Basel II - A reality check

Posted: 2006-06-18 00:00:00+05:30 IST
Updated: Jun 18, 2006 at 0000 hrs IST

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: 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...