After 31st March 2010 Indian banks will have to adhere to the Basel II norms. India had adopted Basel I guidelines in 1999. Later on in February 2005 the RBI had issued draft guidelines for implementing a New Capital Adequacy Framework, in line with Basel II. The deadline for implementing Basel II, originally set for March 31, 2007, has now been extended. Foreign banks in India and Indian banks operating abroad will have to adhere to the guidelines by March 31, 2009.
So let us dig what is this Basel II al about and how it will affect the Indian Banking sector.
What is Basel II?
Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II, which was initially published in June 2004, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face.
Basel II uses a “three pillars” concept – (1) minimum capital requirements (addressing risk), (2) supervisory review and (3) market discipline – to promote greater stability in the financial system.
Let’s dig out how all the three above pillars will bring changes in the Indian banking segment.
The first concept deals with minimum capital requirements. This is one of the most important and prime tool which makes our Indian Banking Sector jealous.
Banks have to keep aside 9 % capital againstØ various risks. The risk consist of interest rate risk in the banking book, foreign exchange risk, liquidity risk, business cycle risk, reputation risk, strategic risk. This rate is expected to increase after much talked about Basel II norms come into place. So all the above risk will make the Indian banking sector more secured and more stable just like the one during the US financial crisis.
In other words it can be described as theØ minimum amount of capital a Bank should maintain to cover its various business risks. This might affect the credit growth of banks since in first place Indian Banks are basically born skeptical which also acts as a boon in times of crisis. Banks will have to increase their margins for providing loans and moreover may reduce the rate of percentage of sanctions they make in usual conditions.
Now a question might come up in the mind thatØ what will be the affect on loans-this will be answered after 31st March 2010 when Basel II comes in to play.
The second pillar of Basel II is supervisory review. Banks have been given the power by which they will not only maintain the minimum capital requirements but will also be able to have a process by which they can assess their capital adequacy themselves. This process, and its assessment by the supervisory authority, is central to the second pillar of the Basel II Accord.
This also ensures that banks will be able to make arrangements to ensure that they hold enough capital to cover all their risks. The prime responsibility will lie on the individual banks to compile with the norms.
This review process will provide benefits when another financial crisis will hit in the future. We should not forget that when the US banks were getting sold out the Indian Banking segments stood still as if nothing has happened. That’s why we can go off to sleep when our prime wealth is being safely preserved in the Indian banks. It works in this frame work shown below.
The last but the most important one of Basel II is market discipline.
The recent financial crisis in US and the bailouts of the Century old Banks have raised the voice of market discipline. This is one of the most important pillar of any financial process.
Market Discipline in banking and financial sector is highly required in coming days as more globalization will expand. Market discipline as per Basel II focuses on:
To achieve increased transparency through expanded disclosure requirements for banks.
This will make sure that the banks are well positioned to handle the complex business process.
This will bring transparency in the process followed with adequate updating to the banking regulators on the involved process of the various banks in dealing complex products.
So over all it can be concluded that with the advent of Basel II, banks with a risk appetite, i.e. high risk – high return lending strategy or lending without proper appraisal merely to generate additional business will find the going tough. We believe that such business models, which take disproportionately high risks, will not survive. The business models, which should survive, will be where risks are within acceptance levels for the banks backed by adequate returns.
After implementing Basel II our Indian Banking will feel more jealous.
Authored by: Indranil Sen Gupta, Research Analyst