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INTRODUCTION OF BASEL 1

Basel I is a framework for calculating Capital to Risk-weighted Asset Ratio (CRAR). Itdefines a banks capital as two types: core (or tier I) capital comprising equity capital anddisclosed reserves; and supplementary (or tier II) capital comprising items such as undisclosed

reserves, evaluation reserves, general provisions/general loanlossreserves, hybrid debt capital instruments and subordinated term debt.

Under Basel I, at least 50 per cent of a banks capital base should consist of core capital.

In order to calculate CRAR, the banks assets should be weighted by five categories of credit risk

0, 10, 20, 50 and 100 per cent. In 1996, an amendment was made to Basel I to incorporate

market risk, in addition to credit risk, in the calculation of CRAR. To measure market risk, banks

were given the choice of two options:

a. A standardized approach using a building block methodology

b.An in-house approach allowing banks to develop their own proprietary modelsto calculate capital charge for market risk by using the notion of Value-at-Risk(VaR).

Adopting the general approach of gradualism, India implemented the Basel I frameworkwith effect from 1992-93 which was, however, spread over 3 years banks with branchesabroad were required to comply fully by end March 1994 and the other banks wererequired to comply by end March 1996. Further, India responded to the 1996 amendmentto the Basel I framework which required banks to maintain capital for market riskexposures, by initially prescribing various surrogate capital charges for these risksbetween 2000 and 2002.

LOOPHOLES OF BASEL I:

Because of a flat 8% charge for claims on the private sector, banks have an incentive to movehigh quality assets off the balance sheet (capital arbitrage) through securitization thus reducingthe average quality of bank loan portfolio. It does not take into consideration the operational risks of banks, which become increasinglyimportant with the increase in the complexity of banksAlso, the 1988 Accord does not sufficiently recognize credit risk mitigationtechniques, such as collateral and guarantees.

The regulatory Capital requirement has been in conflict with increasinglysophisticated internal measures of economic Capital.

It was concentrating on only on credit risk

INTRODUCTION OF BASEL 2

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This study explores the impact of Basel II on the Indian banking sector and how it would lead to

shifts in lending structure, benefit the larger and sophisticated bank like SBI and enhance the

competitiveness of the bank in general, ahead of the opening up of the sector to foreign banks in

2010. It then elaborates on the key challenges that SBI is facing after the implementation of Ba-

sel II guidelines, mainly in the areas of infrastructure requirements, development of creditassessment models, and supervisory skills. The study drills deep into the foundations of credit

assessment using Internal Ratings method and data requirements for each determinant of credit

risk before analyzing the progress of Indian banks on the implementation of these advanced

approaches. The concluding section outlines the additional improvements Indian banks would

have to register in order to become globally competitive.

DISCUSSION OF PROBLEM

Banks are under increasing pressure to comply with Basel II guidelines. But many are finding thatimplementation of Basel II is becoming a challenge. Indian banks appear to be uncertain about

the actual intent of Basel II guidelines. The main point that all Indian banks and particularly those

in the public sector are missing is that Basel II is more about the risk governance structure of a

bank and risk calculation is only an intermediate step towards building that structure.

Some of the key issues that require an attention of all sorts are:- Should banks be looking at the potential business benefits accruable from Basel-IIimplementation, besides the compliance requirements? Quantification of the end benefits from Basel compliance what does the bank stand togain by ramping up and complying with Basel II?

What is the ideal phase-wise approach to implement Basel-II in the Indian context? What are the practical problems that banks are certain to face or are currently facing inimplementing Basel II? Is Basel II a technology that can be bought off the shelf or does it involve businessprocess re- engineering or is it merely a new way of calculating a bank's risk profile?

INDUSTRY OVERVIEW

The Indian banking sector has acquired a greater degree of resilience due to the financial reforms

implemented in a gradual and sequential manner under the watchful eyes of Reserve Bank of

India and Ministry of Finance. This was implemented by a participative process aimed at

reduction in statutory pre-emption

.An assessment of the banking sector performance shows that banks in India have experiencedstrong balance sheet growth in the post-reform period in an environment of operational flexibility.Improvement in the financial health of banks, reflected in significant improvement in capitaladequacy and improved asset quality, is distinctly visible. These significant gains have been

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achieved even while renewing the goals of social banking by maintaining the wide reach of thebanking system and directed credit.

Banks in India have always played a pivotal role in providing a thrust to the development of the

country by assisting in the development of the priority sector in India which includes agriculture

as well as in the industrial and infrastructural development. Changes in these sectors are essential

to boost comprehensive growth and revival of the economy. Thus, in the current challenging

times of economic stagnation affecting these sectors, it becomes all the more necessary to provide

the much required fiscal support to the banking industry.

The risk aversion which has crept into the domestic banking sector on account of theinternational banking crisis has created a situation of deep concern and threat for the real

economy and all the players in it. Challenges facing the Indian Banking sector this year include:compliance with Basel II norms and competition from foreign banks.

There has been a lackluster demand for credit despite sufficient liquidity in the system and

lowering of interest rates by banks, following the phased reductions in cash reserve ratio and

policy rates by the Reserve Bank of India. The reduction in PLR required cut in deposit rates as

well.

Credit targets of public sector banks had been revised upwards to reflect the needs of the

economy, which called for a recapitalization plan for banks to improve their soundness and their

ability to withstand sudden shockslike the ongoing global crisis that has devastated many of

top-notch US banks. There is a negative impact on the banking sector due to lending at fixed

ceiling rates to focus sectors. Margins have been hurt as the banking sys-tem has raised a large

portion of its liabilities at high rates in the recent past.

With economic slowdown being the major issue at present, the bankers' main concern is to fund

growth without facing any hurdles. The obvious choice, according to bankers, which has to be

acted upon, is infrastructure funding. Though there has been a revival of economic growth and a

pick up in the pace investment cycle, the banking sector expects several positive measures in the

near future, so that they can continue to play a vital role in intermediating between the demand

and supply of funds

STATE BANK OF INDIA

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State Bank of India (SBI) is Indias largest commercial bank. SBI has a vast domestic network of

over 9000 branches (approximately 14% of all bank branches) and commands one-fifth of

deposits and loans of all scheduled commercial banks in India.

The State Bank Group includes a network of eight banking subsidiaries and several non-banking

subsidiaries offering merchant banking services, fund management, factoring services, primary

dealership in government securities, credit cards and insurance. The eight banking subsidiaries

are:

State Bank of Bikaner and Jaipur (SBBJ)

State Bank of Hyderabad (SBH)

State Bank of India (SBI)

State Bank of Indore (SBIR)

State Bank of Mysore (SBM)

State Bank of Patiala (SBP)

State Bank of Saurashtra (SBS)

State Bank of Travancore (SBT)

The origins of State Bank of India date back to 1806 when the Bank of Calcutta (later called the

Bank of Bengal) was established. In 1921, the Bank of Bengal and two other Presidency banks

(Bank of Madras and Bank of Bombay) were amalgamated to form the Imperial Bank of India. In

1955, the controlling interest in the Imperial Bank of India was acquired by the Reserve Bank of

India and the State Bank of India (SBI) came into existence by an act of Parliament as successor

to the Imperial Bank of India.

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Today, State Bank of India (SBI) has spread its arms around the world and has a network of

branches spanning all time zones. SBIs International Banking Group delivers the full range of

cross-border finance solutions through its four wings the Domestic division, the Foreign Offices

division, the Foreign Department and the International Services division.

State Bank of India (SBI) (LSE:SBID) is the largestbankinIndia. If one measures by thenumber of branch offices and employees, SBI is the largest bank in the world. Established in1806as Bank of Calcutta, it is the oldest commercial bank in the Indian subcontinent. SBIprovides various domestic, international andN RI products and services, through its vast networkin India and overseas.

With an asset base of $126 billion and its reach, it is a regional banking behemoth. The

government nationalized the bank in1955, with the Reserve Bank of India taking a 60%

ownership stake. In recent years the bank has focused on three priorities, 1), reducing its huge

staff through Golden handshake schemes known as the Voluntary Retirement Scheme, which saw

many of its best and brightest defect to the private sector, 2), computerizing its operations and 3),

changing the attitude of its employees (through an ambitious programme aptly named 'Parivartan'

which means change) as a large number of employees are very rude to customers.

REVIEW OF LITERATURE

Daniel Tabbush, Head of CLSA Banking Research (2008) in his report stated Mortgage-loanrisk weightings drop from 50% to 35% under Basel II, making them much more profitable interms of regulatory capital required, while small and medium-sized enterprise (SME) lending canmove from 100% to 75%. Anand Wadadekar (2008) in his study Basel Norms & Indian Banking System revealedthat Basel II Norms offers a variety of options in addition to the standard approach to measuringrisk. Paves the way for financial institutions to proactively control risk in their own interest andkeep capital requirement low. C.P.Chandrasekhar & Jayati Ghosh(2007) in their study Basel II and India's bankingstructure examined what the guidelines involve, their effects on the banking structureand behavior and some likely outcomes of implementing them. Rana Kapoor, managing director, YES Bank (the latest entrant to new generation privatebanks in India), holds Most (Indian) banks are likely to start with simpler, elementaryapproaches, just adequate to ensure compliance to Basel II norms and gradually adopt moresophisticated approaches. The continued regulatory challenge will be to migrate to Basel II in anon-disruptive manner. P.S. Shenoy, chairman and managing director, Bank of Baroda, believes Basel IIcompliance will eventually result in banks acquiring a competitive edge, stating `Banks that moveproactively in the broad direction outlined by the Basel Committee will have acquired a definiteedge over their competitors when the new accord enters the implementation phase

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Niall S.K. Booker, chief executive officer, HSBC India and chairman of the IBA

Committee on Basel II states There is the possibility that in international markets access may be

easier and costs less for banks adopting a more sophisticated approach.however in a market

like India it seems likely that the large domestic players will continue to play a very significant

role regardless of the model used.

Mandira Sharma & Yuko Nikaido (2007) in their study onCapital Adequacy Regime in

India examined issues and challenges with regard to the implementation of CRAR norms under

Basel II regime in India. They also tried to identify limitations, gaps and inadequacies in the

Indian banking system which may hamper the realization of the potential benefits of the new

regime.

Ernst & Young in their survey in 2008 revealed that Basel II has changed the competitive

landscape for banking. Those organizations with better risk systems are expected to benefit at the

expense of those which have been slower to absorb change due to increased use of risk transfer

instruments. It also concluded that portfolio risk management would become more active, driven

by the availability of better and more timely risk information as well as the differential capital

requirements resulting from Basel II. This could improve the profitability of some banks relative

to others, and encourage the trend towards consolidation in the sector.

RESULTS & ANALYSIS

m

im

BASEL 2

PILLAR 1Min capital requirmnt

Describe the calculationfor regulatory capital forcredit, operational andmarket risk

PILLAR 2Supervision review

Bridges the gap betweenregulatory and capitalrequirementGive supervisor discretion toincrease the regulatory capitalrequirement

PILLAR 3Market discipline

Allow market disclipine tooperate by requiring lenders to

publicily provide their riskmangmnt activities,risk rating

process and risk distribution

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PIllar 1 spells out the capital requirement of a bank in relation to the credit risk in itsportfolio, which is a significant change from the one size fits all approach of Basel I. Pillar 1allows flexibility to banks and supervisors to choose from among the Standardized Approach,

Internal Ratings Based Approach, and Securitization Framework methods to calculate the capitalrequirement for credit risk exposures. Besides, Pillar 1 sets out the allocation of capital foroperational risk and market risk in the trading books of banks. Pillar 2 provides a tool to supervisors to keep checks on the adequacy of capitalization

levels of banks and also distinguish among banks on the basis of their risk management systemsand profile of capital. Pillar 2 allows discretion to supervisors to (a) link capital to the risk profileof a bank; (b) take appropriate remedial measures if required; and (c) ask banks to maintaincapital at a level higher than the regulatory minimum.

Pillar 3 provides a framework for the improvement of banks disclosure standards for

financial reporting, risk management, asset quality, regulatory sanctions, and the like. The pillaralso indicates the remedial measures that regulators can take to keep a check on erring banks andmaintain the integrity of the banking system. Further, Pillar 3 allows banks to maintain

confidentiality over certain information, disclosure of which could impact competitiveness orbreach legal contracts.Basel II gave a free hand to the RBI to specify different risk weights for retail exposures, in casethey think that to be more appropriate. To facilitate a move towards Basel II, theRBI has alsocome out with an indicative mapping of domestic corporate long term loansand bond creditratings against corporate ratings by international agencies like MoodysInvestor Services.

Mapping for Corporate Loans and Bond Ratings and risk weights as indicated by the RBI

OBJECTIVES OF BASEL II

Creating a better linkage between the minimum regulatory capital and risk, enhancing market

discipline, supporting a level playing field in an increasingly integrated global financial system,

establishing and maintaining a minimum capital cushion sufficient to foster financial stability in

periods of adversity and uncertainty, and grounding risk measurement and management in actual

data and formal quantitative techniques.

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Basel II is the effort to improve risk measurement and management, especially at our largest,

most complex organizations. Thus it would be reasonable to infer that the main focus of the new

framework (Basel II) is on providing the right incentives to the banks to adopt data-based,

quantitative risk management systems to be able to adopt the advanced risk-sensitive approaches

of the revised framework, which, in turn, would contribute to systemic and financial stability

CHALLENGES FOR INDIAN BANKS UNDER BASEL II

1) Costly Database Creation and Maintenance Process:

The most obvious impact of BASEL II is the need for improved risk management and

measurement. It aims to give impetus to the use of internal rating system by the international

banks. More and more banks may have to use internal model developed in house and their impact

is uncertain. Most of these models require minimum 5 years bank data which is a tedious and

high cost process as most Indian banks do not have such a database.

2)Additional Capital Requirement:

In order to comply with the capital adequacy norms we will see that the overall capital level of

the banks will raise a glimpse of which was seen when the RBI raised risk weightages for

mortgages and home loans in October 2004. Here there is a worrying aspect that some of the

banks will not be able to put up the additional capital to comply with the new regulation and they

may be isolated from the global banking system

3) Large Proportion of NPA's:

A large number of Indian banks have significant proportion of NPA's in their assets. Along withthat a large proportion of loans of banks are of poor quality. There is a danger that a large numberof banks will not be able to restructure and survive in the new environment. This may lead toforced mergers of many defunct banks with the existing ones and a loss of capital to the bankingsystem as a whole.4)Low Degree of Corporate Rating Penetration:

India has as few as three established rating agencies and the level of rating penetration is not very

significant as, so far, ratings are restricted to issues and not issuers. While Basel II gives some

scope to extend the rating of issues to issuers, this would only be an approximation and it would

be necessary for the system to move to ratings of issuers. Encouraging ratings of issuers would be

a challenge.

5) Cross Border Issues for Foreign Banks:

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In India, foreign banks are statutorily required to maintain local capital and the following issues

are required to be resolved; validation of the internal models approved by their head offices and

home country supervisor adopted by the Indian branches of foreign banks. Date history

maintained and used by the bank should be distinct for the Indian branches compared to the

global data used by the head office capital for operational risk should be maintained separatelyfor the Indian branches in India

CAPITAL ADEQUACY STANDARD IN INDIA

Capital adequacy is an indicator of the financial health of the banking system. It is measured by

the Capital to Risk-weighted Asset Ratio (CRAR), defined as the ratio of a banks capital to its

total risk-weighted assets. Financial regulators generally impose a capital adequacy norm on their

banking and financial systems in order to provide for a buffer to absorb unforeseen losses due to

risky investments. A well adhered to capital adequacy regime does play an important role in

minimizing the cascading effects of banking and financial sector crises.

India adopted Basel I norms for scheduled commercial banks in April 1992, and its

implementation was spread over the next three years. It was stipulated that foreign banks

operating in India should achieve a CRAR of 8 per cent by March 1993 while Indian banks with

branches abroad should achieve the 8 per cent norm by March 1995. All other banks were to

achieve a capital adequacy norm of 4 per cent by March 1993 and the 8 per cent norm by March

1996.

In its mid-term review of Monetary and Credit Policy in October 1998, the Reserve Bank of India

(RBI) raised the minimum regulatory CRAR requirement to 9 per cent, and banks were advised to

achieve this 9 per cent CRAR level by March 31, 2000.9 Thus, the capital adequacy norm for

Indias commercial banks is higher than the internationally accepted level of 8 per cent.

The RBI responded to the market risk amendment of Basel I in 1996 by initially prescribing

various surrogate capital charges such as investment fluctuation reserve of 5 per cent of the

banks portfolio and a 2.5 per cent risk weight on the entire portfolio for these risks between 2000

and 2002. These were later replaced with VaR-based capital charges, as required by the market

risk amendments, which became effective from March 2005. India has gone a step ahead of Basel

I in that the banks in India are required to maintain capital charges for market risk on their

available for sale portfolios as well as on their held for trading portfolios from March 2006

while Basel I requires market risk charges for trading portfolios only.

FACTS BEHIND INDIAN BANKS RESISTANCE FROM GLOBAL FINANCIALTURMOIL

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The global financial crisis didnt directly affected India as Indian financial system has sound

fundamentals and the Indian Government has put in place, systems and practices to promote a

safe, transparent and efficient market to protect market integrity.

This was possible due to classic reports and model given by Mr. Narasimham about the policy

framework for the Government of India and the RBI to formulate the structure of Indias banksand financial institutions was based on adequate capitalization, good provisioning norms and

well-structured supervision. The Committee also recommended gradual liberalization of the

banking sector by adopting measures such as reduction of statutory preemptions, deregulation of

interest rates and allowing foreign and domestic private banks to enter the system. Along with

these, the Committee also recommended adoption of prudential regulation relating to capital

adequacy, income recognition, asset classifications. While the liberalization was aimed at

bringing about competition and efficiency into Indias banking system, the prudential regulation

was aimed at strengthening the supervisory system, which is important in the process of

liberalization.

Government of India and RBI accepted these recommendations and proceeded to implement

them. The RBI enforced strict capital adequacy requirements and if any financial institution or

bank exceeded the specified limits of exposure to stock markets, it would have to provide more

capital. This effectively insulated the banks and financial institutions from volatility of the

bourses. Enforcement of the above instructions has paid good dividends. Erosion of capital of the

banks and financial institutions has been reduced. These exposure limits, however, deserve to be

reviewed from time to time.

The Narasimham Committee endorsed the internationally accepted norms for capital adequacy

standards, developed by the Basel Committee on Banking Supervision (BCBS). BCBS initiated

Basel I norms in 1988, considered to be the first move towards risk-weighted capital adequacy

norms. In 1996 BCBS amended the Basel I norms and in 1999 it initiated a complete revision of

the Basel I framework, to be known as Basel II. In pursuance of the Narasimham Committee

recommendations, India adopted Basel I norms for commercial banks in 1992, the market risk

amendment of Basel I in 1996.

By and large, India has been spared the panic that followed the collapse of banking institutions

such as Fortis in Europe, and Merrill Lynch, Lehman Brothers and Washington Mutual in the

U.S. Global financial crisis. The turmoil in the international financial markets of advanced

economies that started around mid-2007 has exacerbated substantially since August 2008

This shows that there was no impact of the sub prime episode on the Indian banks & none of the

Indian banks or the foreign banks, with whom the discussions had been held, had any direct

exposure to the sub-prime markets in the USA or other markets.

However, a few Indian banks had invested in the collateralized debt obligations (CDOs) / bonds

which had a few underlying entities with sub-prime exposures. Thus, no direct impact on account

of direct exposure to the sub-prime market was in evidence. However a few of these banks did

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suffer some losses on account of the mark-to-market losses caused by the widening of the credit

spreads arising from the sub-prime episode on term liquidity in the market, even though the

overnight markets remained stable.

Finally Indian banks global exposure was relatively small, with international assets at about 6

per cent of the total assets. Even banks with international operations had less than 11 per cent oftheir total assets outside India. Moreover 34 percent of our deposits were in government securities

and cash with the RBI. The consumer loan to GDP ratio was just 10 percent, whereas this ratio is

as high as 100 percent for the US.

IMPACT OF BASEL II ON INDIAN BANKS

Indian banks are strongly regulated and supervised entities. In particular, weak banks and those

banks, which show signs of problems, are subjected to rigorous on-site and off-site supervisionand stringent prudential standards. Thus, risks inherent in inter-bank exposures are not

comparable to that of the corporates. There is, therefore, a need for a modified treatment for

claims on banks. The Basel Committee has provided discretion to national supervisors to assign a

lower risk weight to the exposures to the sovereign of incorporation, denominated in domestic

currency and funded in that currency.

Basel II is the new regulatory framework within which all banks will have to work. Its aim is to

safeguard the stability of the financial sector and one of its aspects is a comprehensive approach

to risk. The first phase of the Accord took effect in 2007, and the second phase was implemented

in 2008.

The Accord regulates the amount of capital that banks will have to set aside for their loans. In

addition, it prescribes that this capital must be a better reflection of the actual credit risks

represented by the companies to which the banks lend. Banks can select from three methods of

determining the risks and the associated capital requirements; the banks with the most

sophisticated risk management will be rewarded with a lower capital requirement relative to their

existing capital bases. This is one of the reasons why credit will not necessarily become more

expensive. There is also no question of credit crunch; banks' loan portfolios have in fact grown as

a proportion of their total assets.

As from 1 January 2007, banks were required to have historical credit information on their

lending customers; this information is needed to evaluate their customers creditworthiness. Three

quarters of companies are currently reported to have insufficient information about the banks'

new credit risk criteria.

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An increase in the transparency of company accounting and of the information exchanged with

banks has intended to result in greater objectivity with regard to the granting of new credit lines.

The more favorable the company's risk profile, the better the credit risk rating and the more

favorable the bank's terms and conditions will be.

Thus Indian banks have developed:

Credit and Operational Risk Models

Business Models and Surrounding Processes

Skill levels of Operating Personnel

Valid and Integrated Data Backup

With the advent of Basel II, Indian Banks may be required to raise over Rs.1, 70,000 crs

additional Capital during the coming 3 years. Basel II has tightened up requirements on the

demand side for loans and it is worth giving serious consideration to limit borrowing

requirements and to alternative credit products, which can have a considerable impact on a

company's balance sheet. Moreover new Framework has helped to reduce Capital Base of Indian

Banks by 1% to 2%, except a few Banks. Under Basel II, the banks are little forced to make its

loans more expensive, to restrict outstanding credit lines, or to refuse to grant further loans.Als o

the basic lending criteria are certainly continued to be the competence of themanagement, the company's ability to repay the loan, and adequate equity.

IMPACT OF BASEL II ON SBI

The impact on SBI can be best studied by analyzing the different types of risk involved withBasel II which is as follows:- CREDIT RISKThe risk that a borrower or counterparty might not honour its contractual obligations which isvery relevant to operating staff.There are two approaches for credit risk:i.Standardized Approach (SA)ii.Internal Ratings Based (IRB) approach

In SA, credit risk is measured in a more risk sensitive manner, i.e. by linking credit ratings of

credit rating agencies to risk of the assets of the bank. The responsibility of providing the risk-

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weights corresponding to various assets, under SA, lies with the supervisory authority of a

country.

As far as the IRB approach is concerned, banks are allowed to use their internal estimates of

credit risk, subject to supervisory approval, to determine the capital charge for a given exposure.

This would involve estimation of several parameters such as the probability of default (PD), lossgiven default (LGD), exposure at default (EAD) and effective maturity (M) corresponding to a

particular debt portfolio.

Credit Risk State Bank of Indias Preparedness Existing Internal Credit Risk Assessment System refined and extended to cover AdvanceAccounts of Rs. 25 lacs and above.

Existing Internal Credit Information System is being fine-tuned to meet Basel IIrequirements, now covering Whole Bank

Models for implementation of Integrated Risk Management and Operational RiskManagement are being implemented.

Consultants are being appointed for Portfolio Credit Risk Modeling Exercise MARKET RISKThe risk of adverse price movements such as exchange rates, the value of securities, and interestrates - Less relevant to operating staff, more or less centralized at corporate centre.Market Risk State Bank of Indias Preparedness Exploring the feasibility of using KVaR+ software for mapping Treasury Operations formarket Risk.

Developed adequate hedging mechanisms to absorb the impacts of Market Risk. Their investment Risk is akin to the Country Risk and thus well protected

Implementation of Oracle Based ALM Software is in progress, to provide comprehensiveALM data analysis.Market Risk State Bank of Indias Concerns

During the FY: 2005-06, additional Capital charge of around Rs. 1200 crore has beenprovided on account of Market Risk on AFS category of Investments.

Securitization Transactions are subjected to stringent treatment thus making them lessattractive. OPERATIONAL RISK

The risk of loss resulting from inadequate or failed internal processes, people, and systems orfromexternal events Newly introduced & also very relevant to operating staff.

In order to calculate the capital charges for operational risk, three approaches are used:

1. Basic Indicator Approach (BIA),

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2. Standardized Approach (SA) and

3. Advanced Measurement Approaches (AMA)

In the BIA, an estimate of the capital charge for operational risk is provided by averaging over afixed percentage of positive annual gross income of the bank over the previous three years.

Under SA, at first the banks business activities are divided into eight business lines. For each

business line, a capital charge is calculated by multiplying the gross income of the business line

by a factor. A capital charge for each business line is thus calculated for three consecutive years.

Under AMA, a bank can, subject to supervisory approval, use its own mechanism fordetermining capital requirement for operational risk

Operational Risk State Bank of Indias Preparedness Operational Risk Management Committee, is developing the ORM Policy to assess thelosses to:1) Physical Assets2) Business and Systems3) Process Management and Delivery Mechanism.

Business Process Re-engineering Team is in place evaluating the processes and redefining theSystems & Procedures to mitigate incidence of losses on account of processes and Systems.Operational Risk SBIs Concerns

At 12% CAR, the Bank may be required to provide additional capital charge of aroundRs. 4500 crore towards Operational Risk.

The Bank has established systems and procedures and hence, may be required to providelesser capital for Operational Risk under Advanced Approaches.

However, given the current level of MIS and Technical Sophistication, our Bank for thepresent, may be in a position to adopt Basic Indicator Approach only.

Challenges in Implementation at SBI

Complexities in Systems and Processes involved in Basel II make the implementationprocess difficult, time consuming and costly. Availability and mapping of Validated and Auditable Data and Integration of the same toBasel II norms. Adaptability of Operating Personnel to the New Skills Internationally active Bank like ours will face problem due to localization of Basel IInorms in different Geographical Zones due to Home & Host Country Regulations

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An Integrated Risk Governance Structure is set up to facilitate early migration to Basel II. Separate departments are set up to monitor and manage Credit Risk, Market Risk andOperational Risk. Risk based Internal Audit has been implemented across the Bank. An In-house Committee is overseeing the Transition to Basel II.Main implications of Basel II on SBI

Currently the bank is moderately affected on account of Credit Risk, but adverselyaffected on account of Operational Risk. Without any additional Capital support, Basel II would tend to reduce CAR of the bankby around 150 bps. The Projected CAR tends to slide immediately by around 1.50%, but the negative impactis expected to be neutralized over a period of 5 yearsThus in a nutshell Basel II is basically a Risk Management Exercise which:- Doesnt seek to change business models of the Bank. Requires to fine-tune/update Risk Management practices. Robust enough to capture all possible Risks the Bank is facing or likely to face. Initiate adequate and appropriate Risk Mitigation measures through effective Systemsand Procedures

FINDINGS

Changes have been and will be there in the quantum of data collected due to the new Basel II

norms. This has had an impact on the manpower requirements and the time availability for the

job, which was one of the common problems faced by the banks during this phase, though some

bankers feel its just the aggregating of the data available in various databases. This data

collection though is critical for the banks for the purpose of ratings.

2.

While bankers say that there have been privacy and security issues faced during the collection of

data for the purpose of rating but they were not clear on how they had overcome those issues,

most others say that they did not have any issues related to privacy since the customer is obliged

to provide data for the processing of the application with regards to security issue they were not

aware of any security issues faced so far. The bankers say that industry risk data, business risk

data are also available with the banks which help in the rating process, so data privacy is not a

major problem they say.

3.

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The bank is of the view that with the advent of Basel II there will be better capital adequacy since

they are based on the risks involved unlike the ones in Basel I, where a single brush approach was

adopted without taking any specific risks into consideration. But it has also been affecting their

business in a way; like for instance the underarm limits for NPAs has been increased from 100%

to 150% so there is an impact on the amount available for lending.

4.

Basel II has not affected the short term lending of the banks, the way it was predicted to affect,

but the bankers say that there will be an impact on the pricing of these short term lending of the

banks. The banks have a firm belief that short term lending is a major weapon in the banks

armory for the better utilization of the banks short term resources.

Further the banks are of the view that the excess liquidity with the banks can be divertedthrough into this route.5.

Mostly the bank had their ICAAPs in tune with the regulatory capital requirements set by the

regulatory authorities and IBA. They had used Liquidity risk, Interest risk on banking book

(MVE & Earning Perspective), Credit concentration risk and others to calculate the ICAAP.

Those that had actually calculated ICAAPs had their capitals at well above the regulatory

requirements averaging at around 12%.

6.

The interview with manager and officials threw up contradicting views regarding the number of

rating agencies available in the country. Some of them were of the view that in India there is no

much demand for rating of corporate bonds and other instrument, their argument is that very few

organizations which go for ratings, get a good rating, so the purpose of ratings which is actually

to increase the value of the instrument is actually not working. Some also argue that the situation

is opposite where the rating agencies are behind the banks to rate their instruments.

7.

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Most of the banker is of the view that its difficult to classify the expense incurred as a capital

expenditure or revenue expenditure. There was feeling that there needs to be proper demarcation

of the expenses incurred in order to have better comparability between the banks. Some of them

were already demarcating some expenses as capital expenditure or revenue expenditure but this

has been varying from bank to bank.

8.

The question related to pro-cyclicality seemed to be irrelevant as none of the bank felt that they

have been affected or find any reason that they will be affected in the near future because of this.

They were also of the view that their portfolios are well diversified to handle any such situation.

The banker were of the view that the prevalent economic and market conditions are pointers for

consolidation and that the impact of the Basel II norms needs to be understood by both the banks

and its customers. They feel its good to wait for the stabilization period to end rather than to

proceed to advanced measurement approaches in haste. The one exception which I said earlier

was eager to proceed to the advanced approaches as they were confident of handling it.

10.

Earlier there were no separate departments for managing risks, but after implementing Basel II

separate departments have been entrusted with the task of managing Credit Risk, Market Risk and

Operational Risk.

11.

Regarding the comparability of the capital standards post Basel II, banks had varying views some

were of the view to wait and watch what happens next, some were of the view that it definitely

achieves the purpose it was set due the basic theme, i.e. the ideas propounded by Basel II and

because it advocates for the international best practices to be adopted by banks, others were of the

view that there needs to be further study regarding this

RECOMMENDATIONS

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Bank has to train all its employees so that everybody can understand about Basel Accord. Finally, Basel II is fundamentally about better risk management anchored in sound

corporate governance. The central bank needs to ensure strong corporate governance practices in

the banking industry, the Indian Banking Association needs to conduct regular workshops on

corporate governance for the banks board members

REFERENCES

ARTICLES:1.Approach to Basel II (Speech) by Mrs.Shyamala Gopinath.2.Challenges and implications of Basel II for Asia (Speech) by Dr.Y.V.Reddy3.Demystifying Basel II (Speech) by Shri V.Leeladhar, Deputy Governor, Reserve Bank ofIndia4.Basel II and Credit Risk Management (Speech) Shri V. Leeladhar, Deputy Governor, andReserve Bank of India at the program me on Basel II and Credit Risk Management.5.

Regulation and Risk Management: Implementing Basel II (Speech) by Address of Shri V

Leeladhar, Deputy Governor, delivered at the Platinum Jubilee Celebrations of the South Indian

Bank Ltd., Thirussur on 2005

6. Indias Preparedness for Basel II implementation,(Speech) The Special Address delivered byShri V. Leeladhar, Deputy Governor, Reserve Bank of India at the Panel Discussion duringFICCI-IBA Conference on Global Banking : Paradigm Shift.

7. Implementation of Basel II An Indian perspective(speech) Address by Ms. Kishori J Udeshi,Deputy Governer, RBI at the Annual International seminar on Policy changes for financial sectoron June 2005

BOOKS :1.Preeti PhuskeleBasel II Norms- Implications on Business I S BN : 81-3141-166-9ICFAI University Press.2.Nagarajan NImplications of Basel II for Risk Management and CapitalStructureISBN:81-7881-335-1ICFAIUniversityPress

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WEBSITES: www.bis.org www.articlesarchive.com http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=303 www.rbi.org.in/rdocs/Publications/Docs/21113.doc http://www.iba.org.in/basel_II.asp http://www.banknetindia.com/index.htm

www.banknet.com/banking/81022.html . www.epaper.thehindubusinessline.com www.ficci.com/surveys/II.pdf