimum capital requirements for the banking organisations. It
capitalises on the modern risk management techniques and seeks to establish a more
riskresponsive linkage between the banks' operations and their capital requirements. It also
provides a strong incentive to banks for improving their risk management systems. The risk
sensitiveness is sought to be achieved through the now-familiar three mutually reinforcing
Pillars.
The Pillar 1 stipulates the minimum capital ratio and requires allocation of regulatory capital
not only for credit risk and market risk but additionally, for operational risk as well, which was
not covered in the previous Accord. The Pillar 1, unlike the previous Accord, provides a
menu of approaches, from the simplified to the advanced ones, for determining the capital
charge for each of the three categories of risks. The credit risk mitigants used by the banks
have been specifically recognised to provide appropriate capital relief.
The Pillar 2 of the framework deals with the "Supervisory Review Process" (SRP), and is
probably not that well understood as the other two Pillars. In fact, this is the element which
makes the revised framework very comprehensive in its sweep by addressing the entire risk
domain of the banks. Let me elaborate a little. It requires the banks to develop an Internal
Capital Adequacy Assessment Process (ICAAP) which should encompass their whole risk
universe - by addressing all those risks which are either not fully captured or not at all
captured under the other two Pillars - and assign an appropriate amount of capital, internally,
for all such risks, commensurate with their risk profile and control environment. Under the
Supervisory Review, the supervisors would conduct a detailed examination of the ICAAP of
the banks, and if warranted, could prescribe a higher capital requirement, over and above the
minimum capital ratio envisaged in Pillar 1.
The Pillar 3 of the framework, Market Discipline, focuses on the effective public disclosures
to be made by the banks, and is a critical complement to the other two Pillars. It recognises
the fact that apart from the regulators, the banks are also monitored by the markets and that
the discipline exerted by the markets can be as powerful as the sanctions imposed by the
regulator. It is premised on the basic principle that the markets would be quite responsive to
the disclosures made and the banks would be duly rewarded or penalised, in tune with the
nature of disclosures, by the market forces.
Preparatory measures for Basel II implementation
Let me now say a few words about the process adopted in India for implementation of Basel
II. Though the Indian banks became fully compliant with Basel I Accord in March 2005, the
RBI had initiated preparatory measures even prior to that. In August 2004, soon after the
new framework was released by the BCBS, the banks were advised to conduct a
selfassessment of their risk management systems and to initiate remedial measures, as needed,
keeping in view the requirements of the Basel II framework. Further, to secure a consultative
and participative approach for a non-disruptive migration to Basel II, a Steering Committee
was constituted in October 2004, comprising senior officials from 14 select banks (a mix of
public sector, private sector and foreign banks). It formed several sub-groups to address
specific issues under Basel II and made its recommendations to the Reserve Bank. Based
on these inputs, in February, 2005, the RBI issued the draft guidelines, for public comments,
on implementation of Pillar 1 and Pillar 3 requirements of the Basel II framework. In the light
of the feedback received from a wide spectrum of banks and other stake holders, the draft
guidelines were revised and again placed in public domain on March 20, 2007 for a second
round of consultations. Keeping in view the additional feedback received, the guidelines were
finalised and issued on April 27, 2007. As regards the Pillar 2, the banks have been asked to
put in place the requisite Internal Capital Adequacy Assessment Process (ICAAP) with the
approval of their Boards.
I may mention here that even before the final guidelines were issued, the RBI had asked the
banks in May 2006 to begin conducting parallel runs, as per the draft guidelines, so as 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, along with several other prescribed
assessments, is to be placed before the Boards of the banks every quarter and is also
transmitted to the RBI. These reports received in the RBI indicate that implementation of
Basel II in the banks is in the process of getting stabilised.
The minimum capital adequacy ratio prescribed under the Basel II norms continues to be at
nine per cent, at solo as well as consolidated level. This, however, is subject to the stipulated
prudential floors for the first three years of implementation to guard against any significant
decline in the capital ratios of the banks arising from the capital relief that they might accrue
to them under Basel II. The banks are, however, expected to operate at a level well above
the minimum capital requirement. The banks are also required to achieve the Tier I capital
ratio of six per cent not later than March 31, 2010, both on solo as well as consolidated
basis.
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. As regards the market risk, the banks will continue to follow the
Standardised-Duration Method, already adopted under the Basel I framework, under Basel II
also.
Thus, reckoning the well-planned and carefully-sequenced preparatory work already done,
the choices exercised by the RBI under the national discretion, coupled with a phased
implementation schedule, I am inclined to believe that the Indian banking system could be
considered to be in a high state of preparedness and would be well poised for a seamless
migration to Basel II next year, in tune with the envisaged timeframe. This, however, is not to
say that the process would be a cake-walk - as there would be considerable challenges too
that lie head for all of us, during the current phase of implementation as also for moving to
the advanced approaches.
The challenges ahead
Let me now briefly outline some of the salient issues and challenges that might arise for the
Indian banking system from the adoption of the Basel II framework. The list here is, however,
by no means exhaustive.
First, the new norms might, in some cases, lead to an increase in the overall regulatory
capital requirements for the banks, particularly under the simpler approaches adopted in
India, if the additional capital required for the operational risk is not offset by the capital relief
available for the credit risk. This would of course depend upon the risk profile of the banks'
portfolios and also provide an incentive for better risk management but the banks would need
to be prepared to augment their capital through strategic capital planning.
Second, the Standardised Approach for credit risk leans heavily on the external credit
ratings. While the RBI has accredited four rating agencies operating in India, the rating
penetration in India is rather low. Moreover, credit rating in India is confined to rating of the
instruments and not of the issuing entities as a whole. Besides, the credit rating provides only
a lagged indicator of the credit standing of an entity, and is not a lead indicator. The banks
would, therefore, need to actively reckon this aspect in their ICAAP exercise.
Third, the risk weighting scheme under Standardised Approach also creates some incentive
for some of the bank clients to remain unrated since such entities receive a lower risk weight
of 100 per cent vis-à-vis 150 per cent risk weight for a lowest rated client. This might
specially be the case if the unrated client expects a poor rating. The banks will need to be
watchful in this regard.
Fourth, the new framework could also intensify the competition for the best clients with high
credit ratings, which attract lower capital charge. This could put pressure on the margins of
the bank. The banks would, therefore, need to streamline and reorient their client acquisition
and retention strategy.
Finally, implementing the ICAAP under the Pillar 2 of the framework would perhaps be the
biggest challenge for the banks in India as it requires a comprehensive risk modelling
infrastructure to capture all the risks that are not covered under the other two Pillars of the
framework. The validation of the internal models of the banks by the supervisors would also
be an arduous task.
In regard to adoption of advanced approaches available under Basel II, the RBI has not
stipulated any timeframe for adoption of these approaches but a migration to advanced
approaches would certainly pose significant challenges to both - the banks as well as the
supervisors. In this case, a slightly different set of issues and challenges is likely to arise
which would need to be kept in view in any decision to migrate to them.
First and foremost, the banks will need to demonstrate to the supervisors that they meet the
minimum criteria stipulated in the Basel II framework to be eligible to adopt the IRB
approaches. This could require, inter alia, suitable adjustments in the risk-rating design and
its operations for various product lines in the banks as also the governance structure to
ensure the integrity of the rating process.
Second, unlike the simpler approaches under Basel II, the advanced approaches are very
data intensive and require high-quality, consistent, time-series data for various borrower- and
facility-categories for a period of five to seven years to enable computation of the required
risk parameters (such as default probability and loss given default, etc.). The banks would
perhaps need a thorough review of their internal processes with a view to redesign and
upgrade them to be able to capture the information needed for creating the requisite
databases.
Third, a robust risk management architecture, including a strong stress-testing framework for
scenario analyses, would be a necessity under the advanced approaches. A system within
the banks to validate the accuracy of the internal rating processes would be an essential
element of the risk management set up.
Fourth, an overarching requirement for efficient data management and for effective risk
management structures, would be an state-of-the-art technological infrastructure which might
need significant investment and improvement to achieve seamless enterprise-wide
integrated risk management, for which sharply focused strategic planning would be
necessary.
Fifth, with considerable leeway available to the banks under the advanced approaches in
determining the regulatory capital requirements, the highest standards of corporate
governance would be critical for maintaining the integrity of the advanced approaches.
Sixth, the complexity of advanced approaches requires highly skilled staff and the human
resource management in the banking industry, particularly for the public sector banks, could
emerge to be a binding constraint, in adopting advanced approaches. This would need
innovative strategies and concerted efforts on the part of the banks to be able to attract and
retain the right mix of talent in the organisation.
Finally, the advanced approaches would also cast an onerous responsibility on the
supervisors of not only guiding the banking system through the implementation phase but
also of validating the internal models, system and processes adopted by the regulated
banks. This, needless to say, would require considerable capacity building and augmentation
of the domain knowledge and expertise of the supervisors themselves to ensure a
nondisruptive migration to the advanced approaches under Basel II. Let me hasten to assure all
of you that we, in the RBI, are quite live to the issue and strategic interventions have already
been planned in this regard.
Conclusion
I have provided a brief overview of the Indian approach to implementing Basel II framework
and the state of preparedness of the banks in India. Let me conclude by reminding those
present here that the Basel II framework provides significant incentives to banks to sharpen
their risk management expertise to enable more efficient risk-return trade offs; it also
presents a valuable opportunity to gear up their internal processes to the international best
standards. This would require substantial capacity building and commitment of resources
through close involvement of the banks' Top Management in guiding this arduous
undertaking. It is, no doubt, a demanding and daunting task, both for the banks as also the
supervisors, but I am sure that with concerted and dedicated efforts of all of us, we would be
able to measure equal to the task and cross yet another important milestone in our journey of
successfully implementing the regulatory reforms in the country.
Thank you.