International lending to developing and emerging economies.

Under the CP 3, banks have the choice to adopt any one of the following methods for measuring credit risk:

• Standardised Approach (SA)

• Foundation Internal Ratings Based Approach (FIRB)

• Advanced Internal Ratings Based Approach (AIRB) Under the SA, the risk weight for sovereign exposures would depend upon the rating assigned to such sovereign exposures by export credit agencies. Under the IRB (Internal Ratings Based) Approaches, the risk weight would depend upon the rating by the banks' internal ratings model and is computed as a function of the following four factors - probability of default, loss given the default, exposure at default and maturity. While the risk weight for exposures with the lowest rating (Below B-) under the SA is 150%, the same is likely to theoretically go up to 1250% under the IRB Approaches. This clearly illustrates the extent to which the IRB Approaches are more risk sensitive than the Standardised Approach.

It is unlikely that a developing economy would receive the best of the ratings. It is also largely unlikely that an entity in a developing economy would attract a rating better than the sovereign rating of that economy. In the circumstances, a bank adopting the IRB Approach is likely to be more averse to exposures to developing economies both directly (to the sovereign) and indirectly (to entities in that economy). As has been brought out convincingly in the paper 'Basel II and Developing Countries: Diversification & Portfolio effects' by Stephany Griffith-Jones, Miguel Angel Segoviano and Stepphan Spratt - this aversion may translate into either avoidance of risk or appropriate pricing of the risk resulting in the following scenario * :

Widespread adoption of the IRB Approach by internationally active banks would lead to a significant increase in capital requirements for loans to lower rated borrowers. To the extent that the pricing and availability of international bank loans is influenced by the capital requirements that relate to them, this would imply a sharp increase in the cost and/or reduction in the quantity of international lending to developing and emerging economies. The expressed purpose of the Basle II norms is to better align regulatory capital with actual risk. Therefore, failure of the proposals to take account of the benefits of international diversification suggests that, risk has not been measured accurately. By excluding the possibility that banks' capital requirements should take account of portfolio and diversification effects, the proposals effectively impose an inaccurate measure of risk, at the portfolio level. The fact that the proposals under Basle II will not allow these diversification benefits to be taken into account, suggests that the regulatory capital associated with lending to developing countries will be higher than that which the banks would - and currently are - choosing to put aside on the basis of their own models.

RBI is of the view that there is a strong case for revisiting the risk weights assigned to sovereign exposures when the exposures are aggregated as a portfolio which enjoy the benefits of diversification similar to the approach adopted for retail exposures.

The Basel Committee has indicated that the changes made in the trading book are consistent with the changes in the banking book capital requirements under the Standardised Approach. However, the Committee's proposal to provide explicit capital charge on the basis of ratings is not consistent with the banking book capital requirements in respect 'other category' which attracts a uniform capital charge of 8% (risk weight of 100%) and does not compare with the risk weight of 150% being proposed for claims on sovereigns, banks and corporates that are rated below B-. Unless, the capital charge or risk weights are uniform both in the trading and banking books, the New Accord may lead to banks resorting to regulatory arbitrage.

RBI, therefore, reiterates that the capital charge for specific risk in the banking and trading books should be consistent to avoid regulatory arbitrages.

RBI shares the Committee's view that market discipline can contribute to a safe and sound banking environment. RBI also shares the Committee's view that too much information could blur the key signals to the market and agrees with the proposal to make a clear distinction between core and supplementary disclosures. Further, the proposals to mandate frequent disclosures on information, subject to rapid time decay, would facilitate market participants in taking informed decisions.

The Committee's views are apparently based on the assumption that capital discharge would be available on assigning preferential risk weights to claims on sovereigns, banks and corporates, on the basis of external assessments and recognition of more collaterals under credit risk mitigation techniques.

However, RBI feels that the adoption of the New Accord would definitely enhance the minimum regulatory capital, especially for banks domiciled in emerging markets on account of the following:

1. All claims on sovereign in India are currently assigned a uniform risk weight of 0%. The discretion to assign a lower risk weight would henceforth be available to claims on sovereign (or Central Bank) of incorporation, denominated in domestic currency and funded in that currency. Other sovereigns are required to be assigned risk weight in the range of 0% to 150% on the basis of external assessments;

2. Similarly, under the Current Accord, all claims on banks are assigned a uniform risk weight of 20%. The 20% risk weight would become the floor under the proposed accord. Since most of the banks are not rated they would have to be assigned a risk weight of 50%;

3. The population of rated corporates is very small and hence most of them would have to be assigned a risk weight of 100%. The benefit of lower risk weight of 20% and 50% would, therefore, be available only to very few corporates;

4. Past due loans, net of specific provisions, would have to assigned a risk weight of 150% if the specific provisions are less than 20% of the outstanding amount of the loan if it is not fully secured or 15% of the outstanding amount of the loan if it is fully secured;

5. Claims on certain high-risk exposures viz. venture capital and private equity, at national discretion, are also required to be assigned a higher risk weight of 150%;

6. The deduction of significant investments in commercial entities; and

7. Explicit capital charge requirement for operational risk.

The benefit of credit risk mitigation techniques also may not be available as most of the banks in emerging markets are not in a position to comply with the preconditions stipulated by the Basel Committee. These apprehensions were confirmed by the findings of the QIS 3 conducted by the Committee.

The RBI therefore reiterates that unless suitably modified, the adoption of the New Accord in its present format would result in significant increase in the capital charge for banks, especially in emerging markets.

The Reserve Bank of India (RBI) has decided to convene a meeting of banks before this year-end to assess implications of implementing of the New Basel Capital Accord (Basel II) by 2006-07. Although the Basel document is still not final, the basic architecture is now set and the Reserve Bank of India (RBI) in consultation with banks will evaluate the new framework and plan for the transition of Indian banks to Basel II. The timing, approach, and sequencing of Basel II, which seeks to align capital requirements of banks with their actual risks, will have to be closely tailored to Indian circumstances. The reservations, if any, of RBI are based on the fact that Indian banks do not have the support of sophisticated MIS/data processing capabilities that can measure risks. Our Banks do not have robust rating systems and historical data on probability of default. Nor do the supervisory authorities maintain time series data for estimating loss given default to implement the foundation of internal ratings based (IRB) approach. The complexity and sophistication essential for banks for implementing Basel II restricts its universal application in the emerging markets. In regard to the standardized approach, which builds on the existing Basel I, RBI's concerns are in regard to the use of external credit rating agencies.

[Source: Press Interview by RBI Executive Director Ms.Shyamala Gopinath.]

Commenting on the problem faced by the Banks in India, The Economic Times in an article titled "Moving in tandem" in its online issue dated Wednesday, June 18, 2003 observes that "There are 105 banks in the country with 55,000 branches - a majority of the public sector banks lack data due to late computerisation. At the outset then, this means huge scale IT investments are being made to have the one critical element to implement Basel II successfully: Clean and reliable data - data that is accountable.

"Take for example credit risk - according to the New Basel Capital Accord, internal ratings must be 'grounded in the banks historical experience and empirical evidence'. This follows from the fact that data analysis and statistical modelling are the fundamental basis of any internal rating system - wherein the bank's own default and loss experience is the essential data source for the creation of the rating model.

"At this point, it is important to note that as per the Accord, even though the use of pooled data and mapping of internal rating grades to external data sources are explicitly allowed by the Accord, it is also stated that internal data must always be used, at least to complement these techniques. This is because a rating model that is built on internal data using internal resources is likely to be the superior choice for an internal rating system in most circumstances. It would optimally support banks in generation of disclosure reports, aggregation and decomposition of risk measures, generation of migration matrices, conducting vintage analysis for tracking realised default rates, quality control, rating system monitoring and assessing the model validity.

"More importantly, it establishes a solid foundation for a path towards Risk Adjusted Performance Management from a strategy perspective. Thus, on an immediate basis, banks need to collect and store a minimum of 3-5 years worth of historical data, ensure data integrity and timeliness of figures, effectively integrate different risk types and guarantee accurate calculation of risk measures."

Focussing the problem faced by Indian Banks from a different perspective, Business Line, Financial Daily from Chennai in its online edition dated Wednesday, December 12, 2002 observes as under

THE much-publicised and oft-debated Basel-II Capital accord has faced growing opposition and provoked concerns over issues such as systemic risk owing to "model-convergence" and "pro-cyclical lending". Notwithstanding these criticisms, the inordinate delays and inherent complexities of the proposals, major international banks have already started preparing the roadmap for taking full advantage of the new Basel-II regime. Most banks in India and other developing countries will face stiff competition from these large banks, as the opening up of the banking sector under WTO's General Agreement on Trade in Services (GATS) and the rolling out of Basel-II will be more or less coincidental and also because the business implications of the two are complementary in nature.

The internal ratings-based (IRB) approach proposed by the Basel Committee on Banking Supervision seeks to make bank regulatory capital requirements for credit risk approximate the economic capital requirements. The new accord provides for a win-win situation for mostly large and sophisticated global banks. These banks will be able to function at the lower capital requirements at transaction levels and "cherry pick" the best of deals by aggressive pricing. This is particularly true for acquiring AAA type of assets, as these banks will be able to release substantial capital by using sophisticated risk measurement techniques in their IRB models.

On the other hand, small banks, particularly those outside G10, will be able to apply only simple risk measurement (or standardised) approaches. These banks will have a difficult time competing with their big and sophisticated counterparts, as the regulatory capital requirements for them will be far more than the economic capital they actually need and this regulatory overhead will prove to be a major cause of inefficiency. Unable to compete for quality assets in a market where banks are already price takers, these banks will be left with the lower bands of the rating spectrum. Which means a riskier balance-sheet, lower credit rating and higher cost of liabilities. The weak getting weaker in a vicious cycle.

Economic capital-based (ECB) models help banks in capital budgeting, deal pricing and performance measurement in a "risk-adjusted" framework. As against the traditional financial performance measure of absolute returns, banks can now evaluate performance across the business units using the same performance measure: Risk-adjusted returns. Two businesses that make the same amount of money may involve very different amounts of risk and, hence, economic capital. A bank may accordingly decide the capital allocation and form a business strategy with a target risk-return profile, which then gets reflected in its credit rating and share price."

To introduce economic capital models, banks will need to understand two elements of economic capital assessment. The first is calculating aggregate economic capital across all sources of risk (simultaneously capturing the underlying diversification that exists among them). The second is allocating that capital to individual business units or profit centres on a risk-efficient basis. Banks must realise that models based on economic capital framework will help in risk-adjusted capital allocation, risk-adjusted pricing and risk-adjusted performance measurement. Moreover, pillar three of the new Basel accord aims at setting a framework for bolstering market discipline, allowing shareholders to see their risk profile."

"Although the time line for Basel implementation seems to be far off (around 2006) and many areas of the accord have not yet been finalised, it will be prudent for banks in developing countries and local regulators to start initial work. The RBI has already communicated to commercial banks under its jurisdiction that they may upgrade their credit-risk management systems for optimising capital if they wished to take advantage of inbuilt capital incentives available under the IRB models in the new accord.

"There is no doubt that most banks will benefit from the economic capital framework, which is in line with Basel-II discussions and proceedings and modern financial academics. It will provide them with a platform to develop models for managing their businesses efficiently and to compete with the large sophisticated players. It will also help them learn how to use their capital in the most efficient manner, which will be the key to survival in a global, unconstrained and ruthless market in financial services.

"Those banks which develop expertise as well as global standards of risk measurement and analysis, reporting and disclosure now will benefit from improved IRB models and find themselves equipped to face the "activist investor". Those who do not, will be targets for increased consolidation in this capital-starved sector. Some will be purchased and some will go bankrupt, unless there is a bailout package in the offing from taxpayers."

"Basel II represents a logical and appropriate successor to Basel I. Its basic message is that all parts of the international financial system - banks, supervisors and other market participants - can and must become more discriminating in their approaches to risk, and better equipped to anticipate problems before they turn into crisis. The events of the past few years in industrialised as well as developing economies have forcefully driven this lesson home to banks and supervisors alike. Basel II thus reflects both the lessons of the recent past and the direction in which private and official sectors must continue to move.^**

"It is a major, ambitious, and difficult effort, very much a work-in-progress. And it is in all our interests to continue improving it and help make it succeed."^**

Before beneficial implementation of Basel II standards accompanied by expert risk-management techniques suited to reap the optimum advantage of capital usage, Indian Banks need to implement total IT usage in their functioning and operations with inter-connectivity of their branches and administrative offices along with re-engineering of their functional systems & business process, as also human resource development policies at par with global standards. This process started with the Banking Sector Reforms in 1992, but subsequently there is so-down in recent years. But when the transformation in all above mentioned areas comes through, Indian Banking can achive not only global standards but global leadership, together possessing knowledge superiority and cost advantage. Basel II is thus a challenge as well as an opportunity.

^*Stephany Griffith-Jones, Miguel Angel Segoviano and Stepphan Spratt - Basel II and Developing Countries: Diversification & Portfolio effects.
^**Dr.V.L.N.Sastry, Country Head, Firstcall India Equity Advisors Pvt.Ltd.,Mumbai in an article titled "BASEL II - Impact on Banking Sector" published in "Analyst" in its October, 2003 issue.