As the deadline of implementing Basel-II approaches, Indian banks are still preparing to solve the risk puzzle for a more transparent and risk-free financial base

The financial services community worldwide, especially in the UK and the US, is busy solving the '' riddle. As the deadline of implementing Basel-II approaches, India too is gearing up to solve the risk puzzle for a more transparent, and risk-free financial base, on par with its international peers.

According to the Reserve Bank of India, its association with the Basel 'committee on banking supervision' dates back to 1997, as India was among the 16 non-member countries that were consulted in the drafting of the Basel core principles. The RBI became a member of the 'core principles liaison group' in 1998, and subsequently became a member of the 'core principles working group on capital'.

During the annual policy statement in May this year, the RBI announced that Indian banks should come out with a framework by the end of December 2004 for migrating their standards of supervision, accountability and best practice guidelines in line with the provisions of the Basel-II accord. Moreover, the framework adopted by the banks must be adaptable to changes in business size, market dynamics, and introduction of newer products in future. To ensure that Indian banks must:

• Make an in depth analysis of the options available under Basel-II
  
• Adopt 'standardised approach' for credit risk
  
• Adopt 'basic indicator approach' for operational risk
  
• Review the progress at quarterly intervals
  
• Install comprehensive and rigorous system to assess borrower's risk

Further, the RBI said that it would monitor closely the progress made by banks and after adequate skills have been developed, some of them may be allowed to migrate to the IRB Approach.

The central bank has formed a steering committee comprising members from other banks, Indian Banking Association, and the RBI for consultation on various matters concerning the Basel-II norms. Once the RBI receives inputs from the committee, it will prepare draft guidelines to put in place the stringent norms, and place it in public domain.

However, Kishori J Udeshi, deputy governor, Reserve Bank of India, in her speech at the World Bank - IMF - US Federal Reserve Board's 'fourth annual international seminar', said that though cross border issues have been dealt with by the Basel committee, in India foreign banks are statutorily required to maintain local capital. Therefore, the following issues needed to be resolved:

• Whether the internal models approved by the head offices of foreign banks and home country supervisor of their Indian branches need to be validated again by the RBI and / or, whether, the validation by the home country supervisor would be considered adequate?
• Whether the data history maintained and used by foreign banks should be distinct for their Indian branches compared to the global data maintained and used by the head office?
• Whether capital for operational risk should be maintained separately for the Indian branches or, whether it may be maintained abroad at head office?
• Whether foreign banks can be mandated to maintain capital as per basic indicator approach (BIA), the standardised approach (SA) in India irrespective of the approaches adopted by the head office?

She said that the implementation of Basel-II might trigger a round of consolidation in the banking sector. Though, it is difficult to foresee the precise pattern of consolidation, it will be necessary to ensure that mergers are successful in all respects, including manpower and cultural aspects, which are unique in the Indian context, she added.

Adoption Scenario
The RBI has taken a view that only those Indian banks that get 20 per cent of their business from abroad need to follow Basel-II norms. Though, this writer sent email questionnaires to various relevant officials at, RBI, to elaborate more on the specific guidelines for banks to adopt the provisions of Basel-II, there was no response.

In India, banks have been following the earlier Basel-I since 1993-94. In fact, regulators require a minimum capital to asset ratio of 9 per cent, which is above the 8 per cent level mentioned in the Basel-II accord. Despite being one of the fastest growing economies in the world, Indian banks are far behind their western counterparts in modern risk measurement and management tools for credit, market and operational risks. Traditionally, most Indian banks have relied on policies and procedures instead of quantitative evaluations, as the primary tools for risk management.

Arun Kumar Purwar, chairman and managing director, State Bank of India, in a recent report, said that though SBI's international operations contribute about 6 per cent of its business, still it had decided to follow the Basel-II regulations. Purwar said that the bank is moving towards 100 per cent computerisation. Already 6,037 of the 9,000-odd branches have been computerised. The process of interconnecting them, through a core banking software, has begun. This writer tried to find out from various bank chairmen about their current progress in moving towards Basel-II compliance, but met with no response.

Talking to this writer, G Srinivas, deputy general manager, 'risk management group', ICICI Bank Limited, said that the internal rating system had been in existence in ICICI Bank for the past seven years. Credit risk management group (which is independent of the business groups) is in place in the bank, for credit ratings.

Srinivas also said that ICICI, India's second largest bank, would be compliant with all the major stipulations in the accord pertaining to credit risk management framework, such as having an independent rating group, minimum number of rating categories, using ratings for internal decision making, and board as well as senior management level oversight committees. With respect to operational risk, internal analysis has commenced with respect to model development and data collection, he added.

Reports said that HDFC, another new generation private sector bank, is still waiting for final guidelines from the RBI, and will be at the forefront in implementing the new guidelines, when they are rolled out by the central bank.

According to a survey by the Indian Banking Association and CRISIL Limited, most Indian banks have internal rating models for large corporates but not for all types of borrowing entities. The survey indicated varying degrees of preparedness in the area of risk management among different banks. Foreign banks led in the area of internal rating methods as almost all of those surveyed had such policies, compared to a minority of public sector banks, and just over half of private banks.

Speaking at a seminar, 'Risk management in banks in the changing environment', D Ravishankar, director, CRISIL, said that operational risk is a developing area, and a majority of banks have a long way to go. When it comes to measuring and managing market risk, adoption is very limited. Integrated risk management frameworks are far more common in foreign banks than Indian ones. CRISIL is the largest credit rating agency in India.

Experts said that Indian banks do not perceive any immediate value in the new norms as they are globally insignificant players with simple and straight forward balance-sheets. Moreover, their capital structures are fragile as compared to international standards.

Hurdles on the way
The road to the Basel-II will not be an easy one for Indian banks. The significant hurdles on its way are:

IT infrastructure: The technology infrastructure in terms of computerisation is still in a nascent stage in most Indian banks. Computerisation of branches, especially for those banks, which have their network spread out in far flung areas, will be a daunting task. Penetration of information technology in banking has been successful in the urban areas, unlike in the rural areas where it is insignificant.

Data management: Collection of data for the last three to four years, a requirement for conforming to the provisions of Basel-II is another difficult task. Due to a late start in computerisation, most Indian banks lack robust data capture, cleansing and management practices, and this will serve as the single largest limitation in adopting the accord. Moreover, to get rid of the common tradition of individuals maintaining paper work, will be another daunting task.

Risk Management Resources: Experts say that dearth of risk management expertise in the Asia Pacific region will serve as a hindrance in laying down guidelines for a basic framework for the new capital accord.

Communication gap: An integrated risk management concept, which is the need of the hour to align market, credit and operational risk, will be difficult due to significant disconnect between business, risk managers and IT across the organisations in their existing set up.

Huge Investment: Implementation of the Basel-II will require huge investments in technology. According to estimates Indian banks, especially those with a sizeable branch network, will need to spend well over $50-70 million on this.

In a recent survey conducted by the Federation of Indian Chambers of Commerce & Industry (FICCI), 55 per cent of the respondents' claim that Indian banks lack adequate preparedness to be able to conform to the Basel-II provisions by 2006. Whereas, 50 per cent of public sector banks have expressed their preparedness in meeting these guidelines, only 25 per cent of the old and new private sector and foreign banks are likely to be ready to meet them by 2006. According to the survey, concerns of the Indian banks in implementing these norms are:

• 51.6 per cent said due to low levels of computerisation,
  
• 87 per cent said due to absence of robust internal credit rating mechanism,
  
• 80.6 per cent said due to lack a strong management information system,
  
• And 58 per cent said due to lack of sufficient training and education to reach the levels to conform to the provisions of Basel-II.
  

The FICCI survey was based on feedback from more than 75 respondents including leading bankers, financial institutions, intermediaries and other market players in India.

Finance minister P Chidambaram, speaking at a conference, Indian Banking: Realising Global Aspirations, said that one of the major threats to the health of the Indian banking sector is the high level of non performing assets (NPAs). This problem has to be tackled by improving credit quality in terms of better skills, better risk management systems and improvements in monitoring and follow up.

On the whole, the system of supervision and accountability within public sector banks, and many old private sector banks needs to be improved. Bank management need to compare their own systems to those of the global banks, in which the quality of credit appraisals is far superior, supervision is strict and penalties for serious mistakes instantaneous.

Although the level of bad loans in the banking system remains worryingly high, Indian banks were not caught in the financial crisis that rocked East Asian economies in 1997-98. Thus, they are typically healthier than those in some other Asian countries, such as Thailand.

Conclusion
Jaime Caruana, chairman of the Basel committee is of the opinion that whether and when to implement Basel-II is a matter for national supervisors to decide. Being a non-OECD (Organisation for Economic Co-operation and Development) country, India does not face the deadline of 2006-end to adopt the accord. In fact, the chairman of the Basel committee, in a recent interview, said that the committee did not expect other countries to conform to the Basel-II guidelines at the same time as Basel committee member countries. National authorities in each country must assess their priorities and their industry's readiness carefully. They should adopt Basel-II, especially the more advanced approaches to credit and operational risk, only when it is most appropriate in light of national circumstances, he said.

Reports indicate that banks in the US and the UK, too, are grappling with the new accord, and may not be able to meet the implementation deadline of 2006-end. The RBI, instead of moving in for unhurried implementation must do it, a step, at a time. The RBI must come with clear guidelines regarding the criteria, on what kind of banks are going to adopt Basel-II.

A more practical approach is necessary to understand the current risk management framework in the Indian banking industry and the successive progression to the Basel-II in a phased manner. The steering committee formed by the RBI needs to become functional, instead of being present only on paper. Regular meeting and consultations with the banks is essential to guide them in adopting the strategy.

Though, they have a long way to go, the new capital regulation requirements have given Indians banks a chance to re-look at their risk strategies, revamp and hone their current policies to strengthen their immune system against any risk disaster.