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Capital Adequacy Standards - Basel Accord,1988

( towards better Risk Management by Banks)

Credit management is the challenging functional area in a commercial bank. It calls for expert handling, assessing risk exposure at every stage and securing adequately the safety of funds exposed. In spite of best efforts there can be no full-proof safety standards, resulting in the unpreventable emergence of sticky or overdue credit periodically. Credit management is therefore a continuous search for more secure de-risking (effective risk-management) standards, and Asset-Liability Management strategies. Such risk-management expertise built and implemented helps at not eliminating risk altogether, but minimising the same.

Risk management is a subject for advanced study in the modern times in financial institutions and banks. In the coming years risk-management and Asset-Liability Management strategies will receive increasing attention in India, as a consequence of deregulation measures implemented in Indian Banking by RBI and the Government of India. While banks face a variety of risks, the effect of "Credit-Risk" is being severely felt in India. In fact the 1988 Basle Accord exclusively addresses at handling effectively credit-risks. However the proposed New accord to be implemented from 2004 hopes to cover other risks also. Relevant extract from the Consultative Paper issued by Basel Committee on Banking Supervision covering the New Capital Adequacy Framework speaks as under.

"While the original Accord focused mainly on credit risk, it has since been amended to address market risk. Interest rate risk in the banking book and other risks, such as operational, liquidity, legal and reputational risks, are not explicitly addressed. Implicitly, however, the present Accord takes account of such risks by setting a minimum ratio that has an acknowledged buffer to cover unquantified risks."

For details of Asset Liability Management Strategy and Risk Management in Banks, please refer to web pages on the respective subjects.

In India the first effort for standardisation of credit-assets for a better understanding of the inherent risk-component was made in the Eighties, when RBI introduced categorisation of bank-advances termed "Health Code" graded as per risk-content in each type of advance. The object of any coding system is standardization. RBI introduced the Health code system of commercial bank credit to bring industry level uniformity and intended for better transparency. All bank advances are categorized under eight health codes as under-

Health Code No.1 - Satisfactory
Health Code No.2 - Irregular accounts
Health Code No.3 - Sick Viable (under Nursing)
Health Code No.4 - Sick Non-viable (sticky)
Health Code No.5 - Recalled
Health Code No.6 - Suit Filed
Health Code No.7 - Decreed
Health Code No.8 - Bad & Doubtful

Prudential Norms - Ensuring Greater Transparency - Income Recognition and Provisioning

While Health Code provided for the categorisation of Bank-credit based on risk-exposure, it did not provide for risk-coverage on account of Credit-Assets turning non-productive or sticky . It is in this background that Prudential norms of Income recognition and provisioning for sticky accounts were introduced in 1992 when RBI considered it essential to accept Basel Committee Recommendations for Capital Adequacy. Brief description of measures implemented as per guidelines of RBI is given hereunder. More information on Basel Committee Accord are furnished later.

Interest income should not be recognized until it is realized. An NPA is one where interest is overdue for two quarters or more. In respect of NPAs, interest is not to be recognized on accrual basis, but is to be treated as income only when actually received. Income in respect of accounts coming under Health Code 5 to 8 should not be recognized until it is realized. As regards to accounts classified in Health Code 4, RBI has advised the banks to evolve a realistic system for income recognition based on the prospect of realizability of the security. On non-performing accounts the banks should not charge or take into account the interest. On overdue bill, interest should not be charged or taken at income unless realized.

Asset Classification

The banks should classify their assets based on weaknesses and dependency on collateral securities into four categories:

  1. Standard Assets- It carries not more than the normal risk attached to the business and is not an NPA
  2. Sub-standard Asset - An asset which remains as NPA for a period not exceeding 24 months, where the current net worth of the borrower, guarantor or the current market value of the security charged to the bank is not enough to ensure recovery of the debt due to the bank in full.
  3. Doubtful Assets- An NPA which continued to be so for a period exceeding two years (18 months, with effect from March, 2001).
  4. Loss Assets - An asset identified by the bank or internal/ external auditors or RBI inspection as loss asset, but the amount has not yet been written off wholly or partly

Provisioning Norms

Based on the asset classification, banks will have to make the following provisioning:

  • Loss assets - 100 percent of the outstanding amount
  • Doubtful Assets - 100 percent for the unsecured portion, and 20-50 percent for the secured portion
  • Sub-standard Assets - 10 percent of the total outstanding amount
  • Standard Assets - As per recent guidelines 5% provisioning is to be made

Capital Adequacy Ratio - Basle Accord 1988

The growing concern of commercial banks regarding international competitiveness and capital ratios led to the Basle Capital Accord 1988. The accord sets down the agreement among the G-10 central banks to apply common minimum capital standards to their banking industries, to be achieved by year end 1992. The standards are almost entirely addressed to credit risk, the main risk incurred by banks. The document consists of two main sections, which cover

  1. the definition of capital and
  2. the structure of risk weights.

Based on the Basle norms, the RBI also issued similar capital adequacy norms for the Indian banks. According to these guidelines, the banks will have to identify their Tier-I and Tier-II capital and assign risk weights to the assets. Having done this they will have to assess the Capital to Risk Weighted Assets Ratio (CRAR). The minimum CRAR which the Indian banks are required to meet is set at 9 percent.

Tier-I Capital

  • Paid-up capital

  • Statutory Reserves
  • Disclosed free reserves
  • Capital reserves representing surplus arising out of sale proceeds of assets

Equity investments in subsidiaries, intangible assets and losses in the current period and those brought forward from previous periods, will be deducted from Tier I capital.

Tier-II Capital

  • Undisclosed Reserves and Cumulative Perpetual Preference Shares

  • Revaluation Reserves
  • General Provisions and Loss Reserves

What is Basel Committee and what are its "norms". Very brief particulars are provided here. More details on various publications of 'BIS' can be viewed from their web site

Background of the Basel Accord of 1988

The major impetus for the 1988 Basel Capital Accord was the concern of the Governors of the G10 central banks that the capital of the world's major banks had become dangerously low after persistent erosion through competition. Capital is necessary for banks as a cushion against losses and it provides an incentive for the owners of the business to manage it in a prudent manner.

The Existing Framework

The 1988 Accord requires internationally active banks in the G10 countries to hold capital equal to at least 8% of a basket of assets measured in different ways according to their riskiness. The definition of capital is set (broadly) in two tiers, Tier 1 being shareholders' equity and retained earnings and Tier 2 being additional internal and external resources available to the bank. The bank has to hold at least half of its measured capital in Tier 1 form.

A portfolio approach is taken to the measure of risk, with assets classified into four buckets (0%, 20%, 50% and 100%) according to the debtor category. This means that some assets (essentially bank holdings of government assets such as Treasury Bills and bonds) have no capital requirement, while claims on banks have a 20% weight, which translates into a capital charge of 1.6% of the value of the claim. However, virtually all claims on the non-bank private sector receive the standard 8% capital requirement.

There is also a scale of charges for off-balance sheet exposures through guarantees, commitments, forward claims, etc. This is the only complex section of the 1988 Accord and requires a two-step approach whereby banks convert their off-balance-sheet positions into a credit equivalent amount through a scale of conversion factors, which then are weighted according to the counterparty's risk weighting.

The 1988 Accord has been supplemented a number of times, with most changes dealing with the treatment of off-balance-sheet activities. A significant amendment was enacted in 1996, when the Committee introduced a measure whereby trading positions in bonds, equities, foreign exchange and commodities were removed from the credit risk framework and given explicit capital charges related to the bank's open position in each instrument.

Impact of the 1988 Accord

The two principal purposes of the Accord were to ensure an adequate level of capital in the international banking system and to create a "more level playing field" in competitive terms so that banks could no longer build business volume without adequate capital backing. These two objectives have been achieved. The merits of the Accord were widely recognised and during the 1990s the Accord became an accepted world standard, with well over 100 countries applying the Basel framework to their banking system. However, there also have been some less positive features. The regulatory capital requirement has been in conflict with increasingly sophisticated internal measures of economic capital. The simple bucket approach with a flat 8% charge for claims on the private sector has given banks an incentive to move high quality assets off the balance sheet, thus reducing the average quality of bank loan portfolios. In addition, the 1988 Accord does not sufficiently recognise credit risk mitigation techniques, such as collateral and guarantees. These are the principal reasons why the Basel Committee decided to propose a more risk-sensitive framework in June 1999.

The June 1999 Proposal

The initial consultative proposal had a strong conceptual content and was deliberately rather vague on some details in order to solicit comment at a relatively early stage of the Basel Committee's thinking.

It contained three fundamental innovations, each designed to introduce greater risk sensitivity into the Accord. One was to supplement the current quantitative standard with two additional "Pillars" dealing with supervisory review and market discipline. These were intended to reduce the stress on the quantitative Pillar 1 by providing a more balanced approach to the capital assessment process. The second innovation was that banks with advanced risk management capabilities would be permitted to use their own internal systems for evaluating credit risk, known as "internal ratings", instead of standardised risk weights for each class of asset. The third principal innovation was to allow banks to use the gradings provided by approved external credit assessment institutions (in most cases private rating agencies) to classify their sovereign claims into five risk buckets and their claims on corporates and banks into three risk buckets. In addition, there were a number of other proposals to refine the risk weightings and introduce a capital charge for other risks. The basic definition of capital stayed the same.

The comments on the June 1999 paper were numerous and can be said to reflect the important impact the 1988 Accord has had. Nearly all commentaries welcomed the intention to refine the Accord and supported the three Pillar approach, but there were many comments on the details of the proposal. A widely-expressed comment from banks in particular was that the threshold for the use of the IRB approach should not be set so high as to prevent well-managed banks from using their internal ratings.

Intensive work has taken place in the eighteen months since June 1999. Much of this has leveraged off work undertaken in parallel with industry representatives, whose cooperation has been greatly appreciated by the Basel Committee and its Secretariat.

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