residential mortgage and 125 % for personal loans. these are hard decisions which we, as a regulator, have taken with a view to capturing the true level of underlying risk knowing fully well that this might cast a burden on the banks in india. d ) internal capital adequacy assessment process the internal capital adequacy assessment process which forms an important element of pillar ii is an integral and important part of the basel ii framework. yet, some doubts are being raised with regard to its relevance for banks adopting standardised approach and basic indicator approach. i would like to mention here that though pillar ii is not a formal part of basel i framework, the reserve bank has been discharging some of the pillar ii responsibilities even under the current framework. the basel ii framework takes this a step forward by making it a formal requirement. the additional element which casts some formal responsibility on the banks under the new framework is that banks are required to put in place an effective internal capital adequacy assessment process ( icaap ) which should not only address the 3 major risks ( viz. credit risk, market risk, and operational risk ) but also other risks for which explicit capital has not been prescribed under pillar i. further, banks are also required to address suitably other dimensions of the three pillar i risks. a professionally managed bank would suo moto strive to plan for and achieve most efficient use of capital even if there were no formal regulatory requirement. the icaap merely attempts to formalise these efforts of bank managements as a part of the capital adequacy framework. i am sure this would clarify the relevance of including icaap as an integral part of pillar ii. e ) stress testing stress testing has become an integral part of banks ’ risk management systems and is used to evaluate their potential vulnerability to certain unlikely but plausible events or movements in financial variables. the supervisory review process under pillar 2 of basel ii framework 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. banks must demonstrate, under the internal capital adequacy assessment process prescribed by pillar 2, that they have enough capital to not only meet the minimum capital requirements but also to withstand a range of severe but plausible shocks. in the above background, the need for banks in india to adopt ‘ stress tests ’ as a risk management tool has been emphasised in the annual

a perverse incentive to remain unrated. since it might not be fair to assume up - front that all unrated entities are high risk entities, we have decided to presently adopt the 100 per cent risk weight for unrated exposures – as prescribed in the basel ii framework. however, we propose to review the health of unrated exposures in banks through the pillar ii process as well as the other onsite and offsite feedback mechanisms and revise the risk - weights for unrated exposures, if warranted. the domestic rating agencies are also placed in a unique situation, which impacts their default statistics. two significant factors in this regard are : ( a ) they have a small base of rated entities and ( b ) they lack the geographical diversification benefits which the international rating entities enjoy. interaction with the rating agencies have indicated that the processes and methodologies adopted by them were generally in alignment with those of the international rating agencies and despite the above two constraining factors their default statistics may not be out of sync with the basel trigger ratios. c ) national discretion the basel ii framework offers the national supervisors an element of discretion in several areas to enable them to adopt the framework to suit their respective banking systems. it is likely that the discretion available under the framework might induce apprehension / expectation in some quarters that national supervisors might adopt the most lenient options – thus diluting the rigour of the basel ii framework. in india, we have adopted an objective approach while deciding on the items of national discretion. consequently, we have taken a conservative view on certain areas of national discretion. some of the areas where the discretion exercised by us is on a more conservative level are : o state government guaranteed exposures attract a higher risk weight of 20 per cent, though the framework allows a zero per cent risk weight. o exposures to public sector enterprises are treated on par with corporate exposures though the framework allows them to be treated on par with bank or sovereign exposures. o while, under option 1, we have discretion to apply 20 % risk weight for exposures to all banks we have decided to extend this concessionary risk - weight only to exposures to scheduled banks. exposures to non - scheduled banks will be treated separately and assigned a riskweight of 100 %. o though the basel ii framework allows lower risk - weight of 35 % for residential mortgage and 75 % for personal loans ( as part of retail ) we have opted to assign a higher risk - weight of 75 % for