Banks will have to continuously improve the quality of their internal loss data with Basel-II requiring them to have at least five years of data, including a downturn.
Basel panel chief Nout Wellink highlights areas of importance.
New Delhi, March 6 The Rs 60,000-crore loan waiver announced in the Union Budget 2008-09 to benefit four crore farmers in the country and the hit that ICICI Bank has taken — marked-to-market losses of $264 million due to exposure to overseas credit derivatives and investments in fixed income assets — together exemplify the predicament of the country’s banking industry, in not being able to price risks properly in their core competence of lending.
No doubt, India is bracing itself for implementation, from March 2009, of the New Capital Adequacy Framework by Banks under Basel-II, with the regulator, the Reserve Bank of India, monitoring the ground-level action by the commercial banks.
Financial turmoil
It is interesting to note that on Tuesday, the President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, Dr Nout Wellink, laid out how the implementation of the Basel-II framework would provide an opportunity for banks and supervisors to strengthen the banking system against financial and economic shocks.
It is interesting to note that on Tuesday, the President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, Dr Nout Wellink, laid out how the implementation of the Basel-II framework would provide an opportunity for banks and supervisors to strengthen the banking system against financial and economic shocks.
No doubt, the Basel-I framework played a key role in raising capital levels across the banking system over the late 1980s and 1990s. But as recent events demonstrate in the wake of financial market turmoil, following the onset of sub-prime crisis in the US and the exposure of leading financial institutions to financial innovations, Dr Wellink said it has failed to deliver on the four objectives.
The first objective was to develop a more meaningful link between banks’ on- and off-balance sheet risk exposures and the capital supporting them. The second objective was to beef up the links between sound regulatory capital and risk-based supervision, as a way to foster strong risk management practices at banks.
The third objective was to enhance market discipline through better information about banks’ risk profiles, risk measurement techniques and capital. And the fourth objective, the Basel Committee endeavoured to develop framework that was adaptive to rapid financial innovation.
Business strategy
Underlining the need for banks to put in place sound internal ratings classification systems that decompose any exposure into its probability of default, loss given default and exposure at default, subject to stringent supervisory standards and internal controls, Dr Wellink outlined a few areas of importance, relevant to the current crisis plaguing the global financial markets.
Underlining the need for banks to put in place sound internal ratings classification systems that decompose any exposure into its probability of default, loss given default and exposure at default, subject to stringent supervisory standards and internal controls, Dr Wellink outlined a few areas of importance, relevant to the current crisis plaguing the global financial markets.
First, Basel-II delivers great risk differentiation. Banks that move from prime into sub-prime mortgage lending or that move from traditional corporate lending into leveraged lending would see a hike in their capital, commensurate with the changing business strategy and risk profile. Under Basel-I, all such exposures receive the same charge.
Second, off-balance sheet contractual exposures to Structured Investment Vehicle (SIVs) and conduits would be brought into the fold and subject to regulatory capital, whatever the accounting treatment.
Third, there will be much more risk-sensitive treatment for securitisation exposures. This would foster more neutral incentives between retaining an exposure on the balance sheet or distributing it in the market through securitisation.
Four, banks will have to develop more rigorous approaches to measure and manage their operational risk exposures and hold commensurate capital.
Fifth, banks will have to develop more rigorous methodologies for capturing counterparty credit exposures, including so-called wrong way risk.
Capital Cushions
Over and above these, banks will have to continuously improve the quality of their internal loss data with Basel-II requiring them to have at least five years of data, including a downturn. The requirement for banks to perform stress tests of their on- and off-balance sheet exposures is an additional safeguard.
Over and above these, banks will have to continuously improve the quality of their internal loss data with Basel-II requiring them to have at least five years of data, including a downturn. The requirement for banks to perform stress tests of their on- and off-balance sheet exposures is an additional safeguard.
Based in part on these stress tests, banks would need to demonstrate to supervisors that they have adequate capital cushions to manage through a down cycle.
As Dr Wellink put it, taken together, these measures would introduce a more rigorous, forward-looking perspective on the types of risks that banks could face in a downturn. They will require banks to factor these risks into minimum regulatory capital, internal capital planning and disclosures to the market.
Financial analysts contend that the country’s apex bank should take the cue from the thoughtful suggestions of Dr Wellink and maintain due vigilance on the country’s financial institutions’ growing exposure to high-risk financial instruments and also loan losses they are subjected to, at the behest of political dispensation.
G. Srinivasan
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