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1.1 BACKGROUND OF THE STUDY Basel II is the second of the Basel Accords, (now extended and effectively superseded by Basel III), which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. Basel II, initially published in June 2004, was intended to create an international standard for banking regulators to control how much capital banks need to put aside to guard against the types of financial and operational risks banks (and the whole economy) face. One focus was to maintain sufficient consistency of regulations so that this does not become a source of competitive inequality amongst internationally active banks. Advocates of Basel II believed that such an international standard could help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. In theory, Basel II attempted to accomplish this by setting up risk and capital management requirements designed to ensure that a bank has adequate capital for the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability. Politically, it was difficult to implement Basel II in the regulatory environment prior to 2008, and progress was generally slow until that year's major banking crisis caused mostly by credit default swaps, mortgage-backed security markets and similar derivatives. As Basel III was negotiated, this was top of mind, and accordingly much more stringent standards were contemplated, and quickly adopted in some key countries including the USA. The final version aims at: 1. Ensuring that capital allocation is more risk sensitive; 2. Enhance disclosure requirements which will allow market participants to assess the capital adequacy of an institution; 3. Ensuring that credit risk, operational risk and market risk are quantified based on data and formal techniques; 4. Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.


While the final accord has largely addressed the regulatory arbitrage issue, there are still areas where regulatory capital requirements will diverge from the economic capital. Basel II uses a "three pillars" concept (1) minimum capital requirements (addressing risk), (2) supervisory review and (3) market discipline. The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk was not dealt with at all. 1.2 STIPULATIONS OF THE THREE PILLARS UNDER BASEL-II

The Pillar 1 stipulates the minimum capital adequacy ratio and requires allocation of regulatory capital not only for credit risk and market risk but additionally, for operational risk as well, which was not covered in the previous accord. The Pillar 2 of the framework deals with the Supervisory Review Process (SRP), and it requires the banks to develop an Internal Capital Adequacy Assessment Process (ICAAP) which should encompass their whole risk universe by addressing all those risks which are either not fully captured or not at all captured under pillar 1 and assign an appropriate amount of capital internally. Under the Supervisory Review, the supervisors would conduct a detailed examination of the ICAAP of the banks, and if warranted, could prescribe a higher capital requirement, over and above the minimum capital adequacy ratio envisaged in Pillar 1.

The Pillar 3 of the framework, Market Discipline, focuses on the effective public disclosures to be made by the banks, and is a critical complement to the other two Pillars. It is based on the basic principle that the markets would be quite responsive to the disclosures made and the banks would be duly rewarded or penalized by the market forces. It recognizes the fact that the discipline exerted by the markets can be as powerful as the sanctions imposed by the regulator.









In August 2004, soon after the new framework was released by the BCBS, the banks were [3]

advised to conduct a self-assessment of their risk management systems and to initiate remedial measures, as needed, keeping in view the requirements of the Basel-II framework. A Steering Committee was constituted in October 2004, comprising senior officials from 14 select banks (a mix of public sector, private sector and foreign banks). In February, 2005, based on the inputs received from this committee, the RBI issued the draft guidelines, for public comments, on implementation of Pillar 1 and Pillar 3 requirements of the Basel-II framework. In the light of the feedback received from a wide spectrum of banks and other stake holders, the draft guidelines were revised and the final guidelines were issued on April 27, 2007. As regards the Pillar 2, the banks have been asked to put in place the requisite internal Capital Adequacy Assessment Process (ICAAP) with the approval of their Boards. The minimum capital adequacy ratio prescribed under Basel-II norms continues to be nine per cent.










Even before the final guidelines were issued, the RBI had asked the banks in May 2006 to begin conducting parallel runs, as per the draft guidelines, so as to familiarize them with the requirements of the new framework. During the period of parallel run, the banks are required to compute, on an ongoing basis, their capital adequacy ratio both under Basel-I norms, currently applicable, as well as the Basel-II guidelines to be applicable in future. This analysis, along with several other prescribed assessments, is to be placed before the Boards of the respective banks every quarter and is also transmitted to the RBI.


The foreign banks operating in India and the Indian banks having operational presence outside India are required to migrate to the Standardised Approach for credit risk and the Basic Indicator Approach for operational risk with effect from March 31, 2008. All other Scheduled commercial banks are encouraged to migrate to these approaches under Basel-II, not later than March 31, 2009. It has been a conscious decision to begin with the simpler approaches available under the framework. As regards the market risk, the banks will continue to follow the Standardised-Duration Method, already adopted under the Basel-I [4]

framework, under Basel-II also.


First, the new norms might, in some cases, lead to an increase in the overall regulatory capital requirements for the banks, if the additional capital required for the operational risk is not offset by the capital relief available for the credit risk. Second, the Standardised Approach for credit risk leans heavily on the external credit ratings. While the RBI has accredited four rating agencies operating in India, the rating penetration in India is rather low and it is confined to rating of the instruments and not of the issuing entities as a whole. Third, the risk weighting scheme under Standardised Approach also creates some incentive for some of the bank clients with loan amount less than Rs.10 crores to remain unrated, since such entities receive a lower risk weight of 100 per cent against 150 per cent risk weight for a lowest rated client. Fourth, the new framework could also intensify the competition for the best clients with high credit ratings, which attract lower capital charge, but will put pressure on the net interest margins of the bank. Finally, implementing the ICAAP under the Pillar 2 of the framework would perhaps be the biggest challenge for the banks in India as it requires a comprehensive risk modeling infrastructure to capture all the known and unknown risks that are not covered under the other two Pillars of the framework. Though the implementation of Basel-II would be a challenge for the Indian banks, it provides an opportunity to leverage capital base, improve the risk management practices and enhance the bottom-line by moving from capital adequacy to capital efficiency. 1.3 BASEL II PILLAR I


Credit risk, Market risk and Operational risk are covered under Pillar 1 of Basel II framework. Credit risk still claims the largest share of the regulatory capital and it underscores the significance of credit risk in banks operations. This is hardly surprising reckoning that the several banking crises in many countries had their roots in lax credit standards, poor portfolio risk management, and the inability or failure to evaluate the impact of the changing economic environment on credit worthiness of the banks borrowers. The [5]

sub-prime crisis in the USA is the most recent example of the inadequate credit risk assessment. The advent of advanced approaches for credit risk in India under the Basel II framework in the days to come, could be expected to provide an impetus for adopting more sophisticated credit risk management techniques in banks.

CREDIT RISK Credit Risk is defined as The inability or unwillingness of the customer or counter party to meet commitments in relation to lending, hedging, settlement and other financial transactions. Hence Credit Risk emanates when the counter party is unwilling or unable to meet or fulfill the contractual obligations / commitments thereby leading to defaults.


Under Pillar 1, the framework offers three distinct options for computing capital requirement for credit risk. These approaches for credit risks are based on increasing risk sensitivity and allow banks to select an approach that is appropriate to the stage of development of banks operations. The approaches available for computing capital for credit risk are Standardised Approach, Foundation Internal Rating Based Approach and Advanced Internal Rating Based approach.

RBI has decided to implement the Standardised Approach within the stipulated time frame. As regards the migration to advanced approaches, the RBI has not indicated any specific time frame. However, the banks that plan to migrate to the advanced approaches would need prior approval of RBI for which requisite guidelines would be issued in due course.


Standardised Approach is the basic approach which banks at a minimum have to use for moving to Basel II implementation. It is an extension of the existing method of calculation of capital charge for credit risk. The existing method is refined and made more risk sensitive by: Introducing more number of risk weights thus aiding finer differentiation in risk [6]

assessment between asset groups. Assignment of Risk weights based on the ratings assigned by External Credit rating agencies recognized by RBI, in case of exposures more than Rs.5 crores. Recognizing wide range of collaterals (securities) as risk mitigants and netting them off while determining the exposure amount on which risk weights are to be applied. Introducing Retail portfolio with total exposure up to Rs.5 crores and yearly turnover less than Rs.50 crores as a separate asset group with clear cut definition and criteria. Assignment of Risk weight for NPA accounts.

The rating assigned by the eligible external credit rating agencies will largely support the measure of credit risk. Unrated exposures will normally carry 100% risk weight. But for the financial year 2008-09, all fresh sanctions or renewals in respect of unrated borrowers in excess of Rs.50 crores will attract a risk weight of 150%. From 2009-10 onwards, unrated borrowings in excess of 10 crores will attract risk weight of 150%.


CRM refers to permitted methods of netting the exposure value for computing Risk Weights by using Collateral, Third party guarantee (Guarantee) and On-balance sheet netting. CRM is available subject to several conditions. Before netting, Exposure Value (EV) and Collateral Value (CV) are to be adjusted for volatility and possible future fluctuations. EV to be increased for volatility (premium factor) and CV to be reduced for volatility (discount factor). These factors are termed as Haircuts (HC). Therefore, EV after risk mitigation = (EV after HC CV after HC)

EV after Risk mitigation will be multiplied by the Risk Weight of the customer to obtain Risk-weighted asset amount for the collateralized transaction.



Market Risk is the possibility of loss to a bank caused by changes in market variables. Market risk is also defined as the risk that the value of on or off balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices. Market Risk Management of a bank thus involves management of interest rate risk, foreign exchange risk, commodity price risk and equity price risk. Market risk is also concerned about the banks ability to meet its obligations as and when they fall due, as a consequence of liquidity risk. Sound liquidity management can reduce the probability of a default. Liquidity risk is related to banks inability to pay to its depositors. It has a strong correlation with other risks such as interest rate risk and credit risk. Under Basel II, the present system of computing capital requirement for Market risk under the standardised duration method will continue.


Operational risk is defined as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events. The definition includes legal risks, but excludes strategic and reputation risk. Operational risk is pervasive and its ownership and measurement are challenges. Some of the important causes for operational risk are inadequate segregation of duties, insufficient training and poor HR Policies, lack of management supervision and inadequate security measures and systems.


Basic indicator approach, Standardised approach and Advanced Measurement Approach are the three methodologies allowed under Basel II for arriving at the capital charge for operational risk. RBI has advised the banks to apply the Basic Indicator Approach to migrate to Basel II in the beginning. Under Basic indicator approach, banks have to hold capital for operational risk equal to a fixed percentage of the average of positive annual gross income over the previous 3 years. Thus, capital charge under Basic indicator approach KBia = (GI / n) x A, where,


KBia = Capital charge under Basic Indicator Approach GI A n = Total gross income over the previous three years = 15% = No. of years ie 3 years for which income is positive.


Banks in India are required to maintain a minimum Capital to Risk-weighted Assets Ratio (CRAR) of 9% on an ongoing basis (However, Basel II prescribes 8% only). RBI may consider prescribing a higher level of minimum capital ratio for each bank under the pillar 2 framework on the basis of their respective risk profiles and their risk management systems. Banks are also encouraged to maintain a Tier 1 CRAR of at least 6% and banks which are below this level must achieve this ratio on or before 31st March 2010.


The Basel Capital Accord classifies capital under three Tiers. Tier 1 capital and Tier 2 capital including the following: TABLE: 1 TIER 1 CAPITAL Permanent equity Perpetual non-cumulative Revaluation reserves shareholders TIER 2 CAPITAL Undisclosed reserves

preference shares Disclosed reserves General Provisions / General loan-loss reserves Innovative instruments capital Hybrid debt capital

instruments and subordinated term debt

Further, at the discretion of the financial regulator of the individual countries, banks may employ a third tier of capital (Tier 3), consisting of short-term subordinated debt for the sole purpose of meeting a proportion of the capital requirements for market risks. [9]

CAPITAL ADEQUACY RATIO Capital Adequacy Ratio (CAR), also called Capital to Risk (Weighted) Assets Ratio (CRAR), is a ratio of a bank's capital to its risk. National regulators track a bank's CAR to ensure that it can absorb a reasonable amount of loss and complies with statutory Capital requirements. Capital adequacy ratios (CARs) are a measure of the amount of a bank's core capital expressed as a percentage of its risk-weighted asset. Capital adequacy ratio is defined as: (TIER-I CAPITAL + TIER-II CAPITAL) / (RISK WEIGHTED ASSETS) where Risk can either be weighted assets ( ) or the respective national regulator's minimum total capital requirement. If using risk weighted assets, CAR = ( T1 + T2 ) / a 10% The percent threshold varies from bank to bank (10% in this case, a common requirement for regulators conforming to the Basel Accords) is set by the national banking regulator of different countries. Two types of capital are measured: tier one capital ( above), which can absorb losses above), which can

without a bank being required to cease trading, and tier two capital (

absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors. This ratio is used to protect depositors and promote the stability and efficiency of banks. 1.4 BASELII PILLAR II & III INTRODUCTION One of the unique aspects of Basel II is its comprehensive approach to risk measurement in the banking entities, by adopting the now-familiar three-Pillar structure, which goes far beyond the first Basel Accord. To recapitulate, these are: Pillar 1 the minimum capital ratio, Pillar 2 the supervisory review process and Pillar 3 the market discipline. The Pillar 1 [10]

provides a menu of alternative approaches, from simple to advanced ones, for determining the regulatory capital towards credit risk, market risk and operational risk, to cater to the wide diversity in the banking system across the world. Pillar 2 requires the banks to establish an Internal Capital Adequacy Assessment Process (ICAAP) to capture all the material risks, including those that are partly covered or not covered under the other two Pillars. The ICAAP of the banks is also required to be subject to a supervisory review by the supervisors. The Pillar 3 prescribes public disclosures of information on the affairs of the banks to enable effective market discipline on the banks operations.

RBI GUIDELINES UNDER PILLAR-2 The Pillar-2 of the framework deals with the Supervisory Review Process (SRP). The objective of the SRP is to ensure that the banks have adequate capital to support all materials risks in their business as also to encourage them to adopt sophisticated risk management techniques for monitoring and managing their risks. This, in turn, would require a welldefined internal assessment process within the banks through which they would determine the additional capital requirement for all material risks, internally, and would also be able to assure the RBI that adequate capital is actually held towards their all material risk exposures. The process of assurance could also involve an active dialogue between the bank and the RBI so that, when warranted, appropriate intervention could be made to either reduce the risk exposure of the bank or augment its capital. Under Pillar-2, the banks have been advised to put in place an ICAAP, with the approval of the Board. Thus, ICAAP is an important component of the Supervisory Review Process. What is important to note here is that the Pillar 1 stipulates only the minimum capital ratio for the banks whereas the Pillar 2 provides for a bank-specific review by the supervisors to make an assessment whether all material risks are getting duly captured in the ICAAP of the bank. If the supervisor is not satisfied in this behalf, it might well choose to prescribe a higher capital ratio, as per its assessment.

PILLAR-3 This pillar aims to complement the minimum capital requirements and supervisory review process by developing a set of disclosure requirements which will allow the market participants to gauge the capital adequacy of an institution. [11]

Market discipline supplements regulation as sharing of information facilitates assessment of the bank by others, including investors, analysts, customers, other banks, and rating agencies, which leads to good corporate governance. The aim of Pillar 3 is to allow market discipline to operate by requiring institutions to disclose details on the scope of application, capital, risk exposures, risk assessment processes, and the capital adequacy of the institution. It must be consistent with how the senior management, including the board, assess and manage the risks of the institution. When market participants have a sufficient understanding of a bank's activities and the controls it has in place to manage its exposures, they are better able to distinguish between banking organizations so that they can reward those that manage their risks prudently and penalize those that do not. These disclosures are required to be made at least twice a year, except qualitative disclosures providing a summary of the general risk management objectives and policies which can be made annually. Institutions are also required to create a formal policy on what will be disclosed and controls around them along with the validation and frequency of these disclosures. In general, the disclosures under Pillar 3 apply to the top consolidated level of the banking group to which the Basel II framework applies. 1.5 CAMELS RATING SYSTEM

The CAMELS ratings or Camels rating is a supervisory rating system originally developed in the U.S. to classify a bank's overall condition. It's applied to every bank and credit union in the U.S. (approximately 8,000 institutions) and is also implemented outside the U.S. by various banking supervisory regulators. The components of a bank's condition that are assessed:

(C)apital adequacy (A)ssets (M)anagement Capability (E)arnings (L)iquidity (also called asset liability management) (S)ensitivity (sensitivity to market risk, especially interest rate risk)

Ratings are given from 1 (best) to 5 (worse) in each of the above categories. [12]

CAPITAL ADEQUACY Capital provides a cushion to fluctuations in earnings so that credit unions can continue to operate in periods of loss or negligible earnings. It also provides a measure of reassurance to the members that the organization will continue to provide financial services. Likewise, capital serves to support growth as a free source of funds and provides protection against insolvency. While meeting statutory capital requirements is a key factor in determining capital adequacy, the credit union's operations and risk position may warrant additional capital beyond the statutory requirements. Maintaining an adequate level of capital is a critical element.

ASSETS The asset quality rating is a function of present conditions and the likelihood of future deterioration or improvement based on economic conditions, current practices and trends. The examiner assesses credit union's management of credit risk to determine an appropriate component rating for Asset Quality. Interrelated to the assessment of credit risk, the examiner evaluates the impact of other risks such as interest rate, liquidity, strategic, and compliance.

MANAGEMENT CAPABILITY Management is the most forward-looking indicator of condition and a key determinant of whether a credit union possesses the ability to correctly diagnose and respond to financial stress. The management component provides examiners with objective, and not purely subjective, indicators. An assessment of management is not solely dependent on the current financial condition of the credit union and will not be an average of the other component ratings.

EARNINGS PERFORMANCE The continued viability of a credit union depends on its ability to earn an appropriate return on its assets which enables the institution to fund expansion, remain competitive, and replenish and/or increase capital. In evaluating and rating earnings, it is not enough to review past and present performance alone. Future performance is of equal or greater value, including performance under various economic conditions. Examiners evaluate "core" earnings: that is the long-run earnings ability of a credit union discounting temporary fluctuations in income and one-time items. A [13]

review for the reasonableness of the credit union's budget and underlying assumptions is appropriate for this purpose. Examiners also consider the interrelationships with other risk areas such as credit and interest rate.

LIQUIDITY Asset/liability management (ALM) is the process of evaluating, monitoring, and controlling balance sheet risk (interest rate risk and liquidity risk). A sound ALM process integrates strategic, profitability, and net worth planning with risk management. Examiners review (a) interest rate risk sensitivity and exposure; (b) reliance on short-term, volatile sources of funds, including any undue reliance on borrowings; (c) availability of assets readily convertible into cash; and (d) technical competence relative to ALM, including the management of interest rate risk, cash flow, and liquidity, with a particular emphasis on assuring that the potential for loss in the activities is not excessive relative to its capital. ALM covers both interest rate and liquidity risks and also encompasses strategic and reputation risks.

SENSITIVITY Sensitivity to market risk, the "S" in CAMELS is a complex and evolving measurement area. It was added in 1995 by Federal Reserve and the OCC primarily to address interest rate risk, the sensitivity of all loans and deposits to relatively abrupt and unexpected shifts in interest rates. In 1995 they were also interested in banks lending to farmers, and the sensitivity of farmers ability to make loan repayments as specific crop prices fluctuate. Unlike classic ratio analysis, which most of CAMELS system was based on, which relies on relatively certain, historical, audited financial statements, this forward look approach involved examining various hypothetical future price and rate scenarios and then modelling their effects. The variability in the approach is significant.



DuPont analysis (also known as the dupont identity, DuPont equation, DuPont Model or the DuPont method) is an expression which breaks ROE (Return On Equity) into three parts. The name comes from the DuPont Corporation that started using this formula in the 1920s. ROE ANALYSIS The Du Pont identity breaks down Return on Equity (that is, the returns that investors receive from the firm) into three distinct elements. This analysis enables the analyst to understand the source of superior (or inferior) return by comparison with companies in similar industries (or between industries). The Du Pont identity is less useful for industries, such as investment banking, in which the underlying elements are not meaningful. Variations of the Du Pont identity have been developed for industries where the elements are weakly meaningful. Du Pont analysis relies upon the accounting identity, that is, a statement (formula) that is by definition true. ROA & ROE RATIO The return on assets (ROA) ratio developed by DuPont for its own use is now used by many firms to evaluate how effectively assets are used. It measures the combined effects of profit margins and asset turnover.

The return on equity (ROE) ratio is a measure of the rate of return to stockholders. Decomposing the ROE into various factors influencing company performance is often called the Du Pont system.


WHY IT MATTERS The DuPont Analysis is important determines what is driving a company's ROE; Profit margin shows the operating efficiency, asset turnover shows the asset use efficiency, and leverage factor shows how much leverage is being used. The method goes beyond profit margin to understand how efficiently a company's assets generate sales or cash and how well a company uses debt to produce incremental returns. Using these three factors, a DuPont analysis allows analysts to dissect a company, efficiently determine where the company is weak and strong and quickly know what areas of the business to look at (i.e. inventory management, debt structure, margins) for more answers. The measure is still broad, however, and is not a substitute for detailed analysis. The DuPont analysis looks uses both the income statement as well as the balance sheet to perform the examination. As a result, major asset purchases, acquisitions, or other significant changes can distort the ROE calculation. Many analysts use average assets and shareholders' equity to mitigate this distortion, although that approach assumes the balance sheet changes occurred steadily over the course of the year, which may not be accurate either.





2.1 INDIAN BANKING SECTOR Over the past couple of years, the Indian banking sector has displayed a high level of resiliency in the face of high domestic inflation, rupee depreciation and fiscal uncertainty in the US and Europe. In order to stimulate the economy and support the growth of banking sector, the Reserve Bank of India (RBI) adopted severe policy measures such as increasing the key monetary policy rates such as repo and reverse repo 16 times since April 2009 and tightening provisioning requirements. Amidst this economic scenario, the key challenge for the Indian banking system continues in improving their operational efficiency and implement prudent risk management practices. Some of the key trends expected to emerge in the near future are as under:-


High interest rates, subdued industrial production and domestic consumption impacted the growth of the Indian economy which slowed down from 8.4% in FY11 to 6.5% during FY12.The scheduled commercial banks (SCBs) overall credit grew at a slower pace during FY12 at 17% y-o-y as compared to 21.5% registered during FY11.As per the recent RBI data, the non-food bank credit increased by 15.5% in Oct2012 over its corresponding month previous year, as compared to 18.2% witnessed in Oct2011 over its corresponding month previous year. Similarly, credit to industry and services sector recorded a slower growth of 15.2% and 13.7% respectively as against 23.1% and 18.4% during the same period. As per RBIs second quarter review of monetary policy for FY13, the GDP growth estimates for FY13 is revised downwards from 6.5% forecasted earlier to 5.8%.Any further slowdown in the Indian economic growth is likely to impact the demand for bank credit.

RBI MAY LOWER KEY POLICY RATES, IF INFLATIONARY PRESSURES EASE Inflation continued to remain sticky and much above the RBIs comfort zone throughout the year. In fact headline inflation as measured by WPI remained above 7.5% from Feb to Oct 2012. As a result the RBI has kept the repo rate at an elevated level, reducing it by 50 basis points only once during 2012, in April-12 to support growth. However, in order to support the flow of funds to the productive sectors of the economy and ease the liquidity crunch in the banking system the RBI has cut the CRR by 175basis points [18]

during the course of the year which stands at 4.25%, as on Nov 2012. Given the easing of international commodity prices, particularly of crude, decline in core inflation as demand conditions moderate, there has been some steady moderation in inflation in the recent period. As a result the RBI might decide to ease the policy rate furthermore.


During FY12, asset quality of banks was severely impaired, as revealed by the steep increase in non-performing assets (NPAs) of SCBs, particularly for public sector banks (PSBs) owing to their significant exposure to troubled sectors such as power, aviation, real estate and telecom. There was a significant increase noted in the NPA levels during FY12. Gross NPAs value recorded a y-o-y growth of 45.3% and net NPAs registered a y-o-y growth of 55.6% during FY12. As per RBI, this increase was due to inadequate credit appraisal process coupled with unfavourable economic situation in the domestic as well as foreign market.

Apart from increase in NPAs, the weakening asset quality trend was also apparent from the significant increase in restructured assets. Restructured standard advances of the SCBs, recorded a y-o-y growth of around 58.5% during FY12 and the ratio of restructured standard advances to gross advances also increased from about 3.5% in FY11 to 4.7% in FY12.

As per the recent data available with CDR cell as on Sep 2012, a total of 466 cases have been referred to the cell, with 327 cases amounting to Rs. 1,873.9 bn have been approved since the start of CDR mechanism. Of the total cases referred, 64 cases corresponding to Rs. 311.2 bn were under finalisation of restructuring packages as on Sep 2012 as compared to 34 cases amounting to Rs. 264.5 bn as on Sep 2011.

The slowdown in the economy increases in the risk of default and restructuring of loans can increase which could further lead to deterioration of asset quality. However, implementation of stringent policies could prevent a sharp deterioration in asset quality.



Traditionally, banks have derived limited income from fee based services such as wealth management, credit card services, treasury services, investment banking and advisory services. However, as the economy is showing signs of slowdown and the demand for credit is slowed banks are struggling to keep their margins intact. Also, with changing times, consumer needs have changed with various avenues of investment available. This is likely to increase banks focus on offering fee based services as the earnings from such services are more stable than interest bearing products and it also helps in mitigating risk via diversification of products and services.


As per census 2011, huge section of Indian population is still unbanked. The overall percentage of households availing banking services in India stood at around 59% as on 2011, which means still over 40% of total households, lacks access to formal banking services. This is largely driven by rural areas and/or low income group (LIG) population, due to their financial illiteracy, low level of income and savings, lack of collateral and absence of verifiable credit history.

Thus, in recent years, the RBI and Government of India have increased its focus on providing formal banking/financial services to the huge unbanked population. It is encouraging banks to develop low cost products and services designed to suit the requirements of this group of population.

RBI has undertaken several policy initiatives to promote financial inclusion, such as encouraging opening of no-frills accounts, engaging intermediaries to provide financial and banking services. In the course of action, there has been increase in number of no-frill accounts from 50.3 mn in FY10 to 105.5 mn in FY12, registering a CAGR of 44.8% during this period. Similarly, the number of business correspondent (BC) agents also noted a CAGR of 70.2% during the same period.


RBI also advised banks to allocate minimum 25% of the total new branches in unbanked rural centres during a year. In the process, the number of banking outlets in villages with population above 2,000 and less than 2,000 also witnessed a CAGR of 73.5% and 55.7% during FY10 to FY12.

Further, in India there are several micro-finance institutions (MFIs) and self-help groups (SHGs) which lend credit to the LIG. This is expected to play a significant role in achieving financial inclusion by extending credit to the LIG.


In order to sustain the business growth amid highly competitive market and slowing Indian economy, banks are likely to expand in the overseas market. They will try to tap emerging opportunities by expanding into newer markets such as Africa, former Soviet region and other South East Asian countries, in which India has maintained good trade relations. They can set up captive operations or expand through inorganic means by undergoing M&A with banks in foreign countries. However, high capital cost for setting up foreign operations can act a deterrent in the way of expansion.


With the adoption of technology, the Indian banking sector has undergone significant transformation from local branch banking to anywhere-anytime banking. Over the past couple of years, there has been huge growth registered in the number of transactions done through mobile devices. As per RBI, there were 49 banks with a customer base of about 13 mn offering mobile banking services as at the end of Mar 2012. During FY12, around 25.6 mn mobile banking transactions valued at Rs. 18.2 bn were transacted, recording a growth of 198% y-o-y and 174% y-o-y respectively. This rapid growth is driven by availability of 3G/4G network, increasing number of smart phones and several telecom companies offering economical data usage packages.

In order to encourage cashless transactions, particularly for small value transactions, the RBI raised the cap on mobile banking without end-to-end encryption from Rs. 1,000 to Rs.5,000. [21]

Further, the transaction limit of Rs. 50,000 per customer per day was removed, by permitting banks to fix the transaction limits based on their own risk perception. In the near term, it is expected to emerge as one of the most preferred medium for banking transactions.


In Aug 2011, the RBI drafted guidelines for licensing of new banks in the private sector. Thus, with the entry of new players in the market, competition among banks will increase. This is expected to benefit the consumers in the long-run as with increased competition banks will adopt fresh strategies to retain and attract customers and protect their market share. For instance, increasingly banks are tying up with insurance companies to sell insurance products. In this business model, both bank and insurance companies share the commission. Further, with the deregulation of savings rate in Oct 2011, competition among banks has already intensified. Passage of Banking Laws (Amendment) Bill aimed at attracting more foreign investments With an aim to reform and strengthen Indias banking sector, the Lok Sabha passed the Banking Amendment Bill in Dec 2012, it will pave way for RBI to issue new banking licenses to private sector and attract more foreign investments in the sector.

The Bill also proposes to enhance the voting rights of investors in case of both public sector and private sector banks from existing 1% to 10% of public sector banks and from 10% to 26% of private sector banks. This move will attract more foreign investment in the sector. The Competition Commission clause in the new Bill allows the RBI to continue with its role as the banking regulator, while the Competition Commission of India (CCI) will regulate mergers and acquisitions (M&A) and will have powers to investigate and clear M&As in the banking sector.

Moreover, the bill has a clause, which will allow foreign banks to convert their Indian operations into local subsidiaries or transfer its shareholding to a holding company of the bank without paying stamp duty.






Pramartha is a risk consulting firm with expertise in actuarial, quantitative and analytics practices. Pramartha is one of the few Indian firms working in the wider area of Actuarial Applications Enterprise Risk Management Quantitative Techniques and Analytics.

The Company has developed in house tools and techniques to access a company's risks across sectors and geographies. With their in depth expertise in formulating cutting edge strategies they convert business risk into opportunity.

Vision: To be a Global leader in Risk Management and Consulting MANAGEMENT Founder and Managing Director Mahidhara Davangere V. MBA, MFC, MSc (Maths), DAT (UK), AIA Mahidhara is an Associate Actuary and a Risk consultant. He is the Founder of Pramartha and has over a decade of extensive experience in Research and financial valuation covering industries like Banking, Insurance and financial sectors in India, South Africa and other emerging African markets. Also, has experience in US Mortgage industry. His expertise lies in commercializing innovative ideas to practical realities. He is an eloquent speaker and is passionate about Mathematics and Art. Board of Advisors: Drew K Wilson Drew is currently the Founder and Principal of Turnstone Applied Research based in Australia. He has 20+ years growing Investment and Wealth management businesses across institutional and retail sectors in Australia, India & Canada. Prior to starting his own firm he co founded Atom Funds Management, an Australian Small Cap Investment Boutique with offices in Sydney and Bangalore. He raised $ 75 million in institutional mandates and retail [24]

FUM for Atom. He also launched Fat Fund, a $30 million Listed investment company on the ASX.

R. Krishnan Krishnan joined SBI as a Sportsman in 1974 and worked as banker with State Bank of India (SBI) with more than 25 years of experience in Credit Management and implementation of Asset Liability Management (ALM). He also worked as the Secretary of Local Chapter of Indian Institute of Bankers for a period of about 3 years. From 2001 to 2009 he was connected with Bangalore Baptist hospital in the as a financial advisor and Auditor. He is currently a visiting faculty to various B-Schools like Mount Carmel, Sheshadripuram College, Global Institute of Management, Acharya Institute of Management in the areas pertaining to Banking, Finance, and Hospital management. He was a Hockey Player and is passionate about Cricket, Music and Philately.

Pattabhi B. N. M.Com FCA Pattabhi is a Chartered Accountant and is presently partner in M/s Parimal Ram & Pattabhi, Chartered Accountants, Bangalore. He has 10 plus years of experience in auditing and taxation. He has also been instrumental in various M&A activities for his clients in India and US. He also acted as an advisor to Government of Karnataka, Department of Pre-University Education in setting the new syllabus for I and II PUC. He is also a visiting faculty to various prestigious B-Schools in India. His hobbies are swimming and numerology.

Pundi Narasimham Pundi is an American citizen, a serial entrepreneur, having built and sold many companies in last three decades in North America and Asia Pacific Region covering India, Malaysia and Philippines. He represented the Fulton county and city of Valdosta in the state of Georgia, US to promote bilateral trade & service between India and US. He has diverse experience in the area of Life Sciences, Bio Technology, Analytics and Risk Management, IT staffing and Knowledge Process Outsourcing. He has steered the acquisition of many IT companies in US. He has also published 14 research papers and 4 US Patents in the area of optical fibre research.


Praveen Kumar. P Praveen is an Investment analyst working in Sanlam Equity Analytics, India. He has eight years of experience in the field of investment and finance. He has analyzed stocks in various sectors like capital goods, mining, banking and utilities across countries like Australia, Africa and Asia Pacific Regions. He has also worked as a quant analyst and has been a part of development of financial softwares. He is passionate about Photography and Investments.





4.1 TITLE OF THE STUDY Comparative Analysis of Risk Capital in both Public and Private Banking Sectors based on Basel II

4.2 STATEMENT OF THE PROBLEM In analyzing the Risk of the bank, a Risk Matrix has to be prepared, in the process of preparation there is a need to analyze the risk capital for both public and private sector banks. 4.3 OBJECTIVES OF THE STUDY 1. To analyze Capital Risk borne by different banks. 2. To gain knowledge on how banks are able to manage Risk by using Capital Adequacy. 3. To analyze the financial indicators by DuPont model.

4.4 SCOPE OF THE STUDY The scope of the study is that I have only considered Risk capital i.e. the Pillar- I under BASEL- II and in the components of capital only Tier-I and Tier-II is considered.

4.5 DATA COLLECTION The data can be of two types: Primary Data Secondary Data

Secondary Data are those data which are already collected and stored and which has been passed through statistical research. In this project, data has been collected from following sources: Annual Reports Books Magazines [28]

4.6 LIMITATIONS OF THE STUDY Due to the limited time period the project is done based on taking the single bank in both public and private sector. It could have been better if DuPont analysis is done to all the banks in public and private sectors.





CAPITAL ADEQUACY RATIO Capital adequacy ratios are a measure of the amount of a bank's capital expressed as a Percentage of its risk weighted credit exposures.

TABLE: 2 TOTAL CAPITAL BANKS SBI PNB CANARA BOI AB TIER- 1 9.79% 9.28% 10.35% 8.59% 9.13% TIER-2 4.07% 3.35% 3.41% 3.36% 3.73% ADEQUACY RATIO 13.86% 12.63% 13.76% 11.95% 12.83%



120000 100000 80000 60000 40000 20000 0




50000 40000 30000 20000 10000 0 SBI CANARA PNB BOI ALLAHABAD BANK



sbi tier 1 tier 2 total cap adequecy ratio 9.79% 4.07% 13.86%

pnb 9.28% 3.35% 12.63%

canara 10.35% 3.41% 13.76%

BOI 8.59% 3.36% 11.95%

AB 9.13% 3.73% 12.83%


RBI raised the minimum regulatory CRAR requirement to 9%. As seen in the above graph all banks are maintaining above 9%. All the banks are maintaining a cushion of 3-5% extra which seems to be a good sign. As CRAR is high, it helps the bank in maintaining its time liabilities and other risks such as credit, operations. From the above graph, we can clearly see that SBI has the highest CRAR followed by Canara Bank and the lowest is BOI, so SBI has the added advantage to maintain its risks.

Canara Bank has the highest tier 1 Capital Adequacy Ratio which means that it can absorb higher risks than the other banks. [32]



3500000 3000000 AMOUNT IN CRORES 2500000 2000000 1500000 1000000 500000 0 TIER 1 CAPITAL HDFC 2867137 ICICI 56498 AXIS 27079.97 KOTAK 20592.12 YES 9912.2


1400000 1200000 AMOUNT IN CRORES 1000000 800000 600000 400000 200000 0 TIER 2 CAPITAL HDFC 1227078 ICICI 30021 AXIS 9772.62 KOTAK 7916.37 YES 4023.02




20.00% 18.00% 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% tier 1 tier 2 Total Capital adequecy ratio Axis 9.45% 4.21% 13.66% Hdfc 11.60% 4.90% 16.50% Icici 12.68% 5.84% 18.52% Kotak 13.90% 1.50% 15.40% Yes 9.90% 8% 17.90%


RBI raised the minimum regulatory CRAR requirement to 9%, as seen in the above graph all banks are maintaining above 9%. From the above graph, we can clearly see that ICICI has the highest CRAR followed by YES Bank and the lowest is Axis Bank, so ICICI has the added advantage to maintain its risks.

Kotak Mahindra Bank has the highest tier 1 Capital Adequacy Ratio which means that it can absorb higher risks than the other banks.


The capital structural position of the banks can be analyzed using the following ratios: 1. DEBT EQUITY RATIO 2. FUNDED DEBT TO CAPITALIZATION RATIO 3. SOLVENCY RATIO

Analysis of Debt Equity Ratio: It basically indicates the relationship between loan and the net worth of company, which is known as gearing. If the proportion of the debt to the equity is low, a company is said to be low geared, and vice-versa. A debt equity ratio of 2:1 is normally accepted. The higher the gearing, the more volatile the return to the shareholders. Debt-Equity Ratio = Long term debt / Shareholders funds or Net worth GRAPH: 7

D/E ratio
18 16 14 12 10 8 6 4 2 0






D/E ratio 13.03276344 14.98549632 15.09826901 16.71280268 16.05537466


D/E ratio

D/E ratio 11.14389479 9.091851415 6.56545712 6.908127682 15.13132461


INTERPRETATION: As D/E ratio is higher for all banks the shareholders will have less dividend payout and it shows that higher profits are paid back to creditors as a part of interest. Even if the EBIDT is high the banks will have less net profit.

Analysis of Funded Debt to Total Capitalization Ratio: The funded debt to total capitalization ratio establishes the relationship between the long term fund raised from outsiders and total long term funds available from the owners of the business. It explains the capital structure position of the company. Normally the smaller the ratio the better it will be. Total capitalization = Total Debt + Equity GRAPH: 9


500000 400000 300000 200000 100000 0






TOTAL CAPITALIZATION FOR 254604.13 444669.83 365269.08 371292.05 179194.17 PUBLIC SECTOR



600,000.00 500,000.00 400,000.00 300,000.00 200,000.00 100,000.00 0.00






TOTAL CAPITALIZATION FOR 276,984.51 365,467.72 504,661.08 63,112.79 93,685.41 PRIVATE SECTOR


INTERPRETATION: In the public sector we observe that SBI has least total capitalization and hence it can have very less risk to handle and in the private sector we observe that Kotak Mahindra bank is maintaining less risk.

Analysis of Solvency Ratio: It shows the relationship between total liabilities to the outsiders to total assets. It provides a measurement of how likely a company will be continue meeting its debt obligations. Lower ratio i.e. outsiders liabilities in the total capital of company the better is the long term solvency of the company. Different forms of solvency ratios are: Current Ratio, Quick Ratio. 1. CURRENT RATIO: A liquidity ratio that measures a companys ability to pay short-term obligations. The Current Ratio formula is:


Axis Title 0.06 0.04 0.02 0 CURRENT RATIO SBI 0.05 PNB 0.02 CANARA 0.03 BOI 0.03 AB 0.01


0.15 0.1 0.05 0 HDFC CURRENT RATIO 0.08 ICICI 0.13 AXIS 0.03 Axis Title


YES 0.08


INTERPRETATION: In the public and private sectors all the banks are having the ratios < 1 hence it suggests that the company would be unable to pay off its obligations if they came due at that point. While this shows the company is not in good financial health, it does not necessarily mean that it will go bankrupt - as there are many ways to access financing but it is definitely not a good sign.

2. QUICK RATIO: It measures the ability of a company to use its near cash or quick assets to extinguish or retire its current liabilities immediately. It includes those current assets that presumably can be quickly converted to cash Quick Ratio = (Cash equivalents + Short term investments + Accounts receivable ) / Current liabilities


40 Axis Title 30 20 10 0 QUICK RATIO SBI 12.05 PNB 23.81 CANARA 29.11 BOI 20.79 AB 32.65


25 20 15 10 5 0 HDFC QUICK RATIO 6.2 ICICI 16.71 AXIS 21.63 Axis Title


YES 17.83


INTREPRETATION: In public sector AB bank has the higher quick ratio and in private sector Axis Bank has the higher quick ratio it reflects that more likely the banks are be able to pay its short term bills.

The CAMEL Framework helps to measure banks performance through five different categories. The CAMEL Framework is: (1) Capital adequacy ratio (2) Asset quality (3) Management quality (4) Earnings performance and (5) Assessing liquidity

1. CAPITAL ADEQUACY RATIO: TABLE: 3 BANK SBI ICICI 2012 13.86% 18.5% 2011 11.98% 19.5%

25.00% 20.00% 15.00% SBI 10.00% 5.00% 0.00% 2012 2011 ICICI


INTERPRETATIONS: ICICI pays lesser dividends than SBI, thereby improving their Tier-1 Capital Adequacy Ratio which in turn improves the overall CRAR. In future ICICI can sustain to any kind of risks when compared with SBI because its Tier-1 and CRAR is very high. It also indicates that ICICI is very cautious about the future as it knows that the market is dynamic.


FOR 2011-12 TABLE: 4 NPA TOTAL ASSETS NPA IN % OF ASSETS SBI ICICI 15819 1894 1335519 473647 1.18% 0.39%

FOR 2010-2011





12347 2458

1223736 406234

1.01% 0.60%


1.50% 1.00% 0.50% 0.00% 2012 2011 0.39% 1.18% 1.01% 0.60% SBI ICICI


INTERPRETATION: For SBI the management efficiency of the bank has been commendable. It can also explains the amount of provisioning done to decrease the percentage of NPA from books of accounts aligning to the RBI norms However NPA has piled up in ICICI books of accounts which are the worrying things for the management as it directly hits the profitability of the bank.






31574 10386

1335519 473647

2.36% 2.19%

FOR 2010-11





25336 9048

1223736 406234

2.07% 2.22%




2.40% 2.30% Axis Title 2.20% 2.10% 2.00% 1.90% SBI ICICI 2012 2.36% 2.19% 2011 2.07% 2.22%

INTERPRETATION: The profits are increasing for SBI and for the ICICI the profits are decreased this can be clearly see from the above graph. This means that SBI is better utilizing their assets to generate profit than ICICI.

TABLE: 6 FOR 2011-12





26068 78504

109186.89 34985.50

23.87% 224.39%


FOR 2010-11





23015 34985.50

88959.12 27931.58

25.87% 125.25%



250.00% 200.00% Axis Title 150.00% 100.00% 50.00% 0.00% SBI ICICI 2012 23.87% 224.39% 2011 25.87% 125.25%

INTERPRETATION: Increase in the ratio means that the ICICI bank has incurred more expenses due to their operations than the previous year. This ratio in case of SBI has decreased slightly, this shows that SBI have improved their operational efficiency.



To assess the earnings performance of a bank, it will be helpful to look at a variety of ratios and measures; these include: (1) Return on equity (ROE), (2) Return on assets (ROA) and (3) Net interest margin to total assets.

FOR SBI: TABLE: 7 2011-12 ROE (%) ROA (%) NIM TO TOTAL ASSETS (%) 14.36% 0.88% 3.85% 2010-11 12.84% 0.71% 3.32%


2011-12 ROE (%) ROA (%) NIM TO TOTAL ASSETS (%) 11.1% 1.5% 2.73%

2010-11 9.58% 1.34% 2.64%



DuPont Analysis
16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% SBI ICICI SBI ICICI 1.60% 1.40% 1.20% 1.00% 0.80% 0.60% 0.40% 0.20% 0.00% ROE (%) NIM TO TOTAL ASSETS (%) ROA (%)

INTERPRETATION: Here ROE has increased because ROA has also been increased. When compared with ICICI, SBI is having a high ROE and as a result the shareholders will receive a better return on their investment. While coming to ROA it is higher for ICICI and therefore we can say that the management is effectively utilizing the companys assets to generate profit. SBI and ICICI have the positive net interest margin means the investment strategy pays more interest than it costs.

It can be broken in three main parts: (1) Profit margin, (2) Asset turnover, and (3) Equity multiplier.

TABLE: 8 FOR 2011-12





11707 6465.26

120872.90 41450.75

9.68% 15.59%


FOR 2010-11





8265 51513

96329.45 33082.96

8.57% 1.55%



18.00% 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 2012 2011 SBI ICICI


For Both the banks the Profit margin increased, while if we consider SBI the profit margins are constantly improving and it is a good sign for the bank. While ICICI has increased its profit margin by a huge percentage and from overall for both the banks they have strong operating management.


TABLE: 9 FOR 2011-12





41450.75 120872.90

473647 1335519

8.75% 9.05%

FOR 2010-11





96329.45 33082.96

1223736 406234

7.87% 8.14%


9.20% 9.00% 8.80% 8.60% 8.40% 8.20% 8.00% 7.80% 7.60% 7.40% 7.20% 2012 ASSET TURNOVER (%) 2011 SBI ICICI



For ICICI when compared with SBI it is having a high percentage and we can say that ICICI is successfully generating revenue by using its assets. More or less both banks are performing well and based on this we can say that both the banks have strong asset management.

TABLE: 10 FOR 2011-12





1335519 473647

671.04 1152.77

FOR 2010-11





1223736 406234

635 1151.82


SBI 1990 ICICI 1927






INTERPRETATION: Here SBI is having higher the ratio and thereby we can say that it is having less financial leverage. While ICICI has the lesser ratio thereby it will have high financial leverage when compared with SBI.



QUICK RATIO 12.05 16.71

FOR 2010-11


QUICK RATIO 8.50 15.86


Current Ratio for SBI has increased that means SBI is more capable of paying its obligations and for ICICI it is much higher so it is giving a sense that the ability to turn its product into cash is very good.

Quick Ratio for both the banks is good. But when compared to SBI, ICICI has a better advantage of meeting the short term obligations by its most liquid assets.






Capital adequacy ratio is important for a bank because it has to safeguard their depositors. If the banks wants to be risk free then it has to have a high Capital adequacy ratio. Tier-I capital will play a key role in absorbing losses because it is the core capital that is readily available with the bank. Risk management plays a key role in the banks performance. DuPont analysis helps in giving an insight that exactly which part of the bank is not performing.


Banking industry in India is undergoing aggressive growth. So that banks needs to maintain adequate regularity capital so as to protect itself from various types of risk such as credit risk, market risk and operational risk Basel II norms provide the banks to improve the risk management process. So banks should follow the Basel II norms strictly. Apart from stipulated rate of 9% CRAR banks are required to maintain 6% core CRAR. For this strong equity capital base should be sustained other than external and sub ordinate debts. Employees should be given proper training in order to cope up with the changing stipulations under Basel accord IT infrastructure in the banks need to be more supportive for the implementation of Basel II accord Investment portfolio of the bank should be designed taking into consideration the risk weight concerted with each and every investment opportunity Minimize lending loans and advances to lower rated and unrated companies since they fetch higher risk weights


Finally analyzed the Capital Risk borne by different banks using Capital Adequacy Ratio, Debt-Equity Ratio, Current and Quick Ratios and gained knowledge on why Capital Adequacy Ratio is important for the banks and thereby analyzed the financial indicators of SBI and ICICI by DuPont Analysis and found out that SBI is the best performing bank out of all banks in both public and private banking sectors.






WEBSITES 1. 2. 3. 4. occasionally for any doubts relating to the topic.