Basel II - A reality check

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: After some debate on whether Basel II should apply only to "internationally active" banks or to all commercial banks, the Reserve Bank of India (RBI) opted for the second alternative. In the Draft Guidelines for Implementation of the New Capital Adequacy Framework, released in February 2005, the RBI has stated that banks should initially adopt the standardised approach for credit risk by March 2007 and possibly move towards foundation internal ratings based approach (FIRB) a few years later. The final guidelines are awaited. The RBI has also stated that it is possible that the March 2007 implementation date may be stretched slightly, given the state of preparedness of various banks. Most banks in India are now aware that Basel II proposals aim to bring the regulatory capital more closely into line with economic capital. They also recognise that their risk management system as a whole will need to be strengthened under Basel II, and while Basel I required capital allocation only for credit and market risk, the Basel II provisions would also take operational risk into consideration. Most Indian banks will initially adopt the standardised approach for credit risk and basic indicator approach (BIA) for operational risk.

Banks that want to adopt more advanced approaches should submit a detailed roadmap to the RBI, clearly specifying their plans for migration. Banks will be allowed to adopt the advanced approaches only after obtaining the specific approval of the RBI. It is unlikely that any of the banks would follow more advanced approaches before 2009/2010. As far as computing capital for credit risk is concerned, none of the Indian banks presently have a credit-risk-grading system compatible with Basel II.

While a few of them are in the process of developing such systems, neither is their data quality (potential default (PD) rates on various classes of assets, for example) likely to be extensive, nor have their credit risk models yet been tested. Nevertheless, one or two of the more advanced Indian banks (mainly private ones) have started putting building blocks in place in order to eventually adopt FIRB, and it is possible that they may do so by 2009/2010.

Since the standardised approach relies on external credit ratings, banks will have to cope with the fact that most of their borrowers are unrated. According to the RBI draft guidelines, such unrated borrowers would attract a risk-weighting of 100%, the same as under Basel I. Further, the claims on rated corporates are to be risk-weighted as per the national ratings assigned by rating agencies registered with the Securities Exchange Board of India and recognised by the RBI. The RBI's draft guidelines propose a risk-weighting of 20% to 'AAA'-rated corporates, 50% to 'AA'-rated companies, 100% to single-'A' and un-rated companies, and 150% to companies rated 'BBB' and below. The proposed risk-weightings using national ratings alone are not totally consistent with the Basel II standardised approach as far as appropriate capital allocation may be concerned. This is because national ratings are unique to a country and differ substantially (particularly in low rated sovereigns) from international ratings assigned by international rating agencies such as Fitch, Standard & Poor's or Moody's in terms of default probabilities. For example, Fitch assigns an international long-term rating of 'BB+' to National Thermal Power Corp (NTPC), an Indian corporate entity engaged in the power sector (India's sovereign rating is also 'BB+'). NTPC has also been assigned a national rating of 'AAA (ind)' by Fitch India, Fitch's wholly owned subsidiary. As is obvious from the above illustration, the risk-weighting for NTPC will only be 20% under the RBI's proposed guidelines (its national rating being 'AAA'), but 100% if NTPC's international rating ('BB+') were to be considered. Clearly, the capital requirements will be vastly different (a multiple of five times in the above example) depending on whether NTPC is treated as 'AAA' or 'BB+' risk. Also, the fact that an unrated borrower gets a more favourable treatment (100% risk-weighting) than a 'BBB'-rated borrower (which will attract 150% riskweighting) appears harsh for 'BBB'-rated borrowers, and possibly at variance with the authorities' objective of increasing disintermediation and encouraging greater disclosure and more widespread use of external ratings. However, this is similar to the provisions in the Basel II proposals under the standardised approach, which also penalises lower rated borrowers ('BB-' and below) more than unrated ones.

Further, the RBI guidelines propose a zero risk-weighting to all direct exposures to the Central and state governments in India in the local currency. Given that many state governments are in relatively poor financial health and even the sovereign is rated 'BB+' for its local-currency obligations, such risk-weighting appears generous. Especially so, since Indian banks have more than 25% of their assets in government paper, and to the extent that they will not be allocating any capital towards such credit exposures, their capital ratios will be somewhat inflated.

Similarly, the RBI has chosen to implement "Option 1" for claims on banks, meaning that the risk-weighting for all such exposures would be one category less favourable than the sovereign. In other words, all local-currency claims on scheduled commercial banks will be risk-weighted at 20% (as the sovereign will attract zero risk-weighting). This will result in a low risk-weighting even for banks that are of poor credit quality, enabling them to hide behind the sovereign's risk-weighting, which is considered inappropriate. Not only would this lead to the problem of moral hazard (with sound and not so sound banks both being treated equally in terms of risk characteristics) but this also seems at variance with the philosophy of bringing greater alignment between regulatory and economic capital.

Retail asset class

While retail assets generally attract a lower capital charge under the Basel II standardised approach, Indian banks would attract a higher capital charge for most classes of their retail assets, as is currently applicable under RBI guidelines. For example, residential mortgages would attract a risk-weighting of 75% ( 6.75% capital charge based on minimum total CAR of 9%) under the Basel II RBI guidelines; this is quite conservative compared with the 35% risk-weighting (2.8% capital charge based on minimum total CAR of 8%) proposed under the Basel II standardised approach. While mortgage lending by Indian banks has a relatively short history (and therefore, the portfolio may not be fully seasoned as yet) and the delinquency rates may also turn out to be higher than in developed markets, the fact that Indian banks will allocate a capital charge that would be 2.4 times higher for every dollar of mortgage loan compared with other standardised banks elsewhere in the world, makes them look conservative on this measure. Currently, mortgage lending by Indian banks constitutes about 15% of their total loan portfolio, and it is expected to grow faster than other loans. Similarly, some other retail loans, such as credit cards, currently attract a risk-weighting of 125%, which will likely continue under the Basel II regime. Unless, the RBI revises these risk-weightings in future or the default experience of the Indian banks is unusually large compared with global standards, Indian banks may have an in-built buffer on capital as far as their mortgage/retail loans are concerned. Given the concerns expressed about risks on consumer lending being understated in some Asian countries, the RBI's approach is very prudent. Claims secured by mortgages on commercial real estate may attract a risk-weighting higher than the 100% proposed, as RBI has increased the risk-weightings for such lending to 150% in April 2006 in view of the rapid expansion in credit to this segment.

As proposed under the Basel II standardised approach, the RBI guidelines have also defined an "other retail category," which would attract a 75% risk-weighting, provided certain conditions are met. To qualify for this lower risk-weighting, the exposure may either be to individuals or SMEs, but the portfolio should be sufficiently diversified with no aggregate exposure to one counterparty exceeding 0.2% of the overall regulatory retail portfolio. The maximum aggregate retail exposure also has an absolute threshold limit (less than Rs 5 crore or about $1.11 million) and the SMEs should have an annual turnover of less than Rs 50 crore ( $11.1 million). As for corporate exposures, under the supervisory review process (Pillar II), the RBI would evaluate at periodic intervals the risk-weights assigned to the retail portfolio against the default experience for such exposures, and may make appropriate modifications in future, if necessary.

Summary

Discussions with the RBI and some of the major banks reveal that most banks will enjoy some "capital relief" on their credit portfolio under the Basel II regime. The bulk of the capital relief will arise due to the use of national ratings on their highly rated ('AA' and above) corporate portfolio. The unrated corporates will attract similar risk-weightings as under Basel I and therefore, the impact of such loans will be capital neutral. Interestingly, and contrary to the experience of other standardised banks globally, retail assets of Indian banks would largely continue to attract the same capital treatment as in Basel I unless the RBI revises some such risk-weightings under Pillar II at some point in future.