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International Research Journal of Finance and Economics

ISSN 1450-2887 Issue 23 (2009)


© EuroJournals Publishing, Inc. 2009
http://www.eurojournals.com/finance.htm

Potential Impact of Basel II in Developing


Economies: Experiment on Bangladesh
Md. Akhtaruzzaman1
Managing Director, SIMARCH Asia Pte Ltd, Singapore

Abstract

In 1988, an agreement was reached in Basel to set the common requirements of


bank capital towards promoting the soundness and stability of the international banking
system. Banks are required to hold capital in proportion to their perceived credit risks. In
June 2006 Basel Committee on Banking Supervision issued a comprehensive document on
New Capital Adequacy Framework to replace the 1988 Basel Accord and to foster a strong
emphasis on risk management and to encourage ongoing improvements in banks’ risk
assessment capabilities. The paper examines the potential impact of Basel II on the
developing economies, in particular reference to Bangladesh. A pilot testing model for
Basel II parallel calculations are being employed to measure the impact of capital
requirements of Mercantile Bank Limited, a commercial bank in Bangladesh. The result
shows that the capital requirement to comply with Basel II has been increased by 41.94%
as compared to Basel I capital requirements. The capital requirement under Basel II regime
increased due to additional burden of capital from Market Risk and Operational Risk. There
are many possible negative impacts of an unchecked implementation of Basel II. However,
Basel II is here to stay and the competitive forces will compel banks to follow the example.
The option here is to decide what form of the Basel II norms should be applied and to what
extent to ensure the survival and growth for the developing economies. Ultimately, the
norms are for strengthening the banking systems globally and this objective should not be
lost. Developing Economies need to be prepared and to adapt to the changing global
conditions and to adapt the norms to their own advantage.

Keywords: Basel I, Basel II, Risk Weighted Assets, capital requirements, pilot testing
model, developing economies

1.1. Background
Until the late 1970s, banks were highly regulated and protected entities with hardly any competition
among them. Collapse of the Bretton Woods agreement put them in a new environment of increased
competition, leading to gradual erosion of capital that started to alarm the regulators. Dealing with the
problem on international level seemed to be the only possible way of finding a proper solution without
increasing competitive differences between banks from individual countries. Hence, a special
committee was set up under the auspices of the Bank for International Settlements(BIS) in Basel. The
Committee2, initially known as the Cooke Committee and later renamed the Basel Committee on

1
Views expressed in this paper are author’s own
2
Committee on Banking Regulations and Supervisory Practices or shortly the Basel Committee was established in 1974 by the governors of central
banks of the Group of Ten (G10) countries (Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, Switzerland, United Kingdom and
International Research Journal of Finance and Economics - Issue 23 (2009) 47

Banking Supervision (BCBS), formed a proposal in which it suggested that a common framework for
calculating the capital adequacy of banks should be formed. This document, known as the 1988 Basel
Capital Accord, became a huge success after its adoption – it not only managed to level the playing
field, but it also brought national practices on capital adequacy of banks in line.
In 1988, the Basel Committee published a set of minimal capital requirements for banks, known
as the 1988 Basel Accord. These were enforced by law in the G-10 countries in 1992, with Japanese
banks permitted an extended transition period. The 1988 Basel Accord focused primarily on credit risk.
Bank assets were classified into five risk buckets i.e. grouped under five categories according to credit
risk carrying risk weights of zero, ten, twenty, fifty and one hundred per cent. Assets were to be
classified into one of these risk buckets based on the parameters of counter-party (sovereign, banks,
public sector enterprises or others), collateral (e.g. mortgages of residential property) and maturity.
Generally, government debt was categorized at zero per cent, bank debt at twenty per cent, and other
debt at one hundred per cent. Off-Balance Sheet(OBS) exposures such as performance guarantees and
letters of credit were brought into the calculation of risk weighted assets using the mechanism of
variable credit conversion factor. Banks were required to hold capital equal to 8% of the risk weighted
value of assets. Since 1988, this framework has been progressively introduced not only in member
countries but also in almost all other countries having active international banks.
Close on the heel of the 1996 amendment to the Basel I Accord, In June 1999 BCBS issued a
consultative paper on New Capital Adequacy Framework to replace the 1988 Accord. The new capital
framework consists of three pillars: minimum capital requirements, which seek to refine the
standardized rules set forth in the 1988 Accord; supervisory review of an institution's internal
assessment process and capital adequacy; and effective use of disclosure to strengthen market
discipline as a complement to supervisory efforts.
The 1988 Basel I Accord has very limited risk sensitivity and lacks risk differentiation (broad
brush structure) for measuring credit risk. For example, all corporations carry the same risk weight of
100 per cent. It also gave rise to a significant gap between the regulatory measurement of the risk of a
given transaction and its actual economic risk. The most troubling side effect of the gap between
regulatory and actual economic risk has been the distortion of financial decision-making, including
large amounts of regulatory arbitrage, or investments made on the basis of regulatory constraints rather
than genuine economic opportunities. The strict rule based approach of the 1988 accord has also been
criticized for its `one size fits all’ prescription. In addition, it lacked proper recognition of credit risk
mitigants such as credit derivatives, securitisation, and collaterals. The recent cases of frauds, acts of
terrorism, hacking, have brought into focus the operational risk that the banks and financial institutions
are exposed to. Basel II is claimed by BCBS to be an improved capital adequacy framework intended
to foster a strong emphasis on risk management and to encourage ongoing improvements in banks’ risk
assessment capabilities. It also seeks to provide a `level playing field’ for international competition and
attempts to ensure that its implementation maintains the aggregate regulatory capital requirements as
obtaining under the current accord. The new framework deliberately includes incentives for using more
advanced and sophisticated approaches for risk measurement and attempts to align the regulatory
capital with internal risk measurements of banks subject to supervisory review and market disclosure.
The ultimate choice of what capital standard to adopt will be made by national authorities, and
it is likely several developing countries will seek to adopt Basel II as early as possible. The World
Bank and the IMF have publicly stated their desire to support countries preparing for the decision of
whether, when and how to implement Basel II. However, both institutions emphasize that Basel I
remains a viable option in the foreseeable future, and that Basel II must be built on a solid foundation
(as exemplified by compliance with key codes and standards) of sound accounting and governance
standards, realistic valuation rules and loan classification and provisioning practices, effective legal
and judicial systems, and adequate supervisory resources and powers.

USA) and Luxemburg. Its work focuses on (1) strengthening the soundness and stability of the international banking system, and (2) reducing the
distortion of competition between international banks. The Basel Committee’s meetings are usually held at the Bank for International Settlements.
48 International Research Journal of Finance and Economics - Issue 23 (2009)

In Bangladesh, Basel II Road Map has already been issued by Bangladesh Bank, the central
bank of the country. Basel II would be implemented from January 2009(Bangladesh Bank,2007). In
this regard a Quantitative Impact Study (QIS) to assess the preparedness for implementing Basel II as
well as the bank’s view on the optional approaches for calculating Minimum Capital Requirement
(MCR) as stated in Basel II was carried out in April-May 2007. Basel II would be implemented with
the following specific approaches as initial steps with the parallel calculations starting from January
2009:
• Standardized Approach for calculating Risk Weighted Assets (RWA) against Credit Risk
supported by External Credit Assessment Institutions (ECAIs)
• Standardized Rule Based Approach against Market Risk and
• Basic Indicator Approach for Operational Risk.
The questions to be addressed in this paper are as follows:
1. What are the implications of Basel II implementation in the developing economies?
2. What are the spill-over impact of Basel II Implementation in Developed economies on
Developing economies?
3. What are the changes in capital requirements in the developing markets, in particular
reference to Bangladesh due to Basel II implementation?

2.1. Scope and objectives


The paper focuses on the implementation of Basel II Standrdized/Basic Approaches in the developing
economies. Basel II parallel calculations have been used only for Pillar I: Minimum Capital
Requirements. Specific objectives of the study will be as follows to respond the research questions:
I. To identify the implications of Basel II implementation in the developing economies.
II. To find out the domino effects of Basel II Implementation in Developed economies on
developing economies.
III. To measure the changes in capital requirements in the developing markets, in particular
reference to Bangladesh due to Basel II implementation.

2.2. Literature Review


According to the existing theories, the main justification for capital regulations of banks is often given
in terms of “moral hazard” problem. The problem states that in the presence of a mis-priced deposit
insurance scheme, bank managers may not do enough to reduce risk. Instead they will opt for risky
projects that are accompanied by higher return, which, if not stopped in time, may compromise banks’
solvency in the long run. Therefore, the theoretical reason for capital adequacy regulations is to
counteract the risk-shifting incentives originating from deposit insurance 3.
Several strands of theoretical literature have emerged on the topic. A first strand uses the
portfolio approach of Pyle (1971) and Hart and Jaffee (1974), where banks are treated as utility-
maximizing units. In a mean-variance analysis that allows banks’ portfolio choice to be compared with
and without a capital regulation, Koehn and Santomero (1980) showed that the introduction of higher
leverage ratios will lead banks to shift their portfolio to riskier assets. As a solution to such a situation,
Kim and Santomero (1988) suggested that this problem can be overcome if the regulators use correct
measures of risk in the computation of the solvency ratio. Subsequently, Rochet (1992) extended the
work of Koehn and Santomero and found that effectiveness of capital regulations depended on whether
the banks were value-maximizing or utility-maximizing. In the former case, capital regulations could
not prevent risk-taking actions by banks. In the latter case, capital regulations could only be effective if

3
Deposit insurance creates moral hazard problems with respect to insured banks’ holding less capital after getting insurance. When deposits are insured,
managers of these banks’ start to believe that risk is lower and start investing in risky loans. Simultaneously, share-holders reduce monitoring of these
banks because risk of loosing deposits is offset by the insurance.
International Research Journal of Finance and Economics - Issue 23 (2009) 49

the weights used in the computations of the ratio are equal to the systematic risk of the assets. A further
theoretical ground argued that banks choose portfolios with maximal risk and minimum diversification.
The second strand of literature on the topic utilizes option models. Furlong and Keeley (1989)
and Keeley (1990) developed several models under this framework and showed that higher capital
requirements reduce the incentives for a value-maximizing bank to increase asset risk, which is
opposite to the conclusions of the first generation studies discussed above. They criticized the utility-
maximizing framework, which comes to opposite conclusions, as inappropriate because it
mischaracterizes the bank’s investment opportunity set by omitting the option value of deposit
insurance and the possibility of bank failure. However, this evidence of the option model was
weakened by the findings of Gennottee and Pyle (1991). They relaxed the assumption that banks invest
in zero net present value assets and found that there are now plausible situations in which an increase
in capital requirements results in an increase of asset risk.
Using a dynamic framework (multiple periods), as opposed to the static framework used in the
studies above, Blum (1999) found that capital regulation may increase banks’ riskiness due to an
intertemporal effect. Using a two-period model, he showed that banks find it too costly to raise
additional equity to meet new capital requirements tomorrow or are unable to do so, they will increase
risk today. He also pointed out that this second effect will reinforce the well-known risk-shifting
incentives due to the reduction in profits. Subsequently, Marshal and Prescott (2000) showed that
capital requirements directly reduce the probability of default and portfolio risk and suggested that
optimal bank capital regulations could be made by incorporating state-contingent penalties based on
banks’ performance. At the same time, Vlaar (2000) found that capital requirements acted as a burden
for inefficient banks when assets of banks are assumed to be fixed. However, such regulations
increased the profitability of efficient banks.In short, whether imposing harsher capital requirements
leads banks to increase or decrease the risk structure of their asset portfolio is still a debated question
and, at least for now, it seems, there is no simple answer to this question.
Empirical work in the area concentrates on two aspects of capital regulations. First, to
investigate whether banks fulfill the capital requirements by increasing capital or by altering the risk-
weighted assets; and second, to test if the enforcement of capital requirements can result in a
contraction in banks’ supply of loans, a situation best described as a credit crunch. Many of these
works use a simultaneous equations approach, which allows comparing the behavior of
undercapitalized and adequately capitalized banks with respect to changes in risk and capital ratios.
Shrieves and Dahl (1992) use several periods of cross-section data on commercial banks in the U.S.
under the simultaneous equations framework. They find that the effectiveness of risk-based capital
regulations depend on how well the regulations reflected the true risk exposure of banks. U.S. studies
are not easy to interpret since the implementation of the second stage of the Basel Accord, between
end-1990 and end-1992, overlapped with the passage of the Federal Deposit Insurance Corporation
Improvement Act (FDICIA) in December 1991. Section 131 of FDICIA, Prompt Corrective Action
(PCA), went a step further than the Basel Accord by including five categories in which banks are
classified according to their compliance with the capital ratios. Thus, it is hard to ascribe the findings
of the two papers by Aggarwal and Jacques (1998, 2001) to the Basel Accord as opposed to FDICIA,
as U.S. banks’ behavior is likely to have been affected by both regulations over the period that they
consider. They found that banks in the undercapitalized categories increased their capital target ratios
more quickly than other banks with higher initial capital. But, if one is interested in the impact of
capital regulations in a broad sense, then this is not a big problem.
The study by Jacques and Negro (1997) deals exclusively with the consequences of the Basel
Accord, as it concentrates on the years 1990-91, which is the period before FDICIA was passed. They
find that capital regulation has a significant impact on risk and vice versa. But the problem of this
study is the very low number of undercapitalized institutions in Jacques and Negro’s sample – less than
2 percent of the total number of banks, which may have reduced the reliability of some of their
estimates.
50 International Research Journal of Finance and Economics - Issue 23 (2009)

Ediz, Michael, and Perraudin (1998) and Rime (2001) present some non-U.S. evidence
regarding the relationship between capital ratios and credit risk. Ediz, Michael, and Perraudin (1998)
employ confidential U.K. data including detailed information about the balance sheet and profit and
loss account of all British banks during the 1989-1995 periods whereas Rime (2001) uses Swiss data
for the period 1989-1996. Ediz, Michael, and Perraudin (1998) used a limited information technique
different from the simultaneous equations framework. Their study used a period 1989-1995 sample and
applied a random effects model. They found that capital regulations were effective in increasing the
capital to meet the minimum standard. Unfortunately, Ediz et al.’s model leads to the puzzling result
that banks are adjusting their capital levels each year by more than the difference between the current
level and the target they have in mind, which means that banks are overshooting the target (and by
more and more each year).
The study by Rime (2001) is interesting because it provides the application of the simultaneous-
equations model. His results indicate that Swiss banks react to capital regulations by increasing their
capital, but this did not change banks’ risk-taking. One of the problems with this study might be the
fact that Rime adopted the PCA regulatory classification to measure regulatory pressure on Swiss
banks, which might be inappropriate given that the additional requirements set by PCA have not been
adopted formally by any country other than the U.S. Sheldon (1996) used an option-pricing framework
to analyze the risk effects of capital adequacy on eleven G-10 countries. He found that the Basel
Accord did not have a risk-increasing impact on banks’ portfolio. But this result is not easy to interpret
as he did not control for regulatory and non-regulatory influences. Moreover, sample coverage of this
study is not representative for the countries they represent.
Van Roy (2003) studied the impact of capital requirements on risk taking by commercial banks
of seven OECD countries within the framework of the simultaneous equations framework. He found
that changes in capital and credit risk were negatively related over the period studied, which supported
the argument that stringent capital requirements went hand in hand with greater financial stability in
addition to imposing a higher capital buffer against unexpected credit risk losses. However, they also
found evidence indicating that the regulation was ineffective in raising the capital ratio of
undercapitalized banking institutions in France and in Italy, which leaves room for the validity of the
argument presented above.

3.1. Methodology
To measure the potential impact on the capital of banks in developing markets, the pilot testing model
are being constructed in line with the recommendations of BCBS 128 publication entitled
‘International Convergence of Capital Measurement and Capital Standards’, A Revised Framework
Comprehensive Version, June 2006. The pilot testing model with relevant data is annexed in Appendix
A. With the help of the tools given in Appendix A, the parallel calculations for the capital requirement
of bank under Basel II are being carried out. Capital requirements for Credit Risk, Market Risk and
Operational Risk are being calculated as per Standardized/Basic Approaches of Basel II. The data from
the public domain,i.e. the Annual Report of Mercantile Bank Limited, a commercial Bank in
Bangladesh are compiled and are put in the model. Data are collected for the year 2007.

4.1. Implementation of Basel II in Developed Countries and its Impact on


Developing Countries
Most of the large and internationally active banks(except US Banks) belong to the developed countries
already implemented the Basel II. Major multilateral lending institutions such as the World Bank
would also implement them. Implementation of Basel II in developed countries would impact the
developing economies in the following ways:
International Research Journal of Finance and Economics - Issue 23 (2009) 51

4.1.1 High Cost Lending and Reduced Lending to Developing Economies


The Basel II accord has provided two approaches towards credit risk management. Banks in advanced
countries and multilateral lending institutions are expected to implement Basel II and they are the
major lenders to the developing economies.
Under the Standardized approach the biggest change would be experienced by borrowers rated
B and below, as the risk weight for such borrowers would increase from today’s 100% to 150%. On the
other hand, an IRB approach would be even more stringent and applies extraordinarily heavy risk
weights. It is to be noted that a large number of developing economies have ratings below B and they
would be adversely impacted. From the Table-1 it is revealed that borrowers below BBB have higher
capital charge in Internal-Ratings Based(IRB) Approach than that of Standardized Approach.
Table 1: The relative impact of an IRB approach

Ratings Probability of Default(PD) Risk Weight


Standardized Approach IRB Approach
AAA 0.00% 20% 14.80%
AA 0.00% 20% 14.80%
A 0.03% 50% 14.80%
BBB 0.20% 100% 44.80%
BB 1.40% 100% 110.80%
B 6.60% 150% 202.90%
CCC 15.00% 150% 307.20%
LGD=45%, Maturity =2.5 years, EAD=100%, Corporate Exposure and the minimum estimated PD permitted is 0.03%.
Source:
1. Ward,J. “The New Basel Accord and Developing Countries: Problems and Alternatives” (2002),Cambridge Endowment of Research Finance,
Working Paper No. 4, http://www.cerf.cam.ac.uk/publications/files/Ward04.pdf, p.14
2. Basel Committee on Banking Supervision (2006). ‘International Convergence of Capital Measurement and Capital Standards’, A Revised
Framework Comprehensive Version, Bank for International Settlements.

4.1.2 The Vicious Circle of Curtailment of Credit to Developing Countries


The lower ratings will reduce the availability of funds in the developing countries. This has the
potential to deteriorate the situation in these countries leading to further recession. The reduced market
access and high costs of funding will further impact the ratings of these countries leading to a vicious
circle with each aspect feeding the other in a downward spiral.

4.1.3 Higher Interest Costs and Competitive advantage of corporate borrowers


Globalization has meant increased competition with financial engineering an important source of the
competitive advantage, more so for developing economies where the strength has been cost
competitiveness. The Higher Interest costs to the banks will ultimately translate into higher cost of
borrowing for the corporate skewing the playing field in favor of the developed countries.

4.1.4 Impact on Infrastructure development


Major sources of funding for infrastructure in the developing countries have been multilateral lending
institutions such as World Bank. The Basel II document impacts the Interest rate determination process
and attributes higher risk to project finance than corporate finance. All the developing economies have
been suffering from the paucity of Infrastructure to sustain development and this has the potential of
severely hampering the Infrastructure development process.

4.1.5 Shorter Term to maturity of lending


Both the Basel I and II accords have a preference for short-term lending. This is because of the ease in
exiting the investment in case the situation turns adverse. Also the interest rates on short term will also
tend to be lower further incentivising such borrowings. This shall impact both banks and ultimate
borrowers in developing economies because of the change in the interest rate term structure and the
need for Asset and Liability Management(ALM).
52 International Research Journal of Finance and Economics - Issue 23 (2009)

4.1.6 Impact on capital flows


Short Term lending will further increase the volatility of capital flows within developing countries.
This was a major reason of the Asian financial crises. There would be a tendency to press the panic
button at the smallest change in the situation, further deteriorating it, leading to crisis. In the highly
integrated global economy of today this will lead to stronger world economic cycles.

4.1.7 Impact on Companies


The Shortened term funding of banks will find its way to the balance sheets of companies because of
the need for matching maturities. This would impact output levels in corporates and skew the capital
structure in favor of short term borrowings and working capital finance. The Liquidity position and the
companies’ ability to globalize would be hampered by this difficulty in raising long-term capital.

4.2. Implementation of Basel II in Developing Economies


Developing Economies do not have to implement the Basel II norms in Toto. After assessing their
impact their regulations have the option of deciding how to calibrate the norms for their smooth
implementation. The potential minefields in Implementation of Basel II within developing economies
and their impact are put forward:

4.2.1 Problems
4.2.1.1 Standardized Approach and External Credit Rating Problems
One of the two approaches prescribed for Credit Risk in Basel II is the standardized approach, which
makes use of external credit ratings for attaching risk weights. Being the easier of the two approaches
and also because of the continuity from the Basel I norms it is most likely to be implemented in
developing countries. One of the major problems is the availability of credit ratings in developing
countries. While Bangladesh has been fortunate in this respect with two Credit Rating agencies(Credit
Rating Information and Services Limited and Credit Rating Agency of Bangladesh Ltd.),many
developing countries are not so equipped in this field. Even in Bangladesh the penetration of credit
ratings is not deep. The supply-demand imbalance would make it even more difficult for smaller
players to get ratings. High prices are making credit more costly for them.

4.2.1.2 Difficulties in Implementation of IRB based Credit Risk Management Approach


Various models have been proposed for the Internal Rating Based Credit Risk Assessment. A major
problem is data availability. In Bangladesh, State-owned banks are still in the process of
computerization. The extent of historical data required to formulate and then convincingly test
Indigenous IRB models is simply not available. The IRB based approach being one of the more
stringent approaches is the more ideal of the two to strengthen the financial system. The actual
implementation of an IRB based model for credit risk mitigation would require excellent information
retrieval and assessment capabilities. A high-end IT Infrastructure with Risk Management Software
collating real-time information is needed. This preparedness is not there in a majority of banks in
developing markets. Hurrying into an IRB based approach could cost banks dearly because of the
involvement of high capital expenditure. Inaccurate IRB models could defeat the very purpose of better
risk mitigation.

4.2.1.3 Costs of Implementation: IT spending and Training Costs


The single largest cost of implementing Basel II is the IT costs. The required capital expenditure would
be far higher than small banks could bear. There is an unavailability of trained manpower for risk
management and audits. Many countries have a paucity of skilled manpower in this area. The training
cost is another factor in implementation, especially in state owned banks in developing economies
where a majority of the workforce requires retraining.
International Research Journal of Finance and Economics - Issue 23 (2009) 53

4.2.1.4 Multiple Supervisory bodies and dearth of skilled professionals


The Basel II definition of a banking company is very broad and includes banking subsidiaries such as
insurance companies. In many developing countries, there is no single regulator to govern the whole
‘bank’ as per Basel II. In Bangladesh, Securities Exchange Commission, Bangladesh Bank, National
Board of Revenue, Dhaka Stock Exchange and Ministry of Finance would regulate different aspects of
Basel II. The consolidated balance sheet of the bank has to conform to Capital adequacy regulations. In
Bangladesh, Regulatory capital norms do not apply to Insurance companies. The Pillar II
implementation is the more difficult portion of the three pillars. Risk Audits in banks are still in their
nascent stages in Bangladesh. The availability of trained risk auditors is another problems. Basel II
calls for a Risk Management structure in banks with Risk Management committees for Credit, Market
and operational Risk formulating the Risk Management standards. While banks in Bangladesh are
implementing this, it has remained a ceremonial process without the training at the grass root level to
see every activity with the lens of risk.

4.2.1.5 Greater burden on supervisory capacity


The greater burden and wide discretion placed on them by Pillars 1 (e.g. model validation) and 2 (e.g.
treatment of other risks) will stretch scarce supervisory resources and will require a step-up
improvement in available skills and information technology. In addition, regulators must have the
ability to carry out ex-ante impact analysis before rule issuance, which represents a substantial change
from an environment that has traditionally been compliance-driven. Even when supervisors build up
required skills, it is likely that many of them will be poached by domestic banks that are eager to adopt
these new risk management tools and able to provide them with higher salaries – an unfortunate
consequence of the fact that regulators often drive (rather than respond to) change in many developing
countries.

4.2.1.6 Home-host supervisory coordination


Given the significant presence of G-10 banks in developing countries and the considerable discretion
given to national supervisory authorities, a significant degree of home-host cooperation is essential to
ensure consistency across jurisdictions.

4.2.1.7 Ineffective Pillar 3


Aside from the broader issue of the relevance of specific disclosures for market participants, this Pillar
is not a very useful discipline device in countries with small private markets or few incentives for
creditors to monitor banks (e.g. due to presence of implicit public guarantees). In addition, the Pillar 3
might be inapplicable in those countries whose systems are dominated by foreign banks, since the latter
will likely have entered by purchasing and delisting the domestic institution. Since those banks are not
obliged to publicly disclose information for their operations in such jurisdictions (unless requested by
the domestic authorities), there is little market transparency or discipline.

4.2.1.8 Unavailability of required risk data in easily accessible or comprehensive format


Historical loss data is required to calculate the main IRB risk parameters; that data are frequently
incomplete/unavailable (i.e. not required to be collected in the past) or prohibitively expensive to
collect (i.e. not in electronic format). Particularly for the development of rating systems and LGD
parameters, individual banks may not have a meaningful loss dataset to enable them to build the
required models and back-test their performance. In such an environment, it is essential to tackle the
root causes of this problem (e.g. legal or cultural factors impeding loss data collection and sharing)
prior to proceeding with Basel II adoption.
54 International Research Journal of Finance and Economics - Issue 23 (2009)

4.3. Impacts of Basel II Implementation


4.3.1 Improved Risk Management and Capital Adequacy
One aspect that the staunchest critics of Basel II agree to is the fact that it will tighten the risk
management process, improve capital adequacy and strengthen the banking system.

4.3.2 Curtailment of Credit to Infrastructure Projects


The norms require a higher weightage for project finance, curtailing credit to this very crucial sector.
The long-term impacts for this could be disastrous.
4.3.3 Preference for Mortgage Credit to Consumer Credit
Lower Risk Weights to Mortgage credit would accentuate bankers’ preference towards it vis-à-vis
consumer credit. This trend has been observed in many countries with the growth of Mortgage credit
outstripping growth of consumer credit.

4.3.4 Basel II: Advantage Big Banks


It would be far easier for the larger banks to implement the norms, raising their quality of risk-
management and capital adequacy. This combined with the higher cost of capital for smaller players
would queer the pitch in favour of the former. The larger banks would also have a distinct advantage in
raising capital in equity markets. Developing Market Banks can turn this challenge into an advantage
by active implementation and expanding their horizons outside the country.

4.3.5 Consolidation in the banking Industries


To the greatest extent possible, all banking and other relevant financial activities (both regulated and
unregulated) conducted within a group containing an internationally active bank has to be captured
through consolidation. Thus, majority-owned or –controlled banking entities, securities entities (where
subject to broadly similar regulation or where securities activities are deemed banking activities) and
other financial entities should generally be fully consolidated.

4.3.6 Non-implementation could impact Sovereign rating


Non-implementation of Basel II and a weak banking system would impact the sovereign rating further
worsening the situations for banks and the governments which borrow capital from advanced countries.

5.1. Findings
After pilot testing of the model for Basel II parallel calculations for Mercantile Bank Limited, it has
been found that the capital requirements to comply with Basel II Standardized/Basic approaches would
go up significantly. Under Basel I the minimum capital requirements for the Bank is BDT 2,903.66
million. Basel I Capital Accord only requires capital only for credit risk in Bangladesh. Market Risk
component of Basel I Accord has not yet been implemented even though it has been implemented since
1996 across the globe. As per the Basel I Capital Accord, the Bank is well-capitalized. After running
the pilot testing of the model for Basel II, it has been found that the capital requirement to comply with
Basel II has been increased by 41.94% as compared to Basel I capital requirements. The capital
requirement under Basel II regime increased due to additional burden of capital from Market Risk and
Operational Risk.
International Research Journal of Finance and Economics - Issue 23 (2009) 55
Table 2: Change in Capital

BDT in Million
Risk Weighted Assets(RWA) Basel I Basel II
A1. Credit Risk 29,036.56 37,749.64
A2.Market Risk - 537.10
A3.Operational Risk - 2,927.92
B. Total RWA(A1+A2+A3) 29,036.56 41,214.66
C. Tier I Capital 2,871.63 2,871.63
D. Tier II Capital 457.87 457.87
E. Total Capital(C+D) 3,329.50 3,329.50
F. Capital Adequacy Ratio-CAR(E/B) 11.47% 8.08%
Required Capital(10% against RWA) 2,903.66 4,121.47
Increase(Decrease) in Capital Requirement - 41.94%

6.1. Conclusion
There are many possible negative impacts of an unchecked implementation of Basel II. However,
Basel II is here to stay and the competitive forces will compel banks to follow the example. The option
here is to decide what form of the Basel II norms should be applied and to what extent to ensure the
survival and growth for the developing economies. Ultimately, the norms are for strengthening the
banking systems globally and this objective should not be lost. Developing Economies need to be
prepared and to adapt to the changing global conditions and to adapt the norms to their own advantage.
56 International Research Journal of Finance and Economics - Issue 23 (2009)

References
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International Research Journal of Finance and Economics - Issue 23 (2009) 57

Appendix A
Experimental Calculation under Basel II
SUMMARY / OVERALL CAPITAL ADEQUACY RATIO
(BDT in Million)
Tier 1 Capital
1.1 Paid-up Capital 1,498.90
1.2 Non-repayable Share Premium Account
1.3 Statutory Reserve 966.50
1.4 Other Reserve 103.36
1.5 Retained Earnings 302.87
1.6 Minority Interest in Subsidiaries
1.7 Non-cumulative irredeemable Preference Shares
1.8 Dividend Equalisation Account
1.9 Sub-Total (1.1 to 1.8) 2,871.63
Deductions:
1.10 Book value of Goodwill
1.11 Shortfall in provisions required against classified assets irrespective of any
relaxation allowed.
1.12 Deficit on account of revaluation of investments held in AFS category
1.13 Any increase in equity capital resulting from a securitization transaction
1.15 Other deductions (50% of the amount as calculated on CAP 2)
1.16 Sub-Total (1.10 to 1.15)
1.17 Total eligible Tier 1 capital (1.9-1.16) 2,871.63
Tier 2 Capital
2.1 General Provisions or general reserves for loan losses-up to maximum
of 1.25% of Risk Weighted Assets 361.03
2.2 Asset Revaluation Reserves
2.3 Exchange Equalisation Account 2.32
2.4 Revaluation Resreves of HTM (upto 50%)
2.5 Provision for Off-Balance Sheet Items 94.52
2.6 Subordinated debt -upto maximum of 50% of Total eligible Tier 1
2.7 Total Tier 2 Capital (2.1 to 2.6) 457.87
Deductions:
2.8 Deductions (50% of the amount as calculated on CAP 2)
2.9 Total eligible Tier 2 Capital (2.7-2.8) 457.87
Tier 3 Capital (eligible for market risk only)
3.1 Actual Tier 3 Capital
3.2 Eligible Tier 3 Capital
58 International Research Journal of Finance and Economics - Issue 23 (2009)

Appendix A
4 Total Supplementary Capital eligible for capital adequacy ratio (2.9+3.2) 457.87
(Maximum upto 100% of Total eligible Tier 1 capital)

5 Total Eligible Capital (1.17+4) 3,329.50


Risk Weighted Assets
6.1 Total Credit Risk Weighted Assets 37,749.64
6.2 Total Market Risk Weighted Assets 537.13
6.3 Total Operational Risk Weighted Assets 2,927.92
6.4 Total Risk Weighted Assets (6.1+6.2+6.3) 41,214.68
Capital Adequacy Ratios
7.2 Tier 1 Capital to Total Risk Weighted Assets (1.17 / 6.4) 6.97%
7.3 TOTAL CAPITAL ADEQUACY RATIO (5 / 6.4) 8.08%
CAP 2
OTHER DEDUCTIONS FROM TIER 1 AND TIER 2 CAPITAL
(BDT in Million)
1.1 Investments in equity and other regulatory capital of majority owned securities
or
other financial subsidiaries not consolidated in the balance sheet
1.2 Significant minority investments in banking, securities and other financial
entities

1.3 Equity holdings (majority or significant minority) in an insurance subsidiary

1.4 Significant minority and majority investments in commercial entities exceeding


15% of bank's capital
1.5 Securitization exposure subject to deduction
1.6 Others
1.7 Total Deductible Items to be deducted 50% from Tier 1
capital and 50% from Tier 2 capital

Appendix A
Credit Risk: Standardized Approach
1.Calculations of Risk Weighted Assets for Credit Portfolio
A. Corporate Portfolio BDT in Million
% of Total Exposure Credit Risk Adjusted Credit Rating Risk Weight Risk
Portfolio Mitigation Exposure Weighted
(CRM)** Assets
100% 27,903 3,069 24,834 Unrated 100% 24,834
Adjusted Exposure=
Exposure(1-CRM) Corporate Portfolio= Total Loans and Advances-Retail Portfolio-Commercial Real Estate-Past Due Loans

B. Retail Portfolio
B1. Residential Mortgage
Amount Risk Weight Risk Weighted Assets
1,278 35% 447

B2. Retail Loans other than Residential Mortgage


Amount Risk Weight Risk Weighted Assets
784 75% 588

C. Commercial Real Estate


Amount Risk Weight Risk Weighted Assets
1,019 100% 1,019
International Research Journal of Finance and Economics - Issue 23 (2009) 59

Appendix A

D. Past Due Loans


Category Amount Specific Past Due Loans, net Provision Risk Risk Weighted
Provision Kept of Specific Provision Kept Weight Assets
Kept
SS 16 2 14 Less than 20% 150% 20
DF 65 28 37 20% or more 100% 37
BL 814 535 279 50% or more 100% 279
Total 894 564 337
SS=Sub-Standard, DF=Doubtful and BL=Bad and Loss

2.Calculations of Risk Weighted Assets for Balances with Banks and FIs &
Money at Call and Short Notice
% of Total Portfolio Exposure Risk Weight* Risk Weighted Assets
100% 729 20% 146
*Maturity <=3 Months

3.Calculations of Risk Weighted Assets for Investments


Type Volume Credit Rating Risk Weight Risk Weighted Assets
Govt Instruments* 4,876 - 0% -
Others* 2,095 Unrated 100% 2,095
Total 2,095
*Investments include only banking book assets. Trading Book Assets will be considered in the capital requirements for Market Risk.

Appendix A

4.Calculations of Risk Weighted Assets for Fixed Assets and Other Assets
Exposure Risk Weight Risk Weighted Assets
1,516 100% 1,516

5.Calculations of Risk Weighted Assets for Off-Balance Sheet Items


OBS Items (Total Exposure) Gross Credit Risk Adjusted CCF Credit Risk Risk
Exposure Mitigation** Exposure Equivalent Weight Weighted
Assets
Direct Credit Substitute 3,226 510 2,716 100% 2,716 100% 2,716
Performance Related 5,781 867 4,914 50% 2,457 100% 2,457
Contingencies
Trade Related Contingencies 9,383 1,407 7,975 20% 1,595 100% 1,595
Commitments (maturity <= 1 50% - 100% -
year)
Commitments(maturity >1 20% - 100% -
year)
Revocable Commitments 515 - 515 0% - 100% -
Total 18,904 6,768
Adjusted Exposure= Gross Exposure-CRM
Total Risk Weighted for Credit Risk 37,749.64
**CRM is assumed from the industry practices.
60 International Research Journal of Finance and Economics - Issue 23 (2009)

Appendix A
RISK WEIGHTED ASSETS FOR MARKET RISK
SUMMARY
(BDT in Million)
A Capital Charge for Interest Rate Risk
i. Total market risk capital charge for Specific Risk -
ii.Total market risk capital charge for General Market Risk -
Total -
B Capital Charge For Equity Exposure
i. Specific Risk 22.80
ii. General Market Risk 22.80
Total 45.60
C Capital Charge for Foreign Exchange Risk 8.11
D Total Capital Charge for Market Risk (A+B+C) 53.71
E Risk Weighted Assets for Market Risk (D x 10) 537.10

Appendix A

CAPITAL CHARGE FOR EQUITY POSITION RISK


BDT in Million
Inside Bangladesh Outside Bangladesh* Total
DSE CSE
Specific Risk Charge
Equities
Long positions 228.00 228.00
Short Positions
Equity Derivatives
Long positions
Short Positions
Total Gross Positions (a+b+c+d) 228.00 228.00
Risk Weight 10% 10% 10% 10% 10%
Specific Risk Charge (f x e) 22.80 22.80
General Market Risk Charge
Net Long/Short Positions (|a-b| + |c-d|) 228.00 228.00
Risk Weight 10% 10% 10% 10% 10%
General Market Risk Charge (h x i) 22.80 22.80
Total Capital Charge for Equity Exposures (g + j) 45.60 45.60
International Research Journal of Finance and Economics - Issue 23 (2009) 61

Appendix A
CAPITAL CHARGE FOR FOREIGN EXCHANGE RISK
Multiple Currency-Shorthand Method
(BDT in Million)
Position in Currency
Currency Net Spot Net Guarantees Net Others Net delta-based Total net BDT Position
Position Forward future equivalent of long Rate in BDT
Position income/ foreign (short)
expenses currency Positions
options
1 2 3 4 5 6 7 8 9 10
USD 0.67 0.67 68.57 45.94
EUR 0.07 0.07 100.91 6.76
GBP 0.11 0.11 136.72 14.36
JPY 4.80 4.80 0.61 2.93
CAD 0.05 0.05 69.91 3.50
AUD 0.12 0.12 59.98 7.20
CHF 0.007 0.007 60.81 0.43
Overall Long/Short Position 81.10
Capital Charge Rate 10%
Total Capital Charge 8.11

Appendix A

Calculation of Capital for Operational Risk


Basic Indicator Approach
BDT in Million
Items 2005 2006 2007 Avg α Capital Charge
Interest Income 2,405 3,130 3,686 3,074
Interest Expenses 1,987 2,663 3,159 2,603
A. Net Interest Income 418 467 527 471
Investment Income 315 369 764 483
Commission, Exchange and Brokerage 560 794 790 715
Other Operating Income 192 339 320 284
B. Net Non-Interest Income* 1,067 1,502 1,875 1,481
C.Gross Income(A+B) 1,485 1,969 2,402 1,952 15% 292.79
Capital Charge 292.79
Risk Weighted Assets for Operational Risks (Capital Charge*10) 2,927.92
*Net Interest Income be gross of any provision and gross of Operating Expenses.
It also excludes realized profits/losses from the sale of securities in the banking book and excludes extraordinary or irregular items as well as income
derived from insurance.

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