BASEL Norms and the risk management by Banks in India

Submitted by

VARUN.VM

Group A, PRN: 13010223028, Class of 2013-18

Symbiosis Law School NOIDA

Symbiosis International University, Pune

In

February, 2017

Under the guidance of

Mr. AMIT BAGGA

Faculty for International Banking and Finance

Symbiosis Law School NOIDA

Symbiosis International University, Pune

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 CERTIFICATE

The project entitled BASEL norms and the risk management by Banks in India
submitted to the Symbiosis Law School, NOIDA for International Banking and Finance
as part of internal assessment is based on my original work carried out under the guidance
of Mr. Amit Bagga from 06/January/2017 to 25/February/2017. The research work has
not been submitted elsewhere for award of any degree.

The material borrowed from other sources and incorporated in the thesis has been duly
acknowledged.

I understand that I myself could be held responsible and accountable for plagiarism, if
any, detected later on.

Signature of the candidate

Date:22/02/2017

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 Acknowledgment

It is a great opportunity for me to do a project on Basel norms and risk management by

Banks in India. At the time of doing this project I had gone through different books and
websites which helped me to get acquainted with new topics.

I acknowledge my sincere gratitude to Mr. Amit Bagga my respective teacher, whose

motivation has always been sincere and helpful in making me understanding the legal
concepts.

I thank the librarians of Symbiosis Law School NOIDA for their sincere support for
helping me to find various books. I also thank my family, teachers and friends for their
guidance and support. At last but not the least I thank Almighty God for giving me an
opportunity to do and submit this project on time.

Thank you

Varun.VM

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 Table of Contents

Contents Page number

Introduction- Emergence of Basel Norms 5

What is risk management and need for 6

improvised risk management

What are the recent global initiatives for 8

strengthening risk management practices in
Banks?

Risk management in State Bank of India. 12

(Case study)

Conclusion 13

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INTRODUCTION- EMERGENCE OF BASEL NORMS

Post chaotic liquidation of Herstatt Bank in Germany which was direct effect
of failure of Bretton Woods system, there was a call for need for formation of
body or committee to formulate guidelines and recommendations on banking
regulation. In the year 1974, Committee of Banking Regulations and
Supervision was established by the Central Banks of G-10 Countries. The
Committee had regular meetings at the Bank for International Settlements
located at Basel, Switzerland. This Committee was later renamed as the
Basel Committee on Banking Supervision. At present, the committee
comprises of 27 members and each member country is represented by their
respective Central Bank.

As a part of Banking regulation and supervision, the first set of Basel

accords, commonly called as Basel I came to force in 1988. It concentrated
on credit risk and recommended establishment of banking asset
classification system on the basis of the inherent risk of the asset. The
second set of Basel accord was issued in June, 2004 with an object to
regulate the misuse of Basel I norms through regulatory arbitrage. The Basel
II accord focused on creating a uniform international standard on the
amount of capital that banks need to guard themselves against risks,
specifically- financial and operational risks. As per this norm the Banks are
required to maintain adequate capital proportional to the risk to which bank
is exposed. The Basel II accord emphasized on disclosure requirements. The
third Basel accord which is considered as child of global financial crises is still
in process and will be implemented by 2018. It focuses on strengthening of
capital requirements, bank liquidity and leverage. The Reserve Bank of India
commenced the implementation of Basel III norms in April, 2013 and its
expected to complete implementation by the end of 2019.

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This research paper aims to build a deeper understanding of the emergence
of BASEL banking norms, its objectives and relevance. The primary purpose
of developing this understanding is to further analyze the extent of
effectiveness of the BASEL norms in risk management in Indian scenario.
This research project also covers about the risks to which the banks are
exposed and role of RBI in mitigating such risks through effective risk
management.

WHAT IS RISK MANAGEMENT AND NEED FOR

IMPROVISED RISK MANAGEMENT?

For the sake of understanding, the research question has been sub-divided
as follows:

1. What is the meaning of term risk?

Before answering this research question it is essential to understand what is

the meaning of term risk with respect to banking sector. As the meaning is
subjective in nature, literature review has been adopted as the tool to define
the term risk.

A risk can be defined as an unplanned event with financial results

resulting in loss. (Vasavada Kumar, Rao & Pai, 2005)1
Risk refers to a condition where there is a possibility of undesirable
occurrence of a particular result which is known or best quantifiable
and therefore insurable. (Periasamy, 2008)2
Risks may be defined as uncertainties resulting in adverse outcome,
adverse in relation to planned objective or expectations. (Kumar,
Chatterjee, Chandrasekhar & Patwardhan 2005).3

1
Vasavada, Gaurang., Kumar, Sharad., Rao, S. Upendra., Pai, Satish.(2005). General Bank
Management. Mumbai: Indian Institute of Banking and Finance
2
Periasamy, P. (2008). Financial Management. India: Tata McGraw Hill Education India)
Private Limited

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2. What are the types of risks to which the banks are exposed to?

Liquidity risk: The liquidity risk of banks arises from funding of long-
term assets by short-term liabilities, thereby making the liabilities
subject to rollover or refinancing risk.4
Interest rate risk: Interest Rate Risk arises when the Net Interest
Margin or the Market Value of Equity (MVE) of an institution is affected
due to changes in the interest rates. In other words, the risk of an
adverse impact on Net Interest Income (NII) due to variations of
interest rate may be called Interest Rate Risk.5
Operational risk: An operational risk is the risk of direct or indirect loss
resulting from, inadequate or failed internal processes, people and
systems or from external event.6
Solvency risk: The term solvency is always associated with sufficiency
of fund. It is the risk of not having adequate capital to meet out the
losses arising due to all other risk factors.
Market risk: This is usual risk faced by bank due to change in market
variables. The risk of adverse deviations of the mark-to-market value
of the trading portfolio, due to market movements, during the period
required to liquidate the transactions is termed as Market Risk.7

3. What is risk management?

The term risk management simply means anticipation of risk involved in a

particular sector and averting or minimizing the loss arising out of such risk.
When it comes to banking sector it can be defined as the process of

3
Kumar, Ajay., Chatterjee, D.P., Chandrasekhar, C. & Patwardhan D.G. (2005). Risk
Management. Mumbai: Indian Institute of Banking and Finance.
4
ibid
5
Sharma, H.S. (2003, May). Risk management in banks emerging issues. Banking
Finance, 2-6
6
Jurgen H M, Van Grinsven, Improving operational risk management, Amesterdam, 2nd ed.
2009
7
Supra note 3

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identification and measurement of risk followed by monitoring and reporting
to ensure that the returns are appropriate to the risk undertaken and risk
undertaken are commensurate with the risk appetite and risk tolerance.8 The
bank has to ensure that the it holds sufficient capital backed by reserves to
maintain the solvency.

4. What is the need for improvised risk management?

The two most watershed developments that have made it mandatory for
Commercial banks in India to emphasize on risk management are as follows:

Deregulation: Early 1990s witnessed deregulation in financial sector-

both Banking and Insurance. Deregulation provided banks more
autonomy in lending, investment, interest rate etc. Followed by
deregulation, the banks managed their business themselves and
maintained liquidity and profitability. This made banks think about
improved risk management.
Technological developments: Information Technology has changed
the face of banking sector. It provided an effective platform for
improvisation of services. It also enabled the bank to manage assets
and liabilities in an efficient way. But, all these developments also
increased the diversity and complexity of risks which the banks were
exposed to. This compelled the bank to implement effective risk
management policies.

WHAT ARE THE RECENT GLOBAL INITIATIVES FOR

STRENGTHENING RISK MANAGEMENT PRACTICES IN
BANKS?

8
Why risk management assumes greater significance in banks: RBI , available at
http://www.indiainfoline.com/article/news-top-story/why-risk-management-assumes-
greater-significance-in-banks-rbi-114050900190_1.html

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The 1988 and 2006 Basel accords gave weightage to importance of risk
management. It linked the banks capital adequacy to the risk weighted
assets (hereinafter referred to as RWA) on account of credit and RWA
equivalent for market and operational risks.9 The second Basel accord used
principle of proportionality as a tool for the purpose of risk measurement and
management of credit, market and operational risks. The three pillars can
thus be summarized10 as follows:

Pillar 1 sets out minimum regulatory capital requirements the

minimum amount of regulatory capital banks must hold against
the risks they assume;
Pillar 2 sets out the key principles for supervisory review of a
banks risk management framework and its capital adequacy. It
sets out specific oversight responsibilities for the Board and
senior management, thus reinforcing principles of internal
control and other corporate governance practices; and
Pillar 3 aims to bolster market discipline through enhanced
disclosure by banks.

Basel III compared previous accords emphasize on improving the quality and
quantity of loss absorbing capital that a bank holds and aims at increasing
the risk coverage of capital framework, in particular for trading activities,
securitizations exposures to off-balances sheet vehicles and counterparty
credit exposures arising out of derivatives.11 Basel III framework regarding
risk management can be summarized as follows12:

9
Supra note 8
10
Risk review and disclosures under Basel III Framework for the period ended 31 March
2015 available at https://www.sc.com/in/assets/pws/pdf/SCB-India-Pillar-3-Disclosures-
31st-March-2015.pdf
11
Supra note 8
12
ibid

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 Banks are required to raise the amount of common equity from 2% to
4.5% of assets by January, 2009.
Minimum for Tier one capital has been increased to 6%.
The innovative elements of the Basel III requirements include
additional layers of capital in form of the Capital Conservation Buffer
and Countercyclical Capital Buffer, minimum Liquidity requirements
in the form of short term Liquidity Coverage Ratio (LCR) and long
term structural Net Stable Funding Ratio (NSFR), a leverage ratio as
a back-stop to the risk based capital framework and additional
proposals for the Global Systemically Important Banks (G-SIBs).13
The Capital Conservation Buffer is prescribed as 2.5% of common
equity in addition to the 4.5% minimum requirement bringing the
total common equity requirements to 7% which if breached would
restrict pay-outs of earnings to help protect the minimum common
14
equity requirement.
To mitigate credit risk, the framework further increased the minimum
capital requirement from 8 percent to 10.5 percent.15
Basel III framework proposed a leverage ratio which provides that
banks total assets should not exceed its capital by 33 times.16

WHAT ARE THE RECENT DEVELOPMENTS AND EMERGING

REGULATORY SCENARIO IN INDIA FOR IMPROVING RISK
MANAGEMENT IN BANKS?

13
ibid
14
ibid
15
Dr. Ravindra Tripathi, Analysis of Basel III and Risk Management in Banking, available at
http://www.newmanpublication.com/May15_issue/5.pdf
16
ibid

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Following are steps taken by RBI to implement Basel III accord in India. The
implementation started in the year 2013 and is expected to be completed in
the year 2019.

As against the minimum Tier 1 leverage ratio of 3 per cent proposed

by the Basel Committee of Banking Supervision (Basel Committee)
during the parallel run period beginning from January 1, 2013 to
January 1, 2017, the Reserve bank has prescribed a minimum Tier 1
leverage ratio of 4.5 per cent during the parallel run period. The
leverage ratio framework is being revised in line with the recent
proposals of the Basel Committee.17
The Reserve Bank has issued enhanced Pillar 3 disclosure
requirements effective from quarter ended September 30, 2013 to
improve transparency of regulatory capital and to enhance market
discipline.18
Comprehensive liquidity risk management (LRM) guidelines were
issued on November 7, 2012. Based on the recent guidelines
published by the Basel Committee on Liquidity Coverage Ratio (LCR)
in January 2013, the Reserve Bank is in the process of finalizing its
guidelines on LCR which are expected to be issued shortly.19
The guidelines issued by the Reserve Bank on July 2, 2013 (effective
January 1, 2014) on capital requirements for bank exposures to CCPs
provide incentives for banks to clear standardized OTC
derivatives contracts through qualified central counterparties20.
While none of the Indian banks figure in the list of G-SIBs, domestic
SIBs have to be identified. A draft framework for dealing with the D-
SIBs has been published on December 2, 2013. It requires that

17
Supra note 8
18
ibid
19
ibid
20
ibid

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 additional common equity capital requirement applicable to a D-SIB
with highest systemic importance will be 0.8% of RWAs.21
The Reserve Bank revised its guidelines on securitization in May
2012 and introduced norms on minimum holding period, minimum
retention ratio, and standards for due diligence to align the interest
of the originators and investors, and induce Skin in the Game
concept to discourage Originate to Distribute models 22.
Un-hedged foreign currency exposures (UFCE) of the corporates are
a cause of concern as they pose risk to the individual corporates as
also to the entire financial system. Guidelines on risk management of
un-hedged exposures as also the methodology to be followed by
banks for computing incremental provisioning and capital
requirements for exposure to corporates having un-hedged foreign
currency exposures have since been introduced 23.
The Reserve Bank has from time to time also issued regulatory
guidelines on other areas such as Corporate Governance, Fit &
Proper, Know Your Customer/Anti Money Laundering, Credit
Information Sharing, Customer Services in addition to specific
guidance on credit, market and operational risk management etc., to
strengthen the over-all risk management culture in Indian banks 24.

RISK MANAGEMENT IN STATE BANK OF INDIA

The following chart25 summarizes the risk management framework in State

of India. The existing framework is in accordance with the Basel II accord
guidelines.

21
ibid
22
ibid
23
ibid
24
ibid
25
International Journal of Management (IJM), ISSN 0976 6502(Print), ISSN 0976 - 6

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CONCLUSION

Risk factor is unavoidable in banking business. Its not possible to nullify

totally the loss caused by various risks. But through effective management
of it is possible to mitigate the extent of damage caused by risks. Currently
banks in India are working in accordance with the risk management practice
laid down in Basel II accord. The credit goes to RBI for effective
implementation of risk management policy. Apart from this, RBI is also
carrying out on-site and off-site surveillance methods for effective risk
management. This caution on the part of RBI has always protected the
economy of country from economic downfalls.

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