1.

Introduction- Banking is a highly leveraged industry characterized by high debt-equity

ratio and low capital asset ratio. They earn by taking risk on their creditors money rather than shareholders money. Therefore their appetite for risk needs to be managed. As evident form recent US crisis the failure of one bank may spill over to other banks and beyond the banking system to the financial system, to the domestic macro economy and to other countries.

1. Risks in Commercial Banks- There are various kinds of risks that can adversely affect the

smooth operations of bank. To minimize the risks the total capital ratio must be no lower than 8% and Tier 2 capital is limited to 100% of Tier 1 capital. Various risks can be divided into three broad categories:-

1.1 Credit Risk- Credit Risk is the potential that a bank borrower/counter party fails to

meet the obligations on agreed terms. There is always scope for the borrower to default from his commitments for one or the other reason resulting in crystallization of credit risk to the bank. These losses could take the form outright default or alternatively, losses from changes in portfolio value arising from actual or perceived deterioration in credit quality that is short of default. Credit risk is inherent to the business of lending funds to the operations linked closely to market risk variables. The objective of credit risk management is to minimize the risk and maximize banks risk adjusted rate of return by assuming and maintaining credit exposure within the acceptable parameters.

1.1.1

Reserve Bank of India Regulation- RBI follows Basel 2 norms for calculating credit risk. Credit Risk for each corporate, sovereign and bank exposure. The risk components include measures of the probability of default (PD), loss given default (LGD), the exposure at default (EAD), and effective maturity (M). Under the RBI regulation, every bank has to get itself rated either through external rating system (done by rating agencies like- CRISIL, ICRA, FITCH, and CARE or through internal rating system.

1.1.1

Internal Regulation- Almost all banks have formed committees for reducing and implementation of norms put by RBI. They have integrated risk management committee consisting of various sub-committees for tackling different types of risks. Some of the committees for reducing credit risk are Credit Risk Management Committee (CRMC), Asset Liability Committee (ALCO), Risk-based Internal Assessment (RBIA) Future Aspects

1.1.2

1.2 Operational Risk- Operational risk is defined as the risk of loss resulting from

inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk. Operational risk is most sophisticated type of risk. Operational risk may materialize directly or indirectly through credit or market risk. It is second most important risk and hence needed to be tackled with efficient and effective strategy.
1.2.1

1.2.2

Reserve Bank of India Regulation- RBI has various rules and regulations to mitigate operational risk, some of these are taken from Basel 2 recommendations and some of them are formulated with consideration of local market conditions. RBI, in accordance to Basel 2 norms, recommends using one of -The Basic Indicator Approach (BIA), The Standardized Approach (TSA) and the Advanced Measurement Approach (AMA) for measurement of operational risk. All the three approaches differ in their complexity and the banks are encouraged to move along the spectrum of approaches as they obtain more sophistication in their risk management practices. Internal Regulation- Most of the banks have internal skill sets to monitor and minimize the operational risks and sometimes bank even hire a consultant for this job. At executive level, Operational Risk Management Committee (ORMC) functions for successful implementation of norms put by RBI. Internal regulation is one of the most effective ways to tackle operational risk. As operational risk depends on credit risk and market risk, various committees need to have excellent coordination to reduce overall risk.

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Future Aspects-

1.3 Market Risk- Market Risk may be defined as the possibility of loss to bank caused by

the changes in the market variables. It is the risk that the value of on-/off-balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices. Market risk is the risk to the banks earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities, of those prices. Market Risk Management provides a comprehensive and dynamic frame work for measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity as well as commodity price risk of a bank that needs to be closely integrated with the banks business strategy.
1.3.1

Reserve Bank of India Regulation- Value at Risk (VaR) is a method of assessing the market risk using standard statistical techniques. It is a statistical measure of risk exposure and measures the worst expected loss over a given time interval under normal market conditions at a given confidence level of say 95% or 99%. Thus VaR is simply a distribution of probable outcome of future losses that may occur on a portfolio. The actual result will not be g known until the event takes place. Till then it is a random variable whose outcome has been estimated. Internal Regulation- Banks employs dedicated staff for monitoring of market risk. In survey it has been found that around 17% of the dedicated staff is looking after market risk management.

1.3.2

1.3.3

Future Aspect-

1.4 Settlement Risk- Settlement Risk could arise in bank when payment and receipt of

fund is not simultaneous. As a result of this delay, credit is extended from one bank to another bank. To reduce this risk, RBI has introduced Real Time Gross Transfer Settlement System. All inter-bank settlements are done through this RTGTS system.

Basel I and Basel II norms While Basel I framework was confined to the prescription of only minimum capital requirements for banks, the Basel II framework expands this approach not only to capture certain additional risks in the minimum capital ratio but also includes two additional areas, viz. Supervisory Review Process and Market Discipline through increased disclosure requirements for banks. Thus, Basel II framework rests on the following three mutually- reinforcing pillars: Pillar 1: Minimum Capital Requirements prescribes a risk-sensitive calculation of capital requirements that, for the first time, explicitly includes operational risk along with market and credit risk. Pillar 2: Supervisory Review Process (SRP) envisages the establishment of suitable risk management systems in banks and their review by the supervisory authority. Pillar 3: Market Discipline seeks to achieve increased transparency through expanded disclosure requirements tor banks.

Basel 3 Basel 3 Norms aims at improving the quantity and quality of the capital held by the banks to withstand the Financial crisis. They are consistent with the renewed

focus of the central bank on the Financial stabilty of system as a whole rather than micro regulation of individual bank. Thus the mantra of Basel III is the Macro prudential stability The New requirements demands the bank to hold top quality capital totaling 7 percent of their risk bearing assets. This include new Capital Conservation Buffer of the 2.5 percent. Also norms advocate the national regulators to impose surcharge on the systemically important Bank as they grapple with the too big to fail problem. Apart from this Basel III norms also proposed a Counter Cyclical buffer amounting to between 0 to 2.5 percent of tier 1 capital for the times when there is excessive credit growth in the system. This would enable the bank to offset any potential losses without having to raise any fresh capital immediately. Central bank may impose restrictions on payouts such as dividends , share buybacks and bonuses on the banks which fail to keep the capital ratio above the buffers Another change proposed is the way top quality capital i.e. Tier 1 capital is calculated. Tier 1 capital would now include only the equity capital and retained earnings and not include deferred tax asset and mortgage servicing rights. Also the investment in financial institution over 15 percent of common equity component will not be part of tier 1 capital. Thus the quality of loss absorbing capital is increased. To ensure that the bank do not overreach themselves higher capital to risk-weighted assets ratio is to be supplemented with a debt to equity ratio. Thus new norms impose a ceiling on build up of leverage in banking sector. The Tier 1 capital should be atleast 3 percent total asset . Thus Bank balance sheet size cannot increase 33 percent of Tier 1 capital. Basel III norms involve two regulatory standards for managing liquidity risk. For ensuring short term resilience there should be a liquidity coverage ratio and for long term Net stable funding ratio. Liquidity Coverage ratio requires banks to have sufficient easily liquidated assets on hand to cover a month's worth of outgoings.

Basel III and INDIA As on June 30, 2010 , the aggregate capital to risk weighted assets ratio of Indian banking system stood at 13.4 percent of which the Tier 1 capital was 9.3 percent, according to RBI data. Thus the banking system in India would not be significantly stretched to meet new capital rules both in terms of overall quality of capital and quantity of capital.

However there may be some impact due to the shifting of some deductions from Tier 1 capital and Tier 2 capital to common equity . Public sector bank rely a lot on perpetual debt instrument to shore up their Tier 1 capital. Thus they have lower Tier 1 ratio in comparison with private banks. Therefore a quick transition to Basel III will impose a greater capital requirement on them. One of the major disappointment of the Basel III is the time table laid out for the adherence. Jan 2019 set for implementation is far too stretched. Also the rules laid are very lenient. Thus RBI should insist on more stringent norms for Indian banks and should continue to remain step ahead.

In Indian Context the major challenges would lie in implementing the liquidity standards as Indian banks have limited capability to collect the relevant data accurately and granularly and to formulate and predict the liquidity stress scenarios. Basel III norms will reduce the leverage hence the returns on equity would be less and it would also impact the growth of bank.

Critique of RBI Historically the Risk management policies of RBI are greatly influenced by Basel norms. When RBI implemented Basel I by 1999, the Scheduled Commercial Banks (SCBs) in the country experienced, a noticeable drop in their non-performing assets (NPAs), from 8.1 per cent to 2.9 per cent of net bank credits (NBCs) between 1997-98 and 2003-04. The major concern with Adoption of Basel II in India is its over-emphasis on financial stability as a goal in itself. This goal goes contrary to credit distributional norms and growth potentials of the Indian economy. The Capital requirement as per Basel II are too high for Indian banks as Indian banks unlike their foreign counterparts are not much involved in speculative activities. This increased capital requirement will make bank more risk averse to credit dispension.

Banking sector is undergoing restructuring with the Basel norms and its implications will not limited to the reduced Non performing Assets. It will have strong bearing on the distribution of bank credit . With priority sector mandate and focus of the bank on risk weighted assets the loans to small sector Industry will suffer .This would be indeed a concern because employment generated by the organised sector of the manufacturing industry is only 14 per cent compared with 86 per cent by the unorganised sector of which small and medium enterprises remain the major component. Also small and medium enterprises, which include the SSIs, currently contribute 40 per cent of the total industrial production and over 34 per cent of national exports for the country. Thus limitations of the guiding principle of the Basel norms for banking industry in a country like India where credit needs to be re-directed to units which are deserving, not only in terms of productive contribution but also in terms of social priorities is a serious concern. Another concern is the short time frame with in which Basel 2 was implemented. Much of this so- called risk-aversion with regards to credit dispension can also be attributed to quick adoption of Basel - approved credit risk adjusted ratios for capital. Though the Basel II norms are implemented in India, t. Thus based on the degree of sophistication in Indian banking system, cost of implementation and compliance it was decided that bank in India will initially adopt the standardised Approach for credit risk, basic indicator approach for operational risk. Adoption of the advance approaches like, Internal rating based approach for credit risk and Advanced Measurement Approach for operational risk,would have helped bank to maintain low capital. But there are constraints faced by domestic banks in terms of availability of historical data, required skill-sets and technological adoption so they do not meet the minimum requirement specified in the Basel framework to migrate to advance approach. Thus Basel 2 was implemented in India before the banks were ready for it and as a result they have to keep extra capital charge. Third concern is Basel norms might lead to systemic risk and subsequent consolidation in the banking industry. Since Capital requirement in advance

approaches of risk measurement is lower, many large banks are keen to implement advance approaches. Cost of implementation of advance approaches in large banks would be compensated by resulting reduction in capital but for smaller banks this cost would not be compensated. As a result larger banks would be able to pass benefits of reduction in regulatory capital. Thus due to arbitrage opportunity the low risk assets would be attracted towards larger banks and smaller banks would be left with high risk assets. This adverse selection presents intrinsic systemic risk in times of economic downturn. To meet the capital adequacy norms of Basel II the public sector banks needed avenues to raise capital. RBI facilitated capital raising options by enabling the issuance of several instruments by banks viz perpetual debt instruments, Perpetual non cumulative preference, redeemable cumulative preference share and hybrid debt instrument . Now with the changes in the norms way tier 1 capital is calculated PSB would require to direct a lot of capital for adequacy which implies less credit dispension. Also Basel norms impacts the growth of the banks thus to the goal of financial inclusion.