Sub-sectoral Institutions in EU-China Energy Cooperation

A strong banking system is the basic requirement of a healthy economy. The monetary authorities in different countries regulate the banking system and in India, RBI carries the Central Banking functions and regulates the Indian banks under RBI Act 1934 and Banking Regulation Act 1949. The objectives of such regulation and supervisions are:

 Improving the health of banking system by prescribing prudent guidelines on capital requirement, assets quality etc.

 promoting sound business and supervisory practices

 Controlling and monitoring the systemic risk

 protecting the interest of various stakeholders including depositors, public, govt. etc.

Basel II Guidelines

The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory authorities that was established by the central banks' governors of the Group of Ten countries (G-10) in 1975 under Bard( for International Settlements (131S). It consists of senior representatives of bank supervisory authorities and central banks from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and the United States. It usually meets at the Bank for International Settlements in Basel, where its permanent Secretariat is located.

1988 Basel Accord (Basel-I) : Basle Committee on Banking Supervision (BCBS) gave its recommendations in the year 1988 for putting in place the minimum capital requirements for banks all over the world, to improve their financial health.

Implementation of Basel I in India: With a view to adopting the framework on capital adequacy which takes into account the elements of credit risk in various types of assets in the balance sheet as well as off-balance sheet business and also to strengthen the capital base of banks, Reserve Bank of India decided in April 1992 to introduce a risk asset ratio system for banks (including foreign banks) in India as a capital adequacy measure. Essentially, under the above system the balance sheet assets, non-funded items and other off-balance sheet exposures are assigned prescribed risk weights and banks have to maintain unimpaired minimum capital funds equivalent to the prescribed ratio (minimum 9% in India) on the aggregate of the risk weighted assets and other exposures on an ongoing basis.

Implementation of guidelines on Market Risk: Reserve Bank has issued guidelines to banks in June

Compiled by Sanjay Kumar Trivedy , Senior Manager , RSTC, Mumbai 82 | 2004 on maintenance of capital charge for market risks on the lines of 'Amendment to the Capital Accord to incorporate market risks' issued by the BCBS in 1996.

2006 Basel Accord (Basel—II) : The BCBS released the "International Convergence of Capital Measurement and Capital Standards: A Revised Framework" on June 26, 2004. The Revised Framework was updated in November 2005 to include trading activities and the treatment of double default effects and a comprehensive version of the framework was issued in June 2006 incorporating the constituents of capital and the 1996 amendment to the Capital Accord to incorporate Market Risk.

The Revised Framework seeks to arrive at significantly more risk-sensitive approaches to capital requirements. The Revised Framework provides a range of options for determining the capital requirements for credit risk and operational risk to allow banks and supervisors to select approaches that are most appropriate for their operations and financial markets.

Fundamental objective of Basel II : The fundamental objective of the CoMmittee's work to revise the 1988 Accord has been :

 to develop a framework that would further strengthen the soundness and stability of the international banking system while maintaining sufficient consistency that capital adequacy regulation will not be a significant source of competitive inequality among internationally active banks.

 to promote the adoption of stronger risk management practices by the banking industry. The key elements of the 1988 capital adequacy framework, including

(a) the general requirement for banks to hold total capital equivalent to at least 8% of their risk-weighted assets;

(b) the basic structure of the 1996 Market Risk Amendment regarding the treatment of market risk;

and

(c) the definition of eligible capital have been retained in the Basel II.

Major features of Basel II Accord

 more risk sensitive capital requirement

 take into account operational risk in addition to credit and market risk for capital purpose

 provide range of options for determining the capital needs for credit risk and operational risk

 to promote stronger risk management practices.

BASEL II - Three pillars

The revised framework is based on 3 important aspects, called three pillars which include : (a) minimum capital requirement,

(b) supervisory review and (c) market discipline.

Pillar— t : Different Types of approaches for Minimum Capital Standard Pillar — I : Type of risk for which capital to be

maintained

Approach to be followed

Credit risk Standard Approach

Internal Rating based Foundation approach Internal Rating based Advance Approach

Market risk Standard Approach — Maturity Method

Standard Approach — Duration Method Internal Models Method

Operational risk Basic Indicator Approach

Standard Approach

Advance measurement approach

Tier-I : Capital Standards- Minimum CAR or CRAR

As per BCBS, the banks shall maintain minimum CgAR of S% but as per R131 directives on CAR, the bank in India shall maintain Total CRAP. of 9% and also Tier I capital of 6% (to be achieved by

31.03.2010). Further, the minimum capital would be subjected to a prudential floor, which shall be higher of minimum capital required to be maintained OR a specified percentage of minimum capital required for credit & market risk as per Basel I.

The ratio is to be calculated both for Tier I and for Capital Fund as under:

Eligible Tier I Capital Funds

Tier I CRAR = --- X 100 Credit Risk RWA + Market Risk RWA + Operational Risk RWA

Eligible TotalI Capital Funds

Total CRAR = --- X 100 Credit Risk RWA + Market Risk RWA + Operational Risk RWA

Capital fund under Basel II

Capital Fund has two tiers - Tier I and Tier II. Tier I has major items such as paid-up capital, statutory reserves & other disclosed free reserves, Innovative Perpetual Debt Instruments etc. Tier II includes revaluation reserves, general provisions and Loss Reserves hybrid debt capital Instruments and subordinated debt (long term unsecured loans.

Tier I Capital should at no point of time be less than 50% of the total capital.

Risk weighted assets

Fund based assets include cash, loans, investments and other assets. Degrees of credit risk expressed as %age weights is assigned by RBI to each such asset As regards the non-fund based (called off-balance sheet) items, the exposure is first calculated by multiplying the face amount of each of the off-balance sheet items by the credit conversion factor_ This is then multiplied by the relevant weightage.

Capital standard for Credit Risk

For this, there are 2 approaches for providing capital which include (a) Standardised Approach and (b) Internal Rating Based Approach (IRB). IRE approach could be either (a) foundation IRB approach or (b)

advanced IRB approach.

Standardized Approach for Credit Risk : Under this, the risk weightages would be prescribed by the Central Banks (RBI in India) and would be adopted by the banks without any discretion to modify. This approach is based on ratings from External Credit Rating Institutions (ECRA) for sovereigns, banks and corporates. This approach is more suitable, for the time being, in view of lack of historical data in India and other such factors. The nature of the risk assets and the risk weights would be as under:

Asset Category ( called claimed ) Risk %

Govt../central banks (based on credit rating) on a scale of 1 to 8 (0 to 150%), as under:

. Risk score 0-1 0% 0%

. Risk score 2 20% 20%

Risk score

3

50%

^50%

Risk score 4 to 6 100%

. Risk score 7 & above 150%

Official entities such as BIS, ECB,EC, World Bank group) 0%

Banks and Securities Firms (based on ECA risk scoring) 20-150%

Unrated Corporates ( including insurance companies) 100%

Rated corporates: (20% to 150%)

AAA to AA- 20% 20%

. A+ to A- 50%

. BBB+ to BB 100%

. Below BB 150%

Compiled by Sanjay Kumar Trivedy , Senior Manager , RSTC, Mumbai 84 | Retail portfolio, not past due for more than 90 days (small loans/ credit card exposure to individuals with

proper diversification) 75%

_Loanssecuredbymortgageofresidentialproperty 50% to 75%

-Loans secured by commercial real estate 150%

Past due loans (100% to 150):(Can be up to 50% with RBI permission if provision is not less than 50%)

. where provisions are less than 20% : 150%

.. where provision is not less than 20% 100%

. Higher risk categories (as decided by Central Bank) : - 150%

Other assets 100%

Off-balance sheet items (after conversion byapplying conversion factor) (0 to 50%)

.-for cancelable commitment, 0%

-for up to 1 year maturity 20%

- f o r m o r e t h a n o n e y e a r m a t u r i t y ) 50%

Ratings Agencies: RBI has identified 4 external domestic rating agencies namely CRISIL, ICRA, CARE & Fitch for use of their rating. The international agencies are Fitch, Moody's and Standard &

Poor's.

Internal Ratings-Based Approach

As an alternative to standardised approach, the banks can adopt the IRB approach (having two variants i.e. foundation or advanced), with approval from the Reservel Bank.

Risk components for [RBA: The risk components include measures of the probability of default (PD), loss given default (LGD), the exposure at default (EAD), and effective maturity (M). In some cases, banks may be required to use a supervisory value as opposed to an internal estimate for one or more of the risk components.

The IRB approach is based on measures of unexpected losses (UL) and expected losses (EL). The risk-weight functions produce capital requirements for the UL portion.Expected losses are treated separately.

The asset classes are defined first. Adoption of the IRB approach across all asset classes transitional arrangements_ The risk components, serve as inputs to the risk-weight functions that have been developed for separate asset classes. For example, there is a risk-weight flu^-teflon for corporate exposures and another one for qualifying revolving retail exposures. The treatment of each asset class begins with a presentation of the relevant risk-weight function(s) followed by the risk components and other relevant factors, such as the treatment of credit risk mitigants. The legal certainty standards for recognising CRM apply for both the foundation and advanced IRB approaches.

Foundation approach : Under the foundation approach, as a general rule, banks provide their own estimates of Probability of Default (PD) and rely on supervisory estimates for other risk components.

Advance approach : Under the advanced approach, banks provide more of their own estimates of PD, Loss given default (LGD) and exposure at default (EAD), and their own calculation of effective maturity (M), subject to meeting minimum standards.

For both the foundation and advanced approaches, banks must always use the risk-weight functions provided in this Framework for the purpose of deriving capital requirements..

Subject to certain minimum conditions and disclosure requirements, banks that have received supervisory approval to use the IRB approach may rely on their own internal estimates of risk components in determining the capital requirement for a given exposure.

Foundation and advanced approaches : For each of the asset classes covered under the IRB framework, there are three key elements:

Risk components — estimates of risk parameters provided by banks some of which are supervisory estimates.

Risk-weight functions — the means by which risk components are transformed into risk-weighted assets and therefore capital requirements.

Minimum requirements — the minimum standards that must be met in order for a bank to use the IRB approach for a given asset class

D i f f e r e n c e b e t w e e n t h e f o u n d a t i o n a n d a d v a n c e d a p p r o a c h

Parameter / Who will determine Foundation IRB Advanced IRB

Probability of Default (PD) Bank Bank

Loss givendefault(LGD) Supervisor Bank

Exposure at Default (EAD) Supervisor Bank

Effective Maturity (M) Bank or supervisor Bank

Risk weight Function provided by Committee Function provided by committee Data Requirement Historical data to estimated PD —

5 years Historical loss data to estimated LGD 7 years and historical exposure data to estimate EAD — 7 years plus that for Pt)

estimation.

Capital standard for Market Risk

Market risk is the risk of possible losses in, on-balance sheet and off-balance sheet positions, due to movements in market prices. The market risk positions, subject to capital charge requirement, are (a) the risks pertaining to interest rate related instruments and equities in the trading book and (b) Foreign exchange risk throughout the bank.

The Basle Committee has suggested two broad methodologies for computation of capital charge for market risks (a) standardized method and (b) batiks' internal risk management models method RBI has decided that, to start with, banks may adopt the standardised method.

Under the standardised method there are two principal methods of measuring market risk, a

"maturity" method and a "duration" method. Banks are required to measure the general market risk charge by calculating the price sensitivity (modified duration) of each position separately.

Capital standard for Operational Risk

Operational risk is defined as the probability of loss resulting from inadequate or failed internal processes, people and systems or external events. Some factors for operational risk could be lack of competent management and/or proper planning and controls, incompetent staff, indiscipline, involvement of staff in frauds, outdated systems, non-compliance, programming errors, failure of computer systems, increased competition, deficiency in loan documentation etc. Approach : The risk can be measured by adopting one of the 3 approaches i.e. Basic Indicator Approach (BIA), Standardised Approach and Advinced Measurement Approach.

Banks which move to Standardised approach or AMA, will not be allowed to move back to BIA.

(1) Basic Indicator Approach : As per this, a bank will have to hold capital, equal to average of previous 3 years' positive annual gross income (i.e. net init. income + net non-intt. income), as a fixed

%age (denoted alpha i.e. 15%). If there is negative gross income for any year, it will be excluded both from numerator and denominator.

Capital requirement = Annual positive gross income for three years x 15% / no. of years for which gross income is positive.

(2) Standardized Approach : As per this, average gross income will be segregated into 8 business lines i.e. (1) retail banking (2) retail brokerage (3) asset management (4) commercial banking (5) agency services (6) corporate rmance (7) trading and sales (8) payment and settlements. These elements carry varying degree of capital.

Total capital charge is the sum of capital charges across the business lines.

(3) Advance Measurement Approach : As per this, the capital charge will be equal to the internally generated measure based on (a) internal loss data (b) external loss data (c) scenario analysis (d) business environment and internal control factors.

The risk mitigation will be allowed up to 20%.

2nd Pillar: SUPERVISORY REVIEW PROCESS

Supervisory review process is intended to ensure that banks have adequate capital to support all the risk in their business and encourage them to develop and use better risk management techniques in

Compiled by Sanjay Kumar Trivedy , Senior Manager , RSTC, Mumbai 86 | monitoring and managing their risk Central banks are to evaluate as to how well banks are assessing their capital needs considering their risk profile. There are 4 key principles of supervisory review:

a) Principle-I: Banks should have a process for assessing their overall capital 'adequacy in relation to their risk profile and a strategy for maintaining their capital levels.

b) Principle-2: Supervisors should review and evaluate banks' internal capital adequacy assessment and strategies, and ability to monitor/ ensure their compliance with regulatory capital ratios.

c) Principle-3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.

Principle-4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of the bank. It should require remedial action if capital is not maintained or restored.

3rd Pillar — Market Discipline

The objective of 3rd pillar is to complement the minimum capital requirement and supervisory review process through various kinds of disclosures such as

1. capital structure (Tier I and its components on a quarterly basis), 2. total amount of Tier 2 capital,

3. bank's approach to assess the capital adequacy to support its current and future activities i.e.

capital required for credit risk, market risk or operational risk, 4. interest rate risk in the banking book.

In document ZHANG CHAO (página 192-197)