Towards Basel-II

After much debate on Basel-II, the new capital adequacy norms for banks, the Reserve Bank of India has finally released the draft guidelines for implementation.

By March 31, 2007, all banks in India will adopt, at a minimum, the Standardised Approach for credit risk and the Basic Indicator Approach for operational risk.

Essentially, Basel-II adopts a more rational and nuanced basis for allocating capital to risks, replacing the one-size-fits-all system currently in place.

To take an oft-quoted example, it will ensure that exposure to a triple A-rated blue chip company will require less capital than exposure to a small-scale firm.

It also ensures that banks provide for operational risk. One telling example of such a risk is the payment by a large public sector bank of dividend warrants tendered through clearing when the account of the company issuing the warrants hadn't been funded.

In addition to the minimum capital requirement arrived at by allotting weights for credit risk, market risk and operational risk, the new rules also provide for two additional pillars in the shape of a supervisory review process and market discipline.

One consequence of all this is that banks will need to learn and adopt more sophisticated risk management techniques. They will have to gear up their systems and manpower to ensure greater sensitivity to risk.

Banks will have to ensure that they not only capture all the data needed, but that they can then build models that will map risk-reward relationships in a more dynamic fashion.

For public sector banks with far-flung branch networks, this is a huge task.

Another issue raised by the new norms is that of a higher requirement of capital for weaker banks. Banks have already started lining up IPOs and Tier-2 issues to increase their capital requirements in order to take care of Basel-II.

The concern is that the finer matching of capital to risk will result in higher capital requirements and, consequently, higher costs for weaker banks.

That could be addressed by mergers and acquisitions, and in fact the introduction of Basel-II provides a good opportunity for consolidation in the banking sector.

In short, Basel-II will push the Indian banking system towards improved health.

At the same time, however, there are limits to what regulations can do. Mergers and acquisitions mean little when banks are not allowed to shed redundant staff or when, as in the case of Oriental Bank of Commerce, they have to ensure that the high salaries of staff in bankrupt banks being taken over are protected.

Moreover, while ensuring that banks comply with Basel-II, surely they also need some relief from the system of mandated lending currently in place? There exists a fundamental contradiction between the philosophy of directed lending and that of fine-tuning the allocation of capital to risk.

Similarly, incentive structures in public sector banks need to change. More attention also needs to be paid to cooperative banks, the weak underbelly of the financial system.

In the final analysis, the introduction of new technology and competition will do more to make the Indian banking system stronger than mere regulations.