Date:12/04/2005 URL: http://www.thehindubusinessline.com/2005/04/12/stories/2005041200040800.htm
Back Basel II Accord: More credits than debits

T. K. Rajan

The Basel Committee is treading carefully in introducing the advanced approaches for measurement of capital charge for credit and operational risk. Skilled personnel with expertise in quantitative techniques would be critical for successfully implementing Basel-II, especially the advanced approaches. Therefore, banks need to devise systems to attract and retain personnel with the requisite skills.

THE Basel Committee on banking supervision has introduced the new global supervisory framework for assessing the capital adequacy of banks. Known as the Basel II framework, it is available for implementation from year-end 2006, save for the advanced approaches, which will, perhaps, be implemented from year-end 2007 after one full year of parallel calculations.

While the revised accord is admittedly more complex than the existing one, a dispassionate analysis reveals that there really is no option. There is universal acceptance that the current capital accord has outlived its utility.

While its simplicity is still attractive, features such as "one size fits all" approach, inadequate differentiation of credit risk, lack of explicit capital charge for operational risk, lack of built-in incentives for banks to adopt improved risk mitigation techniques, avenues for regulatory capital arbitrage, have raised serious question marks over its utility to differentiate banks based on the risks they take.

The large-scale failure of banks during the South-East Asian crisis, despite many of them maintaining the minimum regulatory capital based on the current accord, proves this point.

There was, thus, clearly a need to have a framework, which not only prescribes a minimum capital ratio with adequate risk sensitivity, but also ensures continuous monitoring by the national supervisory authority of risks undertaken by banks vis-a-vis the quantum of capital held by them.

Evidently, there is a trade-off between a simple framework (such as the current Accord) which may not have much utility in the fast-changing banking environment and a more complex framework with superior capability to differentiate risks undertaken (and, hence, the level of economic capital required) by institutions.

The Committee has sought to address the issue of complexity as best as it could in the following ways:

  • for each of the three risks for which capital is to be measured and set aside — credit, market and operational risk — the framework offers a menu of approaches ranging from a relatively simple standardised methodology at the one end of the spectrum to sophisticated ones based on banks' own internal models;

  • a great deal of discretion is being offered to the national supervisory authorities to phase out the implementation process. As a matter of fact, the Committee has recognised that implementation of the revised accord may not be the first priority in many non-G-10 supervisory jurisdictions.

    While the new framework was unveiled in June 2004, rapid developments in the field of risk management would mean that significant modifications, especially in respect of the advanced approaches for credit and operational risks, could still be expected in the next two-three years.

    For example, the revised Basel Accord has stopped short of recognising economic capital churned out by various proprietary credit risk models (Credit Metrics, Credit Risk+, Credit Portfolio View) for regulatory capital setting purposes.

    This is on account of the fact that modelling credit risk still poses significant hurdles such as data inadequacy, difficulties in measuring credit correlations, and so on, and, therefore, the robustness of the available proprietary models are still being evaluated. However, rapid strides are being made in this area and one can expect recognition of such models for capital-setting purposes in the none-too-distant future.

    Also, some more refinement in the advanced approaches for measurement of capital charge could be expected.

    For example, the Basle Committee is treading carefully in introducing the advanced approaches for measurement of capital charge for credit and operational risk.

    This can be seen from the application of prudential floors based on the existing Basel Accord.

    Thus, a bank adopting the foundation internal rating-based approach for credit risk will be subject to a floor capital charge of 95 per cent (based on the existing accord) for the year-end 2006 gradually decreasing to 80 per cent for the year-end 2008. The Committee will use the transition period to review the approaches for possible corrections/modifications. So, where does all this leave the banks?

    Clearly, there are tremendous gains to be had by developing systems that facilitate the adoption of more risk-sensitive methods of measurement of economic capital.

    Indeed, it will even be a necessity for large international banks (and we hope to see some such Indian banks in the next five-10 years) to adopt more risk-sensitive measurement systems, given the fact that they will be handling large exposures, complex financial products and large volume of transactions, making their activities significant from a systemic point of view.

    While the current state of risk management systems in banks does not allow them to adopt advanced methodologies, which are more risk-sensitive, there is greater awareness among top management of the need to develop more robust systems.

    Indeed, many banks are making significant strides in this direction as evidenced by initiatives such as setting up of integrated risk management architecture, implementation of core banking solution, adopting improved MIS (management information systems) and so on.

    Lack of historical database to compute parameters such as probability of default poses a serious challenge.

    Today, much of the studies and data in this area are available based on corporate default histories in the US and published by rating agencies such as Standard and Poor's and Moody's, which are of little relevance to our country.

    Therefore, the priority should be to take steps to develop historical databases. The way forward would be to use pooled data from a large number of banks to build the necessary volumes. Indian rating agencies could also attempt building proprietary databases based on studies on the lines done by international rating agencies.

    Another area to work on is the low level of rating penetration in the country and the fact that ratings are done of issues and not issuers. The challenge, therefore, would be to put in place systems to encourage wider usage of ratings by entities.

    Skilled personnel with expertise in quantitative techniques would be critical for successful implementation of Basel-II, especially the advanced approaches.

    Therefore, banks need to devise systems to attract and retain personnel with the requisite skills.

    The implementation of the revised Basel Accord, though fraught with significant hurdles, promises significant gains for the economy. Risk-based capital maintenance by banks enhances financial stability.

    Economic capital could be used to compute "risk adjusted return on capital'' (RAROC) on every activity undertaken by banks.

    This promotes risk-based pricing (something which is absent under the current loan dispensation by banks), ultimately contributing to enhancement of shareholder value.

    Risk adjusted measures also facilitate linking executive compensation to his/her contribution to value creation in a transparent manner.

    Greater market disclosure under Pillar III of the Accord would help the market distinguish banks based on their risk taking behaviour, thereby providing incentives to managements to adopt sound risk management practices.

    In the near term, Indian banks might have to start the implementation process by adopting the simpler approaches.

    In the medium term, with better risk management systems, adequate data availability and experience gained, the internationally active banks could switch over to more risk-sensitive advanced approaches.

    (The author is an Assistant General Manager, Reserve Bank of India, Chennai. The views expressed are that of the author and do not represent that of the organisation.)

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