labels: finance - general, economy - general, banks & institutions
Basel II: Capital requirements manageable, long-term benefitsnews
21 May 2005

Authors Ritesh Maheshwari and Pallav Sangal* provide some highlights from their research for CRISIL.

The incremental capital requirement of the scheduled commercial banking sector on the implementation of Basel-II norms from March 31, 2007, is manageable, and can be met mostly through internal accruals and fresh capital issue.

Our research reveals that if the proposed new capital adequacy framework announced recently by the Reserve Bank of India (based on the Basel II norms) were to be applied to the banking sector's portfolio as on March 31, 2004, the overall capital adequacy would have declined by 1.6 percentage points from 12.9 per cent to 11.3 per cent.

This overall decline would be the combined effect of a lower capital requirement for credit risk, and higher capital requirements for market and operational risk. Banks should welcome the proposed framework, as the implementation of Basel II norms will, in the long-term, encourage banks to be more risk-sensitive, leading to an improvement in their risk management systems.

Modest decline in capital adequacy, manageable capital requirements
The 1.6 percentage points decline in capital adequacy is a function of a 0.7 percentage point gain on credit risk, and declines of 1.2 percentage points and 1.1 percentage points respectively on market risk and operational risk. (See: Methodology for estimating the impact) The overall 1.6 percentage point decline (in comparison to the banking sector's capital adequacy of 12.9 per cent as on March 31, 2004) is modest and can be offset comfortably, both through the internal accruals of the banking sector, and through fresh issuances (Tier I and Tier II) in the capital markets.

Credit Risk: Capital release, incentive for risk-based pricing
CRISIL expects that the banking sector would have gained 0.7 percentage points on capital adequacy, as a result of the implementation of the 'Standardised Approach' for credit risk.

A risk-based approach to allocate capital is the key difference between the current framework and the proposed framework. The loans and advances portfolio of the banking sector (see Table 1 below) has a significantly higher proportion of exposures falling in the high safety rating categories ('AAA' and 'AA' rating) and the 'retail ' category, than in the moderate safety ('BBB' rating) and speculative grade rating categories (BB rating and below). This results in a net capital charge saving for the banking sector. Similarly, the banks' portfolio of bonds and debentures also has a higher proportion of exposures in the higher rating categories than in the lower ones, resulting in a further reduction in the capital charge.

Table 1- Capital charge based on the risk profile
 

Rating/ Risk buckets

 

AAA

AA

A

BBB and below

Unrated

'Retail'#

Loans & Advances (%)

12.8%*

3.0%

0.7%

2.0%

37.6%

43.9%

Current framework

 

 

 

 

 

 

Risk weight

100%

100%

100%

100%

100%

100%&

Capital charge

9.0%

9.0%

9.0%

9.0%

9.0%

9.0%

Proposed framework (based on Basel II)

 

 

 

 

 

 

Risk weight

20%

50%

100%

150%

100%

75%

Capital charge

1.8%

4.5%

9.0%

13.5%

9.0%

6.8%

Note: The table is based on CRISIL's understanding of the risk profile of the banking system loans and advances portfolio. CRISIL has an outstanding rating on 26 banks which comprise 65 per cent of the total assets of the banking system. The ratings have been assigned on the basis of the outstanding issue ratings of the various domestic rating agencies.

ยท. AAA exposures include exposure to Food Corporation of India and deposits placed with NABAR

# CRISIL believes that based on the orientation and granularity criterion in the proposed framework, a significant proportion of agriculture and small scale industry (SSI) advances will qualify for 'retail' exposures, and has accordingly included the same in 'retail'

& Includes individual housing loans which qualify for 75 per cent risk weights (6.7 per cent capital charge)

The proposed framework will provide capital incentive for risk-based pricing by banks, as the capital allocated to an 'A' rated exposure would be five times that allocated to a 'AAA' exposure. The extra capital on a lower-rated exposure will necessitate a higher credit spread on the lower rated exposure, thus incentivising risk-based pricing.

Table 2- Capital charge to determine pricing premium

Calculation of Credit Spread

 

Capital charge for a 'AAA' rated exposure (a)

1.8%

Capital charge for a 'A' rated exposure (b)

9.0%

Excess capital charge for a 'A' rated exposure over a 'AAA' (b-a=c)

7.2%

 

 

Assumed Return on Equity (ROE) * (d)

20.0%

 

 

Credit spread (over a 'AAA' on a 'A' rated exposure for ROE of 20% (c*d=e)

1.4%

* The banking sector earned a ROE of around 20 per cent in FY2003-04

As is evident from Table 2, an extra yield of 1.4b per cent is required on an 'A' rated exposure to earn the same ROE as that of a 'AAA' rated exposure.

The proposed norms, however, create a disincentive for weaker credits to get rated. The capital charge for an unrated exposure is the same as that of an 'A' rated exposure. As a consequence, weaker credits that are more likely to be rated 'BBB' or below, will prefer to remain unrated.

CRISIL expects the proposed framework to lead to risk-based pricing and stronger risk management systems. Moreover, as banks progress towards the internal ratings based (IRB) approach for credit risk, the internal models and systems will have to be further strengthened to stand the test of supervisory review.

Market risk: Higher capital charge, however better understanding of price risk
The proposed framework is set to bring about a paradigm shift in the appreciation of market risk at banks. The risk-based capital framework for market risk would reduce the capital adequacy by 1.2 percentage points.

The proposed framework is more scientific as it considers both the
Modified duration is a measure of the weighted average term to maturity of a security. It is a useful concept in measuring the price-sensitivity of a security to interest rate movements. The higher the duration, the higher the price sensitivity of a security to interest rate movement.
value and the price risk (as measured by modified duration)

of a trading exposure. Hence, CRISIL believes that the proposed framework will encourage banks to be more sensitive to price risk. The current framework requires banks to assign a flat capital requirement of 0.2 per cent on all exposures in the entire investment book, with no linkage to the actual market risk. However, the proposed framework is going to change this 'broad brush' approach. Banks will be required to maintain capital charge based on the price risk of a security. Hence, the capital charge would be higher for a longer-duration security and vice versa. (Table 3)

Table 3- Higher the price sensitivity higher the capital charge

Capital charge

1 year GoI security

10 year GoI security

Current framework

0.2%

0.2%

Proposed framework

4.4%

0.9%

Thus, the capital requirement will be based on the price sensitivity, and will enable the bank to better withstand extraordinary mark-to-market losses.

The capital charge for market risk, however, is only on the trading book (the 'available for sale book' and the 'held for trading book' have been collectively referred to as the trading book). Since banks can now keep a higher proportion (25 per cent of the net demand and time liabilities) of securities in the 'held to maturity' (HTM) book, they can save on capital.

CRISIL has factored this change into its analysis. As a consequence, the decline in capital adequacy on account of market risk has been limited to 1.2 percentage points. Were it not for this, the capital adequacy on account of the market risk charge would have declined by as much as 2.6 percentage points.

Operational risk: A beginning has been made
The capital allocation for operational risk would result a 1.1 percentage point decline in capital adequacy ratio.

Operational risk, though inherent in the banking business, has so far not received adequate attention. Under the 'Basic Indicator' approach, stipulated in the proposed framework, the capital charge on a bank due to operational risk will be 15 per cent of its previous three years' average gross income (defined as the net interest income plus the non interest income. Non interest income excludes the profits / losses from securities in the 'held to maturity' book).

Thus, simply put, the larger a bank's income, the more the capital it will need to maintain.

Although the capital requirement for operational risk does not differentiate between banks on the effectiveness of internal controls, CRISIL believes that a beginning is being made.

Overall Impact
The overall impact is a decline of 1.6 percentage points. This is the combined effect of a 0.7 percentage point gain for credit risk, a 1.2 percentage points decline on account of market risk, and a 1.1 percentage points decline for operational risk. In conclusion, CRISIL is of the view that the proposed framework will have a positive impact on the banking sector, and will place a modest capital demand on the banking sector.

The proposed framework, as mentioned earlier, is comprehensive in its coverage and provides for risk-based capital allocation. In the long term, the proposed framework will encourage banks to be more risk-sensitive, leading to an improvement in their risk management systems.

Limitations of the study

  • In the absence of sufficient data, the CRISIL study has not estimated the incremental capital requirements on the 'contracts and derivatives' portfolio of the banking sector. This has been assumed to be the same as under the current framework.
  • In the absence of specific information regarding the term of credit exposures, the rating distribution of the credit exposures banking sector has been extrapolated mainly on the basis of long-term ratings.
  • The rating distribution of the off-balance-sheet exposures has been extrapolated based on the rating distribution of the on-balance-sheet exposures.
Methodology for estimating the impact
The proposed new capital adequacy framework (based on Basel II) to be applicable from March 31, 2007, has been applied on the banking sector's portfolio as at March 31, 2004.

Estimating capital requirements for credit risk: The credit risk in the loans and advances book and the investment book is estimated by assigning risk weights for the various exposures. The capital charge is then calculated on the risk-weighted exposures. The risk weights are based on CRISIL's understanding of the risk profile of the banking sector's loans and advances and investment portfolio. CRISIL has an outstanding rating on 26 banks, which comprise more than 70 per cent of the total assets of the banking sector.

Estimating capital requirements for market risk: The entire investment book of the banking sector is split into the trading book and the HTM book. It is assumed that banks would transfer the maximum possible amount of securities to the HTM book to derive full capital benefit.

The capital requirement for market risk is then calculated on the trading book based on the duration and a specified yield change (applied as per the proposed framework). Each of the investment categories (government securities, other approved securities, shares, debentures and bonds and others) has been separately evaluated to estimate the capital requirement.

Estimating capital requirement for operational risk: Capital requirement for operational risk is equal to 15 per cent of the previous three years' average gross income.

*Ritesh Maheshwari is head, SME ratings and Pallav Sangal is manager financial sector ratings at CRISIL


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Basel II: Capital requirements manageable, long-term benefits