International Banking laws: Basel

INTERNATIONAL BANKING LAWS

What Does Basel Mean?

A set of agreements set by the Basel Committee on Bank Supervision (BCBS), which provides recommendations on banking regulations in regards to capital risk, market risk and operational risk. The purpose of the accords is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses. The first Basel Accord, known as Basel I, was issued in 1988 and focuses on the capital adequacy of financial institutions. The capital adequacy risk, (the risk that a financial institution will be hurt by an unexpected loss), categorizes the assets of financial institution into five risk categories (0%, 10%, 20%, 50%, 100%). Banks that operate internationally are required to have a risk weight of 8% or less. The second Basel Accord, known as Basel II, is to be fully implemented by 2015. It focuses on three main areas, including minimum capital requirements, supervisory review and market discipline, which are known as the three pillars. The focus of this accord is to strengthen international banking requirements as well as to supervise and enforce these requirements.

There are 3 Basel laws; Basel 1 Basel 2 Basel 3

What Does Basel I Mean?

A set of international banking regulations put forth by the Basel Committee on Bank Supervision, which set out the minimum capital requirements of financial institutions with the goal of minimizing credit risk. Banks that operate internationally are required to maintain a minimum amount (8%) of capital based on a percent of risk-weighted assets. The first accord was the Basel I. It was issued in 1988 and focused mainly on credit risk by creating a bank asset classification system. This classification system grouped a bank's assets into five risk categories: 0% - cash, central bank and government debt and any OECD government debt 0%, 10%, 20% or 50% - public sector debt 20% - development bank debt, OECD bank debt, OECD securities firm debt, non-OECD bank debt (under one year maturity) and non-OECD public sector debt, cash in collection. 50% - residential mortgages. 100% - private sector debt, non-OECD bank debt (maturity over a year), real estate, plant and equipment, capital instruments issued at other banks. The bank must maintain capital (Tier 1 and Tier 2) equal to at least 8% of its riskweighted assets. For example, if a bank has risk-weighted assets of $100 million, it is required to maintain capital of at least $8 million.

What Does Tier 1 Capital Mean?

A term used to describe the capital adequacy of a bank. Tier I capital is core capital, this includes equity capital and disclosed reserves. Equity capital includes instruments that can't be redeemed at the option of the holder

What Does Tier 2 Capital Mean?

A term used to describe the capital adequacy of a bank. Tier II capital is secondary bank capital that includes items such as undisclosed reserves, general loss reserves, subordinated term debt, and more.

What Does Tier 3 Capital Mean?

Tertiary capital held by banks to meet part of their market risks, that includes a greater variety of debt than tier 1 and tier 2 capitals. Tier 3 capital debts may include a greater number of subordinated issues, undisclosed reserves and general loss reserves compared to tier 2 capital. Tier 3 capital is used to support market risk, commodities risk and foreign currency risk. To qualify as tier 3 capital, assets must be limited to 250% of a banks tier 1 capital, be unsecured, subordinated and have a minimum maturity of two years.

What Does Capital Requirement Mean?

The standardized requirements in place for banks and other depository institutions, which determines how much liquidity is required to be held for a certain level of assets through regulatory agencies such as the Bank for International Settlements, Federal Deposit Insurance Corporation or Federal Reserve Board. These requirements are put into place to ensure that these institutions are not participating or holding investments that increase the risk of default and that they have enough capital to sustain operating losses while still honoring withdrawals. Also known as "regulatory capital". In the United States, the capital requirement for banks is based on several factors, but is mainly focused on the weighted risk associated with each type of asset held by the bank. The capital requirements guidelines are used to create capital ratios, which can then be used to evaluate and compare lending institutions based on their relative safety.

An adequately capitalized institution, based on the Federal Deposit Insurance Act, must have a Tier 1 capital-to-risk weighted assets ratio of at least 4%. Institutions with a ratio below 4% are considered undercapitalized and those below 3% are significantly undercapitalized.

What Does Basel II Mean?

A set of banking regulations put forth by the Basel Committee on Bank Supervision, which regulates finance and banking internationally. Basel II attempts to integrate Basel capital standards with national regulations, by setting the minimum capital requirements of financial institutions with the goal of ensuring institution liquidity. Basel II is the second of the Basel Committee on Bank Supervision's recommendations, and unlike the first accord, Basel I, where focus was mainly on credit risk, the purpose of Basel II was to create standards and regulations on how much capital financial institutions must have put aside. Banks need to put aside capital to reduce the risks associated with its investing and lending practices

BASEL II Risk Risk is the likelyhood of losses occuring or obtaining less-than-expected results. Sound banking is all about seeking profits without taking excessive risks. History has taught us lessons on what happens when banks go bust. It has also taught the banks he necessity to optimize leverage. The different tyypes of risks faced by a bank are: 1. Credit Risk 2. Liquidity Risk 3. Interest Rate Risk 4. Market Risk

5. Country Risk 6. Solvency Risk 7. Operational Risk This is an inclusive list of different risks faced by a bank. There are further business risks as well which banks need to consider while developing their risk management systems. In view of the regulatory requirements and sound business practices needed to tackle the complicated business scenario, risk management assumes utmost importance in this industry.

Need for Capital

Enough is already said and written about the support an economy derives from its banking sector. It shall not be wrong to say that the banking sector moves more or less in tandem with the overall economy of any nation. To have a stable economy therefore, a stable financial sector is a pre requisite. Such financial stability can exist when the system is resilient to cope with an array of economic and financial shocks with least disruption and greatest preparation. Regulatory or otherwise, banks need to maintain capital as a buffer against the unforeseen conditions. However, the trick of the trade is to optimally capitalize the organization in the light of its overall risk profile, growth strategies and organizational objectives. Why Capital Adequacy Norms? Before 1988, many central banks allowed different definitions of capital in order to make their countrys bank appear as solid than they actually were. As a result the definition of capital began to diverge more and more. In order to provide a level playing field the concept of regulatory capital was standardized in the first BASEL CAPITAL ACCORD or BASEL 1. Along with definition of regulatory capital a basic formula for capital

divided by assets was constructed and an arbitrary ratio of 8% was chosen as minimum capital adequacy. Capital was divided into two components Tier 1 and Tier 2 capital. Tier 1 comprised of the shareholders equity and Tier 2 was mainly comprised of subordinate debt. Similarly, the total assets were risk weighted. Certain assets such as loans to corporation were weighted at 100 %, while others; for instance, short term loans to banks in certain developing countries were weighted at 20%. These risk weighting were totally arbitrary and no empirical correlation existed. Rationale behind BASEL II The shortcomings of BASEL I were the major reasons for the origin of BASEL II. BASEL I was overly simple to deal with the complex scenarios of a dynamic industry. It assigned the same risk weight to one class of exposure therby not appreciating the quality differences in different clients of the same class. To put in simple words, exposures to Reliance Industries, Arvind Mills, Mars Group and Haldirams all were treated at par. Similarly, lower risk was assigned to loans given to banks irrespective of country disparities. So lending to a European bank, Middle East bank and Thai bank were consdered equally risky. Thus, in a nutshell,

The calculation of RWA was incorrect in the sense that creditworthiness of different parties was not given due consideration Asset classification was broad Ignored differences in the countries

And thus emerged the need for a revised capital adequacy norm.

The sub prime crisis of mid 2007 has brought out the vital role of regulatory capital. The contraction of liquidity in certain structured product and interbank markets, as well as an increased probability of off-balance sheet commitments coming onto banks balance sheets, led to severe funding liquidity strains for some banks and central bank intervention in some cases. These events emphasised the links between funding and market liquidity risk, the interrelationship of funding liquidity risk and credit risk, and the fact that liquidity is a key determinant of the soundness of the banking sector. Another objective of BASEL II norms was to strengthen links between regulatory capital and risk based supervision as a way to create an incentive for strong risk management practices in banks.

Source: ICRA Rating Feature,

Scope of BASEL II

Following are the parties which will be affected by the BASEL II norms: All banks in the 110 countries that have signed Basel II will be affected. -owned or controlled insurance entities. Moreover, insurance companies that own or control banks/non-insurance financial services functions will be covered by the new rules. -20 central banks and the regulatory authorities of most of the countries that are signatories to Basel II are applying the policies to all the financial service institutions in their specific jurisdiction and are expecting the other countries to follow suit.

Kingdom, and the rest of the European Union are moving quite aggressively to use the Basel II framework in their areas to harmonize the capital adequacy and regulatory oversight rules and regulations across all sectors of the financial industry. Similar efforts are also under way in Australia, Singapore, India, and Hong Kong. Many emerging market countries that are signatories to Basel II are also in the process of implementing this framework, using this as an opportunity to re-structure their financial industry.

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Implementation of BASEL II globally and locally

In 1998, the BASEL committee was convinced that BASEL I norms werent fool proof and it could not be patched up by a few modifications. In fact, the need of the hour (and the future) was a complete overhaul of the capital accord. Thus after 10 years we now have the new recommended capital accord which is more popularly known as BASEL II. It has been updated since then to incorporate various improvements.

Globally, BASEL II is in implementation since 2006. In India, the foreign banks and Indian banks that have overseas operations are required to switch over to BASEL II from 31st March, 2008 while the other banks can switch over from 31st March, 2009.

In Switzerland, the norms were implemented from 2006. Way back in 2005, the US had started out with some apprehension adopting the new capital accord. However, right at the outset the US had prescribed the banks with foreign exposure above a minimum threshold limit to adopt advance measurements for credit and operational risks.

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THE BASEL II CAPITAL FRAMEWORK

The 3 Pillars of BASEL II

The entire making of the BASEL II norms is based on the 3 pillars on which it stands.

Pillar 1 Minimum Capital Requirement: It is the most important part of the BASEL II norms. This pillar identifies three most significant risks faced by the banks and accordingly aligns the capital requirement. These risks are:

1. Credit Risk This type of risk arises from the possibility of default or dimunition in the credit quality of the borrower. Such dimunition in credit quality may be actual or as perceived by the bank. Such risks arise from a variety of banking activities like direct lending; issuing letters of credits or guarantees, treasury operations etc.

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There are two approaches to calculate this risk Standardized Approach and Internal Ratings Based Approach. The RBI has recommended the Standardized Approach to begin with. The assessment and calculation under this method is relatively simplistic. However, it is more accurate than the BASEL I approach of one size fits all. The risk weights are related to the external ratings of the counter party. These risk weights could range from 0% to 150% depending upon the ratings. Better the rating, lower the risk weights. Unrated exposures are weighted at 100%. The RBI has authorized the use of ratings issued by 4 rating agencies namely CRISIL Limited, CARE Limited, ICRA Limited and Fitch India. In case of ratings for international exposure, the ratings issued by Standard and Poor (S&P), Moodys and Fitch are used. The banks must disclose the ratings used and it should also be consistent in using the ratings. Cherry picking of the ratings is not permitted. In case an exposure is rated differently by 2 agencies, the banks can take the higher of the 2 and in case 3 agencies have all rated the exposure differently, the bank can choose the second best. The risks weight differ according to the exposure quality (NPA or otherwise), the counterparty (sovereign, corporate, retail etc.), security and collaterals.

The Internal Ratings Based approach differs from the Standardized approach in the aspect that instead of calibrating exposures as per the ratings assigned by the agencies, the banks can use their internal models to rate the exposures. This technique requires sophistication of risk assessment and measurement models. The IRB technique is based on assessing the risk taking into consideration Probability

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of Default (PD), Loss Given Default (LGD) and Exposure at Default (EAD). The total risk is given by: PD * LGD * EAD.

In case of Foundation IRB, the banks internally determine PD but LGD and EAD are determined by the regulator. In case of Advanced IRB all three variables are determined by the bank and validated by the regulator. The RBI has suggested the use of Standardized approach in the initial stages of implementation after which the banks may graduate to IRB methods. Only those banks which satisfy the minimum criteria laid down by RBI can adopt the IRB method. The underlying idea of BASEL II is to sensitize banks to different intensities of risks borne by them and have a cushion against such risks in terms of capital. However, maintaining high capital at all times is a costly affair and hence the banks will try to minimize the regulatory capital required. This can be done by using various Credit Risk Mitigation techniques. One such technique is calling for eligible collateral and setting it off against the exposure and then risk weighing the exposure.

For a collateralized transaction, the exposure amount after risk mitigation is calculated as follows:

E* = max {0, [E * (1 + He) C * (1 Hc Hfx)]}

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Where, E* = exposure value after risk mitigation E = current value of the exposure He = haircut appropriate to the exposure C = current value of the collateral received Hc = haircut appropriate to the collateral Hfx = haircut appropriate for the currency mismatch between the collateral and exposure

2. Market Risk - Market risk is defined as the risk of losses in on-balance sheet and off balance sheet positions arising from movements in market prices. The market risk positions subject to capital charge requirement are:

(i)

The risks pertaining to interest rate related instruments and equities in the trading book; and

(ii)

Foreign exchange risk (including open position in precious metals) throughout the bank (both banking and trading books).

It includes addressing Liquidity Risk, Interest Rate Risk and Foreign Exchange Risk. Liquidity Risks manifest in terms of (i) Funding Risk need to replace net outflows due to unanticipated withdrawal/non-renewal of deposits (wholesale and retail); (ii) Time Risk - need to compensate for non-receipt of expected inflows of funds, i.e. performing assets turning into non-performing assets; and

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(iii)

Call Risk - due to crystallization of contingent liabilities and unable to undertake profitable business opportunities when desirable.

Interest rate risk is the risk where changes in market interest rates might adversely affect a banks financial condition. The immediate impact of changes in interest rates is on the Net Interest Income (NII). A long term impact of changing interest rates is on the banks net worth as the economic value of banks assets, liabilities and off-balance sheet positions get affected due to variation in market interest rates. The interest rate risk when viewed from these two perspectives is known as earnings perspective and economic value perspective, respectively. Earnings perspective involves analyzing the impact of changes in interest rates on accrual or reported earnings in the near term. This is measured by measuring the changes in the Net Interest Income (NII) or Net Interest Margin (NIM) i.e. the difference between the total interest income and the total interest expense. Economic Value perspective involves analyzing the expected cash flows on assets minus the expected cash flows on liabilities plus the net cash flows on offbalance sheet items. It focuses on the risk to net worth arising from all repricing mismatches and other interest rate sensitive positions. The economic value perspective identifies risk arising from long-term interest rate gaps. Foreign Exchange Risk maybe defined as the risk that a bank may suffer losses as a result of adverse exchange rate movements during a period in which it has an open position, either spot or forward, or a combination of the two, in an individual foreign currency. The banks are also exposed to interest rate risk, which arises from the maturity mismatching of foreign currency positions.

Trading book for such purposes will include securities under HFT category, securities under AFS category, open gold position limits, open foreign exchange

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position limits, trading positions in derivatives and derivatives held for hedging trading book exposures.

Models Used for Market Risk Purposes

The VaR method is employed to assess potential loss that could crystallize on trading position or portfolio due to variations in market interest rates and prices, using a given confidence level, usually 95% to 99%, within a defined period of time.

Simple maturity/reprising schedules can be used to generate simple indicators of the interest rate risk sensitivity of both earnings and economic value to changing interest rates. When this approach is used to assess the interest rate risk of current earnings, it is typically referred to as gap analysis. To evaluate earnings exposure, interest rate sensitive liabilities in each time band are subtracted from the corresponding interest rate sensitive assets to produce a reprising "gap" for that time band. This gap can be multiplied by an assumed change in interest rates to yield an approximation of the change in net interest income that would result from such an interest rate movement.

A maturity/reprising schedule can also be used to evaluate the effects of changing interest rates on a bank's economic value by applying sensitivity weights to each time band. Typically, such weights are based on estimates of the duration of the assets and liabilities that fall into each time band. Duration is a measure of the

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percent change in the economic value of a position that will occur given a small change in the level of interest rates.

The minimum capital requirement is expressed in terms of two separately calculated charges, (i) specific risk charge for each security, which is designed to protect against an adverse movement in the price of an individual security owing to factors related to the individual issuer, both for short (short position is not allowed in India except in derivatives) and long positions, and (ii) general market risk charge towards interest rate risk in the portfolio, where long and short positions (which is not allowed in India except in derivatives) in different securities or instruments can be offset. There are two methods of calculating Market Risks Standardized method (under which one can use Maturity method or Duration method) and Internal Models method. Under the Standardized method, as the Duration method is more accurate, we use the duration method for calculating the market risks. Accordingly, banks have to measure general market risk by calculating the price sensitivity of each position separately. Modified duration is standard duration divided by 1 + r, where r is the level of market interest rates - is elasticity. As such, it reflects the percentage change in the economic value of the instrument for a given percentage change in 1 + r. Duration reflects the timing and size of cash flows that occur before the instrument's contractual maturity. Generally, the longer the maturity or next repricing date of the instrument and the smaller the payments that occur before

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maturity (e.g. coupon payments), the higher the duration (in absolute value). Higher duration implies that a given change in the level of interest rates will have a larger impact on economic value.

3. Operational Risk Operational risk is the risk arising from failure or inadequacy of internal processes, people and systems and external events. The new capital accord provides for 3 measures to assess Operational Risk Basic Indicator Approach, Standardized Approach and Advanced Measurement Approach. Operation risk is an important risk facing the banks. The underlying motive of assessing and providing for Operational risk I is strengthening the systems and procedures. Under the Basic Indicator Approach, banks must hold capital for OR equal to the previous three years of a fixed percentage (denoted alpha) of positive annual gross income.

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Figures for any year in which annual gross income is negative or zero should be excluded from both the numerator and denominator when calculating the average. The charge may be expressed as follows;

Where KBIA = the capital charge under the Basic Indicator Approach GI = annual gross income, where positive, over the previous three years n = number of the previous three years for which gross income is positive = 15%, which is set by the BCBS, relating the industry wide level of required capital to the industry wide level of the indicator.

Standardized Approach is a variant of the Basic Indicator Approach. Here, the activities of the bank are divided into eight business lines: namely corporate finance; trading & sales; retail banking; commercial banking; payment and settlement; agency services; asset management and retail brokerage. Within each business lines, a fixed percentage multiplier (specified as beta; varies from 12% for retail brokerage to 18% for corporate finance) is specified by Basel II. The capital charge for each business line is calculated by multiplying the beta for each business line with its annual gross income. The total capital charge for the bank is the three-year average of the summation of the capital charge across each business line. The negative capital charges for a business line can offset a positive capital charge from another business line in a year, but not across years.

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Under the Advanced Measurement Approach, banks are required to have an internal system which measures the operational risk. To migrate to this method, the bank must satisfy the stringent qualitative and quantitative criteria laid by RBI.

Globally as well only those banks which use IRB method for credit risk calculation are generally permitted the use of AMA.

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Pillar 2 Supervisory Review Process

This pillar complements the first pillar of new capital accord. The objective of this pillar is to ensure that the bank has adequate capital to cover all its risks and to encourage management to enhance its risk management systems. It ensures that in the case that adequate capital is not maintained by the banks the supervisory authority can intervene at the early stages and prevent the damage. This process deals with additional risks that:

1. Are considered under Pillar one but not fully provided for or 2. Risks that are not accounted for by Pillar 1

Basel II sets out four guiding principles that provide the framework for the supervisory review process: 1) Banks must have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels. 2) Supervisors should review and evaluate banks internal risk assessments and strategies and should take appropriate action if the results of this process are not satisfactory. 3) Supervisors should expect banks to operate above the minimum regulatory capital ratios 4) Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the banks risk characteristics. Implicit in the first principle is that all material risks faced by a bank should be addressed by the bank. The supervisor acts when capital is clearly below the minimum levels required to support all of the material risk

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characteristics of the bank. Three material risk characteristics that supervisors will pay particular attention, and that will be particularly suited to treatment under pillar 2 are considered below.

Step 1 can be ensured by considering the Boards and the senior managements approach to risks, soundness of systems used to assess capital requirement, comprehensiveness of the risks assessed, monitoring and reporting through ICAAP and Internal Control Review.

Step 2 can be ensured by the supervisory authorities by reviewing the process used by the banks to Assesses its capital adequacy Risk position Resulting capital levels Quality of capital held

Emphasis of the review should be on the quality of the capital maintained by the bank. It can be done by conducting external audit, on-site or off-site inspections or discussions with the bank management. A careful study of assumptions and assessment of stress tests should be done. Step 3 can be ensured by assessing whether or not the capital maintained by the bank is over and above the minimum level. The underlying rationale is that in case of emergencies it is costly to raise additional capital. There may also be certain risks which though not accounted for, arise.

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Step 4 can be implemented by undertaking a range of actions against those banks which do not adhere to the norms set. As a part of this SRP, all banks are required to maintain a record of well defined Internal Control process called Internal Capital Adequacy Assessment Process (ICAAP). Along with this, banks should have strategy to maintain capital levels and operate at levels in excess of minimum CAR (Capital Adequacy Requirement). ICAAP should be commensurate to the size, level of complexity, risk profile and scope of operations of the bank.

The steps involved in such an assessment process are: Identification and measurement of risk Appropriate level of capital according to risk profile Application and development of risk management systems in the bank

Top management involvement is critical for the success of ICAAP. Hence, RBI makes it mandatory that the ICAAP has to be prepared by the board of directors and the CEO. Top management is responsible for carrying out crucial tasks such as qualitative assessment of risks like Strategic risk and Reputation risk. Hence, the responsibilities of the top management are: tolerance levels for risk, develop systems to monitor risk exposure and compliance, communicate policies prepare strategic plan to outline banks current and future capital needs, capital expenditures and desired capital level

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Pillar 3 Market Discipline The purpose of Market discipline in the New Framework is to complement the minimum capital requirements (detailed under Pillar 1) and the supervisory review process (detailed under Pillar 2). The aim is to encourage market discipline by developing a set of disclosure requirements which will allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes, and hence the capital adequacy of the institution. Pillar 3 disclosure frame work does not conflict with requirements under accounting standards, which are broader in scope. The BCBS has taken considerable efforts to see that the narrower focus of Pillar 3, which is aimed at disclosure of bank capital adequacy, does not conflict with the broader accounting requirements. The Reserve Bank will consider future modifications to the Market Discipline disclosures as necessary in light of its ongoing monitoring of this area and industry developments. Banks, including consolidated banks, should provide all Pillar 3 disclosures, both qualitative and quantitative, as at end March each year along with the annual financial statements. Banks with capital funds of Rs.100 crore or more should make certain interim disclosures on quantitative aspects, on a stand alone basis, on their respective websites.

Sought Impact of the New Capital Accord

In the advent of globalization of the banking industry it becomes imperative that certain norms be standardized the world over. This gives a base for comparison of two units in terms of quality of service provided by them, safety of operations etc. It provides more meaning to profitability and other elements of the financials of the banks across the

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globe. With the countries seeking to adopt IFRS for preparing their financials, BASEL II will help in creating a level playing field for all players at the international level.

Firstly, the most obvious impact of BASEL 2 is the need for improved risk management and measurement. It aims to give impetus to the use of internal rating system by the international banks. It seeks to incentivize the banks to assess accurately the risks in exposures to different counterparties based on their soundness, credit ratings and servicing capabilities.

Secondly, in order to comply with the capital adequacy norms the overall capital level of the banks will rise. Here there is a worrying aspect that some of the banks will not be able to put up the additional capital to comply with the new regulation and they will be isolated from the global banking system.

Thirdly, banks will have to be more circumspective in their lending activities. Their credit appraisal and credit control policies should evaluate the impact of exposure on capital requirements. Any exposure should be assessed in terms of credit, market and operational risk that it will create.

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Credit Risk The bank manages its credit risk through continuous measuring and monitoring of risks at each obligor (borrower) and portfolio level. The bank has robust internal credit rating framework and well established standardized credit appraisal / approval processes. It is a decision enabling tool that helps the bank to take a view on acceptability or otherwise of any credit proposal. The internal rating factors, quantitative and qualitative issues relating to management risk, business risk, industry risk, financial risk and project risk besides, such ratings consider transaction specific credit enhancement features while assessing the overall ratings of the borrower. The data on industry risk is constantly updated based on market conditions. The bank has put in place a well structured Credit Risk Management Policy. Credit risk is monitored by the bank on a bank wide basis and compliance with the risk limits approved by the Credit Committee is ensured. The Committee takes into account the risk tolerance level of the bank and accordingly handles the issues relating to Safety, Liquidity, Prudential Norms, Exposure Limits by aligning the past experience and performance like default experience, recovery experience etc. and also to take into consideration any regulatory and legal issues. The credit appraisal and monitoring guidelines take into account

the counterparty the purpose of facility the source of repayment

It also constitutes guidelines that address specific situations related to

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 countries economy, political situation industries stage of development, growth rate, certainty of cash flows counterparties reputation, management, holding concentration transactions purpose, repayment, maturity, legal issues CRM also includes internal rating of counterparties (the policy is confidential to BNP Paribas). In addition to Credit Risk Management Policy, the bank has also framed Board approved Loan Policy, Investment Policy, Counterparty Risk Management Policy and Country Risk Management Policy which form integral parting the monitoring credit risk in the bank. In line with the regulatory requirements, the bank has put in place a well articulated policy on Collateral Management and Credit Risk Mitigation Techniques. The policy lays down the types of securities normally accepted by the bank for lending and administration / monitoring of such securities in order to safeguard / protect the interest of the bank so as to minimize the risks associated with it. It also clearly states the legalities that must be verified before any collateralized or netting contract is made. It also defines on who is eligible to act as a guarantor and the operational requirements for guarantees. The bank has adopted the comprehensive approach relating to credit risk mitigation under Standardized Approach, which allows fuller offset of securities (prime and collateral) against exposure, by effectively reducing the exposure amount by the value ascribed to the securities. Thus, the eligible financial collaterals are fully made use of to reduce the credit exposure in computation of credit risk capital.

Involvement of CRISIL CRISIL was the rating agency appointed by the bank to perform rating migrations and carry out the calculations for credit risk. The input was given by different teams of the

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bank as regards various transactions, exposures etc. The data was then sorted by CRISIL into correct BASEL asset class. Further classification of banks was done into domestic (scheduled, non-scheduled) and foreign. Other clients were classified into Capital Market exposure and Commercial Real Estate exposure. Various transactions were sorted into drawn exposures, Off Balance Sheet, Repo style and OTC derivatives. The facility under each transaction was classified into fund based, non-fund based and investments. For the off balance sheet items, required CCFs were applied. CRISIL compiled the external ratings available in the public domain for all the counterparties with outstanding limits. The ratings were compiled as per the following category: Bonds & CPs issued by Corporate and Banks Issue Ratings Ratings of foreign banks (by International Rating agencies) CRISIL also undertook various stress test analyses to ensure that capital is maintained at prudent levels. This output (at the final and intermediary level) was constantly validated by the senior authorities of the bank.

Market Risk

The bank has put in place Board approved Market Risk Management Policy and Asset Liability Management (ALM) policy for effective management of market risk in the bank. Other policies which also deal with market risk management are Investment Policy, Forex Risk Management Policy and Derivative Policy. The policy sets various risk limits

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for effective management of market risks and ensuring that operations are in line with banks expectation of return to market risk through proper Asset Liability Management. The policy also deals with reporting framework for effective monitoring of market risk. Liquidity is managed through the GAP analysis, based on residual maturity / behavioral pattern of assets and liabilities, on a daily basis based on best available data coverage, as prescribed by the RBI. Liquidity profile of the bank is evaluated through various liquidity ratios. The bank has also drawn various contingent measures to deal with any kind of stress on liquidity position. Interest rate risk is managed through GAP analysis of rate sensitive assets and liabilities and monitored through prudential limits prescribed. The bank has also put in duration GAP analysis framework for management of interest rate risk. The bank estimates Earnings at Risks (EaR) and Modified Duration GAP (DGAP)periodically against adverse movement in interest rate for assessing the impact on Net Interest Income (NII) and Economic Value of Equity (EVE) with a view to optimize shareholder value. The bank identifies the risks associated with the changing interest rates on its on-balance sheet and off-balance sheet exposures in the banking book from a short term (Earning perspective) and long term (Economic value perspective) by applying notional interest rate shock up to 100 bps as prescribed in banks ALM policy. For the calculation of impact on earnings, the Traditional Gap is taken from the Rate Sensitivity statement i.e. at every reporting Friday. The limits are fixed based on the previous years NII. The bank has adopted Traditional Gap Analysis combined with Duration Gap Analysis for assessing the impact (as a percentage) on the Economic Value of Equity (EVE) by applying notional interest rate shock of 200 bps. For this purpose, a limit of (+ / -) 1.00% for the Modified Duration Gap on the Balance Sheet is prescribed in banks ALM policy and the position is monitored periodically on a monthly basis. Bank calculates Modified Duration Gap (DGAP) and the impact on the Economic Value of Equity (EVE). Assets, excluding Investments and Liabilities are grouped as per Rate Sensitivity statement and

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bucket wise Modified Duration is computed for these groups of Assets and Liabilities using common maturity, coupon and yield parameters. For investment portfolio, the Modified Duration of individual items are computed and taken. The DGAP is calculated by the bank once in a month (based on last reporting Friday) and is reported to ALCO and Board. The Asset-Liability Management Committee monitors adherence of prudential limits fixed by the bank and determines the strategy in the light of market condition (current and expected).

Operational Risk The bank has framed Operational Risk Management Policy duly approved by the Board. Other policies adopted by the bank which deal with management of operational risk are Information Systems Security Policy, Forex Risk Management Policy, Policy document on Know Your Customers (KYC) and Anti Money Laundering Procedures, IT Business Continuity and Disaster Recovery Plan (IT BC DRP). The operational risk management policy adopted by the bank outlines organization structure and detail processes for management of operational risk. The basic objective of the policy is to closely integrate operational risk management system into day-to-day risk management processes of the bank by clearly assigning roles for effectively identifying, assessing, measuring, monitoring and controlling / mitigating operational risks and by timely reporting of operational risk exposures, including material operational losses. Operational risks in the bank are managed through comprehensive and well articulated internal control frameworks.

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Other Risks Other risks that are identified and accounted for in case of BNP Paribas, India are:

1. Business Risk - Prospective risk to earnings arising from changes in the business environment and from adverse business decisions, improper implementation of decisions or lack of responsiveness to changes in the business environment. This covers the risk of fall in operating profit due to factors not covered under credit or market risk.

2. Reputation Risk - By definition, it is the loss of long term shareholder value due to failed risk management, corporate governance, environmental, social and ethical performance, customer relationship, compliance and financial performance. In the current market scenario in India, with a number of corporate suffering losses due to unanticipated rise in the rupee against the dollar and weakening of dollar against major currencies globally, many forex deals the corporates had with the banks have caused them heavy losses. Corporate now blame the banks for selling them exotic products which they didnt comprehend completely and some have even taken legal action. In such a scenario, the reputation of the bank can take a severe beating and hence lead to lesser business and lesser revenue.

3. Settlement Risk - This is defined as the risk that one party will fail to deliver the terms of a contract with another party at the time of settlement. This could be due to default or timing differences at settlement.

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4. Strategic Risk - The risk associated with the adverse impact of strategic decisions such as organic growth, competitive environment, mergers and acquisitions and disposals etc. is called Strategic risk.

CHALLENGES IN IMPLEMENTING BASEL II

The most important challenge in adopting BASEL II successfully is in the form of maintaining a sea of data. The second is to build the kind of infrastructure that is required to store, transfer and retrieve data. Not only that the systems must now be guarded, as much as possible, against frauds, thefts and loss. The systems should have the inbuilt ability to perform a variety of functions.

With many public sector banks operating on a wide scale in remotest village, obtaining that kind of infrastructural command will be a big problem.

The stringent second and third pillar requirement puts a great deal of demand on the skills and talents of the top level management. The new capital accord will require realignment of strategies to minimize the risks and optimize capital. The advanced methodologies will require experience and superlative training. Procuring that kind of manpower will be an issue in the first couple of years.

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Some models of measuring risks require a thorough understanding and an accurate estimation. For example, the long time horizons required in case of VaR model. Getting accuracy in such cases is difficult in the initial years.

Also, banks globally had started implementing BASEL II since 2006. The apex institutions there have also allowed many banks to use internal ratings for credit risk and advanced methods for operational risk. They have a natural advantage in the understanding of the system over the Indian banks and hence over a period of time they will gain a competitive advantage over domestic banks.

In most of the cases, the banks will need to maintain more capital than they were maintaining under BASEL I. This is likely to happen because of the additional capital that will be needed to provide for operational risk. This will cause an additional burden on the smaller banks.

The standardized approach requires the ratings assigned by the eligible external agencies. However, the rating penetration in India is not too deep. Also, rating here is only issue based and not issuer based and it provides a lagging perspective rather than a leading perspective.

Implementing the pillar 2 requirement of ICAAP will be another hurdle for the Indian banks at it requires comprehensive assessment of risk modeling and management and have to compute the risks other than those mentioned in

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What is Basel III? It is the third set of banking rules agreed by central bankers and regulators from around the world at meetings in Basel ,Switzerland, hence the name. Banks will have to raise hundreds of billions of Euros in fresh capital over the next few years. More specifically, they will have to increase their core tier-one capital ratio a key measure of banks' financial strength to 4.5% by 2015. In addition, they will have to carry a further "counter-cyclical" capital conservation buffer of 2.5% by 2019. Basel III is part of the continuous effort made by the Basel Committee on Banking Supervision to enhance the banking regulatory framework. It builds on the Basel I and Basel II documents, and seeks to improve the banking sector's ability to deal with financial and economic stress, improve risk management and strengthen the banks' transparency. A focus of Basel III is to foster greater resilience at the individual bank level in order to reduce the risk of system wide shocks

Why does it matter? The idea is that if banks hold a bigger capital cushion they will be better prepared for another downturn so we avoid a re-run of the financial crisis . Instead of holding capital equivalent to just 2% of their risk-bearing assets, banks will have to hold 7% of topquality capital in reserve. How has it been received? The deal is important because it removes much of the uncertainty that has dogged the banking sector in recent months, and markets breathed a sigh of relief today because the new rules will be phased in over a much longer time period than expected. The British Bankers' Association had called for a long timetable, warning that the rules "suck money out of the economy". The new rules were welcomed by the European Central Bank, the Financial Services Authority and American regulators

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What does it mean for consumers? There won't be a return to the era of cheap money as banks build up their capital reserves ahead of the deadlines. UK banks have already made big efforts to raise their capital levels since the crisis struck, and taxpayer-backed Lloyds Banking Group now has a core tier-one capital ratio of 9% while Barclays's is 10%. Angela Knight, chief executive at the BBA, warned the move would end the "cheapmoney era" as it becomes more expensive to run a bank, which will in turn be passed on to consumers through higher loan and mortgage costs.

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Thank you

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