BANK

MANAGEMENT
ABS
TRA
CT

Bank
s
face
a
varie
ty of
risks
such
as
the
ones
we
saw
durin

I would like to thank Dr Deepak Tandon for his guidance and timely inputs
without which this report would have never seen the daylight.

Introduction
After the economic reforms, which started transforming India into an openmarket economy credit started to grow in India. Bank credit to industrial sector
was at an elevated rate of over 20 percent on average between the years 20122016 before slipping down to -0.2 percent in August 2016. Bank credit in India
averaged 12.9 percent between 2012 and 2016, peaking at 18.70 percent in
April 2012.
With the growth of credit in India default rates increased. As of June 2016, the
total amount of gross NPAs for public and private sector banks is around `6 lakh
crore. Stressed loan in Indias banking sector crossed $138 billion in June 2016,
an increase of nearly 15% in just 6 months.
Risk management is the process of identification, analysis and
acceptance or mitigation of uncertainty in investment decisions.
---Investopedia (What is Risk
Management?)

Objective of the Study

To study the evolution of the BASEL Accords and the implications in the Indian
scenario.

Types of Risks
The bad picture of the NPAs and stressed loans in India proves the fact that risk
management has strong significance, especially in the financial world. The
probability that a health of banks are affected due to contingent factor(s) is the
risk of the banks. Risks in banks can be classified as follows:
Risk

Nonfinancial
Risk

Financial
Risk

Market
Risk

Credit Risk

Borrower
Risk

Intrinsic
Risk

BASEL

Portfolio
Risk

Interest
Rate Risk

Liquidity
Risk

Strategic
Risk

Currency
Forex Risk

Fumding
Risk

Hedging
Risk

Political
Risk

Legal

Operation
al Risk

The Bretton Woods system for managing foreign exchange broke down in 1973 1.
In 1974, there was a problem in Germany due to over-leverage in a bank. In
1974, in U.S., the Franklin National Bank of New York was closed after huge
foreign exchange losses.2
In 1975, the central bankers of G10 countries established Committee on Banking
Regulations and Supervisory Practises. This committee was later named as the
Basel Committee on Banking Supervision (BCBS). The committees objectives
were to provide for a forum for regular cooperation of the member countries on
banking supervisory matters and to enhance financial stability by improving the
quality of banking supervision across the world.

BASEL I
In 1988, the BCBS released a document titled International convergence of capital
measurement and capital standards. Also, known as the BASEL I norm for the
banking industry this document focusses on credit risk and defines the capital
requirements of a bank. See Appendix 1 for more details.
The committee recognized two classes of capital by function of its quality- Tier 1
and Tier 2. Tier 2 capital was limited to a maximum of 100% of Tier 1 capital. The
total capital a bank was required to hold was set at a minimum of 8% of riskweighted assets.
Although BASEL I introduced worldwide standard in regulations, introduced riskweighted assets concepts and segregated capital it had a few shortcomings.

Lack of risk sensitivity A loan to a small highly levered company and a

loan to a hug AAA-rated company consumes the same regulatory capital
because they are both risk-weighted at 100%
Limited Collateral recognition
Incomplete coverage of risk sources only credit risks were taken
care of. Market risks were included in an amendment to the document in
1996
Emphasis on book values rather than on market values

The BASEL I framework, though was relevant for retail banks, there was no
separate market risk discussion about Investment Banks.
In India, RBI had, in 1985, introduced the Health Code System indicating the
health of individual advances under eight categories satisfactory, irregular,
sick (viable), sick (sticky), advances recalled, suit filed accounts,
decreed debts, bad and doubtful debts. (Appendix-2)
The First Narasimham Committee Report recommended the introduction of riskweighted assets system for banks in India since April 1992. It was decided that
foreign banks operating in India would reach CRAR level of 8% by March 1995
and Indian banks with branches abroad would comply by March 1997. All other
1 Herstatt Bank: https://en.wikipedia.org/wiki/Herstatt_Bank

2 http://libn.com/2003/04/11/1974-franklin-national-bank-goes-under/

banks were required to reach CRAR level of 4% by March 1993 and 8% by March
1996.
Most banks had met the capital adequacy norm by March 1997. Although few
banks had negative CRARs during 2000-02 they reached minimum regulatory
levels by 2006. The public-sector banks, however, had to be infused with cash
from the government since most of them had shown losses after the introduction
of international standards. (Appendix-3)
Banks in India also tried to reduce their NPAs post-implementation of BASEL I
norms. (Appendix-4)

BASEL II
Since the implementation of BASEL I the banking scenario had undergone a lot of
change. Based on the inputs from the central bankers worldwide and from other
stakeholders BCBS released a document titled International Convergence of
Capital Measurement and Capital Standards: A Revised Framework popularly
referred to as the BASEL II Accord (Appendix- 5). Apart from the credit and
market risk; operational risk was considered in the calculation of CRAR
calculation.
The objectives of BASEL II document was:
1. To increase the international banking systems quality and stability
2. To create and maintain a level playing field for internationally active banks
3. To promote the usage of more stringent practises in the risk management
field
The first pillar of BASEL II Accord was Capital Requirement. The calculation for
minimum regulatory capital was an extension of the BASEL I accord. BASEL II has
recommended at least 8% CRAR and 4% Tier 1 CRAR. Though the 8%
requirement continued to be the reference value the way the assets were
weighted was significantly refined. Whilst BASEL I values were rough estimates,
BASEL II values were directly and explicitly derived from a standard simplified
credit risk model. There were three approaches to calculate the risk-weighted
value of assets standardized approach, foundation IRB, and advanced IRB. IRB
stands for Internal-ratings based approach to be calculated by the bank
themselves. The more advanced techniques required less capital for the bank.
Another important innovation in the first pillar was the Operational Risk an
explicit capital requirement for banks for risks related to losses arising from
process errors, internal fraud and information technology failures.
The second pillar to the framework was Supervisory Review. It required banks
to have internal systems and models to evaluate their capital requirements in
parallel to the regulatory framework and integrate their risk profiles to the
overall regulatory framework. Under pillar two, regulators were expected to see
that the requirements of pillar one were effectively respected. Regulators were
also required to evaluate the appropriateness of the banks internal models. If
the regulators determined that the banks capital wasnt sufficient, they could
take various actions to remedy the situation. Pillar two was very flexible because
it wasnt prescriptive. The most interesting part of the framework was that it
would oblige regulators and banks to closely cooperate in evaluating internal

models. This was done to create a dynamic necessary to standardize and better
understand the methods of evaluating credit risks. It was expected that this
would pave the way to internal model recognition and to its use as a basis for
calculating capital requirements.
BASEL IIs third pillar concerns market discipline requiring banks to disclose
market-related investments. These comprehensive reports on internal risk
management systems were required to be disclosed to the market at least twice
a year. This raised some confidentiality issues in the sector since the list of
elements to be published was thought to be exhaustive and confidential to a
bank. Parameter options chosen for Basel II included the description of risk
management objectives and policies, internal loss experience by risk grade,
collateral management policies, and exposures by maturity, industry, and
geographical location. The goal was to let the market place additional pressure
on banks to improve their risk management practices. It goes without saying that
bank credit and equity analysts, bond investors, and other market participants
found the disclosed information very useful in evaluating a banks soundness.
In summary, the six most noteworthy innovations that Basel II Accord brought to
banking regulations were
1.
2.
3.

Increasing sensitivity to capital requirements for different risk levels

Introducing regulatory capital needs for operational risk
Providing important flexibility in Basel II through several options that were
left at the national regulators discretion to suit local needs
4.
Increasing national regulators power, as they were expected under pillar
two to evaluate a banks capital adequacy by considering its specific risk
profile
5.
Improving the recognition of risk-reduction techniques
6.
Implementing detailed mandatory disclosures of risk exposures and risk
policies
Those measures should help the global industry progress in its general
understanding of credit risk management issues. The measures also constitute
the intermediary step before full internal model recognition.
In February 2005, RBI issued primary guidelines on BASEL II. Initially the target
for implementation was set for March 2007 but was later postponed. RBI
maintained a conservative approach and set a minimum of 9% CRAR and a
minimum Tier 1 capital CRAR requirement was 6% instead of 4.5% as originally
proposed by BCBS in Basel II Accord.
Till March 2009, except for local and regional rural banks, all Scheduled Banks in
India implemented BASEL II guidelines. The dates for implementation of
advanced models are as given I Appendix-6.
BASEL II has rewarded banks with superior asset quality and risk weights lower
due to risk sensitivity. On an average Indian banks CRAR improved due to the
implementation of BASEL II. (Appendix-7)
The drawbacks of BASEL II are as given below:

1. It provided incentive to a banks management to underestimate credit

risks. BASEL II norms allowed banks to implement their own models to
assess risks and ascertain the capital amount to meet regulations. Most
bankers followed overly optimistic risk models that allowed them to allot
less capital towards regulatory norms and to increase return on equity.
2. BASEL IIs effectiveness depended a lot on a strong regulator. The banks
had all the freedom to implement risk models and thus required strong
regulator to ensure that the norms were implemented in the true spirits.
3. BASEL II norms were not adequate in covering market risks. This was
especially true for investment banks which had large exposure to marketlinked securities. BASEL II allowed bonds issued as a part of securitization 3
to be treated as AAA securities. The shortcoming was particularly evident
after the sub-prime crisis in U.S.A. in 2007.

BASEL II.5
BASEL II.5 was implemented to strengthen the capital base, and so the banks
ability to withstand risk, by increasing the banks capital requirements.
BASEL II.5s four main features
1.
An additional chargeincremental risk charge (or IRC)was introduced.
This was introduced to estimate and capture default and credit migration risk.
Credit migration risk is when a customer moves his loan from one bank to
another bank.
2.
An additional charge for comprehensive risk measure was introduced. This
was introduced to correctly measure how one risk related to other risks. Often,
a rise in one risk also leads to a rise in another risk, although the effects may
show later. In finance, this risk is also known as correlational risk.
3.
Basel II.5 introduced stressed value at risk (or SVaR) as an additional
requirement to calculate capital requirements. The idea behind SVaR was that
under stressed conditions, banks may require more capital, and such capital
requirements arent fully captured in normal value-at-risk calculations. So to
include capital requirements under stressed conditions, SVaR was included.
4.
Basel II.5 also introduces standardized charges for securitization and resecuritization positions. Securitization and re-securitization were problems for
all regulators, as the popularity of these instruments was leading to loans
being incorrectly classified.
Basel II.5 tried to cover market risk for investment banks like Morgan Stanley and
Goldman Sachs, banks with major investment banking arms like JPMorgan and
Citibank, and other investment banks in an ETF.

BASEL III
After the financial crisis of 2008 a need was felt as banks in the developed
economies were under-capitalised, over-leveraged and had a greater reliance on
short term funding. The Lehmann Brothers fiasco was a good example as it
3 Securitization is the process of selling various types of loans like government,
mortgage, auto, and card loans pooled together as bonds. However, most of
these bonds contained assets that were junk grade.

showed that even big banks did not always understand the risks too well or were
ignoring the costs of inorganic expansion.
The banking sector was also poorly governed and their incentive structure
encouraged too much risk taking. The combination of these factors was manifest
in the mispricing of credit and liquidity risk and the excess credit growth.
To address these concerns, Basel Committee on Banking Supervision came out
with Basel III Accord (Appendix-8) in September 2010. Features of the proposed
BASEL III Accord are as follows:
1. Enhanced Capital Requirement: Banks in India are required to maintain
a minimum Tier 1 CRAR of 9% on an ongoing basis. With a view to
improving the quality and quantity of regulatory capital; it has been
decided that the predominant form of Tier-I capital must be in the form of
Common Equity. Non-equity Tier-I and Tier-II capital would continue to form
a part of the regulatory capital subject to eligibility criteria laid down by
BASEL III norms.
2. Introduction to Capital Conservation Buffer: This is an additional
reserve buffer of 2.5% raising the total requirement of Tier I capital to 7%.
This buffer is introduced to conserve enough capital to build buffers at
individual banks and the entire banking sector which can be used in times
of stress.
If a bank has complied with the minimum Common Equity Tier I capital
and Tier I capital ratios then the excess Additional Tier I capital can be
admitted for compliance with the minimum CRAR of 9% of Risk Weighted
Assets. (Appendix-9)
3. Introduction of Counter Cyclical Buffer: Per the new rules the local
regulators are not only responsible for controlling banks compliance with
the BASEL requirements but also for regulating credit volume in their
national economies. If credit is expanding faster than GDP, regulators can
increase the capital requirements with the help of Countercyclical Buffer.
Varying between 0% to 2.5% it can thus, preserve national economies
from excess credit growth.
4. Leverage Ratio (Ratio of Tier I capital to Total Assets): Per BASEL III
Tier I capital must be 3% of the Total Assets even if there is no risk
weighting during the parallel run period by 2017.
For the Indian Banks provisions relating to leverage ratio contained in
BASEL III document are intended to serve as the basis for testing the
leverage ratio during the parallel run period. During the period of parallel
run, banks should strive to maintain their existing level of leverage ratio
but, in no case, the leverage ratio should fall below 4.5%. Banks with
leverage ratio lower than 4.5% should endeavour to bring it up to 4.5% as
early as possible. Final leverage ratio requirement would be prescribed by
the RBI after the parallel run considering the recommendations of the
BASEL Committee.
5. Liquidity Risk Management: BASEL III introduces a new tool for liquidity
risk measurement called the Liquidity Coverage Ratio (LCR). It has been
designed to ensure that the bank maintains an adequate level of high
quality assets that can be converted into cash within a 30-day period
under an acute liquidity stress scenario specified by supervisors. The
standard specifies that the ratio be no lower than 100%. To ensure that

investment banking inventories, off-balance sheet exposures,

securitization pipelines and other assets and activities are funded by at
least a minimum amount of stable liabilities in relation to their liquidity
risk profiles the new Accord introduces Net Funding Stability Ratio (NSFR).

NSFR=

availableamount of stable funding

100
amount of stable funding required

Although BASEL III is, till date, the most stringent banking regulation, it still has
shortcomings.
1. The high regulatory capital requirement will increase barriers to entry in
the banking sector. This will benefit existing players by reducing
competition. It also carries significant risk in the sense that existing banks
might not be able to cater to the unbanked population of the earth,
anytime soon. (38% of the worlds adult population still doesnt
have a bank account) On the other hand, it increases capital
requirements of bigger players- systemically important players who are
more likely to be efficient, hindering their growth.
2. It doesnt change the risk weighting methods a major reason behind the
sub-prime crisis. Banks often hold structured AAA-rated products, but
those structured products are backed by assets that are often junk rated
and not AAA-rated.
Basel III also incentivizes banks to accumulate AAA assets, as they have
little or no capital requirement.
3. A lot of risk weighting depends on credit rating agencies. So Basel III is still
dependent on bond rating agencies, as weights are assigned based on the
rating. Evidence from the subprime crisis shows that credit rating agencies
can go wrong.
4. It aims to harmonize banking regulations across the world. Different
countries have different regulatory requirements. Some countries have
better regulatory frameworks than Basel III. In fact, some academic
studies suggest that when regulations are sought to be harmonized across
the world, they tend to move towards the worst regulations.
5. Its been suggested by some economists that Basel III Accord is likely to
hurt a countrys growth by keeping the scarce capital tied up. This is even
truer for less developed and developing nations.
Despite its shortcomings, BASEL III is currently the best possible regulatory
framework. Its designed to make banks more resilient. It also incorporates
lessons from the 2008 global financial crisis and aims to harmonize banking
regulations in an ever more interconnected world.
Basel III will help banks become stronger. Because of Basel III norms, banks have
increased their Tier 1 capital (see chart above). This makes capital base stronger,
and as a corollary, banks are better able to withstand external and internal
shocks.
But there are two sides of a coin to everything. Going ahead into the future, the
higher capital requirements imposed by Basel III will lower the return on equity of

banks, as more capital will be tied up and unproductive. This is likely to

negatively impact a banks valuation.

Challenges of Indian banking sector

With expected higher growth of GDP, the credit growth in India is expected to
pick up in the coming years mainly due to higher requirement of credit to
infrastructure sector and governments drive on financial inclusion. The
implementation of the BASEL III framework within 2019 would mean that the
banks would now need higher capital. So the cost of capital of the banks would
go up. This is because to meet the new norms, apart from government support a
significant number of banks must raise capital from the market. This will push
the interest rate up, and in turn, cost of capital will rise while return on equity
(RoE) will come down. To compensate the RoE loss, banks may increase their
lending rates. However, this will adversely affect the effective demand for loan
and, thereby, interest income, which may in turn affect the profitability of banks.
Further, with effective cost of capital rising, the relative immobility displayed by
Indian banks with respect to raising fresh capital is also likely to directly affect
credit offtake in the long run. All these will affect the profitability of banks.
Considering the current high level of NPAs along with poor operating profits, the
requirement of capital will be much more mainly in PSBs. Thus, to maintain the
required CRAR along with optimal use of capital the banks might make extra
effort in the following areas:
1. Shift from corporate to retail banking which requires lesser capital.
2. Change their facility from long-term lending to short-term lending thereby
allowing to manage the banks asset liability mismatch and reduce
liquidity risks.
3. Implementation of robust MIS and advanced data collection techniques
would improve their risk weighting capabilities thereby significantly
reducing the cost of capital.
4. Framing sophisticated risk management models for estimating major risks
correctly, setting up enterprise wide risk management systems so that all
types of risk in the bank in a single platform but also helps to save capital
through diversification benefit for capital computation where various risks
are negatively correlated.
5. Banks need to review their capital allocation to each client segment and
price it in line with the profile to ensure that capital is allocated to
segments that generate higher risk-adjusted returns.

Appendix 1:
BASEL I: Asset Classes &
Weights

Appendix-2: Health-Code System

(1985-86)

Appendix 3: Distribution of CRAR

during BASEL I implementation

Appendix 4: NPA position after

BASEL I

Appendix 5: Pillars of BASEL II

Appendix 6: Expected Dates of
Implementation of BASEL II

Appendix 7: CRAR under BASEL I

& II

Appendix 8: BASEL III

Appendix-9: BASEL III Capital

Requirements

Appendix-10: Comparative
Analysis of BASEL Accords
Types of
Risk
Covered

Main
tools of
Risk
Managem
ent

Basel 1
Credit Risk
Market Risk

Capital
to
Risk
Weighted
Assets Ratio
(CRAR)

Ways of Simple but

Calculati
standard
on of
Risk
4 major risk
Weighted
categories
Assets
of assets

Basel 2

Basel 3
Credit Risk
Market Risk
Operational Risk
Liquidity Risk
Counter Cycle Risk
1. CRAR
2. Supervisory
Review
3. Market Discipline
4. Liquidity
Coverage Ratio
5. Counter
cycle
Buffer
6. Capital
Conservation
Buffer
7. Leverage Ratio

Credit Risk,
Market Risk &
Operational Risk

1. CRAR
2. Supervisory Review
3. Market Discipline

Type

From Simple to Complex & flexible

Approach
Lesser Risk Weights in Complex
Approaches
of

Method 1

Method 2

Method 3

Same as Basel 2
but
additional
capital for Capital
Conservation
&
Contra
Cyclical
Buffer

and CRAR

and risk
weights
according
to it

Risk
Credit
Risk

Market
Risk
Operatio
nal
Approac
h

Major
Contribut
ion

First
International
Measure
to
cover
banking risk

Limitatio Too simple to

ns
cover
all
risks
Banks had to
raise
additional
capital

Minimum
CRAR per
BCBS

CRAR= 8%

Minimum
CRAR per
RBI

CRAR= 9%

Introduct
ion

1988: Credit
Risk
1996: Market
Risk

Standardi
zed
Approach
Standardi
zed
Approach
Basic
Indicator
Approach

Foundatio
n Internal
Rating
Based
Internal
Approach
Standardiz
ed
Approach

Advanced
Internal
Rating
Based
Model

Advance
d
Measure
ment
Approac
h
1. Covered Operational risk apart from credit Liquidity
Risk
& market risk
Management
2. Recognized differentiation & brought Will help to build
flexibility
capital
during
3. Better asset quality helped banks to
good time, which
reduce Capital Requirements
can be used in
stressed situation
by Counter Cycle
Buffer
Introduction
of
Capital
Conservation
Buffer
1. Additional Capital requirement for Op. Risk Requirement
of
2. Higher capital requirement in stressed
additional CRAR
situation as asset quality reduces. Capital
between 2.5% to
markets also dry at that time.
5%
3. High costs for up gradation of technology, Increased
disclosure & information system
requirement
of
4. Increased supervisory review required in
common equity
case of advanced approaches
share
capital
5. Subprime crises exposed the inadequate
also.
credit & liquidity risk covers of banks
CRAR= 8%
CRAR= 10.5% TO
Tier 1= 4%
13%
Tier 1= 6%
Common
Equity=
4.5%
CRAR= 9%
CRAR= 11.5%
Tier 1= 6%
Tier 1 = 7%
Common Equity= 3.6%
Common
Equity=
GOI recommended CRAR for PSU= 12%
5.6%
2004
2010

Impleme
ntation in
India:
Time line

1994

First Phase: 2008: Foreign Banks in India,

Indian Banks with presence outside India:
Basic Approaches
Second
Phase:2009:
Other
Scheduled
Commercial Banks
Till 2014: Complete Implementation

2013 to 2018
phased manner

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in