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Risk based banking

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BASEL vs Risk based supervision system – global trend
Owing to the internationalization of the banking business, the globalization of markets and the free movement of capital flows after the Second World War coupled with global economic crisis and the number of bank failures, it was inevitable to have a system of banking supervision to control banks in each individual country.
Basel Committee on Banking Supervision recommended international standards for banking supervision. Accordingly, banking supervision systems were set up in some countries with the objective to supervise national banks, maintain monetary and financial stability. This system attempts to cope with the volatile universal developments to formalize uniform global criteria for banking supervision worldwide.
What is Basel
Basel is born out of the collapse of German Bank Herstatt in 1974. G-10 countries formed the Basel committee under the guidance of the Bank of International Settlement. In 1988, Basel Committee recommended minimum levels of capital for internationally active banks to be adopted with flexibility which suits their economy. As per its recommendation which is popularly called Basel I norms, Banks should maintain at least 8 per cent capital of their risk weighted loan exposures. Across the globe, Basel I norms were quickly adopted by the Banks including India. In India, Reserve Bank of India asked the banks to maintain a higher capital risk-weighted assets ratio of 9 per cent, one per cent higher than the 8 per cent set by Basel I. As years passed, there arose a need to overcome the new risks faced by Banks due to in-depth changes in the banking system

after 15 years of adoption of Basel I norms. Then the same Basel delivered another sort of guidelines called as Basel II.
Basel II norms are more complex than Basel I. Capital requirement, Supervisory Review and Market discipline known as “three pillars” essentially form the base for Basel II. It puts up a contentious as well as an alarming challenge for the banks while lots of scopes for various services have emerged in India. Overall, Basel II deals with various risks faced by banks particularly credit, market and operational risks and also market discipline.
Owing to the different institutional, cultural and administrative conditions as well as the economic progress and development of capital market, nature of banking regulatory authority varies from one country to another. Let us see how it functions in a few economically powerful countries:
United States of America
Banking supervision in the US is one of the most complicated structures. Commercial banks and financial institutions in the US have the option of obtaining State or federal character.
  • US have a diverse banking system including over 11000 commercial banks regulated by five banking supervision authorities viz.
    • The Federal Reserve – state licensed banks that are members of the Federal Reserve System (FRS).
    • The Federal Deposit Insurance Corporation – State licensed banks that are not members of FRS.
    • The Office of the Comptroller of the Currency-supervises national banks.
    • The Office of Thrift Supervision supervises saving as well as loan associations
    • The National Credit Union Association
    • Duties
      • Supervising local and international banking transactions executed by banks and other financial institutions.
      • Approving the regulations and restrictions of asset and liability management for both internal and external transactions adopted by banks and financial institutions.
      • Following up the implementation of the rules and regulations on banking supervision adopted by the Federal Reserve.
      • Examining the accounts and documents of banks and financial institutions.
Federal Banking Supervisory Office (FPSO) in close cooperation with the Deutsche Bundesbank (the most independent Bank in the world) exercises supervisory functions over 4000 banking corporations. FPSO reports directly to the Federal Ministry of Finance. The FPSO issues administrative legislation and laws organizing the banking business after consultation with Sovereign Bundesbank functions lie within its responsibility.

o National Credit Council headed by Minister of Finance and Economic Affairs.
o Banking Regulations Committee chaired by Minister of Finance and Economic affairs.
o The Credit Institutions Committee chaired by the Governor of the Bank of France.
o Banking Commission chaired by the Governor of the Bank of France.
It is apparent that several primary agencies are involved in banking supervision and regulation in France. The Bank of France exercises significant authority over the supervision and regulation of the banking system. Its independence is confined to formulating and implementing the monetary policy.
Financial Services Authority (FSA) is the lead regulator for all financial services in England. Bank of England’s responsibility was concentrated in executing the significant monetary policy to maintain the stability of the whole financial system. Treasury is also involved in the banking supervision. It is responsible for the ultimate institutional structure of banking supervision. This does not conflict with the action taken by the FSA and Bank of England. They co-opt each other.

Financial Supervisory Agency is established to organize, manage and supervise the financial institutions in Japan which were earlier dealt with by Bank of Japan and the Ministry of Finance.
The only G-7 country with essentially a single supervisor is Italy. Bank of Italy (central bank) is responsible for the supervision and regulation of banking system. It is responsible for the supervision and regulation of banking system. Bank of Italy is responsible for establishing regulations for credit institutions, establishing new banks/branches.
The only G-7 country where the central bank has a very limited role in supervising and regulating the banking system is Canada. The Office of the Superintendent of Financial Institutions is the sole supervisory authority. It is reporting to the Minister of Finance.
Thus, in a nutshell, it could be observed that the supervisory functions are undertaken broadly on the following manner in the above countries:
  • Central bank independently undertakes the responsibility of banking supervision – ‘Central Bank Model’
  • Specialised agencies do the supervisory and regulatory function in cooperation with the central bank and the ministry of finance
  • Ministry of finance or specialized authorities to supervise banks
Supervisory role of the central bank is most effective in Italy, less significant in Japan and has the least effectiveness in Canada, it faded totally in England
At present there are several regulators in the financial sector, with varying degrees of gaps and overlaps in respect of the regulated entities. The aim should be to close the regulatory gaps and iron out the overlaps, irrespective of the regulatory structure. In consonance with global trends, as the movement towards consolidations results in emergence of large conglomerates with diverse risk and business profiles, a need is felt for the prompt and proper implementation of consolidated supervision over banking entities that span several business lines and markets.
The United States, assumed to be the follower of the most globalized and refined economics, is not confident of adoption of Basel II recommendations before the end of 2007 but would be adopted only in 2011 when no other road block along the way. This is the plight for the most powerful free economy country like US. The practical difficulties faced by almost all countries around the world feel the pinch in nearing Basel II as extensive infrastructure and elaborate internal changes are needed before Banks could adopt Basel II norms.
According to experts, “the complexity of Basel II may lead to manipulation of supervisors and big banks picking smaller banks that will suffer from the financial cost of implementation. Instead of consolidating the banks globally, it will create a global divide in banking”.
Major contributing factor that causes bank failures abysmally has been the default by borrowers otherwise called in banking term as ‘credit risk’ while market and
operational risks also participate in bank failures. When bank finds it difficult to absorb losses by credit, market and operational risks, its capital is wiped out and it is forced to shut down its doors. At the same time, bank cannot maintain a huge capital that equal its risks borne by it for the reason that maintaining a capital is very expensive.
Having accepted the globalization and liberalization of economy, there is no way the inefficient can survive. There is none to help them except public funds appropriated from the budget by unconcerned politicians. In this background, implementation of Basel II from 2007 and 100 per cent provisioning for doubtful assets over three years from March 2007 are likely to further increase volume of Non Performing Assets from the current 236000 crores.
It is, therefore, important to evolve a structured mechanism for the exchange of information-sharing arrangements on a regular basis between the different supervisors/regulators in the financial sector, not only at the domestic level, but internationally as well.
Basel 2 – Banks would have to provide capital in terms of economic capital rather than the minimum regulatory capital. The concept of economic capital covers all the risks embedded in the bank’s balance sheet. Supervision moves from transaction based approach to a risk based approach to determine the level of risk that each bank is exposed to. Bank managements will therefore have to develop internal capital evaluation according to their risk profile. Risk weights are being constantly revised to take into consideration additional sources of risk. Risk is a much broader concept than exposure as the variability in asset values/income may be not only on account of exposure. Although
there are substantial differences between market risk and credit risk, market risk may lead to credit losses in time of extreme market volatility.
In this competitive environment, there is bound to be some temptation on the part of the operatives to take high risk exposures in the interest of higher earnings and concentrate their loan/investment portfolio among a few borrowers or specific industries/enterprises. This is an area which would demand careful and in depth scrutiny by the supervising auditors.
A complex financial regime such as Basel 2 and financial regulations appear to be designed not so much to serve users of financial services as to prolong the survival of institutions and ways of doing business that are no longer trusted by the public. The regulators in Basel might bear that in mind and thus should amend the norms as practicable as possible to implement globally.
Indian economy was not immune from sporadic events like security scam. Perhaps, one of the most salient positive approaches which must be adopted by the economic authorities on the short run is following expansionary financial and monetary policies and providing financial support for the various sectored industrial, commercial, financial segments in augmenting their economic and social reforms. Accordingly economic policies should be accompanied by effective measures to rationalize imports, activate the supply side and enhance the competition of globalised economy.
The Reserve Bank of India (RBI) has been making efforts continuously to ensure the convergence of its supervisory norms and practices with international best practices. The regulator would need to adopt a more dynamic role in the future as the financial
sector gets increasingly deregulated. Increased monitoring and the institution of more efficient regulation and supervision assume greater importance as the financial sector becomes more open.
The financial year 2009-2010 is in its midway without taking care of Basel II norms intensely as per deadline fixed for its implementation globally. Now crops up a new issue due to global meltdown in which Indian banks have exposure of one billion dollar to five troubled institutions – Wachovia, Washington, Mutual AIG, Fortis and Lehman Brothers… and so many within USA. We have to wait and see how global bankers including ours would attempt to fulfill BASEL 2 totally in future!



Well-known member
Dear Sri S. R. Rajagopal Ji,

It is fantastic that you are posting well researched information on various topics. As you can see though, they have elicited a few comments but nothing in a sustained way. This may be because of the nature of your postings. They are so wee self contained, that there is not much to argue about.

I am just wondering whther your postings can be done at the 'web blog' side of our Forum, where you can start youw own blog and post various topics. Responses are captured, but you don't need to start a new thread everytime you post on different topics. Please look at the bottm of the Forum's topics page to see the webblogs. Hope you would give consideration to this suggestion. Thanks.

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Well-known member

i hope you don't mind this feedback. krs note gave me the oomph for me to pin this note.

i agree with krs re the quality of your articles.

one hand, these may be pure works of joy, written for yourself, and posted here, because the forum is here to post.

on the other hand, if you are like me, you would like to interact with an audience.

in this context, what i normally do, is to produce a brief teaser ie keep the initial salvo small and simple for the public to understand (myself being public, cannot understand much as my knowledge base is very very limited).

in the course of conversations, the topics gets elaborated, and many a times, beyond my initial comprehension.

you, ofcourse are very well read, and there is a level of detail in your posts, which personally, i find very much beyond my initial comprehension. for me and people like me in the public, a step by step approach is probably a better way to increase participation.

whatever it is, you are indeed a welcome addition to the variety that provides the varied spice of this forum. :)

best wishes...


Active member
Dear Sri S. R. Rajagopal Ji,

It is fantastic that you are posting well researched information on various topics. As you can see though, they have elicited a few comments but nothing in a sustained way. This may be because of the nature of your postings. They are so wee self contained, that there is not much to argue about.

Let me be frank. These are some specialised subjects. All good for one's profession or specialisation.In this site most of us like to have something relevant to our day-to-day mundane life, to make it little fresh and fruitful and more familiar to our daily routines.

Many members may have specialised expertise in one or other fields.If we are going to contribute only that it will drive away the general interested majority. The expert opinion can creep in between discussions.It should be like sporadic glittering gilts in a maala.Enriching and enabling.

Even if it is laddu it cannot form a meal by itself-- Konjam karam konjam pulippu ,ney,ellaam venum.



Well-known member

[FONT=&quot]Basel, or no Basel, without following any code of ethics and transparent systems, banks cannot function successfully. Do you have any statistics of bank failures especially in Japan and USA, during the last 2 decades? In USA alone, 25 major banks failed in 2008 and in 2009, so far, 124 banks have failed according to the statistics given by Federal Deposit Insurance Corporation. (Recall the history of Barings Bank, London, Lehman Brothers, Bear Stearns, Merrill Lynch, Morgan Stanley and Goldman Sachs, all Investment Banks in USA, Washington Mutual and Northern Rock, Depository Banks in USA, American International Group, Insurers, USA, Fannie Mae and Freddie Mac, Government Sponsored Enterprises, USA and all other credit unions or savings banks who suffered the most due to sub-prime crisis, triggered by the greed and speculative transactions of these institutions on a very large scale). In the name of strategic mergers, some of the global banks have managed to hide their bad performance from the public view.[/FONT]
I am not for accepting any prescriptions from the west, as it is. It could be banking or anything else (agriculture included). Let us learn from them, but not copy or imitate them.

[FONT=&quot]I am particularly worried about fall/decline of agriculture, fine arts, arts and handicrafts, village industries and Tiny Sectors, who use naturally and locally available resources and manpower and still contribute significantly to creation of employment, national income, GDP and the overall growth and development of the nation.[/FONT]

[FONT=&quot]There is no harm in introducing so many statistical tools and control mechanisms in any field. But does a common man understand the implication of ratings given by different agencies for Equity/Preference Capital, Debentures, Corporate Bonds, Certificate of Deposits, Inter Corporate Deposits, Units of several Mutual Funds and Unit Trust of India etc.? Even all educated people do not understand the different rating models, different notations used for this purpose and their short term and long term risks and implications. (Why does not the SEBI or the government make it mandatory for these rating agencies to spell what exactly the ratings like P+ or A- or B++ mean in their advertisements through various types of media, in simple, clear terms?)[/FONT]
Without interference from the politicians, they should have total autonomy and professional administration in all matters. They must also be compelled to introduce corporate governance and voluntary disclosures in all critical areas, in the interests of all.

[FONT=&quot]In our own country, Narasimham Committee's other recommendations were not given serious attention and adequate publicity e.g.[/FONT]

[FONT=&quot]1.[/FONT][FONT=&quot]Appointment of whole time directors in banks, especially professionals with varying background - economics, banking, law, international business, accountancy, finance, taxation and computers.[/FONT]

[FONT=&quot]2.[/FONT][FONT=&quot]Doing away with targeted lending (social lending), that is thrust upon the banks
by the government, much against the wish of these banks. (However, the government may give attractive incentives/compensation to those banks who excel in certain types of social lending that are basic and essential to the society and unavoidable too).

[FONT=&quot]3.[/FONT][FONT=&quot]Non-interference from the government in the functioning of banks, starting with
withdrawing of its appointee directors (drawn from RBI and Ministry of Finance) from the bank boards.

[FONT=&quot]4.[/FONT][FONT=&quot]Merger of weak banks with stronger banks, so as to have synergies, requisite volumes and financial strength to face the future challenges. (This is a hot topic today, 16 years after the Narasimham Committee made its recommendations).[/FONT]

[FONT=&quot]Basel II does not take into account certain basic things.[/FONT]

[FONT=&quot]Capital adequacy and asset provisioning alone are not sufficient for sound banking. In addition, so many other factors must be gone into. For instance, each bank has a unique identity, the universal norm of ‘one cap fits all’ cannot be applied in each and every realm or area. Certain bank-specific guidelines may be required to be prescribed in addition, in many cases. It all depends on the geographical area/region in which a particular bank functions, its specific strengths and weakness, professionalism in management, succession planning, type of manpower it has and their core skills, HRD policies in place, specialized focus of operation, areas/functions identified as highly risky and areas/functions that are identified as quite natural and rewarding for that bank, roadmap or long range plans laid out for the next 10 years and so on.[/FONT]

[FONT=&quot]Some standards are required only in limited key areas. Sometimes, too much of regulation will result in clandestine violation. Remember, what happened in Satyam? It is a classic lesson for everybody. In their case, even an accounting firm of international repute namely, Price Waterhouse colluded in the management frauds. When the internal and external controls fail totally, nobody can do anything to prevent massive frauds and the huge losses that follow.[/FONT]

[FONT=&quot]In India, the NPAs in all areas cannot be the same. Agreed some exceptions have been given, by linking the repayment of agricultural and rural debts to the harvest season. But, how about gold loans? India is the only country in the world that gives loans against gold jewellery. Therefore, NPAs in this area must not have the same norms as others.[/FONT]
More particularly, the South Indians have a lot of sentimental attachment towards gold ornaments, bought on some important and memorable occasions in their life. So, barring a few, no one will forget to redeem the gold ornaments, by paying the loans at least after a year or two, may be in instalments at irregular intervals or as a bullet payment. Similarly, many other occupations and industrial activities depend on agriculture, either directly or indirectly. As such, stipulation of the same 90 day period to such sectors is not very relevant or fair.

[FONT=&quot]Big Corporate houses have Corporate Debt Restructuring (CDR), which is euphemism for sizeable sacrifice on the part of the banks, in case of delinquent corporates, whatever be the causes or reasons. In contrast, SSIs and small businesses do not enjoy this facility, for their genuine losses and other financial difficulties (especially units having cyclical nature of businesses like cotton, textiles, real estate/social projects, some engineering activities, exports etc.)[/FONT]

[FONT=&quot]Agricultural/Rural Debt Relief Schemes have been extended by the Centre and the States. But, is there any incentive for persons who promptly repaid their loans? While we reward dishonesty, by writing off or waiver of unpaid interest or even principal, why and how do we forget the honest persons who paid their loans, amidst similar financial distresses? What social message are we sending across? Do we tell the Indian masses not to repay their bank loans, in order to enjoy several benefits?[/FONT]

[FONT=&quot]While extending such largesse, why shall we not extend similar succour to other poor strata of the society like hawkers, auto-drivers (excluding Chennai), fruits, flower and vegetable vendors, fishermen, weavers, artisans and craftsmen, automobile mechanics, tailors, electricians, barbers, milk vendors, washermen, tradesmen and technicians from all other fields, cooks, other petty trade and business people?[/FONT]

[FONT=&quot]On the other hand, is the government very prompt in compensating the Primary Agricultural Co-operative Societies, Urban and District Co-operative banks and the Scheduled Commercial Banks, for the losses suffered by them, on account of such debt relief schemes? So far, the record of several governments on this score has been dismal and highly disappointing. Why do even the opposition party leaders do not open their mouths in this matter? Is that because it is a joint loot and all the politicians regardless of their political affiliations are beneficiaries of such schemes?[/FONT]

[FONT=&quot]The stock market scams are still wider and much deeper and affects people from all walks of life alike. Frauds committed by the management (promoters) themselves, insider trading, embezzlement, misappropriation, tax evasion/tax frauds, insurance frauds etc. require a separate chapter, if not a book.[/FONT]

[FONT=&quot]Why speculative transactions with huge risks like derivatives are traded freely, without attendant pre-cautions and checks in place? Where is the need for commodity futures and options? (What is called a hedging tool has become the true poison for the financial system as a whole and also to the innocent peasants and small investors).[/FONT]

[FONT=&quot]How come so many financial scandals of gigantic proportions have gone unpunished, for decades? How all ill-gotten wealth of politicians, industrialists, bureaucrats, dictators and terrorists is allowed to be stashed in Swiss Banks?[/FONT]
Does anybody have an answer to my questions?

Note: I have tried to avoid as many banking and economic jargons, as possible.

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