Challenges for Indian Banking System under Basel II

A feature, somewhat unique to the Indian financial system is the diversity of its composition. We have the dominance of Government ownership coupled with significant private shareholding in the public sector banks and we also have cooperative banks, Regional Rural Banks and Foreign bank branches. By and large the regulatory standards for all these banks are uniform.

Costly Database Creation and Maintenance Process: The most obvious impact of BASEL II 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. More and more banks may have to use internal model developed in house and their impact is uncertain. Most of these models require minimum 5 years bank data which is a tedious and high cost process as most Indian banks do not have such a database

Additional Capital Requirement: In order to comply with the capital adequacy norms we will see that the overall capital level of the banks will raise a glimpse of which was seen when the RBI raised risk weightage for mortgages and home loans in October 2004. 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 may be isolated from the global banking system.

Large Proportion of NPA’s: A large number of Indian banks have significant proportion of NPA’s in their assets. Along with that a large proportion of loans of banks are of poor quality. There is a danger that a large number of banks will not be able to restructure and survive in the new environment. This may lead to forced mergers of many defunct banks with the existing ones and a loss of capital to the banking system as a whole.

Relative Advantage to Large Banks: The new norms seem to favor the large banks that have better risk management and measurement expertise. They also have better capital adequacy ratios and geographically diversified portfolios. The smaller banks are also likely to be hurt by the rise in weightage of inter-bank loans that will effectively price them out of the market. Thus banks will have to restructure and adopt if they are to survive in the new environment.

Increased Pro-Cyclicality: The appropriate question is not then whether Basel II introduces pro-cyclicality but whether it increases it. The increased importance to credit ratings under Basel II could actually imply that the minimum requirements could become pro-cyclical as banks are required to raise capital levels for loans in times of economic crises.

Low Degree of Corporate Rating Penetration: India has as few as three established rating agencies and the level of rating penetration is not very significant as, so far, ratings are restricted to issues and not issuers. While Basel II gives some scope to extend the rating of issues to issuers, this would only be an approximation and it would be necessary for the system to move to ratings of issuers. Encouraging ratings of issuers would be a challenge.

Cross Border Issues for Foreign Banks: In India, foreign banks are statutorily required to maintain local capital and the following issues are required to be resolved;

  • Validation of the internal models approved by their head offices and home country supervisor adopted by the Indian branches of foreign banks.
  • Date history maintained and used by the bank should be distinct for the Indian branches compared to the global data used by the head office
  • capital for operational risk should be maintained separately for the Indian branches in India

IT infrastructure: The technology infrastructure in terms of computerization is still in a nascent stage in most Indian banks. Computerization 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.

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 organizations 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 computerization,
  • 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.

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