Basel II to spur capital recast, to affect profits

The capital structure of the banks will have to be revamped to afford phase-wise implementation of the Basel II capital accord.

According to treasury heads of public sector banks, the capital adequacy of even sound public sector banks will come down by 1-2 per cent due to the migration to Basel II.

Capital will be hit mostly on account of operational risk, which is yet to be quantified in terms of risk weightage. Under the proposed norms, banks will have classify risk into three categories "" credit risk, market risk and operations risk.

Credit risk requires the banks to rate their credit portfolio either through an external rating methodology or an internal rating system. This is likely to ease the pressure on capital provisioning. Credit risk is risk arising from defaults.

The capital charge on operational risk and market risk is likely to substantially alter the capital equation.

Some banks have already started rating their credit portfolio and pegging a capital charge on it. This has helped, they said, as under the previous norm, banks had to levy uniform risk weightage to their entire portfolio irrespective of credit worthiness.

At present, the risk weightage varies in proportion to the quality of the assets.

Therefore, capital charge has come down on good assets. Bankers said things are not clear about operational risk, which is poised to impact banks' capital structure significantly.

This is because, under the norm, banks have to account for all risks that could affect their operations, including strikes, theft, robbery, information technology etc.

The provisioning norms for operational risk is most stringent as it has been specified that 15 per cent of the total income should be set aside for capital charge.

Bankers see this drastically affecting profitability. Even banks in Europe and United states have raised concerns over the operational risk norm. They said discussions are still on with the central banks regarding levying capital charge on operational risk.

The issue being debated is whether to have a uniform capital charge for operational risk or graded capital charge as per the risk assessment.

The Basel Committee on Banking Supervision (BCBS) would be issuing the New Capital Accord, called Basel II, by June 2004 end. It is expected to be implemented by the end of 2006.

Capital charge on market risk refers to a system whereby banks will have to provide capital in proportion to the risk level of activities.

Market risk arises from fluctuations in factors affecting treasury operations of the banks, which include interest rates and exchange rate variations. At present, a flat 2.5 per cent risk weightage is provided across banking activities, irrespective of the risk assessment.

In the first phase, banks will have to maintain capital charge for market risk in respect of their trading book exposure (including derivatives) by March 31, 2005.

The book contains instruments used by banks for day to day trading activity in the financial market.

In the second phase, banks would be required to maintain a capital charge for market risk on securities included in the "available for sale" (AFS) category by March 31, 2006.

AFS securities are not used for daily trading but are kept to take advantage of profitable opportunities that crop up.